Richard Pzena is bullish on technology and financial sectors below is an excerpt from the firm’s Q2 shareholder letter on that topic.
Though the lag of deep value over such an extended period can be discouraging, there is cause for optimism. As investors chased safety and stability in the wake of the U.S. and European financial crises, they left behind solid business franchises with strong balance sheets and high free cash flow that are sensitive to macroeconomic activity.
To demonstrate this dichotomy, we analyzed earnings yields across a number of sectors as an indicator of valuation opportunity (Figure 3).
Although the earnings yield for the S&P 500 overall appears close to its average, there is a significant skew in the data, with “safe” sectors like utilities and REITS trading at yields well below history while financial and technology shares offer significant premiums. Despite recent strong returns, the financials sector remains deeply depressed, in the 93rd percentile of historical valuations (Figure 2).
The technology sector embodies both the promise and threat of a shift to tablet and cloud computing, creating opportunities for investors who are able to identify strong business franchises with the scale to harvest mature technologies and the resources to reinvest for the future. Twelve-month relative trailing price-to-earnings ratios are at the lowest point in 35 years (Figure 4), however, providing the disciplined investor an extraordinary opportunity to buy world-class franchises at considerable discounts. Many of these businesses are generating significant amounts of free cash flow and have solid balance sheets.
onsider Microsoft. The company currently has a 9.5% free cash flow yield despite being the largest software company in
the world with a pristine balance sheet, generating $3.27 per share in free cash flow. Though the company faces challenges, investors overlook the company’s undeniable strength in its enterprise software franchise which contributes 70% of earnings, and its responsiveness and determination to protect its consumer franchise. Even assuming low growth, we see the valuation as compellingly cheap.