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Pzena Commentary

Fear and uncertainty have driven equity Valuations – A Silver Lining

valuations to an extreme across a broad Clearly, the experience of the past year has been painful. But
range of industries. Our message: don’t resulting from that pain is a level of valuations, for the market
panic, think long term, and take advantage in general and value stocks in particular, that is compelling. We
regularly track the value of equities versus 10-year treasuries
of the opportunity. using a dividend discount model, and have not seen this deep
a discount to fair value for equities (56%) in almost 30 years
A World of Extremes (see Figure 1). The next-most-attractive discount for equities
Events of the past year have created an environment where it was 37.4% in September 2002, followed by a 34.5% discount
seems everything is at an extreme – uncertainty, emotions, vola- in August 1986. Although the past is not necessarily prologue,
tility, valuations. These are not easy times to navigate, particu- cumulative returns for the S&P 500 for the following three year
larly when it comes to portfolio decisions. Our objective in these periods were 58.9% and 62.2%, respectively. Even if we adjust
pages is to provide a perspective on what we believe to be the the 10-year yield to 4.5% (from 2.2% at December 31, 2008)
outsized return potential now available to equity investors (and to account for a possible “treasuries bubble,” exacerbated by
value investors in particular), how these opportunities stack up investors’ flight to safety, equities would still appear to be 40%
against fixed income alternatives, and the conditions that led to undervalued.
these valuation distortions. Our message is simple: don’t panic, Put another way, risk premiums are at their widest point in
think long term, and take advantage of the opportunity. the 28 years of data we maintain on the subject. Today’s equity
risk premium, or the expected return on equities less the risk
The Environment – Volatility Abounds free rate, is 13.3%. This compares to an average over the 28
We have just lived through one of the most volatile periods year period of 2.7%, and the next-highest reading prior to 2008
in stock market history. This past quarter, the VIX Index (a was 8.0% achieved in September 2002. This is a clear sign of
measure of market volatility) averaged 58.6, hitting an all-time risk aversion in the markets.
high of 89.5 during the trading day on October 24th. The index So what about our portion of the investment world…value
has averaged 19.7 since inception in 1990. In addition, the S&P stocks? Again, we look to the historical data. On a price-to-
500 experienced moves of greater than 2% on over 60% of the book basis, there has only been one period in the past 43 years
trading days during the fourth quarter (39 out of 64). The S&P where the spread between the cheapest quintile of stocks has
500 fell by 21.9% and MSCI World, net by 21.8% during this pe- been wider than at present, and that was at the end of the
riod, leaving these indexes down 37.0% and 40.7% for the year, internet bubble, when the magnificent overvaluation of the S&P
respectively. What, then, can we observe about valuations that 500 was the main contributor to the outsized spread. Today, the
have resulted from this turbulent period? cheapest quintile of the largest 500 U.S. listed companies (our

Figure 1: S&P 500 Valuation Relative to Bond Market HEADLINE: DIN2:

Figure BOLD 8.5toPTBook Value vs. S&P 500
Assuming Normal Equity Risk Premium Price to Book of Cheapest Quintile of 500 Stock Universe to S&P 500

RULES: Stroke 0.25Limited
PT, 100%
Value black
Opportunity RULES: S
Premium (Discount) to 10 Year Bonds

% Discount to S&P 500

S&P 500 Overvalued Y AXIS: DIN50%

REGULAR 7.5 PT, track -25, right aligned Y AXIS: DI
Normal Range SIDEWAYS:60%
DIN REGULAR 7.5 PT, track -25, center aligned SIDEWAY
X AXIS: DIN REGULAR 7.5 PT, track -25 X AXIS: DI
-30% 70%
S&P 500 Undervalued GRAPHIC: Use 100% black or blue for bars, curves, dotsSignificant Value Opportunity GRAPHIC
-60% 80%
‘80 ‘85 ‘90 ‘95 ‘00 ‘05 ‘65 DIN‘70
COLOR LEGEND: ‘75 7.5‘80
REGULAR PT, 10 ‘85 ‘90 track
PT leading, ‘95 -10‘00 ‘05 COLOR LE

Source: San ford C. Bertstein & Co., Pzena Analysis Source: Sanford C. Bernstein & Co., Pzena Analysis


large cap universe) sells for a 68% discount to the S&P 500 on a the following table shows data that seem intuitively correct—
price-to-book basis, 13% points more than on average. As you more reward for more risk:
can see in Figure 2, this discount is higher than at any other pe-
riod of wide spreads, excepting the height of the internet frenzy Expected
in 1999. Security Return
10-Year Treasuries 2.2%
Opportunities Broaden AAA Bonds 5.1%
BBB Bonds 8.5%
Spreads began to widen during the third quarter of 2007, led by
Equities - S&P 500 15.5%
sharp declines in the financial services sector, followed shortly
thereafter by consumer discretionary stocks. The second major Source: Sanford C. Bernstein & Co., Pzena Analysis
event took place during the second half of this year, as sectors
that were perceived as being shielded from a U.S. slowdown by We can also observe the spread between the expected return
strong emerging market economies started their precipitous de- on equities versus treasuries and BBB corporate bonds over
cline. This included energy, materials, and industrial cyclicals, time in Figure 3, noting the massive widening of all spreads to
some of which are now sporting valuations that have pushed peak levels during 2008.
them squarely into the cheapest quintile of our investment Not only can we observe superior expected equity returns by
universe. Our opportunity set has thus broadened. Not only are asset class, but we can also make similar observations using
valuations attractive, but they are now available across a wide the following illustration.
variety of sectors, giving us the ability to add attractively valued Compare three different specific opportunities. Johnson
holdings while also adding to the diversity of our portfolios. & Johnson (a high quality/low leverage company), Allstate (an
insurance company that has some risk in its own investment
Stocks or Corporate Bonds? portfolio and medium leverage), and Liz Claiborne (a retail
One of the perceptions circulating in the investment community business with fairly high leverage) to see what apples to apples
is that bonds are more attractive investments than equities, as situations look like. As can be seen in Figure 4, in each case the
spreads have widened for bonds as well, and may have similar expected return on the firm’s equity far surpasses the expected
returns with less risk. Let’s examine this question from two yield (yield to maturity) on their debt. True, equity holders as-
perspectives: First, consider the expected return for debt se- sume a higher degree of risk than debt holders, but those risks
curities versus the expected return to equity in comparable risk appear to be more than compensated for in their pricing and
situations, and then look at the empirical evidence coming out expected returns.
of the 1990 downturn. We would specifically note that in the corporate bond arena,
Note the expected return on various classes of securities in opportunities for truly outsized returns (e.g. LIZ), are associated

