When the blue chips are down, seek value

It's not that easy to find value in the market these days. The third quarter was not kind to growth funds, blended funds, or value funds - all of which were losers. As a result, mutual-fund investors headed into the final three months of the year with lackluster expectations for the stock market and growing concerns about the economy.

Perhaps now is a good time to invest in value funds - funds that look for companies trading at substantial discounts. But the decision to buy may depend on your definition of value, say some money managers and financial planners.

"I don't see any risk in stocks at all right now," says Mark Keeley, a chartered financial analyst who helps manage the Keeley Small Cap Value Fund. "We don't buy things that are so cheap that nobody wants them. We're looking for undervalued situations, but these companies must have a bright future. Despite the market's volatility, these companies do exist."

The $150 million Keeley Fund takes a unique approach to the market by investing in corporate spinoffs, bankruptcy survivors, and conversions of savings and loan and insurance companies. It may sound risky, but the fund is rated four out of five stars by Morningstar and has ranked in the top 8 percent of its fund category over the past 10 years.

But at current prices, value managers are having a hard time finding bargains. That has led many value investors to put substantial amounts of their holdings into cash for the time being. "Value is value," says Brooks Cullen, the manager of the Cullen High Dividend Equity Fund. "We're trying to get the most potential for the least amount of risk. Our strategy is useful, regardless of whether we are dealing with a bull or bear market."

Over the past 75 years, almost half of the stock market's growth has come from dividends, Mr. Cullen points out. Over the past 20 years, the dividend growth of the 13 highest-yielding stocks on the Dow has increased from 4.5 percent to 16 percent.

"We buy stocks with at least a 3 percent dividend yield," says Cullen. "We got through the tech bubble because of our conservative approach. In fact, we have outperformed the S&P 500 for 40 of the past 44 months."

Thanks to low inflation and low interest rates, what qualifies as a value investment - a stock priced at a substantial discount to its true worth - has expanded. "Favorable economic conditions make the market look inexpensive from a long-term perspective," says Bill Miller, manager of the $14.5 billion Legg Mason Value Trust, which has beaten the S&P 500 index for 13 straight years. "By some measures, stocks are selling at a 20 percent to 30 percent discount to their fair value."

But according to some value-fund managers, bargains are not as commonplace as they were in the summer of 2002. Back then, Wall Street was still recovering from the deflated tech bubble and cash flow for many companies was not as strong as it is today.

The IMS Capital Value Fund, a mid-cap value fund, takes an investment approach that emphasizes not just finding companies with potential for growth, but also when to buy into a stock. "You can't time the stock market," says Carl Marker, the manager of the fund, which has $85 million in assets and has had an average annual return of 15 percent over the past five years. "But you can time the entry point as to when you buy a specific stock. We think most value managers are too early when they buy into stock. We don't mind being late to the investment party."

For Mr. Marker, the investment horizon is two to three years. He's upbeat about the market and sees upside potential in each of his major holdings - H&R Block, Lincoln Financial, AG Edwards, and Sprint. Each of these companies meets Marker's standards: well-established firms in the $2 billion to $10 billion range that he sees as undervalued. "Value comes down to a company that is close to turning a corner," he says. "We avoid sitting on 'dead money' - waiting for a stock to rebound. Ours is a very conservative approach that has performed well even in a down market."

Value, of course, is a relative term. An established market leader like General Electric could hardly be considered a company about to turn the corner. But over the past five years, GE has had an average price-to-earnings ratio of 30. (P/E ratios are a common way to value stocks.) Right now, GE is trading at 21 times earnings. In an environment where returns are not as stellar as they were a few years ago, the company has found its way into many value funds, including the $2 billion Thornburg Value Fund.

"I like value funds in any portfolio," says Joel Ticknor, a certified financial planner in Reston, Va. "It's important to have a balanced, diversified portfolio. And over time, investors are rewarded for buying value funds."