Does value investing make sense for retiree portfolios? Warren Buffett, at 83 years old and with a net worth of about $60 billion, doesn’t seem to worry about time horizon when buying stocks — the true value of which might not be realized for many, many years.
But what about average, nonbillionaire retirees and retirement savers? Should they consider buying so-called value stocks for their retirement portfolios, especially when their time horizons might seemingly be short and they run the risk of not witnessing their investment flower?
Well, as with all things related to money, much of it depends on your household’s personal circumstances. There’s never a one-size fits all answer.
“Ultimately a retiree’s allocation to stocks will depend on a financial plan that takes into account time horizon, risk tolerance, and investment objectives,” said David Zuckerman, a principal and chief investment officer with Zuckerman Capital Management. “Some risk-averse retirees with extremely well-funded retirement plans may not need any exposure to stocks. For these investors, returns from fixed-income securities may provide adequate returns to fund retirement.”
Still, experts say there are plenty of reasons to invest in value stocks.
Invest for a long retirement
Anyone who has a short time horizon shouldn’t be playing too heavily in the stock market regardless of whether they are pursuing a value or a growth strategy, according to Stephen Horan, managing director and co-leader of education at CFA Institute, and co-author of a forthcoming McGraw Hill book, Strategic Value Investing.
Bob Johnson, a faculty member of the Heider College of Business at Creighton University and co-author of Strategic Value Investing, agrees that those with a very short-term time horizon shouldn’t have much exposure to the stock market.
But Johnson also said that retirees often make a big mistake in believing they have a very short time horizon, when in fact, they have a much longer one. “For example, a 65-year old male has a life expectancy of about 15 more years,” he said. “Longevity risk — that is, outliving your assets — is a tremendous risk that is unwittingly assumed by many retirees.”
Others agree. “The vast majority of retirees need exposure to stocks in order to achieve the returns necessary to fund retirement,” said Zuckerman.
Or put another way: Don’t avoid value stocks just because you think your time horizon might be short. If you consider your life expectancy and the odds that you might live to a very advanced age your time horizon in retirement might be 30 or more years.
Consider using the Living to 100 Life Expectancy Calculator to estimate how old you will live to be and how many years of retirement you’ll need to fund.
Tilting the balance in your favor
To be sure, there is one inherent problem with value stocks: It may take some time for their value to be realized in the market, said Christopher Cordaro, the owner and chief investment officer of Regent Atlantic. “That’s why a retiree would want to diversify and buy many stocks because we can never judge with any accuracy when the catalyst will occur to make the value realized.”
Lane Steinberger, a partner and chief investment officer with Redwood Wealth Management, agrees that the possibility the value premium associated with this or that value stock will never be realized over the course of your retirement. So, he recommends mitigating that risk by using what he calls a value tilt.
“I only tilt the portfolio toward value, so I will never be fully invested in value stocks,” Steinberger said. What’s more, Steinberger diversifies the U.S. value tilt by investing in international small-value funds. “Thus, in general, when value is outperforming in the U.S., it does not outperform in international stocks,” he said. “In fact, the international small-cap premium tends to be negatively correlated to the U.S. value premium.”
Going against the crowd
It’s not easy investing in stocks that might seem out of favor, as is often the case with value stocks. But doing so is far better than buying high and selling low, a strategy used far too often by average investors.
“It is very difficult to be a value investor in a momentum world,” said Johnson. “Investors are always looking to identify the next big thing.”
And typically that means, Johnson said, shifting into specific stocks or sectors that have recently shown strong performance. “The problem is that too often investors make that switch late in the cycle — buying companies that have recently run up in value — while they should be identifying stocks that the market has not yet recognized,” Johnson said. “This behavioral bias makes it difficult for investors to practice value investing.”
According to Johnson and Horan’s research, stocks — including individual stocks and sectors — show mean reversion. “That is, outperforming stocks or sectors, those that have achieved returns higher than the mean, will underperform over future long-term periods and those stocks and sectors that have underperformed in the recent past will outperform over future long-term periods.”
Investors, said Johnson, typically focus on those stocks that have recently done well, then overpay for them, and end up being disappointed in their returns. “This behavioral bias is why many the typical individual investor underperforms market indexes and averages,” said Johnson. “Retirees should be drawn to value investing, as it typically involves selecting companies with higher than normal dividend yields and lower than average price/earnings (P/E) ratios.”
Horan is of the same opinion. “Retirees certainly tend to have a higher need for dividend income, which tends to correlate at least loosely with value investing,” said Horan. “So, that is a dimension on which things align nicely.”
For his part, Cordaro favors value stocks over growth, or, better said, cheap stocks relative to expensive. “When I boil it all down there is really only one thing a savvy investor can do and that is identify what’s cheap vs. what’s expensive and then take that bet over and over again.”
For the record, U.S. large value stocks, as of June 30, were the best performers among 12 different global asset classes surveyed GersteinFisher, a SEC-registered investment adviser. And if that trend continues until the end of 2013, GersteinFisher reports that it would be the first year in a decade that U.S. large value led the pack — and the first year that it even placed in the top three. Read Is it Time to Abandon a Global Stock Portfolio?
Value stocks also offer downside protection, according to Zuckerman. “Even though value stocks may take time to realize fair value, every stock portfolio should have an allocation to value stocks,” he said.” Value stocks tend to limit downside risk better than growth stocks. Many sophisticated value investors focus on ‘margins of safety’ by only buying companies that are trading for significantly less than fair value. Retirees seeking to limit risk in their equity portfolios can consider focusing on deep value stocks that typically employ larger margins of safety.”
