The Unlikeliest Bubble
Value investors scoff at the madness of the crowd when it chases the next Google. But what happens when the crowd is mad for value?
(MONEY Magazine) – VALUE INVESTORS RELISH THEIR ROLE AS THE MARKET'S SKEPTICS. No high-flying glamour stocks for them. They seek out unloved companies at bargain prices, sit tight and wait for the crowd to come to its senses. But what happens when, like today, value investing works so well that everybody becomes a convert--when investors turn exuberant about, of all things, being sensible? You start to get some eerie reminders of the bubbly days when everyone "knew" that the future belonged to high-growth tech stocks. If you remember how that ended, you might be a little concerned about the parallels.
• ONE STYLE IS RED HOT Since the tech crash of 2000, value investing, which focuses on companies trading at prices far below what the buyer believes to be their true worth, has worked like a charm. In the meantime, growth investors, who buy companies with rapidly increasing earnings and high price-to-earnings ratios, have suffered. Result: Money has poured into value funds since 2001, while investors have pulled out of growth funds. And more than 100 value-oriented mutual and exchange-traded funds were launched in the past year. But remember: Between 1995 and 1999, growth stocks returned more than twice as much as value stocks.
• FUND MANAGERS ARE ROCK STARS Just as growth managers Helen Young Hayes and Tom Marsico were hailed by investors and the financial press, including MONEY, in the '90s, value managers are hot today. Take Joel Greenblatt, a hedge fund manager who teaches finance at Columbia University. His book The Little Book That Beats the Market, which outlines a basic formula for picking value stocks, soared to the top of the bestseller lists after receiving fawning reviews. Soon to hit the shelves is a follow-up, The Little Book of Value Investing, a primer written by Christopher Browne, co-manager of the Tweedy Browne funds. Browne has won praise of late for his firm's attacks on newspaper baron Conrad Black, who is now facing charges of financial fraud. Browne, whose company once did stock trading for legendary value investor Benjamin Graham, writes, "I like to think of Tweedy as the Vatican City of value investing, and although we do not have a pope, we have great cardinals and bishops." So much for skepticism.
• THERE'S A NEW PARADIGM Big names are also fueling the rush to value. Financial editor and money manager Robert Arnott and Wharton professor Jeremy Siegel are both pushing value-style ETFs that they claim are revolutionary alternatives to market-capitalization-weighted indexes like the S&P 500. Their approach, which they call fundamental indexing, focuses on financial measures rather than stock market value. The result is that growth stocks don't count for as much in their ETFs. (See the sidebar on page 68.) Siegel, who wrote Stocks for the Long Run, the bible of '90s investors, recently declared, "We're at the brink of a huge paradigm shift." Gulp. The last time a guru was flogging a new paradigm so hard was 1999, when financial pundit James Glassman argued that the Dow, then around 10,000, was worth 36,000.
To be sure, the chances that value investors will suffer the disastrous results growth investors saw earlier this decade are remote. The value creed is to buy cheap, after all, and most value adherents sell a stock when it reaches what they figure is the stock's fair value.
The bigger problem is that many investors are piling into value just as the style may be losing steam. As more cash has flooded into value stocks, which are typically found in slower-growing sectors of the economy like finance and basic industry, prices have climbed, which leaves bargain hunters with fewer opportunities. "We've been having trouble putting money to work," says Browne. "Back in 1999 there was a tremendous disparity between the most expensive and the cheapest stocks, but that's less true today." As a result, many value funds have closed to new money, including Tweedy Browne's, Third Avenue Small Cap Value and Dodge & Cox Stock.
Of course, no one can predict exactly when value investing will stop beating the market. But after six years of rich returns, value is likely closer to the end of its run than the beginning. Review your portfolio and add up how much you have invested in value funds compared with other assets. If you haven't rebalanced in a few years, your value stake has likely grown much larger than you intended. Scale back and look for more promising investments. Here are three guidelines.
NO. 1 Don't tilt heavily toward value unless you have a lot of fortitude. You may not realize it, since the style has performed so well, but value investing is hard. Yes, academic studies have shown that value outperforms other strategies over 20 or 30 years. However, as Chris Cordaro, an investment adviser in Chatham, N.J., points out, "There are long stretches when growth whips the tar out of value." And owning value stocks or funds when they underperform is a real test of your self-image. It's one thing to own plain-Jane companies when they're making you money. But when they're not?
