Hunting Value Stocks After the Long Rally

Should value investors await some market retrenchment or are good stock picks still plentiful? The debate is on as second-quarter results loom

By David Bogoslaw

With the Standard & Poor's index of 500 stocks up nearly 35% from its Mar. 9 low of 676.53, this can be a confusing time for value investors. The economic signals are mixed, with tentative signs of life in the housing market offset by weak readings on manufacturing. Despite the buzz about the "green shoots" of recovery, a double-dip recession remains possible. Amid worries about growth, there's also a raging debate about whether deflation will take hold—or inflation will begin to boil.

Moreover, the signals that value investors watch most carefully—equity valuations, chiefly measured by price-to-earnings ratios—are erratic and changing constantly.

David Kelly, chief market strategist at J.P. Morgan Funds (JPM), describes the period we're in as the lull between two equity rallies, the Armageddon-has-been-averted rally having finished and the rebound-is-for-real rally not yet begun. With stock prices pulling back over the past few days, "it's not really clear where we stand," says Lawrence Creatura, a manager of $300 million in value funds and separately managed client accounts at Federated Clover Investment Advisors. "We'll know a lot more in two weeks when [second-quarter] earnings start to come home."

The enormous bounce in stock prices over the past three months tends to frighten investors who focus on quarterly results and worry about overpaying for a company that may be punished for turning in disappointing earnings within the next 3 to 12 months. Value managers, on the other hand, have minimal turnover in their portfolios; if they are confident that a stock that may be reporting earnings at or near their lowest levels of the current downturn will be able to increase earnings to near peak levels over the next five years, they may be willing to pay a little more for that opportunity, says Mike Breen, a mutual fund analyst at Morningstar (MORN).

a protracted runup sows doubts

It's currently more difficult to use a mutual fund's overall p-e ratio as an easy check on whether it meets an investor's value criteria, he says. Now they have to dig in a little deeper to size up individual stocks in the portfolio. "The [fund] with the lowest p-e doesn't necessarily have the most upside. You have to look at the prospects of growth of the stocks they own. Maybe they have slow growers," says Breen.

The Federated Clover Funds invest with a time horizon of 18 months to 3 years, selling stocks after sentiment has stabilized and earnings have recovered, says Creatura. He says he's been harvesting more expensive stocks recently and his firm has stepped up the pace of selling slightly in the past month or so. But many of his funds' holdings are still cheap despite the rally, he adds.

"It's psychological. When you see such a protracted runup, there's some people who think this has moved too quickly. They feel [stocks] might pull back and [they] might be able to establish a new position at a better price," says Greg Estes, who manages the Intrepid All Cap Fund (ICMCX), which has $8 million in assets, plus separately managed accounts worth roughly $67 million.

He says he hasn't added any new positions since the end of March, but instead of completely exiting old positions that have benefited from the rally, he's been trimming them back.

This market demands a strong stomach

"It's much harder to invest in a huge bull run like the one we had through [late] 2007 than the kind of volatile market we have now. You can pick and choose your spots carefully," he says. "If you assume volatility and prices are bouncing around, if you know what a business is worth and when you want to buy it and sell it, you can make the volatility work for you."

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