Why Shades of Value Matter

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Why Shades of Value Matter

Consider the following as a great example of why investors need to understand how their fund managers define value. Big ABC Value Fund and Big DEF Value Fund are both large-cap funds that fall into the value fund side of the fund world, but their performances over the past three years have been startlingly different. Big ABC has lost 8.6%, landing in the category’s basement, while Big DEF has gained 7.3%, making it a top category performer over the trailing time period.

Why their returns differ

What made the difference? Different definitions of value and different strategies. The manager of Big ABC and his team use fundamental research to identify both struggling companies and industries in a rough patch. He often invests in companies going through management changes, strategy shifts, or cost cuts, and pays dirt-cheap valuations. That strategy has paid off in the past, but the fund’s gutsy approach has also backfired at times. Owning—and adding to—the likes of mortgage-exposed entities during the recent market meltdown were among ABC’s worst moves.

Meanwhile, the manager of Big DEF also looks for attractive valuations and scans for historically low P/E, price/cash flow, and price/book ratios as well as companies that pay dividends. Once he finds a cheap company, though, he will only buy if it has a solid balance sheet, good competitive position, and historical earnings per share and dividend growth. Recently, the manager held a significant cash stake as he waited for bargains to appear, allowing him to beat the pack during the depths of the downturn.

Why their futures would differ

On the flip side, during market rallies, Big DEF Fund’s conservatism can cause the fund to badly lag (and often it had ended up in the category’s basement in bull markets). Big ABC, on the other hand, can roar back during speculative market rallies, as its deeply out-of-favor names bounce back hard.

So, although both funds are value vehicles, the execution is vastly different, and can lead to strikingly different performance profiles. Thus, it is important to truly understand how a fund is run and what kind of performance you may expect in different market environments.