In tough market, value still possible

If you’re a value investor, you like bargains. What if you could buy a value fund at a discount? That would be like a clearance sale at Costco or 50 cents off from the dollar store. But you can now buy several value funds at a discount price, and a few of them are genuine bargains.

Value investing is a school of stock analysis based on a few fairly simple propositions. The first is that stock prices can rise and fall dramatically over time. The second is that sometimes they do so for fairly stupid reasons, giving investors a chance to buy the stocks of good companies cheaply.

For example, Apple Computer, creator of the iPod, the iPhone and the Apple computer, cost $194.84 on Jan. 2, before swooning to $119.15 by Feb. 26, a 39 percent decline. The stock now sells for about $179, or 9 percent less than its starting point this year.

Was Apple really worth 39 percent less in February than it was in January? Not likely. One could argue, with the benefit of hindsight, that Apple was a screaming bargain at that price.

The dark side to value investing is that some companies whose stocks have fallen sharply are just stinkers, or wildly overvalued in the first place.

Many value funds have been clobbered this year because mutual fund managers snapped up cheap stocks that were merely awful. Legg Mason Value Prime, for example, once outperformed the Standard & Poor’s 500-stock index every year for 15 years running, thanks to manager Bill Miller’s eye for spotting bargains. This year, though, the fund has plunged 27.6 percent – 16.3 percentage points more than the Standard & Poor’s 500-stock index has.

One problem: Miller, like many other value investors, owned a big slug of financial stocks – about 22 percent of the portfolio, according to Morningstar, the mutual fund trackers. Value investors tend to gravitate to financials because such stocks often carry low prices, relative to earnings, as well as decent dividend yields. But bank stocks have the unfortunate habit of melting down every decade or so, catching value investors flat-footed.

The fact that value funds are lagging these days should hardly consign value investing to the scrap heap of history. Investment styles, after all, move in and out of fashion. It’s hard to argue with the proposition that buying stocks cheap is a good idea. And, interestingly, investors now have a chance to buy some fairly good value funds at an additional discount. Here’s how.

A few fine value fund managers run closed-end funds, which are a peculiar breed of mutual fund. Like all funds, closed-end funds invest in a portfolio of securities. Most garden-variety funds continually issue and redeem shares as investors move in and out of the fund. But closed-end funds issue a set number of shares, just as a company does when it goes public. The fund then uses the proceeds from the sale of those shares to buy and sell securities. The closed-end fund’s shares trade on the stock exchange, just as a company’s stock does.

What makes closed-end funds so peculiar? Most times, a closed-end fund’s share price doesn’t accurately reflect the value of the securities in its portfolio. Consider Dreman-Claymore Dividend & Income fund (ticker: DCS). On Wednesday, the fund’s securities were worth $11.78 a share. But the fund sold for $10.09 a share, or a 14.35 percent discount, in closed-end parlance. Put another way, in the unlikely event that DCS were to liquidate and distribute the proceeds, shareholders would enjoy an instant gain.

The fund’s manager, David Dreman, is a noted value manager and, like Miller, Dreman has gotten his clock cleaned lately. DCS has fallen 31.3 percent this year, according to Morningstar. It’s not hard to see why. Among the fund’s top 25 holdings are Fannie Mae, down a stunning 79 percent this year, and Washington Mutual, off 68 percent.

The difference between finding a big bargain at a thrift store and one in the stock market is that the thrift store gives you instant gratification: You can lug home that cut-rate moose head right away. Stock bargains take a bit more patience - but they can be far more rewarding than a moose head.