Richard Pzena First Quarter Letter: Disaster Myopia and Cycles of Value Investing
Cycles of Value Investing – A Follow-Up In last quarter's newsletter we examined the cycles of value investing over four decades. One of our observations, illustrated in Figure 1, is that despite the history of deep value delivering nearly 500 basis points per annum of excess return over the S&P 500, value cycles tend to be long, and five years after a cycle peak, the cumulative returns of a naïve deep value benchmark* usually lag those of the broad market. This quarter we offer some possible explanations as to why value works over an extended period, and offer evidence from value cycles going back to the late 1960's for illustration.
Human Biases Impact Behavior The stock market is forward-looking, determining a company's value based on future earnings and cash flow. With thousands of market participants, and relatively equal access to information, stock prices in theory should reflect an unbiased, well-informed view as to the intrinsic value of a business – otherwise known as the efficient market hypothesis. Yet, the history of investing is that valuation distortions are common. Researchers in psychology and behavioral economics have examined this issue, and provided insights into how sentiment and history shape an investor's assessment of an uncertain future.
Cognitive psychologists Amos Tversky and Daniel Kahneman of the Hebrew University conducted scientific studies into the forces impacting an individual's view of the future, which is presented in their 1974 article "Judgment and Uncertainty: Heuristics and Biases." Tversky and Kahneman explain that people develop rules of thumb, also known as heuristics, to assess the likelihood of an event. This subjective probability is highly affected by how recently a particular event has occurred, and has been coined the "availability heuristic" which is when people "assess the frequency of a class or the probability of an event by the ease with which instances or occurrences can be brought to mind." In other words, when an event has recently occurred, people tend to overestimate the likelihood of its recurrence. This recency bias can be exacerbated by the event's severity, which makes it even more memorable. But memories eventually fade and expectations normalize. At the extreme, fading memories can lead ultimately to complacency and underestimation of risk.
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Richard Herring and Jack Guttentag of the Wharton School of the University of Pennsylvania extended Tversky and Kahneman's work to credit rationing, financial disorder and banking crises. They noted that the availability bias creates a type of Disaster Myopia, causing individuals - and the institutions for which they work - to become overly cautious following busts and crises, and to under-estimate risk once enough time has passed.
Disaster Myopia and Value Investing
Evidence of Disaster Myopia can be found in investor's behavior as well, which we believe is an underlying driver to market cycles and the cycles of value investing. Revisiting Figure 1, we see that it usually takes over five years on average following the peak of a value cycle for the relative performance of a naïve deep value benchmark to catch up to the broad market. Ultimately, the deep value benchmark goes on to produce substantial outperformance over the entire value cycle. Given this history, we ask the question: why does it take so long for the cycle to play out?
We dug into the patterns of the last four complete cycles, and found evidence of Disaster Myopia, time and again in a number of sectors. Company fundamentals in the industry at the center of the initial downturn had substantially improved well before the five year mark, yet stocks in that industry had generally not yet recaptured their underperformance by that point. We also see this pattern emerging in the current cycle that began in 2007. This corresponds to our firm's experience over the last 16+ years of value investing – that the results of management's corrective action become visible well before investors reward the progress. It takes time for investor skepticism to fade, even in the face of evidence of the recovery. But eventually facts overtake emotion, and value ultimately wins over the long term.
This gradual return to previously out-of-favor industries by investors may also be part of the explanation for the longevity of value outperformance during the cycles – almost 7 years on average.
We now offer observations on industries at the center of the last four complete value cycles, as well as the current cycle, covering a period of 42 years.
1969 - 1978: Defense Industry
The early 1970's were not kind to defense stock prices. As the Vietnam war wound down in the early 1970's, investors anticipated lower defense outlays, causing defense shares to underperform the S&P 500 by 51% over five years. Earnings, however, started to recover less than three years into this cycle, as companies shifted work from development to production and cut costs while a wave of consolidation swept the industry. After five years, the industry had fixed its problems, and earnings were 26% above 1969 levels. Earnings continued to improve through the end of the cycle, almost tripling by 1979. An investment made in early 1974, five years into the cycle, would have earned 180% in relative outperformance through 1978.
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1979 - 1988: Autos and Housing
In the late 1970's and early 1980's the U.S. economy was battered by a spike in oil prices and a double-dip recession. U.S. auto manufacturers paid a steep price when fuel efficient cars from Japan captured massive market share. Ford stock, for example, lost three-quarters of its market value, and Chrysler had to be bailed out by the U.S. government. As the economy plunged into recession in early 1980, the housing market was similarly pummeled. Earnings, however, bottomed less than two years into the cycle, and started an almost uninterrupted climb that lasted over seven years, as managements successfully dealt with their problems, introducing a number of new models, including the Chrysler K car in 1981. Earnings would ultimately go on to exceed their prior peak by 40%. Five years into the cycle, however, auto & housing stocks were only about even with the S&P 500. From that point to the end of the cycle an investor in these industries would have achieved absolute returns of 132%, outperforming the broad market by 17%.
