Pzena Q2 Commentary is out it is titled: A Protracted Value Cycle
The history of deep value investing is one of long cycles which last on average approximately ten years. The initial periods are defined by underperformance versus the broad market, followed by even longer periods where deep value wins, resulting in meaningful deep value outperformance over the complete cycle. This margin has averaged 390 basis points per annum in the U.S. (Figure 1).
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This cycle, however, has tested the patience of even the most committed value investor. Now six years and three months since the peak of the last value cycle in February 2007, deep value has yet to match the performance of the market. Using U.S. data for illustration, deep value has returned 3.0% per annum cycle-to-date, versus 4.6% for the S&P 500. By this time in all four previous cycles, deep value had made up all the underperformance of the cycle’s early phase, and was outperforming the broad market cumulatively. This leads to the inevitable question: Is it different this time?
What’s Different This Cycle
We would point to four major factors that have contributed to the prolonged nature of the current cycle:
• severity of the early part of the cycle (March 2007 – November 2008);
• permanent impairments suffered by value stocks during that period, particularly in financials;
• interruptions of the recovery in 2011 and 2012 by Europe’s financial and sovereign debt crisis; and
This cycle’s early days were defined by a severe financial crisis, with a wholesale sell-off of equities, and particularly deep stress in the cheapest quintile of stocks which was dominated by financials. Although the S&P 500 fell 33.4% over the 21 month period, deep value stocks declined by a shocking 56.3%. These losses included not only panic selling, but also reflected permanent capital impairments, mainly in the financial sector, due to bankruptcies and massively dilutive capital raises. Though the cycle hit bottom in November of 2008, it wasn’t until the Fed stress tests of early 2009 when a tenuous confidence was restored to the markets, and the value recovery began.