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How to Pick a Large-Value Fund

Have your portfolio ready when investor sentiment swings to the value side of the style box.

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As you make your investing plans for 2021 and beyond, bolstering the value side of your portfolio is worth considering. Value stocks appear to be one of the few underpriced areas of the U.S. equity market, as Morningstar's Dave Sekera and Amy Arnott have recently noted in separate articles. The extreme value-growth spread has been a noted feature of the market for a number of years, for reasons not fully understood, but believers in mean-reversion would expect that pattern to shift at some point, perhaps in an extreme fashion. GMO's Ben Inker, for instance, argued in a recent letter to investors that "no matter where you look, no matter how you slice it, value looks cheap," while DFA's Gerard O'Reilly made a similar case for value on a recent episode of Morningstar's The Long View podcast.

Moreover, there is now some momentum on the side of value proponents. In the fourth quarter of 2020, the Russell 1000 Value Index outperformed its large-growth counterpart, 16.3% to 11.4%. And finally, if you have simply let your portfolio ride the markets in recent years, that would likely lead to an overweight on the growth side of your portfolio, so even if only for rebalancing purposes, it may make sense to reinvest in value funds. I am no proponent of market-timing, but there are plenty of fundamentally based reasons to be thinking about value strategies.

In this column, I'm reprising an approach I took about a year ago with large-growth funds. If you are considering reviewing, replacing, or adding to the value funds in your portfolio, this article can help you think through some of the key characteristics and factors you should take into account, as well some pointers on how to identify best-in-class choices. In the interest of space, this article focuses on U.S. large-value funds (which usually will constitute the bulk of a U.S. investor's value allocation), but there are significant discounts in other areas, including mid- and small-cap value stocks as well as foreign value.

Modes of Value Investing
Traditional value investing, as famously espoused by Graham and Dodd, seeks out companies trading at discounts to their intrinsic values (as determined through fundamental research) and ideally with a "margin of safety" built into the stock price. Value strategies require patience on the part of investors, as they depend in part on the market's eventual recognition of their holdings' worth--but that can take considerable time. Value funds are identified in the Morningstar Style Box by their lower relative price/earnings and price/book ratios, among other metrics, but value managers may incorporate a range of other valuation metrics including enterprise value, EBITDA, and free cash flow.

Deep value adherents tend to be dyed-in-the-wool contrarians who seek cheaper valuations, emphasize more heavily out-of-favor sectors or troubled companies, and lean into their value picks even more when prices go down (if they believe their thesis remains in play). Managers who take a relative value approach, by contrast, aren't quite as strict in their valuation discipline and may look at valuations in the context of a company's history, an industry, or the wider market; they may also look to filter out companies with weaker financial quality, which often fetch the lowest valuations. That approach allows them to buy stocks with somewhat more expensive valuations and can lead them to companies in more growth-oriented sectors, such as technology or healthcare.

A substantial group of large-value funds fall into the equity-income bucket (often though this is not always indicated in their names). These funds have a mandate to produce some level of income or purchase a certain percentage of dividend-paying stocks. Historically, such strategies have exhibited relatively strong defensive characteristics, as consistent dividend-paying companies are often financially sound, but this kind of resilience can't be assumed; certain higher-yielding sectors, such as energy, can court significant volatility.

Key Characteristics to Consider
Beyond the broad investment approach taken by large-value managers, there are many finer distinctions an investor should take into account. I take as my starting sample all large-value Morningstar Medalists: funds and exchange-traded funds receiving a Morningstar Analyst Rating of Bronze or higher.

Concentration Level
The most concentrated funds hold 30-50 stocks, while very diversified portfolios contain 100-200 positions (and even more in the case of index funds). Also check the percentage of assets held in a fund's top 10 holdings; some managers with lots of holdings may still concentrate heavily in their highest-conviction picks, leading to increased idiosyncratic risk potential.

