Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
‘We go where the pain is’: value, after the bubble
It seems that value is back – not just in a sputtering short-term rally that will soon be dispatched by rejuvenated growth stocks, but in a new cycle that US-based Pzena Investment Management believes will last a little over five years, like every other value cycle before it. They’re “gut wrenchingly testing”, particularly at the start, but usually stick around. This one is a scant 18 months old, born from the vaccine announcements that gave a line of sight to the post-Covid world.
“It’s been one of the most fantastic opportunities ever to be a value investor over the last two years,” says Allison Fisch, portfolio manager for Pzena’s Emerging Markets Value Fund. “You see spreads blowing out in every region of the world; we’ve reached levels we didn’t think we’d ever go back to anywhere, and it’s unfolded since then in a very positive way for value investing… History would tell you it’s early days.”
Fisch was responsible for pioneering emerging markets at Pzena in the heyday of 2004, taking up the position of portfolio manager after a “jack of all trades” analyst role that saw her scrutinising “the small cap companies that fell through the cracks.” It was essentially mucking around with the firm’s money, Fisch says, while proving that value could work when applied to emerging markets – something nobody else was working on at the time.
Figuring out country effects was one part of that, with the team applying different discount rates to ensure that the cheapest quintile, where Pzena fishes, isn’t populated entirely by Russian SOEs or Chinese banks. That feeds into the new debate raging in EM – whether it’s worthwhile owning China in the wake of both last year’s regulatory upheaval and this year’s geopolitical upheaval.
There’s a generalized belief that Xi Jinping will one day try to reunite China by invading Taiwan, a belief supported by the fact that Xi is vocally gung ho to do just that, leading to similar problems that big pension and super funds experienced during the Russia divestment.
Fisch has heard both sides of the debate from investors; in the US, some state plans exclude the country for political reasons, while other investors were already looking to break their China exposure out of EM as it began to comprise a massive chunk of the index (which, ironically, forces super funds yoked to the Your Future, Your Super test to invest there).
But for a value investor, China is now a land of opportunity. Many of the former darlings Pzena couldn’t invest in have now fallen into that cheapest quintile. Every single company is exposed to regulatory risk, Fisch says – “the government could wake up tomorrow and put you out of business” – so there’s no monster positions, and Pzena has instead taken a basket approach (the valuation of which would suggest they should be much larger positions than they are).
“We’ve been underweight China for years and we were beat up about it when China was doing well,” Fisch says. “Now we’re heroes, of course. With all these companies doing so poorly, we’re seeing more and more of them screaming out to us.”
After a 13-year “anti-value phase”, there are those who were convinced that the world had changed and that the disruptors had won – but it’s always going to matter what you pay. A punishing, indiscriminate sell-off like the one we’ve just had will have most value managers intermittently scratching their heads and jumping for joy, given the wealth of bargains it leaves lying on the floor.
Value is all about psychology, Fisch says; if investors were rational these opportunities wouldn’t exist, but there are so many companies that are cheap because of forces that are clearly temporary.
“You take a company in an industry with decent structure that’s suffering, because their costs have gone up due to inflation and supply chain strains, and you punish the stock price because the quarterly earnings are low and they haven’t yet pushed the pricing through on the other side,” Fisch says. “That’s not the permanent state of affairs, yet the market will price the entire business as though its totally impaired… We go where the pain is.”
