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Richard Pzena of Pzena Investment Management Second-Quarter Commentary
Posted by: Holly LaFon (IP Logged)
Date: July 27, 2012 04:35PM
Stay Focused on the OpportunityOver the course of 16+ years of value investing, our firm's focus has always been on buying deeply undervalued securities in order to produce superior long-term investment returns for our clients. We have faced many challenging environments; the dot-com bubble, currency crises, financial crises, and recessions. Each period has presented its own unique set of issues, but the common denominator across these time periods is that in each, powerful consensus views drive wide valuation discrepancies. Today, the environment is dominated by the fear of a potential Eurozone meltdown and a weakening global economy. That has created a bubble in "safe" assets - U.S. government bonds, high dividend-paying stocks, and stable earners.
Although we are not insensitive to the outcome of macro events, we have learned that the valuation discounts created by these fears and uncertainties can offer significant rewards for the patient investor. Low valuation is the opportunity, but the key to successful value investing is understanding the business. Our focus, therefore, remains on identifying and owning good businesses, where we understand the reasons for undervaluation and where the long-term earnings power of the franchise is sustainable. We also look to protect against permanent impairment of capital by avoiding companies where financial risk (leverage in particular) can trump the equity holder's stake in the business. In light of today's heightened worries, we thought it useful to reinforce our investment process, including the lessons we have learned over the years to protect against permanent impairments. In this context, we review the current opportunities in our portfolios, including a range of global and regional industry leaders with high free cash flow yields and strong balance sheets that have been overlooked due to macro fears.
Methodically Identify ValueCompanies may be undervalued for several reasons, including:
- The company itself has disappointed or undergone a stressful experience or mishap,
- The industry or geography the company operates in is cyclically depressed, or
- Investors fear the company's future may be vulnerable to structural change.
As is often the case, we are investing in companies where markets have developed a profoundly negative view that will take time to dispel. This is how we get to buy them cheaply. But because market valuations are partially driven by sentiment, negative perceptions can exist for extended periods, just as euphoria can lead to long phases of excessive valuation. Our objective is to identify the opportunities that flow from negative perceptions and position the portfolio to benefit as normal earnings power is realized, perceptions change, and the company is afforded a higher valuation.
Guard Against Permanent ImpairmentWe understand that we can't guarantee companies won't be impacted by near-term shocks, but we target those businesses that we believe can adapt and adjust to the environment, thereby protecting our downside. History supports this approach, as companies have had a consistent record of restoring returns in the face of a wide range of macro environments. Thus, a key element in our investment process is to guard against permanent impairment of capital, particularly during periods of near-term stress, so as to afford a company time to retool and recover.
We would contrast our approach with one of simple aversion to stock price volatility. Volatility has always been useful to the value investor: it creates the valuation opportunity. In fact, it is one of the reasons why the cheapest quintile of stocks has produced excess returns over the long-term - the "value advantage." The real challenge is to exploit volatility while also guarding against the permanent impairment of capital.
In 2010, we conducted a study which explored the impact of volatility on a deep value portfolio. One of our observations was that moderate volatility is good for the value investor. Extreme volatility, however, can actually detract from performance, as it may signal impending failure, either from excess leverage, or as a precursor to management actions that ultimately destroy value. Over the years, we have generally avoided high levels of leverage due to the increased risk of bankruptcy it introduced. Our study re-emphasized the need to be cautious about leverage, and provided another metric - extreme volatility - as a tool to improve downside protection and potentially enhance performance.
Based on this finding, our research reviews include a volatility profile for each company's trailing 12 month share price. We take this metric into consideration explicitly in our investment process, for both whether to invest and, if so, in establishing the position size. The tangible result is that our portfolios today generally have less than 10% of their weight in the most highly volatile stocks in their universe. We view this as an enhancement to our investment approach which should improve our ability to exploit the long-term value advantage for our clients.
Today's OpportunitiesOur bottom-up research process continues to identify deeply undervalued securities on a global basis, with some pronounced themes across geographies and sectors.
Europe is CheapestAs the table below captures, equity markets are reflecting large perceived differences in economic risk by region. Geographies perceived to have the least stress are priced accordingly. Europe trades at a very significant discount to other markets, reflecting the sovereign debt crisis and fears about European financial institutions.
