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Pzena Investment Management, Inc. (NYSE:PZN)

Q1 2009 Earnings Call

April 29, 2009 10:00 am ET

Executives

Wayne A. Palladino – Chief Financial Officer & Treasurer

Richard S. Pzena – Chairman, Chief Executive Officer, & Co-Chief Investment Officer

Analysts

Marc Irizarry – Goldman Sachs

Hugh Miller – Sidoti & Company

Kenneth Worthington – JPMorgan

William Katz – Buckingham Research

Operator

Good morning. My name is Russell and I will be your conference operator today. At this time, I would like to welcome everyone to the Pzena Investment Management First Quarter 2009 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions) Thank you. Mr. Palladino, you may begin your conference.

Wayne A. Palladino

Russell, thank you very much. I am Wayne Palladino, Chief Financial Officer of Pzena Investment Management. And I am pleased to welcome you to our first quarter 2009 earnings conference call. As always, I’m joined by Rich Pzena, Chief Executive Officer and Co-Chief Investment Officer of the firm.

Our first quarter earnings press release contains the financial tables for the periods we are going to discuss. If you don't have a copy, it can be obtained on our website at www.pzena.com in the Investor Relations section. Replays of this call will be available for the next week at our website or by telephone at the number given in the press release.

From time-to-time, information or statements provided by us, including those within this conference call, may contain certain forward-looking statements related to future events, future financial performance, strategies, expectations, competitive environment and regulations. Forward-looking statements are based on information available at the time these statements are made and/or management's good faith belief as of that time with respect to future events and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in or suggested by the forward-looking statements. Such risks and uncertainties include, but are not limited to loss of revenues due to contract terminations and redemptions, our ownership structure, catastrophic or unpredictable events, unavailability of third-party retail distribution channels, damage to our reputation or interpretation thereof, positioning relative to the market, fluctuations in the financial markets and the competitive conditions in the mutual fund, asset management and broader financial services sectors.

For a discussion concerning some of these risks and other risks, uncertainties and other important factors that could affect future results, please see forward-looking statements and, where applicable, risk factors in the company's Annual Report on Form 10-K as filed with the Securities and Exchange Commission on March 13, 2009. In addition, please be advised that because of the prohibition on selective disclosure, the company, as a matter of policy, does not disclose material that is not public information on our conference calls. If one of your questions requires the disclosure of material non-public information, the company will not be able to respond to it.

Before I highlight some of our financial results, I would like to draw your attention to the format of our financial statements, which has changed slightly from previous releases. A change in accounting guidance now deducts non-controlling interest previously known as minority interest from consolidated net income and classifies them on the balance sheet as a component of equity. This change does not impact our results or financial position in anyway. In fact, we think that this change actually makes our corporate structure easier to visualize and more inline with how we actually view the business.

We reported revenues of $13.7 million for the first quarter of 2009, operating income of $5.2 million, diluted net income of $2.8 million, and diluted net income per share of $0.04. As a reminder, diluted net income assumes that all operating company membership units are converted into company stock at the beginning of the reporting period and the resulting change to company income arises as a result of its increased interest and its taxed that are effective corporate tax rate.

I’ll review our financial results in greater detail in a few minutes. First, I would like to turn the call over to Rich Pzena who will discuss our view of the investing environment and how we’re positioned relative to it.

Richard S. Pzena

Thank you Wayne. The last four months have been like a tale of two worlds. The nascent post election stock market recovery that started in November came to a screeching halt in early January as investors reacted to government action that appeared to had drift and uncertain and in an economy that continued to deteriorate. The depression case became viewed as more than just a theoretical possibility, and the S&P 500 was down by almost 25% from January 1st to March 9th following the 37% decline in 2008.

Then on March 10th the depression was seemingly called off. Secretary of the Treasury, Timothy Geithner provided details of the public-private initiative to rid banks of toxic assets and very early signs of economic stability started to appear. Since that time equity markets have staged a remarkable recovery. The MSCI world index is up 26.4% from March 10th through April 28th with the S&P 500 up in almost identical 26.7% during the same period.

Even more dramatic has been the recovery of our own portfolios. The John Hancock Classic Value Fund for example has appreciated by a stunning 50% from its trough. Of course we have a lot of ground to make up. But in the past seven weeks we have recouped nearly half of our under performance of the prior three years. We’ve been gratified by the reaction of our clients and the consulting community during this volatile and at many times painful period. Although we experienced net outflows in our separately managed accounts during the third and fourth quarters of last year, I’m happy to report that net flows were flat during the first quarter of 2009 with this group of clients, which makes up slightly more than 60% of our assets.

