As some of the major financial institutions on Wall Street post billion-dollar losses and even show their chief executives the door, the reality is that the subprime lending crisis is still at its earliest stages. The resulting uncertainty is fueling a stock market that seems increasingly prone to triple-digit swings in the Dow Jones industrial average.
Yet the market’s behavior isn’t keeping Tracy Brown awake at night. The investment adviser at William Tell Financial Services in Latham, New York, counsels her clients on an old value investing standby: buy and hold. That not only helps them avoid obsessing about every fluctuation in the market, it also generates solid returns. “Value investing–while using a long term strategy–is the best way to combat volatility,” she says.
Brown represents the contingent of investors lost in the din of the bull-market run over the past five years. So-called value investors are always on the lookout for a good buy, but their time horizons–generally three to five years–are much longer than those of their growth-investing counterparts. They look for companies that may look bad at first glance–thanks to management turmoil, an earnings shortfall, or market jitters–but on closer inspection show otherwise healthy companies that have been cast aside and forgotten. These companies generally trade below book value and have compelling growth horizons.
For her clients seeking mutual fund options, one of Brown’s favorites is Pioneer Equity Income (PEQIX). It’s a large-cap value fund that focuses on dividend paying stocks. It’s earned an average annual return of more than 13% for the past five years, almost a full percentage point better than the S&P 500.
In recent years, hot growth stocks have handily outpaced value stocks, but their valuations might give hints of a coming realignment, value investors say. “People are not getting paid for a lot of risk they are taking on,” says Tim Fidler, a portfolio manager at Ariel Capital Management (No. 2 on the be asset managers list with $16.1 billion in assets under management). Fidler notes that in bull runs, investors underestimate risks such as credit problems, inflation, and economic cyclicality.
What’s more, they also fear any sign of weakness, piling onto market darlings. “People are so afraid of underperforming these days,” says David Giroux, a portfolio manager of T. Rowe Price Capital Appreciation (PRWCX), a moderate allocation fund that invests in both stocks and bonds. “What we have here is a momentum-based market that is being led by things that have been very good stocks over the last five years.” Examples include companies such as Google (GOOG) and Apple Inc. (AAPL) as well as oil services companies. “But the valuation really doesn’t matter, and it is not justified in a lot of these names.”
To be sure, finding companies on the cheap is still not an easy task. But value investors’ ability to unearth a few stones allows them to end up with some nice gems once polished. “We don’t have to get all of these picks right,” says David King, a senior portfolio manager for Putnam New Value (PANVX). “There is so much potential in the better ones, they more than make up for it.”
Indeed, value managers are seizing the day with a few names among the most pummeled sectors this year. One such group is mortgage insurers, which provide insurance to lenders in case homeowners default on their loans. Rising foreclosure rates sent investors running for the exits, and now, some companies’ trade below book value. Even if those values were fair, they would imply economic conditions not seen since the Great Depression–or maybe never–King says.
Both King and Giroux have scooped up shares of Genworth Financial Inc. (GNW), down more than 25% since July. Genworth’s mortgage insurance division accounts for a relatively small portion of its business. The vast majority of its operations–areas such as life insurance, long-term care insurance, and
retail and institutional investment products–are doing fine and generate about 84% of the company’s revenue. Even without the mortgage insurance division, Giroux estimates that shares of Genworth will be worth $35, well above the $25 share price as of early November. It also has a strong balance sheet to weather any storm, with a low debt-to-equity ratio of 0.62.Housing woes have also tarnished home improvement retailers such as Home Depot Inc. (HD) and Lowe’s Cos. (LOW), both trading at multiyear lows as of early November. About 25% of their business is exposed to existing and new-home renovations. “This part of the business has taken it on the chin,” says Giroux, who adds the good news is that it’s unlikely that revenues will face another significant hit. What’s more, some 50% of their sales come from so-called replacements–home items that eventually need replacing, from appliances to fuses and light bulbs. And Giroux says the remaining 25% comes from sales of non-cyclical items such as gardening equipment, lawn mowers, plants, and seasonal sales that provide steady revenue streams.
Giroux says he expects a deceleration in the decline of same-store sales growth this year. That means earnings growth can probably resume if the companies buy back stock. He expects the housing market to stabilize in 2009, meaning all areas of the company will see growth. Giroux also estimates a 50% appreciation potential over the next 18 to 24 months.
Banks also present opportunities for those with strong stomachs. Fidler, portfolio manager of Ariel Focus (ARFFX), has bought shares of UBS AG (UBS), the Swiss investment bank and wealth manager. The stock, trading at less than 10 times 2008 earnings, has taken a beating in part due to the subprime debacle that resulted in a $3.4 billion write-down in October. Still, Fidler sees a silver lining: UBS’ asset management business, the world’s largest with $2.6 trillion in assets, accounts for 50% of the bank’s revenues.
“It’s really a company that has been left to rot by the investment community,” says Fidler. Meanwhile, its wealth management business, with operating margins in excess of 40%, is poised to make big gains around the world, especially with the accumulation of wealth in emerging economies, Fidler believes.
With shares of the forlorn in hand, value investors now sit poised to wait out their picks, far from the momentum chasers piling onto today’s growth stocks. “It’s so hard to invest on a three-month time horizon,” Giroux says. “All you are doing is chasing and predicting short-term news flow. That’s really speculation, not investing.”