It is often said that value funds outperform in down markets. But these days, many value managers are getting clobbered, while some less value-conscious managers have been doing comparatively well.

For example, take John Arnold, Rory Flynn and their fellow value-oriented colleagues at Dublin-based AGF International Advisors Co. Ltd. They have had an absolutely miserable year with AGF Global Value Fund, as they have had with many of their other mandates.

Meanwhile, the less valuation-sensitive Jerry Javasky, senior vice president of investments with Toronto-based Mackenzie Financial Corp. and manager of Mackenzie Ivy Foreign Equity Fund, has begun to shine.

Comparing summary statistics on the holdings of the Mackenzie fund and the AGF fund reveals some interesting facts. The AGF fund has a lower average price/equity ratio (8.7 vs 11 for the Mackenzie fund); a lower price/book ratio (1.0 vs 3.9), a higher average market cap ($36.4 billion vs $23.2 billion) and a much higher average dividend yield (6% vs 2%). The AGF fund also holds more stocks (77 vs 26).

After assessing these numbers, you might expect the AGF fund to outperform the Mackenzie fund in a bear market, given that large-cap stocks trading at lower price multiples have traditionally held up better in down markets. However, the performance of these funds in recent months proves that the statistics on their own reveal little about a fund’s ability to weather a bear market.

To help explain this confounding result, let’s dig into these two funds in detail.

Arnold, CEO and managing director of AGFIA, and his team start their investment process by screening the U.S. and international markets for stocks that trade at discounts of at least 30% to the market’s P/E multiple, yield at least 30% more than the market and trade at prices that are at least 30% below their 18-month highs.

The resulting short list of stocks is then put through a more thorough analysis. Typically, the stocks the AGFIA managers buy are out of favour when the AGF fund initiates a position, which allows for getting in at depressed valuations.

“On the surface, this strategy seems conservative, but its aggressiveness lies in its execution,” says Morningstar Canada analyst Jordan Benincasa in Toronto. “Without formal industry sector limits in place, the managers are not afraid to invest heavily in areas [in which] they find value, which has typically been the financial services sector. Their emphasis on dividend-paying stocks [has] caused them to load up on financial names.”

Shortly after taking the reins in 2006 from departing manager Harris Associates LP of Chicago, AGFIA ramped up the AGF fund’s exposure to financial services stocks to 51% of assets under management from 21% of AUM by ploughing funds into banking and insurance stocks.

This approach worked well until last August’s liquidity crunch started to depress valuations of many financial services names. Based on management’s screens, many of these names only became more attractive. Specifically, many banks and insurance companies saw their share prices fall to more than 30% below their 18-month highs.

And as good value managers do, the AGFIA team began to buy more shares as valuations fell. Case in point is Royal Bank of Scotland Group. The AGF fund essentially doubled its position in January 2008 — when the stock was trading around $8 a share — and again in June of 2008 at around $4 a share. At the time of writing, RBS was trading at $1.50 a share.

It’s fair to say the AGFIA team never expected things would get so ugly for financial services companies — few people did. As of early October, the AGF fund’s returns are down by 37.6% over the past 12 months.

In fact, the AGF fund’s performance would have been worse if it hadn’t been buoyed by the falling loonie, a boon for foreign equity funds denominated in Canadian dollars.

In contrast, the Mackenzie fund, which has produced lacklustre returns over a period of several years, has been holding steady throughout the financial collapse. From January 2003 to the beginning of the financial system’s meltdown in August 2007, the Mackenzie fund had returned 27%, compared with more than 50% for both the MSCI world index in Canadian dollars and the Morningstar global equity fund index.

Since that time, the Mackenzie fund has outpaced both indices by about 15%.

@page_break@Javasky and his team at Mac-kenzie Financial pursue stable long-term growth by investing in about 20 to 25 businesses. The Mackenzie fund invests predominantly in well-known, large-cap companies from developed countries around the world, paying no attention to benchmark sector weightings. Names such as McDonald’s Corp., Nestlé SA and PepsiCo Inc. adorn the list of top holdings.

Using a bottom-up approach, the Mackenzie fund’s managers focus on the quality of the company first and valuations second. The Mackenzie team prefers to buy these companies on the cheap, but doesn’t mind paying up a little to get companies with strong brands and wide economic moats.

The Mackenzie team’s search for quality has led it to invest heavily in consumer staples and health care, two defensive industries that have held up relatively well during the latest market crash. (See page 42.) The Mackenzie fund’s largest holding — McDonald’s Corp. — has lost just 10% year-to-date; making it the second-best performing stock in the Dow Jones industrial average.

“With Javasky’s consistent aversion to heavily leveraged companies and banks with complicated structures, the [Mackenzie] fund is well positioned to absorb the financial meltdown,” says Morningstar senior fund analyst Brian O’Neill. “This kind of downside protection is nothing new. For all negative trailing 12-month periods since its October 1992 inception, the fund’s average loss has been only 5.4%. This compares favourably with the benchmark’s average loss of 13.8% over the same time frame, especially when you consider that the fund has had fewer negative periods.”

Despite Javasky’s outstanding performance in previous bear markets, many clients and advi-sors had given up on the money manager during the commodities-led bull market of 2003 to 2007.

With stock markets around the world in meltdown and a recession arguably underway, Javasky has began to surface to the top of the category again.

Comparing the approach and resulting performance of the Mackenzie and AGF funds helps us understand why history doesn’t always repeat itself, and why value funds don’t always outperform in a bear market: each bear market has its own set of issues and characteristics that define it.

If you’re looking to find a fund that will hold up in down markets, you can’t assume any value fund will serve that purpose. IE



David O’Leary is manager of fund analysis for Morningstar Canada in Toronto.