Pension funds that stuck to their value guns despite the style's slow performance in recent years are finally reaping the benefit.
Value stocks continue the recovery that began in mid-April, thanks to increases in commodity prices, hints of higher interest rates by the Federal Reserve and slower company profits, managers and consultants said.
Pension executives have stuck with value despite the depressed performance of the style in recent years, but it hasn't been easy, said Mary Sue Dickinson, consultant with William M. Mercer Investment Consulting Inc., New York.
"Some have re-examined the suballocation structure and done some tweaking. But value is 45% to 50% of the available (equity) universe. That would be a huge bet against a significant portion of the U.S. stock market," she said.
Alabama's approach
"We've made up for a lot of lost ground, but is this sustainable?" asked Darren Schulz, director of investments for the $22 billion Retirement Systems of Alabama in Montgomery.
"The one thing that is probably muting our enthusiasm (for the rally) is the knowledge that the rate of response to good news in these historical cycles peaks in a short time relative to (the same rate of response) for growth stocks," said Mr. Schulz, who actively runs about $650 million in midcap equity investments for Alabama's internally managed pension fund. About 36% of the fund is invested in domestic equities, predominantly value stocks.
Last year the pension fund widened its value approach and moved a few growth names into the midcap and large-cap value portfolios to improve performance, he said.
Dramatic turnaround
With just a small overweighting in basic materials, Alabama saw its portfolios turn around drastically starting in mid-April to return 10.3% for the year as of May 31 compared with 1.5% for its benchmark, the Standard & Poor's 400 midcap index. Mr. Schulz started April down 4.5% for the year compared with the benchmark's -6.4%.
His portfolio benefited across the board,"more from sector bets than active stock selection," he said, but there were noticeable boosts from positions in chemical companies such as Praxair Inc. and Great Lakes Chemical Corp. He also won points with the stocks of communications equipment and networking companies Northern Telecom Ltd. of Canada and ECI Telecom Ltd., an Israeli digital equipment manufacturer.
Mr. Schulz said he is using the rally to both take gains and garner some of the stronger value positions he sees today, such as in telecommunications companies.
"I think we've been somewhat cautious, capturing outperformance but scaling out of large overweight positions in value. We've pared down our commodities and some chemicals, using the weakness in tech to add positions," he said.
Continuation predicted
Glenn Davis, consultant at Eager Manager Advisory Services in Louisville, Ky., said that from a statistical standpoint, conditions suggest value will outperform over the next three to four years.
Asian companies that had reached rock-bottom inventory levels last fall began to again purchase goods from U.S. companies. The fulfillment of orders led to stronger-than-expected earnings for commodity companies in the first quarter and increased expectations for stocks such as Mead Corp. and Aluminum Co. of America.
A stable rise in commodity prices will continue to boost value stocks, even if second-quarter earnings for commodity firms are moderate, money managers said.
That corporate profits overall are decelerating in the United States is another good sign for value, said longtime value investor Anthony Hitschler, chief investment officer of Brandywine Asset Management Inc., Wilmington, Del. "The market will pay more attention to the commodity prices than stated earnings," he said. "Stated earnings are the rearview mirror. The prices will tell you about the future earnings, and that will drive the stock prices."
Brandywine manages about $3.5 billion in institutional tax-exempt assets, of which about $2 billion is in small-cap value and $500 million is in non-U.S. value stocks.
"Small-cap (value) has made huge rebounds, up 22% from the lows of April. Large-cap value is up about 10% year to date. Value stocks will hold their own. The problem now is that the growth stocks will go down and drag the market down," Mr. Hitschler said.
"We see this as a sustainable 12-month rally at least," said Kevin Hart, portfolio manager at Freedom Capital Management Corp., Boston.
"If the interest rate environment continues to move the way of a Fed hike, it will hurt growth stocks more than value," he said.
In January, Mr. Hart switched from 100% growth stocks to 100% value for the $272 million tactical equity index account that he manages. "It was uncomfortable in January, February and March, but when it turned in April, it was the most forceful thing I've ever seen. It was definitely better to be early than late," he said.
His fund is up 10.8% year to date as of June 22, compared with his benchmark, the S&P 500, which was up about 9%.
Pension funds are unlikely to make any drastic movements into value despite the current uptick, said Thomas Reilly, a managing director and chief investment officer for global value equity at Putnam Investments in Boston. "We could see some small movement. There's a probability that the spread between value and growth will continue," he said.
$10 billion in value
Putnam manages more than $10 billion in domestic large- and small-cap value stocks for U.S. tax-exempt institutional investors, compared with $35 billion in domestic growth stocks.
Putnam's institutional large-cap value investments were up 11% year to date as of June 18, compared with 5.6% year to date for the institutional core growth portfolio on that date.
"In general, last summer everything sold off except large-cap growth. High-yield, emerging markets and value stocks all did poorly last year. Now everything has come back, with small-cap value being the last one up," he said.
The Russell 2000 small-cap value index was up 3.9% year to date on June 21, quite a rise from the -9.7% posted in the quarter ended March 31, and the -6.5% return for 1998. Comparatively, the Russell 2000 small-cap growth index was up 10.1% year to date as of June 21, up from the -1.7% return in the first quarter and well over the 1.2% return small-cap growth posted for 1998.
And since most activity is based on perception, it's difficult to say when such a dramatic spread could happen again, Mr. Reilly said.
"The two styles take turns, but when you're in it, it's totally unpredictable. Investors panic and become too narrow in their focus. For the overall market to do well, it must have breadth," he said.
About 34% of all active domestic equity investments made by U.S. tax-exempt institutions are in value stocks, according to Pensions & Investments' 1998 survey of money managers. Some 266 managers included in the survey had invested a total of $540 billion in value equities on behalf of tax-exempt clients as of Dec. 31; the most common value style is large cap, used by 186 managers for a total of $418.4 billion.
Fewer hirings
According to Eager data, fewer managers were hired by pension funds for value assignments in 1998 than in previous years, 84 compared with 118 in 1997, 109 in 1996 and 144 in 1995.
Mr. Hitschler said clients that had value holdings before the style began to do well in the early 1990s have been more loyal to value during its recent down years than have those that first came into value when it was up in the mid-'90s.
The outperformance of value over growth puts an end to the widest gap in recent memory between the two equity styles, managers said.
As of June 21, the Russell 3000 value index was up 2.8% for the month vs. 3.8% for the Russell 3000 growth index. Year to date, the value index was up 12.2% as of June 21, compared with 7.4% for the growth index. That's quite a turnaround compared with the first quarter of 1999, when the Russell 3000 growth index beat the value index 5.8% to 0.6%. In 1998, the growth index returned 35% vs. 13.5% for value.
There is another 25 percentage points of relative performance between growth and value to be earned, said Tom Jackson, portfolio manager at Prudential Investments, Newark, N.J. He runs $13 billion in large-cap value equity, of which $50 million is institutional.
