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Fear and uncertainty have driven valuation dispersions to historically wide levels, giving the value investor an opportunity to scoop up good companies at deep discounts.


Just as global equity markets were bolstered in 2017 by expectations for synchronized global growth, they were shaken by fear and uncertainty in 2018. It was remarkable how quickly the tide turned despite so much positive news coming from the corporate sector. More hawkish telegraphing from the US Federal Reserve seemed to light the fuse, and investors became increasingly agitated by a growing chorus of negative headlines that included monetary tightening, rising interest rates, trade wars, Brexit, whipsawing oil prices, and political dysfunction, to name a few. The bloom also came off the rose for the FAANGs (Facebook, Apple, Amazon, Netflix, and Alphabet, the parent company of Google) which had risen by over 300% since early 2015.

Faced with mounting uncertainty, investors found refuge in segments of equities that should have been considered safe (e.g., utilities and real estate investment trusts, or REITs), whereas economically sensitive sectors and businesses facing the most controversy, became downright maligned. Across developed markets, the cheapest stocksi in the index significantly underperformed both the broad universe and the value indices (Figure 1), whereas in emerging markets, the collapse in growth names had a larger impact, and cyclicals held up somewhat better.

 

Figure 1: The Most Undervaluated Stocks Trailed Significantly

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Source: Frank Russell Company, MSCI, Sanford C. Bernstein & Co., Pzena analysis
Broad and value indices based on Russell 1000, MSCI Europe, MSCI Japan, MSCI EM, MSCI World. Low P/B is the cheapest quintile based on price-to-book values of (equally-weighted) stocks in the following universes ranked by market capitalization: ~1000 US; ~500 European; ~300 Japanese; ~1100 emerging markets; ~1,600 developed world. Data through December 31, 2018; does not represent any specific Pzena product or service. Past performance is not indicative of future returns.

 

SOME SHARES ARE EXCEPTIONALLY CHEAP

In 2018, the bifurcating market expanded the valuation dispersions between the cheapest and most expensive stocks, leaving them at extreme levels reached only three other times over the last 40 years (Figure 2). Note that the peaks reached between 1998 and 2001 reflected back-to-back Black Swan events including a credit crisis in Asia and the unwinding of the internet mania that distorted prices.

 

Figure 2: Global Valuation Dispersions are Enticing

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1Based on the dispersion between the 20% lowest valued versus the 20% highest valued shares on a price-to-book basis; equally-weighted data
2Universe is the largest ~1,600 stocks by market capitalization in developed world. Source: Sanford C. Bernstein & Co., Pzena analysis

 

Notwithstanding investors’ shedding of still expensive growth darlings in 2018, wide price differentials reflected the markets’ flight to safety alongside punishment of economically sensitive businesses. To illustrate, consider the risk-reward tradeoff between utilities (often thought of as bond proxies for their dividend yields) and banks. US banks ended 2018 trading at a 38% discount to the S&P 500 Index on a price-to-earnings (P/E) basis. Bank valuations were nearly as depressed as at the onset of the global financial crisis, despite their healthier balance sheets, more fortified capital ratios, as well as their solid earnings, revenues, and margins. In contrast, the typically slow-and-steady utilities sector traded at a 4% premium to the S&P 500 by year’s end, an amount that may not sound drastic, but it’s higher than its 10-year average.

As can be seen in Figure 3, utilities’ valuation relationship to banks reached an extreme, in the 97th percentile, for the 54-year history that the data was available.

 

Figure 3: Utilities are Expensive Compared to Banks

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Source: Empirical Research Partners analysis, Pzena analysis
1Capitalization-weighted data

 

Today’s value opportunities extend beyond any one sector, particularly after the market distortions in the fourth quarter of 2018. Spread widening can be painful for value-driven investors, given the deterioration in some of the more undervalued shares. However, it leaves an abundance of good businesses at attractive valuations from which to construct value portfolios. The key is to take advantage of near-term price dislocation to identify opportunities where extreme undervaluation is a result of temporary problems rather than a permanent impairment of the business franchise.

WIDE DISPERSIONS CAN AMPLIFY LONG-TERM RETURNS

Historically, wide valuation differentials have preceded periods of significant value outperformance. We have found that when dispersionsii extend beyond one standard deviation from the long-term average, the probability of outperformance grows for the cheapest quintile of stocks.i In reviewing the 44 years of available data, we observed five major events (Figure 4) that pushed spreads beyond one standard deviation from the norm worldwide. On all five occasions, the low P/B returns beat the MSCI World index on a 5-year rolling basis. Moreover, the average annualized outperformance was in the double digits after four out of the five events.

 

Figure 4: Have Wide Spreads Preceded Value Outperformance?

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1Based on price to book, equally-weighted data
2Qualifying months contained within the period when dispersion between the cheapest and most expensive stocks was one standard deviation or greater.
3Average 5-year-forward annualized performance of qualifying months. Since January 2015, dispersions have bounced mostly between one and two standard deviations. It’s too soon to tell what the driving factor has been or what it will ultimately mean for market returns in the coming years.

 

The most recent incident — which started in 2015 and brought dispersions to an even more provocative level approaching two standard deviations above the norm today — is a rare event that is indicative of the broad opportunity now available.

CONCLUSION

As fear and uncertainty drive down stock prices, it gives the disciplined value investor an opportunity to invest in good companies at deep discounts, planting the seeds for truly superior long-term returns. The current dislocation in markets has presented us with numerous opportunities, and we discuss several of these in our Global Research Review.

i The “cheapest stocks” / “value stocks” are defined as the least-expensive quintile based on price-to-book value.
ii The difference between the midpoint of the least expensive stocks and the most expensive shares in the developed-world universe. (See Figure 2 for further details.)


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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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.

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