Pzena Investment Management commentary for the third quarter ended September 30, 2015.
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H/T Dataroma
Successful Value Investing Provides More than Passive Exposure to a Value “Factor”
The recent underperformance of many value investors has raised questions about whether value investing works the way it once did. The proliferation of ETF’s and other passive/ low fee strategies also begs the question of whether active investing is “worth” the fees. In last quarter’s newsletter we addressed this issue by highlighting the long run advantage of active strategies in general. In this piece, we discuss the drivers of long term outperformance for a value manager such as Pzena Investment Management. Specifically, we want to address the difference between having a generic exposure to a value cycle (or factor) versus an active exposure to company- specific research.
A Value Cycle Interrupted
Value cycles over the last fifty years have unfolded in a pattern closely related to the macroeconomic cycle. Value investing strategies typically struggle as economies slow and the fear of earnings declines becomes the preoccupation of investors. Then, as valuations bottom and expectations for an improvement in the economy and corporate earnings replace the fear, value strategies tend to outperform during and coming out of a recession. The strongest relative returns are earned as the economy picks up steam and stocks that had embodied the fear outperform, benefitting from both earnings normalization and re-rating by investors. The late stages of expansion are the most challenging period, as stresses have ebbed, and investors chase momentum with little regard to valuation. Then excesses in the economy build, counterforces act to cool the economy, and the cycle starts again. For forty years through February 2007, value cycles have lasted on average about ten years and resulted in value stocks outperforming the broad market by 480 basis points per annum1.
The current cycle, which started in February 2007 in the U.S., has not fit this pattern. The rebound off the bottom occurred in 2009 in the U.S. following the financial crisis, and in 2012 in Europe following Mario Draghi’s “whatever it takes” speech signaling the European Central Bank’s determination to protect the monetary union. Those sharp recoveries were very much consistent with value cycle history. But this time, there has been no follow through after the initial ebbing of fear. Following each period of outperformance value stalled, as another set of fears interrupted the value cycle, most recently over the slowdown in emerging markets. Persistently low interest rates are another reflection of the environment of fear from which we have yet to emerge.
Value Has Underperformed
While value strategies have struggled, growth and momentum have done exceedingly well, with this trend accelerating over the last twelve months (Figure 1). Investors flocked to companies with either demonstrated or prospective growth prospects, resulting in growth indices trouncing value. This is a global phenomenon. As a result, this value cycle – so far – has skipped the “sweet spot” of strong relative performance following the recovery off the bottom and moved on to a period that looks a lot like the momentum-driven late stages of the cycle. The middle stage – characterized by strong growth and improving earnings – seemingly has yet to take place.
Adding Value Through Individual Company Research
One conclusion from the foregoing discussion is that in this cycle, value as a factor has disappointed. The environment has been a significant headwind to value investing and a difficult one to overcome. As we observe in Figure 2, a simple factor that describes value (low price-to-book in this case) has mostly underperformed. Yet the DNA of value investing going back to Benjamin Graham has always been rooted in bottom-up research and human psychology. We believe viewing value investing as a discipline, not a factor, offers the opportunity for a more favorable outcome than a simple quantitative approach provides. In spite of recent headwinds, our research-driven portfolios have outperformed low price-to-book stocks over the last five years (Figure 2). Given our disciplined approach, it is hard for us to escape correlation with naïve value benchmarks, but our goal is to add value through understanding the specifics of every individual company we buy. Our aim is to buy good businesses with temporary impediments, rather than simply buying “cheap” stocks. Put another way, our long-term performance is a function of two drivers:
Long term Outperformance = Exposure to Value Factor + Alpha from Proprietary Research
In this cycle, the benefits of exposure to a naïve value strategy have been dubious, but our proprietary research has continued to provide alpha.
What Lies Ahead?
Although it is impossible to predict whether value as an investment style will ultimately outperform this cycle, it is reasonable to believe that it will when the pain of the Global Financial Crisis (“GFC”) has run its course. China’s current slowdown (possibly the delayed effect of the GFC and accompanying fiscal interventions) is certainly impacting many “value” stocks negatively today. Is this the start of another global value cycle, or is it simply emerging markets being the last region to fall in a long global unwind, setting us up for a sustained outperformance phase of the value cycle? It’s hard to know. What we do know is that valuation spreads today support the prospect for an outperformance phase of the value cycle (Figure 3).
Conclusion
Regardless of the outcome of this cycle, we believe the odds are in favor of an active value investor, and that company-specific research is the key to achieving investment success. Value investing is not a simplistic factor, but rather a philosophy that requires research to outperform over the long-term. We are in an environment where poor earnings performance of companies tied to the global economic cycle provides us with what we believe are some very attractive buying opportunities. We are focused on identifying a select number of these companies using our disciplined, rigorous research process to uncover the best in terms of risk and reward.
1Value stock defined as the cheapest price-to-book quintile of the 1,000 largest U.S. listed companies. Similar patterns have been observed in global markets. Does not represent specific performance of any Pzena service.
