One of the investors we follow closely at The Acquirer’s Multiple is Rich Pzena at Pzena Investment Management (Pzena). Pzena recently released its Q1 2017 commentary in which they demonstrate how investing in the cheapest stocks provides superior investment performance over the long term.
Here’s an excerpt from the Q1 2017 commentary:
Our opportunity set of deep value stocks offers similar fundamentals to more expensive stocks.
Value cycles reach an extreme when investors embrace a group of stocks widely viewed as winners that are immune to current issues. They leave behind companies considered permanent losers, which results in the widening of valuation spreads. Value stocks underperform during this phase, but it also creates the opportunity to buy good businesses at very depressed valuations. Rationality ultimately prevails, spreads narrow, and the cycle shifts to its pro- value phase when value outperforms.
In previous cycles, companies with high growth rates and returns on capital dominated the winners, capturing investors’ imaginations with new technology or the promise of reshaping an industry with a disruptive business model. The Nifty-Fifty were at the center of the 1970’s value cycle, and no company exemplify it more than Polaroid. With break-through technology and marketing pizzazz, investors thought there was no limit to the company’s growth. Polaroid’s stock price peaked at $118 per share in 1972, but ultimately reality fell short of the promise, and the stock declined 90% peak-to-trough, never recapturing its former glory. The internet bubble of the late 1990’s also provided numerous examples (remember pets.com?).
Most recently, the winners have been different than in the past. This cycle has had its share of high growth disruptors, the so-called FANGs (Facebook, Amazon, Netflix, Google), viewed as being impervious to virtually any economic conditions. But the winners have also included stocks that looked like bonds – “bond proxies” – chased by investors for yield and stability, as central bankers pushed interest rates toward zero in a low growth environment. Although their valuation multiples never hit the likes of Polaroid or the FANGs, they reached high levels for low- growth businesses.
Interestingly, in this environment there is an opportunity to buy stocks with similar fundamentals to the bond proxies but at lower valuations. Although there is typically some issue depressing valuation, it appears that what one is giving up is more than offset by attractive growth rates and returns on investment.
SIMILAR FUNDAMENTALS AT CHEAPER PRICES
We examined valuations by quintile and corresponding data on earnings, return on equity, and revenue growth (Figures 1 and 2). As expected, valuations become more expensive on all metrics, as we move from the cheapest (quintile 1) to the most expensive (quintile 5) stocks. But the next observation is striking. Investors who pay up for stocks in the more expensive quintiles appear to be getting short-changed; they receive less in earnings and returns with similar growth rates as those buying cheaper stocks. The cheapest two quintiles in the U.S. delivered on average 17.5% return on equity and 9.5% growth versus 11.5% and 10.5%, respectively, for the most expensive two quintiles (Figure 1). The analysis holds even excluding quintile 5, which shows some counterintuitive results due to anomalies within the quintile. Of course, on an individual stock basis there are exceptions, but in aggregate it is startling. This is also true outside the U.S. (Figure 2) where we see a very similar pattern – similar fundamentals available at cheaper prices.
Figures 1 and 2: Similar Fundamentals at Different Prices Key Financial Data by Valuation Quintile
- Valuation quintiles based on Pzena’s price-to-normalized earnings estimates. Total quintile earnings calculated using 2016 earnings.
Return on Equity and revenue growth calculated over trailing 10-year period. Price/Earnings ratio uses “street” 1-year forward earnings estimates.
Universe is the largest ~1000 U.S. stocks by market capitalization; largest ~1500 largest stocks outside the U.S. by market capitalization (includes both developed and emerging market stocks).
Data as of March 31, 2017.
Does not represent any particular Pzena product or service.
- Source: Reuters, Pzena Analysis
To illustrate the point, we compare the fundamentals of selected companies from the most and least expensive quintiles of valuation (Figure 3). Procter & Gamble and L’Oreal are the types of businesses investors flocked to in search of yield and stability. They are valued at 22.0x and 26.1x earnings, respectively, with high return on tangible capital but low growth. What investors have paid up for is dividend yield – 3.0% in the case of Procter and Gamble – and stability of earnings.
Contrast these with investment options available in the cheapest quintiles of the market and that we own in our portfolios. McKesson, the largest pharmaceutical distributor in the U.S., operates in a highly consolidated industry with almost unscalable barriers to entry. It has averaged over 60% return on tangible capital over its history, and trades at 11.5x earnings, as it manages through what we see as temporary issues. China Mobile is another example – high returns on tangible capital and reasonable growth at a 14.3x multiple of earnings.
Figure 3: Examples of Today’s Investment Opportunities
- 1These companies are held in certain of our Focused strategies as of 3/31/2017.
- 2These companies are not held in our strategies as of 3/31/2017.
Historical growth rate calculated over a 10-year period through 12/31/2016.
Historical return on capital employed is a 10-year average through 12/31/2016.
Financial data is as of 12/31/16; stock price is as of March 31, 2017.
Highlighted holdings are illustrative of our research process.
Source: Reuters, Capital IQ, Pzena Analysis.
RESEARCH UNCOVERS VALUE
Decades of academic research and empirical evidence support the proposition that investing in the cheapest stocks provides superior investment performance over the long term1. The data presented in Figures 1 and 2 also suggest a reasonable expectation for superior investment outcomes when investing in similar fundamentals at cheaper prices. Of course, the data shown are simple averages across many companies. Clearly, if it were possible to identify individual investment opportunities with fundamentals and upside opportunity that exceed even those of the valuation quintiles in which they reside, returns could be substantially better. At Pzena, we believe that the best way to achieve this is by using a disciplined, valuation-based investment approach
- 1Fama, E.F., French, K.R. (1992) “The Cross Section of Expected Stock Returns” The Journal of Finance 47 (2) 427.
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