Quarterly Report

January 2008

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Value investing may be rewarding in the long term, but can be painful in the short term. Can that be avoided? And is now the wrong time for value?

These are the times that try value investors’ souls, to paraphrase Tom Paine. Our Value and Large Cap Value strategies were each off by more than 12% for the year and our global strategy was down nearly as much. In the second half alone, the declines in our U.S. portfolios exceeded more than 18%. Our newest clients have felt the biggest sting, but even longtime clients have felt the pinch. They know that value is cyclical – Figure 1 highlights the unpredictability of short-term returns – and they also know that over time, the return pattern can smooth out and value investing can be a very rewarding strategy (Figure 2). But the interim periods are no less painful for all that.

Figure 1: Pzena Value Annual Returns Since Inception Figure 2: Pzena Value Three-Year Holding Periods Annualized Performance

And with fears about the economy rising, the obvious question is: Is this one of those times when value investing doesn’t work? In fact, the present scenario – though the details might differ – is one we’ve seen many times. And though the recovery has not yet set in, history suggests it can be signi?cant. To demonstrate this, we discuss in the pages that follow what drives value returns, how that relates to both market dynamics and momentum investing, and where we are in the cycle today.

Crisis = Opportunity

Value’s periodic underperformance is the ?ip side, of course, of its main return driver. Bargains generally present themselves only when there’s trouble, what Baron Rothschild described as “buying when there’s blood in the streets.” When a solid business with a record of earnings growth experiences some problems, the market reacts negatively. It’s simple human nature to extrapolate current trends into the future, to expect that what is good will get better and what is bad will get worse. The value investor buys on that weakness, knowing that frequently the problems are actually temporary. Adding to the challenge, however, is that the biggest value opportunities generally come in a period of crisis for the entire market. The chart below compares the price-to-book value for the cheapest stocks versus the S&P 500, and the greatest differentials have come during times of the greatest stress. So just when everyone else is running for the exits, the value investor is doubling down.

Figure 3: Biggest Disconnects Between Cheapest Stocks and S&P 500

The Value/Momentum Cycle

These opportunities re?ect the movements of the market in response to investor sentiment, times when investors pay almost no attention to valuations. That cyclicality is clear when we view the same relationship of the cheapest price-to-book quintile of our 500-stock universe and the S&P 500 over time, as in the chart below.

Although the cycle caused by that shifting sentiment is usually referred to as a value/growth cycle, further analysis suggests it is more accurate to talk of a value/momentum cycle. Generally, when momentum investing—buying stocks that are increasing in price with little focus on the value of the underlying fundamentals—does well, value does not, and vice versa.

Momentum investing, almost by de?nition, is driven by emotion. Investors are looking for what’s doing well in the expectation that it will continue do so, and tend to extrapolate trends and ignore valuations. Each peak in momentum investing has a story that investors have bought into, justifying their con?dence, as well as their disregard for traditional valuations. In the early Seventies, the Nifty-Fifty would make money forever. In 1990, fears of in?ation drove the market to embrace energy and technology stocks. In the bubble at the turn of this century, the internet revolution was perceived as making traditional industries irrelevant. Today, the world seems to have completely adopted the China/India growth story, believing it means a permanent shortage of commodities. At the same time, the subprime crisis is thought to have undermined the world’s ?nancial system.

Figure 4: Price to Book of Cheapest Quintile of 500 Stock Universe to S&P 500

This has led to record valuation spreads between commodities and ?nancials, as you can see in Figure 6. In fact, the spread in valuations is wider now than at any time in the past 55 years. In our experience, the extreme views driving this spread are a perfect example of momentum “group think,” which rarely turns out to be correct, and we believe present us with an extraordinary value opportunity in ?nancial stocks.

The Recession Factor

History shows that there are distinct environments that favor momentum and value. Figure 5 shows periods when either a value approach to investing or a momentum approach outperformed. In general, momentum strategies typically performed well late in an economic cycle, and value strategies typically performed well during recessions and the early stages of an economic recovery. It’s logical for momentum to enjoy late economic cycle outperformance as the market becomes complacent, earnings grow, multiples expand, and valuation is mostly ignored. Value stocks, on the other hand, tend to begin their periods of outperformance once the recession has started and investors begin to price in the recovery.

This has led to something of a see-saw relationship between value and momentum over time. Although value outperformed in 2001, and momentum in 2007, they experienced almost identical performance from 2002-2006. It makes sense that the two approaches are not mutually exclusive – after all, when value stocks outperform, they become almost by de?nition, momentum stocks!

Figure 5: Average Annualized Returns of Momentum and Value Strategies

Currently, the distinction seems to be very clear. Financial stocks are suffering from the fear that each month will bring news of additional writeoffs. But the fear is disproportionate to the likely reality. After all, Citigroup wrote down $8-11 billion in 2007, but saw its market cap drop by some $129 billion. Once it’s clear what the true damage is, history tells us the underperformance should begin to reverse.

Economic data increasingly indicates we’re entering a recession now. Housing, job, and manufacturing numbers are off, and although GDP grew well in 2007, investors seem to be expecting a recession: they’re in fear mode and failing to pay attention to valuations. If history is any guide, when those recession fears are realized, investors will focus on the impending recovery and value should outperform.

Figure 6: Ratio of Price-to-Book Ratios: Commodities & Financials Sectors

Staying the Course

In the meantime, experience tells us the best route to long-term outperformance is sticking to our discipline. During the Internet bubble, many of our value-oriented peers succumbed to the intense pressure to shift their strategies to more closely follow the indices—what is commonly referred to as style drift and what John Bogle calls “mongrelization.” The danger is obvious, as a deep value strategy has beaten both the broad market and the value indices over time. We’ve discussed the Fama/French academic data before, which demonstrated that signi?cant excess return was available by investing in an equal-weighted portfolio of companies with the lowest price-to-book value, and with less risk to boot. In fact, Fama/Fench’s seventh and eighth deciles, surely more value-oriented portfolios than the median, offered only a 2.1-2.2% annual return advantage over the median, compared to the 5.5% of the lowest decile.

There’s also a danger in waiting too long to invest in a “bargain” stock, as that “wait and see” approach risks missing the snapback in price, which is usually rapid. And bailing too early risks missing all the outperformance, which rarely comes at one time. Needless to say, value investing is not easy. And it isn’t always pleasant. But in the long run, it’s very pro?table.


Past performance is no guarantee of future results. The historical returns of the specific portfolio securities mentioned in this commentary 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 commentary 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.