Why Value Will Bounce Back

For much of this decade, value investors have beaten the pants off their growth counterparts. But just when you thought you'd figured out the secret of making money in the stock market, value stocks have stopped behaving the way you'd expect -- and have given investors who got used to seeing strong gains a most unpleasant surprise. As an investing strategy, is value dead?

Value's track record
After the end of the tech-led bull market of the 1990s, returns on growth stocks lagged behind value plays for years.  

 

2001

2002

2003

2004

2005

2006

Value

(6.3%)

(15.2%)

29.5%

16.1%

6.6%

22.5%

Growth

(20.8%)

(27.7%)

29.2%

6.2%

4.8%

8.9%

Source: Morningstar. Returns are for Russell 1000 Value and Growth indexes.

During 2001 and 2002, value's outperformance was easy to understand. Typically, value stocks have performed better during down markets than growth stocks, because market downturns often result from stalling economic growth that in turn forces high-growth companies to slow down the pace of expanding their businesses. That was certainly the case after the tech bubble burst, when companies like Cisco Systems (Nasdaq: CSCO  ) , Oracle (Nasdaq: ORCL  ) , and Yahoo! (Nasdaq: YHOO  ) had to come to terms with a new economic reality that ripped their stock valuations apart.

More surprising, though, is how even after stocks overall started to recover from the bear market, value kept on doing better than growth stocks. One reason may be that although the economy rebounded from its 2000-2002 slowdown, the rebound was relatively weak in comparison to previous economic recoveries. From the beginning of 2003 to the end of 2006, real GDP grew at less than a 3% annual rate. Compare that to the similar period from 1996 to 1999, when real GDP grew at more than 4.3% per year.

As a result, growth stocks never really experienced a period of solid economic growth during this cycle. Continually thrown off guard by a dicey economy, investors stuck to the value side of the market.

Why value stopped working
In hindsight, it was just a matter of time before value stocks' streak of outperformance came to an end. Banks like Wells Fargo (NYSE: WFC  ) and Bank of America (NYSE: BAC  ) benefited from unprecedented low interest rates during the final Greenspan years. Wall Street firms like Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) were able to use the leverage those low rates made possible to multiply their returns -- as long as the economy remained favorable.

Yet value's gain from the unusual economic cycle has also proved to be its downfall during the bear market. Unlike past recessions, where banks and financial institutions were able to capitalize on low rates and investor skittishness to build assets and improve margins, the epicenter of the current slowdown is squarely within the financial sector. Companies that had routinely returned capital to shareholders through dividends and stock buybacks over the years have suddenly found themselves short of cash at a critical juncture, forcing many to slash dividends.

Nothing lasts forever
From all this, you might think value investing is dead. Nothing could be further from the truth.

Looking for companies that are priced cheaply compared to their potential future value will always be on the wish list of great investors. What people have found out is that there's more to finding real value than just looking at stocks that have fallen sharply -- even a steep drop may not price in the full risk of a troubled company.

Yet as investors throw out value stocks willy-nilly -- which is likely, since many investors avoid out-of-favor investments -- some attractive stocks will get beaten down with the crowd. If you're ready, you may well score on the best opportunity in years to buy good stocks cheap.

The past two years haven't been good to value investors. But eventually, value will bounce back -- and give you the returns you've been hoping to see.

For more on value investing, read about:

To learn exactly how to position yourself for value's next move up, be our guest at the Fool's Inside Value newsletter service. For 30 days, you'll get no-holds-barred access, absolutely free. And with two stock recommendations per month, you could see value from Inside Value for years to come. 

Fool contributor Dan Caplinger will be ready when value turns around. He doesn't own shares of the companies mentioned in this article. Bank of America is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy bounces back in the wash.


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