Where Have All the Value Stocks Gone?

The great stock market fire sale of 2009 is over. The broad Standard & Poor's 500-stock index has jumped 58% since March, and it's common to find stocks that have doubled or tripled in price since those panicky days.

If they had the courage to buy when everyone else was selling, value investors have done well. But now what?

Those committed to the value style of investing—made famous by value guru Benjamin Graham and Berkshire Hathaway's (BRKA) Warren Buffett—are scrambling to find stocks that could still be called cheap.

It's not easy. "It's harder now to find things that meet our valuation parameters," says Mark Travis, chief executive of Intrepid Capital Management.

A Different Market "There are not as many bargains as there were in the past," says John Buckingham, chief investment officer at Al Frank Asset Management. In March, you could have thrown darts at stock listings and found firms that were trading at deep discounts, he says.

Value equity managers try to buy and sell stocks based on intrinsic measures, such as earnings or cash flow, that they believe reflect what a company is really worth. They're likely to ignore temporary buy-or-sell signals, like economic trends or market fads, and make long-term bets that can take years to pay off.

"If you buy companies that are selling for less than they're worth, we think over time you get rewarded for that," says Brett Hawkins, a portfolio manager at Thompson, Siegel & Walmsley.

The surprise of the last seven months is how quickly value managers' once-unfashionable investments have paid off. Buckingham, for example, bought shares of car dealership firm Lithia Motors (LAD). Though the auto industry has struggled, Lithia shares now trade at five times their price in April. Value managers found lucrative bargains in similarly unpopular industries, such as banking and insurance.

Unpopular Sectors Some of the most successful value investors this year have been those who were flexible about where they found undervalued stocks. In normal times, technology stocks, the favorites of growth managers, are seen as too expensive by value managers. But many value investors snapped them up in early 2009 when tech stocks plunged along with the rest of the market.

Mutual fund managers with this approach did very well, says Anthony Natale, who follows value managers for Morgan Stanley Smith Barney.

(Not all value managers have excelled, however. Those who focus on dividends have struggled, Natale says, as many firms slashed their dividend payouts.)

Now that the easy money has been made, it's tougher for value managers to find underpriced gems. "There aren't a lot of opportunities that are screaming buys right now," says Ryan Leggio, a fund analyst at Morningstar (MORN).

Post-Rally Blues After the rally, value investors are getting worried that their portfolio holdings no longer look like value plays. Dave Stepherson, a portfolio manager at Hardesty Capital Management, worries that might be the case for the technology stocks he owns. "Those stocks have done very well, and valuations are a little on the high side," Stepherson says.

But look elsewhere, value investors say, and there are still deals out there. The last seven months have rewarded low-quality companies that at one point looked endangered by the recession. However, many higher-quality names have languished.

"We're finding value in things that have not performed well because they're supersafe," Buckingham says. He is buying pharmaceutical companies and utilities, or a discount retailer such as Wal-Mart (WMT), which has seen its stock barely budge in the last seven months.

"The market has not paid for quality," Hawkins says. "It has really missed higher-quality [firms, generating] sustainable cash flow. We still think there is an opportunity to buy quality at a reasonable price."

Charlie Smith, chief investment officer at Fort Pitt Capital Group, owns AT&T (T) and Verizon (VZ), telecom firms that have lagged the broader market by a mile despite solid results. Even amid recession, "these are businesses that continue to grow," Smith says.

Bargains Remain The stock market may look expensive compared with March, says Hardesty's Stepherson, but many stocks still look cheap compared with fundamental measures. "Even after the big moves, they're still trading at near-historic lows on valuation," he says. He owns Comcast (CMCSA), saying it is cheap relative to its cash flow, and also Target (TGT), arguing its price-to-sales ratio is ridiculously low.

Despite the runup in stock prices, value managers haven't made big shifts in their portfolio holdings, Natale says. Many managers seem to expect 2010 corporate results to soon provide justification for stocks' recent rally. Stocks still aren't pricing in the "normal rate of earnings growth" one would expect after a recession, Smith says.

These days, one of the biggest challenges for value managers is their reliance on fundamental measures such as earnings. These are uncertain times. After two years of financial crisis and recession, calculating a company's future earnings power has gotten very difficult.

Adding to value investors' heartburn is a volatile market driven more by investors' moods or broad economic trends than by individual company results.

Value investors like to think they possess patience and a long-term perspective. They might wish to add strong nerves to that list.

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