Unpacking Value Investing with Rich Pzena

Welcome to Compound Insights, a podcast by CFA Society New York. I'm your host Gary Farber, today we're very fortunate to have with us Rich Pazina. Rich is the founder of Pazina Investment Management, established in 1995. He is principal, chairman, co-chief investment officer, as well as a portfolio manager at the firm. Prior to founding the firm, Rich was the director of U.S. Equity Investments and Chief Research Officer for Sanford C. Bernstein. Currently, Pazina manages approximately $80 billion, focused on a disciplined, valued, investing approach across 27 strategies. Rich, welcome to the Compound Insights podcast. Thank you. Happy to be here. Obviously, you know, a tremendous accomplishment to build a firm up like that to $80 billion from ground up. Can you share with us how the firm evolved over time, what was some of the keys to success for those who were sort of aspiring to be emerging managers today? Well, 30 years ago, it's 30 years now, so we just celebrated a big anniversary, at the outset, all you do is hope that you don't go out of business. And mostly it was a dream, I had been at Sanford Bernstein, I watched them grow from a relatively small firm. When I joined there, they had about $4 billion in assets under management, and when I left, coincidentally, they had about $80 actually. And I watched what they did from $4 to $80, and I thought there were some great aspects of what I could take away, which is maintaining a disciplined, valuation approach, focusing on research. But there were also things that I didn't want to do, which was have no limits on the assets you take in any individual strategy, and because it makes it more and more difficult to execute a strategy. If you have a concentrated value strategy, and even 40 years ago, when I joined Bernstein, if you have a 30 stock large cap value strategy, and all of a sudden you find yourself managing $30 billion, which is what happened, you would have to find 30 cheap stocks that could absorb a billion dollars, which at the time, 30 to 40 years ago, wasn't easy. So they went to 40 stocks, and then 50 stocks, and then 60 stocks. And so we didn't want to do that, we wanted to be pure, not be impacted by those issues, yet be disciplined as a value investor. So that was the premise of when I started, the reason, and mostly it's a dream, I mean, you're doing something that you love, and you think you're pretty good at it. And you have to have a little bit of craziness to go out and quit your job and try something new, not new, but try something on your own in a world where the success rates are not that high. But to me, what created the firm, you have to get a little lucky, and we were lucky, the first two years were pretty good. And then we went into two and a half years, where the only thing that mattered was the internet, and we had this amazing internet bubble, where stocks went up and up and up and up, and we did nothing and nothing and nothing and nothing. And after five years, found ourselves 6,000 basis points behind the S&P 500, 60 percentage points. So you sort of say it's over, you know, who's going to ever hire you, and some of the early luck we had in attractive clients turned around and we started to have some redemptions, but we stayed disciplined. We said to, we met with all of our clients that we were fortunate enough to have attracted and said, look, I don't understand what's going on. I'll just give you a funny story, because probably the most memorable client experience that I had, a woman came into the office, sat down and said to me, my grandmother is a better investor than you are. So what you have to do is buy Cisco, everybody in the world has figured this out except you, and you're just stubborn. And so I tried to do arithmetic with her, I said, you know, at the time, Cisco was the first company to hit half a trillion dollar valuation. Now that's like peanuts almost, but you know, I said, if you want, if you're going to buy the whole company and write a check for 500 billion dollars and you want to make 20% a year return, they have to earn 100 billion dollars a year, and they earn 1 billion dollars a year. Don't you think there's something wrong with that, and she said, you don't get it, do you, to which I agreed. And so we stayed disciplined. We had a whole host of things that were really interesting to buy at the time. Many, many, many of our competitors gave up during that period of time, changed their stripes, added stocks just so that they wouldn't be missing out. You know, even if you didn't put Cisco in, there were people who put value investors that put IBM in their portfolios that were also elevated in valuation, and we didn't. So when it turned in 2000, we were, we had a unique position and had kind of five straight years of really spectacular investment performance and it's what made the firm. And do you think, you know, it's interesting point that back then even people did not appreciate value investing, do you think today there's still some aspect of it that sort of misperceived or sort of underappreciated by investors? Well, I mean, it's been such a laggard for so many years that it's not, it's not irrational that people have some doubts about value investing. What I like to point out is that performance of traditional value, I'll talk not just about us, but some of the people that engage in traditional value investing, the last 10 to 15 years have been no different than the prior 10 to 15. So we've chugged along making 10, 11, 12% a year, but then the market went to 14 and 15% a year, and and after a long period of that, you sort of say, well, why would anybody want to do value investing and, you know, my response is, if you can, if you can make 10 to 12% performance over a lifetime, you're going to bind up being very, very happy with that and you shouldn't be. Overly influenced by what's going on in the marketplace and the marketplace today and we all know the issues big tech companies that have giant franchises that have done wonderfully no doubt about it, but an ownership in the S&P 500 is a highly concentrated bet on those companies and for us as a business philosophy saying this is what we do not what they do. Has been the reason for our business success and so to me, nothing has changed in value investing. What's changed is the environment, the alternatives that people have had to value investing and, and they are extrapolating the last 10 to 15 years into the future, no matter how unlikely that actually is to occur. And over that time, has your process, investment process sort of evolved as a change how you find companies and things like that, I mean the actual process is unchanged the actual process is pretty straightforward we're trying to buy. Find businesses that are selling at a low price relative to what their sustainable long term earnings power is over a full economic cycle, that now that does that sounds like. Motherhood and Apple pie, but but the reality is you know when you when you doing this for a long time you also wind up at times being on the other side of the table listening to presentations that other investment managers make and I always struck me that no matter what you do whether you're a value or growth stock investor people say the same thing we buy good businesses for low prices that's what we do. And I have a much more realistic of you because good businesses don't sell for low prices what sells for low prices are things where there's something going wrong doesn't mean they're bad businesses. But it means