Finding value in a bull market
June 14, 2013
Dan Newhall: Hello. I'm Dan Newhall of Vanguard's Portfolio Review Group. I'm here with Pzena Investment Management's Tony DeSpirito, who is one of three portfolio managers from Pzena that manages a portion of the Vanguard Windsor Fund.
Tony, thanks for joining us.
Tony DeSpirito: Dan, thanks for having me. It's a pleasure to be here.
Dan Newhall: So, Tony, why don't we start by having you tell us a little bit about Pzena and the investment team that you work with to make decisions on the portfolio?
Tony DeSpirito: Sure. Sure. We, at Pzena, we're a boutique, long-only, deep- value manager. And we've been in business since 1996. We now have $20 billion in assets under management, both retail and institutional. All we manage is assets in a value style.
In terms of our investment team, there are 22 investment professionals, 13 of us have been together for over seven years now, so there's a lot of longevity. I've been at the firm actually since the first year of our inception.
Dan Newhall: As a value manager, what do you make of the recent run-up in stocks that we've really all been enjoying. But in your opinion, is the market still broadly attractively priced?
Tony DeSpirito: Yes, it is, and let me tell you why. So when you look out at the market, I think fixed income is in a bubble, right? Fixed income yields, whether it's on corporate bonds, treasuries, or high-yield bonds, are all at all-time, at or near all-time lows. The equity market, if you look at the PE [price/earnings] multiple of the equity market in the United States, it's about at long-term averages. The result is that if you think about it in terms of an equity-risk premium, that equity-risk premium is approaching all-time highs.
So I look at that and I say, "Stocks are a pretty good investment, particularly given the alternatives." Now, within the equity markets themselves, I would tell you if you peel back the onion one more layer, what you'd see is that there's a real dichotomy of valuation. On one hand, there are stable, perceived safe companies that pay high dividends. Investors have been chasing those stocks upward.
On the other side, anything cyclical has been sold off. No one wants to own cyclical stocks because investors are looking out their rear view mirror and saying, "I remember what happened in 2008." And so that's creating a large value opportunity for us.
Dan Newhall: You do have meaningful overweights within your portfolios to financials. What's led you there? There were really tarnished investments through 2008. They've come back a long way. What is still the attraction for you and how do they fit the framework you have for evaluating companies?
Tony DeSpirito: The reality is actually the businesses have changed for the better, substantially changed for the better. In terms of valuation, despite the run-up, on a relative basis, their valuations are pretty close to the all-time lows, actually in '08 and '09.
Now, in terms of the safety and soundness of the institutions, that has been much improved. The balance sheets are much better today than they were either prior to the global financial crisis or certainly during the depths of the global financial crisis. They've all raised capital, retained earnings, and the result is that capital ratios are, depending on the company, 50% to 70% higher today than they were prior to the financial crisis.
The underlying outlook is also much better. If you think about what had driven loans to go bad, it was unemployment—people lost their jobs so they weren't able to pay their loans—or home prices fell so much that owners were actually incented to give the keys back to the bank because they were so under water on their mortgage. Well, as you know, home prices have stabilized, and they're actually to the point where homes are as affordable now as they've ever been. So the indications are that they should remain stable to upward. And similarly, employment's improving. The result is fewer losses on the loans.
Dan Newhall: You've also been substantially overweight technology stocks. What makes this traditionally very "growthy" sector so appealing to you as a value investor?
Tony DeSpirito: Anything that's perceived as old technology—Microsoft, Hewlett-Packard, Oracle—these companies are trading at very low multiples, in some cases, single-digit multiples. And what I'd say is it's almost like tech investors tend to take a grain of truth and extrapolate that truth to the Nth degree.
So if you go back to the late '90s, was it true that the internet was growing? Yes, it absolutely was true. Those investors took that grain of truth and were paying 100 times earnings for Cisco. They were buying business that really had no business model other than that they were on the internet, right? Today, there's a grain of truth, right? PC sales are shrinking because of the adoption of tablets. People are printing less. So that's all true, right, but investors are treating these businesses as if they're worthless and that they won't throw off any free cash flow, etc. And so that's where we come in as value investors.
Dan Newhall: Really, did you ever think you'd end up owning the likes of Microsoft as you do in the Windsor portfolio?
Tony DeSpirito: We now have the opportunity to buy some really great businesses. Microsoft is a fantastic franchise, and I think what many investors have lost sight of is, this company has evolved to really being an enterprise company, not a consumer company. And we estimate about three-quarters of the earnings actually comes from the enterprise side of the business. And in the enterprise, they're actually viewed as the low-cost solution, the operating system on servers, Exchange, Office.
By the way, Microsoft, in addition to being a good business, has a very healthy balance sheet, about $7 a share net cash. And once you take that cash into consideration, the stock is trading at nine times its current run rate of earnings.
Dan Newhall: Maybe you could talk a little bit about your attraction to Hewlett-Packard's prospects.
Tony DeSpirito: Hewlett-Packard is one of those companies that investors have left for dead. It trades at five times its current earnings. Now, Hewlett-Packard has had its problems. Well, first of all, I'll tell you, Hewlett-Packard's a good business, actually. It's highly diversified. It's actually the largest, tied with IBM, the largest tech company in the world. It's number one or number two in virtually everything it does.
Now it's had its problems recently and that's what gives us the opportunity as value investors. Now some of that's because of what's gone on in the market, PC sales, for example. But you know what? PCs only account for 8% of the earnings power at Hewlett.
Some of the problems have been self-inflicted. They went through a period of, I'll call it rapid CEO turnover, where they had three CEOs in just over a year. But that's in the past. Meg Whitman's been at the tiller now for over a year and she's a steady hand. And so, the business where you see the biggest impact from the management turnover is in the services business because it's a people business. And so that's the business that's struggling the most today but it's also the business that has the most earnings upside from here.
Dan Newhall: A fair question I always ask a value investor, so when are these things going to change? What's that catalyst that's going to get people to come back to financials or come back to some of these technology companies that you own?
Tony DeSpirito: Well, I think to be a value investor you have to have patience. In fact, I know you have to have patience. These turnarounds often occur in fits and starts, and they take a while to materialize. But what's interesting is when the price of a stock has gotten so low—and this is the case in technology, this is the case in the financial sector—when the price is so low, but the value's so much greater, you're being paid to be patient. And that's what it takes to be a value investor, that kind of patience.
One of the most fundamental tenets of investing is to make sure you have the right investment philosophy, the right investment strategy. And if you've done that right, if you set that up right, then the trick is to stay disciplined.
Dan Newhall: Terrific. Makes sense to me. Tony, thank you for your time today.
Tony DeSpirito: Thank you, Dan.
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Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
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A conversation with Tony DeSpirito of Pzena Investment Management
In this recent video interview, Tony DeSpirito of Pzena Investment Management, which oversees a portion of Vanguard Windsor™ Fund, talks about finding value in financial and technology stocks, including one company that "investors have left for dead."
- All investments, including a portfolio's current and future holdings are subject to risks, which may result in the possible loss of the money you invest.
- Past performance is not a guarantee of future results.
- Diversification does not ensure a profit or protect against a loss in a declining market.
- Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
- Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
- High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings. While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates.