Pzena Investment Management 2Q16 CommentaryVW Staff
Pzena Investment Management commentary for the second quarter ended June 30, 2016.
Valuation spreads are wide, approaching those last seen during the internet bubble. History strongly suggests this is a significant opportunity for value.
Throughout our history we have consistently highlighted the phenomenon of valuation spreads. Spreads measure the valuation difference between cheap stocks and “the market” and so naturally are of interest to value investors. To put it simply, when spreads are wide, the opportunity for value investing increases. Figure 1 illustrates this idea for a global universe comprising the largest 1600 stocks in the developed world1 over a period extending from December 1974 through June 2016.
Figure 1 presents the theoretical upside to a first quintile stock upon getting re-rated to a book-to-price valuation commensurate with that for the equally-weighted universe (see box on page 20 for methodology). A value of 150%, for example, would imply a fair value (upon re-rating) of 2.5x the current stock price. Wide spreads are characterized by a high implied upside for the cheapest quintile, with narrow spread environments by low values, as the figure indicates.
A visual inspection of Figure 1 suggests a cyclical pattern for spreads, albeit one where the cycles are neither regular nor predictable. Periods of wide spreads represent times when investors come to believe in “one thing,” shunning one set of stocks in favor of another. The most extreme example of this was the 1998-1999 period, where investors came to believe that “old economy” stocks tied to the negative events of the Asian currency crisis were to be sold in favor of the limitless possibilities available in the dot-com boom. As is evident from the chart, the resulting spread in valuations grew to be the largest in the history, and an investment in Q1 stocks at that time implied a theoretical upside of more than 150%, when spreads blew out to a level more than 4 standard deviations2 above their long-term average level.
Pzena Investment Management – Looking at spreads by region
While the global spreads of Figure 1 are certainly of interest, they are also affected by differences in valuation across regions, making interpretation of the data more difficult. Figures 2-4 separately examine spreads for the United States, Europe, and Japan. As is the case with Figure 1, each chart shows three horizontal lines representing the long-term mean and ±1 standard deviation relative to the mean. Each region shows a cyclical pattern of spreads tied to fear and greed, periods when investors came to believe in the “one thing.” The United States chart, like the global one, is dominated by the 1998/1999 spike. However, other periods of wide spreads are visible as well, such as the “Nifty Fifty” era of the early 1970’s (Polaroid at a 400 P/E!), the onset of the 1980 recession, and the commercial real estate crisis of the early 1990’s. In Japan, the 1987 asset bubble stands out. In Europe, the mid-90’s recession (Germany’s postreunification blues) created worries visible in the lowest rated stocks, and the period since 2008 has been dominated by first the Global Financial Crisis and more recently the Sovereign crisis affecting the Eurozone in particular.
While the above observations look at the spread of cheapest quintile relative to the midpoint of the universe, it is also instructive to examine the spread between the lowest and highest quintiles of valuation. In doing so, one gets a better representation of true valuation dispersion. Figure 5 plots this spread by region, now measured in terms of the number of standard deviations vs historical averages rather than in terms of the percentage upside.
The figure shows that in the United States, 1Q vs 5Q spreads at the end of June were close to 4 standard deviations wide versus historical average, with Europe and Japan about 2 standard deviations wide. These high levels suggest that part of the wideness we observe in spreads today is due to the high valuations for fifth quintile stocks in comparison with history. Investors are clearly awarding premium valuations to certain segments of the market. Interestingly (though we do not show the data here), those segments are largely composed of two types of stocks. As one would expect, there are the high growers (e.g., parts of technology and biotechnology), but there are also many stocks in health care and consumer staples, areas more associated with stability of earnings than with growth. In the uncertain macro environment that has prevailed since the Global Financial Crisis, so-called bond proxies have essentially become momentum stocks. The data suggest that one possible path for spreads to narrow toward normal levels is for confidence to rebound and for this group to under-perform.
Spreads and performance
Theoretical upside as described by spreads is fine, but the more interesting question is whether wide spreads have historically been associated with subsequent outperformance for value strategies. To put it another way, when spreads get to an interesting level (say, one standard deviation wider than average), what does that signal for future relative performance? To explore the issue, we examined all incidents where spreads crossed the one-standard deviation threshold, then looked at subsequent 3- and 5-year performance for Q1 versus the market capitalization weighted performance of the defined universe.
The results are summarized in the table of Figure 6. There are a total of 14 times in the observation period where we could observe subsequent 3-year performance (6 for the United States, 6 for Europe and 2 for Japan) and 12 such times with subsequent 5-year performance observable. 3-year relative performance (alpha) for Q1 was positive for 13 out of 14 observations across the three regions (6 out of 6 for United States, 5 of 6 for Europe, and 2 of 2 for Japan). The average 3-year alpha ranged from 7.6% to 12.6% across the three regions. The picture for 5-year relative performance is similar, with positive alpha in 11 out of 12 observations.
These numbers strongly suggest that periods of wide spreads signal opportunity. Investors willing to be patient for 3-5 years following a widening of spreads are overwhelmingly likely to be well-rewarded. This is not to suggest that precise timing strategies are readily available: the findings do not apply to shorter time frames, and even when we restrict attention to 3- and 5-year horizons, history is not without its painful exceptions, including the very recent period. Indeed, the data highlight the misery of value-based strategies over the past eight years. In October of 2008, spreads in Europe crossed one standard deviation, but subsequent 3-year and 5-year relative performance was poor. Post-2011 performance for low P/B has been similarly disappointing in the United States and the five year record is likely to be negative.
Nevertheless, the historical numbers remain extraordinarily compelling. And with wide spreads across all developed world regions today, a phenomenon not observed over the historical period, the environment suggests a bullish outlook for value investors today.
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