Pzena Investment Management letter for the third quarter ended September 30, 2016.
Quarterly Report to Clients
To Our Clients:
Equity markets staged a powerful post-Brexit rally and, in a dramatic reversal of course, economically sensitive sectors led the way, with stable-earners and bond proxies losing ground. This started to reverse a long run that pushed valuation spreads to extremes not seen since the internet bubble of the late 1990’s. Our portfolios outperformed their benchmarks across all geographies in this environment.
Is this the long-awaited turn in the value cycle?
[drizzle]It is hard to pinpoint turns in the cycle except in hindsight, but history suggests that we have many of the ingredients that have preceded previous pro-value periods. Our Commentary below extends the research we presented last quarter on valuation spreads and examines the relationship between spreads and the value cycle. We focus on how investor expectations and uncertainties cause valuations to bifurcate, much like we’ve experienced over the last two-plus years, which creates substantial opportunities for value investors. Out-of-favor companies then restructure, uncertainties that caused the widening of spreads abate, spreads narrow, and value outperforms. During the internet bubble, euphoria over tech, media, and telecom stocks and an uncertain prognosis for “old economy” companies led to the widening of spreads to unprecedented levels. Of course, that ultimately corrected in spectacular fashion as old economy companies adapted and prospered, leading to a long period of value outperformance.
Uncertainties driving the recent cycle have been primarily centered on falling interest rates (lower-for-longer), pushing financials and other economically sensitive stocks to deep undervaluation, while propelling the valuation of stable earners and bond proxies. As in previous cycles, managements are restructuring and adapting, with tangible results. Spreads remain wide, and all that remains is for conditions that gave rise to the uncertainty – expectations of falling interest rates – to stabilize. Once that happens, we believe value will be well-positioned to outperform.
Danske Bank, our Highlighted Holding on page 6, is a good illustration of how companies, particularly banks, are adapting. Management has leveraged the company’s core strengths and utilized the levers under its control to restore profitability and returns in spite of a negative interest rate environment. Danske is no exception – we see similar progress in many of our holdings, as we discuss in our Global Research Review.
Although the drivers and timing vary across the globe, there is a common theme: value outperforms over the long term, even in cases when cycles are interrupted. The pro-value portion of the cycle typically lasts almost three times longer than when value underperforms, and has generated average annual outperformance of 4.0%. Maintaining a strict valuation-based investment discipline has historically led to substantial rewards for the patient investor.
We thank you for your continued support, and look forward to your thoughts.
Pzena Investment Management
Pzena Investment Management Commentary
Wide valuation spreads and the resolution of uncertainties have generally preceded extended periods of value outperformance.
Examining Value Cycles
Value cycles tend to be driven by investor expectations and uncertainties which cause valuations to bifurcate into two distinct groups: one that reflects a favorable outlook embraced by conventional wisdom (e.g., dot com stocks in the late 1990’s) and one that is at odds (e.g., the “old economy” companies during the same period). Valuation spreads widen, creating a substantial opportunity for value investors. Companies that are out of favor then restructure or reposition themselves to adapt and succeed. When the uncertainties around the out of favor abate, value outperforms and spreads narrow.
Today, the obvious issue in markets is “lower for longer” with regard to interest rates, which has created wide valuation spreads. Valuations of companies favored by the “lower for longer” school of thought (e.g., bond proxies such as REITs and dividend paying stocks) benefitted as interest rates continued to fall, whereas those viewed as facing an uncertain future in this environment (e.g., banks) have been written off as perpetual underperformers, much like the “old economy” stocks in the late 1990’s. Once again, however, these companies are restructuring and adapting (see our Highlighted Holding, Danske Bank, on page 6). All that remains is for conditions which gave rise to the uncertainty – expectations of falling interest rates – to stabilize. Once that happens, we should be poised for the next pro-value cycle to begin.
In the past, wide spreads have generally led to periods of value outperformance. This article presents the historical evidence of this relationship in developed markets.1
Defining the Cycles
To define value cycles, we compare the performance of an equally weighted portfolio of the cheapest quintile of price-to-book stocks to the performance of the market cap weighted universe. Because of the varying length of cycles and the non-linear path of the market, there is a subjective element to defining a cycle. For the purpose of our analysis, we define turning points in value cycles as occurring when 1) the relative performance is at a peak or trough and 2) the relative performance since the last peak or trough is +/- 1500 basis points. We then define a full value cycle as consisting first of a period when the cheapest quintile underperforms, followed by a period of outperformance.
Value Outperformance Over the Cycles
Figures 1-3 present the value cycles for the U.S., Europe, and Japan. As we examine value cycles across regions several patterns emerge. First and foremost is that over long periods, value outperformed the broad market. Of the nineteen cycles in developed markets, value outperformed across 14 out of 19 cycles and the average annualized outperformance is 4.0%. Second is the variability in the length of the cycles, with some as short as a few years and on the other extreme the ‘super’ value cycle from 1995 through 2007 in the U.S. which lasted 11.5 years. The period of value underperformance is typically shorter than the period of outperformance, with the period of outperformance almost three times as long on average. We also note that value has worked across a range of various economic and market conditions.
Value Cycles and Valuation Spreads
If we overlay the periods of outperformance onto the regional valuation spread charts we presented last quarter, the relationship between extreme valuations and the subsequent normalization becomes clear. Figures 4-6 on page 20 present regional valuation spreads with the shaded bars representing periods of value outperformance.
Looking at the charts, one can see that the periods of value outperformance are generally accompanied by periods of spread contraction, whereas periods of underperformance are generally marked by widening spreads. There is clearly some market behavior that causes spreads to widen and then there is some clear tendency for spreads to return back to normal. And the wider the spreads, the greater the potential relative performance for value as spreads narrow.
But every value cycle doesn’t lead to outperformance over the full cycle. During the most recent value cycle in the U.S., we saw a sharp contraction in spreads in early 2009. However, unlike previous cycles where spreads contract from approximately one standard deviation above the historical average to one standard deviation below, spreads stopped contracting prematurely in late 2009. Spreads