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Pzena Investment Management

Second Quarter 2017 Commentary

since the financial crisis. European order books are filling,


Improving fundamentals coupled with wide and profits are inflecting higher. Companies around the world
valuation spreads make for an attractive have undertaken extensive self-help measures creating the
environment for deep value stocks. Self- opportunity for accelerated profit recovery with even modest
help measures have been an important top-line support. And green shoots are appearing in unexpected
places corporate actions are unlocking value in Korean
contributor to an improved profit picture.
chaebols, Chinese state owned enterprises have initiated
The strong value run of 2016 paused in the first half of 2017 as dividends, and Japanese managements have renewed focus on
market leadership shifted to growth. A narrow range of tech stocks corporate governance and shareholder returns. A clear-eyed
- the FAANGs in the U.S. and Alibaba and Tencent in China - lead view of the landscape shows a broad picture of opportunity.
the pack in those regions. This abrupt shift leaves one wondering
whether the value cycle is over, or if the environment is conducive to Redemption for U.S. Banks
a resumption of value outperformance.
Three criteria typically set up the opportunity for extended For the U.S. banks, the recent stress test results were an
value outperformance: affirmation that, as the banks fixed themselves and the pace
Uncertainty, either broad-based or company-specific, of regulatory headwinds slowed, investors would see rising
which creates earnings yields and cash payouts. The U.S. Federal Reserves
Wide valuation spreads between companies punished for go-ahead for the large banks to return higher levels of capital
these uncertainties and those favored by investors, then than expected was quickly followed by announcements from
A dissipation of uncertainties which leads to the the banks themselves that they would immediately begin to
re-rating of value stocks. aggressively return capital and earnings to shareholders.
There are many such cases of uncertainty today. Whether The median payout request for the next six quarters was 97%
it be major U.S. banks that are just regaining the confidence of of earnings, up from 84% in the 2016 stress tests and an average
investors a decade after the global financial crisis, European payout of 79% from 1999 to 2006. Those banks that plan to return
industrials whose valuations have been punished by a painfully slow more than 100% of earnings, including Citigroup, JPMorgan, and
economic recovery, Japanese companies put in the penalty box Morgan Stanley, are signaling that their capital ratios are high
for a generation of low shareholder returns, or emerging market enough after years of steady increases. The fact that there was
businesses cheap for their own specific reasons, there is a long list not a single quantitative or qualitative failure in this years stress
of companies suffering from uncertainty. Valuation spreads between test shows not just the safety in the banking system, but also how
these companies and the much-loved growth darlings and bond far the banks have come in understanding and satisfying the Feds
proxies are still near 50-year highs (Figure 1). requirements.
Yet when we look around the world, we see reasons for The expected payouts over the next six quarters at several of
optimism. U.S. banks just received their best report card the banks equate to annualized yields of more than 10% of market

Figure 1: Valuation Spreads Are Still Extreme Figure 2: U.S. Bank Payouts To Shareholders Rising Substantially
1Q vs 5Q Spreads by Region, expressed in Standard Deviations Illustrative Payout Yield As % of Current Market Cap for U.S. Universal Banks

7
6
5
4
3
2
1
0
-1
-2
-3
1964 1970 1975 1980 1985 1990 1995 2000 2005 2010 2016
Europe Japan US

Note: Data as of June 30, 2017. 2017 based on CCAR results. 2019E is illustrative assuming return of 100% of
Source: Sanford C. Bernstein & Co., Pzena analysis. excess capital by year-end 2019. Source: Capital IQ, Pzena analysis

