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Deep-Value Funds for Patient Investor

Stan LuxenbergSpecial to TheStreet

NEW YORK (TheStreet) -- Deep-value funds struggled last year.
Among the worst performers was Third Avenue Value , which lost 20.7% and lagged 96% of peers in the world stock category, according to Morningstar. Other funds that finished in the bottom half of their categories include Oakmark International , Vanguard Windsor and Mutual Shares .
Seeing the bad results, investors are dumping deep-value funds. But that could be a mistake. For patient investors, deep-value funds can be intriguing holdings that help to diversify portfolios.
The deep-value funds buy unloved stocks that sell at big discounts. The portfolios of the deep-value funds tend to be even cheaper than the holdings of typical value funds. While the average large value fund has a P/E of 11.64, Vanguard Windsor has a multiple of 9.96.
While deep-value stocks can deliver strong long-terms returns, they tend to take investors on rough rides, sinking hard during downturns and soaring in bull markets. During the past year, deep-value stocks were poor performers as investors fled shaky financials and fled to the safety of rock-solid blue chips.
When markets sank in 2008, deep-value funds were crushed. Many shareholders sold near the bottom, but that was a bad decision because the funds soared in 2009 when the markets rallied. "The deep-value stocks were hammered, but they bounced back because most of the companies survived the financial crisis and did better than investors expected," says Russel Kinnel, Morningstar's director of mutual fund research.
One of the funds that suffered big losses was Vanguard Windsor. Hurt by troubled financial holdings, the fund lost 41.1% in 2008 and lagged 81% of its peers. With investors fleeing the fund, total assets dropped from $14.7 billion in 2006 to $6.6 billion in 2008. Then in 2009, the fund gained 34.7%, outdoing the S&P 500 by 8 percentage points and topping 91% of its large value peers.
To take advantage of deep-value funds, investors must be prepared to hold a fund for years. While many investors buy when the funds are hot, the best time to try a deep-value fund is after it has recorded a cold streak. Now that many of the funds have delivered weak 12-month returns, this year could be a time to try the deep-value approach.
Despite recent setbacks, some of the top deep-value funds boast strong long-term records. Over the past 15 years, Third Avenue Value returned 6.8% annually, outdoing 70% of peers. Third Avenue takes only companies with strong balance sheets and good growth prospects. In recent years, the fund has placed a big bet on Hong Kong property companies. The stocks were slammed last year when the Chinese government began limiting bank lending and trying to cool red-hot property markets.
Third Avenue portfolio manager Ian Lapey argues that his holdings still represent attractive bargains. The companies have little debt and rich profit margins, he says. Leasing income has been growing at double-digit annual rates. At current levels, the share prices sell for big discounts to the value of assets, he says.
A favorite stock is Cheung Kong Holdings (CHEUY.PK), which develops property in Hong Kong and China. Lapey says that the company has been shrewd about buying and selling real estate. Last year, Cheung Kong sold commercial real estate in China at big profits. The company has fat profit margins on its property development, and the leasing income has been growing at an annual rate of 12%.
One of the steadier deep-value funds is Mutual Shares. The portfolio managers limit risk by buying solid companies selling at very low prices. In addition, the fund typically keeps 10% to 20% of assets in cash and bonds. That provides some cushioning during periods when deep-value stocks collapse.
Among the fund's unloved holdings are tobacco stocks, including Altria , the producer of Marlboro cigarettes, and British American Tobacco , which makes the Lucky Strike and Kool brands. While U.S. cigarette sales are declining, the tobacco companies can deliver steady earnings by raising prices and cutting costs. The companies generates rich cash flows and pay healthy dividends. Another holding is UnitedHealth Group , an insurer. The stock suffered when investors worried about the impact of President Obama's reform legislation on health spending. But the company has been reporting growing revenues.