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Fear of recession has depressed valuations of many economically sensitive businesses. Contrary to popular belief, this may be an opportune time to invest, with the added benefit that many of these businesses have improved their financial strength and operating flexibility.


The first quarter marked another period of growth beating value, with most outperformers falling into the paradigms of high-flying growth or so-called safety stocks that offer higher dividends, low volatility, and stable earnings. Meanwhile, many of the valuations of traditionally cyclical businesses already appear to be discounting a recession. This has pushed valuation dispersions between the cheapest and most expensive stocks to their widest point since the internet bubble (Figure 1).


Figure 1: Valuation Dispersion at an Extreme

DIVERGING VALUES BETWEEN CHEAPEST AND MOST EXPENSIVE STOCKS1

graph

Data through March 2019 Source: Sanford C. Bernstein & Co., Pzena analysis
Dispersion based on price to book; equally-weighted data
Universe is the largest ~1,600 stocks by market capitalization in developed world


While we can never predict when such a trend will reverse, the historical pattern has been for cyclical shares to become heavily discounted amid fears of a recession, and then outperform once the prospects of a recession become clearer. Currently, valuations in financials, energy, autos, and housing-related stocks are heavily discounted. While the reasons for their weakness vary by industry, we believe each offers a meaningful investment opportunity.

TOO EARLY TO INVEST?

In considering the viability of investing in these businesses today prior to a downturn, we evaluated returns relative to the market when bought within 24 months of a recession and then held for three years. Because the global financial crisis (GFC) was such an outlier, we wanted to differentiate its results from what has typically happened around a recession.

Leading into the GFC, it’s no surprise that financials did not deliver a positive return over the ensuing three years. However, buy-and-hold investors in consumer discretionary stocks were rewarded for purchasing virtually any time within six to eight months of the crisis.

In more mundane recessions, like the four prior to the GFC, patient investors were rewarded for owning undervalued cyclical stocks. Figures 2a and 2b show just how strong the outperformance for financials and consumer discretionary stocks were over the three years surrounding these recessions.

Now in various stages of repair, we also believe that many of these companies are better prepared than in the past for a downturn — even as their valuations imply that the opposite is true.


Figure 2: Low Valuations Lead to Outperformance

FORWARD 36-MONTH RELATIVE RETURNS1 PRIOR TO RECESSIONS 1975 – 2001 VS. GLOBAL FINANCIAL CRISIS
2A: US LARGE-CAP FINANCIALS

graph



2B: US LARGE-CAP CONSUMER DISCRETIONARY

graph

Source: National Bureau of Economic Research, Empirical Research Partners, Pzena analysis
1Equally-weighted cumulative returns of sector versus capitalization-weighted returns of the largest ~750 US stocks by market capitalization
Past performance is not indicative of future returns. Does not represent performance of any Pzena product or service.

Now in various stages of repair, we also believe that many of these companies are better prepared than in the past for a downturn — even as their valuations imply that the opposite is true.

FINANCIALS: PROGRESS YET TO BE FULLY REWARDED

The distrust created during the GFC has not been fully resolved in investors’ minds, so financials remain heavily discounted (Figure 3). Their current valuation relative to the broad market places these stocks in the 97th percentile of the past 45 years, meaning they’ve only been cheaper 3% of the time. However, given their profitability, capital strength, and liquidity, we believe the discount is unwarranted.


Figure 3: Financials are Still Heavily Discounted

US LARGE-CAP FINANCIALS RELATIVE TO THE MARKET1 1974 - PRESENT

graph

Data through March, 2019
Source: National Bureau of Economic Research, Empirical Research Partners, Pzena analysis
1Largest ~1,000 US stocks ranked by market capitalization
Ratios of price-to-book values relative to the equally-weighted broad market data as stated above
Past performance is not indicative of future returns.


Both US and European banks have improved their fundamentals and fortified their balance sheets by:

  • increasing tier-1 core risk-based capital ratios to over 13%, from 7%-8% at the end of 2006;
  • raising liquidity ratios: in the US by nine percentage points, almost triple precrisis levels (See Figure 4); European banks have similarly improved liquidity management.
  • scaling back risk-taking to reduce the likelihood of a major institution upending the system;
  • implementing self-help that cut costs, improved governance, focused on higher-return businesses, and installed next-generation technology to better serve clients.

