Business Matters Another look at value stocks

By Kevin FitzGerald

I’ve been looking over my investments and while they seem OK, I remember from one of your earlier articles something about value stocks. Could you refresh me a little on this?

— J.B., Bronx

The inclusion of stocks in a portfolio is essential to meeting most financial goals, since equities historically have outperformed all types of bonds and cash-equivalent securities over the long term, and their higher returns help combat inflation. Sharp price swings in stocks that can arise due to market volatility, however, can cause even some of the most disciplined investors to turn jittery and unload their portfolios. In a turbulent market environment, investors looking for the growth potential that equities provide — with a lower level of principal risk — often find value stocks appealing.

Value stocks are those that are perceived to be "bargains" or are undervalued — that is, those whose true values are not reflected in their current prices and, over time, whose prices are expected to increase faster than stocks that are fully priced. Value stocks tend to be inexpensive or "cheap" compared to what they are currently worth. The market is not willing to pay more for them because their underlying companies or industries are out of favor. The job of value investment managers is to identify companies poised for a turnaround, potentially leading to rising earnings and higher stock prices.

Before an investment manager identifies a value stock as a "buy," he or she needs to determine if a positive change has occurred in the underlying company that is yet to materialize at the stock’s current price. Positive changes include:

€ an aggressive management change or significant productivity improvements;

€ a restructuring to reduce costs, which would make the company more likely to continue profitability over the long term; and

€ financial conditions that are strong or improving.

Quality is just as important a determinant as price in value stock selection. Strong balance sheets, long-term consistent operating histories, and experienced proven management dedicated to heightening shareholder value are among the fundamental criteria value managers look for when choosing individual value stocks for their clients or selecting stocks for a value mutual fund.

Value managers generally use a "buy and hold" strategy. This means that a stock will be held until it meets its target price, and in some cases, even longer if the underlying company demonstrates the potential for continued profitability. Value managers will sell stocks that appear overvalued or have experienced deteriorating fundamentals.

Large-company value stocks typically are more attractive than small-company value stocks during times of market volatility because these stocks are from companies that are established market or industry leaders. They therefore generally withstand market setbacks better than small cap stocks and experience smaller price swings during market volatility.

Of course, like all stocks, large company value stocks are subject to market risk and will undergo fluctuations in stock prices downward (as well as upward) trends can occur over short or extended periods.

Dividends can add protection

In addition to capital appreciation, value stocks typically pay investors a steady stream of income through dividends. Dividends provide:

€ Cash return to the investor — Dividends are a major reason to invest in stocks at any point in the stock market cycle. Stocks that pay attractive dividends are appealing since they offer the potential for above-average growth of investment capital and steady income.

€ Downside protection — High dividend yields of underlying companies can serve as a "cushion" for companies’ share prices if they temporarily fall out of favor with the market. This protection plays an even more important role in volatile or declining markets.

Value stock in your plan

Value stocks are especially appealing in turbulent times because they tend to be more defensive than other equity styles. That is why many conservative investors, investors nearing retirement and first-time stock investors have found them so attractive. They allow investors to participate in the larger gains associated with stocks while helping to manage risk.

Value stocks can play a valuable role in an investor’s portfolio. Selecting those stocks appropriate for your investment plan, however, is a demanding process that requires the inclination and time to analyze companies, study the forces that influence the economy and assess the trends in the financial markets. In volatile markets, this challenge can prove even more daunting.

A professional management program can be the appropriate strategy for building an appropriate portfolio of value stocks. For more information about how you can diversify your portfolio with value stocks, and information about other defensive investment strategies that may be appropriate in a volatile market environment, please contact your financial advisor.

€

The information contained herein has been obtained from sources believed to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.

Kevin FitzGerald is first vice president-investments at Paine Webber. He focuses on the areas of professional money management, asset allocation and retirement planning. He can be reached at 1 (800) 423-3381.