Third Quarter 2019 Commentary

When we look at the fundamental earnings power of what we own and compare these companies to the broader market, we don’t mind waiting for today’s anomalies to readjust.

The clipping below was written in the second quarter of 1998, when Pzena was approaching its second anniversary.

Figure 1: “Nostalgia is not what it used to be”1

1 Source: French film actress Simone Signoret (1978)
Source: Pzena Investment Management, Shareholder letter, June 1998

At the time, value had been thrashed by growth for years. While a small subset of stocks ticked ever higher, the rest were left behind. Everything we said back then applies today. We can’t help but think of the old proverb, “the more things change, the more they stay the same.”

Today’s pro-growth cycle has lasted more than twice as long, as demonstrated in Figure 2. The chart shows the ratio of the MSCI World Value Index and the MSCI World Growth Index, illustrating that while value has had a tough run, it’s still the undeniable winner over the long term. The length and magnitude of the current cycle has prompted investors to perpetually choose growth over value thinking that the current environment is fundamentally different from the past. But history has demonstrated that the longer and deeper the anti-value cycle, the greater the recovery for undervalued stocks when markets eventually normalize.

Figure 2: Value Works Over Longer Periods — but is this Time Different?

Results since inception of the indices. The gold-bar periods represent anti-value cycles. The numerical labels represent the number of months when growth beat value in the last two cycles. Returns are calculated in US dollars. Past performance is not indicative of future returns. The information is provided for equity returns including dividends net of withholding tax rates as calculated by MSCI.


For over 20 years, we have remained steadfast in our commitment to value investing with no drifting and no excuses. We still own good companies that are facing questions over their ability to generate future earnings. Once again, global economic and stock-specific uncertainty are testing their resilience.

In the first quarter, we highlighted that entire industries were grappling with these concerns. The valuations of banks, energy equipment and services, and automobile manufacturers have each endured outsized pain throughout the current business cycle. In the third quarter, we delve into the stories of specific companies in these segments — each one trades at an extreme discount of approximately 60% compared to the median valuation of the global universe. How many growth managers can say that?


We view European banks as deeply undervalued. This industry ended the third quarter trading at approximately half the multiple on forward earnings (and nearly double the dividend yield) of Europe more broadly, based on their respective MSCI indices.1,i

These stocks raise concern for market participants: amid low or negative interest rates, investors question the banks’ ability to generate profits; in a recession, investors wrestle with recency bias, concerned about their exposure to credit risk; and investors worry about disruption by fintech companies.

We believe investors have become overly pessimistic toward banks, whose valuations already reflect these negative scenarios. UBS Group (UBS), has been exceptionally hard hit relative to the other European banks. According to our estimates of long-term earnings, UBS’ shares trade at a 62% discount to the global market’s median valuation.


As Switzerland’s largest bank, and the world’s leader in wealth management, UBS is a high-quality franchise that has transformed its balance sheet and de-risked its business mix since the global financial crisis (GFC). For instance, it has run off most of its book of mortgage-backed securities (MBS) and now has little exposure to credit-sensitive trading business. Across operations, UBS has rotated from volatile, balance-sheet-intensive investment banking activities, formerly 80% of revenues, to asset and wealth management, providing more consistent performance throughout the economic cycle.

With wealth management as its cornerstone business, UBS offers all the characteristics that investors prefer in a quality business: a structural rate of growth higher than that of GDP, its global reach and modest interest-rate sensitivity, low capital intensity, as well as a sticky client base. Since 2011, the wealth division has increased assets under management by 50%, to $2.3 trillion.iii This division accounts for 55% of UBS’s profits today compared to 29% in 2010 (at the start of the European sovereign debt crisis).2,ii

Despite all these positives, by nearly any measure, UBS’ stock is priced as if its business model is in a structural decline or a major financial crisis is imminent.


The Group’s shares have retrenched in the face of macro-uncertainty since the start of 2018. In our view, the market has failed to recognize how well-positioned UBS is to manage investors’ concerns. The bank’s profitability remains resilient in the face of low interest rates. After all, net interest income accounts for 17% of total revenues, a relatively small portion compared to the average of 56% for European banks overall.iii Through self-help, the bank has been able to improve its return on equity even with negative interest rates in Switzerland (as seen in Figure 3).

