Clobbered stocks mean it might be time to add a value fund

If you own a value fund, odds are good that your fund is just stuffed with bargains. Unfortunately, your manager probably bought those bargains when they were twice as expensive as they are today.

Does that mean that we should consign value investing to the Hall of Stuff That Sounded Good at the Time, like passenger pigeon sandwiches and asbestos cigarette filters? No. It just means that there's no single perfect investment philosophy. That said, it's probably a good time to add a value fund, if you don't have one already.

Value investing revolves around the premise that it's best to buy stocks when they are cheap — a tough proposition to argue against. Value investors look for stocks that Wall Street has clobbered and waits for them to return to their fair value.

In theory, value investing has several virtues:

•Lower volatility. Value stocks have already been beaten up, so they should fall less than other stocks when the broad market is down.

•Higher dividends. Value stocks often pay above-average dividends, so you get paid to wait for their recovery.

•Less guesswork. Ideally, a value investor is waiting for a stock to return to normal — not using a crystal ball to determine when its earnings are going to soar, or whether a new product will take off.

Value funds held up well in 2001, a bear market year, falling 5% vs. a 12% loss for the Standard & Poor's 500-stock index, including reinvested dividends. Bargain-hunting funds fell less than the S&P 500 in 2002 as well.

But in 2008, value funds lagged behind the S&P 500, albeit slightly. What happened? Stocks that are cheap can always become cheaper, and many value managers snapped up stocks at what they thought were bargain prices — only to see them fall deeper into the bargain basement.

Consider American International Group, which sold for about $49 a share in May 2008. The stock fell to less than $20 a share in August, meaning you could have bought AIG stock in August for 59% less than its May price. A bargain, no?

Well, no. The stock stopped falling and began plummeting instead, hitting a low of just 33 cents a share this month. Had you bought at $20 and sold at 33 cents, you would have lost 98% of your investment. (The stock rallied to $1.62 Thursday, so if you held tight, you'd be down just 92%.)

In value investing, too soon is too bad. AIG might be an interesting stock at $1.62, but it was a catastrophe at $20, or $10, or even $5.

A good value investor doesn't just look for cheap stocks. They have to be stocks that are cheap because they are mispriced. In the words of the late Sir John Templeton, one of the world's premier value investors, you have to look for stocks that are selling for 50% less than their underlying assets.

Naturally, Templeton's rule isn't easily followed either, which is why there are so few Sir John Templetons in this world. If you want to determine a company's underlying assets, you have to be fairly adept at figuring out ... well, the value of a company's assets. As AIG's case points out, you may not realize that the company has some assets that may best be described as nameless voids.

Unfortunately, many value funds are drawn toward financial stocks and industrial stocks — two industries that traditionally sell for lower price-earnings ratios than the rest of the market. (A company's P-E ratio is its price divided by its past 12 months' earnings per share. Lower is cheaper.) Both areas were devastated in this bear market.

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