Q: What is the history and mission of the fund?
Pzena Investment Management, LLC was founded in late 1995 and started managing money in early 1996. Today we manage $33.5B in assets under management. Our singular mission was to manage concentrated, deep value portfolios. In 1998 the firm launched its first mid-cap value strategy, and we currently manage roughly $2.5 billion in assets in our mid-cap value strategies. Our mid-cap value strategies are co-managed by three portfolio managers, John Flynn, Rich Pzena and Ben Silver. Three years ago we decided to offer the Pzena Mid Cap Value Fund (PZIMX). The mission of the fund is to seek out investment opportunities that are misunderstood and undervalued by the market.
Q: What is your investable universe?
While the fund may invest in any company whose market capitalization is the range of those found in the Russell Mid Cap Index, we focus on U.S. companies that have market caps between $2.5 billion and $27 billion (largest U.S. Companies ranked 201-1200). We look for industry leading franchises that are well structured, high return businesses that are significantly undervalued.
Q: How do you define your investment philosophy?
Philosophically, we are value investors that follow a strict discipline of identifying the cheapest opportunities within a pool of deeply undervalued securities. From that pool, we layer on our superior research which allows us to identify the best opportunities for long-term alpha generation.
Specifically, we will generally buy names in the cheapest 20% of the universe as defined by our internal estimate of normalized earnings. From that pool, we identify the most promising opportunities. Before adding a name to the portfolio, we undertake an in-depth analysis to understand the issues facing the company and why it is undervalued.
Q: How do you categorize yourself in terms of value? Do you look for a catalyst?
We are disciplined deep value investors. We focus on companies with good earnings histories and strong return on capital profiles. Typically the company has experienced a self-inflicted disruption or suffered from some sort of dramatic cycle that has caused its earnings to collapse. Our research will focus on understanding what happened and whether the issues the company faces are temporary or permanent.
While we may identify potential catalysts in our research, we are usually investing pre-catalyst as once the catalyst is identified the market reacts quickly. We believe that investing successfully just on catalyst insights is almost impossible.
Q: What is your investment process?
We start our process with a quantitative screen and look for businesses that earn their cost of capital over the course of a cycle. We look for the following five criteria in each position we take: 1.) current earnings are below historical levels; 2.) cheap on a price-to-normalized earnings basis; 3.) earnings issue is temporary; 4.) the business has a history of earning attractive long-term returns; and 5.) significant downside protection.
We have a proprietary model that analyzes all 1,000 stocks in the mid-cap universe by looking at the past 10 year’s performance. We then rank the universe from least expensive to most expensive based on normalized earnings. Our portfolio management team screens the cheapest quintile of that universe to identify the most promising opportunities. Then, the selected stocks are assigned to analysts.
The analysts are tasked with doing an initial review where they answer the following fundamental questions: what does this business do; how does this business work; what is the business model; why does it exist; what happened to make the stock cheap; and what do we have to believe to get comfortable with it as an investment.
We have a meeting twice a week with all the portfolio managers where the analyst presents their research. The goal of the initial review is not to make an investment decision, but to decide whether we should go forward with the research process. At that point, we will kick out about 70% of the names as not interesting. If we do decide to move forward, that’s when we will work our way through the issues we have identified in that initial review.
Once we have flushed out the investment thesis, we do an on-site visit with the company’s management team. A portfolio manager accompanies the analyst to make sure they have a credible plan for fixing the issues that have been identified and to make sure that our understanding of the issues align with management’s.
After we have completed our due diligence, the analyst brings the research back for research review where we have a robust discussion around what we think the normalized earnings estimates should be five years out. If after review, the stock is still the in the cheapest quintile on a price-to-normalized earnings basis, it is a candidate to go into the portfolio.
Once the name is in the portfolio, we continually monitor the company for any additional information to make sure it is consistent with our investment thesis. If we get information that would change our thesis or our normalized earnings estimate, we will go through the research process again, adjust our normalized earnings estimate as appropriate and then based on the new price-to-normal multiple adjust the position sizing.
Q: Can you describe your research process with a couple of examples?
One of the names that we recently added to the portfolio is Mylan N.V., the generic drug manufacturer. Mylan’s best known product is EpiPen, the auto injector for severe allergic reactions, and the company became a poster child for aggressive drug pricing resulting in fines and a congressional hearing.
With the market focused on the impact of declining EpiPen sales and the repercussions of the Congressional investigation, Mylan’s stock price has been under pressure. What people missed is that Mylan also had a world-class, generic manufacturing operation. We looked at the other 80% of their business and quickly realized that it had real value. With its single digit price-to-earnings ratio, we would be buying a generic manufacturing company at a discount to fair value, regardless of the EpiPen situation.
