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Published by Devon Shire

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Categories:Business/Law, Finance
Published by: Devon Shire on Jan 29, 2012
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The market today is faced with the age old conundrum of whether to believe what it sees or whatit fears. Corporate profitability has remained robust, yet the market is giving these profits a belowaverage valuation. The reason for this anomaly seems clear; the financial crisis in the Eurozone andthe fear that its effects will spill over and infect the global economy. The near death experience in thedeveloped economies that started almost 5 years ago is still fresh in the market’s mind. This persis-tent fear is keeping overall equity valuations low, and in many good cyclical businesses the valuationsare extremely low.As investors try to make sense of the current environment, they are also questioning whether val-ue investing – identifying good, but undervalued companies – still works in a world that has reacted toglobal macro events more than company fundamentals this year. In our Commentary section startingon page 2, we look at the cycles of value investing, and observe that despite all the day-to-day noise inthe market, the underlying cycles of value investing are as relevant as ever. In fact, 58 months sincethe peak of the last cycle, value’s performance relative to the broad market is right in line with thehistorical averages. Furthermore, the wealth of attractively valued, cyclical companies available todayhas resulted in our portfolios being among the cheapest in our history.Illustrative of these opportunities is Staples, Inc., our Highlighted Holding on page 14. Staples wasone of the pioneers in the office supply superstore concept, and, along with its internet and deliverychannels, is now the largest supplier of office products worldwide (not to mention the world’s secondlargest on-line retailer). Investors penalized Staples in 2011 as sentiment toward economic growthdimmed, driving the stock down by over 40%. Despite these cyclical concerns, we see a business thathas industry leading profitability, a strong balance sheet, and a free cash flow yield in excess of 10%.Staples has captured market share from its weaker competitors during the downturn, and, we believe,is well positioned to benefit from an eventual upturn in employment.As we start 2012, we acknowledge the pain investors have endured. Yet as disciplined valueinvestors we are mindful that history teaches that the real investment opportunities are often hiddenamong the weeds of deepest fear. Warren Buffet’s wisdom on this point seems particularly timely;“Investors should remember that excitement and expenses are their enemies. And if they insist on try-ing to time their participation in equities,they should try to be fearful when othersare greedy and greedy when others arefearful.”From time to time the market deliv-ers the message that valuations do notmatter. This happens when greed is at afervor pitch, and it happens when fear isat its most severe. Value investors thrivewhen fear dominates. While we can neverknow exactly when the fear will ease, orwhat the precise triggers are that causethe shift in sentiment, human behavior isencouragingly consistent and we remainpoised to benefit.
The cycles of value investingappear firmly intact, and thecurrent cycle is on-par withwhere we might expect to besince the prior peak.
Global Research Review
Good cyclical businessescontinue to dominate ourresearch this quarter.
Portfolio Strategies
 We focused mainly on buildingpositions initiated during thethird quarter. Portfolios areamong the cheapest in ourhistory.
Highlighted Holding
Staples, Inc., the world’s largestoffice supplies company, is aprime example of an industryleader left behind in investors’flight to safety.
Quarterly Report To Clients
FOURTH QUARTER 2011 VALUATION SUMMARYP/N* P/N**UniversePortfolioU.S. Large Cap ValueU.S. ValueU.S. Mid Cap ValueU.S. Small Cap ValueGlobal ValueEAFE ValueEuropean ValueEmerging Markets Value
*Price-to-Normalized Earnings ratio. **Reflects the investmentuniverse price-to-normalized earnings ratio for the related strategy.
Is Value Investing Dead?
