This bubble could hurt too
Value investing is all the rage. Here are three guidelines for making sure you don't get burned.
NEW YORK (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.
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.
Just as growth managers Helen Young Hayes and Tom Marsico were hailed by investors and the financial press, including Money Magazine, in the 1990s, 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.
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. Siegel, who wrote "Stocks for the Long Run," the bible of 1990s investors, recently declared, "We're at the brink of a huge paradigm shift."
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 percent vs. 0.18 percent 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.
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