For value equity managers, more rough times expected

It’s always darkest before the dawn, the saying goes. For U.S. value equity managers, it may get darker still before sunlight peaks through.

U.S. large-cap value stocks lost 16.1% in the 12-month period ended July 31, according the Russell 1000 Value index, compared with -7.6% for domestic large-cap growth stocks, according to the Russell 1000 Growth index.

It could get worse before it gets better. The next few quarters could be particularly rough for value stocks, particularly banks and other financial organizations, said Ed Clissord, senior global analyst for Ned Davis Research in Venice, Fla. Financials comprise 27.2% of the Russell 1000 Value index.

“The hangover from the decline in the housing market will take a while to fix itself because so much is tied into housing prices,” he said. “It’s going to be hard for banks to recover from the significant losses they are having.”

Mr. Clissord said his firm, which advises money managers, prefers growth over value stocks. In today’s environment, it is recommending underweighting financials and overweighting companies that produce consumer staples or utilities that can pass along increases in energy costs to consumers.

Jeb Doggett, a partner with Casey Quirk & Associates LLC, Darien, Conn., an adviser to money managers, agreed. “It’s unlikely that financials are going to perform well in the near future,” said “There is an overhang with financials related to subprime,” he said.

Money managers and consultants to institutional investors aren’t writing off financials for the long term. The debate is about how long a recovery will take. “There is a huge amount of disagreement (in the) mortgage-related space, Fannie Mae, Freddie Mac and other financials,” said Dennis Jensen, a portfolio manager for Russell Investments.

“Even managers that are not buying financials agree these stocks are cheap,’’ he said. “Managers think they will rally but are unsure when. They don’t want to take the risk between now and then because they don’t know how to figure out which ones have hidden bombs.”

Mr. Jensen said the key to finding great opportunities in buying financials comes down to the question of timing. “The best investment opportunities come at maximum pain,” he said. “The question is, are we at maximum pain?”

Despite the tough times, value managers are holding firm to their investment approach. “If you look at the last nine recessions, value has outpaced growth,” said Jay Feeney, chief investment officer, equities, in Robeco Investment Management Inc.’s Boston office. “The average recession lasts 10 months and it’s the middle point when the value stocks start outperforming the growth stocks.”

Mr. Feeney estimates the recession started about five months ago, so now might be the right time to buy value stocks. “The price you pay for a stock is the single most important factor; prices have fallen dramatically,” he said. “We see a pretty significant opportunity.”

But value supporters also saw opportunities in 2007, “doing what they do best,” buying stocks with “risky fundamentals,” said Russell’s Mr. Jensen. The results have not been pretty. He said deep-value managers were hit hard buying stocks of home builders and mortgage-related financial companies. “Those things started to blow up, in 2007 those deep-value managers got decimated,’’ he said.

“Around 20 to 30 of the value managers tracked by Russell had losses of 30% or more,” he said. Mr. Jensen added the same managers had done well after the technology bubble. “Their performance was off the charts,” he said.

“Those with poor results include top money managers,” he said. “A lot of them are well-known players. They are doing the same thing they have always done, sometimes it works, but it’s been a tough 12 months.”

Data from Morningstar Inc. show the hardest hit large-cap institutional mutual funds for the year ended July 31 were the Touchstone JSAM Institutional Large Cap Value fund, down 48.7%; the ING Large Cap Value I fund, down 35.4%; the Osprey Concentrated Large Cap Value Equity fund, down 33.3%; the Allianz OCC Value Fund Institutional fund, down 30.94%; and the John Hancock Classic Value I fund, which is subadvised by Pzena Investment Management LLC, down 30.2%.

While value managers like Robeco’s Feeney argue the end of the recession is in sight, others aren’t so sure.

“My personal view is that the economic slowdown will be longer than average because of the housing crisis and the impact on the consumer,” said Christopher Jones, senior portfolio manager at JPMorgan Asset Management, New York. “The cycle may go for two or three more quarters,” he said.

Mr. Jones said, “To a large extent, the issue of growth vs. value comes down to whether technology stocks are going to outperform financials.” Technology equities make up the largest percentage of the Russell 1000 growth index at 22.9%.

Mr. Jones said technology stocks offer a better opportunity because the companies produce essential products for business. He said corporations are not reducing technology spending, even with the recession. “It’s mission critical: Your network has to be up, your e-mail has to be functioning. It is the heart of many businesses,’’ he said.

Steve Foresti, managing director and head of the investment research group of Wilshire Associates Inc., Santa Monica, Calif., said what concerns him is when money managers start making investment decisions outside their area of expertise because they want to capture market trends. It’s a “red flag’’ that the money manager is likely making a losing bet, he said.