How things change. How they stay the same.
“Could we have guessed last year that value investing would be sexy and the Cubs would be in first place?” mutual fund analyst Christine Benz of Chicago-based fund-tracker Morningstar Inc. said at her firm’s annual investment conference last month.
Indeed, value investing–generally defined as buying out-of-favor stocks with low prices in relation to earnings–came into vogue last year, as technology growth stocks (high prices, little or no earnings) cratered.
In the first half of 2001, value stocks among the Standard & Poor’s 500 companies outperformed S&P 500 growth stocks by more than a 2-1 ratio.
But the S&P 500–value and growth–is underwater this year, and even with Friday’s sharp drop, has moved sideways since mid-April, trading in just over a 100-point range.
As a result, after years of pouring money into low-cost index funds and going along for the market’s meteoric ride, investors are being told to turn off the autopilot. The key to successful investing, we’re being told, is not chasing sector fads or churning a portfolio, but picking individual companies with long-run potential.
“It’s not how often you’re right or wrong, but the magnitude of being right or wrong,” Bill Miller, chief executive of Legg Mason Funds Management Inc. and a current investment celebrity, said at the Morningstar conference. “The outsized returns come from one or two names.”
This message has a familiar ring. In the late 1990s, the trick was to pick a handful of tech stocks that enjoyed powerful market momentum despite dubious business prospects.
Today, Miller said, the trick is to identify underappreciated stocks representing sound business prospects. It’s a more costly and demanding process than chasing a market mania, but one that implies stable returns over time, he said.
Easy for him to say. Out of thousands of active fund managers, only one beat the no-brainer S&P 500 return each year for the past 10 years, according to Lipper data. That was Miller.
With the tech bubble now burst, more portfolio managers this year have outperformed market benchmarks still burdened by overpriced technology stocks. As stocks rallied in the second quarter, actively managed equity funds on average beat the S&P 500 index total return (with dividends reinvested), 6.6 percent to 5.8 percent. But the 6.7 percent S&P loss in the first half beat the 7.3 percent average loss by active managers in the first half, according to Lipper.
There’s no guarantee that another sector bubble won’t emerge–say in biotech or energy or a replay of tech/telecom–to undo stock-picking once again. But so far, this year has been a “utopian period for stock selection,” said Michelle Seitz, head of the investment management department at Chicago-based William Blair & Co.
Funds invested in small-capitalization value stocks outperformed all other fund categories in the first half.
The emergence of small-stock performance reflects historical patterns, such as declining interest rates and the likelihood of a rebounding economy. Small-company stocks tend to excel in such an environment, often for extended periods.
Coming out of a recession in 1960, for example, small-company stocks decisively outperformed large-company stocks for seven of the next eight years, according to data from Ibbotson Associates.
Work pays off, pickers say
But stock-pickers insist that more than a cyclical bounce has turned in their favor. Their tried-and-true investment discipline, which avoids sector fads and focuses on individual business fundamentals, finally is generating sustainable payoffs, they say.
The tech story of the late 1990s predicted correctly that companies would rush or be pushed by competitors to improve productivity by upgrading their computer technology and telecommunications.
Investors simply climbed aboard this so-called paradigm shift by buying shares in technology and telecom innovators.
Federal Reserve Board Chairman Alan Greenspan stoked the optimism by speaking glowingly about permanent gains in the labor productivity–more output per hour worked–through technology.
Such optimism boosted tech stock prices but obscured the more important issue for investors–the productivity of capital, said George Greig, manager of the William Blair International Growth Fund.
Investors trading shares with one another amid a stock-buying mania failed to ask the essential question, he said: How much cash were technology innovators likely to make on the dollars shareholders and lenders contributed to them?
In many cases, the answer was zero. Indeed, many tech and telecom companies needed ever more capital just to avert bankruptcy.
Tech innovators enabled business to achieve greater returns on labor. But many tech suppliers had no hope of producing sufficient returns on capital. “That was the lesson of 2000,” Greig said.
Today, the investment focus has moved from paradigm shifts and other general themes to “the evolution of the balance sheet,” with a focus on cash returns to capital employed in individual companies, he said.
Of course, analyzing the guts of companies and selecting the best-evolving balance sheets is far more labor-intensive and costly than betting broadly on the labor-saving technology trend or other market themes.
Faced with the renewed popularity of stock-picking, active fund managers say they must work harder to outperform their peers, even if returns on major market indexes, still dominated by overpriced tech stocks, can be surpassed easily.
“You’ve got to be more focused than ever,” said John Rogers of Chicago-based Ariel Capital Management.
“There’s a tendency to try to follow too many companies,” he said. “You can’t get to know them as well as you need to. If you’re going to be successful in this tough business, you have to know more about your companies than any of your competitors.
“In doing research, you’ve got to more than ever have your own independent sources of information. You can’t underestimate the contacts and relationships you need to build over time. It’s like being a good investigative reporter. We really don’t care too much what Wall Street has to say about our companies.”
Such rigorous stock-picking is a full-time job, active fund managers say. Investors seem to agree. Amateurs burned by the tech wreck are turning away from do-it-yourself nostrums. Shares of online brokers have plummeted, as the firms have slashed jobs and shifted strategies to offering more advice.
Rewards versus costs
But the hunt for the next stellar small-cap stock is far more difficult and may be no more rewarding than betting on the next sector fad, especially after the costs of the search are deducted.
The explosion of information about the economy and companies has done little so far to improve forecasting prowess or generate extraordinary long-term investment results.
But conditions–lower interest rates, investors eager for new ideas, hundreds of poorly researched companies–have never been better for improvements in the craft of stock-picking.
Amid weak performance by major stock benchmarks and dull trading patterns on Wall Street, active managers at last have their chance to shine, like the Cubs in first place.