Sector Weightings
Consider whether you prefer a manager who stays within a close range of the benchmark's sector weights, or one who ventures far afield. There can be significant deviations from the benchmarks. Financials, a mainstay of value funds, take up about 20% of the Russell 1000 Value Index, but medalist funds hold as much as 30% in financials, while one fund has zero exposure. (JPMorgan Value Advantage (JVASX) recorded the highest level, while Lazard Equity Franchise (LZFIX) held 0%. Five other funds, including AMG Yacktman (YACKX) and AMG Yacktman Focused (YAFFX), held less than 10% in financials.) Technology is another interesting case: While the index holds about 10% in the sector, the most tech-heavy medalist fund, iShares MSCI USA Multifactor ETF (LRGF), holds triple that amount, while several managers hold only around 2% of assets in tech, including Invesco Diversified Dividend (LCEAX).

Style-Box Orientation   
Although any fund classified as belonging to the large-value Morningstar Category will by definition have a substantial slug in the large-value corner of the style box, there is a surprisingly wide range around that. Even the Russell 1000 Value Index has only about 30% of its assets in the large-value square, with one fourth or more of its assets falling into the mid- or small-cap market-cap ranges. In the medalists subset, plenty of funds have 70% or more of their holdings tagged as value stocks, but a handful hold 30% or less. Such distinctions can help the investor determine whether, for instance, the manager takes more of a deep-value or relative value approach. Moreover, those details can help shape your portfolio allocation decisions. Perhaps you prefer one value fund with the flexibility to invest in large and smaller-cap stocks; on the other hand, if you already hold a small-cap value fund that you like, you may prefer a more focused large-value strategy.

Quality
Quality metrics are another important area to consider when evaluating value funds. As I noted earlier, some value managers will temper their value instincts with quality filters, while others are willing to dive headlong into troubled companies that they believe are priced way below their future prospects. Neither approach is inherently superior to other, but as an investor you should decide what kind of value exposure you want. The Portfolio tab on a fund's profile page on Morningstar.com provides a passel of data points that can help illuminate a fund's quality orientation. You can consult the moat coverage percentage to determine how much of a fund's portfolio consists of companies with an economic moat, in the judgment of Morningstar equity analysts, while the Factor Profile section can show you to what degree a fund's returns have loaded on the quality factor, relative to category peers or a benchmark.

Risk
Finally, while the above items will give you insight into the fundamental sources of a fund's risk profile, it can be helpful to confirm those perspectives by examining other measures of risk. Standard deviation, Sharpe ratio, and Morningstar Risk are all well established metrics. (Morningstar Risk is calculated relative to the category, but the other two are absolute measures and should be compared with the category or a benchmark for context.) Given the potential downside risks of value strategies, however, it makes sense to pay special attention to measures focusing on that side of the equation. The downside-capture ratio (displayed on the Risk tab of a fund's profile) is useful in that regard but also consider examining a how a fund performed in distinct bear-market periods, such as the 2008 financial crisis or the 2020 pandemic downturn. While value historically has been considered a lower-risk investment approach, that's been less true of late, as the value segment performed worse than the broad market in both of those bear markets.

Positioning Large-Value in Your Portfolio 
How much of your domestic portfolio should consist of value, and particularly large-value stocks? Using market-cap-weighted indexes as a guide would suggest somewhere between 15% to 20% in large-value, and perhaps another 8% or so in small- and mid-cap value. Use that as a baseline, but then tweak it to fit your own preferences. Keep in mind that even broad market indexes have tilted toward growth owing to the dominance of growth behemoths like Amazon.com (AMZN) and Facebook (FB). Also, if you want to be precise in your allocations, use a tool like Morningstar.com's Portfolio X-Ray feature to pinpoint the underlying holdings across your portfolio, rather than simply the category of your funds, since few funds are rigidly style-pure.

Given that framework, I'm going to suggest some funds that can fit particular roles or style preferences within a portfolio. But this is just a starting point. Check out this list of Silver and Gold medalists across the value category spectrum to get additional ideas.

