This is from the Pzena Investment Management earnings call: Thanks, Wayne, and good morning everyone. The second quarter of the year was awful. There’s no other way to describe it. Fear gripped the marketplace and sent almost all share prices lower, especially the shares of the financial services sector. We’re now in territory where rational analysis has been discarded and emotion is driving securities prices. While this is the type of market that allows traditional value investors like us to source our best opportunities, it is also the type of market that is very painful for our clients. Let me use Wachovia Bank as an example of the emotion gripping the market. We purchased shares in Wachovia immediately after its capital raise. Our analysis concluded that there was very little likelihood of a need for further capital and, when conditions return to normal in a few years, it could earn around $5 per share. In the panic, investors sold shares of Wachovia down by two-thirds, clearly believing the capital was inadequate and the franchise value was irrelevant. When Wachovia reported earnings last week, with what we thought was clear evidence of no need for more capital, the initial trading was down 10%. Following the conference call, the shares closed up 27%, a 37% swing in one day. Clearly, the franchise value of Wachovia didn’t change by 37% during the course of the day. This is pure emotion. During the quarter, we had moves of more than 1% in our portfolio on 52% of the trading days and moves of more than 2% on 12% of the trading days. This is a classic momentum market. No one is interested in what kind of franchise a business has or what it’s worth. The only issue has been what is going to happen next? A light off, a capital raise, a dividend cut; price has become totally irrelevant to the marketplace. Over the past 18 months, if you had simply bought a portfolio of naive momentum stocks, no research, just the stocks that did the best the prior nine months, you would have compounded at about 17% per year. And if you had simply bought cheap stocks, based on price-to-book, you’d have lost 17% a year. That kind of dramatic spread has happened at the end of every economic cycle in the past 40 years, as fear of the looming recession drives investors to lose sight of the valuation of the companies that are negatively impacted by the recession, and flee to the stocks that are working, in this case, energy and commodities. But if history is a guide, once the session is underway and the safe haven momentum stocks turn out not to be immune from the normal rules of economics, valuation discipline should return and value stocks should outperform. What’s interesting about this cycle is that the spread in valuation between the haves and the have-nots is at an all time record high. If we examine the valuation spread between financials and commodities, it is at its highest point in 55 years. In fact, at the end of June, financials broke the previous record, in terms of pure relevant valuation set in 1990. The sector is now as cheap as it has been in recent history. We are buying financial companies at valuations of as low as three times their normal earnings power. These stocks would have to quadruple to be fairly valued today, based on our long-term earnings estimates. There is unusually large performance potential locked up in financial stocks. So the question is, what do you do now? Do we say, well we can’t figure this kind of market out. We’re just getting out. Or, do we say, this is what we’re really paid to do; to react to market sentiment, to take advantage of it, particularly when it gets irrational. And it’s definitely at that irrational point. We clearly believe our job is to do the latter, react to irrational market sentiment. Our clients also expect us to do that. As you might imagine, we have had hundreds of calls with our clients over the past several months. In each case, they’re checking to make sure we are sticking to our discipline and doing what they hired us to do, be value investors. As a result, our business has been quite stable. During the quarter, we actually had $700 million of net inflows. But when will performance actually turn? Unfortunately, as value investors, we don’t ever get to know the answer to that question. If we knew, it is highly unlikely the securities would be priced where they are today. Instead, let me talk about why we think financials are cheap and try to address some of the arguments against them. The most significant case against financials is that de-leveraging and higher capital requirements will render the financial services industry incapable of generating the kinds of profits that it previously generated. Actually, we believe this thinking is backwards. Can you imagine if the entire oil industry got together and said, “We’re going to withhold 10% of our volume from the market and save it for a rainy day.” The price of oil would skyrocket and investors would bid up the price of oil stocks because they would understand that the future earnings power is going to be higher than the present earnings power. Banks do essentially the same thing when they de-leverage. De-leveraging means that you don’t make loans, because you’re building your capital base. You withhold supply from the market. The price of loans or the spreads have already gone through the roof, yet nobody is forecasting higher profits in the future, in spite of net interest margins that are already widening in the earnings reports. The second anti-financials argument is that, due to their high leverage, these companies are more likely to go bankrupt or suffer permanent capital destruction than other industries and so value investors should avoid them. If history is a guide, this is just wrong. We calculated the average rate of business failure for the thousand largest U.S. companies over the past two decades, a period including two recessions and credit cycles. We define failure as an 80% decline in share price over three years, sufficient evidence for permanent capital destruction. We found that financial firms are actually half as likely to fail as other businesses. And that’s in spite of the fact that there is excess leverage in