How the smart money got it wrong

By Jon Markman

The past 12 months may go down in some circles as the era when alternative energy caught a spark or the era in which the term "subprime" went prime time. But in the history of investment management, 2007 will go down as the one in which some of the brainiest, battle-tested value managers in the country got absolutely shellacked.

Smart money? Not so much. A review of the one-year results of value-focused funds with some of the best long-term records shows that a virus of total stupidity savaged their ranks as one after another bought into banks, credit card providers, home builders and retailers at bargain-basement prices that seemed too good to be true -- and were.

In a year when the Nasdaq-100 Index ($NDX) rose 18% and the S&P 500 Index ($INX) went up 3.5%, the $4 billion-in-assets John Hancock Classic Value (PZFVX) fund defied its tremendous long-term record by plunging 19.7% in 2007. (The fund was No. 1 or No. 2 in its category in the bear years of 2000, 2001 and 2002.) Long-term standout Weitz Value (WVALX) sank 13%. Even Legg Mason Value Trust (LMVTX), led by venerated manager Bill Miller, lost 12.2%.

Going into 2008, none of these funds appears to have altered its approach to value investing one iota. All continue to be heavily invested in banks and brokerages despite their multibillion-dollar losses, management chaos and extreme legal exposure -- at the onset of a recession. So the question naturally arises: Are these guys insane, or could they possibly come out ahead once the credit storm passes?

• Talk back: Would you touch financial stocks now?

My own research suggests a few of the big banks are technically bankrupt and shouldn't be approached until they trade in the single digits, if ever, as you know from my previous columns. We're barely into the start of the unwinding of a credit bubble of historic proportions that is murdering household wealth and consumer spending and is likely to send corporate earnings into a tailspin all year.

Yet I'm also cognizant that down cycles turn higher when you least expect it, so you at least have to listen to the successful value guys. Although they clearly erred by jumping into financials way too early, if the Federal Reserve wakes up and slashes interest rates by more than 1.5 percentage points -- creating instant yield-curve profits for the banks -- they might have the last laugh after all, bitter as it may be.

A Citi revival?

Earlier this week, I talked with Richard Pzena, one of the deans of the value camp. His company, Pzena Investment Management (PZN, news, msgs), which I mentioned last week as a buy on big dips, runs $25.5 billion in value money for clients worldwide, including that once-sterling John Hancock fund that's now in the tank. He was defiant, contending that he expects to double his money on such road kill as Citigroup (C, news, msgs), Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) over the next three years. I think he's dreaming, but he does manage $25.49 billion more than I do, so perhaps you should lend him an ear.

Pzena's main point is that though losses in subprime mortgages have generated the most headlines in the sector, few banks actually have much exposure to them. He sees Citigroup, for instance, as a global consumer-credit business that generates most of its money by issuing plastic overseas. The way he sees it, virtually every adult has a credit card while few have subprime loans, so what's the problem?

To be sure, Citigroup has had monumental write-downs on its mortgage portfolios and gotten stuck with illiquid structured investment vehicles on its books, and credit card defaults will lead to more losses. But before too much longer new management will have taken out the garbage, and the remainder of the company will have a chance to shine again.

"We view it as a great global franchise that's inefficiently priced," Pzena says. "We don't think the real value of the firm has come down at all, even though it's lost over $125 billion in market cap."

Pzena says he doesn't know how long he will have to wait to be right -- and if he did know, the stock wouldn't be cheap. His analyst team has torn the company's financials apart, stress-tested them to the most outrageous negative cases and sees its business getting back on track in every scenario.

"The reason it's so depressed is that no one really knows how bad it will be, but we think that sometime in 2008 there will be clarity and we'll start to see buyers come back," he says. "They might have to cut their dividend -- which would not be so terrible -- to shore up their capital base, but they're not going out of business. They will weather this storm."

The manager says his analysts have put their money where their spreadsheets are -- buying more Fannie, Freddie and Citi for their personal accounts than at any time in the past five years. "They believe they have properly analyzed these franchises and should buy even though they don't know when the turn is coming," Pzena says. "There's no dissension about this position within the firm. Buying low is a strategy that has never failed to work."

Continued: The contrarian strategy

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