What Makes a Great Value Investor – Richard Pzena

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Richard “Rich” Pzena is the founder and chief investment officer of Pzena Investment Management, a New York-based deep value investment firm with over $20 billion in assets under management.

According to Graham and Doddsville, Pzena Investment Management’s Value fund has compiled an annualized compounded return of 16.3% since inception, compared to a compounded annualized return of 9.3% for the S&P 500.

Back in 2005, Pzena gave a great interview to Value Investing Insight, where he discussed his investing strategy, how to screen for potential buys, and advice for investors interested in a value investing approach.

Lets take a look…

The following is an excerpt from the February 2005 edition of Value Investing Insight.

Q. Start us off by describing your investing strategy and process.

RP: The philosophy is old-fashioned value: Try to find good businesses when they go on sale. That’s it. How do we define what’s value? We’re looking to buy basically when we can satisfy five criteria: First, the price is low relative to the company’s “normal” earnings.

Normal is what should this business earn given a variety of factors — its history, the industry structure in which it competes, competitor margins, its individual company strengths and weaknesses, its management and its business plan. While the screening process we go through is scientific, obviously [our estimate of normal earnings] is not a scientific number.

Second, we look for current earnings that are below normal. 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 skeptical.

Q. Does it matter why performance is below historic norms?

RP: Of course, but the primary question is whether you can convince yourself that the situation is temporary and can reverse itself. Take Boeing, which was our largest holding last year. The prior time we bought Boeing was because the company had screwed up.

The market was healthy, but they didn’t execute. By the way, in general, we appreciate it when management screws up, because that gives us an opportunity to buy. More recently though, it wasn’t a company screw-up [that lead to Boeing’s performance shortfall] – it’s that people just stopped buying airplanes. Whatever the reason, I don’t care. I’ll invest if I believe the situation is not permanent.

So we seek out businesses that are at a low valuation and under-earning. That way you have two ways to win: One is improved valuation and the other is an earnings rebound — and growth rates can be enormous as you’re coming off a depressed level to a more normal level.

The third thing we’re looking for is whether management’s plan to restore their business back to historic norms is a sensible plan, and whether they can execute it. That is pure judgment. All you’re doing is gathering information on industry conditions and then you’re listening to what they say. Does it make sense? What does the track record say?

Q. Including an analysis of whether the competitive environment has simply changed?

RP: Correct. If that’s the case and management’s plan doesn’t make sense, then we don’t buy. Of course, we don’t know if the plan is going to work, so we have to consider the case where the plan fails. Our fourth and fifth criteria point to that.

The fourth is to ask whether the business is a good business. To us, the definition of a good business is if you can specifically identify reasons why it should be able to earn a return in excess of its [cost of] capital. It could be anything: a competitive cost position, a franchise brand, an installed base of business, unique technology – some reason to believe that even if the current management fails to restore earnings, somebody else would want to try. Say, an acquirer of the assets.

Or the board replacing management with other management. Or even the same management trying another plan, because it’s worth trying and you can specifically understand why it’s worth trying.

The fifth point is that we need downside protection. We don’t want to lose a lot of money if we’re wrong. That protection generally comes in one of two forms: in the company’s physical assets, or in the established revenue franchise of the business. For example, if you were going to look at Whirlpool, the physical assets of the company are probably not worth a lot. What is worth a lot is the Whirlpool brand.

So we’d say if this management team screwed up, somebody else would want to buy the valuable piece of property of the Whirlpool brand. So even if we were wrong on our earnings expectations, we probably wouldn’t get killed. Our metrics typically are that we can envision losses of no more than 25% in any of the companies we own. And we expect upside significantly above that, giving us a more favorable risk/reward outcome.

Q. When are the stocks cheap enough for you to buy?

RP: Ideally, we want to buy stocks at 5x what we’ve determined to be their normal earnings. In a good environment, we can find plenty of businesses to buy at 5x to 8x normal earnings power. As you know, today’s market is different.

We’re finding that you have to pay about 8.5x for the hairiest stocks you can imagine, and for the boring, relatively safe ones, you’re paying around 9x. We’re usually deciding it makes more sense to pay the 9x. Overall, I’d say our portfolio today is probably at about a 25% to 40% discount to our estimates of current value.

Q. How do you screen for potential buys?

RP: We have relatively sophisticated computer model that ranks our value universe of the 1,000 largest domestic companies. It ranks all 1,000 companies from cheapest to most expensive, on the basis of current price to the “normalized” earnings we extrapolate from history five years into the future.

From this computer screen, we do an initial review on the cheapest quintile of these stocks, looking more closely at the company financials and the industry dynamics. After this initial research, we reject about 75% of these companies. The other 25% we do detailed analysis on, including visiting the company and meeting management. Of those, we normally reject another 50% after this detailed analysis.

So, in the end, we buy roughly 10% to 15% of the cheapest 200 stocks in our universe. Overall, we generally own between 30 and 40 stocks, with half of our portfolio assets concentrated in the top ten holdings.

