Value Strategies Making a Comeback

Each quarter, Morningstar stock analysts review the shareholder letters and holdings of a select group of fund managers in an attempt to learn more about their stock-selection process. In reading through the first-quarter letters of the fund managers we follow--written not long after the market lows reached in March and a full year after the failure of Bear Stearns--we were reminded of a quote from Will Rogers: "Last year, we said, 'Things can't go on like this,' and they didn't; they got worse."

Things looked dark at the time, but, as the managers as  Tweedy, Browne (TWEBX) put it, "global equity markets rose like a phoenix late in the quarter producing one of the biggest three week turnarounds on record." Like the market, many of the managers we follow also experienced a bit of a resurrection at the end of the quarter. Almost all of the funds on our reading list have outperformed the S&P 500 so far in 2009, many by a substantial margin.

Macro Fears Led to Bargain Prices
We think the excellent performance of these funds once again validates the efficacy of the value approach, and the importance of a consistent investment philosophy, as we pointed out last quarter. Unfortunately, like so many times in the past, investors turned away from proven strategies in droves over the last few months in order to jump on the latest hot trend. As the managers of  Longleaf Partners (LLPFX) wrote in their first-quarter letter, "Never in our investing career has the obsession with macroeconomic trends so overwhelmed the interest in fundamental analysis. People ask about our forecasts on interest rates, economic growth, inflation, currencies, government debt, geopolitical events, commodity prices, and the stock market... Because macro events indeed dominated all asset classes in 2008, people illogically are extrapolating that macro events will exclusively dictate all future performance."

Not surprisingly, with bearish macroeconomic sentiment reaching a fever pitch earlier this year, investors were hesitant to buy stocks at any price, effectively having "sworn off equities for fear of short-term macro uncertainties." Yet as the team at  Yacktman (YACKX) points out in its recent commentary, "With many securities now trading at a fraction of their former prices, there is considerably less risk over the long term assuming the earnings power of a company is not permanently damaged."

Manager Watch List
Fund	YTD Performance*
Fairholme (FAIRX)	12.87%
Gabelli Asset (GABAX)	4.39%
Longleaf Partners (LLPFX)	22.05%
Mutual Shares (TESIX)	3.88%
Oakmark Select (OAKLX)	15.02%
Sequoia (SEQUX)	1.38%
Third Avenue Value (TAVFX)	14.67%
Tweedy, Browne Value (TWEBX)	1.59%
Weitz Partners Value (WPVLX)	9.91%
Yacktman (YACKX)	23.14%
S&P 500 Index	2.13%
*YTD performance as of May 31, 2009.

The Storm May Be Passing, but Some Damage Is Permanent
On the other hand, the nearly unprecedented macroeconomic environment experienced in 2008 and 2009 cannot be completely ignored. The relative roles played by bad business decisions and macroeconomic conditions in the demise of firms like Bear Stearns, Lehman Brothers, and Washington Mutual can be debated, but there is no question that the moats of many other businesses have been breached as a result of recent events. Additionally, after at least two speculative bubbles in less than a decade, and with a drastic financial retrenching taking place, the "new normal" state of the economy is not yet clear--it's possible that growth and corporate profitability have reset at lower levels, at least temporarily.

In the words of the  Sequoia (SEQUX) management team, "In this environment, we find it very challenging to ascertain normalized earnings power for many companies...when we are not sure what 'normal' will look like in the future... In our many years of investing, we cannot remember a time when visibility was this low and estimating the intrinsic value of businesses was this challenging." For example, Sequoia's managers believe that the increasing use of private-label consumer products in the current recession could produce a permanent decrease in the earnings power of firms like  Procter & Gamble (PG), as consumers "realize that the laundry and the dishes look the same" after using private-label products.

Clouds of Uncertainty Have Silver Linings
Looking on the bright side, economic uncertainty is what creates opportunities for investors in individual stocks. Although we don't think the market as a whole is as cheap as it was in November and March, Morningstar analysts are still recommending a number of 5-star stocks. Mario Gabelli of  Gabelli Asset (GABAX) agrees, proclaiming that "This is a stock-picker's market." Gabelli is "not buying the market," but rather he is "picking specific companies," believing that "there are bargains out there."

Some investors, such as  Oakmark's (OAKLX) Bill Nygren, were even more positive, proclaiming himself to be "excited about investing in stocks today" and asking investors to remember that "at the end of the first quarter of 2009, the managers of Oakmark and Oakmark Select were [their] most bullish managers." Nygren has history on his side, and he made this point by comparing current news headlines to those appearing at market bottoms in 1932 and 1974. In fact, stock market investors in those years, able to buy stocks at low prices, realized more than adequate returns despite a similarly gloomy economic outlook--several more years of depression in the first case and stagflation in the second.

Finally, it's worth noting that as of this writing, the S&P 500 is still cheaper than it was when Warren Buffett went public with a buy recommendation in October. For these reasons, we're still confident that bargains in individual stocks remain for investors with a long time horizon.