In fact net flows in our separately managed accounts since the beginning of our underperformance in 2006 have been essentially flat, which most likely reflects our efforts at educating prospective clients and consultants on the long-term focus of our strategy and our intense client service efforts that aim to keep clients and consultants continually informed on the latest developments in our portfolios. We continue to experience moderate outflows in our sub-advised accounts, but we’ve started to see moderation in this area as well. Overall, with an 80% of our AUM decline since the peak in June of 2007 is attributable to performance as opposed to client withdrawals.

Needless to say our overall decline in AUM has taken a toll on our revenues and profitability. We remain profitable with a 37.9% operating margin in the first quarter, of course down substantially from peak margins of 70% and we continue to be cash generative. We paid down $8 million of our term loan during the first quarter and made an additional payment of $2 million last week, bringing our term loan down to $12 million.

Cash plus accounts receivable of $37 million at March 31st exceeded our total debt of $30 million by a comfortable margin. And you may recall we are not subject to any financial covenants. Although new manager searches in the value space overall came to a virtual standstill during the market melt down, we are starting to see signs of life, and we believe we continue to be well regarded in the consulting community for our adherence to a time tested disciplined investment process has witnessed by a new substantial relationship that funded during the first quarter.

Despite these positive developments, we are still cautious about calling March 9 to the bottom. There continues to be uncertainty surrounding the health of the global economies along with the efficacy of government stimulus. We have as always stuck to our knitting for this entire cycle focused on constructing portfolios of deeply undervalued companies with the prospect of returning to a normalized level of earnings over the long-term. Although we're clearly not out of the woods yet, maybe instructed to look at the long history of value investing then compare this cycle to how we faired in prior cycles, which should help answer the question, was it different this time.

Absent in unusual talent for market timing, sticking to a time tested investment strategy has proven to be the most effective means of generating excess returns over the long haul, even despite the inevitable setbacks that are part of such a strategy. As you know, we’ve stuck to the strategy of deep value investing. Unfortunately many in the investment world have used the Russell 1000 Value Index as a proxy for a value approach. It is far from that and as a result, comparisons of our deep value performance to the performances of this index are misleading.

We’ve all seen the well-regarded Fama and French data that shows that over long periods of time investing in companies with low price to book value generate significant excess returns. Unfortunately, the performance of the Russell 1000 Value Index doesn't capture that affect. Our own version of the calculation shows that simply a naïve low price to book strategy, a deep value strategy comparable to the academic work produced over 240 basis points of excess annual return over the Russell 1000 Value Index for the 30 year period ending March 31, 2009 and a 290 basis point annual advantage over the S&P 500 Index.

There are however periods of significant underperformance that punctuate the powerful long-term record. There have been five periods of significant underperformance defined as declines of 10% or more in the cumulative level of performance with the most recent period being the worst. Yet the long-term track record of deep value investing remains intact despite these periods of volatility, for the investor that was willing to endure the periods of underperformance, which were at times extreme, the pay-off has been quite large over the entire market cycle. Our own performance has mimicked that of the deep value proxy.

Since the beginning of the recent period of deep value underperformance, our Pzena value strategy underperformed the Russell 1000 Value Index by 19.8 percentage points measured from the January 2006 high point of our relative performance through the November 2008 trough, but we didn’t underperform by as much as the 21.1 percentage points that the naïve low price-to-book proxy underperformed. Nevertheless, we've added significant value over the Russell 1000 Value Index over the long-term, even after two powerful anti-value cycles, the current one and the Internet bubble, Pzena value has generated 48 percentage points of cumulative outperformance since our inception.

Each value cycle has its own unique characteristics, but there are many similarities. With few minutes reviewing the two most recent anti-value cycles to see what lessons we can learn. The dot-com heyday and its recessionary aftermath and the commodity run-up, financial crisis recession of '06 to '08. Pre-recession anti-value cycles are typically characterized by extreme investor sentiment and momentum that trump issues evaluation. Investors scurry to exit from those sectors that they fear will be negatively impacted by the cycle regardless of the valuation and at the same time they ride the winners that they perceived will not be impacted by the economic cycle. Pure value investors like us tend to underperform during these periods since we have little or no exposure to hot momentum areas and some times are caught in positions that fail.

