Choosing a value fund manager
A track record is far more than a single number showing a fund’s annualized return, and investors who pick top-performing value managers are often led astray.
Investors must dig deeper than the headline numbers to get at the roots of a prospective value manager. Proper analysis can determine if she/he has the proper temperment to stay the course through the most challenging market environments.
Portfolio turnover
Value fund managers practice a buy-and-hold philosophy because companies that are cheap may take years to revalue. A company may trade cheaply relative to its current or expected earnings for any number of reasons that the market does not recognize.
Value managers often wait patiently for their vision to be realized, and that fact is reflected in the portfolio turnover statistic for their funds.
Portfolio turnover is a ratio that depicts the percentage of the portfolio that has been turned over, or sold in any one year.
A fund manager with a 25% turnover ratio sells only one-quarter of his portfolio in any year, on average. Looked at another way, the manager holds companies an average of four years, which is often the practice of a patient value manager.
Style drift
Managers with turnover ratios greater than 100% are not true practitioners of the value-investing style. These managers are buying and selling stocks too frequently and actually may be straying from their stated value style.
In the late 1990s, some value managers couldn’t resist the technology mania that was dominating stock markets and felt under pressure to perform better. Those managers who deviated from their professed value style can be exposed by high or rising portfolio turnover.
Other indications of style drift are discerned by looking at the style boxes that mutual fund research providers calculate for each fund. A manager who buys low valuation stocks will be categorized as a value manager. Any change in fundamental characteristics of his or her portfolio will be noticeable by a movement in the style box.
Bear market performance
Value investors tend to outperform in bear markets and often under-perform in bull markets.
Over the past two decades, value investors have outperformed growth managers, on average, because they made safer investments and had shallower losses. Since expensive growth stocks have farther to fall than already cheap value stocks when the market is selling off, value funds tend to outperform in those environments.
Investors should look to the performance of a prospective value fund manager in prior bear markets. Did he or she perform better than the market?
For example, many value fund managers beat their benchmark stock index from 2000 to 2003 because the index endured heavy losses during that time. Value fund managers who stuck to their knitting and held on to their cheap stocks – or even bought more as they became cheaper – tended to fare best when the market rebounded sharply in 2003.
Bull market performance
Investors should not be perturbed by value fund managers who have not outperformed in bull markets. They often don’t because the stocks that rise most in bull markets are often not indicative of value investments.
Often times these stocks have high and rising prices in anticipation of high and rising earnings.
In the most recent bull market, investors bid up the prices of energy and materials stocks on the back of rising commodity prices. These sectors have historically been cyclical – rising and falling in three- to five-year cycles. Therefore, many value investors won’t buy these stocks in the latter part of a cycle because these companies have high returns on equity that tend to fall back with the cycle.
Value fund managers need to demonstrate resolve when the market is moving against them. Those who stick to their buy-and-hold principles tend to be vindicated over the long term, and investors can look to the data for clues to which managers are true value managers.
