The first 10 years of this century have been called a Lost Decade for equity investors. Indeed, between the technology stock bust of 2000 ad the financial panic of 2008, investors have endured two of the most severe bear markets on record.
The latest data from Morningstar (through Nov. 30, 2010) shows the total return of the S&P 500 at an annualized -0.02% for the last 10 years. Domestic stock funds returned 1.4% a year, on average, hardly what investors have hoped for during the uncertain period.
Investors, of course, want to do better than average. And it's true that investors prescient enough to invest in the tiny Fairholme Fund soon after inception would have seen $10,000 grow to more than $29,000, in the 10 years through the third quarter of 2010. During that same period, $10,000 invested in then-huge Fidelity Growth & Income would have dwindled to less than $6,600.
Still, gazing over the last disappointing decade, it's vital to know that value funds outperformed growth on average, and why. Large-cap value funds returned 2.9% annually over the 10 years ending Nov. 30, according to Morningstar. Hardly exciting, but better than the S&P's 0.8% return or the 1.8% produced by all domestic stock funds as a group.
Mid-cap value nearly matched the S&P MidCap 400, 7.25% to 7.27%. Handily beating out the Russell 2000 return of 6.4%, small-cap value funds ended the decade with a 9.63% annualized return, on average, which in this context sounds quite good.
These positive results may seem a bit surprising, especially considering that the most recent-and steepest-market slide, from the fall of 2008 to the winter of early 2009, included a debacle for financial companies, the darling of value funds, In fact, financials can account for as much of 30% of some value indexes, says Matt Norris, a portfolio manager at Waddell & Reed in Overland Park, Kan.
But to some observers, the latest figures simply confirm well-established patterns. "Value stocks have outperformed growth stocks in most 10-year periods," says Tim Courtney, chief investment officer of Burns Advisory Group in Oklahoma City. "The primary determinant of your return from a stock is the price you pay."
CHARTING THE CYCLES
If financials flopped so spectacularly, how did value funds post superior numbers for the trailing 10 years? The short answer is that they held few technology stocks and emerged from the burstng tech bubble with a lead they held through the decade, says Michael Breen, associate director of mutual fund analysis for Morningstar.
The last years of the 20th century saw one of the greatest bull markets ever, one that was led by technology, media and telecom (including dot-com) stocks. Those stocks were largely held by growth funds and sometimes shunned by value funds, which lagged in that period. "Then growth-oriented funds were toppled when the tech bubble burst," says Tom Roseen, Denver-based senior analyst for Lipper, a Thomson Reuters company.
From 2000 through 2002, the S&P 500 plunged each year, losing 37%. Growth funds lost more than 40%, as calculated by Lipper. But financial stocks did comparatively well during those years, helping value funds, which actually gained in 2000 and 2001 and suffered fewer losses than their growth counterparts in 2002. As a result, Lipper figures show that value funds-including large-, mid- and small-cap-emerged from the three-year market slump with a total loss of only about 3%.
After the tech bubble burst, investors were not encouraged to go back to growth," Roseen says. "So value funds took over market leadership."
As the last bear markets have amply demonstrated, large losses make subsequent recoveries difficult to achieve. If a hypothetical growth fund lost 40% in the 2000-2002 bear market, it would need to gain nearly 67% to recoup those losses. On the other hand, a value fund with a 3% loss would make it up with a scant gain.
In the bull market that followed, value funds beat the broad market in some years (2004, 2006), kept pace some years (2003, 2005) and lagged badly in 2007, thanks largely to weakness in financial stocks. For the five years, growth led value, but the outperformance was modest. While growth funds gained over 100% in that period, value funds gained more than 90% by Lipper's calculations.
The tech bubble is a familiar story that bears repeating. "At the end of many economic cycles, investors are all chasing a few stocks," Norris explains. "They pile into familiar names. In 1999, the stocks everyone wanted to own were some visible tech stocks." Veteran investors also will remember the "Nifty Fifty," buy-and-hold growth stocks of the 1960s and 1970s.
As Courtney puts it, it's simply too easy for growth managers to make picks that have future growth already priced into the stock. "The time to buy Apple, for example, was 10 years ago, when it had a $10 billion market cap, rather than now, when its market cap is around $200 billion." As always, too many people bought the Apples too late.
The 2003-2007 bull market varied that pattern somewhat. Real estate was the hot asset class, up about 170% from 2003 through 2006, while growth funds enjoyed only moderate outperformance.
