Catalysts for change

John Goetz

Pzena Investment Management

How do you spot the coming shift from growth to value? Ride the winners. That’s the obvious investment strategy favoured at the end of a cycle. It’s easy, really. Just select the few dominant technology “masters of the universe” that everyone loves, sit back and enjoy the multiple expansion.

It’s happening again this cycle. And, true to form, valuation spreads between cheap and expensive stocks have reached all-time highs all over the world. Further, questions about whether value will ever work again, or whether there is a new definition of value, have become commonplace. It is reminiscent of the late 1990s internet bubble when Michael Lewis’ 1999 book The New New Thing described all you needed to know.

Investors then, like investors today, were mesmerised by unfettered growth opportunities.

But value’s 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 believe that the seeds for unwinding today’s extremes have been planted, especially as our COVID-dominated world has led us into a recession that history shows is the key marker for the shift.

Consider the following four possible catalysts that could already be signalling that a shift is upon us:

1. Recession
The recession is in place and the path toward economic recovery is becoming clear. We examined recessions in the US over the last 100 years and in Japan over the last 45 and the evidence is compelling. The US experienced 14 recessions during the past century, and looking at the five- year returns from the beginning of the recessions, value outperformed the broad market by an average of 530 basis points per annum.

2. Interest Rates
Interest rates stop falling, bringing multiple expansion for growth stocks to an end. Interest rates have been in structural decline for the past 40 years. This has led us to a world where one can buy value stocks at P/E’s of 10, just like any time in the past 70 years, while average growth stock multiples have doubled from 30 to 60 times. Even if rates don’t rise, it's hard for us to see the tailwind enjoyed by growth stocks continuing.

3. Growth Expectations
(Irrationally) exuberant growth expectations for the technology “masters of the universe” revert to normal. Consider the math, using Microsoft as an example. 

Microsoft’s stock price is up 10 fold over the past 10 years, or 25% per year, helped by strong growth in cloud technology replacing on-premise hardware demand. During this period, Microsoft’s operating income has doubled, growing at an 8% annualised rate. To justify an 8% return starting from today’s stock price, operating income would need to grow at 10% for the next 20 years to levels greater than six times where it is today. Yet market analysts estimate that cloud penetration of data needs has reached 30% – 35%, and that the possible maximum penetration for the cloud will be approximately 70%, therefore, we are about halfway to saturation. So where will additional growth come from?

4. Disruptions
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 (and other incumbent auto companies) must shrink? Tesla’s stock is one of the darlings, rising over tenfold during the past five years. VW’s stock has barely changed in the same period.

But there are ultimately only two ways to win in auto manufacturing: (1) charge higher prices — in other words maintain a brand premium, and (2) manufacture at lower costs. It seems inevitable that these truths will apply to electric vehicles, and that VW will succeed in porting their brand 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.

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This document is intended solely for informational purposes. The views expressed reflect the current views of Pzena Investment Management (“PIM”) as of the date hereof and are subject to change. PIM does not undertake to advise you of any changes in the views expressed herein. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance is not indicative of future results. All investments involve risk, including risk of total loss. This document does not constitute a current or past recommendation, an offer, or solicitation of an offer to purchase any securities or provide investment advisory services and should not be construed as such. The information contained herein is general in nature and does not constitute legal, tax, or investment advice. PIM does not make any warranty, express or implied, as to the information’s accuracy or completeness. Prospective investors are encouraged to consult their own professional advisers as to the implications of making an investment in any securities or investment advisory services. ¹Source: Cabinet Office of Japan, Federal Reserve Bank of St. Louis, Kenneth R. French, MSCI, Sanford C. Bernstein & Co., Pzena analysis. Data use 14 US recessions from 1929 - 2009 and eight Japan recessions from 1977 - 2012. The US universe is all NYSE, AMEX, and NASDAQ stocks defined by Kenneth R. French data library and excluding the smallest 30% of companies based on market capitalization to replicate our investable universe. The Japan universe is the MSCI Japan Index. Value is defined as the cheapest quintile of stocks on a price-to-book basis for each respective universe. All returns equally weighted in US dollars. Past performance is not indicative of future returns. Does not represent any specific Pzena product or service For European Investors Only: This financial promotion is issued by Pzena Investment Management, Ltd. Pzena Investment Management, Ltd. is a limited company registered in England and Wales with registered number 09380422, and its registered office is at 34-37 Liverpool Street, London EC2M 7PP, United Kingdom. Pzena Investment Management, Ltd is an appointed representative of DMS Capital Solutions (UK) Limited and Mirabella Advisers LLP, which are authorised and regulated by the Financial Conduct Authority. The Pzena documents are only made available to professional clients and eligible counterparties as defined by the FCA. The value of your investment may go down as well as up, and you may not receive upon redemption the full amount of your original investment. The views and statements contained herein are those of Pzena Investment Management, LLC and are based on internal research. For Australia and New Zealand Investors Only: This document has been prepared and issued by Pzena Investment Management, LLC (ARBN 108 743 415), a limited liability company (“PIM”). PIM is regulated by the Securities and Exchange Commission (SEC) under U.S. laws, which differ from Australian laws. PIM is exempt from the requirement to hold an Australian financial services license in Australia in accordance with ASIC Corporations (Repeal and Transitional) Instrument 2016/396. PIM offers financial services in Australia to ‘wholesale clients’ only pursuant to that exemption. This document is not intended to be distributed or passed on, directly or indirectly, to any other class of persons in Australia. In New Zealand, any offer is limited to ‘wholesale investors’ within the meaning of clause 3(2) of Schedule 1 of the Financial Markets Conduct Act 2013 (‘FMCA’). This document is not to be treated as an offer, and is not capable of acceptance by, any person in New Zealand who is not a Wholesale Investor. For Jersey Investors Only: Consent under the Control of Borrowing (Jersey) Order 1958 (the “COBO” Order) has not been obtained for the circulation of this document. Accordingly, the offer that is the subject of this document may only be made in Jersey where the offer is valid in the United Kingdom or Guernsey and is circulated in Jersey only to persons similar to those to whom, and in a manner similar to that in which, it is for the time being circulated in the United Kingdom, or Guernsey, as the case may be. The directors may, but are not obliged to, apply for such consent in the future. The services and/or products discussed herein are only suitable for sophisticated investors who understand the risks involved. Neither Pzena Investment Management, Ltd. nor Pzena Investment Management, LLC nor the activities of any functionary with regard to either Pzena Investment Management, Ltd. or Pzena Investment Management, LLC are subject to the provisions of the Financial Services (Jersey) Law 1998. For South Africa Investors Only: Pzena Investment Management LLC is an authorised financial services provider licensed by the South African Financial Sector Conduct Authority (licence nr: 49029).

John Goetz
Managing Principal, Co-Chief Investment Officer
Pzena Investment Management

John is a co-portfolio manager for the Global, International, European, and Japan Focused Value strategies.

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