financial services firms. We also looked at Moody’s data over the past 40 years and found that, on a global basis, the default rate for banking and financial services is among the lowest of all industries, again, in spite of the fact that these companies are much more highly leveraged. From what we read in the media, we would think that the capital base of the entire financial services industry has been decimated. That too is untrue. In reality, the change in book value per share for financials was actually a positive number in 2007, up about 3.5%, just as it was in the last downturn in 1990, during that banking crisis. Yet, the declines in share prices, both in 1990 and recently, were enormous. Now let’s talk about capital because this is what we hear about all the time. I’m going to use Fannie Mae and Freddie Mac as the most extreme of these examples. The conventional wisdom is that Fannie and Freddie must raise capital. That’s despite the fact that the companies say they have adequate capital. Their regulator says they have adequate capital. The Secretary of The Treasury says they have adequate capital. The Fed says they have adequate capital and every analysis that we do says they have adequate capital. Let me walk you through that analysis. Both companies together insure an [initial] amount over $5 trillion of residential mortgage debt with about $90 billion in capital and reserves, an implied leverage ratio of over 50 times. So, the argument goes, a small downturn in the real estate market can bankrupt the company. Of course, that ignores the fact that $7.5 trillion of real estate, at current home prices, secures the debt and that Fannie and Freddie together are projected to generate over $20 billion per year in pre-tax earnings before credit costs. So even the worst case forecast currently perceived by the market, $100 billion in losses, wouldn’t eat into their capital base as it would take more than five years for those losses to fully materialize. Furthermore, the delinquency rate would have to increase six to seven fold from current levels, even to get to $100 billion in losses. While this is possible, it is highly unlikely. Before the capital and reserves of Fannie and Freddie are depleted, delinquencies would have to rise 12 fold. So, it’s an issue of confidence. Right now, investors lack confidence because they’re blinded by fear. Once they take a close look at the financial services sector, the leading companies, they’ll see that there’s adequate capital in most of them. Even if some of the firms do fail in some way, or their managements succumb to the pressure to raise excessive amounts of capital, the valuations are so extreme that investors in this sector could absorb the failures and still see spectacular returns. And now, I’ll turn it back over to Wayne for more details on our financial results, after which, we’ll take any questions.
this guy was deep in financials last year and has been adding all year long, getting crushed along the way…its tough to listen to anything he has to say at this point…when you are down over 30% in a year it doesn’t matter how you try to rationalize anything…
Really? Your opinion is “he’s down so he’s wrong”? No actual comment on anything he said? Anything about his idea that deleveraging will not decrease returns long term?
nope, no comment on that. And no, not “he’s down so he is wrong”. He has been down for awhile, and in my mind escalating it by adding to positions all the way down. I guess you could call it lowering his dollar-cost avg, but I would refer to escalation bias if we are quoting curriculum. I was on a call with him 2 weeks ago and he was talking about this same stuff. While I agree that momentum and fear have been driving things more than fundamentals lately, that does not mean you can rationalize the fact that you didn’t alter your strategy to reflect this. Maybe someday his fund will come back around (he sure holds enough beaten down things) due to his views if they are correct, but the story isn’t compelling enough for me to put money to work there at least for the intermediate term.
“the default rate for banking and financial services is among the lowest of all industries, again, in spite of the fact that these companies are much more highly leveraged” Is this really the case if we look at recent history and you include SIV’s, conduits, FI hedge funds and CDO’s as types of financial firms??? “De-leveraging means that you don’t make loans, because you’re building your capital base” Fine, but there are a lot of pi55ed off politicians out there who don’t enjoy bailing out the private sector with public money and they are going to legislate that you hold more capital and are more prudent going forward. Effectively the model is broken. The world has changed. I am sure these guys are very smart, but they seem to be saying “the market is wrong” I hope they have deep pockets.
It seems that some people here don’t understand the concept of value investing. My only disagreement with the overall sentiment of this analysis is that if capital requirements are going to increase, I don’t see how that will be a positive for the industry’s return on capital.
tvPM Wrote: ------------------------------------------------------- > nope, no comment on that. And no, not “he’s down > so he is wrong”. He has been down for awhile, and > in my mind escalating it by adding to positions > all the way down. I guess you could call it > lowering his dollar-cost avg, but I would refer to > escalation bias if we are quoting curriculum. I > was on a call with him 2 weeks ago and he was > talking about this same stuff. While I agree that > momentum and fear have been driving things more > than fundamentals lately, that does not mean you > can rationalize the fact that you didn’t alter > your strategy to reflect this. Maybe someday his > fund will come back around (he sure holds enough > beaten down things) due to his views if they are > correct, but the story isn’t compelling enough for > me to put money to work there at least for the > intermediate term. Sounds as if your bitterness having lost money with him is clouding your judgment. Perhaps it is you who has the opposite of escalation bias.