The fall of 2007 marked a market top that was followed by the disaster of 2008 and the first quarter of 2009. Growth funds lost nearly 42%. Value funds actually led in 2008, if you can call losing 37% "leadership."
Some value fund managers might have found it hard to find financials they wanted to own, and others dodged the category, Breen says. Those that were light in financials avoided the worst losses of 2008.
Putting it all together, value funds have beaten growth funds in each of the four bad years, plus the bull market years of 2004 and 2006. Minimizing losses has been the key to long-term outperformance.
Growth funds are leading value again in the latest rally. But planners would do well to remember that value funds seem to have provided some bear market protection. "They've done better in downdrafts," Breen says.
Can value funds continue to deliver such encouraging returns? "Value funds have good prospects," says Peter Greenberger, manager of mutual fund research for Raymond James, in St. Petersburg, Fla. "Many good companies have fallen out of favor, so they look attractive now to value managers."
Norris, a value investor, agrees that he sees plenty of opportunity in today's market. "We are looking for double-digit free cash-flow yield, assuming normal operations for a company. There are lots of opportunities out there."
He's finding those cash flow yields in technology companies, especially large-caps, and some property/casualty insurers. "Their stocks might be off because return on equity (ROE) is only 11%, say, when it's normally in the low- to mid-teens for that company. In some cases, we think the ROE will go back up, and the stock's a buy for us."
Breen sees a favorable outlook for the category as a whole. "Managers have been able to buy high-quality stocks at good prices," he says. They may be fallen growth stocks in technology, oil companies, financial or healthcare companies.
Dividends are also coming into play. "Some value managers like dividend-paying stocks, for their income stream, while others prefer companies that are buying back their own stock," Breen says.
As Americans age, dividend-paying stocks will add to the appeal of value funds, says Lipper's Roseen. "Value funds may get returns from two sources, capital appreciation and income," he points out. Older investors may increasingly seek both in one investment. The cachet of Warren Buffett, a value-stock investor, won't hurt, either.
When advising clients on investing for long-term goals, an allocation to value funds seems essential. The next steps, of course, are to make basic decisions about choosing between large-, small- and mid-cap stocks, and whether to opt for stock-picking or indexing strategies.
Passive investors insist that the low costs and low turnover of indexes bring superior performance, long term. The recent evidence is mixed, however. Through November 2010, Vanguard Value Index Fund had a 10-year annualized return of 1.8%, while Morningstar's large-cap value category returned 2.5%. DFA's U.S. Large Cap Value, which uses a passive but not a true indexing strategy, had an annualized return of 5.3% for the past 10 years.
Both active and passive value funds, it turns out, can pluck talking points from the results of the past decade. "Our data shows that actively managed value funds in both the large- and mid-cap arenas had approximately the same results as their mirroring value indexes," Greenberger says.
Small-caps appear to be the exception. The common claim that small companies are lightly followed and relatively inefficient, fertile grounds for skilled active management was borne out in the last decade among actively managed small value funds, which outperformed their index on average, according to Greenberger.
Small-cap value funds may hold hundreds of stocks at any one time.Courtney, whose firm tilts clients' portfolios toward value, using both active and passive funds, argues that the large numbers of holdings helps diversify these funds, giving them more chances to succeed.
"Value's historic outperformance typically comes from a small subset of undervalued stocks," he says. "They start out as value stocks then become growth stocks."
About one of out four companies in a small- or mid-cap value index migrates each year, Courtney says. "You'll want to own them, and you'll need a well-diversified fund to pick up the ones that will migrate. You might miss them if you had a concentrated fund."
VARIETIES OF VALUE
Financial planners who prefer active management should realize that value funds are not all alike. Some of them invest in well-established high-quality, dividend-paying companies that currently trade at low price-to-earnings or price-to-book value ratios.
Stock dividends help to compound returns over long time periods. Moreover, some dividend-paying stocks may be attractive in a period of low yields to savers, and low tax rates on dividend income might give them a competitive advantage over interest-paying accounts.
Other value funds are managed by contrarians who buy troubled companies where they see the chance of a turnaround. The "value" label can be applied to a wide variety of funds. That includes funds that will concentrate holdings in a few companies or a few market sectors, taking increased risk in pursuit of superior returns.
The key, Greenberger, says, is to look for value funds with a strong long-term record, especially those that have performed relatively well in recent market meltdowns. Even after all the recent carnage, it appears that some traditional wisdom remains true: Investing in value stocks and small stocks can serve your clients well.