Has Value Investing Worked to Protect the Downside?

A few months ago I published an article highlighting mutual funds that avoid disaster. I suggested that adhering to Benjamin Graham's advice to buy earnings cheaply and avoid companies with large amounts of debt helped  Yacktman (YACKX),  Sequoia (SEQUX), and  Greenspring (GRSPX) hold up in bad times. (Graham was Warren Buffett's teacher at Columbia Business School and is widely considered to be the founder of value investing.)

As the markets have continued to plummet, the debate about whether value investors have protected on the downside has been rekindled among Morningstar's fund analysts. Some point to members of the value school who outperformed the S&P 500 Index in 2008 (that is, lost less than 37%) and claim victory for Graham and his students. Others aren't satisfied with the relative outperformance of this rather narrow list of managers or point to other value hounds, who were crushed by owning struggling financials in 2008 and judge failure. Still others say it's silly to point to one-year performance numbers and thus trot out good relative cumulative 10-year records of funds that were pummeled in 2008.

I'm in the camp that thinks long-term performance numbers matter most, but I also think some value investors have protected the downside well in the recent downdraft. In this follow-up article, I'll discuss why Graham-inspired investors held up better in 2008 than has been acknowledged, and I'll highlight two Graham-inspired funds.

The Case Against Value
The main value indexes didn't outperform the broader market in this downturn. The Russell 1000 Value Index and the Russell 3000 Value Index both dropped around 55% from mid-2007 through February 2009, more than the 49% drop of the broader the DJ Wilshire 5000 Index. Also, large- and mid-value funds in aggregate dropped by around 52% in that timeframe, so active managers in the aggregate didn't outperform the broader market either. Lay the blame on financials. They've been a mainstay in value portfolios for years, and they got pounded during the second half of 2007 and in all of 2008.

Some high-profile value funds also got hit especially hard by the financial mess.  Dodge and Cox Stock (DODGX),  Oakmark Select (OAKLX),  Legg Mason Value Trust (LMVTX),  Weitz Value (WVALX),  John Hancock Classic Value (PZFVX), and  DWS Dreman High Return Equity (KDHAX) all suffered mightily. The first three are managed by former winners of the Morningstar Manager of the Year award. These managers not only bought financials, but added with gusto to several institutions that ultimately went bust or remain in their death throes, including  Citigroup (C),  Fannie Mae (FNM),  Freddie Mac (FRE),  AIG (AIG), Merrill Lynch  Wachovia , Washington Mutual, and Countrywide.

The Value Rebuttal
The most straightforward reply to this damning evidence is that the value indexes don't truly represent value investing. A fund manager who understands his investment universe to be the Russell 1000 Value Index or Russell 3000 Value Index isn't really a value investor. Index-hugging funds can be fine, but they don't employ a true value approach based on Graham's tenets.

The main difference between an index approach and a Graham-inspired approach is debt. Graham made numerous warnings against debt and opaque balance sheets in his writings. So although financials find themselves in the value indexes because of their perennially low price/earnings and price/book ratios, value investors from the Graham school are often leery of them. In fact, value hedge-fund manager Seth Klarman has remarked that many value investors habitually avoid commercial banks and property/casualty insurance companies because of their opaque balance sheets. Additionally, Walter Schloss, an associate of Graham, whom Buffett himself cites as one of the finest investors of his time, has also said that avoiding debt is among his most important investment principles. Finally, Buffett himself says bank financial statements are basically unanalyzable and that an investment in a financial stock is effectively a bet on the integrity of management.

Many value investors like to hold cash at times, which also puts them at odds with all equity indexes. The main reason for this is that value investors don't think they can predict when opportunities will arise, and they never want to be caught without the ability to pounce. All the funds I mentioned in my previous piece--Yacktman, Sequoia, and Greenspring--often carry large amounts of cash. All held up relatively well in 2008.

So the argument that value indexes haven't held up during this bear market isn't an indictment of traditional value investing, because funds with Graham-inspired strategies don't pay attention to indexes or the Morningstar Style Box.

Those who got crushed in this downturn simply failed to heed Graham's warnings about debt. They concentrated too much on the income statement and not enough on the balance sheet. Many, such as Bill Miller, Bill Nygren, the team at Dodge & Cox, Wally Weitz, Rich Pzena, and David Dreman, were seduced by falling stock prices without fully understanding underlying value and the potential havoc that weak balance sheets can wreak.

Below are two funds that didn't make that mistake in 2008.

 Royce Special Equity  (RYSEX)
This small-cap fund is managed by our current Domestic-Equity Manager of the Year, Charlie Dreifus. Dreifus is explicitly influenced by Graham and his accounting teacher Abraham Briloff, who has detailed ways in which accountants can distort the economic truth of a business' situation. Dreifus picks underfollowed, out-of-the-way, prosaic businesses that have simple accounting. They tend to expense things on the income statement rather than capitalize them, and they tend to have unshakable balance sheets. There is no exposure to financial stocks in his fund, and he typically holds healthy amounts of cash. Arden Group  is symbolic of Dreifus' style. An owner of 18 upscale supermarkets in Southern California, the firm has a balance sheet with $177 million in assets, including $90 million in cash and short-term investments, against only $54 million in total liabilities. It has produced returns on equity above 15% for the past decade and is more than 60% owned by insiders.

Dreifus lost 19.6% in 2008, when the S&P 500 Index dropped 37%. He has also doubled investors' money over the trailing 10 years through February 2009, with a 102% cumulative return versus a 29% cumulative loss for the index.

 First Eagle Global (SGENX)
This is Jean-Marie Eveillard's all-cap global fund. (He also runs and  First Eagle Overseas (SGOVX) and  First Eagle U.S. Value (FEVAX)). Eveillard buys well-capitalized companies of all sizes. He will also consider bonds, if he thinks they fundamentally make more sense, and often holds cash. Finally, gold is a perennial favorite of his for its insurance in the event of a market collapse. Currently 78% of the fund's portfolio is in stocks. Eveillard does have some financial exposure, but a chunk of it is  Berkshire Hathaway (BRK.A), which has a AAA credit rating. He doesn't buy the completely underfollowed small caps that Dreifus likes, but he's similar in his emphasis on balance sheet strength. Eveillard and his protege Charles de Vaulx, who ran the fund from the beginning of 2005 through early 2007, avoided the large investment and commercial banks over the past few years because of their complicated and sometimes questionable balance sheets. Despite Japan's decades-long troubles and dependence on increasingly-strapped American consumers, he is also strongly attracted to Japanese stocks now because of their impressive balance sheets, which carry very low levels of debt.

Even though the fund is officially classified in the global allocation category because of its investments in (mostly corporate) bonds, its 21% loss in 2008 versus a 40% decline in the MSCI World Index is impressive. Over the trailing decade through February 2009, the fund's 185% cumulative return has smashed the 29% loss of the S&P 500 Index.

Eveillard is retiring at the end of this month, and although his successors may well carry on his torch, his retirement represents a loss to true value investing.