Michael Mackenzie & Ajay Makan

The demise of ?risk-on, risk-off? style trading across markets is welcome news to the battered ranks of stockpickers. Buying cheaply priced or ?value? stocks has been a fruitless endeavour since 2008 as the financial crisis and eurozone debt problems have overpowered any sustained focus on company fundamentals, the tenet of stock investing.

Now, doing your homework and buying undervalued or cheap stocks is finally paying off as equity volatility has dropped sharply against the backdrop of better US data and big liquidity efforts by the European Central Bank.

The risk, stockpickers acknowledge, is that the return of ?risk-on, risk-off? could be around the corner. Just as the ECB?s offer of long-term loans has been a balm for markets so far this year, a messy Greek default or another macro event could yet trigger a sell-off.

But for now, the turnound in value is eye-catching and comes after notable value investors such as Bill Miller of Legg Mason threw in the towel last year. So far this year, the S&P Value index has rallied 7.8%, ahead of the S&P 500?s rise of 6.9% and the 6.2% gain for the S&P Growth index.

For investors in the Fairholme Fund, managed by Bruce Berkowitz, a leading value proponent, 2012 has already delivered a gain of 16.4%, after its performance was crushed 32.4% last year. However, many investors missed the rebound: Fairholme?s assets under management of $7.4bn are less than half what they were a year ago.

The game changer has been the 24% drop in equity volatility as measured by the CBOE?s Vix, which currently trades below a reading of 20, indicative of low stress levels.

?Now, at least for the moment, we seem to have a capital market that actually cares about fundamentals rather than the monotonous cadence of ?risk-on, risk-off?,? says Nicholas Colas, chief market strategist at ConvergEx Group. Jim Paulsen, chief investment strategist at Wells Capital Management, says: ?Stockpicking is coming back.?

Given the significant underperformance of value stocks in recent years, the stage may be set for a strong run should macro risk from China to Europe remain contained.

The return of stockpicking and lower volatility has been accompanied by a sharp decline in trading volumes of exchange traded funds, which fell to a four-year low in January. Declining use of what are essentially indexing products comes as no surprise with stockpicking back in favour.

In turn, actively managed funds are leaving passive index funds behind so far this year. According to Birinyi Associates, the 50 largest actively-managed domestic equity funds have beaten the S&P 500 by 1.24 percentage points in the year to date, which equates to an excess return of $12bn.

Leading the value charge have been financials, where fears of being exposed to contagion from a meltdown among eurozone banks, crushed the sector last year.

Now the S&P financials sector has recovered sharply, up 12.7% in 2012, and moreover, its price-to-book ratio is back above 1, or equal to the value of the sector?s stated assets. The ratio is up from under 0.9 at the start of the year and, historically, such a low price to book ratio has attracted value investors who patiently bide their time waiting for vindication.

Phil Orlando, who manages a portfolio for Federated Investors, added to an existing position in JPMorgan, and purchased shares in Wells Fargo at the start of January. Those two stocks have rallied 14.8% and 10% respectively this year, matching the sector, but lagging Bank of America?s 43% year to date return by a distance.

Yet it is still hard to find a value manager who has made the plunge into BofA stock, despite an enticing market capitalisation, which is just 40% of its book value. Concerns about financial regulation remain high for the sector. ?Stockpicking is not simply about attractive valuations,? says Mr Orlando. ?We?re intentionally sticking to higher quality names – it may give less upside, but it allows us to sleep at night.?

Blue-chip stocks that also pay solid dividends are highly attractive in a world where the US 10-year Treasury yield remains below 2%, evidence that the bond market and the Federal Reserve remain cognisant that macro risk events still loom this year.

In this environment, Oliver Pursche, a portfolio manager at Gary Goldberg Financial Services, prefers to focus on balance sheet strength, and is enticed by the estimated $2tn in cash sitting on the balance sheet of US non-financials.

Mr Pursche initiated a position in Microsoft, a company with $50bn in cash or short-term investments, in early December. Microsoft increased its dividend by 20% and supported its share price with $2bn of share repurchases in the second half of 2011, and its shares have rallied 18.2% to $30.24, since December.

Value investors are also starting to spread their wings. Highly cyclical material stocks, which have climbed 16.6% this year, but are among the most vulnerable to a global slowdown, are beginning to attract attention, despite weaker balance sheets.

Mr Pursche has been building a position in Cliffs Natural Resources, a coal miner, heavily exposed to China. Cliffs has rallied 20% this year to $74.99 after slumping more than 30% in the second half of 2011 as fears over China slowing sharply have abated lately.

?Our strategy is generally to buy globally diversified blue-chips that yield high dividends, and our clients are comfortable with that, but some stocks have been beaten down so much, the valuations are compelling,? Mr Pursche says.

Valuations meant precious little in 2011, but, after January?s impressive run, stockpickers are hoping they continue to be a strong guide to performance in 2012.?If this trend continues, it is unalloyed good news for active managers, provided, of course, they get their calls correct,? says Mr Colas.

? The Financial Times Limited 2012