Q. Tell us about the last step in your research process.

RP: We invite in a Wall Street analyst who is a bear, and they come in and make a pitch why we shouldn’t buy this stock. We want to see if the reason they don’t like it is if they see a real structural flaw in the business that we didn’t pick up on, or if it’s just that they don’t know what’s happening.

Most of the time they’re negative just because of “no earnings visibility,” which is Wall Street language for “I don’t really have a clue what’s going to happen next.”

Q. Tell us, in general, how you decide to sell?

RP: When a stock reaches the midpoint of the ranking we talked about, from cheapest to most expensive, we sell automatically. The good outcome is you buy, the stock price goes up and gets more and more expensive relative to its normal earnings, so it falls in our ranking. As a stock price goes up and becomes less cheap, we’ll want to hold less and trim it back as it’s going up, and we’re out when it reaches the midpoint.

Q. How did you arrive at that discipline?

RP: You know what? I arrived at that because otherwise I would have no idea how to sell. It struck me that if you let your emotions dictate when to sell, you risk falling in love with companies that have been doing well and you ride them too long, and then something goes wrong. I guess I have the classic value mentality. It’s instinctual for me to want to sell as things go up and I start getting nervous. For me, having something systematic that says “this is cheap” or “this is fairly valued” is really, really important.

Q. Speaking more generally, you seem to find opportunities often when there are accounting issues. How do you distinguish between the lethal and non-lethal?

RP: I guess I’d say the most important differentiator in these cases is common sense. Sit back and ask what appears to be happening vs. what should be happening. Take Enron. The whole business strategy, that it was going to make tons and tons of money from buying electricity from company A and selling it to company B without taking any risks, never struck me as a strategy that would work.

You either make a lot of money because you take a lot of risk, or you make a little money taking no risk. But making a lot of money by taking no risk didn’t strike me as logical. At Computer Associates, the accounting was clearly unusual – let me use that word – because of the way generally accepted accounting principles are applied to multi-year software license agreements.

But here, it was clear the software buyer didn’t care about the accounting. They just care how much they have to pay to license the software. Here the cash flow was king, and you could see that cash flow clearly, running at $1.3 billion a year. I’ll tell you one I blew also: We made a small investment in WorldCom.

We bought around $2 and sold for basically nothing. We missed what was clearly common sense that we should have seen, which was that their volumes were falling sharply and they didn’t have any margin erosion. In a business that is highly fixedcost, like telecom, that just shouldn’t happen – you should have margin erosion. We listened to them saying they were cutting SG&A dramatically and we just missed the whole idea.

Q. Value investing – in which you often own the stock of reviled businesses – can be tough on the psyche, no?

RP: When I talk about the companies I invest in, you’ll be able to rattle off hundreds of bad things about them – but that’s why they’re cheap! The most common comment I get is “Don’t you read the paper?” Because if you read the paper, there’s no way you’d buy these stocks.

Q. I don’t know if he originated the phrase, but Bill Miller once said, “If it’s in the headlines, it’s in the stock price…”

RP: Absolutely. They’re priced where they are for good reason, but I invest when I believe the conditions that are causing them to be priced that way are probably not permanent. By nature, you can’t be short-term oriented with this investment philosophy. If you’re going to worry about short-term volatility, you’re just not going to be able to buy the cheapest stocks.

With the cheapest stocks, the outlooks are uncertain. In my whole career I have yet to find the great business with a wonderful management team, high margins, a dominant market position and all the conditions everybody wants, at a low price. The stocks of such companies don’t sell at a low price. If I find one, I’ll cheer, but it hasn’t happened yet.

Q. To wrap things up, Rich, do you have any advice for people interested in value investing, getting better at it, and maybe even getting into the business?

RP: It’s funny how things work out. When I was in business school I took a class called Security Analysis, which was the worst class I ever took. It was awful. The professor taught that investing was all about linear regressions on sales forecasts – no thinking at all.

One of my friends went to work for Fidelity as an analyst out of school, and I remember thinking “What an idiot. Why would anyone want to do that?” Of course he’s retired now, and has been for 10 years, but that was my impression back then.

I don’t think being a value investor is something you can learn. You can learn how to be better at it and the analytical support for it, but you can’t sit there and say, “I’m going to make an intellectual decision that I’m going to become a value investor.”

My personal belief is that you’re either born as a bargain hunter type or you’re born as a brighteyed optimist. You have to be skeptical and pessimistic, and you have to really enjoy the bargain hunting process, and it has to be part of your whole life. I find that the people who are the best at this are the type of people who are absolutely thrilled to find a pair of shoes for $20 that they could have paid $150 for at a department store.

Q. Do you have to be a bit of curmudgeon, a skeptic?

RP: You can still be a nice person. Hey, people would look at me and say “You obviously can’t be skeptical, look at what you’re buying.” (Laughter.) I need to have a historical framework for understanding a business that makes me comfortable buying it. What you’re skeptical of is what matters.

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