Rich Pzena Talks Quality, Value Stocks, And ESG

When investors think about investing in quality, they often think of it as a factor, but it is much more than just a factor. According to Rich Pzena of Pzena Investment Management, value investors should be thinking about quality and valuation when they look for stocks to buy.

In an interview with Raul Panganiban of ValueWalk, Pzena discussed the value cycle and value stocks, the importance of considering quality with value stocks, and much more.

Value cycle

When asked what part of the value cycle we are in, Pzena noted that value cycles could happen for various reasons, the most notable being the economic cycle. When economies falter, cyclical stocks tend to do poorly early in the downturn. However, this time was different because the economy shut down overnight, causing management teams to react much faster than what is seen in a typical economic cycle.

“When you look at the duration of value cycles, the upside tends to work, the mirror image of the downside, so when things start to get better, managements are still unsure that they’re really going to get that. And so they’re slow to add costs back. And that’s why the value cycles tend to be prolonged for in many cases, years, because you don’t know for sure what’s going to happen.”

As the world’s economies recover, we should see margin expansion because revenues will rise faster than costs, which will surprise people and create earnings momentum.

“A typical value cycle that’s tied to an economic cycle lasts for quite some time,” Pzena said. “… The momentum stocks in the market become the same stocks as the value stocks. It’s what people don’t really understand when you’re late in an economic cycle. It’s the growth stocks that are the momentum stocks. But today, if we look forward over the next two years, and you took a universe of cheap stocks of value, and looked at what their earnings growth forecasts, not even ours, the consensus forecasts, but the next couple of years, the growth rates are higher than they are for growth stocks. And so as that plays out, you tend to get an extended cycle.”

Possible tailwind for value stocks

Pzena believes we are early in the cycle for various reasons, like the long length of the interest rate cycle. Falling interest rates enhance growth valuations, so when interest rates stop falling, some of the valuation tailwind from growth will go away.

“So today, if you looked at the cheapest stocks, and compared them to the most expensive, that gap is almost as wide as it ever gets,” Pzena opines. “The only time we saw anything comparable was during the internet bubble from, you know, 20 years ago now.”

Currently, capital to fund almost any kind of investment idea with big potential is almost limitless. However, Pzena believes that the flow of capital will dry up, providing a tailwind for the “boring value companies” he invests in rather than the “exciting growth stocks that everybody’s gotten so used to over the last two decades.”

Inflation and value stocks

Asked if inflation will help value stocks, Pzena said he’s uncomfortable saying anything but the truth, which is that he has no idea. However, Rich believes that it’s hard to believe that there can be so much stimulative monetary policy globally without a consequence and inflation.

“There’s a couple of ways that inflation impacts value stocks, in particular,” he said. “One is through the back channel of interest rates. So if interest rates wind up going up, because we’re in a more inflationary environment, it’s not good for the market at all, generally, but it’s worse for growth stocks.”

Pzena added that investors could build a portfolio where they had to hold the stocks for life and couldn’t sell them. The stocks should have a stream of cash flows based on a moderate, rational view of their futures. According to Pzena, it would be impossible to produce double-digit returns without valuations increasing just from the cash flows. However, it isn’t easy to do that now in most of the marketplace.

“Now, remember, equities are going to be better than fixed-rate bonds, because you don’t have any offset. At least the companies have the ability to raise their prices to offset some inflation. And we see some of that happening now. And so inflation doesn’t necessarily have to be bad for equities. It’s bad for valuation, but it doesn’t have to be bad for the earnings of these companies.”

The importance of quality

Pzena notes that there is a difference between investing for quality and avoiding bad quality. Investing for quality requires you to pay a higher price. Pzena has been looking for a “spectacularly high-quality business at a cheap price” his entire life, but it just doesn’t happen. Rich adds that you can get burned if you only look at the price and ignore the quality. Pzena says that one part of the evolution of his investing process has been looking at the quality of potential investments.

“I would have told you after the Benjamin Graham and Dodd research that I did that when I was in school, quality is irrelevant,” he states. “As long as the company’s not losing money, you could just buy anything. If it was cheap enough, it would work out today. I think that there are businesses that can destroy capital over time. And you want to rule those out. So that has become a fundamental part of our approach.”

Incorporating ESG

Pzena believes ESG is an interesting concept because some businesses are related to the environment, while others are related to governance or societal changes. He says these factors have always been part of his process.

“You can’t invest in oil stock without thinking about the fact that maybe 30 years from now, we won’t be using oil,” Pzena said. “It’s not possible to think about that. So now, so that’s been a part of our process from day one, but we never called it ESG.”

Rich explains that they don’t do ESG investing, which means investing in those companies that will drive societal and environmental change. Pzena states that’s a growth stock business model, and it’s not their expertise. Instead, they invest in companies where the environmental or societal or governance impacts are reflected in the valuation. They also look for companies that are working to improve things.

“You have to take it with a grain of salt because the data is not compelling,” Pzena says. “It’s not long enough to really draw statistically significant conclusions, but you can observe. And the observations that we see are that companies that improve their ESG rankings are actually a more reliable place to invest than companies that already have high ESG rank… Buying companies that are actively making changes to their business to try and be better players, even if they are starting from a lower quality perspective, or base is actually very consistent with a value philosophy.”

Risk and avoidance

Panganiban asked Pzena what areas pose the most risk today and what areas he was avoiding. Pzena believes the biggest risks are in the “high-flying companies that have built businesses off of raised capital and have gotten valuations that are… mind-numbingly high.”

“You routinely see companies with valuations that are 30 times revenues, not making any money,” he explains. “I think there’s a lot of risks in these companies from a share perspective. I think from a macroeconomic perspective, there’s risks, and in rising interest rates, there’s always risk and in company management’s executing properly.”

Pzena adds that government behavior is also a risk to investing, which is one reason having a diversified global portfolio doesn’t focus on any of those risks, although they exist.

“We think from a cycle perspective, we’re in a good part of the value cycle,” he said. “So if you define risk as the relationship between the upside potential and the downside loss potential, I think broadly speaking, we’re less risky than normal in the value stocks and more risky than normal in the higher flying growth stocks.”

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