Home / Deep value still, despite full prices (except at News Corp)

(Pictured: Richard Pzena)

by Barrie Dunstan

Pzena Investment Management, New York-based deep value investor, is still finding opportunities for its style of investing in current markets with a tilt to European markets, a selective over-weight stake in big oil groups and US financials – and a recent sortie into Rupert Murdoch’s News Corporation.

Richard Pzena, founder and architect of the firm’s strategy, has been in Australia to meet its six local clients who have about A$2.5 billion as part of Pzena’s total US$28 billion (A$35.9 billion) funds under management.

Pzena admits being a deep value investor is “still a bit of a hard sell.”  This, he says, is partly because a value investor’s job is to take advantage of other people’s fear of volatility – and this requires some exposure to volatile stocks. The trick has been to find the right screen to eliminate the most volatile or risky stocks.

After analyses of returns over the last 30 years, he believes concentrating on stocks which are cheap can reduce the frequency of losses over rolling 10-year periods while also providing higher real returns. He says buying cheap stocks showed returns of 11.9 per cent versus 8.5 per cent for the S&P 500, while the probability of losses declined from 11 per cent for the index to only 2 per cent for ‘cheap’ stocks.

In the GFC downturn, Pzena was heavily exposed to banks, such as Citigroup. Now, it has an additional overlay to avoid stocks with excessive leverage, using  a measure of the most extreme volatility  (rather than debt to equity ratios) as a way of avoiding  the danger of leverage.

After the GFC,  Pzena’s investment assets dropped 70 per cent (including the market fall). Most of this was in its newer retail funds, run for John Hancock, which, after rising to $10 billion in four years, then fell to $2 billion in the next two years to make up most of the losses. Its institutional business held fairly steady.

Its Australian business originally began as a result of inquiries from customers. Now, it has David Taylor, originally from the UK and an ex-NAFM executive, as a principal running a marketing and service office in Melbourne. Pzena is now considering a similar approach in London.

As a value investor in the current market, Pzena thinks that both the big integrated oil groups and major financials are cheap. Big energy stocks are at their lowest price-to-book ratio since 1968 and financials similarly are at the low point since 1987.

The group has been using its new volatility screening since 2009 and hasn’t had a bankruptcy or dilutive share issue in its portfolio since –  even in the Euro crisis. “We think it’s working” Pzena says, “so we continue to buy- out-of favour stocks and wait for the recoveries.”

Pzena spent several years with US oil major Amoco as well as time as a sell-side analyst, initially covering the oil industry with Sandford Bernstein. As a result, he approaches investing in oil stocks with a deep knowledge of the industry’s history.

Since 1971, before the first oil shocks, he says oil prices (in 2014 dollars) have risen at an annual rate of 1.7 per cent a year in real terms. He says it will take a few years for supply (now perhaps at 5 per cent excess capacity) to adjust and for prices to move back to their long-term range.

He compares the current market, where 85 per cent of non-OPEC oil came from new fracking wells in North America, to the 1980s emergence of North Sea oil. Now, as then, it will take time for the industry to adjust from boom time drilling and for oil prices to recover.

He thinks between US$60 and US$80 a barrel is a long-term price range for oil. But US shale projects and offshore deep water wells both require oil at US$80 a barrel and Canadian tar sands need more than $100 a barrel, Pzena says, leaving the major integrated oil groups as the most attractive investments.

Pzena also likes banks and financials (despite the episode with Citigroup) because of their 27-year low in valuations. This has seen the Pzena global fund move to slightly over-weight in energy (11 per cent versus an 8 per cent index weight), while it is holding 30% per cent in financials against an index weight of 20 per cent.

Pzena says banks provide the best risk/return trade off that his group can find, particularly the big US banks like Citigroup, Bank of America, JP Morgan and Goldman Sachs, which are selling at their book values. Their balance sheets are strong and their earnings are OK; they are earning around 8 per cent on assets( which should be 12 per cent). The reason, says Pzena, is low interest rates.

 Geographically, the global fund is heavily underweight North America with 41 per cent against an index weighting of 61per cent  and instead it’s over-weight in Europe (30 per cent against 18 per cent index weight) and in the UK with 14 per cent against an 8 per cent index weighting.

The group has recently emerged as a substantial shareholder in News Corp shares with Pzena admitting to a shareholding of almost 7 per cent of the voting ‘A’ shares in  Rupert  Murdoch’s newspaper and media listed arm. A recent SEC filing disclosed holding 26.5 million ‘A’ shares and Pzena also has a lesser number of ‘B’ shares, first bought in late 2013.

Pzena says recent share prices effectively give holders the Australian and UK newspaper franchises for free. Even though challenged by the internet, he thinks News should be able to find a way to benefit through is dominant market position. He thinks there is still a role for newspapers; the tricky part is to work out how to charge for news via the internet.

“Maybe I’m still old fashioned,” he says, “but I can’t believe that normal human beings can process Twitter feeds all day long without someone sitting there and being the editor.”