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PZENA INVESTMENT MANAGEMENT

SECOND QUARTER 2019 COMMENTARY

Value investors buy stocks when investors are fearful and where pessimism is already reflected in valuations, but the long-term earnings potential is not recognized.

VALUATION EXTREMES AND RARE OPPORTUNITIES

Investors seem to be chasing recent performance, flocking to growth and so-called safety shares despite their high valuations that we view as unsustainable given the current trajectory of earnings. In contrast, cyclical shares have been shunned, remaining undervalued throughout the past market cycle, and are now priced at recessionary levels. The improved fundamentals and positive earnings trajectory of these companies, during the recovery, have not protected their stocks from being disproportionately weighed down by every negative news headline.

Dedicated value investors seize on opportunities to pick stocks when pessimism is already priced in, but earnings potential is not yet recognized. We believe the world is facing one of those rare points when fear has reached an extreme, and a tremendous number of overlooked but good companies are available at fire-sale prices.

A WORLD AT RARE EXTREMES

Amid rising macroeconomic uncertainty, investors’ commitment to near-term favorites alongside the dismissal so many others has created wide valuation dispersions.1 Figure 1 illustrates that today’s polarization, based on price-to-book (P/B) measures, has spiked to over three standard deviations from the mean. This extreme level surpasses 99% of the monthly observations in the 45-year history of our global data.

Figure 1: Dispersions are Approaching those of the Internet Bubble

DEVELOPED WORLD VALUATION DISPERSION BETWEEN CHEAPEST AND MOST EXPENSIVE STOCKS

graph

Data through June 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

Based on our proprietary estimates of price-to-normalized earnings (P/N), we see stocks in the cheapest quintile trading at 50% discounts to median valuations across the global universe.2 Within our own portfolios, the spreads between our median P/Ns and those of their respective universes are very attractive, and in many cases, they are as wide as other periods of extreme market stress such as in 2008, 2011, or 2016.

Today, growth’s dominance over value has reached an extreme not seen since the peak of the internet bubble. Given the extent of the current dislocation, and the long drought in value investing, it’s easy to forget that value stocks have traditionally outperformed over the long term. Moreover, this outperformance has corresponded with times of wide dispersion in valuations.

THE GROWING COST OF HIGH-PRICED STOCKS

During the current cycle, investors have paid up for the promise of growth in an attempt to improve returns amid the most tepid recovery of any in the US post-war era.i

Stocks in the highest valuation quintile of the US universe have largely raised the multiple for the broad index during this cycle, as implied in Figure 2. While the stocks within the cheapest quintile performed positively this cycle, they lagged the broader market. As a result, their valuations never rerated after the GFC, moving from a lowly 6x earnings in 2009 to just 8x today. Meanwhile, the more expensive stocks started the period at an already high price to earnings (P/E) of 29x in 2009 but have grown to an excess of 80x today. What’s resulted is the largest dispersion in valuations in the 68-year history of the data — a distortion that we argue is not sustainable.

Figure 2: The Most Highly Valued Stocks Have Led the Market Higher

RECORD VALUATION DISPERSION

graph

Source: National Bureau of Economic Research, Sanford C. Bernstein & Co., Pzena analysis
The lines show the market-cap weighted trailing P/E ratios for the most expensive and cheapest quintiles of the US market. Data is from 1951 through 2018
Universe is the largest ~1,500 US stocks ranked by market capitalization

Today’s valuation is higher than the level reached by a similar segment of expensive US stocks in the heyday of the dot-com bubble. Substantial growth is necessary to warrant these lofty valuations, and while a few remarkable companies may be able to achieve this feat, the vast majority won’t.

Starting points are critical to investment returns — and purchasing the most expensive shares in today’s market may do more to destroy wealth than protect it.

STABILITY AT THE COST OF GROWTH

The more defensive investors have been moving into stocks that they view as stable, and they’ve been willing to pay a premium for the privilege. Low-volatility shares within the MSCI ACWI Index, for instance, are trading at an aggregate P/E of 18.9x,i slightly higher than that of the MSCI’s broad ACWI Growth Index.4, ii Is it sensible that low-volatility shares have a multiple that’s on par with growth stocks without the possibility of much earnings growth?

