Look at the largest holdings of some of the most popular value funds and you might be surprised. Amazon.com, Apple, and Microsoft are the top three of the $84 billion iShares Russell 1000 Value exchange-traded fund, for instance.
The average fund in Morningstar's Large Value category now has 18% of its portfolio in tech stocks that look expensive by classic valuation metrics. For instance, Amazon has a price-to-book value ratio of 5.1. Benjamin Graham and David Dodd, the authors of the famous tome Security Analysis, believed investors should buy stocks trading below book value, an asset-based measure of a company's net worth on its balance sheet.
Few fund managers employ such a "deep value" approach today, in part because most U.S. stocks look expensive, with the S&P 500 having an average price/book value of 5.2 and the Russell 1000 Value index at 3.2, according to Morningstar Direct.
But another reason is that the value of many tech and healthcare companies isn't in hard assets like factories, but rather in intellectual property like software and drug patents. Such intangible assets aren't factored into book value.
Yet there remain a handful of value funds that score well on Graham and Dodd metrics. Some have been strong performers, such as Third Avenue Value. It has an average price/book value of 1.0 and a 19.4% five-year annualized return versus the S&P 500 index's 13.1%.
Third Avenue manager Matthew Fine doesn't screen the stock universe for companies trading below book value, but thinks attractively valued companies with tangible assets and clean balance sheets can provide the "margin of safety" of cheap companies that Graham and Dodd described.
"Very often, the downside protection comes from having tangible underlying asset value, like an aircraft fleet or an offshore [oil] drilling rig fleet," Fine says. "But if you have an enterprise software company with no tangible assets, it might earn very well until it doesn't, and there's nothing underneath it in terms of asset value protection."
Most of Fine's stocks are asset-rich. Yet unlike Graham and Dodd, he tries to assess not only what a company's assets would be worth in a distressed liquidation; he also wants to know what they could be worth when the company is thriving.
The fund has 20% invested in oil stocks like its largest holding, Tidewater, an offshore-rig company. Fine stresses that the investment isn't a bet on future oil prices, but rather on the asset value of Tidewater's rigs. He believes "offshore spending on oil and gas is too low to sustain current production." The industry suffered a cyclical downturn from 2017 through 2020 when many rigs were scrapped, and now there are too few, so Tidewater's assets are undervalued.
Two other deep-value funds are also worth considering: Moerus Worldwide and Aegis Value. Moerus has a similar style to Third Avenue, where its entire management team worked before launching their fund in 2016, although the Moerus portfolio is quite different. Morningstar categorizes it as a foreign small/mid value fund, but like Third Avenue, it's really a "go-anywhere" fund that seeks cheap stocks wherever they exist, including in the U.S.
Meanwhile, Morningstar categorizes Aegis Value as a natural-resources fund because of its large oil and miner stock weightings. But it's really a global small-cap value fund. Lately, manager Scott Barbee has been buying stocks outside of natural resources, such as mortgage insurer Radian Group in March.
"This business got hammered after 2008 [during the mortgage crisis], and has never really recovered a premium valuation multiple since then, despite the fact that they've cleaned up their [insurance] book dramatically," he says. "We bought Radian in the low 30s at seven to eight times earnings." He points out that "defaults are very low in the housing market" today. The stock, at a recent $36.60, trades at one times book value.
That, plus the low default rate, should provide him with the margin of safety that deep-value managers seek.
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