Pzena Investment Management letter for the third quarter ended September 30, 2016.
Quarterly Report to Clients
To Our Clients:
Seth Klarman: Investors Can No Longer Rely On Mean Reversion
"For most of the last century," Seth Klarman noted in his second-quarter letter to Baupost's investors, "a reasonable approach to assessing a company's future prospects was to expect mean reversion." He went on to explain that fluctuations in business performance were largely cyclical, and investors could profit from this buying low and selling high. Also Read More
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?
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 then started widening on fear of a European crisis which continued with global quantitative easing followed by fear of an economic slowdown in China. Consequently, the relative performance generated across this value cycle was negative.
Value Cycle Interruptions
As we discussed in last quarter’s commentary, once spreads widen beyond one standard deviation, the prospective returns of a value strategy to a long-term investor are compelling. But what do we make of an interrupted value cycle? Sometimes, the next crisis unfolds before the prior one was resolved. Japan in the 1990s provides an interesting case study.
In figure 6 we can see the dramatic widening of spreads in 1996 as concerns were mounting about the Japanese banking system. By late 1997 numerous Japanese banks had failed and Japan was facing a domestic financial crisis. Meanwhile, commodities and industrials were hard hit by the Pan-Asian currency crisis. Spreads widened, and value underperformed.
Companies restructured and by early 1998 fear surrounding the Asian financial markets dissipated. Spreads began to come back in line and value outperformed sharply, but not by enough to make up for the underperformance during the dramatic downturn, and annualized relative returns through this period were -3.8%. Before the financial system could completely return to health, dot.com euphoria hit the Japanese market, sending technology valuations soaring and halting the value recovery. It took until the end of the dot.com era for value investors to earn a good return. Those who invested at the beginning of the cycle in 1996 found themselves 3.8% behind the market (annualized) in May of 1999 when spreads prematurely widened and the value cycle was interrupted. When the dot com bubble peaked in late 1999, one was 14.3% (annualized) behind. A pro-value cycle then commenced and combining the two full cycles, value produced annualized excess returns of 9.0%.
A similar phenomenon occurred in Europe when the 1994- 1998 cycle was interrupted by the dot.com era, but the two cycles together produced 6.6% of annualized excess returns. And similar to the U.S., the most recent value cycles have been disappointing because of the massive uncertainty caused by three successive crises – the Global Financial Crisis, the Euro crisis and the slowdown in emerging markets.
Time Is The Friend Of Value
In environments with wide spreads like today, the historical data have been quite compelling; wide valuation spreads and the resolution of uncertainties have generally led to extended periods of value outperformance. Even when the recovery in value is interrupted, as it has been recently in the developed world, staying the course has led to excess returns. Inevitably, the circumstances behind a cycle are exhausted and businesses adjust. Today most of the world is caught up in the same cycle induced by quantitative easing. We expect that eventually this too shall pass, and value will be well positioned to outperform.
Highlighted Holding: Danske Bank A/S
Danske Bank is a case study in how a bank can succeed in a challenging environment through focusing on its core strengths, instituting a series of self-help measures and allocating capital wisely.
Danske Bank A/S is a Denmark-based bank operating primarily in the Nordic region. The company is a market leader and offers a full range of banking services including mortgage finance, insurance, pension, real-estate brokerage, asset management, and trading in fixed income, foreign exchange, and equities.
For the past several years, banks around the world have faced tough market conditions. Low interest rates, deleveraging, higher capital requirements, and increased regulatory and compliance costs have been significant headwinds to bank profitability. Investors have questioned whether these conditions are permanent, and if banks can earn adequate returns in this environment. We believe Danske is a case study in how banks can navigate a difficult environment and restore profitability.
The Danish economy was one of the first OECD countries to enter a recession in 2007 following the collapse of a local housing bubble. It then suffered a double dip recession in 2012 on the heels of the Eurozone crisis. Local interest rates sank below zero for the first time in 2013 and are now among the lowest in the world, reaching -0.75% in 2015 following quantitative easing in the Eurozone. Danske also made an ill-timed expansion into Ireland in 2005 which sowed the seeds for losses when the Irish housing market collapsed and the economy went into a severe recession. During the global financial crisis, the bank received a hybrid capital injection from the Danish government, which it has since fully repaid.
Danish banking regulation has evolved into one of the toughest in the world as Denmark had one of the highest number of bank failures in Europe during the crisis. Denmark was among the first countries to enact a bail-in for bank bondholders, taxed banks to raise rescue funds, and imposed one of the highest capital requirements in the industry. Danske now operates with more than double the Tier-1 capital than it did in 2007, a significant increase that contributes to the bank’s resilience in troubled times, but also weighs heavily on returns.