Figure 3: Expected Equity Return Spreads Figure

HEADLINE: DIN4: Expected
BOLD 8.5 PT Returns for Equities vs. Bonds

Company Security Expected Return*

Johnson and Johnson Bond 3%
15 Stock 16%
RULES: Stroke 0.25 PT, 100% black
vs. 10 Yr. Treasuries
10 vs. BBB Corporate Bonds
Y AXIS: Allstate Bond
DIN REGULAR 7.5 PT, track -25, right aligned 8%
Spread (% Points)

Stock 25%
SIDEWAYS: DIN REGULAR 7.5 PT, track -25, center aligned
Liz Claiborne Bond 28%
X AXIS: DIN REGULAR 7.5 PT, track -25Stock 67%
GRAPHIC: Use return
* Expected 100% for black or blue
bonds is based forto bars,
on yield maturity curves, dotssecurities recently traded.
for representative
Expected return for stocks is based upon Pzena analysis of earnings power and a five year period for
-10 stock prices to return to fair value based on our price to normal earnings methodology. It also presu-
‘80 ‘83 ‘86 ‘89 ‘92 ‘95 ‘98 ‘01 ‘04 ‘07 mes the stock market overall returns to more normal valuation. This is not a guarantee of future returns.
COLOR LEGEND: DIN REGULAR 7.5 PT, 10 PT leading, track -10

Source: Sanford C. Bertstein & Co., Pzena Analysis Source: Pzena analysis
SOURCE: DIN REGULAR 7.5 PT, track -25


with stock valuations that are massively discounted. LIZ is trad- ernment support or in underlying assets.
ing at just over $3 per share having been in the $20’s as recently While fear grips the market, we have been able to find good
as last year. Allstate’s stock should return as much as LIZ bonds businesses that we believe are likely to survive this recession
and three times the return of the Allstate bonds. (maybe even gain share as the weak disappear) trading at levels
As for the observed outcomes from history, Empirical Re- we have never seen. We have found numerous world leading
search Partners examined the returns of junk debt versus value companies at six times normal (we are featuring leading adver-
equities coming out of the 1990 financial crisis. In the three tising companies later in this newsletter). In some cases we are
year period post-October 1990 (the trough of equity valuations buying companies for close to the price of the net cash on their
in that cycle), junk bonds returned 96%, whereas value equities balance sheets, paying almost nothing for the earnings power of
returned 182%, and the average equity was up 112%. the business. While we have no way of gauging timing, we are in
the position at this point that further stock price weakness is just
Conclusion an even better opportunity in the medium to longer term.
We offer the following observations: The universal market perspective today is that the near-term
is bleak and there is not even a hint of pending recovery. History
1. The expected return on equities at current valuation levels shows that opportunity is rarely obvious and even more rarely
is higher than at any time in at least the past 28 years; is it embedded in the short-term. The long-term perspective
2. Valuation spreads are wide, an environment that favors the is difficult to embrace, requires patience and commitment and
value investor; doesn’t work until it works. But the data sure says it’s worth the
3. We believe equity returns should surpass those of fixed wait.
income securities of equally rated issuers; and
4. Equity returns surpassed those of even junk bonds coming
out of the last financial crisis in 1990.

We have not addressed all asset classes in our comparisons.

For example, certain distressed assets such as mortgage backed DISCLOSURES
securities could offer a better return than our equities. We sim-
ply argue that deep value equities should feature prominantly in Past performance is no guarantee of future results. The historical
any asset allocation. returns of the specific portfolio securities mentioned in this com-
mentary are not necessarily indicative of their future performance
Implications for Pzena Portfolios or the performance of any of our current or future investment strat-
Although expected returns on the equity of highly leveraged egies. The investment return and principal value of an investment
companies appear compelling, we have taken a cautious will fluctuate over time.
approach toward investing in non-financial companies with
leverage. Our goal is to own businesses where viability is not in The specific portfolio securities discussed in this commentary were
question and debt levels not excessive, yet they are very cheap. selected for inclusion based on their ability to help you understand
We have limited our portfolio’s exposure to the downside risk of our investment process. They do not represent all of the securities
leverage by investing in companies with strong balance sheets purchased, sold or recommended for our client accounts during any
and solid business franchises that we believe will survive the particular period, and it should not be assumed that investments in
recession, regardless of how long and deep, and prosper in the such securities were, or will be, profitable.
eventual recovery. As more of these opportunities outside of
the financial sector have become available recently, they have
become a larger percentage of our portfolios. We continue to
have meaningful weight in financials, where leverage is inherent
in their business model, as this sector continues to provide some
of the most attractive valuations. We have, however, limited our
financial positions to those situations where we believe there is
compelling downside protection, whether through explicit gov-