“Despite increased chatter among investors surrounding higher and higher equity valuations, we continue to find what, in our view, are compelling opportunities with the potential for double-digit returns within the cheapest stocks.” -- Richard Pzena
Richard Pzena (Trades, Portfolio) of Pzena Investment Management operates a hedge fund that works with institutional investors and high-net-worth individuals.
The company is publicly traded, providing an opportunity to own a piece of a hedge fund.
But would you want to own this fund?
Who is Pzena?
Born in 1959, Pzena earned a Bachelor of Science degree and an MBA from the Wharton School of Business; the latter degree was awarded in 1980.
His early career involved stints at Amoco Corp., where he held financial and planning positions. In 1986, he joined Sanford C. Bernstein & Co. as an oil analyst; he was recognized for his achievements there by being named to the Institutional Investor All-American Research Team from 1988 through 1990. He was named chief investing officer for small-cap equities at Bernstein in 1994; in addition, he assumed broader domestic equity responsibilities.
He founded Pzena Investment Management in 1996 to pursue deep value in a concentrated portfolio. By deep value, he means stocks that are “extremely depressed” because something has gone wrong with the company.
What is Pzena Investment Management?
According to its website, the company calls itself a global investment management firm. It says it consistently applies a classic, deep-value strategy based on a commitment to extensive research.
It says research provides a deep understanding of a company’s long-term prospects and intrinsic value. Further, the depth of that research gives it the confidence to make “significant” investments in “businesses whose low present value has been set by investors who cannot look past near-term problems.”
As of March 30, the firm had $31.4 billion of discretionary and non-discretionary assets under management. At the end of December, $18.9 billion of the total was invested in equities. To manage that money, Pzena operates 14 private mutual funds and other vehicles, which are segmented by geography and capitalization.
The company trades publicly on the New York Stock Exchange under the symbol PZN (PZN, Financial). GuruFocus reports that only 24% of the total shares outstanding are in the float and actively traded. Of those shares, institutional investors own 14.4% and insiders own almost 16%. In the Form ADV Part 2A, Pzena himself is listed as the principal owner.
Whatever the results for clients, Pzena has brought little good news to its investors:
It is a very big hedge fund, and a publicly traded one. It has grown dramatically, apparently thanks to its deep-value investing strategy combined with research that is intensive enough to run a concentrated portfolio. Little of that gain, though, is reflected in the company's share price.
Strategy
As noted, Pzena and his firm use a deep-value approach to find businesses with low present value because investors do not see the longer-term opportunities.
According to the Form ADV Part 2A, they further develop this by focusing on comprehensive earnings forecasts and the resulting company value. The next step is to build portfolios of securities they consider undervalued, compared to their long-term earnings power.
Turning to process, Pzena first ranks companies within a universe that matches the strategy of the portfolio. They rank these companies, from cheapest to most expensive, based on price-normalized earnings. Normalized earnings refers to the earnings level they expect the target company to produce within the next five years, given the company’s position within its industry and management’s ability to successfully execute strategic plans.
Second, the investment team looks at the most undervalued segment of those companies. Within that group, they prioritize research to favor the stocks that are both cheapest and offer portfolio diversification benefits.
Third, and after the initial screening is complete, they do what they call rigorous and in-depth analysis of candidate companies. This involves discussions with management, including on-site visits. As part of research process, analysts are expected to ask, “Would we buy the entire business at the current price?”
Fourth, they refine the earnings model, come up with a final estimate of normalized earnings and make a final decision.
Once added, the firm monitors and evaluates each position. After a stock is added to a portfolio, the team keeps checking to see if their expectations for a return to normal earnings are being met.
On average, the holding period for each security is about three years. On the sell side, they will usually get out of a position after it reaches fair value, more attractive opportunities arise or the company’s fundamentals change.
In his second-quarter 2017 commentary, Pzena offers five areas where he believes opportunities exist. He says these opportunities arise out of three criteria for "extended value outperformance":
- Uncertainty at the industry or company level.