During the dot-com period we missed out on performance from tech, telecom and media and also had a few failures in our portfolio, the most notable of which was Fruit of the Loom. In the case of Fruit of the Loom, our analysis of the franchise value turned out to be accurate, but the company was restructured and we as shareholders didn’t get to participate in that franchise value. Warren Buffet did as he bought it out of bankruptcy. During the most recent anti-value cycle we did not have exposure to the hot momentum sectors, energy and commodities.

Similarly, we experienced a number of failures among our financial holdings, most notably Fannie Mae, Freddie Mac. Fannie and Freddie were taken into government conservatorship and will wind up being restructured we believe into viable business enterprises in the future. But it is irrelevant since we won’t get to participate in that future franchise value. The obvious questions are how do we avoid such failures and can we outperform during the long-term even if we happen to get caught with them.

As you might imagine, we spend countless hours trying to improve our process to avoid repeating mistakes in the future, but the compelling conclusion is that even with the failures, we’ve managed to generate an impressive long-term record. During the dot-com period we underperformed the Russell 1000 Value Index by 33 percentage points from peak-to-trough. The major sources of under performance were the lack of exposure to technology and utilities 8.9 percentage points and 4.1 percentage points respectively as well as our overexposure to materials and processing, 4.6 percentage points, but, 12.9 percentage points of the underperformance came from the failure of Fruit of the Loom and Burlington Industries, two companies where we didn’t get a chance to recover our investment because they went bankrupt.

This cycle, our total underperformance has been 19.8 percentage points from peak-to-trough, with 5.5 percentage points coming from underexposure to energy and 9.7 percentage points coming from the permanent failure of a number of our financial holdings. A relevant question is, can we recover the 9.7 percentage points and still outperform in the long run? Well, if the last cycle is any indication, we think we should be able to. And the source of the outperformance during the last cycle was the avoidance of the sectors that were overheated combined with exposure to companies and industries where valuations were extremely low and fundamentals intact.

In a period subsequent to the dot-com bust we not only made up a permanent impairment of 12.9 percentage points, but we outperformed in aggregate by 125 percentage points. There are good reasons to believe that the excess returns of the past are available once again to the value investor. In fact valuation data suggest that this may be one of the most opportune moments in a generation to construct a portfolio of deeply discounted businesses, many of which are leaders in their respective industries. We believe equities in general are more undervalued than at anytime in the past 30 years, and the most undervalued segment is one of the most attractive relative valuation levels in almost 40 years.

Let’s contrast this opportunity with where we stood at the end of the last powerful anti-value cycle that ended in March 2000. The absolute valuation of the cheapest quintile of our investment universe today is 0.6 times book value versus 1.3 times in March of 2000, or approximately 52% lower. So, not only has the broad equity market fallen in value, but there has been an extraordinary and rapid decline in the valuation of value stocks. This opportunity is also reflected in the valuation of our own portfolios. At approximately 5 times price to normalized earnings, our portfolio is at the cheapest valuation level in our history.

There are only two other periods where we had opportunities almost as attractive. March of 2000 the end of the dot-com bubble, and in early 2002 during a period of recession and geopolitical uncertainty. Both our history and that of market cycles in general would suggest that valuation plays a critical role at this point, and that it is typically value strategies that lead market performance coming out of a recession. That's because at times like these, investors flock to safety and the spreads between the cheap “unsafe” stocks widen to spectacular levels compared to those perceived to be safe stocks. The cheapest quintile of valuation has typically provided a significant level of excess return in the year following a market bottom, that’s for two reasons. First, the evaluations become extreme and second the companies that are feeling the pinch of a recession learn how to cope and produce earnings that aren’t as bad as the naysayers believe.

Although we make no pronouncements as to the timing of the bottom, we believe that our portfolios are taking advantage of the low valuation opportunity, while the managements of these companies are hard at work to restore profitability even without an economic recovery. We expect that they will succeed.

I would now like to turn it over to Wayne Palladino, our Chief Financial Officer for a review of our first quarter results.

Wayne A. Palladino

Thank you Rich. I would like to start out by discussing our assets under management or AUM, our fee rates and revenues. Our assets under management during the first quarter of 2009 declined by $2.1 billion or 19.6% from $10.7 billion of December 31, 2008 to $8.6 billion at March 31, 2009. Consistent with our experience last quarter and last year, over 80% or $1.7 billion of this decline was investment performance related with net outflows of $0.4 billion accounting for the remainder of the decline.