These combined actions make the banks much better positioned to weather future credit events or market shocks.


Figure 4: Higher Liquidity Improves Resilience to Volatility

LIQUIDITY RATIO1

graph

Source: Federal Deposit Insurance Corporation (FDIC), Pzena analysis
1Liquid assets (cash, Treasuries, and municipals) / tangible assets; data from 2002Q1 through 2018Q4
Chart represent FDIC-insured commercial banks and savings institutions


From a credit perspective, the overall environment today remains benign, and non-performing loans are below their historical range. The recent outsized growth in leveraged loans alongside loosening lending standards in this space has raised some concern. With most loans being packaged and dispersed among institutions and within financial products, the additional risk will be born across markets. The extent to which investors bear this additional risk remains important and may be accentuated in the event of a downturn.

Exposure among the banks remains constrained, and we don’t believe it warrants their current valuation discounts. As a result of stronger risk management and higher regulatory requirements, banks today turn over their leveraged loan inventory as rapidly as every 60 days, three times faster than before the GFC. We continue to watch for new developments but believe that any problems surrounding these loans will be limited in scope, and the risk of systemic contagion is low.

Investors also penalize the sector as interest rates remain persistently low. The reality is that financials have demonstrated an ability to adapt by raising revenue and restoring earnings. Even with the combination of low interest rates and increased regulatory capital requirements, US banks have restored profitability with return on tangible equity of 15%.E1 European banks face more severe interest rate headwinds than those in the US. Banks in Europe also have more restructuring ahead to restore profitability; most expect to resume double-digit returns on equity over time.

ENERGY: COMING OFF THE BOTTOM

Energy stocks are also at depressed valuations due to concerns centered around the uncertain path for energy prices. On a price-to-book (P/B) basis, they’re trading in the 98th percentile of the range relative to the market over the last 44 years. In other words, they’ve been cheaper on a relative basis in just 12 months out of the last 528. And each time was on the heels of a rapid oil price collapse.

Companies in the sector have taken significant steps to endure this kind of volatility — cutting operating costs and capital spending to restore profits and cash flow. Meanwhile, the downturn in exploration and development accelerated the decline in global reserves. Falling at a rate not seen in the last four decades (Figure 5), the pace of the fall seems unsustainable. Even with developments in the alternative energy and transportation industries, world oil demand is expected to grow over the next two decades, according to the US Energy Information Administration. The combination of rising demand and depletion will more than offset any reductions from technological advances, and ultimately it will require companies to invest in developing additional reserves.


Figure 5: Reserve Depletion Indicates More Capital Spending is Needed

UPSTREAM CAPITAL EXPENDITURES (LHS) AND RESERVE GROWTH (RHS)

graph

Source: Rystad Energy, Pzena analysis

Oilfield service companies would be central to that development but have been particularly vulnerable of late. Figure 5 shows that upstream capital expenditures fell by 44% from their 2014 peak. After having endured sharp declines in revenues (-49%) and margins (-63%), these companies have shown progress. With only a slight improvement in revenues, these companies doubled their margins to 10.4% by 2018 (from 5.1% in 2014) by focusing on cost cutting and supply chain efficiencies. In many cases, they have also shown disciplined capital management by aggressively trimming debt. We believe the more austere approach of these companies should allow them to come through this period as leaner, more efficient operations. With these companies trading near historical lows relative to the market, investors are essentially getting a free option on increased energy capital spending whenever the recovery occurs.

HOUSEHOLD DURABLES AND AUTOS ARE ALSO UNDERVALUED

Within the consumer discretionary sector, household durables and automobiles have faced a perfect storm. Their natural tendency for a late-stage selloff may have been intensified by headwinds such as trade-related cost increases, that are specific to the current cycle. Building product manufacturers and homebuilders have underperformed on slower growth in housing starts and the impact of rising rates on affordability. Costs surrounding materials and transportation have risen substantially since the beginning of 2018, and labor’s been tight.

