Rich Pzena: How To Be A Successful Value Investor In Disruptive Times

In his latest shareholder letter, Rich Pzena at Pzena Asset Management provides some great advice for investors who are finding it difficult to invest in disruptive times saying:

“We are handling the current wave of disruptions the way we always have: by conducting intensive research to find skewed risk / reward opportunities in companies with resilient business franchises.”

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Here’s an excerpt from that letter:

“New” always gets people’s attention. In 1999, Michael Lewis captured the seductive energy of the internet boom in his memorable book, “The New New Thing.” Today, the new thing is referred to as “disruption.” 2017 stock market returns reflect investors’ adoration of disruptors, as sentiment swung back powerfully to growth-style investing.

Growth indices outperformed value in the U.S. by 17%, in emerging markets by 19%, in EAFE by 8%, and in Europe by “just” 5% (Figure 1). Leading this disparity was the surge in stock prices of disruptors, many of which are in the U.S. and China, supported by the notion that these companies will displace incumbents in a fight-to-the-death battle. Investment pundits love a good acronym: in the U.S. we now have FANG MAN (Facebook, Apple, Netflix, Google; Microsoft, Amazon and Nvidia) which were up a cap weighted 46% in 2017, representing 23% of the Russell 1000’s overall gains and 13% of its market cap.

In Asia we have the BATs (Baidu, Alibaba, and Tencent) which rose a cap weighted 96%, accounting for 18% of the MSCI Emerging Market index’s gain and now account for 8% of its market cap. Those subject to disruption have lagged, opening the door to clear-eyed analysis of risk and opportunity.

Assessing Disruption

Market sentiment aside, there is nothing new about the concept of disruption. Disrupted stocks have hit our investment screens ever since we opened our doors twenty-two years ago.

Rich Pzena

The question is: are the disrupted companies going away? Of course, we don’t know the answer to that question. But we do know that disruption is difficult, and it doesn’t happen very often, even though it is regularly forecast.

For example, when low-cost Asian manufacturers came on the scene in the late 1990’s, western industrial companies were thought to be on the way to being “disrupted” out of business, yet they still retain their dominant positions today. On the other hand, digital cameras completely “disrupted” Kodak. How does one distinguish between the two?

The truth is, it is difficult. So, we resort to our tried and-true approach – intensive research. If a stock is priced as if the disruption is a near-certainty, yet management has a credible plan to retain the business, we might choose to invest. If management is right, we can realize a significant upside. If management is wrong and the business erodes, well, that’s what the market expected anyway. Low initial valuation and slow decline of the existing franchise should allow an exit from the position with limited losses.

In Kodak’s case, management’s plan to contest digital photography was to enter the digital camera business. Yet Kodak had no manufacturing capability and no experience in the cut-throat world of digital consumer electronics – basically, no edge. On that basis, Kodak seemed like gambling, and we passed on the investment.

Meanwhile, we invested in western manufacturers that had a multitude of advantages they were able to exploit to thwart the competitive threat, including extensive global dealer and service networks, longstanding reputations for quality and reliability, and an ability to lower their own manufacturing costs by moving manufacturing offshore. Two completely different risk/reward profiles, and two completely different outcomes.

Our investment approach is to apply our bottom-up, intensive research process to expose client portfolios to skewed potential outcomes, where deep undervaluation, an identifiable path to earnings normalization, and downside protection provide the opportunity for significant upside with limited downside. Downside protection can take many forms, but some common characteristics include regulatory and scale advantages, the power of incumbency, and flexible cost structures that provide financial and operational resilience.

You can find the entire shareholder letter here.

For more articles like this, check out our recent articles here.

Article by Johnny Hopkins, The Acquirer's Multiple



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.”