All of our net outflows came from our sub-advised accounts. At March 31, 2009 the company’s $8.6 billion in AUM consisted a $5.3 billion in separately managed accounts and $3.3 billion in sub-advised accounts. Assets in separately managed accounts decreased $1.1 billion or 17.1% to $5.3 billion at March 31, 2009 from $6.4 billion at December 31, 2008 due entirely to $1.1 billion in market depreciation. Sub-advised assets declined $1 billion or 23.3% during the first quarter from $4.3 billion at the end of 2008, due primarily to $0.6 billion in market depreciation and $0.4 billion in net outflows. Our first quarter 2009 revenues were $13.7 million, down 54.3% from $30 million in the first quarter of 2008 and down 23.9% from the fourth quarter of 2008, which were $18 million.

In both comparative periods, the reduction in revenues was due primarily to declines in average assets under management. Year-over-year, this decline was offset to an extent by an increase in our weighted average fees. Average assets under management were $9.2 billion for the first quarter of 2009, down 58.2% from $22 billion for the first quarter of 2008 and down 24% from $12.1 billion for the fourth quarter of 2008. Our weighted average fee rate was 59.4 basis points in the first quarter of 2009, up from an average of 54.5 basis points in the first quarter of 2008 and down slightly from 59.5 basis points in the fourth quarter of 2008. The year-over-year increase was mainly due to an increase in the weighted average fees generated by our separately managed accounts.

Separately managed accounts continue to comprise approximately 60% to 61% of our average assets under management. Weighted average fees for separately managed accounts were an average of 71.5 basis points for the first quarter of 2008, up from an average of 64.6 basis points for the first quarter of 2008 and down from 75.2 basis points for the fourth quarter of 2008. This year-over-year change was mainly due to a higher mix of assets in our international and global strategies, which generally carry higher fees than our domestic strategies.

The sequential decline in separately managed weighted average fees rose as a result of the slightly lower mix of assets in our certain of our higher-fee strategies. Weighted average fees for our sub-advised accounts increased slightly to an average of 40.6 basis points for the first quarter of 2009, from an average of 38.9 basis points for the first quarter of 2008 and from an average of 37 basis points for the fourth quarter of 2008. These increases were generated by the timing of asset flows in our sub-advised accounts, and the impact of that timing on the calculation of weighted average fees.

Now, let's turn our attention to the remainder of the P&L. As I alluded to earlier the format of our financial statements has changed slightly due to changes in accounting guidance. Non-controlling interest formerly known as minority interest are now deducted after consolidated net income not before. In other words the focus is on the entire firm’s net income, not just the piece specifically attributable to the public. For a company with a structure such as ours, we feel these changes reduce complexity and actually mirror the way we view our business internally. They ultimately have no effect on the bottom line.

For the first quarter of 2009 our compensation expense was approximately $6 million, a decrease of $2.9 million or 35.5% from the first quarter 2008 compensation expense of $9 million. Sequential comparisons of compensation expense are not meaningful due to the reversal in the fourth quarter of 2008 of previously accrued discretionary bonuses that generated a compensation benefit in the quarter. The year-over-year decline in compensation expense was a result of lower overall compensation levels and reduced AUM based variable compensation cost.

General and administrative expenses were $2.5 million in the first quarter of 2009, a decrease of $0.5 million or about 19% from the $3 million level in the first and fourth quarter of 2008. This is a result of decreased professional fees and data system costs arising from ongoing efforts to reduce overall operating expenditures. Operating expenses were $8.5 million for the first quarter of 2009 compared with $12 million for the first quarter of 2008.

Again sequential comparisons of operating expenses are difficult because of the bonus reversal in the fourth quarter of 2008. Year-over-year we have reduced our operating expenses by approximately 30%. While we continue to look for ways to further reduce operating expenses we expect our cost structure to remain relatively consistent with the first quarter barring any major changes to AUM levels. Operating margins were 37.9% for the first quarter of 2009 and 60% for the first quarter of 2008. Other expense was $2.7 million for the first quarter of 2008 and consisted primarily in $1.8 million charges related to the negative performance of the company’s investments in its own products and I apologize that was 2009.

The other expense also included a charge of $6.6 million in other expenses associated with an increase in the company’s liability through its selling and converting shareholders associated with changes in the realizability of its related deferred tax asset. Assuming asset and expense levels will remain constant we expect to incur approximately $200,000 in charges each quarter for the remainder of the year as the benefit of the fourth quarter 2008 waiver is used up. The remainder of the other expense consisted largely of interest expense.

