This from Money Morning:

Value funds have long been viewed as conservative investments. So why are they down an average of 42% during the past 12 months, and what’s wrong with them?

No question, such numbers are scary, especially for large-cap value fund investors who have experienced that 42% drop. And the fact that some of the biggest names in value investing have taken such big beatings has to be especially disconcerting for investors who already have had their confidence badly shaken and their portfolios eviscerated.

Bill Miller’s once-vaunted Legg Mason Value Trust fund (LMVTX) has dropped 62%. Meanwhile, Marty Whitman’s Third Avenue Value Fund (TAVFX) is down 50%. Even the Dodge & Cox Stock Fund (DODGX) fund has tumbled 49% year to date.

For many investors who viewed value funds as comparatively “safe,” low-risk investments, this has to feel like a betrayal. And that’s understandable, given that history has repeatedly shown the value discipline to be one of the strongest, most stable investment strategies available for navigating a bear market.

What’s different this time?

Some managers – like Legg Mason’s Miller, as well as the Dodge & Cox team, for example – simply underestimated the depth and severity of the challenges facing their investments. Adding insult to injury, they concentrated their investments in a relatively small number of core holdings they thought they “knew.” During good times, this concentration strategy can dramatically boost returns when stellar companies that had been trading at deep discounts subsequently rebound. But now, when times are tough, as is readily apparent, stockpiling money in one or two holdings like Lehman Bros. Holdings Inc. (OTC: LEHMQ) or Freddie Mac (FRE) can be devastating.

Others, like Whitman – a gentleman who is often regarded as the “Dean of Value Investing” – simply don’t sell all that often, preferring to ride out market gyrations, which they view as a mere nuisance. So their performance is likely to suffer in line with the markets. But that’s not necessarily a bad thing. In fact, Whitman, who is notorious for looking beyond what the public markets do, doesn’t care that prices have fallen so low. He believes that undervalued companies will be taken over, liquidated or refinanced which, as he pointed out in an interview with Brian Zen last year, is “where you make your money.”

While such strategies put value players on the losing side of the investment ledger for now, it will be a different ballgame when the markets turn, as they eventually will.

In fact, when we emerge from the other side of the current financial crisis – which we will, and probably sooner than everybody realizes – the deep-value choices available today will be some of the highest-performing investments for decades to come.

And for all the right reasons: Many of the underlying companies are still expecting solid business growth, diversified revenue streams and a clear path to higher earnings.
That means that one of the smartest moves a savvy investor can make today is to stick with the value-investing discipline. The historical record suggests that the best choices continue to be those companies with low or no debt, a high proportion of international revenue, and a history of solid dividend growth that pays us cold, hard cash for the ownership risks we take.

That is why there is nothing “wrong” with making value investing a key component of your investment strategy. Especially now.

As for the notion that “value” investing is broken, we don’t buy into that. Studies show that investing styles come and go. For instance, indexing might hold sway for awhile, until it gives way to a total-return strategy. Then the momentum players hold the majority. And so on.

What’s important to understand, however, is that styles don’t work all the time; they work over time, which is why it is more important than ever to maintain a laser-like focus when the going gets tough. The following five guidelines can help you keep that focus.

Five Keys To Consider Right Now

• Be Patient: Investors have fled the markets in droves lately. According to TrimTabs Investment Research, mutual fund investors have pulled $175 billion out of stock funds so far this year, with $56 billion of that capital exodus taking place in October alone. This is the first year that equity flows have been negative since 2002, which reaffirms something we frequently point out: Investors tend to rush in at market tops and out at market bottoms. And that suggests that we may be approaching a bottom – even if it’s not immediately apparent.

• Rebalance: Tough markets can really skew your financial perspective. And your portfolio balance. “Rebalancing” can help you get back on track to higher returns, as we’ve mentioned in the past. Not only does rebalancing force you to take profits, but it also encourages you to put more money to work in areas that have been hit the hardest (and which are also poised for the biggest-potential rebounds, studies show).

• Look For Consistency: As redemption requests mount and conditions deteriorate, some value funds are shifting managerial styles in an attempt to make up lost ground. Not only does this suggest that these funds never had a strategy to start with, but it also suggests a lack of discipline, which is exactly what we don’t want right now. Studies show that value funds, in particular, tend to rebound more sharply than other investment choices because they’re often chocked full of quality stocks trading at deep – but temporary — discounts.