Oh please. I understand just fine. My point is that this is not a new thesis. The guy has been loading up since early 2007. I can dig it if you are sitting there now saying these things and taking the opportunity to pick up some names at these levels, but this guy has ridden the ship all the way down. Its like he bought wrong all the way down and now says that things look attractive…what? It isnt hard to see that the portfolio is loaded with losses, tough to dump it and start fresh, so of course he is hanging on trying to say that things will turn out just fine, heck he has to just to slow the redemptions. Sure he may have valid points on some of the issues now, but where were those before, why no comment on the awful buys in the past year before they all became “value” buys. Bottom line, not impressed, not getting any of the $ I am running, maybe he will pop back when financials show a stronger recovery someday, until then it is just painful to hold that fund. I should also note he is a smart guy with a smart team around him, I just think he got himself into a nasty mess with bad bad decisions.
I actually haven’t lost much money with him as I dumped it across the board in November…
He just raced into financials too quick. Wait until the dust is settled and everyone else has forgotten and been disappointed.
We’ve all done an excellent job rehashing what HAS happened. How about what he actually said, particularly about prospects? If we’re bumping around a bottom here his fund is a screaming buy. I’m not trying to pick on tvPM, but “too painful to hold right now” sounds like capitulation.
I guess I dont like the holdings. Fannie/Freddie=not sure what is going to happen here no matter what he says. C=dont think they are done yet COF=think this might be the next wave of pain overall there are too many downside risks just on the surface that tell me to stay away. I am not trying to pick the bottom on this, but think there are too many things that could still drop more to get in now, thus its too painful to hold right now. Maybe someday, but til then I am happy that we have many other alternatives. I am sure this could blow up in my face and he could make back all the $ he lost over the past year, but he lost my confidence awhile back, I dont jive with all his views(banks holding money is not the same as oil companies, banks make money in part by loaning funds and it is not a 1x sale…holding funds til rates go up to 50% and then deciding to loan funds is not a viable option in my mind), and I am not going back in there.
tvPM I echo VOBA’s sentiment. There seems to be a lack of understanding of the basic premise of value investing. Pzena is a bottom-up investor NOT a stock market prognosticator. Value investors favor longer holding periods and typically weather large drops in the value of their holdings as a result of their contrarian nature. “Be fearful when others are greedy and greedy when others are fearful” W.E.B. They do not call bottoms and don’t market time. If a security drops in price and the market value is considerably less than their estimate of intrinsic value - it’s generally an indication to buy if a margin of safety is present. Mohnish Pabria was down ~40% in 02’-‘03’ ish (don’t quote me on the exact date) and his holdings came roaring back. He has been compounding money at 25%+ / year. If you don’t buy into the philosophy, then you shouldn’t be allocating your capital with the manager because thinking like this will result in buying high and selling low.
ValueAddict, the way I read what he wrote… he’s coming across as a value pretender. Value investors would never step up and buy something just because it’s cheap UNLESS they had (and here’s where he screwed the pooch)… a catalyst. Value is not a catalyst in and of itself. Also, value investors tend to wait for investor exhaustion… which tends to take 2-3 years. Value doesn’t happen “suddenly.” Rich got drawn in. I’m sure he’ll do fine in the long run since he’s not leveraged and his investor base is still sending him capital.
I agree that catalysts certainly help and are preferable to situations without catalysts. But the strategy doesn’t require a catalyst. It can only require a narrowing between price and intrinsic value over time rather than a hard event like a spin-off, restructuring, etc. A gradual narrowing in my book isn’t a catalyst. I have some familiarity with Pzena (but not extensive) so you may be in fact correct in terming him a pretender.
well if he thought some of these picks were “values” before they lost 80%+ of their price then at least he is sticking to his thesis now saying they are great deals…I just think a better play (here comes the hindsight) would be to buy it after it is beaten down where it may be a value, rather than buying it and riding it all the way down and copping out saying it is a value play…of course it is NOW. Hey, if you looked at his fund for the first time today you may say he is well positioned if things turn around and that he has some great “values”…I am not denying that. If you owned it last year and rode the thing down you are probably shaking your head wondering if it is even worth dumping or if you have to hope it comes back someday. Or if you are me and you dumped it awhile after the pain began but far from what it has become, you have no desire to step back in with the guy regardless of what he is saying now. Maybe I am missing an opportunity being jaded or something, thats fine there are plenty of others out there