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1988 - 1995: Banks
U.S. bank shares underperformed the S&P 500 by over 45% in the early part of the 1988-95 value cycle, driven by a collapse in net income caused by commercial real estate and loans to developing countries, principally Latin America. Earnings bottomed less than two years into the cycle, and stock prices started to regain a portion of their relative performance, yet it was not until almost four years into the cycle that bank shares had recaptured all their earlier underperformance. Ultimately, an investor that recognized the stabilization of earnings that occurred in 1990 would have gone on to outperform the broad market by almost 150%.
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1995 - 2007: Capital Goods
Relative performance of capital goods stocks was impacted by three events during this cycle: the collapse of Asian currencies in 1997, the internet bubble that peaked in early 2000, and the recession of 2001. In the wake of these events, U.S. manufacturers were left for dead. Capital goods manufacturers underperformed the broad market by an astounding 48% during the first five years of the cycle. This occured despite ample evidence that the business franchises these manufacturers built over decades endured, and that managements actions restored and, in many cases, improved profitability by relocating production to low cost geographies. Although profitability suffered in the wake of the 2001 recession, the downturn was short-lived, and earnings continued their upward trajectory, tripling by the end of the cycle. An investor that recognized the folly of internet valuations and the strength of these business franchises would have outperformed the broad market by 142% from the end of 2000 through completion of the cycle seven years later.
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2007 - Today:
Financials Perhaps the most searing experience affecting investors in the last 75 years was the collapse of residential real estate in the U.S. and the global financial crisis of 2007/08, which triggered the deepest recession since the 1930's. Financials were at the epicenter of this economic tsunami, as liquidity dried up and near-panic ensued in late 2008. Massive government intervention was required, with many institutions suffering a permanent impairment of capital as highly dilutive capital raises were used to shore up balance sheets and restore confidence. By early 2009, however, the situation, though still grave, appeared to have hit an inflection point.
Much progress has been made in the intervening three years. Banks in the U.S. have strengthened their capital ratios, balance sheet liquidity is at multiples of pre-crisis levels, net charge offs have plunged as the economy improved and bad loans were purged from balance sheets, and returns on assets have recovered. Not surprisingly, net income has shown a similar rebound, as seen in Figure 6 below. Industry consolidation, exiting of marginal players and the ability to increase pricing for trading and loan activities is also playing a large part in the restoration of returns to long term norms.
Yet investors continue to avoid financials, which have underperformed the S&P 500 by almost 20% since 2007. Reasons cited, to name a few, are uncertainty over regulatory reforms, inability to adequately assess balance sheet risks, and potential contagion from a meltdown in the Eurozone. It would be hard to ignore the simple fact that the memories of 2008 are still fresh in investors' minds. Although these risks cannot be dismissed out-of-hand, it appears equally cavalier to avoid exposure to the most undervalued sector in the market without taking a balanced view of the risks and opportunities. The financial sector as a whole, which is made up of a wide variety of businesses (insurance, banking, wealth management, processing, etc.) has been painted with a broad brush, where many companies have little if any exposure to these issues, yet are suffering from depressed valuations.
Although the environment is changing rapidly, the long history of financial companies is their ability to adapt to regulatory and economic changes. We see recent examples in the credit card industry, where returns rebounded quickly following the adoption of consumer protection reforms in 2010. Even if financial institutions were forced to exit certain activities, current valuations, which are generally at a discount to book value, provide the opportunity to shrink in a manner that would be accretive to shareholder value.
Financial shares are not the only sector shunned in this cycle. Investors continue to be wary of housing-related businesses, as well as mature technology companies that need to prove they are still relevant in an age of tablets and cloud computing, and defense companies where uncertainty around procurement budgets weigh on valuations. Investor's skepticism of economically sensitive industries in this cycle can be seen in Figure 1 on page 5, as valuation of high beta stocks are at an historically wide spread to low beta stocks.
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We see repeated evidence of Disaster Myopia in value cycles over the last 40 years. It creates significant opportunity when investors are afraid to "jump back in the pool" even when there is ample evidence of tangible improvement. Many of those that had the foresight to exploit these opportunities in prior cycles were well rewarded. We appear to be in one of those stages right now, particularly with respect to financial stocks, and we believe the potential is in place for similar rewards this cycle.
DISCLOSURES 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.