Why Value Funds Could Lead the Markets

NEW YORK (TheStreet) -- Plenty of academic studies show that unloved value stocks have outdone high-priced growth shares over the long term. But value has struggled lately. During the past five years, the Russell 1000 Growth index has returned 4.1% annually, while the Russell 1000 Value lost 1.6%. Value also trails for the past decade.

Growth stocks have led partly because financials account for a heavy weighting in the value benchmark. During the financial crisis, banks and insurance companies were crushed, and they still sell at low multiples compared to historical levels.

This year, cyclical stocks -- such as industrials and natural resources -- have trailed and held back the Russell Value benchmark. The cyclicals, which rise and fall with the economy, do best in booms. With the growth in profits slowing lately, investors have shifted away from cyclicals and toward growth champions, such as Apple , which deliver steady profits in hard times.

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If the economy remains sluggish, as many analysts expect, then growth could continue leading this year. Still, long-term investors should consider overweighting value funds now. After trailing recently, value stocks look cheap, and odds are good that they will overtake growth in coming years. In the past, value stocks have suffered periods of underperformance, but they have always rebounded.

Some of the steadiest value funds focus on dividend-paying stocks. The dividends help to cushion results in downturns. Top choices for investors seeking large value funds include Federated Equity-Income , Nuveen Dividend Value , and Oppenheimer Equity Income .

The Oppenheimer fund has proved particularly reliable in downturns, outdoing peers by wide margins. During the past five years, the fund returned 2.8% annually, surpassing 96% of large value competitors. Aiming to deliver rich income, portfolio manager Mike Levine follows a distinctive strategy. He puts about 80% of assets in dividend-paying stocks and most of the rest of the portfolio in convertible securities. The convertibles tend to be relatively steady because they generate bond-like income. A big stake in convertibles helped to limit the fund's losses during the downturn of 2008.

Levine holds a mix of different kinds of dividend-paying stocks, including familiar blue chips and less well-known small-caps. While some holdings provide high dividend yields and little growth, other stocks in the portfolio have meager dividends that are growing rapidly. The aim is to maintain a diversified portfolio that can produce income and growth.

A high-dividend holding is AT&T , which yields 5.4%. Levine says the company's wireless business is growing, but the landline operation is shrinking. As a result, he doesn't expect the company to report much earnings growth. Still, the dividend alone should deliver decent results. "This is a steady stock that should help to reduce the volatility of the fund," Levine says.

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A growing holding is CVS Caremark , which operates a retail drug chain and a pharmacy benefit manager. The stock only yields 1.4%, but the company should grow as drug sales continue climbing relentlessly.

Nuveen Dividend Value returned 2.7% annually during the past five years, outdoing 96% of peers. The fund looks for rock-solid companies that seem likely to increase their dividends. The portfolio managers aim to find shares that have fallen out of favor.

The managers recently bought Carnival after one of the company's cruise ships sank off Italy. The shares plummeted as investors reacted to the negative headlines. "Carnival has very good cash flows, and the cash flows are improving," says David Chalupnik, Nuveen's head of equities.

Another holding is Pfizer . Because it is showing little growth, the pharmaceutical giant may look boring. But Chalupnik says the company generates huge amounts of cash. The management is unlocking value by selling off parts of the company at rich prices.

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A low-risk fund is Federated Equity-Income, which has returned 1.0% annually during the past five years, outdoing 83% of peers. The fund excelled during 2008, outdoing 93% of peers. Portfolio manager John Nichol limited losses by avoiding financials with uncertain prospects. Nichol emphasizes blue chips with growing dividends. Holding include International Business Machines and Chevron .