Investment Thesis
Pzena Investment Management is a firm founded and run by
Richard Pzena along with co-founders John Goetz and William Lipsey. Pzena is dedicated to value investing and his
firm now (Oct ‘20) has approximately $33B assets under management. In this write-up, I discuss why I took a
position in PZN earlier this year and why I believe it was a relatively safe
investment, with a limited risk of permanent capital loss. It is my view that anything short of a
complete melt-down in the company’s model and/or global markets will likely
sustain operations at a level equal to or above the current level. I estimate that the company is currently fairly
valued given today’s market conditions and recent earnings of PZN.
Should there be a substantial market recovery among
investment firms such as PZN and/or a return to favor in value stocks, the
stock price could double in the next 3-5 years. Because the firm primarily serves
institutional investors, Pzena has been successful in growing the company despite
generally under-performing the S&P 500 index over the last decade. With the move toward passive/robo/index
investing in the past few years, this growth has not been without its
challenges. Active investing firms that have
underperformed have struggled to retain customers. Pzena’s ability to offset this trend coupled
with an expected reversion to the mean for value companies in the coming years supports
the decision to invest in the low to mid-$5 range.
In summary, my investment in PZN is based on 4 main
points.
- Downside protection
- Dividend payout
- Recovery from the pandemic
- Revaluation of value stocks vs expensive stocks (reversion to the mean)
Downside protection
Many articles have been written surrounding the alleged death
of value investing. Pzena has recently
addressed this point in conference calls and particularly in this
video. It was recorded early in 2020 during their
2019Q4 update call with investors. The video
was recorded before the Covid-19 pandemic and Richard Pzena accurately
predicted that “I have no idea what will happen in 2020.” And, despite openly admitting that his firm
has underperformed the S&P500 over the last decade on average, Pzena has
continued to grow his client base. The inflow/outflow
numbers for the last three years show that Pzena’s firm can attract investors
at a higher rate than those leaving the firm for greener pastures even in difficult
environments.
Should the company
performance vs. the S&P500 reverse over the coming years (which R. Penza says
he believes it will) their investments should prosper along with an improved
inflow/outflow ratio. At a time when the
shift away from active management at the retail level is restructuring
investment firms, Pzena’s focus on institutional investing on a global scale
has held up relatively well. During
conference calls, Pzena has repeatedly mentioned that they serve a different customer
than those currently feeling the effects of shift toward passive investing. While he admits there continues to be
pressure on fees, he does not see the current environment any worse than the
general, downward, trend on fees that persisted in the past 5-10 years.
Dividend payout
Pzena (PZN) is a public company. But investors should not be mistaken that the capital structure of the company is intended to primarily benefit investors who
own “A” shares of the common stock. The
capital structure of the company is complicated and difficult to understand,
but essentially there are two classes (A and B shares) with the "A" shares having
only a small percentage of the voting rights.
With a total share count of slightly below 79M, the “B” shares outnumber
the “A” by more than 3.5:1. Further, the "A" shares have voting rights of 1/5 of the “B” Shares. This results in a final “B” share voting
advantage of over 18:1. The "B" (including B-1) shares are owned primarily by
Richard Penza, Directors and Employees of the company, making any outside
influence nearly impossible. With the
complicated structure, investors in PZN are betting that Penza will not exploit
the “A” unit shareholders to the exclusive benefit of the “B” unit
shareholders.
Dividend payments have been both high and growing over the
past few years. At a stock price in the
low $5 range, the payout has been roughly 10% for the past 3 years. This has come in the form of three ($.03)
quarterly distributions and one special dividend of $0.42, $0.49, and $0.46 for
each of the last three years. Pzena did
not suspend the $.03 dividend when their results were punished by the pandemic
and the stock price dropped in mid March of ’20. Even with the continued recovery of AUM through
the final months of the fiscal year, investors should assume that a special
dividend will be significantly reduced or non-existent for FY21. However, the ability of PZN to attract new
investors and limit outflows during the pandemic, and return to a more
normalized environment should help support future special dividends. In the meantime, Pzena has stated that he
believes supporting the dividend is important.
Even in the current, depressed environment, an expectation of 2.2%
payout is reasonable. Higher payouts
will depend on Pzena’s ability to recover from the combined impacts of the
pandemic and overall performance levels of their portfolios and funds.
Recovery from Pandemic
At the time of this writing, PZN shares are in the mid-$5 range. This represents a 60% reduction from the mid
$8 levels that the stock had hovered at prior to the pandemic. Recovery from the Covid-19 environment has
no visible barriers to a return to their previous performance except the
recent dilution of shares that took place at the end of FY19.