Other expenses declined $1.4 million for the first quarter of 2009 compared with the first quarter of 2008 primarily as a result of reduced losses experienced by company investments partially offset by the expense associated with the adjustments to our liability to selling and converting shareholders that I just mentioned. Compared with the fourth quarter of 2008 other expenses declined by $3.1 million again primarily due to the reduced losses generated by our investments. Fourth quarter 2008 other expenses included $2.9 million of income generated from the reduction of liability to the company selling shareholders associated with the waiver of all payments due to them for 2008 and 2009 tax years under the tax receivable agreement.

We prepaid $8 million on our term loan in the first quarter of 2009 with another $2 million prepayment subsequent to the end of the quarter reducing the outstanding principal to $12 million. We expect the absolute dollar amount of our interest expense to come down correspondingly. Our total debt at the end of the quarter was $30 million comfortably less than our total cash and accounts receivable of $37 million. There are no financial covenants in any of our debt. The provision for income taxes was a benefit of $300,000 for the first quarter of 2008 compared with an expense of $1.5 million for the first quarter of 2008, and $700,000 for the fourth quarter of 2008. The first quarter 2009 income tax provision includes approximately $800,000 in benefit related to adjustments to the valuation allowance we recorded in 2008 against the deferred tax asset associated with the tax receivable agreement.

Excluding amounts associated with the tax receivable agreement, the annual and sequential declines in the first quarter provision for income taxes were generated primarily by reductions in taxable income at the operating company. We have provided supplemental income statement data on the last page of the press releases to assist you in deriving our effective tax rate. Excluding amounts associated with the tax receivable agreement, I discussed earlier, our effective tax rate for the first quarter of 2009 was 47.2%. On a similar basis, our effective rates for the first and fourth quarters of 2008 were 45.5% and 45.2% respectively.

The increase in the effective tax rate is driven by certain non-deductible items that impact our unincorporated business tax rate. At our current income levels, we would expect our effective tax rate to be closer to the current rate going forward. As a result of the forgoing, we reported $0.04 of diluted net income per share and $0.07 of basic net income per share for the first quarter of 2009. The differences between basic and diluted earnings per share were generated by the adjustments to the company’s deferred tax asset and the liability to its selling and converting shareholders that had a proportionately greater effect on basic net income.

It’s important to note that there was no material effect to diluted earnings per share as a result of these adjustments. With respect to the balance sheet, cash stands at approximately $26.7 million of March 31, 2009, a number that includes $300,000 of cash held by our consolidated investment partnerships. As many of you may know this will be my last call as Chief Financial Officer of the firm. Effective Friday May 1, I will be focusing 100% of my time as Head of Client Service, turning the CFO reign over to Greg Martin, who is currently our Director of Finance and Accounting.

Greg has been with us for four and half years and I’ve had the pleasure of working closely with Greg for the past two years. Greg is a man of intellect and integrity and has done a terrific job building a top-notch finance team here at Pzena. I wish him well in his new role and know that I’m leaving our accounting and finance function in very capable hands. And now we would be happy to take any questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Marc Irizarry with Goldman Sachs.

Marc Irizarry – Goldman Sachs

Oh, great, thanks. Rich if you can just expand a little bit on the appetite from the institutional perspective for value investing. It would seem that there is a lot of concern about managing assets and liabilities these days and thinking about cash components. Could you just talk a little about when you have discussions with institutional clients, where they see value investing sort a fitting into the equation of doing it in your style relative to just volatility concerns.

Richard S. Pzena

I guess I would say that the institutional investment community went completely frozen on all volatile asset classes or all risky asset classes in the second half of 2008 primarily because of liquidity concerns. And the more illiquid the investment portfolio, typically meaning the higher percentage they had in private equity, and then the surprises they had from the illiquidity of the fixed income markets and from the hedge fund left them sort of feeling like the only liquid asset class was large-cap equities. And so large-cap equities were a source of cash typically in this period. And then the decisions on what to do now have basically been on hold. It’s been pretty much every institution you visit is frozen. They don’t know what to do, they’re panicked about liquidity, and I would say that lasted until maybe the last four weeks. And if you were looking at our activity and I think we’re probably pretty indicative of other value managers, we had spectacular levels of activity that went on for half a decade or more. And it dwindled from that effectively zero by the second half of last year, and now I would say it's higher than zero. I don't know how to put any, and I don't believe the issues are fear of volatility, right now it's very mixed, it's 50% fear of volatility as you mentioned and it’s 50% fear of missing out on a spectacular rally. And it’s now a debate among those two things instead of just one-sided.

