One of the greatest value investors of our time held forth the other day for a small group of listeners. There were no CNBC cameras, no arenas packed with faithful followers, and no talking lizards.
Just a conference call. Four people asked questions and it was over in less than an hour. It wasn’t mentioned anywhere in the financial press and nary a peep from the blogosphere.
The occasion was the quarterly conference call for Pzena Investment Management (NYSE:PZN). The firm’s founder and namesake, Rich Pzena, had some interesting things to say about the bargains he’s been seeing lately. Full transcript here.
Here are few highlights from the call:
On Current Valuations
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.
What Others Are Missing
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 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.
On Technology and Other Sectors
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.