• Make Sure Value Really Is Valuable: “Value” has many different meanings, so it’s important to make sure you understand what the term means when it comes to picking a suitable investment. For some managers, value means companies that are simply trading at steep discounts to other stocks. For others, it means a concentration on those stocks trading in predetermined ranges, perhaps as measured by such indicators as Price/Earnings (P/E) or Price/Book (P/B) ratios.  Different definitions can lead to vastly different types of stocks.

• When Buying On The Cheap, Understand That Near Term Outlook Often Stinks: During good times, value investing is often about buying companies that, at least in the near-term, have fallen on hard times. Now, however, pretty much everything is “cheap,” so the more important issue is identifying those companies with superior fundamentals and improving outlooks that may simply be caught in this bad-market maelstrom.

After all, Wall Street knows the price of everything. But very few people understand the value of anything.

Source: The Five Keys to Value Investing Profits

For example, the typical mutual fund turns over its entire portfolio at least once per year and owns 160 stocks. These are two things that often lead to mediocrity: Too much trading and too many stocks. (Nowadays, investors even flip the funds. Forty years ago, the average holding period was 14 years. Now, people flip funds every few years.)

All that churning fattens the brokers of the funds. And the funds often have unseemly arrangements to direct commissions to brokers who help market the funds. Owning all those stocks also means the fund managers often know little about what they own.

No individual stock matters much, nor does any single issue make much of a difference, so why bother looking at any of them in detail? It is little wonder the typical mutual fund puts in such an indifferent result.

But there is much more…

I’ve written about this topic broadly before, but a new book by Louis Lowenstein (The Investor’s Dilemma) really hammers these points home — along with some new ones. This is a book that will make your blood boil. You shouldn’t buy another mutual fund until you’ve given the ideas in this book some thought. I’m going to highlight the most important ideas for you in this section, and we’ll also look at some things you should look for in a mutual fund.

To begin, the individual investor is in quite a pickle. Lacking the necessary time, interest or aptitude for investing in stocks, he or she often looks, naturally, to professionals. Usually, this means tucking some money into a mutual fund.

But where to begin? The number of mutual funds out there grows like kudzu. There were 300 in 1980. There are over 4,800 today. Fidelity alone has over 300 funds, in 24 different flavors. You’ve no doubt seen the absurd slicing and dicing of mutual funds — mid-cap growth, small-cap value, large-cap blend, etc., etc. These are pointless distinctions. An investor should go where the value is — no matter where it is or what it’s called.

These mutual funds are huge forces in the market these days. They own one out of every four shares of stock out there. It was only 8% as recently as 1990.

The reason there are so many — and why they are so large — is because running money is extremely profitable. A lot of brainpower goes into figuring out how to get your money in a fund.

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As becomes clear by reading Lowenstein’s book that most fund companies have little interest in how well investors actually do in their funds. Instead, mutual fund companies are most interested in growing the amount of assets they manage. This is how they get paid.

Lowenstein runs through the example of T. Rowe Price, which is generally held as one of the better fund houses. T. Rowe earns a net profit of 28% after taxes.

“It’s difficult to think of many legal businesses with comparable returns,” Lowenstein writes.

Now it becomes clear why Fidelity has over 300 funds. “Fidelity is a marketing construct,” Lowenstein writes, “not something fashioned to enhance the welfare of investors.” Lowenstein also points out that mutual fund groups spend more on marketing than they do running the funds.

Best Place to Be — Managing Funds, Not Investing in Them

So it’s not hard to understand why the management companies make all the money. Instead of investing in T. Rowe funds, you’d have done better investing in T. Rowe itself. Paul Samuelson, the famed economist, had a pithy quote on this: “There was only one place to make money in the mutual fund business, as there is only one place for a temperate man to be in a saloon: behind the bar and not in front of it.”

This is something the insiders understand well. Lowenstein goes through many examples. Brian Rogers, chief investment officer of T. Rowe, is one. Has only $1 million in T. Rowe’s funds. By contrast, he has $65 million in the management company. Again, he is not alone, nor is this at all atypical. Lowenstein has many more examples.

In the old days, there was no management company. The mutual fund was a true trust. The first open-end mutual fund to arrive on the scene opened its doors in Boston in 1924. A securities salesman named Edward Leffler hatched the idea, which Lowenstein calls “a uniquely American contribution to finance.” The Massachusetts Investors Trust (MIT) was the first of its kind anywhere in the world.