As a result, Danske’s return on equity (ROE) fell from 13% in 2007 to less than 2% in 2011. Faced with these headwinds, management implemented a range of self-help initiatives, restoring ROE to 11% in 2015 with further improvements in 2016 (Figure 1).
Danske’s Recipe For Recovery
As industry challenges unfolded, Danske leveraged its market position and comprehensive product offerings to refocus its business and restore profitability. Danske is one of the largest players in Danish banking, evidenced by its 30% share of a market where 80% is concentrated among the top five players. In addition, it offers a diverse range of products, making it less reliant on net interest income and offering the opportunity to improve fee revenue. Management took a range of actions to leverage these strengths, which included:
- Managing net interest income through better funding and product pricing
- Developing new fee revenue streams
- Tightly focusing on cost management
- Optimizing and redeploying capital effectively
As a result, total revenue at Danske was actually higher in 2015 than 2007 and costs fell by 4%. These actions drove Danske’s ROE back to double digit levels (Figure 2).
Managing Net Interest Margins
Denmark’s benchmark interest rates have been in decline since 2008. The Central Bank of Denmark reduced its main interest rate from 4.25% in 2008 to -0.05% in 2013 then to one of the lowest levels in the world at -0.75% creating significant revenue pressure for all banks. Danske addressed the revenue challenge posed by this interest rate environment through a combination of improvements on the asset side as well as on the funding side of its balance sheet.
The company reduced its funding costs by lowering interest paid on personal deposits to zero, started charging small business accounts for deposits, and passed on full interest rate declines to corporate clients. While charging interest for deposits was previously unheard of, other banks in the industry followed and Danske was able to maintain its competitive position while recapturing its interest spreads. The company also initiated a program to close unprofitable retail accounts while at the same time launching a benefit program for their most profitable customers, which in turn led to market share growth in the private banking segment. On the lending side, disciplined pricing has helped expand lending spreads and improve yields. This is a phenomenon seen in other low rate markets such as Switzerland.
As a result of these actions, Danske recouped more than 50% of its revenue decline, and kept its net interest margin flat in spite of the negative interest rate environment.
Robust Fee Generation
Danske increased its fee income by 17% from 2007 to 2015 by realigning its existing fee structure and pricing, as well as creating new fee streams. The company made its deposit account fees more transaction driven, better aligning deposit revenue with the delivery cost structure. Danske is also considering charging customers for previously free products like cash management. Danske has a strong market position in foreign exchange and capital markets in the Nordic region and has gained market share as foreign banks have exited the region in the last few years.
Vigilant Cost Cutting
Danske has significantly improved its productivity and reduced its cost structure by 4% over the last eight years while growing revenues. Management implemented a range of cost cutting initiatives through a combination of rationalizing branches, setting up a shared service center in Lithuania, merging business units with high synergies such as insurance, asset management, and private banking into one unit, and optimizing IT resources in India.
Improved Credit Quality
While Danske saw significant increases in provisions for non-performing loans during the recession, it was aggressive in cleaning up problematic loans in Denmark and Ireland. This, along with help from low interest rates, led to a healthy balance sheet with limited credit losses. In fact, Danske had provision write-backs in 2015 and is expected to have very low provisions in 2016.
Focus On Capital Deployment
Danske analyzed each of its businesses in light of the new capital requirements and market conditions, and allocated capital to high return businesses while rationalizing or exiting low return businesses. Danske reduced the size of its investment banking and exotic derivatives businesses due to increased capital requirements and exited the Baltic private banking business.
As the company restored profitability, it has managed its balance sheet prudently and returned excess capital to further enhance returns by increasing its dividend for the last two years and initiating a 9 billion Kroner buyback plan.
Applying Danske’s Recipe For Success
Without management actions, the impact of declining interest rates and increased regulation would have led to an 80% decline in profitability for Danske. However, management leveraged its market strength and its integrated business model to utilize the business levers under its control including revenue, costs and capital deployment to restore profitability and ROE (Figure 3).
We view Danske as a good example of how banks in general have a range of self-help initiatives available to improve results and increase returns. Many of our other bank holdings enjoy similar dominant market positions and diverse portfolios of strong businesses. Managements are utilizing the levers under their control and have already improved profitability, with some banks earning low double digit ROEs in spite of an unprecedented low interest rate environment. Improving results, attractive valuations (many at significant discounts to book value), and healthy effective shareholder yields underpin our view that the banks provide a compelling investment opportunity.
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