Mark L. Mallon and Charles A. Ritter
By CAROLE GOULD, The New York Times, June 1, 2003

ALTHOUGH they have lagged behind growth stocks this year, large-capitalization value stocks remain excellent long-term investments, say Mark L. Mallon and Charles A. Ritter, co-managers of the $210 million American Century Large Company Value fund.

Large-cap value funds returned 8.1 percent this year through Thursday, on average, compared with 10.1 percent for large-cap growth funds. But the value funds have held up much better during the difficult market of the last few years, losing 3.1 percent, annualized, in the three years through Thursday, versus a loss of 16.7 percent, annualized, for the growth funds, according to Morningstar Inc.

Because the pendulum had swung in value's direction for so long, the managers do not expect value stocks to outperform the market in the short term, Mr. Mallon said from their offices in Kansas City, Mo. But the long term is another story, Mr. Ritter said. "Over time, value stocks provide a more solid foundation," than growth stocks, he said.

The fund returned 3.3 percent a year, on average, for the three years through Thursday, placing among the top 5 percent of funds that buy large value stocks. That category fell 3.1 percent, annualized, versus a loss of 10.4 percent a year, on average, for the Standard & Poor's 500-stock index, Morningstar said.

The fund lost 8 percent in the last 12 months, compared with declines of 11.7 percent for its group and 9.4 percent for the index.

Those figures do not include a sales charge of 5.75 percent imposed on Feb. 3. Existing shareholders are not affected by the fee and may continue to buy shares directly from American Century. New investors may buy shares only from financial advisers, brokers and banks.

Mr. Mallon, 55, is chief investment officer and senior vice president of American Century Investment Management, the fund's adviser. Mr. Ritter, 51, is vice president of the adviser.

To pick the 80 to 90 stocks in the fund, the managers screen the biggest 1,000 United States companies, in search of bargains. Specifically, they review ratios of price to sales, price to book and price to earnings, among other valuation measures, using 12-month projections from Wall Street analysts.

About 120 to 150 companies pass those screens. The managers then evaluate the companies' businesses and look for strategic errors like poor cost controls or movement away from a core business that can be corrected.

"We want to make sure that the stock is not just statistically cheap," Mr. Ritter said. "We want companies that have solid businesses but haven't executed their business strategies well." Mr. Mallon said they look for companies that have the financial staying power, reflected in solid balance sheets, to work through their difficulties.

The managers also examine trends in debt levels. "We're more comfortable with companies that historically have carried debt than companies that recently took on debt," Mr. Ritter said.

They also analyze a company's stock price, aiming to determine when its slide may be over.

The managers recently added more shares of Occidental Petroleum, the oil company based in Los Angeles. They originally bought shares in May 2000 and have paid $27.38, on average, for the entire position; the stock is now at $33.74.

"Occidental has dramatically improved its operations over the last few years," Mr. Mallon said. "They're much more focused on balance sheet management." Shares are still cheap, he said, because the company had lacked financial discipline.

The managers are also adding shares of Best Buy, the electronics retailer. They began buying in September 2002 and have paid $23.75, on average, for the position; the stock now trades at $38.70.

Best Buy stumbled in its 2001 acquisition of Musicland and Sam Goody, Mr. Ritter said, and its shares fell from more than $50 in the spring of 2002 to less than $20 at year-end. "They found that expansion wasn't working and now they're in the process of refocusing on their main business," he said. Management is closing some Musicland stores and offered the entire unit for sale on March 31, he said.

Mr. Mallon calls Freddie Mac, the former Federal Home Loan Mortgage Corporation, "a great franchise and the facilitator of the American dream." The company provides credit guarantees for pools of residential mortgages and buys mortgages for its own portfolio. It is conservatively run, he said, and has a good balance sheet. But share prices have fallen in recent months because its new auditor, PricewaterhouseCoopers, decided to restate past earnings, to price hedging gains and losses at their current market value. "It appears that this earnings restatement actually might be positive," Mr. Mallon said, because the hedging operations appear to have been profitable.

The managers started buying shares in April 2000 at $55.90, on average. The stock now trades at $59.81. 


Questions:

  1. Assume that there are twenty different funds in a certain fund category (e.g. value funds).  If fund managers had absolutely no ability in picking stocks, what would be the likelihood of a particular fund earning the highest return of all the funds in that category over the last year?  What is the likelihood that some fund would have earned the highest return of all the funds in that category over the last year?
  2. Assuming, once more, that fund managers have no ability to pick stocks, what would be the correlation between the performance rankings for a given year and the performance rankings for a given year?
  3. Suppose a fund group with several funds in the same category has the policy of closing any of their funds that fell in the lower half of rankings of funds in that category (and returning the money to investors).  What is the likelihood that that fund would be able to make the following claim:  "All of our funds are above-average."
  4. "Because the pendulum had swung in value's direction for so long, the managers do not expect value stocks to outperform the market in the short term(.)"  What is the implicit assumption in this statement?
  5. If you knew that the last three years had been a period when stocks lost value, overall, what is the likelihood that low beta stocks would have done better during that period than high beta stocks?