As a value investor, Pzena has taught in the past that
investors need to determine whether the reason for a stock to be on sale is
whether the issues facing it are temporary or permanent. Investors who believe, as I do, that most of
the impact of the pandemic-related recession issues are temporary in nature, should
see price improvement over the coming year.
Given the low level of interest in the stock, this will not necessarily
provide a sufficient catalyst for a full recovery even if the AUM fully recovers. It should, however, provide greater than 20%
upside to the current price suggesting a one-year improvement to the mid-$6
range.
Revaluation of value stocks vs expensive stocks
(reversion to the mean)
The final price recovery to previous highs of PZN ($9+) will
likely require that the growth to value disparity in valuations return to more
historical average levels. As Pzena
himself continues to emphasize, this revision to the mean, is reasonable to
expect. Exactly when that will happen,
no one can predict. Rich Pzena openly admits that value investing
has not had a good run since the 2008/09 financial crisis and particularly in
the past three years. However, he remains
committed to their investment philosophies because of the longer-term
outperformance that they have enjoyed as a reversion to the mean has repeatedly
brought value companies back into favor and rewarded a disciplined approach. And while the pandemic impact on US and global
stock markets has amplified the discrepancies between value and high growth
companies, Pzena is betting on some of the most forgotten names and sectors
that he believes will enjoy significant returns in the coming 5-10 years.
Risks and Drivers Away from Estimated Value
The list of risks to investment firms that depend on fees is
well documented. But perhaps the biggest
risk with Pzena Investments is in the name itself. Rich Pzena provides the brand for the company
and the company has only a little over 100 employees. Separating Richard Pzena from the company is
almost certain to have dramatic unfavorable consequences to the common
equity. Should Rich Pzena become ill,
die or otherwise not be able (or wish) to carry forward with his role, the
stock price would likely suffer a devastating blow. I have not done extensive research to
understand the probability of this risk, however, there is certainly the
possibility of this. The probability remains unknown, but my
assessment is that it eclipses all others listed in the 10K.
Other Downside Risk
A protracted, further period of under-performance in value
stocks would certainly weigh the stock price down as AUM, outflows and fees
would all suffer. Pzena has indicated
there is room to cut cost should they feel it necessary, but no cuts to
headcount are indicated at this time. However,
even if costs (headcount) are reduced, it will not be able to keep pace with
the revenue reductions and investors should take any headcount reductions as a
very negative sign.
Another source of downside risk to the stock would be
another round of dilution of the stock aimed at incenting employees or moving
the balance of benefits further toward the “B” shareholders. There is no evidence that this would happen, but
the equity structure presents the risk should times get tougher. While the recently created B-1 shares were
taken as a one-time charge to income, it does signal that Pzena is willing to
dilute the share base. Another round of
dilution would be cause for concern and possible exit from the stock.
To the Upside
Higher Than Expected Growth, Multiplying Impact
This opportunity is very real given value’s long stretch of
underperformance and the distortion in valuations of tech and growth stocks
current present in the market. Pzena’s
long term track record and willingness to weather under-performance is no
guarantee of outsized performance in the next 3-5-10 years, but he does seem to
expect it. If value comes roaring back,
the number of clients knocking on Pzena’s door will undoubtably go much higher
driving AUM, performance fees and the resulting stock price up and to the
right.
Addendum:
A Review of PZN against Buffett criteria
In his 2017 Talk at Google (here), James
O’Shaughnessy presented some of the results of his research in market
performance over time and the factors that impact outcomes. The key factors in Buffett’s methodology for
finding and investing in stocks followed a few simple rules as described on the
slide. For PZN (and all investments that
I make) I apply this quick check to help me stay focused on what has worked
over long periods of time. Below is the
outcome of my review of PZN against this methodology.
Recognizable brands with a wide market: As discussed above, it is Rich Penza’s name
and brand that has provided him with the opportunity that now exists. In the most difficult of times (past 3 years),
inflows in his firm have exceeded outflows.
The addressable market for his size firm is extremely large.
Simple, easy to understand products & services: Investment management says it all.
Consistent, solid earnings over a long time period:
PZN has continued to grow net income over the past 10 years. No losing years over that same period.
Low & manageable debt: 33M Cash &
Equivalents, 0 Long Term Debt, 13M Long term lease obligations, Other long-term
liabilities 29M.
Good ROE and other solid ratios: 5-year average ROE
45%, minimum in that time = 16%. ROIC
lower due to the capital structure of the company.
In this same talk, O’Shaughnessy also presented his findings on total shareholder yield (dividend + buybacks) as a predictor of positive, long-term performance. While the recent dilution does seem to violate this premise, PZN’s payout ratio and buyback program should be enough to offset the negative impact of the B-1 share creation.
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