Cheap for a moment, or cheap for good 

A simple screening process will find cheap stocks in any market. Working out which of them are cheap because a sound business is having a bad few years, and which are cheap because the business itself has changed, is the part that takes months rather than minutes. 

Rakesh Bordia, principal and portfolio manager at Pzena Investment Management, is one of the co-portfolio managers for the firm’s emerging markets strategy around that one distinction.  

The process starts mechanically, with each universe divided into five quintiles on valuation, measured against normalised earnings power, which Bordia describes as the cash earnings of a company over the next ten years condensed into a single number. The cheapest 20 per cent becomes the research universe, and nothing outside it can enter the portfolio. 

The core question 

Everything sitting in that quintile is there because something has gone wrong. “Is it a good business and why is it cheap today?” Bordia says. “Something has gone wrong. And do we believe that problem is temporary or permanent?” 

The first half of the test does a lot of the work. Most businesses we invest in are leaders in their industry, with a real edge over its peers in product, technology or cost, which removes a good part of the cheapest quintile before the research even starts.  

Plenty of companies are cheap for reasons that will never reverse. In emerging markets the starting universe runs to roughly 1,000 names and the cheapest quintile to about 200, the team does detailed work on around a third of those in a year, and somewhere between 10 and 15 make it into the portfolio. 

Ships and oil prices 

Pacific Basin Shipping is the case Bordia reaches for when the answer was temporary. The company is one of the world’s larger dry bulk operators in the handysize and supramax classes, carrying grain, coal and steel, and Bordia puts its daily earnings at roughly a 60 per cent premium to the average rate achieved by other shipping companies, a function of scale and of filling return legs rather than sailing back empty. 

The stock became cheap for an ordinary cyclical reason. Too many ships had been ordered, supply ran well ahead of demand, and daily rates fell.  

Then it got worse for a reason nobody had modelled. Oil prices dropped, bunker fuel is the largest running cost of a ship, and cheaper fuel meant operators ran their vessels faster. A voyage that had taken 30 days started taking 25.  

Effective supply rose without a single new ship arriving, the imbalance persisted and the share price kept falling. 

Pzena added to the position rather than trimming it. The reasoning was that owners had ordered no new ships for several years, a new vessel takes about three years to deliver, and the oil price weakness driving the speed effect was itself temporary. Supply could not arrive, so the balance had to tighten eventually. It took several more years before it did. 

“It all goes back to your true belief in your process, in your research, and having the discipline to act when the world is actually really scared.”

When the past misleads 

The opposite answer came from a Chinese wind power company, the largest in the country, which had produced mid-teens returns on equity for 15 years and was trading well below book value. On the record of the past decade and a half it looked obviously cheap. 

The research found a break in the regime. Wind farms built before 2021 operated under one set of rules and had locked in strong returns, while everything built after 2021 earned significantly less.

As a state-owned company it also carried a mandate to keep building capacity whether or not the returns justified it. “The future of this business looks way different from what the past looks like,” Bordia says. 

This ability to differentiate becomes the true art of deep value investing. A screen applied rigorously can identify a large universe of securities that the market has sold off aggressively, perhaps even below book value.

Rakesh and his fellow co-portfolio managers then use debate and analysis to ascertain whether this selling is a permanent feature of a failing business or a market overreaction to a temporary phenomenon.