In his latest Q3 2020 earnings call, Pzena Asset Management CEO Rich Pzena outlined his reasons why the day is coming for value investing. Here’s an excerpt from that call:
Pzena: Thank you, Jessica. Ride the winners. That’s always been obvious investment strategy favored at the end of every cycle. These are [ph] really just select the few dominant technology masters of the universe that everyone loves, sit back and enjoy the multiple expansion. Meantime valuation spreads between cheap and expensive have reached all-time highs all over the world.
Further, the volume of questions about whether value will ever work again or whether there is a new definition of value have been — have become commonplace. This is reminiscent of the late 1990s Internet bubble, when Michael Lewis’s 1999 book, The New New Thing, described it all you needed to know. Investors then like investors today were mesmerized.
But values day is coming, paying less than the present value of future cash flows remains a winning strategy for long-term investment success, and the environment today makes this path even more attractive than normal. We would argue that the seeds for unwinding today’s extremes are right in front of us, especially as our COVID dominated world has led us into a recession, that history shows it’s the key marker for the shift.
Considering the following four possible catalysts that could already be signaling that a shift is upon us. First, the recession is in place and the path toward economic recovery is becoming clear. The examined recessions in the US over the last 100 years and in Japan over the last 45 years and the evidence is compelling. The US experienced 14 recessions during the past century, I’m looking at the five-year returns measuring from the beginning of the recession, the value outperformed the broad market by an average of 5% per year.
Second, interest rates stop falling bringing multiple expansion from growth stocks to an end. Interest rates have been in structural decline for the past 40 years. The trend has led us to a world where you can buy value stocks at PEs of 10 just like at any time in the past 70 years while average growth stock multiples have doubled from 30 times to 60 times earnings.
Even if rates don’t rise the tailwind enjoyed by growth stocks should dissipate. Exuberant growth expectations for the technology masters of the universe revert to normal. Consider the math using Microsoft as an example, Microsoft stock prices up 10-fold during the past 10 years. That’s 25% per year helped by strong growth in cloud technology replacing on premises hardware demand.
This has led to 8% annual growth in operating income. To get an 8% annual stock price of price appreciation go forward — going forward given Microsoft’s high multiple would now require 20 years of 10% operating income growth. Possible, maybe, but considering that market analysts estimate that public cloud penetration of data needs has reached 30% to 35% and that the possible maximum penetration for the public cloud would be approximately 70%. We’re about halfway to saturation.
So where will 20 years of growth come from, we have yet to see. The cap — and finally the conventional wisdom that technological change comes entirely at the detriment of the existing franchises proves to be mistaken. Let’s consider the case of electric cars and Tesla versus VW. Conventional wisdom and stock price suggest that the answer is obvious, Tesla will win. But even if Tesla grows does it make sense that VW has to shrink.
Tesla stock is one of the darlings rising over ten-fold during the past five years VW stock on the other hand has barely changed in the same period. But there are ultimately only two ways to win an auto manufacturing. One charge higher prices, in other words maintain a brand premium or two manufacturer at lower costs.
It seems inevitable that these truths will apply to electric vehicles and that VW will succeed importing their brands strengths, think Porsche and Audi and scale advantages into the electric vehicle competition. In fact, VW leads all competitors in the number of new electric vehicles that will be introduced over the next several years.
You can listen to the entire earnings call here:
Rich Pzena – Q3 2020 Earnings Call
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