Value investors have finally emerged from one of the longest periods of disfavour since Benjamin Graham - the man who established the principles of value investing in the 1930s - wore short pants. It wasn't the first time that skeptics wondered if value investing made any sense, but it was certainly the most vocal questioning ever of the numbers value investors use to measure the valuation of an individual stock.

"In my 30 years of experience in the industry, this is the longest period that I can remember that value's been out of favour," says Bob Tattersall, president of Howson Tattersall Investment Counsel Limited in Toronto and portfolio manager of the Saxon Small Cap fund.

Not only were the quacks and fringe players touting a new economic reality, but even more authoritative voices wondered if we hadn't entered the investment equivalent of the Age of Aquarius, in which conventional measures of market performance were replaced by the musings of analytical space cadets pondering their lava lamps.

"Value investing has almost everything going for it," said Institutional Investor Magazine in March 1999. "Except for one tiny detail. It's not working."

That much was obvious, as value investors watched on the sidelines while tech stocks and dot-coms skyrocketed into the financial ozone. But the venerable publication went even further: not only was value investing not working, but perhaps the fundamentals of the market had changed as well. "Growth advocates cite new economic paradigms," the magazine said. These paradigms included the wider ownership of stocks by individuals and the transformational power of technology and the Internet.

In the year leading up to March 2000, value was underperforming by 40 per cent against the TSE 300. "I'd never underperformed the market by that amount," says Kim Shannon, chief investment officer and senior vice-president of Merrill Lynch Investment Managers Canada Inc. "To be that far behind the market using a conservative value approach, I never thought it possible."

By mid-2000, the Nasdaq in the United States was trading at 311 times earnings. "That means," says Shannon, "it would take 311 years of current earnings to pay for itself. The normal price-to-earnings ratio is in the mid teens. But anyone who cautioned against investing in such a market was silenced because it went on for so long. They lost credibility, and the cheerleaders captured the floor."

Some of the cheerleaders distinguished the new economy from the old economy. Old-economy stocks, they said, performed according to conventional assumptions, moving predictably in modest increments, like grey-haired men in suits and sensible shoes. If the price of an old-economy stock seemed out of proportion to its earnings, for example, then it wasn't good value. New-economy stocks, it seemed, performed according to some weird alchemy understood only by techno-savvy teenagers sitting in front of a computer screen that displayed the sun rising over the western horizon. "We were in an Alice in Wonderland environment," says Irwin Michael, portfolio manager of ABC Funds in Toronto. "People were hallucinating. People thought they'd made a killing. And they got greedier and greedier."

These market wizards believed that the relationship between a stock's price and the earnings of the underlying company had lost all meaning, and their enthusiasm was infectious. "The Internet offers the possibility that the good times can run a long while," said Forbes magazine in February 2000. "If good times prevail, the gulf between old- and new-economy valuations will not converge." Before the year was over, however, the valuations did converge. And they've continued to converge throughout 2001, although investors in tech stocks might use a stronger word to describe the sudden collapse in value of an entire sector. Meanwhile, beleaguered value investors can finally heave a sigh of relief. At long last, their warnings about overvalued tech stocks have been vindicated. Gradually and grudgingly, even the firmest believers in new paradigms and old and new economies have regained their senses.

In Canada, the monster that ate the investment equivalent of Cleveland was Nortel. Nortel's stock dominated the marketplace and distorted the benchmarks that investors use to measure the performance of their portfolios. "I don't think there's ever been a market like this in modern times, when one stock dominated for so long and value was out of synch for so long," says Michael.

At one time, Nortel accounted for 35 per cent of the TSE 300. That meant that even conservative investors who sought a safe haven in an index fund were at risk. They might have thought they were diversifying their risk over 300 stocks. But, in fact, they were putting 35 per cent of their money into Nortel, which was trading at more than 100 times earnings.

Likewise, the performance of value-oriented investment funds was measured by a benchmark that included Nortel. Unless they bought the stock, they couldn't possibly hope to keep up. "The benchmark is in flux all the time," says George Klar, vice-president of Beutel, Goodman & Company Ltd. in Toronto. "So in the short run, you can find yourself under enormous pressure." Unfortunately, the short run extended over two years and so did the pressure on value managers to modify their style.

As Nortel's stock ascended into the stratosphere, investors wondered why value managers didn't hop aboard the Nortel balloon. After all, it seemed that everyone, from the taxi driver to the hairdresser, had bought Nortel at $25 a share and had tripled their money in three months. If they could do it, why couldn't these big-brained fund managers with their CFAs and their MBAs, their textbooks and their fancy ratios?

"I felt the pressure," says Shannon. "After all, we're all human beings. It was a mania, but no one knew when the pain would end. If we don't have clients, we don't have a job. But if we changed our style, it would be like grabbing a falling knife. You sell yourself as a value manager; clients expect you to stay a value manager."