If you’ve spent any time evaluating mutual funds, you have probably run across the concept of value investing. Mutual funds are often described as being a value fund, a growth fund, or a blend of both. Understanding what these concepts mean and applying them to your investment decisions can have a significant impact on the performance of your portfolio. So let’s take a look at what value investing is, why it matters, and some funds that invest in value oriented stocks.
Value investing traces its history back to Ben Graham and David Dodd who taught at Columbia Business School. Graham and Dodd wrote the Bible on value investing in a 1934 book called Security Analysis. Value investing at its core is simply buying a business (or stock) at a prices that is less than what the enterprise is worth.
As you might have guessed, the trick is in accurately evaluating the value of a company. In this regard, value investing is as much about controlling our emotions as it is crunching numbers. In the tech frenzy of the late 1990s into 2002, it was very difficult to ignore technology stocks. “Everybody” was investing in technology, and you felt like a fool if you missed out on these “great opportunities.” In fact, I know of only one professional money manager (although I’m sure there were more) who refused to jump into technology stocks–Warren Buffett.
By comparison, a growth stock is one that while not undervalued, many believe will continue to grow its earnings. Google is a good example of a growth stock today. Most would not conclude that the stock is undervalued, but you may view it as a good investment if you think it will continue to materially grow earnings over the next 20 years. As an aside, Warren Buffett is unlikely to invest in a company like Google because he would find it difficult to predict how it will perform over the next two decades.
How are value and growth funds categorized?
How does one go about determining whether a mutual fund is classified as a value fund, growth fund, or a blend? Well, the easy way is to look the fund up on Morningstar.com. I’ll show you some examples, but first, let’s look at how Morningstar makes the determination that a fund is value or growth.
There is no universally accepted formula, but most look at financial ratios to determine whether to classify a fund as value or growth. For example, Morningstar looks at the following ratios to calculate a value score for a fund:
- Price/Projected Earnings 50.0%
- Price/Book 12.5%
- Price/Sales 12.5%
- Price/Cash Flow 12.5%
- Dividend Yield 12.5%
As you can tell, each of the measures compare some aspect of the financials or projected financials to price. If the average P/E for the S&P 500 is say 16, value stocks typically will have a P/E lower than 16, while growth stocks with have a P/E higher than 16 (again, generally speaking).
Looking at Morningstar’s style box for Fidelity’s S&P 500 index fund (FUSEX), you can see that it is a blend fund. This makes sense as half of the stocks in the fund will be on the value side, while half will be on the growth side. The red dot represents the weighted average of the stocks in the fund, while the shaded area reflects where 75% of the stocks in the fund fall. Value/growth is measured left to right, with value funds falling to the left and growth funds falling to the right.
An example of a value fund is the Dodge and Cox Stock fund (DODGX). As you can see from the Morningstar Style Box, the fund’s weighted average is in the left style box column, indicating a modest value overweighting. I’ve owned shares of DODGX for a number of years, although I’m in the process now of evaluating whether I should move all of my investments to index funds.
Are Value Stocks/Funds Preferred Over Growth Stocks/Funds?
With a basic understanding of value investing, the big question is this–so what? Should the average investor put his or her money in basic index funds and forget all this business about value vs. growth funds? The short answer is, yes, in my opinion. Now the somewhat longer answer.
Some studies have concluded that value investments have a slightly higher risk-adjusted return than do growth investments. Perhaps one of the most cited studies comes from Roger Ibbotson, who concluded that value funds edge out growth funds. In contrast, John Bogle reaches the opposite conclusion in his book, Bogle on Mutual Fund.
Over the years I have weighted my portfolio a bit toward the value side. That’s why, for example, I own shares of Dodge & Cox Stock fund. Before that I owned shares of Legg Mason Value Trust, run by Bill Miller. However, the tilt toward value funds in my portfolio is very small (see below), and in the end probably makes little difference to the performance of my portfolio:
Note that this image comes from Morningstar. It is available as part of the Premium membership. You can also sign up for a free membership that will allow you to track your portfolio at no cost. The free membership doesn’t offer all of the investing tools and resources, but is still a great value.
With stock investing (as compared to mutual funds), value investing seems absolutely critical to me. That’s exactly the approach Warren Buffett takes, and it makes good sense. Why not look for bargains, even if they are in out-of-vogue industries, rather than paying top dollar for “popular” stocks. Of course, some are better at identifying these bargains than others (which is why I generally stick to mutual funds).
Value Oriented Mutual Funds
If you are interested in the value approach to investing, there are several mutual funds worth considering. Some of these funds are actively managed, but you can also find index funds that are value oriented. Here is a short list of funds to consider:
- Dodge & Cox Stock Fund (DODGX): I’ve owned the fund for several years and have generally been happy with its performance. It beat the S&P 500 index from 2002 to 2006, trailed the index in 2007 and 2008, and is about 5% above the index this year. The big question for me, though, is whether in the long run it makes sense to hold any actively managed funds, at least for U.S. equities.
- Fairholme (FAIRX): This fund has rocked the S&P 500 for several years running. A 5-star fund as rated by Morningstar, it is a value fund that invests primarily in large cap stocks, but also small and medium issuers, too. Minimum investment is $2,500.
- Vanguard Value Index (VIVAX): If you really want to play the value side of investing, this fund has a lot to offer. First, its expense ratio is just 0.21%, well below most actively managed funds. And second, it is heavily overweighted toward value investments (mainly large cap).
- Vanguard Selected Value (VASVX): Value funds aren’t limited to large cap U.S. stocks. You’ll find value mutual funds that invest in foreign issues, small cap, and in the case of VASVX, mid-cap U.S. stocks. The fund has down well against the S&P 500, although that may not be the best index against which to measure performance. While it offers a relatively low expense ratio of 0.38%, it does require a $25,000 minimum investment.
There are many more value funds to consider, and you can research them easily on Morningstar.com. As always, please understand that I am not recommending any of these funds. If you want professional advice, seek out the help of a credentialed investment adviser. These funds may or may not be suitable to you; heck, sometimes I wonder if the funds I own are suitable for me!