Equity investors have been shaken to the core.The cumulative pain of the last five years is palpable, andhas been compounded by the market decline and incessantvolatility of the last six months. Add to that the proliferationof high-frequency trading, ETFs and other new market par-ticipants, and investors are questioning the very foundation ofvalue investing: the notion that, over the long term, the value ofa good, but undervalued, business will ultimately be recognizedby the market. We are hearing echoes of 1999, the last timethe death knell of value investing gained currency. Investorsare asking whether there is a new paradigm, one in which thelong term view is overwhelmed by short term traders reactingto macro events half way around the world. Will value investingever work again?There is no denying that an obsession with macroeconomicevents dominated market activity during 2011. The correla-tion of stock returns is the highest it has ever been, an indica-tion that markets are being driven by broad, unspecified fears.Volatility has also spiked, with the MSCI ACWI moving by morethan 1% on 28 trading days in the July – December period. The“risk-on, risk-off” trade has come to dominate market activity,driving cash flows into sectors considered safe on days whenfears spike, merely to reverse back into economically sensitivesectors when fears abate.Taking a step back from the day-to-day market noise, how-
Pzena Commentary
Although no two cycles are exactly alike,the current cycle is remarkably consistentwith the four prior. If history is a guide,there should continue to be significant op-portunity in the deep value space.
ever, provides a useful perspective in which to assess recentmarket activity, and possibly even identify hidden opportunitiesotherwise obscured. We studied the performance of a naïvedeep value benchmark (referred to as “value” in this article anddefined as the cheapest quintile of the 1000 largest U.S. listedcompanies on a price-to-book basis) versus the S&P 500 indexover the last 42 years, and have a number of key observations:- Recent experience is highly consistent with the historicalebbs and flows of the cycles of value investing;- The most recent period of value outperformance, whichstarted in December 2008, was interrupted in mid-2011for six months, as investor sentiment shifted from opti-mism to uncertainty on concerns over sovereign debt,Eurozone stability, and slowing global economic growth;- We experienced similar interruptions in almost all valuecycles over the last 42 years, and both the magnitude andduration of the mid-2011 interruption are consistent withprior cycles (Figure 1);- The last peak in the value cycle was 58 months ago – aseeming eternity in the investment world. Since then,value has underperformed the S&P 500 by a cumulative11.8%. As it turns out, this cycle-to-date relative perfor-mance for value versus the broad market is almost exactlythe average of the last four full value cycles (Figure 2);- If history is a guide, there is significant pent-up opportunityin the value category (Figure 2);- The flight to safety and across-the-board, indiscriminateselling of cyclical businesses has left a wealth of deeplyundervalued, industry leading companies with solid busi-ness franchises, high free cash flows, and solid balancesheets. Conversely, businesses considered safe (i.e.,stable earnings or high dividend paying such as utilitiesand consumer staples) are at record high valuations rela-
Figure 1: Interruptions Are Common During Cycles of Value Outperformance*
Source: Sanford C. Bernstein & Co., Pzena Analysis*Cheapest quintile price-to-book of 1,000 largest U.S. stocks; Measured from the start of value outperformance vs. S&P 500. Data through 12/31/11**The Nov 90 - Aug 95 cycle had three relatively short, mild interruptions of 2.7%, 2.7% and 2.0% lasting two months each
Jul 73 - Jul 79Dec 80 - Aug 88Nov 90 - Aug 95Mar 00 - Feb 07Average Prior CyclesDec 08 - Present739358847737 (so far)
# of Monthsof ValueOutperformance
176.4%254.1%134.6%171.9%184.3%51.5% so far
umulativeOutperformanceInterruptions of Greater than 5% in RelativeUnderperformance During Value Outperformance Cycle
3, 3, 3, 96, 6N/A**1, 54.56
Duration( # of months )
-7.2% -7.8% -8.2% -5.8%-6.0% -5.9%N/A**-6.2% -10.4%-7.2%-8.8%
tive to cyclical businesses.- Because these undervalued companies have the financialstrength and market position to make it through a range ofeconomic scenarios, share price volatility provides op-portunity without outsized risk of permanent loss relativeto the market.- To a large extent, the macro outcomes are not knowable,so it is prudent to place significant emphasis on balancesheets and competitive position, with a conservative view offuture growth. Even with these conservative assumptions,many attractively valued opportunities exist.
