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Value investors play by their own rules

Volatile markets have forced seasoned managers to decide whether to adapt their styles or ride out the crisis

Special to The Globe and Mail

Value investing these days is a lot like firefighting. With everyone fleeing the credit market inferno, value investors are rushing in to save anything worth saving.

But as the flames spread, they're getting burned. So far this year losses for most pure value funds are well into the double digits - with most of the damage being inflicted over the past 30 days.

"People are fearful, people are uneasy, and that's a situation where a value manager should be happiest," says Rory Flynn, a Dublin-based value investor who manages about $5-billion for AGF Funds Inc.

His flagship AGF Global Value fund is down 25 per cent this year, but that isn't stopping him from shopping for bargains with low price-to-earnings ratios and high dividend yields. "There's a collection of companies that have made it through the recent market and are perceived as the strong and the solid," he says.

Mr. Flynn has been bulking up positions in the hardest-hit companies including BNP Paribas SA, Bank of America Corp., JPMorgan Chase & Co. and non-financials like pharmaceutical giant GlaxoSmithKline PLC.

Value investors invest from the bottom up - focusing on the balance sheets of specific companies before evaluating their sector, region or the broader markets and economy. Mr. Flynn says he's finding the best deals in the European financial sector. "Europe has delivered a higher level of earnings growth than the States in recent years and these sorts of economic crises don't seem to get in the way of European companies making money," he says.

JPMorgan - the bank that swallowed Bear Stearns and Washington Mutual earlier in the credit meltdown - is also the value stock of choice for Burlington, Ont.-based Pat Naccarato. His $125-million AIC Value Fund is down 22 per cent since the start of the year, but he says he's sticking to his value model. "All credit cycles are different but at the end of the day it's just another credit cycle."

His pricing strategy, termed "reversion to mean," considers the current market lows part of a broader cycle that includes equal highs. "You can value things at the peak of the mountain or the bottom of the valley. We believe the true valuation is somewhere in the middle."

He uses General Electric Co. - another favoured value stock in the AIC Value Fund - to make his point. When GE stock was $40 (U.S.) a share in 1999, it traded at 48 times earnings per share. This week GE shares were trading in the mid $20-range but earnings have not dropped in proportion, bringing the price down to a mere 12 times earnings. "It's gone through a full cycle where it was extremely overvalued and we believe today it's considerably undervalued," he says.

The value investor's credo is "buy low, sell high" but the current market bottom remains elusive. There comes a time when every seasoned value investor has to break that cardinal rule and for Mr. Naccarato it came shortly before the failure of mortgage lenders Freddie Mac and Fannie Mae. He is also taking a loss on American International Group Inc. "AIG will be a lot smaller company coming out of this cycle. It is not going to emerge as the AIG of the past."

Deep value Toronto investor Irwin Michael says he's buying into the market downturn right now but is not ready to disclose what he's buying. "People are just selling to get liquidity. They're not really looking at book values, break up, cash flows, etc."

His $1.1-billion family of ABC Funds has suffered losses similar to other value funds and he admits he's had to close some positions at a loss, but says the sun is shining on value investors. "You've got to be paying attention. You've got to be very patient, you've got to stick to your style and not get pulled in by the maelstrom of this rush to liquidity," he says.

Patience is another staple of the value investor, and it pays off most of the time. Nearly every pure value fund on the Canadian market shows positive average annual gains over 10- and 15-year periods.

However, one portfolio manager who has lost patience with value investing is Pierre Bernard, who manages about $1-billion for IA Clarington Investments Inc. in Montreal. "Since October of last year low P/E stocks have not done well, not only in Canada but everywhere in the world."

Mr. Bernard has managed to keep losses in his flagship IA Clarington Canadian Leaders Fund to less than 10 per cent this year by abandoning the P/E model for a sector approach. "The way I manage money is to find sectors or pieces of a portfolio that do not correlate well between each other," he says.

Last summer he took profits from energy stocks and reduced his weighting in the sector from 27 per cent to 5 per cent. In an effort to reduce risk he sank the cash into Canadian bank stocks (Toronto-Dominion, Bank of Nova Scotia and Royal Bank of Canada), and gold stocks (Goldcorp and Barrick). "Having gold stocks and banks together reduces a lot of the volatility in your portfolio," he says.

Many portfolio managers, like Mr. Bernard, employ value models in certain situations. Investment style isn't always listed in a fund's description so investors are advised to speak with a qualified financial adviser.

Dale Jackson is a producer

at Business News Network.

This story appeared on Globe Investor Magazine Online.

© 2007 The Globe and Mail. All rights reserved.

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