Meanwhile, compared to value shares, trading at a P/E of 7.2x, low-volatility stocks globally are trading at premiums not seen since the Asian Financial Crisis (according to Figure 3). In the US, this spread has reached a further extreme with low volatility trading at an all-time high versus value.3,i

Figure 3: Low-volatility Stocks are Expensive Versus Value Shares

graph

Source: Courtesy J.P. Morgan Chase & Co., Copyright 2017
Data from 1993 through May 2019
Value is defined as the combination of P/E, P/B and P/S. Low volatility is based on realized 1-year volatility.

The desire for safety is proving greater during this cycle than previously, but if investors are buying low-volatility at high valuations, they may be exposing themselves to more risk than they bargained for — and downside protection could fail just when they need it most.

VALUATION SHOULD ALWAYS BE LINKED TO EARNINGS POWER

The large number of dislocations in today’s market has some investors asking, “Is this time different?” We noted how much the returns of the high flyers have exceeded their peers during this cycle. Although some of the explanation for this outperformance is due to their stronger profitability this cycle, we believe the most optimistic scenarios are already priced into these stocks. (When positive outcomes are already embedded in share prices, investors take on undue risk.)

Meanwhile, among the stocks that were hit the hardest in the prior recession (consider financials this time), profitability normalization hasn’t been much different from last time. Figure 4 illustrates this point in comparing companies that started in the bottom (10th) decile of profitability based on return on equity (ROE). During both the current cycle (2008 - 2018) and the last one (1997 - 2007), approximately 70% of the stocks that were hardest hit were able to raise their profitability to the average level of their peers within three years.

Figure 4: Businesses with Lower Profitability Catch Up to Peers

MEAN REVERSION OF LOW ROE STOCKS IN S&P 500

graph

Source: Courtesy J.P. Morgan Chase & Co., Copyright 2017

This demonstrates on a broad level what we witness in every cycle with companies facing temporary pain. A business will enact self-help to repair earnings rather than enduring a subpar ROE and falling behind the competition. From an operational standpoint, we don’t believe this time is different. What’s different is the disconnect between valuations and earnings for these companies. After demonstrating the ability to improve earnings at a typical pace, valuations should follow earnings.

In this period, when extreme macro-related headlines are overshadowing all else, we continue to concentrate on the substance of the business. Benjamin Graham once said, “In the short run the market is a voting machine, but in the long run it is a weighing machine.” Ultimately, it’s the market’s fear and indiscriminate reactions without focusing on a company’s fundamentals that create value opportunities.

CONCLUSION

Today’s market offers a wide range of stocks that are trading in deep-value territory, while so many others in the broader markets are priced well above their long-term averages. Value investors buy stocks when the markets are fearful and where pessimism is already reflected in valuations, but the long-term earnings potential is not.

The combination of broad-based valuations, the late stage of the economic cycle, and a host of exogenous threats increase the likelihood that the next five years will post lower stock market returns than the last five years. The likelihood that global market extremes indicate that an inflection point is near underscores the importance of selectivity and a research-driven process that can uncover opportunities without paying a high price.

We invite investors to exploit today’s valuation anomalies, rather than attempting to predict what near-term event will happen next. The current market provides investors rare, significant opportunities to buy good businesses at deep discounts that may have encountered significant issues but are clawing their way back.



1 Valuation dispersions are the difference in the price-to-book ratios between the cheapest and the most expensive quintile of stocks in a given universe.
2 Based on the largest 2,000 stocks in the global universe.
3 Based on relative Standard & Poor’s indices
4 According to MSCI, as of May 31, 2019, based on forward earnings. Since this writing, MSCI ‘s June update shows a forward P/E of 20.4x for the MSCI ACWI Growth Index, in US dollars.

ENDNOTES

iLakos-Bujas, D. et al., “The Value Conundrum,” J.P. Morgan Securities LLC, June 6, 2019, pp. 9, 11
iiMSCI, “MSCI AWCI World Growth Index (USD),” May 31, 2019, https://www.msci.com/documents/10199/f6ed0310-f5df-46a1-9ab3-3360d8b3bad6


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.

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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.

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