Figure 3: Profitability has Improved Alongside Negative Rates

Source: Swiss National Bank, company reports, and Pzena analysis
UBS Group is held in one or more of our strategy composites.
Past performance is not indicative of future returns.

We believe a de-risked UBS should be well-positioned in the event of a recession. Credit risk looks very different today than it did leading into the GFC. The Group has significantly curtailed its investment banking and trading businesses, and the legacy portfolio of MBS that’s in runoff makes up less than 6% of its risk-weighted assets. The banking side wasn’t the problem during the GFC — loan losses came to less than 30-basis points of average earning assets at the time. Nevertheless, the bank has increased its capital cushion and quintupled its tangible-equity-to-asset ratio, providing ample capital if a downturn takes place.

To investors that fear market share loss to fintech, we view the risk to UBS as nominal. Wealth management is a relationship-driven business. High- and ultra-high-net-worth clients require a great deal of customization and communication. Moreover, we see UBS leveraging its scale to deploy technology that improves its service offering.

Simply put, we don’t share investors’ concerns about UBS’ business model. However, we are looking for better execution in cost management, an area in which the bank has lagged its competitors; its wealth management division has maintained a stubbornly high cost-to-income ratio. Management has communicated a plan to tackle these issues, and we expect any progress in this area to offer earnings upside.

We believe UBS’s current yield of 10% (i.e., a 7% dividend yield and 3% in buybacks) offers a generous return to shareholders against a backdrop of slow growth and low yields in most asset classes. At this level, we believe any improvement in either execution or in market sentiment should translate to an improved valuation for UBS. With a share price of just 6.4x our estimate of normalized earnings, UBS’ stock is extremely attractive.


National Oilwell Varco (NOV) is a leading global provider of capital equipment for oil and gas exploration (E&P), including equipment for offshore and land-based rigs, pressure pumping, and associated tools, drills, and supplies. The opportunity to invest in NOV arose as the last boom in E&P capital spending collapsed in 2014 on the back of a precipitous decline in oil prices. NOV’s revenues plunged by two-thirds from a peak of $21.4 billion in 2014 to $7.2 billion in 2016, as new rig construction dried up, and its stock price followed suit, falling from $86 per share to under $30. The stock took a further leg down in 2019 to under $20, as weakening oil prices and the continued austere capital spending by integrated oil majors hit service stocks hard. Spending on oil and gas development is running far below what’s necessary to maintain current levels of oil production, as depletion of existing resources sets in.

Amid this challenging environment, NOV management has brought the company to breakeven profitability through rationalizing its operational footprint and making painstaking efforts to right-size its business, reducing its workforce by nearly 50%. Revenues from its aftermarket operations for servicing and maintaining rigs have served as important downside protection in its Rig Technologies business where NOV has a 45% market share. Spending on maintenance and service can generate the equivalent of about 80% of the original cost of a rig over the course of its lifespan. US onshore activity, though recently weak, should provide a steady stream of revenues for its businesses related to pressure pumping, tooling, and supplies. In addition, the company has a solid balance sheet and consistently generated positive cash flow from operations. NOV’s current leverage is at 2.8x EBITDA3 and management has committed to paying down debt with cash and returning the excess to shareholders.

Figure 4: Is Higher Demand for Rigs on the Horizon?

Source: Baker Hughes, Pzena analysis

We believe the company’s path to earnings normalization will continue through self-help initiatives that can accelerate margin recovery as conditions improve from a cyclical trough. We are encouraged to see some increase in the demand for rigs overseas (See Figure 4). However, we expect orders for new rigs to be muted in the near term, as supply and demand come into balance. As such, our estimate of NOV’s normalized earnings does not include any recovery in its sale of equipment for new drilling rigs but could provide additional upside should a recovery occur earlier than we forecast.

Trading at 5.7x our estimate of normalized earnings, we view NOV as a compelling opportunity to invest in an industry leader that offers both substantial upside opportunity and solid downside protection. Global demand for oil and gas is expected to increase by approximately 1% per annum, and the depletion of existing wells supports the continued need to drill for new reserves. Given its price, we believe the stock offers free optionality on a recovery in equipment and services from the industry’s leading provider. We believe NOV is uniquely positioned to benefit from this trend when the industry recovers from its cyclical trough. The company remains as the dominant provider of the equipment and services that keep rigs running and wells producing.