1 PZENA QUARTERLY REPORT TO CLIENTS | SECOND QUARTER 2017 FOR FINANCIAL PROFESSIONAL USE ONLY
capitalization (Figure 2). The fact that investors have been paying order books are filling, and corporate profits have surprised to
up for 3% dividend yields from the bond proxies (consumer the upside with almost two-thirds of publicly held companies
staples, utilities, and REITS) highlights the very different discount beating expectations in the first quarter of 2017 (Figure
rate they are applying to the safe stocks versus controversial 3). Self-help measures (i.e., cost reduction and efficiency
sectors and names. Looking ahead, we expect rising earnings on improvements) have been major contributors to this progress,
the basis of continued self-help and improving fundamentals, as setting up a situation where even modest top-line growth has
well as potential favorable changes to the stress test process. had an inordinately positive impact on bottom-lines (Figure 4).
Even after the sharp rise in stock prices for all the large
banks from mid-2016, we believe valuations remain extremely Self-Help And Improved Corporate Governance
compelling. As the banks re-establish investor confidence
over time, we would expect the discount rate applied to narrow, In Japan, corporate governance reforms under Abenomics
helping improve valuations further. have ushered in a new era of responsiveness to shareholders.
Greater representation of independent directors on
Europe Emerging From The Doldrums corporate boards, a decline in management-friendly cross-
shareholdings, and a recommendation by the leading proxy
Europe has lagged the U.S. in its recovery; however, green advisory firm ISS to vote against top executives that havent
shoots are starting to emerge. Business sentiment is up, hit a minimum return hurdle have contributed to a renewed
Figure 3: European Corporate Earnings Are Beating Expectations focus on profitability and shareholder returns. As can be seen
70%
in Figure 5, Japanese companies have substantially increased
their dividends and share buybacks.
65% Emerging markets have been a story of improving
60% corporate results in an uncertain environment. After falling
for the last three years, return on equity (ROE) in China is
55% expected to inflect higher for both private and state-owned
50% enterprises (Figure 6), much of it due to expense reductions
and other self-help initiatives, though the upturn should be
45%
more pronounced for companies which have taken more
40% aggressive action. Notwithstanding official China GDP data,
1Q09 1Q10 1Q11 1Q12 1Q13 1Q14 1Q15 1Q16 1Q17
other statistics
Europe % cos beating EPS estimates Median
Universe is STOXX Europe 600
Source: J.P. Morgan, Bloomberg Figure 5: Japanese Companies Are Increasing Payouts to Shareholders

Figure 4: Cost Cutting In Europe Has Created Significant Upside Oper-


16
ating Leverage
U.K. and Continental Europe Operating Leverage: Ratio Between the 14
Year-over-Year Changes in Pre-Tax Income and Sales1 12
1990 Through June 2017 10
5x 8
6
4x 4
2
3x
0
3/2010 3/2011 3/2012 3/2013 3/2014 3/2015 3/2016 3/2017E 3/2018E
2x
Total amount of dividends Net amount of share buybacks

1x
Note: Tokyo Stock Exchange 1st listed companies as of each fiscal year
end, excluding financials and Japan Post. Net amount of share buybacks
0x (reported on cash flow statements). Buybacks forecasted for FY 3/17 and
1990 through 1999 2000 through 2009 2010 through June 2017
FY 3/18 by Mizuho Securities. Data as of May 9, 2017.
U.K. Continental Europe
Source: Corporate Reports, Empirical Research Partners Analysis. Source: Mizuho Securities Equity Research, based on Tokyo Stock
1
Capitalization-weighted data. Exchange data.

FOR FINANCIAL PROFESSIONAL USE ONLY SECOND QUARTER 2017 | PZENA QUARTERLY REPORT TO CLIENTS 2
(e.g.; electricity consumption) would suggest China slowed Of course, there are still uncertainties that can derail
significantly in 2015. It appears China has exited that phase continued recovery, but barring such extraordinary events,
and is pulling its weight again in the global economy. we believe there is ample evidence that conditions provide a
favorable environment for the value investor.
A Good Environment for Value
Figure 6: China Return on Equity Inflecting Upward
26
There are many factors contributing to the opportunities
24
in value stocks today beyond favorable valuations and 22
improving fundamentals. Companies have demonstrated 20
an ability to adjust their cost structures and implement 18
self-help measures to improve current returns and set 16
14
themselves up for significant incremental earnings, as top-
12
line growth re-emerges. There are also many idiosyncratic 10
opportunities driven by factors outside of general economic 8
conditions (the U.S. pharmaceutical supply chains come to 6
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17E 18E
mind). None of these drivers is dependent on the prospects
Overall State Owned Enterprises Private
for reduced regulation, infrastructure investments, and
lower taxes in the U.S. which helped drive sentiment in Note: ROE is bottom-up aggregate with free-float adjustment based
late 2016, but are becoming more doubtful of late. We on current MSCI universe. State owned enterprises (SOE) and Private
(PVT) decided manually after analyzing the current holding structure
see government-led stimulus as additional upside but for all the stocks.
not a requirement for value stocks to resume leadership. Source: MSCI, FactSet, CLSA

DISCLOSURES
Past performance is no guarantee of future results. The historical returns of the specific portfolio securities mentioned in this
commentary are not necessarily indicative of their future performance or the performance of any of our current or future investment
strategies. The investment return and principal value of an investment will fluctuate over time.
The specific portfolio securities discussed in this commentary were selected for inclusion based on their ability to help you understand
our investment process. They do not represent all of the securities purchased, sold or recommended for our client accounts during any
particular period, and it should not be assumed that investments in such securities were, or will be, profitable.

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