Value mutual funds seek out stocks that the fund management considers undervalued by the marketplace – good bargains at current prices. Typically, this involves using fundamental analysis to examine the firm’s sales, its earnings, and the value of the
Value mutual funds seek out stocks that the fund management considers undervalued by the marketplace – good bargains at current prices. Typically, this involves using fundamental analysis to examine the firm’s sales, its earnings, and the value of the company’s assets, for example, and then comparing these figures to the current stock price. In general, value mutual funds tend to be comprised of large-cap stocks.
Here are just a few of the characteristics of value stocks that fund managers seek out:
- Low price-to-earnings ratio (P/E ratio). This ratio compares the price of the stock to the company’s earnings per share.
- Low price-to-book ratio. This figure compares the current stock price to the book value, or how much the company would be worth per share if all assets were sold in their entirety.
- Low price-to-sales ratio. This is the comparison between stock price and revenue per share and is measured against other firms in the same industry.
- High dividend yield. This is the annual dividend divided by the stock price and is measured against the company’s peers.
- Future earnings potential that other investors have (thus far) failed to recognize. Fund managers will quantify this opportunity in various ways.
Value-minded investing is based on the assumption that the stock market is not 100% rational at any given moment, so stocks may be overvalued or undervalued at any time. Value investors believe that the market will tend toward rational behavior over the long term and stock prices will tend to approach what they are really (hopefully) worth.
This means managers of value mutual funds are essentially bargain hunters, who try to take advantage of undervalued stocks that may trend higher toward their true worth as any irrationality is shaken out of the marketplace. Regardless of your sentiment, the market has the ability to move in an adverse direction. Owning a value fund can result in losses if the mutual fund declines in value. The steeper the decline, the greater the loss will be.
Because value mutual funds are usually made up of many different stocks, your investment, in essence, is instantly diversified. In general, price movement for a value mutual fund may be less volatile than an individual stock or the average growth fund. But be careful—diversification doesn’t mean safety. Don’t buy a value mutual fund during uncertain times and naively expect safe haven from the next financial storm. Diversification doesn’t guarantee a profit or ensure against a loss.
Value mutual funds usually take a longer-term view than the average growth fund. As a result, this strategy may have the upshot of lower ongoing fund expenses because the holdings are less actively managed. Across the spectrum for mutual funds, value funds will tend to fall in between index funds and growth funds for both the frequency of trades, known as “turnover”, and for the resulting costs.
Some investors choose mutual funds as a long-term, lower-maintenance trade than choosing individual stocks. If you don’t have the time or inclination for researching value stocks, then buying a value mutual fund may be a strategy to consider. In that case it may be worth paying the higher fees associated with actively managed mutual funds in exchange for the fund manager’s expertise. Keep in mind however, higher fees are not an indicator of better performance. Don’t expect the stocks in your value fund to make a dramatic turnaround once you become a proud shareholder. It’s possible these companies will remain out of favor with investors for some time.
Bottom line: Don’t put your money in a mutual fund, go to a faraway island and forget about it. You need to be as vigilant as you can and keep an eye on your investments.
There are two common methods for investing in mutual funds. Lump-sum investing is when you plunk down a boat-load of cash all at once, or over a short period of time, such as a few weeks. At the other end of the spectrum, some investors choose to employ dollar-cost averaging. This approach entails investing a fixed amount of money according to a pre-set schedule over many years, such as monthly or quarterly, irrespective of how the mutual fund is performing. You can think of it as tiptoeing into the fund, as opposed to shooting off all your bullets at once.
In general, lump-sum investing is well suited for investors who feel they can time their investments well, buying in when the mutual fund is low in price. If correct, the lump-sum investment is likely to outperform similar investments made with a dollar-cost averaging strategy. If instead the lump-sum investment is ill-timed and coincides with a peak followed by a decline, the investment will likely underperform. Ideally speaking, lump-sum investors like their investments to increase at the beginning of the time horizon, and remain at least relatively stable towards the end of the investing period.
Dollar-cost averaging is preferred among investors who choose to invest periodically with smaller amounts. That way, you avoid buying in all at once when the mutual fund is at an anomalous peak, but you’ll also miss investing a lump-sum at the lows. If it declines, you continue buying in. Because you buy more shares as the market declines and fewer shares as the market rises, you lower your average cost per share. Dollar-cost averaging fares better than lump-sum investing if the investment increases in value more towards the end of the investor’s time horizon.