Marc Irizarry – Goldman Sachs

Okay, great. That's really helpful. And then just Wayne in terms of the minority interest piece, I know there is a change in sort of the presentation of the P&L, but the minority controlling interest as a percentage of the operating company earnings I guess went down to 82.3% from 90%. Can you just explain what's happening there?

Wayne A. Palladino

Yeah, there is actually a couple of pieces that you see in that line Marc, it’s both the non-controlling interest of consolidated subsidiaries, as well as, the non-controlling interest of Pzena Investment Management, Inc. So, there was some conversion during the quarter that would have affected the Inc.’s portion of our partnership’s net income, that's increased to about 10.8% on average during the quarter from about 9.5% previously, and then the remainder will just be related to that non-controlling interest of our consolidated investment sops.

Marc Irizarry – Goldman Sachs

So, how should we think about that percentage on a go-forward basis?

Wayne A. Palladino

I’d probably be thinking about on the order of 88% being allocatable to the partnership and 12% allocatable to public shareholders.

Marc Irizarry – Goldman Sachs

Okay, great. Thanks.

Wayne A. Palladino

Sure.

Operator

Your next question comes from the line of Hugh Miller with Sidoti & Company.

Hugh Miller – Sidoti & Company

Hey, morning.

Wayne A. Palladino

Good morning. Thank you.

Hugh Miller – Sidoti & Company

On the last conference call, and on this one as well you mentioned that you were selected from a major firm to sub-advise for their funds. I was wondering if you could just give us a little bit more color on the update with the progress in that relationship, where things stand and whether or not you're seeing opportunities starting to emerge on the horizon with other firms.

Richard S. Pzena

Yeah, let me just clarify that that wasn't a sub-advisory account, that was an institutional relationship and that’s funded. It’s funded in the first quarter. Whether it will lead to more assets in the future or not,we don't really know. There is a shot that it will, but I don't know that there is anything on the horizon there, so that’s already in the numbers.

Hugh Miller – Sidoti & Company

Okay. And so it doesn't seem as though right now, you're seeing activity that would lead you to believe it that there are other possible opportunities with other institutions at this point.

Richard S. Pzena

No, no. I would tell you that the activity level is better than it was in September and October where things bottomed. So, yes, we're actually being included in searches, we’ve actually had search activity after a lull of six months. There is actually we're getting phone calls, so it is nowhere near the level that was at during our peak, but it certainly improved significantly and these are long, long processes, so it doesn’t translate into instant assets under management, but we are encouraged.

Hugh Miller – Sidoti & Company

Okay, and the investment in marketable securities line item on the balance sheet has trended down towards about $11 million. Can you talk about the composition there, what percentage of that is assets that you’re investing in your own products?

Richard S. Pzena

It’s all assets that we are investing in our own products and I’ll give you the exact percentage, they’re roughly half and half that’s deferred comp. It’s 60% actually that’s deferred comp, so it really belongs to our employees and so while the increases and decreases in that goes to our income statement, they eventually are the expense or gain of our employees and the other 40% is incubated product.

Hugh Miller – Sidoti & Company

Okay. And then, I guess one last question is with regards to looking at that tax valuation allowance adjustment. I was wondering maybe you could just talk to us as to why that hit the basic EPS a little bit more than it did on the diluted?

Wayne A. Palladino

Yeah, the reason for that Hugh is because any adjustments to that valuation allowance are done at the Inc. level. So, it’s reflected dollar for dollar in both the basic as well as diluted net income. So, you’re getting that full impact at the basic level and then you are seeing it having a much smaller effect once you go to a fully diluted calculation.

Hugh Miller – Sidoti & Company

Okay. Thank you.

Wayne A. Palladino

And the overall net of that during the period Hugh was about $200,000 so you can see again why the difference between the $0.07 basic and the $0.04 fully diluted. If you back that out of the basic number you actually come back to $0.04.

Hugh Miller – Sidoti & Company

Yeah. Okay. Thank you very much.

Wayne A. Palladino

Great.

Operator

Your next question comes from the line of Kenneth Worthington with JPMorgan.

Kenneth Worthington – JPMorgan

Hi. Good morning. I think you said in the prepared remarks that every value cycle is different. In previous cycles where did you generate your alpha? Kind of thinking back on it like during the post-tech bubble, I assume you generated the most alpha when tech was blowing up, because you were underexposed. In this cycle it seems like you are pretty heavily exposed in financials, as that sector was getting hammered. So, is this cycle really different? It seems very different. And to what extent are the really nice returns you’re generating now just an unwind of the negative alpha in the same positions generated a year or so ago. Am I thinking about this correctly or?