Amid the volatility and rising fears of a recession in 2018, household durables fell by 29% and autos by 34%. After taking a severe battering in the last recession, investors seem to want to steer clear of anything housing or automotive related. While there’s been some recovery within housing this year, US large-cap auto and housing-related stocks continue to trade at a significant discount to the broad market on a price-to-book basis. This quarter’s Highlighted Holding on Ford Motor Company points to some of the challenges facing the auto industry and the actions Ford is taking to meet these challenges.

CONCLUSION

The market’s continued preference for growth and safety has recently left many of the traditionally cyclical businesses out in the cold. While financials, energy, and autos have each been discounted for its own specific reasons, each has been judicious in deploying capital, realigning its business models, and maximizing operational efficiencies.

Meanwhile, valuations in these segments are all attractive. We believe these businesses are better prepared than in the past for a downturn, and history would suggest this is a good time to invest for the patient shareholder.



DISCLOSURES

Past performance is no guarantee of future results. The historical returns of the specific portfolio securities mentioned in this article are not necessarily indicative of their future performance or the performance of any of our current or future investment strategies. The investment return and principal value of an investment will fluctuate over time.

The specific portfolio securities discussed in this article were selected for inclusion based on their ability to help you understand our investment process. They do not represent all of the securities purchased, sold or recommended for our client accounts during any particular period, and it should not be assumed that investments in such securities were, or will be, profitable.

This financial promotion is issued by Pzena Investment Management, Ltd. Pzena Investment Management, Ltd. is a limited company registered in England and Wales with registered number 09380422, and its registered office is at Dashwood House, 69 Old Broad Street, London EC2M 1QS, United Kingdom. Pzena Investment Management, Ltd is an appointed representative of DMS Capital Solutions (UK) Limited and Mirabella Advisers LLP which are authorised and regulated by the Financial Conduct Authority.The Pzena documents are only made available to professional clients and eligible counterparties as defined by the FCA. Past performance is not indicative of future results. The value of your investment may go down as well as up, and you may not receive upon redemption the full amount of your original investment. The views and statements contained herein are those of Pzena Investment Management, LLC and are based on internal research.

This document does not constitute an offer to sell, or a solicitation of an offer to buy, securities or investment advisory services in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information contained herein is general in nature and does not constitute legal, tax, or investment advice. Prospective investors are encouraged to consult their own professional advisers as to the implications of making an investment in any securities or investment advisory services.

These presentation materials are intended for the exclusive purpose of evaluating the investment advisory services of Pzena Investment Management, LLC. Pzena Investment Management, LLC is located at 320 Park Avenue, 8th Floor, New York, NY 10022 and is a registered investment adviser registered with the United States Securities and Exchange Commission. Any other use is strictly prohibited.

Accordingly, neither this booklet nor any portion hereof may be reproduced or redistributed without the prior written consent of Pzena Investment Management, LLC. Disclosure of the information presented in this booklet to anyone other than the recipient’s employees, officers, directors, or financial or legal representatives is also prohibited without the prior written consent of Pzena Investment Management, LLC.

The services and/or products discussed herein are only suitable for sophisticated investors who understand the risks involved. Neither Pzena Investment Management, Ltd. nor Pzena Investment Management, LLC nor the activities of any functionary with regard to either Pzena Investment Management, Ltd. or Pzena Investment Management, LLC are subject to the provisions of the Financial Services (Jersey) Law 1998.

Notable portfolio holdings are discussed for illustrative purposes only.

The specific portfolio securities discussed in this presentation were selected for inclusion based on their ability to help you better understand our investment process. They do not represent all of the securities purchased or sold or recommended during the quarter. Holdings vary among client accounts as a result of different product strategies having been selected thereby. Holdings also may vary among client accounts as a result of opening dates, cash flows, tax strategies, etc. There is no assurance that any securities discussed herein remain in our portfolios at the time you receive this presentation or that securities sold have not been repurchased.

© Pzena Investment Management, LLC, 2019. All rights reserved.