A Fundamental, Valuation-Focused, Time-Tested Approach
Gold-rated Dodge & Cox Stock (DODGX) has been doing value investing as long as virtually anyone (the longest-tenured manager has been on the fund for 29 years), and doing it well. The eight-person committee that runs the fund takes a long-term, contrarian mindset to buying companies that are cheap relative to their future prospects. The portfolio is not excessively concentrated with around 70-75 holdings, and management is not afraid to diverge from the benchmark when it comes to sector weights.

See also: Gold-rated MFS Value (MEIIX)

A Deep-Value, Systematic Strategy
Silver-rated LSV Value Equity (LVAEX) was founded by academics with strong beliefs in fundamental-value investing. They designed a quantitative model designed to identify very cheap stocks underappreciated by the market, based on fundamental factors built into the process. The fund is consistent in its approach, but its deeper-value bent means it often gets hit harder than peers during value droughts, as it has of late. The portfolio is well diversified across some 170 holdings, and it is poised to outperform should value embark on an extended rebound.

See also: Silver-rated Invesco Comstock (ACSDX) (deep-value but not systematic)

A Lower-Risk, Quality-Oriented Dividend-Payer
Gold-rated JPMorgan Equity Income (HLIEX) has been led by Clare Hart since 2004. She and her comanagers focus on companies paying dividends of at least 2%, but they also place an emphasis on a firm's financial health and earnings sustainability. That has resulted in a decent but not excessive income payout level, along with a strong and long-term risk/return profile with good downside results.

See also: Gold-rated American Funds American Mutual (AMRMX)

A Concentrated, Iconoclastic Stock-Picker
AMG Yacktman and AMG Yacktman Focused both receive Analyst Ratings of Silver. While Yacktman Focused is nominally the more concentrated of the two, currently both have around 50 stock holdings, with Focused holding slightly more in its top 10 (41% of assets vs. 38%). Otherwise, both pursue a quality-focused approach that tilts the funds more toward the core portion of the style box and has historically provided significantly superior downside protection. At the same time, the managers reserve a portion of the portfolio for more opportunistic investing in out-of-favor stocks, and during the 2020 pandemic downturn they pounced on such opportunities. As a result, both portfolios currently contain significantly more non-U.S. and small/mid-caps than peers. The strategy has gone through the occasional dry spell, though its long-term performance record is excellent and should reward the patient investor.

See also: Silver-rated Sound Shore (SSHVX)

A Yield-Focused Index-Tracker
Gold-rated Vanguard High Dividend Yield ETF (VYM) tracks the FTSE High Dividend Yield Index. The vehicle sorts the U.S. stock market by expected 12-month dividend yield, selecting from the top half of the universe on a market-cap-weighted basis. The result is an offering that pays a higher yield than the Russell 1000 Value Index and is also weighted toward larger-cap and more value-leaning stocks. Over the long term, this has produced excellent risk-adjusted results alongside the income. Low fees of only 0.06% enhance the effectiveness

See also: Silver-rated Fidelity High Dividend ETF (FDVV)

A Rules-Based Multifactor ETF
Silver-rated Hartford Multifactor US Equity ETF (ROUS) does not explicitly follow a value strategy; rather, it targets three well-vetted factors--value, momentum, and quality--with value weighted more heavily than the latter two. This methodology emphasizes "cheap, profitable stocks with strong recent performance," as Morningstar's Ryan Jackson notes in his report. Compared with other large-value funds, this fund's momentum and quality factors mean that it tilts more into the core square of the style box than the average large-value fund, and its sector concentrations can look quite different as well (for instance, it currently holds nearly double the category's weighting in technology). That has benefited the fund in recent years, though it would likely lag in a value-driven rally.

See also: Silver-rated iShares MSCI USA Multifactor ETF 

Josh Charlson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.