Richard S. Pzena

Yeah. No. It’s the right question Ken. What was interesting is the last cycle, the contributions to our recovery from post to that cycle were very, very broad. When you start to look at the sectors or the specifics that created the unwind it was as you suggested the lack of exposure to technology, and that was probably the biggest contributor, but it was still only 10% or 15% of the total contribution, the remaining 85% to 90% was broad-based just buying cheap stocks that recovered. This cycle it’s uncannily similar actually that you always get killed by something, right. Last cycle we got killed by our excess exposure to industrial cyclicals going into a recession and we had some bankruptcies and then exposure to the same industrial cyclicals created the outperformance going forward, but it wasn’t just that, it was pretty much across the balance sheet valuation. So, this cycle we’re killed in financials and we had bankruptcies and the unwind that we’ve seen in the last seven weeks, our exposure to financials has been the biggest contributor of that relative performance gain, but similarly it’s only 10% to 15% of that relative performance gain and it’s very, very broad based.

Kenneth Worthington – JPMorgan

Okay. Thank you. And this sort of goes along with that that response, like where are we in the deep value cycle, are we kind of in the sweet spot right now or are we just passing the sweet spot or are we getting towards the sweet spot. I think it sounds like a simple question, but I’m really kind of interested what your thoughts are.

Richard S. Pzena

Yeah, these are never easy questions to answer. There are typically two things that create the good side of the deep value cycle. One is valuation extremes and we clearly have valuation extremes. And two is the realization that the world is not as bad as everybody thinks it is and this is where you got the most debate, all right.

When I go and visit our clients, the first question everybody asks is, is this value for real and they always go to the next decade is going to be lousy compared to the prior decade. The prior decade was characterized by excess of greed and leverage and overspending and crazy government policy and you know all the arguments. So, it can’t possibly be as good going forward and I got to say it’s hard to disagree with that. In fact, I have yet to find anyone who disagrees with that, which makes you wonder about it, but certainly I would agree that the next decade is going to be characterized by sort of mediocre GDP. Therefore, that I think everybody gets it wrong, people then say therefore companies won’t make lots of money, and that just doesn’t make any sense to me.

The reality is that when you study corporate earnings over long periods of time what you observe is that the margin structure of companies is unrelated to their level of sales. As hard is that is to believe and as hard as it makes no sense what I just said, because you would say a company that has more sales should have more higher margins, but you can’t find any evidence of that at all in the actual data and I think there is lot of reasons for that. One is that companies have a tendency to waste money when they have it. Companies have a tendency to try and expand their business into other areas.,when they can. Companies that get bigger, maybe get more complex and therefore it’s harder, companies that are smaller turnout to be scrappy.

And so what you’d find is that it’s just knowing what environment that you’re working in that determines your margin, it’s not the environment. We’ve seen it, one of the best examples of that is one of our biggest holdings, which is JCPenney. And JCPenney, which has had really rotten same-store sales and earnings were falling and falling and falling in the last months without any improvement in sales has guided up earnings twice. And I think what we’re going to see is a very some positive surprises on corporate earnings in the absence of the strong economic recovery, that's going to shock people. And I think it's going to be very, very similar to the 70s, where you windup with maybe stagnant overall markets and sort of a heyday for value investing. I think we’re set up with a very similar environment.

Kenneth Worthington – JPMorgan

Great. That was actually interesting and helpful. And then just lastly, today where are you seeing kind of the deep value opportunities, like kind of what sectors are you’re being drawn towards and which are you avoiding?

Richard S. Pzena

Well, our biggest exposure in relative terms where we’re way over exposure is in technology. And technology sort of has every characteristic that we look for, which are really good franchises that don't have any viability issues, because these companies tend to operate with no debt or high levels of cash and very, very uncertain near-term earnings environment. So, people have sold them off dramatically. And typically we’re not buying hi-tech, where you’ve got to make guesses about whether the products are going to be successful. I'm talking about Microsoft and Dell and companies like that where their share prices are up significantly from their peaks. And the conventional wisdom over the last six months has been to go on to safe things like the pharmaceuticals. And so what we’ve been doing typically is selling the pharmaceuticals, good example of this was a trade. We sold Johnson & Johnson at about the same price we had paid for it two years ago, because everybody said this is where you should go, and bought Dell at 75% below where it sold for two years ago, because everyone says who knows how many computers are going to be sold, they don’t say that their franchise is gone, they just say, who knows what the earnings are going to be in the near-term. But there is no viability risk. So, you’ve seen and it’s not just technology, it’s capital goods, it’s energy, it’s consumer cyclical, it’s financial. We’ve one of the broadest portfolios of companies with one characteristic. We have no idea how much they’re going to earn in the next year or two. Because of that inability to know people are discounting the prices by degrees that make no sense.

