Richard Pzena on the Q2 conference call had some interesting comments on fund strategy, macro outlook, value investing and more. Below is an excerpt and the full transcript can be found here. Also check out his Q2 letter to shareholders if you have not already done so.
Richard Pzena – Chairman, Chief Executive Officer
Thanks, Gary. Equity markets around the world had mixed results during the second quarter of the year. The Fed’s hint that its Quantitative Easing program might start to taper sparked a rise in global bond yields and put pressure on equity markets. In the euro zone, equities ended the second quarter about where they began, although monthly performance was very mixed.
In Japan, equity volatility was pronounced as the Bank of Japan announced new monetary stimulus measures in April. And the emerging markets continued their decline amidst fears of slowing growth in China. Against this backdrop, value investors are finally being paid for their patients. Since August of 2012, when the European Central Bank calmed markets, saying they would use all necessary means to backstop the European financial system, value stocks have significantly outperformed. Since then the cheapest quintile of stocks in our global universe has returned 32.4% versus 14.6% for the MSCI World Index.
US has also enjoyed strong results with the cheapest quintile of the 1,000 stock universe, returning 29.9% versus 19.2% for the S&P 500. Yet, the cycle-to-date results are less rosy. Since the peak of the last value cycle in February of 2007, deep value stocks are still behind the market.
By this time in the four previous value cycles dating back to the late 1960s, deep value was ahead of the broad market benchmarks. Thus investors ask the age old question, is it different this time or is deep value just too scary? We would point to four major factors that have contributed to the prolonged nature of the current cycle.
First, the severity of the early part of the cycle for March of 2007 through November of 2008; second, permanent impairments suffered by value stocks during that period, particularly in financials; third, interruptions of the recovery in 2011 and 2012 by Europe’s financial and sovereign debt crisis; and finally, the normal dose of disaster myopia, or put another way, expecting the worst to happen again. 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.
During this time, investors shunned cyclical businesses and fled to the supposed safety of dividend yields, leaving behind solid business franchises with strong balance sheets and high free cash flow that are sensitive to macro-economic activity. To demonstrate this dichotomy, we analyzed earnings yields across a number of sectors as an indicator of valuation opportunity.
Although, the earnings yield for the S&P 500 overall appears close to its long-term average, there is a significant skewing in the data, with “safe sectors” like utilities and REITs trading at yields well below history, while financials and technology shares offer significant premiums. The financial sector remains deeply depressed despite recent strong returns, hovering in the 93rd percentile of the sector’s valuation during the past 48 years.
The technology sector should be a haven for value seekers today as well. The group 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 price to earnings ratios are at the lowest point in 35 years, 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.
As we mentioned last quarter, our portfolios are dominated by these most undervalued sectors, while our average value competitor continues to hold benchmark sector weights.
On the business side, during the second quarter, our assets under management surpassed the $20 billion mark. This 4% increase from the first quarter was driven by market appreciation. As I mentioned last quarter and probably will repeat many times into the future, AUM flows in the institutional investment world are generally lumpy and unpredictable. Our business activity level remains flat from last quarter at a level we would describe as median as measured across our last ten years. Prospects are wondering whether deep value is right for them. This question has particular resonance to investment committees following the global financial crisis, and as I described earlier, is a likely contributor to the slower-than-average value recovery in this cycle.
Our response includes a reminder of one of the key takeaways about value investing from the empirical studies like the famous one by Pharma and French. The most undervalued decile outperformed followed by the next cheapest decile, which outperformed the next cheapest decile and the next and so on and so on. In other words, deep value wins in the long run.
Further, as we have discussed in the past, we conducted a study of volatility and observed that while volatility adds to a portfolio – a value portfolio’s excess return, that is only true up to a point. At the extremes, stock price volatility is likely a market signal that has showed has a negative effect on excess returns, leading us to adjust our process and limit such exposures. When we coupled the empirical evidence that deep value is a powerful strategy for the long-term, with the experience we have gained through the cycles of the last 18 years, we’re very optimistic about the future.