NO. 2 Consider a fundamental index as a value play, not as an index. If you want a broad-based, value-oriented fund, these offerings fit the bill. But an index that's been rejiggered to perform better isn't measuring the market anymore, which is what an index, by definition, is supposed to do. What's more, fundamental index funds charge higher fees than many traditional index funds. The expense ratio for Arnott's RAFI 1000 ETF is 0.60% vs. 0.18% for the Vanguard 500 Index fund. So the ETF starts out in a pretty big hole.
NO. 3 Start shopping for today's bargains. The stampede to value has left many top growth stocks trading at prices so low that value managers are buying them; Browne, for one, has snapped up shares of Microsoft and Wal-Mart. A sensible allocation would be a 60-40 split between value and growth, says Anthony Ogorek, a financial adviser in Williamsville, N.Y. Or opt for a mutual fund that holds both types of companies, such as the Vanguard Total Market Index or Selected American Shares, both MONEY 65 funds. Then you can have your skepticism and enjoy growth too.
An Index That Cheats
New "fundamental" index funds claim to tame the boom-and-bust cycles of benchmarks like the S&P 500
INDEX FUNDS, which mirror benchmarks like the S&P 500, offer low costs, minimal tax bills and a guarantee that you'll get what the market gives. That's more than most funds that actively try to beat the market offer you. But index funds provide no protection when manias drive stocks to dangerous heights. Think March 2000. So a few of Wall Street's big thinkers have devised a new mousetrap. Whether it's a better one is the subject of hot debate.
THE ISSUE: In an index like the S&P 500, stocks are capitalization-weighted--the percentage of the index allocated to a company is based on its share price multiplied by its number of shares. That's a great way to track the overall market, but the more a stock goes up, the more money the index has riding on it. "It's the opposite of buying low and selling high," says Robert Arnott, a money manager and editor of the Financial Analysts Journal. When the process reverses, look out. Plunging tech stocks knocked the S&P down by nearly 50% from 2000 to 2002, for instance. Many value stocks were doing well then, but their small capitalizations couldn't cushion the blow.
So Arnott developed a "fundamental index" that weights stocks based on financial measures such as sales, book value and operating income. Looking at historical returns, Arnott says, his PowerShares FTSE RAFI 1000 (ticker: PRF), had it existed, would have beaten the S&P 500. Investment firm WisdomTree is launching 16 fundamental-weighted ETFs that focus on dividend-paying stocks. Wharton professor and stock guru Jeremy Siegel is working with WisdomTree.
Indexing's godfathers, Vanguard founder John Bogle and Princeton's Burton Malkiel, are unimpressed. "We have witnessed many 'new paradigms' over the years," they wrote in a Wall Street Journal rebuttal to an article penned by Siegel. "None have persisted." Critics say a fundamental index isn't measuring the market at all. And the back-tested returns of fundamental indexes look so good only because they have a large weighting of value stocks. "If value hadn't done so well lately," argues investment adviser Richard Ferri, author of All About Asset Allocation, "we wouldn't be having this discussion."
A big company with a low stock price, like GM, counts for more in a fundamental index than a fast-growing but smaller company, like Google.
NOTES: Data as of July 26. Fundamental index is the RAFI 1000. SOURCE: Thomson/Baseline.
Haven't We Seen This Before?
Today value stocks are what's hot, and no one wants growth stocks. That's just the opposite of what happened in the late '90s, when growth stocks were the rage. And then came trouble.
Value stocks have crushed growth stocks lately.
FIVE-YEAR ANNUALIZED RETURN
Investors are pouring money in.
Value fund inflows [UP]$221 BILLION
Growth fund outflows [DOWN]$45.2 BILLION
And Wall Street is cranking out more value funds.
+103 Number of value or dividend funds created since January 2005
NOTES: Returns are five years annualized as of June 30. Fund flows are for the period between May 2001 and May 2006.
SOURCES: Morningstar, Financial Research Corp., Lipper.
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Additional Reporting By Janet Paskin contributed to this article.