Q: Would you discuss one more name in another industry?
Seagate Technology PLC, the hard disk drive manufacturer, is another name in our portfolio. Historically the hard disk drive space over time consolidated down to two players, Seagate and Western Digital. Profit in the early days in the industry were very elusive, but as it consolidated it became quite a good industry with pricing discipline, a strong return profile and substantial free cash flow.
In the first quarter of 2016, Seagate had an earnings miss. At the end of the first quarter PC shipments declined more than expected and, at the same time, enterprise orders came in lower than expected resulting in a huge margin miss that cut the stock price in half. Investors feared that PC demand was falling even more rapidly than expected and enterprise demand had gone away as well.
We believed that the magnitude of the revenue decline was a function of order timing vs. end market demand. Furthermore, there were meaningful cost cutting measures the company could take to improve margins while the end market demand materialized. Based on the combination of our long-term view of demand and the self-help measures we bought the stock. Several quarters later the enterprise and PC demand improved at the same time the cost cutting measures came through, resulting in a substantial increase in earnings and corresponding reaction in the stock price. In this particular example, the issue that presented the buying opportunity resolved quickly, but that is not always the case.
Q: How is your research team organized?
Our analyst teams are organized by global industries. For instance, our auto analyst covers the entire auto supply chain around the world, including China, Europe, and America. They understand every aspect of the global automotive industry, and they can bring that perspective to the mid-cap market. We also have an excellent research team with 25 professionals. Each member has specific research responsibility and even the portfolio managers have sector coverage responsibility.
One rather unique strategy we use is to rotate coverage responsibility every three or four years. When we are debating a new idea, oftentimes there will be multiple people in the room who have covered the industry. So, we get historical perspective as well as a fresh perspective. The core of the team has been together for quite some time and the culture that has evolved is an important part of our success.
Q: What is your sell discipline?
The number one sell driver is valuation. When a stock has reached the midpoint of the universe on a price-to-normalized earnings basis, it is sold out of the portfolio and we are trimming the position as it approaches the midpoint.
There are two ways a stock can reach its midpoint. There is the good way where the stock goes up, and then there is the bad way where the normalized earnings estimate goes down. But in either case, we maintain our disciplined strategy and once a stock is fairly valued we move on to the next compelling, deep value opportunity.
Q: What is your portfolio construction process? Does diversification play any role?
In our Mid Cap Focused Value strategy, our portfolio normally consists of 30 to 40 names. Our annual turnover is about a third, so we don’t need to identify too many buying opportunities each year. Our maximum position size for any one name is 5% at cost, 7.5% at market. In terms of sector constraints, the maximum sector exposure we allow is 25%, except for the financial sector where we can go up to 45%.
We are very conscious of the drivers of our investment thesis. If we are getting a cluster of names that are centered around the same valuation and the same driver, like the same economic or industry factor, we take that into consideration. When looking at names of equal valuation, if one name replicates an exposure already in the portfolio and one diversifies, we will go with the diversifying name.
The cheaper the stock on a price-to-normalized earnings basis, the larger will be its position in the portfolio. We do take into consideration range of outcomes, leverage, and diversification, but the fundamental driver for the portfolio sizing is always valuation.
While most of our clients use the Russell Mid Cap Value Index as their benchmark, we do not manage our portfolio with a benchmark in mind. We seek to create a portfolio with the most compelling valuation opportunities over time and we think that our portfolio should beat the benchmarks.
Q: What are your views on being overweight in particular sectors in search of deep value?
To take advantage of value dislocations, you have to be willing to be concentrated in an industry or sector when it is under stress. Today, financials make up 37% of our portfolio. We are willing to expose ourselves where we identify value opportunities and if we don’t see opportunity, we don’t feel compelled to have exposure. For example, today we have virtually zero exposure to utilities, consumer staples, and REITs.
Q: How do you interpret valuations and deal with valuation fluctuations?
There are different styles of investing, like value and momentum, that over time have proven successful. To get the full benefit of any one style, you must be disciplined. Attempting to time opportunities when value is attractive versus not attractive is a good recipe for leaving a lot of return on the table.
So, we do one thing and one thing only, and that is deep value investing. We are committed to it and I think the disciplined process along with the strong investment culture that we have here really allows us to exploit the opportunities available in the market.
Q: How do you define and manage risk?
We define risk as a permanent impairment of capital. Our whole research process is really meant to mitigate risk by focusing on the cheapest opportunities and paying attention to downside protection. We aim for a portfolio which is skewed where we make a lot of money if we are right, but don’t lose too much money if we are wrong.
We focus on long-term opportunity. Because we are investing with a three-to-five-year time horizon, we see short-term fluctuations in our portfolio as opportunities rather than risk factors.