- Wide valuation spreads between companies that are being punished for these uncertainties and those that are favored by investors.
- Lessening uncertainty, which leads investors to re-rate the undervalued companies.
Within that context, he sees better times ahead for four sectors:
- American banks: investors are regaining confidence in the wake of successful stress tests, a slowing of regulatory interventions and anticipation of higher dividends.
- European stocks: Pzena says business sentiment is improving, order books are getting filled and almost two-thirds of publicly traded companies beat expectations in the first quarter of 2017.
- Japanese stocks: greater response to shareholder needs because of Abenomics, more independent directors, fewer "management-friendly cross-shareholdings" and proxy voting against executives who fail to meet a minimum return hurdle.
- Emerging market stocks: better corporate results in an uncertain environment, expense reductions and other self-help initiatives in China, and indications China is reversing the slowdown it experienced in 2015.
Pzena wraps up his commentary by noting there is a broadening trend to get costs under control and take self-help measures that will improve company valuations. He also refers to “idiosyncratic opportunities,” which will arise of out of specific company or industry situations.
Pzena and company scan the dregs of various market universes to find stocks that others ignore because they do less research. Once they have identified a subset of cheap names that help diversify portfolio goals, they assess these companies on the basis of normalized earnings. They typically hold these names for three years or until the market's appreciation catches up with reality.
Holdings
This GuruFocus chart shows the sectoral profile of Pzena’s 151 stocks:
This list shows the top 10 equity holdings at the end of the third quarter:
- Mylan NV (MYL, Financial): 3.77%
- Citigroup Inc. (c): 3.2%
- Hewlett Packard Enterprise Co. (HPE, Financial): 2.92%
- Dover Corp. (DOV, Financial): 2.71%
- Voya Financial Inc. (VOYA, Financial): 2.7%
- Cognizant Technology Solutions Corp. Class A (CTSH, Financial): 2.66%
- Bank of American Corp. (BAC, Financial): 2.63%
- Oracle Corp. (ORCL, Financial): 2.54%
- Omnicom Group Inc. (OMC, Financial): 2.48%
- Franklin Resources Inc. (BEN, Financial): 2.43%
Mylan, a generic drugs manufacturer, is Pzena’s largest single holding, while the portfolio as a whole has a heavy bias toward the financial sector. This may reflect, in part, his expectation that Citigroup, Bank of America and other financial holdings will have a strong year in 2018.
Performance
The hedge fund has matched the performance of the S&P 500 over the past five years, and stayed well ahead of the industry average (assuming these results are net, and not gross). This TipRanks chart shows the rocky road of 2015, and the following recovery:
In its 10-K for 2016 (the most recent filing), Pzena provided composite annualized performance figures for each of its 14 private funds. This list shows each fund, its inception date (in brackets) and its net return since inception:
- Large Cap Value (2012): 16.3%
- International Value (2008): 11.7%
- Large Cap Focused Value (2000): 7.4%
- Emerging Markets Focused Value (2008): 3.8%
- European Focused Value (2004): 6.4%
- Global Focused Value (2004): 5.7%
- Global Value (2010): 9.8%
- Focused Value (1996): 10.5%
- Small Cap Focused Value (1996): 12.9%
- International Focused Value (2004): 6.5%
Mixed results, at best, for this guru. He has undoubtedly had some good years, so investors who picked the right fund would have done much better than the benchmark. However, five of the 14 funds underperformed the S&P 500 (7.44%), while only four made it into double digits.
Conclusion
Investors have to ask: What is the point of using a hedge fund when there is no assurance they will beat the benchmark? It is not a question for the Pzena funds alone. The luster seems to have come off much of the industry since the financial crisis.
As for Pzena Investment Management, its share price history is not encouraging. However, GuruFocus gives it a robust 8 (out of 10) for both financial strength and profitability and growth.
Value investors looking for direction should pass by the hedge fund business, but there may be something behind those relatively high rankings for this publicly traded firm.
Disclosure: I do not own shares in any of the companies listed in this article, and do not expect to buy any in the next 72 hours.