Given these valuations, it is not surprising that in our Global and International Value portfolios we have significant exposure to European companies. It is important to note that this is not a contrarian view that European economic activity will prove more robust than the markets fear. Our European holdings, in large part, comprise companies that have a global footprint and are not solely exposed to activity in the European region. Their low relative valuations illustrate how broad macro fears create exploitable opportunities at the company level. Our holdings of this nature include names like Volkswagen, Philips Electronics, Akzo Nobel, Cap Gemini, Royal Dutch Shell, BP and Total. Consider two examples. In the integrated oil sector, Shell (RDS) trades today at 6x our estimate of normalized earnings, about half of our estimate of fair value. By comparison, Exxon Mobil (XOM), with a similar business mix, return on capital, and free cash flow profile, which we also view as undervalued, trades at 8x. In the coatings industry, Akzo Nobel (AKZOY) trades at 7.3x our estimate of normalized earnings, while U.S. company PPG Industries (PPG) trades at 9.1x. Both have international business, with Akzo developing a strong franchise in China.
We recognize that Europe may record anemic growth as it tackles its debt issues. However, we see a European discount already built into valuations although companies we own are financially sound and have interests beyond Europe itself. Of course, the fear of economic slowdown extends beyond Europe with concerns about contagion. Around one-fifth of China's exports currently go to Europe. A slowdown in European demand would impact China, which is already showing signs of softer growth. Investors also fear that U.S. growth will slow and that we may see a synchronized global slowdown. We profess no edge in predicting macro events, but we do think carefully about scenarios that might affect the companies in which we invest. Typically, we find the type of consensus macro expectations we have laid out above (i.e., conventional wisdom) are already priced into markets and individual company valuations. And in today's environment of increasing skepticism over global growth, we see opportunities emerging in industries where earnings estimates are declining and valuations are starting to react accordingly.
Valuations in the U.S. small cap universe reflect an asset class which is viewed as less exposed to European stresses. We continue to identify what we consider to be some excellent unique small cap opportunities. On page 9 we highlight Actuant Corp. (ATU), a global leader in hydraulic tools and lifting solutions, which has been discounted in part due to its European operations.
High Beta Is ValueLooking at the various sectors of the markets, we find that premiums are being paid for earnings certainty. Valuations in sectors like health care, consumer staples, utilities - the lower beta sectors - are at significant premiums to the higher beta sectors where fear is most acute (Figure 1).
With the macro-driven risk-on/risk-off trade such a constant over the last two years, investors seem to be overlooking the value of good businesses that happen to be cyclical in nature, creating opportunity. Although consensus global GDP forecasts remain in the 2% to 3% range, markets are skeptical and seem to be pricing in something more pessimistic. Managements have been cautious, taking a wait-and-see approach to hiring, investing and making acquisitions until the prospects for sustained growth become much more visible. This has helped sustain corporate margins and cash flows at historically high levels.
Technology and defense are sectors where top down concerns and fears of structural change have generated some outstanding opportunities. These are high quality companies with very strong free cash flow profiles and flexible business models. Investors are not rewarding the strong cash flow these businesses are generating, driving cash flow yields to near peak levels. In fact, the free cash flow yield of the non-financial holdings in our portfolios is 10% in our U.S. Large Cap Value strategy, and 7% in our Global Value strategy.
Below Trend Earnings Create ValueTwo areas of the market stand out where earnings are well below trend. The first is housing, where building materials companies trade at modest valuations as investors extrapolate the currently low level of housing construction and renovation activity into the future. In our view, current activity levels are unsustainably low and will recover dramatically at some point. Meanwhile, there are many well managed companies generating solid operating results amid the difficult environment. Examples include Travis Perkins (TVPKF) in the U.K.; Akzo Nobel in Europe; and Masco Corp. (MAS), Fortune Brands Home and Security (FBHS), and Owens Corning (OC) in the U.S.
The other area where earnings are significantly below trend is financials, a sector that is trading at historically low relative multiples on a price-to-book value basis (Figure 2).
Practically all of our financial holdings trade at substantial discounts to book value, and are among the cheapest companies in our investment universes on a price-to-normalized earnings basis. Our portfolios contain broad financial sector exposure including insurance companies (life, property casualty and reinsurance), wealth management franchises, exchanges and processors, regional U.S. banks, and global money center banks, all of which have very different risk profiles. Within this broad group, credit-sensitive banks, which operate globally, are the cheapest names in our investment universes despite equity levels being among the highest in history and improving earnings.