Value is in the eye of the beholder
One note of warning about value stocks. One person’s definition of what constitutes a value stock might not be another’s. “It is true that buying assets at a discount from intrinsic value is the classic definition of value investing,” said Christopher Pavese, chief investment officer of Broyhill Asset Management and BMC Fund. “But we hesitate to classify individual securities as ‘value stocks’ or ‘growth stocks.’ We exploit opportunities wherever they occur and remain indifferent to the type of investment so long as it is available at the right price.”
Easy to mimic great value investors
Another reason to consider value stocks, according to Johnson, is this: “The great thing about investing is there is no such thing as plagiarism or the necessity to have an original investment idea. Investors can mimic the trading activities of very successful investors,” he said. “For instance, a quick perusal of Warren Buffett’s Berkshire Hathaway BRK.A +0.51% BRK.B +0.42% portfolio provides a couple of value investing ideas.”
Johnson said there are three stocks owned by Berkshire Hathaway that he believes are particularly appropriate for retirees, as they sell at a discount to the broader market and have a decent dividend yield which will provide retirees with some income.
One is Buffett’s largest holding, Wells Fargo WFC +0.43% , a stock that is selling at less than 11 times forward earnings and has a dividend yield of 2.70%. Another Buffett stock is Exxon Mobil XOM +1.19% , a company selling at under 12 times forward earnings and also has a dividend yield of 2.70%. A third Buffett company is International Business Machines IBM -0.64% , which again sells at around 12 times forward earnings and has a dividend yield of 2.15%. Over the long haul, investors who mimic Buffett have been quite pleased with the results.
Cordaro, meanwhile, said the most interesting value stocks these days are technology stocks. Apple AAPL +0.18% , Intel INTC +0.66% and Microsoft MSFT -0.48% are all selling at valuations we would have never imagined in the late 90s, he said.
Quality with a catalyst
As for Pavese, he noted while the gap between price and value may widen or narrow over time, investors can reduce risk by owning securities with a catalyst which serves to compress the time horizon in which returns are realized.
“The bottom line is that poor performance at some of America’s largest corporations has driven a number of restless shareholders to rock the boat,” he said. “Several factors are driving this trend: excess liquidity, growing cash hoards, and increasingly receptive institutional investors.”
In his view, recent targets of these restless shareholders have included some of America’s best-known brands. “On their own, many of these businesses represent compelling long-term investments at current prices,” Pavese said. “Empirical data demonstrate that low-risk stocks have substantially outperformed their high-risk peers measured by any yardstick over time. Despite the obvious benefits of this approach, not many have the willpower to stay true to the concept.”
But buying “quality with a catalyst” introduces a bit of excitement into portfolios, while leveraging the structural competitive advantages inherent in these elite businesses, said Pavese.
He said the firm’s largest representative “quality-with-a-catalyst” holdings include Microsoft, given the departure of Steve Balmer and the addition of ValueAct to its board of directors; Apple being prodded along by the likes of Carl Icahn; Vodafone VOD -0.55% , given the recent agreement to sell its 45% interest in Verizon Wireless; Pfizer PFE -0.29% , which is evolving into three distinct business segments with the opportunity to unlock even greater shareholder value; and Procter & Gamble PG -1.96% under the “new, old” leadership of A.G. Lafley who is very motivated to right the ship with a meaningful amount of his net worth still invested in P&G stock.
Pavese said other deeply undervalued businesses with increasing catalysts may be uncovered in the specialty retail sector where strong brands such as Abercrombie & Fitch ANF -1.82% , American Eagle Outfitters AEO -1.40% , and Aéropostale ARO -2.59% have come under increasing pressure to restructure in private hands.
Value-oriented funds are safer
Other advisers, meanwhile, favor value-oriented funds over individual issues.
“Individual value stocks can still equate to a risky equity allocation if they’re not held as part of a well-diversified stock portfolio,” said Zuckerman. “Retirees looking to add exposure to value stocks could consider taking a position in a well-diversified mutual fund.”
One of his favorites, for instance, is Oakmark Global Select OAKWX -0.80% . “The fund’s managers are accomplished value investors that focus on buying companies with margins of safety,” Zuckerman.
And Steinberger, for instance, said he uses only value funds from Dimensional Fund Advisors, a firm co-founded by Gene Fama, the American economist and Nobel laureate in economics who wrote the seminal paper on value premium.
Steinberger noted, for instance, that Dimensional Fund Advisors has profitability funds which are basically growth funds that favor the most profitable companies relative to their book value. “Thus, growth funds tend to be negatively correlated to value funds which means the profitability premium tends to be negatively correlated to the value premium,” he said. “What I have found is that even in periods where the value premium is not realized they will at least perform as well as a core index fund. I do not believe a stock picker will ever consistently beat their funds.”
According to Morningstar, four of DFA’s top performing funds over the past five years, on a relative basis, were DFA Tax-Managed US Marketwide Value DTMMX -1.34% , DFA Tax-Managed US Marketwide Value II DFMVX -1.34% , DFA US Large Cap Value II DFCVX -1.36% , and DFA US Large Cap Value III DFUVX -1.35% .
Also, for the record, DFA’s top holdings overall were Chevron Corp. CVX -0.79% , General Electric Co. GE +0.23%, AT&T Inc. T +0.28% , Bank of America Corp. BAC +0.46% , and Citigroup, Inc. C +0.59% , according to a Dec. 3 Morningstar report. By the way, you can only purchase DFA funds from an adviser or through employer-sponsored retirement plans.