Value Cycles Repeat
As Mark Twain once said, “History does not repeat itself, but itrhymes.” We can see this in Figure 3, where we detail the cyclesof value investing over the last 42 years. Although each cycleis different, there is a distinct pattern, driven by the commondenominators of economic cycles and investor behavior.The value cycle tends to peak at the end of an economic cycle,as investors see impending signs of economic slowdown orrecession. It may be the bursting of a bubble that is the precur-sor (commercial real estate in the late 80’s, internet in the 90’s,housing in 2007). Regardless of the trigger, expectations of aneconomic slowdown cause investors to re-price equities down-ward, as they flee to safer havens. Although this is a time wherevalue tends to underperform the broad market, it sets the stagefor a long run of outperformance, as valuations become compel-ling when investors give up on equities, providing a wealth ofundervalued businesses. It is usually during recessions wherevalue starts to outperform, when valuations fully reflect reces-sionary expectations, and investors start looking forward to aneventual recovery.Value outperformance tends to abate as the economy ispeaking and investors throw valuation to the wind to chase themomentum of “hot” areas. The refrain “but this time it’s dif-ferent” gains widespread currency. Remember the internet in1999? But eventually, traditional forces that drive the economiccycles reappear, and the cycle starts all over again.Periods of value outperformance in these cycles have beenlong and rewarding. Since 1969 these periods lasted 7 ½ yearson average, and delivered 184% of cumulative out-performanceversus the broad market (Figure 1). As a result, over fourentire cycles lasting a total of 38 years, value outperformed thebroad market by 4.8% per annum. All of these periods of valueoutperformance, however, have experienced, on average, twotemporary interruptions, each lasting 4 ½ months, with valueunderperforming the broad market by 7.2%. The 2011 interrup-tion was quite similar, lasting six months and producing relativeperformance of -8.8%.The last value cycle peaked in early 2007, as cracks in thehousing market appeared. This ultimately triggered the globalfinancial crisis, and deep recession that lasted 18 months fromlate 2007 through March, 2009. As is typical, value strategiessuffered as the market underwent a massive re-valuation. Butas the U.S. bank stress tests and subsequent capital raisesstarted to stabilize the market in March 2009, value was poisedfor a strong rebound. This in fact occurred, actually startingright after the U.S. presidential election in November, 2008.From that point through December, 2011, deep value outper-formed the broad market by a cumulative 51.5%.Although we have been buffeted by massive volatility duringthe last half of 2011, the downward re-valuation of global equi-ties occurred mainly during the third (continued on page 16)
Figure 2: The Current Value Cycle Looks Very FamiliarCumulative Relative Performance of Value* vs. S&P 500
Source: Sanford C. Bernstein & Co., Pzena Analysis
*Cheapest quntile price-to-book of 1000 largest U.S. stocks
Months From Prior Peak
Current CycleAverage of Last 4 Cycles
Figure 3: Value Investing Cycles over the Last 42 Years
Source: Sanford C. Bernstein & Co., Pzena Analysis
*Value cumulative **Capitalization weighted 
Feb 69 - Jun 73Jul 73 - Jul 79Full Cycle (Annualized)Aug 79 - Nov 80Dec 80 - Aug 88Full Cycle (Annualized)Sep 88 - Oct 90Nov 90 - Aug 95Full Cycle (Annualized)Sep 95 - Feb 00Mar 00 - Feb 07Full Cycle (Annualized)
Feb 69 - Feb 07
Mar 07 - Nov 08Dec 08 -Cycle-to-Date (Annualized)-8.3%206.9%10.4%17.4%414.7%21.9%-16.2%247.9%16.5%71.8%187.5%14.9%
Low P/B*
S&P 500**Performance
Low P/Bvs. S&P 500
# Months

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