We acknowledge that the current economic and financial climate continues to represent a risky backdrop for banks. In Europe, in particular, credit ratings downgrades are almost daily occurrences and the state of the Greek banks and other institutions with banking activities in southern Europe is clearly of great concern. The lesson learned in the global financial crisis was that stress testing of banks' earnings will not protect the downside if there is a complete loss of confidence that forces a bank to raise dilutive capital in extreme circumstances. This idiosyncratic risk means that it is appropriate to have relatively modest exposure to individual names and a diversity of positions to mitigate risk. Picking outcomes in southern Europe is dubious, so we do not own banks listed in Greece, Spain or Italy. We have very limited and carefully sized exposure to European banks, and our holdings in U.S. and U.K. credit-sensitive names are individually modest across our portfolios. These leading franchises are trading at between 2x and 3.5x what we estimate they are capable of earning in normal conditions, which makes them compelling value and attests to the very gloomy scenario that has been priced into their valuations by the market today.
Portfolios Reflect Deep UndervaluationOften, when economies go into recession it is after a period of boom conditions, when companies have been thriving and managements are taking more risks. Today, in developed markets, this is not the case. GDP is still below trend and companies have been very cautious, limiting capacity-extending capital expenditures, paring cost structures and generally cleaning up their balance sheets. Most are entering this period of economic uncertainty with very strong financial credentials.
Only hindsight will allow us to make a pronouncement on the ultimate length and magnitude of the current value cycle. But one thing is clear: as a result of investor uncertainties, we have been left with a wealth of deeply discounted, cyclical businesses with sustainable franchises, strong balance sheets, and a demonstrated ability to adapt to a wide range of economic scenarios. Many of these businesses have global footprints, are industry leaders, and have demonstrated their ability to restore profitability quickly after an economic shock.
Stay the CourseRather than succumb to the fear that is driving undervaluation, a true value manager gets excited when value opportunities abound. Today, many of our developed markets portfolios are among the cheapest in our firm's history. However, one characteristic of value investing - especially when investing before the catalyst for share price improvement is apparent - is that it requires time for improvement to be recognized and rewarded in share prices.
We believe we continue to be in the early stages of a value cycle, a cycle which is testing the pain threshold of even the most hardened, long-term investors. We remain true to our beliefs. Our conviction is supported by past experience and the rewards that eventually follow such periods of pain. Timing is impossible to predict, of course. All we can do is thoughtfully position our clients' portfolios in today's deepest value opportunities, having carefully assessed the range of potential outcomes for each company we own, and sized the positions accordingly. Underpaying for quality franchises is a long-term investor's true ally. The sign on our head trader's desk says it all: "Patience equals Profits."
A Note On Emerging MarketsTo some degree, we feel we are in a different phase of the value cycle in emerging markets, where we have not witnessed the same stress factors that have brought such a broad range of deep value opportunities in developed markets. As a result, far fewer companies in emerging markets are under-earning their own history. We have likewise found few valuation opportunities in the emerging markets "domestic consumption" space, as investors have been paying up for exposure to this theme, particularly in China. That being said, there are opportunities.
The technology sector is one where we are finding many attractive, undervalued companies. Additionally, fear of weaker foreign demand has created opportunity in a number of manufacturers in China that have significant export businesses but also have exposure to domestic demand, namely shoe manufacturer Stella International and textile and clothes producer Texwinca Holdings. Stella International started life in Taiwan as a dedicated, low-end shoe manufacturer for Wal-Mart and Kmart. Today it is the largest non-athletic footwear manufacturer globally with an estimated 10.5% market share. Its revenues have risen two-and-a-half times in the past seven years. Stella manufactures brands ranging from casual footwear (Clarks, Deckers, Rockport, Timberland, etc.), through fashion (Cole Haan, Nine West, etc.) to high end (Burberry, Prada, Hugo Boss, etc.). They maintain retail outlets in China (just 5% of revenues) but today the shares trade at less than 9x our estimate of normalized earnings on quite conservative assumptions about future growth and operating margins.
Concern about a recession-inspired contraction in world trade has created opportunities in the shipping sphere with fleet owner Pacific Basin (at under 5x our estimate of normalized earnings) and shipbuilder Hyundai Mipo (6x) both held in our Emerging Markets portfolios. Additional opportunities may emerge in economically sensitive sectors as valuations adjust to lower expectations for global growth.
Guru Discussed: Richard Pzena: Current Portfolio, Stock Picks
Stocks Discussed: AKZOY, RDS, XOM, ATU, TVPKS, OC, MAS, FBHS,
Rich does it again.. The Vanguard Windsor mandate just published Re: Richard Pzena of Pzena Investment Management Second-Quarter Commentary
Posted by: jaumepared (IP Logged)
Date: August 4, 2012 10:07PM
They were allocated a good slice of the Windsor Fund. Surely a harbinger of good things.
Guru Discussed: Richard Pzena: Current Portfolio, Stock Picks
Stocks Discussed: AKZOY, RDS, XOM, ATU, TVPKS, OC, MAS, FBHS,