The stock market's gyration gains during the past year have been hard on fund shareholders. But investors who hold shares in so-called “value funds,” which shop for stock market bargains and avoid the highest-flying stocks, have held their own surprisingly well. The typical value fund has gained 11.9% in the past year — almost double the 6% gain for the S&P 500 index.
What Are Value Funds?
What are value funds? Most analysts divide stock funds into two broad categories. The first category includes growth-oriented funds. Such funds are willing to pay premium prices for shares of companies with strong earnings growth prospects. Example: Technology giant Cisco, whose shares have climbed close to 500% during the past three years.
Value-oriented funds — the second category — take a different approach, investing in neglected shares of companies whose earnings prospects may appear uncertain. Value investors are less willing to pay premium prices for shares of popular companies. Instead, they prefer to invest in stocks of firms whose value is unclear to most observers. Often, they'll buy a company's stock when the share price declines due to disappointing earnings. The reason: They may believe the firm has hidden assets or earnings potential, which will eventually attract Wall Street's attention.
Why Value Funds?
One nice thing about value funds is that they tend to reduce risk in a portfolio. After all, the prices of the stocks they buy already reflect bad news about a company; thus, they have less distance to fall in the event of further setbacks.
By contrast, the popular stocks that growth funds hold generally suffer sharp declines when the firms that issue them fail to meet investors' often high expectations. For example, even a minor sign of a decline in profit growth at companies such as Cisco could cause their high-flying shares — and the funds that hold them — to plummet. That’s just what happened this year, when many technology high-fliers came crashing to earth, and brought some growth funds down with them.
The upshot: Value funds are likely to hold up better than growth funds in a stock market decline. Thus, if you're worried that the stock market may be due for more rough weather, it might make sense to add a value fund or two to your portfolio to smooth the ride ahead.
Choosing A Value Fund
But choosing that fund requires considerable care. Many so-called value funds don't have the courage of their convictions: That is, they often avoid the most battered stocks, which sometimes provide the biggest gains. One study of value funds concluded that “Not just any old value manager will do. The good ones are tough contrarians who have the guts to buy really cheap stuff and wait for value to be realized.”
Fortunately, some value funds fit that description well. One solid pick is Oak Value (800-622-2474; $2,500 minimum investment; no-load), whose managers are followers of famous value investor Warren Buffett. Their strategy is to invest in shares of companies with well-recognized products and strong market niches whose businesses offer the potential for strong cash flow. Equally important, they buy those firms' shares when they are trading at a discount from the firm's intrinsic value, based on assets and earnings potential.
The fund’s performance has lagged recently due to its managers’ reluctance to invest in the risky technology sector. But the fund recently has added several cheap technology and telecommunications stocks to its portfolio. You can’t argue with the fund’s long-term performance either. It has returned close to 20% annually for the past five years.
Tweedy, Browne American Value’s (800-432-4789; $2,500 minimum; no load) managers are also devotees of legendary value investors Warren Buffett and Benjamin Graham. Managers William Browne, Christopher Browne and John Spears only invest in shares of companies they’re willing to hold for many years. The fund’s value-oriented approach caused them miss out on the 1999 rally in technology stocks. But the fund’s long-term record suggests that shareholders can rest easy. The fund has returned 17% annually over the past five years.
