Rich Pzena – There Are Many Factors Contributing To The Opportunities In Value Stocks Today

Pzena Investment Management recently released its Q2 2017 commentary saying:

Improving fundamentals coupled with wide valuation spreads make for an attractive environment for deep value stocks. Self-help measures have been an important contributor to an improved profit picture.

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The article goes on to say:

The strong value run of 2016 paused in the first half of 2017 as market leadership shifted to growth. A narrow range of tech stocks – the FAANGs in the U.S. and Alibaba and Tencent in China – lead the pack in those regions. This abrupt shift leaves one wondering whether the value cycle is over, or if the environment is conducive to a resumption of value outperformance.

Three criteria typically set up the opportunity for extended value outperformance:

  • Uncertainty, either broad-based or company-specific,which creates
  • Wide valuation spreads between companies punished forthese uncertainties and those favored by investors, then
  • A dissipation of uncertainties which leads to there-rating of value stocks.

There are many such cases of uncertainty today. Whether it be major U.S. banks that are just regaining the confidence of investors a decade after the global financial crisis, European industrials whose valuations have been punished by a painfully slow economic recovery, Japanese companies put in the penalty box for a generation of low shareholder returns, or emerging market businesses cheap for their own specific reasons, there is a long list of companies suffering from uncertainty. Valuation spreads between these companies and the much-loved growth darlings and bond proxies are still near 50-year highs (Figure 1).

Figure 1: Valuation Spreads Are Still Extreme

1Q vs 5Q Spreads by Region, expressed in Standard Deviationse

Rich Pzena

Note: Data as of June 30, 2017.

Source: Sanford C. Bernstein & Co., Pzena analysis.

Yet when we look around the world, we see reasons for optimism. U.S. banks just received their best report card since the financial crisis. European order books are filling, and profits are inflecting higher. Companies around the world have undertaken extensive self-help measures creating the opportunity for accelerated profit recovery with even modest top-line support. And green shoots are appearing in unexpected places – corporate actions are unlocking value in Korean chaebols, Chinese state owned enterprises have initiated dividends, and Japanese managements have renewed focus on corporate governance and shareholder returns. A clear-eyed view of the landscape shows a broad picture of opportunity.

A GOOD ENVIRONMENT FOR VALUE

There are many factors contributing to the opportunities in value stocks today beyond favorable valuations and improving fundamentals. Companies have demonstrated an ability to adjust their cost structures and implement self-help measures to improve current returns and set themselves up for significant incremental earnings, as top-line growth re-emerges.

There are also many idiosyncratic opportunities driven by factors outside of general economic conditions (the U.S. pharmaceutical supply chains come to mind). None of these drivers is dependent on the prospects for reduced regulation, infrastructure investments, and lower taxes in the U.S. which helped drive sentiment in late 2016, but are becoming more doubtful of late. We see government-led stimulus as additional upside but not a requirement for value stocks to resume leadership. Of course, there are still uncertainties that can derail continued recovery, but barring such extraordinary events, we believe there is ample evidence that conditions provide a favorable environment for the value investor.

You can read the complete commentary here.




About the Author

The Acquirer's Multiple
The Acquirer’s Multiple® is the valuation ratio used to find attractive takeover candidates. It examines several financial statement items that other multiples like the price-to-earnings ratio do not, including debt, preferred stock, and minority interests; and interest, tax, depreciation, amortization. The Acquirer’s Multiple® is calculated as follows: Enterprise Value / Operating Earnings* It is based on the investment strategy described in the book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, written by Tobias Carlisle, founder of acquirersmultiple.com. The Acquirer’s Multiple® differs from The Magic Formula® Earnings Yield because The Acquirer’s Multiple® uses operating earnings in place of EBIT. Operating earnings is constructed from the top of the income statement down, where EBIT is constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–earnings that a company does not expect to recur in future years–ensures that these earnings are related only to operations. Similarly, The Acquirer’s Multiple® differs from the ordinary enterprise multiple because it uses operating earnings in place of EBITDA, which is also constructed from the bottom up. Tobias Carlisle is also the Chief Investment Officer of Carbon Beach Asset Management LLC. He's best known as the author of the well regarded Deep Value website Greenbackd, the book Deep Value: Why Activists Investors and Other Contrarians Battle for Control of Losing Corporations (2014, Wiley Finance), and Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (2012, Wiley Finance). He has extensive experience in investment management, business valuation, public company corporate governance, and corporate law. Articles written for Seeking Alpha are provided by the team of analysts at acquirersmultiple.com, home of The Acquirer's Multiple Deep Value Stock Screener. All metrics use trailing twelve month or most recent quarter data. * The screener uses the CRSP/Compustat merged database “OIADP” line item defined as “Operating Income After Depreciation.”