FUNDS

Dan Wiener of The Independent Adviser for Vanguard Investors explains why he’s keeping a qualified buy rating on one of the best-performing funds of 2012.

It’s been three years since David Palmer joined Peter Higgins on Capital Value (VCVLX) in December 2009. Since then, the fund’s shareholders have been treated to a rockin’ and rollin’ performance, as the fund has generated an 8.1% annualized return through the end of 2012.

Last year’s performance was so strong—up 22.3%—that Capital Value is this year’s Hot Hands fund. So is Capital Value a strong Buy?

I’ve had the fund listed as a Buy for some time, but have also expressed my caveats about it. You might be asking, then, is the 8.1% three-year return a good return, and indicative of managers who’ve put this fund squarely back on its feet after years of underperformance? It depends.

I’d ask the question somewhat differently. By which metric should we measure Capital Value’s performance? Vanguard uses at least three different gauges when evaluating the fund and its managers. In Capital Value’s annual reports, Vanguard compares the fund’s returns to those of the Russell 3000 Value index, as well as the average “multi-cap value” fund.

But when it comes to deciding whether the managers deserve a performance bonus or should be giving back some money to shareholders, Vanguard doesn’t use a value measure at all. They compare the Wellington managers’ performance to the Dow Jones US Total Stock Market Index—a decidedly non-value-leaning measure.

Pick your poison. Either way, in the three years since December 2009, Capital Value has underperformed both the value index and the overall market.

In comparing the fund’s relative performance against the Russell 3000 Value index, as well as Total Stock Market, it’s shown some outperformance and some underperformance. But over the three years, it has lagged both, with the index fund up an annualized 11.2% and the value index up 10.9%. That should put Capital Value’s 8.1% gain into better perspective.

I have quite a lot of respect for the experience and abilities of both managers. However, it’s the strategy they pursue—chasing deeply undervalued stocks—which concerns me.

John Neff, Vanguard’s best known “star” manager until his retirement in 1995, was the dean of deep-value investing. His record is held up as one of great overall returns, but he lagged badly in the final decade of his career, though Vanguard will never admit to it.

When the economy is in a rapid phase of growth—particularly coming out of an economic malaise—and some of the hardest-hit stocks get their due, the “buying $1 worth of assets for 50 cents” value guys often post great returns. Unfortunately, it doesn’t last, and if I could tell you when to buy and when to sell Capital Value, I would.

So, while I will keep my Buy rating on the fund—due in part to its having had a strong 2012, and in part due to my belief that the managers will at times generate strong returns—I am not going to put the fund into the Model Portfolios.

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