Why does value investing work, and what are the best qualities to look for in a business before investing? These are some of the questions Richard Pzena sought to answer in a presentation given as part of Joel Greenblatt’s Special Situation Investing Classes at Columbia University Business School in 2006. The following is a summary of his lecture, taken from notes compiled by an investor who was there at the time.
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Pzena argues that the reason why value investing works merely is that people ignore the data and they expect current trends to continue indefinitely. In other words, generally speaking, investors expect poor companies to continue to do poorly, and good companies to continue to do well. But this often not how situations work out. Poor companies tend to improve while beautiful businesses tend to lose their edge as competitors erode market share or they simply make a fundamental mistake.
“On average, poor companies do better and on average great companies that are doing wonderfully, don’t do as well. That is why value investing works because the markets extrapolate the same trends of high ROE companies continuing with the same or higher ROE while low ROE companies have lower to same trends extrapolated into the future. People just don’t get it (reversion to the mean) despite many years of evidence.”
Pzena goes on to say that investors who believe good companies will continue to earn high returns on capital are “betting against the odds.” While people who invest in low return on equity companies with low expectations should be able to outperform. Pzena estimates it generally takes around five years for a company’s return on equity to revert to the mean.
Things are always cheap for a reason, and you need to find out why that is the case. It may be a missed earnings target or customer problems, but you’ll never find things that are cheap for no reason. Great companies with nothing going wrong rarely trade at reasonable valuations, but companies with good management and high returns on equity can become cheap if they slip up.
“If you can combine a company that has a low valuation and should have a sustainable edge, but may, in the present, may not be experiencing it for some–and it may be temporary–reason, then you have this unbelievably powerful combination. If you can buy a good business at a low price, then you have nirvana.”
The four primary characteristics of good businesses are:
1. High barriers to entry
2. High margins
3. Good management
4. Pricing power
And there’s possibly a fifth requirement, capital intensity. Companies that require a high capital outlay are less likely to attract competition due to the initial high start-up cost. If anyone can replicate the business without having to spend millions, then it is more likely that at some point the company will face fierce competition, margins will slide and return on equity will fall. There are some other factors to the barriers to entry equation including brands, high switching costs, lower operating costs, patented technology, government regulations and customer captivity. Many factors contribute to a good business being a good business. To streamline this process, Pzena is looking for companies where you can ” identify specifically a reason why it should be able to earn an excess return on its cost of capital. It has to be a simple reason that you can see.” If you can quickly and easily identify why a company is a good business, that is half the battle.
So, you have found a good business. The next stage is to wait for value. What creates value, it’s always the same factors according to Pzena:
“The pattern is almost always the same. If you have a company that is chugging along just fine and something falls off trend–that is what creates value. The stock price, especially if the price is looking far out into the future for a continuation of earnings growth, the price will fall dramatically if the earnings fall off their trend. “
However, the issue that the value investors face is the overwhelming amount of evidence that shows investing in deteriorating businesses is not a good investment strategy. This puts investors off from buying the stock when problems are emerging, but if you wait for the earnings to turn and for Wall Street’s view of the company to improve, then it’s likely you will be too late to the party and not get a cheap price.
With this being the case, instead of trying to catch a falling knife, or waiting for the turnaround to begin, Pzena tries to buy the stock when it’s clear management has taken action to stabilize the business. The business deteriorates, management tries to do something, and then the business stabilizes
“This is where I try to buy — in the trough of stabilization of the business.” Most people don’t like buying at this level because at this stage; it is unclear if the business’s recovery is indeed underway. Waiting until this point skews the risk/reward in the investor’s favor. Buying in at the point at which the company has stabilized, limits the downside as you can assume that there is going to be no further deterioration. However, the upside potential is tremendous as the business recovers and revert to the mean.
“Value is created by deterioration. The price drop relates to the deterioration while the value captured is associated with price reverting back to trend or the mean. You have to accept further price declines when you buy while the business continues deteriorating, and if you wait, you will pay up while recovering and miss a good opportunity. Once you can see a catalyst, you are late and you are playing partial momentum here.
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The way you can add value is to distinguish between temporary and permanent problems. Getting a good business at a good price is nirvana. A low price will be associated with problems surrounding the company and its business.”
