This Kiplinger 25 fund is managed by two separate companies with different bargain-hunting strategies. By Nellie S. Huang, Senior Associate Editor September 18, 2012 Two firms that prowl for cheap stocks run Vanguard Selected Value (symbol VASVX). Barrow, Hanley, Mewhinney & Strauss manages 75% of the fund, and Donald Smith & Co. controls the rest. Both seek high-quality, midsize companies that trade at bargain prices. SEE ALSO: The Complete List of Our Favorite No-Load Mutual Funds The unconventional setup has worked over time -- the fund’s 3.5% five-year annualized return tops the typical midsize-company value fund by an average of 1.3 percentage points per year (all returns are through September 17). Over the past 12 months, the fund’s 19.1% gain lagged other midsize value funds by all of 0.4-point, but it trailed its bogey, the Russell 2000 Value index, by 5.9 points. The story behind that? Well, there are two, of course -- one from Barrow, Hanley and one from Donald Smith. From the fund’s launch in 1996 until 2005, Barrow, Hanley, a Dallas firm, was the fund’s sole manager. But in that time, assets had ballooned to $3 billion. So, in the early 2000s, “we asked Vanguard to stop giving us money,” says Barrow, Hanley’s Mark Giambrone, who runs his firm’s 75% share of the fund’s assets with James Barrow. “We had to make sure we had the capacity to do the best for our clients.” Advertisement Vanguard agreed, and in May 2005, it hired Donald Smith & Co., a New York City investment firm, to manage all new cash flowing into the fund. Since then the two firms have run their portion of the Selected Value portfolio independently. “I’ve never met the other guy,” says Giambrone. Barrow, Hanley handles about $3 billion of the fund’s $4 billion in assets; Smith has about $1 billion. Barrow, Hanley, Mewhinney & Strauss's Strategy As it turns out, although both firms have a value bent, their approaches are different. Giambrone and Barrow like good companies with stocks that are down temporarily. As Giambrone explains, the managers play off the market’s tendency to assume that a company will continue going in whatever direction it is going forever. Says Giambrone: “If it’s a growth company, it’s going to grow forever. If the company stumbles, however, it will never get back up.” Advertisement Once the pair find a company with a catalyst that they think will improve its fortunes, they drill down to assess the stock’s value. Their definition of value hinges on three measures: price to earnings, price to book value (assets minus liabilities) and dividend yield. The strategy leads them to favor companies that boast a high return on equity (a measure of profitability), good cash flow (earnings plus depreciation and other non-cash charges), steady profit growth and a good balance sheet. Over time, those characteristics lead to stocks that outperform, says Giambrone. Then there’s the past year: The market’s thirst for yield, Giambrone says, has hurt performance in his portion of the fund. Year-to-date through July, the Barrow, Hanley portfolio was up 7.1%, which is 1.3 percentage points shy of the 8.4% gain in the Russell Mid-Cap Value index. That’s because, Giambrone says, 20% of the index is made up of REITS and 26% is utilities, and income-hungry investors have bid up prices in those sectors. However, the Barrow, Hanley portion of Selected Value has only 15% of its assets in those sectors, and that, says Giambrone, explains his firm’s underperformance. “I don’t want to cry woe,” says Giambrone, “but our job is to outperform.” One upside: The portfolio sector allocation hasn’t hurt the yield in Giambrone’s portion of the portfolio; it was 3.1% in late summer. Overall, the fund yields 2.2%. One boost to returns was a holding in Coventry Health Care, a Maryland health insurance company. The stock was already up 15% year-to-date when insurance giant Aetna announced in August that it would acquire Coventry. The offer, for $7.3 billion, represented a 20% premium over Coventry’s closing share price the day the deal was announced. Takeovers are common among midsize companies. “We have a good track record of that happening -- generally one a year, sometimes more,” says Giambrone. Lately, the folks at Barrow, Hanley have been gearing its small portfolio -- it holds 44 of Selected Value’s 66 stocks -- toward expectations of modest economic improvement. They have loaded up on stocks in economically sensitive sectors, such as industrials, financials and energy. “We’re geared to things being okay,” says Giambrone, “and valuations are low because the market doesn’t think that.” Advertisement The managers recently picked up shares of CA Technologies, a computer software and services company, which Giambrone calls a “mini-IBM” because it has a constant flow of business from a loyal base of customers. A new chief financial officer is on board to help foster growth after a raft of acquisitions. CA quadrupled its dividend earlier this year. The stock, at $27.02, now yields 3.7%, and the company has been buying back shares. The stock hasn’t moved much since the managers started buying at $25 earlier this year. But, with the healthy yield, “we’re getting paid to wait while CA executes on its acquisitions,” says Giambrone. Donald Smith & Co.'s Strategy Unlike Giambrone and Barrow, Donald Smith’s definition of value is based on a narrow slice of a single figure: price to tangible book value. To be more specific, the firm focuses on stocks with market values of $2 billion to $10 billion that sell in the bottom 10% of that measure. “That’s our hunting ground,” says Donald Smith, the firm’s founder and the co-manager of its slice of the Vanguard fund. Tangible book value is not the same as book value. It starts with assets less liabilities, but it also subtracts the intangible, harder-to-value assets, such as goodwill, leases, franchises, and export and import permits. Tangible book value is a better way to assess value than straight book value, says Smith. Companies that grow by acquisition, for instance, often write off goodwill, which is generated when companies pay a premium to buy other firms. “As they do that, companies damage their book value by taking on this goodwill,” says Smith, who shares management duties with colleague Richard Greenberg. “So we don’t count it.” Advertisement A study by market researchers Eugene Fama and Kenneth French going back 50 years buttresses Smith’s argument. The study shows that a strategy of buying stocks with price-to-tangible-book-value ratios in the bottom 10% of the market -- Fama and French cataloged all stocks trading on the New York and American stock exchanges and Nasdaq -- outpaced Standard & Poor’s 500-stock index by an average of four percentage points per year, says Smith. The Smith portfolio of Selected Value is concentrated in just 22 stocks, none of which overlap with the Barrow Hanley holdings. When Smith and Greenberg find a company they like, they devote 5% of their slice of the fund’s assets to it. The managers start selling when a holding tops 10% of assets. Miner Yamana Gold represented 9% of their slice of the fund at last report; the stock has climbed 70% since they bought it in October 2008. Over the past year, the fund has seen a big lift from electric-utility stocks. “We were buying utilities at discount to book when nobody cared about them,” says Smith. One such company, Constellation Energy Group, was acquired by Exelon Corp. for $7.9 billion. The all-stock deal, which closed in March, represented an 18% premium for Constellation shares. Lately, however, the managers have been selling their holdings in electric-utility stocks and putting money into the airline sector, which has been consolidating. “It’s a changed industry,” says Smith. “The big four own about 80% of the market, and they are starting to get pricing power.” Although rising oil prices have squeezed the industry’s profits in the past year, Smith sees prices stabilizing. When that happens, he says, airline earnings will surge. Another favorite industry these days is insurance. Stocks of reinsurance companies in particular, Smith says, sell for about 70% of tangible book value, on average. “It’s like buying a portfolio of short-term bonds at a 30% discount.” Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Subscribe now!