Lessons in value investing: Paying for the darkness and getting the light for free

The latest bout of market volatility is a timely reminder that there is more than one way to skin a cat when it comes to stock market returns. While momentum and concentration have been the dominant themes in recent years, nothing lasts forever. This, too, shall pass. 

With that in mind, my recent conversation with John Goetz, Co-Chief Investment Officer and Portfolio Manager at value manager Pzena Investment Management, couldn't have come at a better time.

Goetz shared critical insights from his 46 years of experience (29 with Pzena) about what he is observing in the financial world right now and how he and his team have been able to deliver outperformance over the journey. The throughline of the conversation also touched on something critical for all investors, regardless of style – discipline.

The value philosophy

The benefit of a long tenure in markets is that you’re more aware of the extremes. As Goetz notes, "Even for good businesses, stock prices cover a lot of territory over time."

He explained that when stocks drop significantly, fear and uncertainty are at play, creating opportunities.

"We decided the best idea was to grossly underpay... by that, I mean a half-off sale," he said, stressing that disciplined investing in undervalued stocks has been Pzena’s guiding philosophy for 30 years.

Addressing long-term market trends, Goetz noted how market leadership changes over time and that the most expensive stocks often underperform in the long run.

"The stock that's at the top of the whole heap, if you will, on average underperforms over the next 10 years – going all the way back to the 1950s – by about 5% per year."

He likened today's market concentration to the dot-com era and warned of a possible downfall:

"We're either sitting on an even bigger debacle of total market cap, or somehow these companies are all going to suspend the laws of gravity."

Fishing in the downtrodden

Pzena’s investment approach involves looking for good companies experiencing significant declines, which he calls "fishing in the downtrodden."

"Those stocks have fallen for a good reason, which is earnings have disappointed,” notes Goetz, adding that the key to generating outperformance is distinguishing between temporary and permanent issues.

"We have to figure out whether those problems are temporary or permanent because that is where the in-depth research really will matter. Is this disease fatal, or is this just a common cold?"

Balancing art and science

Despite his background in mathematics and the team’s focus on using maths as the intellectual horsepower to narrow down the investable universe, Goetz emphasised that quantitative models alone are not enough.

"Our mathematics aren't going to be our long-term differentiator... What we're professional at is these patterns of diagnosis on business issues."

He highlighted that real expertise comes from deep research and industry knowledge. "We hire McKinsey consultants that can use a calculator," he joked, highlighting the importance of combining qualitative insights with quantitative tools.

When it comes to diagnosing business issues, Goetz stressed the importance of going beyond company presentations. "It's taking those facts we've dug up through conversations with experts, maybe talking to competitors, and then going and corroborating with management", said Goetz. 

He also noted that transparency in acknowledging mistakes is key: "If you can't see your mistakes, then your leadership in turning the business around is also going to be weak."

Investing in turnaround stories

One of the misconceptions about deep-value investing is that managers have to move up the risk curve and buy junk, looking to hit home runs on longshots that manage to resurrect themselves. Goetz is keen to dispel that notion and highlighted successful investments in once-downtrodden giants like GE, Microsoft, and Alibaba.

"People think, well, Pzena must be dealing in obscurity to get alpha... but very heavily followed companies like General Electric, Microsoft, or Alibaba still experience dramatic downturns."

"We are not buying garbage hoping to get one more puff on a cigar. We are actually buying well-positioned companies in a very, very dark moment,” said Goetz.

He recounted buying GE 20 years after it peaked in 1999, noting that "even loved stocks have drama in their stock price movements, and our job is to take advantage of those dramatic movements."

The more recent example, Alibaba, has suffered from multiple layers of negativity, according to Goetz, including economic slowdown, government intervention, and failed investments. "There isn't even a willingness to think about upside," he said before adding why Pzena couldn’t go past the opportunity;

"We don't know the future. We just like it when we're paying nothing for the good part of the future. We're only paying for darkness and we get the light for free."

"The light is there... it's just that the visibility of the catalyst isn't there in the moments that we're buying these companies", said Goetz. 

Dimensions of risk

As noted above, Pzena’s investment style requires a long-term lens and a discipline that is probably beyond a lot of retail investors. It is also not without risks. Goetz shared the following three key types of risks that influence his investment approach:

1. Exogenous risks, which Goetz notes, are beyond any control, such as unpredictable global events. According to Goetz, "There are things that we don't know that are coming down the pipe, but that's pretty easy. I don't think anyone would punish us too much for something that was unknowable."
2. Misdiagnosing the business is far more critical and involves misjudging the future of a business. Goetz pointed to an example with Vallourec, a French energy services company. The firm seemed like a solid investment, operating in a niche market with a unique product, but Goetz admits that they missed key issues; "poor management decisions and problematic contracts derailed our thesis." Misdiagnosing a company's issues can be a painful lesson, highlighting the importance of truly understanding a company before making an investment.
3. Management's strategic shifts: Goetz explained that sometimes companies change course in ways that don't align with the original investment thesis. A significant concern for Goetz is when management opts to pursue areas outside their expertise. He highlights instances where CEOs shift from their core businesses into untested or unrelated areas, which can render previous research irrelevant.

"It just terrifies us because now our original research has become irrelevant", said Goetz. 

The role of CEO decisions

When asked whether these "left turns" are often driven by egotistical CEOs, Goetz agreed but added more nuance. He explained that management may pivot for one of two reasons: either due to a lack of confidence in their core business or the allure of entering a more glamorous, high-growth market – the history of Australian mining companies is littered with the latter, which Goetz knew only too well. 

"One is a lack of confidence in the core business, that’s very scary, but the other one is there’s a better idea, there’s a better business" said Goetz.

Where is Pzena hunting now?

Despite market volatility, Goetz sees significant opportunities in the current environment. He emphasised that a diverse set of exposures is key, especially during times of pessimism. While cyclicals like energy and financials were dominant in early 2020, he notes that sectors like healthcare have become increasingly attractive. 

"We've made a huge transition from underweight to overweight healthcare in many of our portfolios," says Goetz. 

He points to healthcare companies like Fresenius, CVS, and Sanofi as examples of companies with significant potential for growth, often due to lingering impacts from the COVID-19 pandemic.

Goetz also highlights the current regional pessimism. He mentions China’s negative perception and the geopolitical challenges facing Europe, particularly after the invasion of Ukraine. "Europe’s in shock," he says, noting how these macroeconomic concerns have led to lower valuations in certain industries and regions.

On the other hand, Goetz sees the U.S. economy performing well and is optimistic about financials. He gives the example of NatWest, which has doubled in value over the past year. While the market has been focused on high-profile tech stocks like those in the "Magnificent Seven," Goetz sees substantial opportunities in undervalued sectors with a longer-term investment horizon.

The final word

Despite the current market’s focus on high-growth sectors, Goetz remains committed to finding value in overlooked or distressed industries, where he believes his firm can deliver superior returns over time.

"Our value proposition is that we will outperform by 2 to 3% over the long run. The only way we’re going to do that is to tread in the downtrodden,” said Goetz.

Managed Fund

Pzena Global Focused Value Fund

Global Shares

View

Managed Fund

Pzena Emerging Markets Value Fund

Global Shares

View