Value Investing Has Failed

It's been a lousy time to be invested in stocks. In the past year, the S&P 500 has had a return of negative 16.8%. Of course, that should be no surprise to anyone who follows stocks. In this sort of market, you're happy to break even.

The more interesting thing about this market is the performance of value stocks versus growth stocks. Historically, value has outperformed during recessions. But this time, value stocks have been horrible investments. Over the past year, the Russell 1000 Value Index is down 18.8%, while the corresponding growth index is only down 10.8%.

This result is so poor that it's almost unparalleled. A study by Ibbotson Associates looked at the performance of value stocks between 1969 and 2005. In that 36-year period, the worst year for value investing was in 1974, with a -21.8% return. But that year, growth did even worse, with a -32.4% return.

So why is value investing performing so poorly?

They're mortal, too
It's not just because the value indexes are picking bad stocks -- a lot of previously successful investors have experienced hard times. One of the biggest losers is Bill Miller, who boasted a 15-year winning streak against the S&P 500. In the year ended June 30, Miller's Legg Mason Value Trust lost more than 30%. He's not the only one. Over that same time period, Bill Nygren's Oakmark Select Fund was down 30%, while Marty Whitman's Third Avenue Value Fund fell behind the market, losing 18.9%.

In each of these cases, the causes vary. Miller seems to have been completely oblivious to the possibility of a housing bust. He owned Countrywide Financial, Freddie Mac (NYSE: FRE), Citigroup (NYSE: C), Pulte Homes (NYSE: PHM), Centex (NYSE: CTX), and even Bear Stearns. In fact, it's hard finding a stock that got clobbered that Miller didn't own.

In contrast, Bill Nygren was mainly hit by Washington Mutual (NYSE: WM). Back in 2004 the stock made up 16% of his fund's assets; it's still a top-10 holding. Whitman's returns have been hurt by his investment in Florida real estate company St. Joe (NYSE: JOE) as well as his bets on financial insurer Ambac (NYSE: ABK).

The problem of value
This market, in particular, is exposing some of the biggest problems in being a value investor.

Obviously, value investors can make mistakes and simply buy the wrong stock. For instance, it seems obvious that Nygren made a mistake holding onto WaMu. A huge portion of Miller's portfolio seems toxic. Some of these companies, like Countrywide and Bear Stearns, were clearly mistakes.

But another ongoing challenge for many value investors is buying too early. Often, temporary bad news will drive a company's shares down to levels that compel value investors to buy. But if bad news simply won't go away -- as we've seen during this real estate bust -- shares can continue to fall. This could be the case with Whitman's picks. Their value may only be realized when the constant bad real estate news fades into the background.

The other big factor causing some value investors to underperform these days is that many value investors focus on businesses that are cheap because they have some flaws. The most pristine, worry-free companies are rarely cheap, so they are sometimes passed over by value investors. But in times like these, when people are terrified of a financial Armageddon, investors don't want companies with warts, no matter how cheap. They want the safety of well-known, secure names. This exodus to "safer" stocks has likely hurt the returns from value stocks.

Avoid value stocks?
Thus, there are some good reasons why value is underperforming. So it probably makes sense to avoid value stocks, right?

Actually, no. Now is the very time that you should most want to own value stocks, because these stocks have become astoundingly cheap. If some of the best value investors in the world say a company is worth buying, and then the shares fall even more, it means those shares are really, really cheap. And you want to be in them when the market bounces back, because the bounce can be spectacular.

After losing 21.8% in 1974, value stocks skyrocketed. In the subsequent two years, the value index almost doubled with returns of 41.5% and 37.3%. A similar occurrence happened after the second worst year for value, 2002, when the value index lost 18.9%. In the subsequent two years, value stocks jumped by 32.6% and 14.9%.

The Foolish bottom line
Of course, nobody knows for sure when value stocks will bounce back. But it doesn't really matter if it's next month or next year. Our Inside Value team has found some stocks that we believe are incredibly undervalued, and with prices like these, we're willing to be patient. You should be, too. If you're interested in seeing our top stocks to buy now, we offer a 30-day free trial.

Fool contributor Richard Gibbons has yet to be impeached, though he has been impaired. He owns shares of Legg Mason. The Motley Fool also owns shares of Legg Mason, which is an Inside Value recommendation. The Fool disclosure policy always reapplies after swimming.