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Embracing the loneliness mindset: Rich Pzena and the deep value dilemma

"I wouldn’t employ someone from a growth house and try to turn them into a value investor," says Rich Pzena. "It doesn't work, they're different people."

Value investing is a lonely road, especially for those practitioners who are looking for real deep value rather than small arbitrages. For this kind of investor, often the stocks they buy are very unloved, and they can stay that way for some time, while everyone else in the market thinks they are nuts.

But value is “the mindset that you have,” says Rich Pzena, founder and chief investment officer of New York-based deep-value investment firm Pzena Investment Management, which manages US$56.4 billion ($87.4 billion). A former oil industry analyst and ultimately, chief research officer Sanford C. Bernstein in New York, Pzena established his eponymous firm in 1996.

“We feel the destination makes the effort involved – focusing on the long term, doing our own research, stomaching the volatility and swimming against the tide of popular opinion – hugely worthwhile. Equally, we recognise – even if we do not fully understand – that others may prefer to follow different investment routes,” he tells The Inside Adviser.

  • The mindset is innate, says Pzena: just as an equities person can’t be turned into a bond person, a ‘value’ equities person is different to a ‘growth’ equities person. “I wouldn’t employ someone from a growth house and try to turn them into a value investor; it doesn’t work, they’re different people.”

    The main difference, he says, is that stocks that represent ‘value’ are cheap, and that’s usually because something bad has happened. The value investor has the mindset to investigate that situation.

    “For the stocks that come up on our screens, the market is acting as though the business is permanently impaired. Our job is to investigate the situation and work out whether that’s true, or whether it’s a temporary problem. If it’s the latter, the earnings will recover, and so will the stock price,” says Pzena.

    From the outside, the dilemma for investors is always in assessing what “cheap” is – on what number is that being determined? Everyone knows – or should know – that the share price at any time only represents the price at which the last transaction was struck. But what’s the other number?

    “Most investors use a price-to-book (as in, ‘book value,’ or what in Australia would be called price-to-net-tangible-assets, or price/NTA), or a price/earnings (P/E) ratio. But we use a figure that we call ‘normalised earnings,’ which is what we would expect a company to earn across a business cycle – say, at the midpoint of the business cycle. Buying companies that are cheap relative to their ‘normalised’ earnings power is how we define value investing,” Pzena says.

    This ‘normalised’ figure only exists inside Pzena’s hivemind. “It’s what should this business earn given a variety of inputs — its history, the industry structure in which it competes, competitor margins, its individual company strengths and weaknesses, its management and its business plan. We go through a scientific screening process, but ultimately, our estimate of normal earnings is a concept, not a mathematically derived figure. It’s just, ‘what should this business earn over the long term?’And very often that’s different from what it is currently earning,” he says.

    When current earnings are below normal, the firm gets interested. “Typically, in the companies we’re buying the margins have fallen below their historic norms. That’s important to us – we avoid companies that are doing better than usual, which makes us really sceptical.

    “On the flipside, one of the questions we always get asked is, ‘how do you avoid value traps? ‘And the answer is, we don’t know. We feel that the very attempt to avoid value traps makes you not a value investor. Because the truth is, you don’t know which are the ones that are not going to work and which ones that are going to work. The traps that we try to avoid are excess financial leverage, so that the bad outcome is disaster, or businesses that are going through a massive structural change, where you can’t evaluate the downside case,” says Pzena.

    Which brings us back to loneliness.

    “Over the last decade and a bit, we’ve used the phrase, ‘value is a philosophy, not a factor,’ because everyone wanted to put you into the bucket based on a factor, and thought they could replicate what you do with simple statistics,” he says. “We’ve had to defend what we do, because when you’re under-performing for a decade by not being in the top-tier growth stocks, it’s very hard to continue to ignore that. It’s very hard to continue in business when you’re losing relative to these guys, year after year after year. Then again, we experienced the same thing during the internet bubble in the late 1990s, and we just kept doing what we were doing.”

    The emergence of value as a ‘factor’ has seduced investors into thinking that finding value is relatively simple, he believes. “A lot of people will argue, all you have to do is buy low P/E and low price-to-book, because I have all this academic literature that shows me that works, over long periods of time. So, what do I need analysts for, why do I need an investment adviser, I can just invest passively in value as a factor. But all that’s doing is giving you exposure to low P/E and low price-to-book – it’s not giving you exposure to value in the true sense.”

    A bit of longevity also helps, Pzena adds.

    “First of all, we believe in our process; and second, we felt even before things turned for value in late 2020, that we’d seen this before. What told us that we were close to a turning point was when a lot of the newer value firms ‘cheated,’ in our view, and put some growth leaders in their portfolio, that may have come off. But just as in the late 1990s, they tended to do it right before the peak. And then when value ticked-up and started to generate strong returns, they didn’t deliver what their clients expected.

    “We’re seeing a lot of that now,” he continues. “We call them ‘value-light.’ And that’s where deep-value earns its keep: when a situation is improving, if you wait till it’s going up, you missed the opportunity to buy at a very low price. And that’s the dilemma we all face.”

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