Kenneth Worthington – JPMorgan

Great. Very helpful. Thank you very much.

Operator

Your next question comes from the line of William Katz with Buckingham Research.

William Katz – Buckingham Research

Hey. Thank you, good morning. Rich in your prepared remarks I apologize I didn’t understand clearly, you mentioned that you had a new relationship in this quarter. I wasn’t sure if you were referring to a new consultant relationship that might lead to more sales or whether or not that was a new mandate that actually generated more sales in the quarter.

Richard S. Pzena

It was the latter.

William Katz – Buckingham Research

Can you quantify the size of that opportunity?

Richard S. Pzena

No. I would prefer not to do that. But it was substantial, it was more than half of our inflows during the quarter.

William Katz – Buckingham Research

I guess you’re referencing what you won in the first quarter not something new into the second quarter.

Richard S. Pzena

That’s correct.

William Katz – Buckingham Research

Okay. I apologize. Another question is, you mentioned in terms of margins, [Inaudible] based on some of your answers in some of the other Q&A, as you think about your own margin, you mentioned that if the AUM were to be flat, your cost structure would be relatively flat as well. What if your scenario were to play out and the equity markets continued to rally or the equity markets themselves are up, but your own assets continued to rally. How should we be thinking about the profitability levels of your company?

Richard S. Pzena

Well, look we had an extreme period in 2000, if you look at the history, when our margins hit 70% or whatever they hit at the peak.

William Katz – Buckingham Research

Right.

Richard S. Pzena

That was unsustainable, because that was bringing in money at a faster pace than you could spend it, even if you wanted to spend it. So, I don't think it's rational to project going back there. On the other hand, if our AUM increases, our margins will increase. We’re not going to take all the money and give it to our employees, but our employees are sacrificing, so some of it will go to the employees and that will be a function really of competitive pay structures. So, our aim is to pay in the top quartile. We still believe we're paying in the top quartile. I do not think, we have any catch-up to do. I just think that there is lots of possibilities, let's say we rebound and our AUM is 50% higher a year from now, but Wall Street salaries are still depressed. When then our margins will expand dramatically. If Wall Street salaries go up a lot, then we'll have to pay. I don’t know any better way to answer that question.

William Katz – Buckingham Research

Okay. Now I understand. Just a couple other questions for you. You mentioned that you’re starting to see some signs of stability in the sub-advised accounts, just sort of wondering where you're drawing that observation from and I guess the question I have is what’s most important thing about flows for that business. Is it the very near-term performance, which has turned up nicely or is it still sort of the rolling one, three and five year track records that you gain half of your alpha back, but not obviously enough yet.

Richard S. Pzena

It’s definitely the rolling one, three and five-year track records. I don’t think the fact that we had to top-off the bottom, it’s going to have a significant influence on our flows. I think you should be aware though that our under performance really stopped in June of 2008. So, when we lap our lousy June of 2008, assuming things are where they are today.

William Katz – Buckingham Research

Right.

Richard S. Pzena

A one-year record will start to look really good in July and it will take longer for our three and five-year records to look good. Again speculating no further changes the one-year record will be good, the 10-year record will be good, the 10-year record will be top percentile and the three and the five will still be challenged.

William Katz – Buckingham Research

Okay. And then just last question, I know I asked this last quarter and I apologize for repeating myself, but as I sort of look at the array of your products, I’m still struck by the relatively small size of the number of these funds given the sharp decline in AUM. Is the size of the AUM any type of gating factor from the consultant community, because one of the things you do here from some of your competitors that mandate seemingly are getting larger, not smaller. So, I was sort of wondering is there a capacity constraint that might counter-balance some of the alpha recovery?

Richard S. Pzena

Not that I can say, in fact most of our activity is actually in small cap. So, I would almost contradict that statement.

William Katz – Buckingham Research

Okay. All right. Thank you very much.

Operator

There are no further audio questions sir.

Wayne A. Palladino

All right. Well, we thank you very much for joining us and we’ll look forward to seeing you next quarter.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Pzena Investment Management, Inc. Q1 2009 Earnings Call Transcript
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