The Buffett Way: Time for a Rethink?

(page 2 of 2)

com/research/stocks/snapshot/snapshot.asp?symbol=GE'>GE), a conglomerate with a troubled financial arm.

Profit Predictions Shaky

But Breen says financials are only part of the story: Even some managers who avoided financials were hurt by big losses in other sectors.

For example, a value investor, whose criteria advises buying stocks at 80% of their intrinsic value, might jump at buying a stock at only 65% of its value—only to see the stock drop to 45%, says Russell Croft, portfolio manager of the Croft Value Fund (CLVFX). "The value traps out there were really big," Croft says.

It seems to have mattered how investors identified value. With earnings estimates falling so quickly in the past year, judging a firm on its future profits got very difficult.

New Focus on Balance Sheets

Value managers say they imagine the worst, and calculate value based on that. "You try to do a worst-case scenario and see if the stock looks cheap," Croft says.

But, in the midst of a credit crisis, the state of a firm's balance sheet has become as important to its long-term value as its future earnings potential.

Greg Estes, a manager at Intrepid Capital Funds, says he looks for "a very attractive balance sheet." The best-performing managers focused on "underlying asset value" and less on earnings, Breen says.

Because of the credit crisis, companies with a lot of debt were hit hard, so value managers suffered who focused on these cheapest-of-the-cheap stocks, Breen says.

Value Is Underperforming

Value investors are insistent on a long-term focus, so it's not exactly fair to judge them on one or two years. (Even if this is a momentous time, when stocks, represented by the Standard &Poor's 500, have lost almost half their value in a year and a half.)

A value investor like Buffett has an "extremely impressive" long-term track record, says Lawrence Creatura, the portfolio manager of several value-focused investment funds at Federated Clover Investment Advisors. This appears to be one of those times when the value style has underperformed. "That doesn't mean that Warren Buffett or value investing are broken," he says.

In fact, many value managers insist the market is full of opportunities. "The selling at times has been so incredibly irrational that there is a high probability that some stocks are mispriced," Creatura says. "The value investor's job [is] to identify those mispricings."

Value Managers Going for Growth

After the plunge in stock prices, "it ought to be heaven for value managers," Layman says. The value approach isn't obsolete. Rather, "it will probably translate into better opportunities going forward."

An irony about the current environment is that many stocks previously considered "growth"—because of their fast growth and expensive valuations—are now being bought by value managers.

A former high-flier like Monsanto (MON) is down 41% from its 52-week high, and Croft has been buying shares. "We've always admired the company but could never get around the valuation of it," he says.

Tech Stocks in Value Portfolios

Breen says many value managers and growth managers are buying the exact same stocks these days—for different reasons. Tech stocks like Microsoft (MSFT), Oracle (ORCL), and even Apple (AAPL) are ending up in value portfolios, he says.

The result is that value and growth managers alike will probably benefit from a stock market rally, and both styles will suffer in a sell-off. That's another surprise from a stock market that in the past couple of years seems to be breaking all the rules.

Steverman is a reporter for BusinessWeek's Investing channel.