Global automobile sales, estimated to fall slightly (-2%) to 92 million in 2019, would mark their first drop in a decade, and China is expected to see the first drop ever.iv Investors in auto manufacturers have anticipated this slowdown for several years, and the cyclical headwinds are made more complex by structural changes in the form of new technologies like electrification.

The world’s leading automaker, Volkswagen (VW), produced 10.9 million vehicles in 2018. As trade headwinds started to blow last year, most of the world’s major auto stocks swooned, but VW’s shares remained relatively stable. The company had already taken its hits due to the 2015 diesel emissions scandal when its stock fell by nearly 60%. The company’s stock remains undervalued today in our opinion, having ended the third quarter trading at just 5.5x forward earnings representing a 65% discount to the MSCI World Index.v

This is a tremendous discount in our view, as the company continues to make quality, widely popular vehicles. Beyond VW’s flagship brand, it has an appealing portfolio of luxury and mass-market names including Porsche, Audi, Skoda, and others. VW’s breadth stretches to heavy trucks also and is one of the largest commercial vehicle producers globally.

Unit sales for VW have held up well. Even in China, where year-over-year sales fell by 10% overall, VW’s results were down by just 3%, leading to an increase in its market share in the world’s largest market for autos. Meanwhile, VW’s US sales have grown faster than any of its top-10 competitors year to date (+4.5%).vi

Volkswagen has maintained its profitability through self-help, as the industry continues to face significant margin pressure. Figure 5 compares BMW and Daimler’s operating margins showing severe deterioration versus VW’s modest decline. Management’s plan to standardize as much as 80% of its mass-market vehicle parts by 2020 should further strengthen the company’s balance sheet cost position, which, when coupled with VW’s liquidity of €15 billion, positions its well in the event of a broader downturn.

Figure 5: VW’s Competitive Advantage is Starting to Show

¹ based on the adjusted earnings before interest and taxes
2 Auto divisions in VW and BMW and car division of Mercedes-Benz for Daimler

Source: company reports (based on the midpoint of guidance offered)

Longer term, Volkswagen seeks to leverage its scale in an aggressive push to electrification. In part, this effort was a response to the diesel crisis that drove the organization to develop a better long-term emissions plan, work that ironically allowed the automaker to gain a significant lead over its peers. VW is prepared to invest €30 billion on the development of electric vehicles (EVs) by 2023. This formidable investment is in addition to the €15 billion contribution from its joint venture partner in China. Although the costs will run through its financials for several years, VW’s ownership of higher-margin, premium brands allows a meaningful portion of the development costs to be absorbed. This illustrates how VW’s unmatched breadth can ensure its ability to invest in ways that the vast majority of its competitors cannot. Given the prospects for EVs, it’s reasonable to expect that this investment will pay dividends in the future.

VW will debut its first EV, the VW ID.3, in November, followed shortly after by Porsche’s Taycan launch. The designs of these highly anticipated vehicles are customized, offering performance advantages over the historical vehicle architectures being used by other traditional manufacturers. While Tesla has a head start in EVs, VW’s ability to produce at scale provides it with a meaningful advantage over Tesla. Electrification is new to VW, but mass-producing quality automobiles is not.

VW’s stock remains in the penalty box for the 2015 emissions scandal and because of myriads of industry headwinds. However, we believe that the competitive cost and brand advantages of the VW franchise create opportunity for future earnings. The company’s shares are priced at 9.6x our estimate of normalized earnings and, in our opinion, represent great value.


Without a doubt, underpriced value stocks have near-term concerns embedded in the valuation. Riding momentum irrespective of valuation has produced better returns for many years now. Yet, when we look at the fundamental long-term earnings power of what we own and compare these companies to the broader market, we don’t mind waiting for today’s anomalies to readjust. Ultimately, we believe our holdings offer significant opportunity for improvement with a better margin of safety.

1 based on their relative trailing 12-month price-to-earnings ratios
2 based on adjusted profit before tax, excluding restructuring and litigation expense, as reported by UBS
3 earnings before interest, taxes, depreciation and amortization



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