'Value Trap' Crushes Value Funds

(Money Magazine) -- Value investors have a simple, elegant strategy. They buy a stock trading cheaply relative to the company's earnings or business value and then patiently wait for the market to catch on to how wonderful it is.

So what happens if a so-called value investment refuses to turn around and instead sinks deeper and deeper into the red? Maybe you need to wait longer. But sometimes it turns out you badly underestimated the problems with the stock - you've fallen into the dreaded "value trap."

And that's precisely what's happened to some of America's smartest value-fund managers this year. They thought they saw solid deals in the bruised financial sector. The scale of the banking crisis turned out to be a whole lot bigger than they had anticipated.

The numbers are truly miserable. The team at Dodge & Cox Stock (DODGX) has lost 44.3% for the 12 months ended Nov. 11. Marty Whitman's Third Avenue Value (TAVFX) fund is down 46.9%. And then there's Bill Miller, the man who famously beat the market for 15 consecutive years. His Legg Mason Value (LMVTX) is off by 56.7%.

Overall, the average large-cap value fund fell 38.3%. That's an especially large shock given how well value strategies held up in the past bear market. "Many investors were lulled into thinking that value funds were a less risky way to invest," says Karen Dolan, director of fund analysis at Morningstar. "But this time around, the poor performance is a reminder that value investing can be very risky."

It's really hard to keep faith with a fund that's done this badly. This isn't just a matter of being caught in an out-of-favor style - some of these managers clung to really awful stuff. Miller, who held Citigroup (C, Fortune 500) and AIG (AIG, Fortune 500), admits he is "quite aware of our mistakes, both of commission and omission."

But there's a case for sticking it out. To put some perspective on the lousy returns, value funds weren't the only losers. Blue-chip growth funds, which buy stocks with high market expectations and high prices to match, are down about as much as value, thanks to their energy and technology holdings.

And with quality stocks trading at big discounts, top value investors say now is an excellent time to put money in the market. But since you clearly have to be careful here, follow these guidelines:

Understand what the manager means when he says "value"

Each fund defines the concept differently. For some it simply means being conservative and buying a lot of unglamorous stocks with lower-than-average prices. For others it's about making opportunistic bets on seriously troubled companies that others shun.

Read the fund's prospectus and shareholder letters to get a feel for this. Generally, if a fund follows a really strict value style - that is, only buying the most beaten-down stocks - you can expect the fund to be more volatile and out-of-step with the market at times.

Some value funds also hold concentrated portfolios of just 20 to 40 stocks, which means one or two of its stakes can boost returns - or torpedo them. That's what happened with Legg Mason Value, both on the upside from 1991 to 2005 and on the downside since the end of the streak. The fund holds only 31 stocks.

For a lower-risk approach, you might consider a fund that's better diversified, such as T. Rowe Price Equity Income (PRFDX), a Money 70 fund with a portfolio of 120 stocks. A few funds even keep a portion of their portfolio in cash to cushion returns, among them Fairholme (FAIRX), another Money 70 fund.

Look for managers who see opportunities in this market

Whatever type of value fund you choose, you want your manager to be consistent. If a long-time value fund is switching strategies because of one or two years of disappointing returns, it probably never had a serious strategy to begin with.

History has shown that value funds tend to rebound sharply after periods of poor returns. A fund that abandons value now may just get its timing wrong a second time.

The most battle-tested value managers are upbeat about the bargains they are finding today. Says 84-year-old Whitman of Third Avenue Value: "I'm seeing the greatest opportunities I've ever seen in my life."

Among the stocks he calls bargains are Toyota (TM) and Forest City Enterprises (FCY). Likewise, Bruce Berkowitz, lead manager of Fairholme, says the team has been reducing its cash stake significantly to buy stock.

You have to be patient too

It's important for you to be as consistent as the managers you hire. Many investors are having trouble with that idea - shareholders yanked a record $104 billion out of funds in September alone. But you can follow the lead of the best value managers by simply rebalancing your portfolio. Shift some money from the funds that held up best in this dire market into those hit hardest. Do this regularly and you'll consistently snag some stocks at bargain prices - a strategy that over time will make anybody a successful value investor.