The Hindu Business Line : Value investing falters in the US

While value investors are having their day in the sun in India, they are still facing rough weather in the US markets. From legendary value investor Warren Buffett to renowned fund manager Bill Miller, who manages Legg Mason’s popular Value Equity Fund, investors who hunted for stocks at a bargain suffered greater losses on their holdings over the past year than those focussed on high-growth, highly valued companies.

That is unusual, considering that value stocks are expected to outperform growth stocks and the broader markets during recessions, as was the case during 2000-2002. But it is not surprising, as the very same financial stocks that bore the brunt of the meltdown in the current recession, have been favourites for value investors.

Financials destroy value

Value investing appears to have had a better track record in the last 10 years in the US markets, compared to growth. Between 2000 and 2006, the Russell 3000 Value Index consistently outperformed Russell 2000 Growth and Russell 3000 Index (Russell 3000 is a broad market index which captures about 98 per cent of US market capitalisation). Since the US market peak of October 2007, however, it has lagged the broader market and growth stocks, thanks to the decimation of financial stocks.

Financials typically have a low price-to-book ratio, a measure used to determine the price of a stock relative to its book value (assets minus its liabilities). Banks, therefore, often dominate the indexes and portfolios of value-style funds in the US. But as the full weight of the crisis descended on the markets and the number of write-downs on assets increased, earlier estimates of the banks’ “intrinsic value” had to be revised downwards as well. Value investors who underestimated the depth of the crisis and loaded up on banks believing they were cheap have been pummelled in the market crash.

Focussing on stocks with lower price-earnings multiples has not paid off as well, as the entire market has undergone a de-rating in the wake of the recession.

Dogs of the Dow

But value investors here still find merit in the “Dogs of the Dow” strategy of investing. The strategy involves investing equal sums of money in the top ten stocks of the Dow 30 ranked by dividend yield (dividend as a percentage of market price) at the end of the year. These stocks should be held for a year and then re-balanced. The stocks are called dogs because their market prices have been beaten down over the previous year.

The strategy, popularised in the 1980s by Michael O’Higgins, supposes that companies which continue to pay a steady dividend are confident about their future and are merely temporarily out of favour.

The strategy did not work well last year, however, with underperformers such as General Motors, Citigroup and General Electric figuring in the list.

The Dogs of the Dow for 2009 (as determined at the end of 2008) are: Alcoa, AT&T, Bank of America, DuPont, General Electric, JP Morgan Chase, Kraft, Merck, Pfizer and Verizon.

In the current circumstances, investors need to be certain that the Dogs of the Dow will maintain or step up their dividends in 2009. Already, there have been announcements of dividend cuts by some companies in the above list. Given the current credit crisis, markets may also choose to reward companies that conserve cash rather than make heavy payouts. So, although this strategy has a good track record over the long term, there is no guarantee that it would work in the current environment.

Interestingly, the strategy has been known to work quite well in India in the past. Business Line picked the top ten dividend yielding stocks of the BSE-100 at the end of every year for several years. The strategy broke an eight-year winning streak in 2005.

(The author, a former BL Research Analyst, is based in New York.)

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