Although we all want the value of our investments to increase over time, lump-sum investors have more of an edge if their timing is well-chosen. However, many investors may not have adequate capital resources for lump-sum investing and prefer to invest over time using dollar-cost averaging.
Please note: If you use a value mutual fund in a market timing strategy, this may involve frequent trading, higher transaction costs, and the possibility of increased capital gains that will generally be taxable to you as ordinary income. Market timing is an inexact science and a complex investment strategy.
Investing in value mutual funds tends to be a longer-term play (one year or preferably more). The goal here is relatively consistent growth over time rather than spectacular short-term gains. Remember to check which fees for different share classes will apply given your time horizon.
When to Get In
Having time on your side is advantageous when investing, so in general, getting in sooner than later is preferable. However, there are some timing considerations for your initial investment. If you are using dollar-cost averaging, you would adhere to your periodic investment schedule.
The challenge of value investing is deciphering between companies that are truly undervalued from stock prices that are low for good reason. It’s best to have some sense that the stocks in the value fund are poised for a recovery, not just beaten up by the markets. If instead the fund owns stocks that are going nowhere fast, or worse, it may be wise to examine other value funds with holdings in different areas of the economy.
When to Get Out
When you buy a value mutual fund, it’s usually a long-term investment. Typically, if you’ve reached your goals, if your investing strategy has fundamentally changed, or if you need the money for some long-term objective, you start to exit your position, either in phases, or all at once.
Ideally, you would like to get out when the value fund is doing well, before you really need the cash for its intended purpose. That way you can pick your spot and try to sell during high times. Take into account this may be contrary to the overall market if your value fund is invested in defensive stocks. If you wait until the last second and you have mounting expenses you need to meet (such as when a child goes to college, you want to buy a home, or you’re about to retire) you could find yourself stuck in the midst of a recession, be forced to sell anyway, and be left with much less than estimated when you first initiated the investment.
Since timing the market is an inexact science and is easier said than done, it may be wise to lighten up your holdings in value mutual funds over time as you get closer to the end of your time horizon. Dollar-cost averaging to exit is one method you could employ to do this. In other words, withdrawing a predetermined amount on a pre-set schedule as the date for completion of a financial goal approaches. Another method is based on asset allocation and is discussed in our series on bonds.
Bear in mind that you need to have realistic objectives. You shouldn’t expect your money to double over the course of a few months. You are also very unlikely to hit the high point of a rally. By trying to milk a trade for every last percentage point, time and again investors have given back too much of their gains. Don’t be one of them.
If your investment is a loser from the start, you have two options: hold tight and weather the storm, or stick to a predefined rule of acceptable losses and head for the exits. Although transaction costs are often minimal when compared to the total investment amount, they are not negligible. So be sure you understand how fees are incurred if you exit after a relatively short holding period. But don’t let them sway you to stay with a non-performing investment that is no longer in your comfort zone.
Because you have a professional fund manager managing your trades, this is a relatively low-maintenance play. You buy in through either a lump-sum or periodic investments, after reading the fund’s prospectus.
Since this is an actively managed fund, there are likely to be modifications in how the fund is managed over time. So review a current prospectus periodically to be aware of any noteworthy changes.
Any time you make an investment, you are obviously expecting the results to be outstanding. But as you know, that will not always be the case. Even the most carefully chosen mutual fund can go south in a hurry, resulting in losses.
It’s also a good idea to keep an eye on your fund’s performance relative to its peers. Of course past performance is not an indication of future results, but if your fund is underperforming, you may want to consider switching to one that’s been better managed on a historical basis.
If you are scaling in or scaling out of this strategy with dollar-cost averaging, you need to be sure to stick to your investment schedule over the life of the investment. Deviate from your schedule only if there is a significant shift in your personal investment plan or financial picture.
Since some stocks can go up while others go down, a value mutual fund’s price movement will tend to be less volatile than the average stock. Because many of the holdings held by value mutual funds have depressed prices, these stocks tend to lose less when the average bear market roars through. These investments also tend to be more stable than your average growth fund during a market downturn. On the flip side, you shouldn’t view value funds as a safe haven. Be sure you are comfortable with the level of risk associated with this investment when running this strategy. Don’t assume that a value mutual fund is low risk just because it may have lesser volatility than another type of investment.
TradeKing Margin Requirements
After the trade is paid for, no additional margin is required. You cannot trade mutual funds on margin.
There are several ways your mutual fund investment can impact your tax liability. Read How Taxes Affect Mutual Funds and consult your tax advisor for the low-down on this important topic.