MIT held stocks for a long time, bought stock intelligently and had extremely low costs. There was no management company and no incentive to bilk shareholders. Today, investors accept 1% management fees as reasonable, even if assessed on billions of dollars of assets. This despite the fact that cost of managing money does not rise anywhere near proportionally with the funds invested. Fees should go down as funds get larger, although this almost never happens.

Over many years, the old MIT standard died out. The new way of doing things meant setting up a separate management company. Now fees suddenly skyrocketed.

In any case, the mutual fund industry is a mess today, filled with people just looking to keep pace with some benchmark. Are real estate stocks too high? Doesn’t matter if you’re running a real estate fund. You buy real estate stocks. All you gotta do is beat your benchmark. Even if it goes down 25% and you go down 20% — that’s success in today’s world.

It’s a sorry state of affairs. One fund describes in its shareholder letter a “fundamental…bottoms-up investment process” in a year when the fund turned over 305%. Again, this is not an outlier or hard-to-find example.

All this flipping means the old art of security analysis is dying. Few look through filings anymore. Nowadays, there is too much focus on what the price is doing. There is not enough on how the underlying business is doing. And there is this fetish about liquidity — the ability to buy and sell easily. Suffice it to say that if selling stock were more akin to the process of selling a house, investors would pay more attention to the details of what they were buying. I always think of Peter Lynch’s great quote:

“Investing without research is like playing stud poker and never looking at the cards.”

Too many funds invest without looking at the cards. But again, why bother when you own hundreds of stocks?

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Tips for Finding Good Funds

There are exceptions, though. There are some good mutual funds. Here are some helpful points to help you find them:

• Look for a small portfolio. The exact number is hard to say. Robert Rodriguez, a great fund manager, says 30-40. Joel Greenblatt says 32 stocks take out 96% of the risk of owning one. There is no right number, I imagine, just as there is no “right” amount of tequila in a margarita, but it probably lies somewhere in that range.
  
• Look at the turnover rate. You can find this info with the performance data. A low turnover rate would be something like 25% or less. That implies a holding period of four years.
  
• The fund should not be too large. The American Funds’ Growth Fund of America has $190 billion — way too large to meaningfully invest in anything but the biggest companies. “The damage that size does to performance is the dirty little secret of the fund management business,” says Jeremy Grantham. As a rule of thumb, I’d say less than $20 billion. Rodriguez capped his fund when it approached $2 billion. Again, the right number is hard to say, but it’s somewhere in that range.
  
• The intangibles are also important. Good fund managers often write good letters to shareholders, explaining their philosophy, talking about successes and failures. If you see boiler plate-type language, that’s not a good sign. Again, managers matter.

“True safety lies in a research-driven search for opportunities,” Lowenstein concludes. I couldn’t agree more. He points out how money management is often a “soulless business” in which people “don’t really enjoy the challenge of searching here and there, far and wide, for the values that have escaped the crowd.”

There are exceptions. “However, there are a few who not only take the challenge, but find a sense of self in doing the best they can for clients.”

The vast majority of my money is in stocks. I currently own only two mutual funds: the Fairholme Fund (MUTF:FAIRX), run by Bruce Berkowitz, and the Third Avenue Value Fund (MUTF:TAVFX), run by Marty Whitman. There are other good ones — Lowenstein talks about some in his book, and I have a list in my book Invest Like a Dealmaker. Some to consider in addition to Fairholme and Third Avenue are CGM Focus (MUTF:CGMFX), Longleaf (MUTF:LLPFX), First Eagle and FPA.

Otherwise, better to put together your own mutual fund, using resources like you’ll find here to help your decision-making.

Sincerely,
Chris Mayer

Source: Don’t Buy Another Mutual Fund, Until You Read This

Marty is a saint in most investing circles… for good reason. His Third Avenue Value Fund (TAVFX) has averaged 14.4% per year for the past 18 years. Not many folks can come close to that kind of sustained investment return for five years, let alone 18.

Problem is, Marty’s fund has been taken behind the woodshed this year. It has a lot of exposure to China and financial shares. Both are disaster areas… and they’ve helped send the fund down about 30% since November.

As you can see from today’s chart, it’s tough out there… even for a saint. In one of the perversions of investing, right now is likely the best time to hire a manager like Marty. This is when most investors will start searching for the “hot fund of 2008″ and abandon an old winner.

Our take? Marty has piled into Asian stocks and real estate lately. His Third Avenue team is among the best in the business at finding great bargains. When Asia gets back into an uptrend, you’ll be a lot better off with Marty than “Mr. Hot Fund.”

Source:  Even the Saintly Investors are Going Through Hell