Richard Pzena (Trades, Portfolio), a brilliant value investor tracked on GuruFocus, recently appeared on CNBC. He talked about a few different subjects and the channel cut the clips up. There are four of them in total. Interestingly, they cut up the tape to where Pzena discusses active versus passive investing in one clip, and in the other he discusses a market divide. They are both at the end of this article. I’m writing this article because what Pzena says in one clip ties into what he is talking about in the other clip. You need to piece things together to understand what environment value investing is in right now.
In the first clip, Pzena talks about how it makes no sense that active investing will continue to underperform passive investing. He says there is a very strong correlation between the value cycle and performance of active investing. When value works, active investing works.
It’s not a coincidence so many great value investors haven’t been doing so well lately. You hear people lament Buffett’s recent performance, Einhorn is in a dip, Icahn and Bruce Berkowitz (Trades, Portfolio) are not doing well. According to Pzena, it is not exclusively value managers that are lagging passive management:
All active investors pay attention to the price. They all consider value. Passive investing pays no attention to the price paid.
That means in a sense, all active investors, within the constraints of their style box, are value investors.
Meanwhile, while allocating to passive, people are actively allocating towards liquid, momentum stocks with low volatility.
In the other clip, Pzena talks about how the market is divided into two groups. One is the group of stocks that are in sync with the 'lower for longer' philosophy. These are the low volatility stocks that include consumer staples, real estate, some health care and some high-flying tech stocks.
The other group is clearly out of sync with that philosophy and is made up of financial service companies, energy companies and basic material stocks.
My portfolios happen to be loaded with asset managers (I’ve written about stocks like these on many occasions: like here and here) and basic material stocks, and I have gotten some healthy energy exposure as well. Virtually all of these picks were made on a bottom-up basis. There are some great values in these industries.
What CNBC missed is that these two observations are not independent.
Exchange traded funds are constructed in such a way that they require their weakest link (lowest liquidity stock) to be a highly liquid stock. ETF owners are getting murdered on some days by either liquidating their stock in that security way below its intrinsic value or buying it way above its intrinsic value. That would cause the ETF to lag the benchmark, which is unacceptable if you want to keep your assets under management. In addition, ETFs need to backtest well. No one is going to buy some hot, new ETF if its performance graph (backtested performance for the basket) shows a very choppy or negative return.
That means there are three criteria for stocks to be included in ETFs: highly liquid, recent strong performance and not too much volatility.
The universe of ETF constituents is not at all an accurate reflection of the overall market.
Financial services have shown a lot of volatility and have been repressed because of regulation thrown at them since 2009. Energy has been killed due to the drop in oil prices, which made many of these companies much less attractive for inclusion in new ETFs. Basic materials have been in a slump for years and for similar reasons are excluded from many ETFs.
The two tracks Pzena describes exist because there is a torrent of money flowing into passive strategies and passive strategies are, for the most part, designed to avoid value stocks.
This is a great time to be a value investor.
Pzena happens to like Citigroup (C, Financial), Bank of America (BAC, Financial), Exxon Mobile (XOM, Financial) and Royal Dutch Shell (RDS.A, Financial).
Pzena on active management.
Pzena on the market.
Disclosure: Author is short a low volatility ETF (LOWV).
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