they may not be performing today and and if you have a healthy dose of realism the realism being that you don't get to buy what everybody wants at a low price and what everybody wants is fast growth high margins dominant market position strong management team clean. Clean balance sheet. I mean everybody in the world would describe a good business exactly the same way and and thinking that you can get one of those at a low price is kind of irrational. And as part of the process quantitative qualitative factors you take into consideration touched on the balance sheet low price are their particular metrics that sort of use in your screens that you're willing to share and things like that that help you construct your investment mosaic. We use a concept called normal earnings power rather than current earnings so if you think about what normal means on a naive basis and there's you can't go and look up what's the normal earnings power of a company you can look up its book value you can look up its current earnings. Normal earnings is a from our perspective on on the stage one is a is a simple concept if you know what business the company is in and how has it done over the last 10 years what would you naively extrapolate from history so for example if the company grew 10% a year and had 14% operating margins on average for the last 10 years assume that happens into the future. And extrapolate that so you're going to get the average margin the average growth rate and and you can go out a few years and then rank the universe based on price compared to that number what you're going to find is what's at the top of the list which are companies that are selling for a low price relative to what their histories suggest they earn in the future. Is a very very rich universe to go in and look for true value because what happens is the computer is just drawing a line that extrapolates the past the reality is often that the present is not on that line something has happened in the business that's caused the earnings to deviate from that historic norms. And the market reacts negatively sometimes significantly negatively but the problems may not be permanent so very often there are gems in those and that's what we use for screening that's what we use for valuation. You asked about the evolution of the process the basic fundamentals of that have never changed what's changed is refining what we mean by a good business and what we mean by stress because I think one of one of the misconceptions of value investing is that you're buying lousy businesses with crappy balance sheets that are distressed but value is not distressed. Distressed is a very very different topic so stressed is when there's excessive financial leverage and the company may or may not make it and debt high leverage is not a friend to value investors because the creditors you don't know how they're going to behave and and if they decide to pull the plug in the short term. Then you're out of luck as a value investor if you're playing distressed there are much better ways to do that in the capital structure than being the equity investor so we're sensitive where we the evolution is making sure that we don't have access financial leverage in the portfolio making sure that we don't buy quote unquote bad businesses meaning that over their full life cycle they don't ever. Are a reasonable return on invested capital. So you can have sickle go businesses that at times don't earn good returns but on average earn our good businesses we would. Love to be in those ones where you know that it's just luck if you play the cycle right rather than buying some business that has some advantage is not what we want to do so those things emerged into our process over time. What about items that don't necessarily show up on a financial screen things like corporate governance capital allocation how do those factor into the factor in in the in the qualitative part of the analysis because if if you think about what. The screen that I that I mentioned will will bring to the forefront are business that is that are under earning their historic norms so then you have to go in and actually do some thinking easy part is the screening part and and you know you can make a. A life just doing the screening and not doing the qualitative part but the qualitative part is basically answering three questions is this business any good. Are the problems facing it temporary and not permanent and is the management plan to restore the earnings back to their historical luster a sound and sensible business plan that's the hard part because there's no formula for how to do that. Right that that is research it's it's identifying reasons why you think the business ought to earn a good return and you do that by looking at its history but you also do that through through basic research of of interacting with the with their competitors their customers. And and seeing if the plan makes sense and makes makes common sense so I would tell you that so governance or you know if you want to use the more ESG kind of term for us there's no difference between looking at fundamental. Business issues as there are looking at environmental or so governance issues that could affect the company if there's something wrong there then. It would be like finding something wrong in the business and you pass that's the it's just that that. What ESG evolved into was making judgments about whether this was a good business for society as opposed to whether the issues of governance and the environment and and social issues could have an impact on their business and so we always. Ignored the things that were not significant financially and only focused on the things that were financially significant. And given the comprehensive investment approach we just discussed today in what other particular sectors or geographies that you're finding a lot of value opportunities and where do you see the most mispricing today. Well there's a couple of areas small cap is an interesting area of where there's a bit miss pricing and the smaller the cap the bigger the miss pricing so the things that people now view as uninvestable which you would call micro cap are just. Price at you know you people talk about how the market is high this market is way lower than its historical norms so you can buy things at five times earnings or less but they're small illiquid maybe not exciting not growth stocks but but very cheap so small is one area. Another area are and we've had a big rotation in our portfolios into into health care related companies but health care particularly health care services and that means to a large extent ensures. Are are now very hated and they're hated by both political parties because they deny coverage they deny they try to manage the care process which basically means restricting access and they've earned the IR of people so we read it all the time like a. PBM I'll use that example which which is an esoteric business of pharmacy benefit manager their goal in life is to manage the pharmacy benefit on behalf of corporate plan sponsors who want to provide pharmacy coverage for their employees but really can't do it on their own because they don't know how to set up the formula is how to negotiate the prices. So they outsource that and you know I when I first looked at a PBM 40 years ago because they've been around for a long long time I had kind of had the same reaction this is kind of a business that will go away because they're a middle man and the reality is that's not what they are now that I that I own a business with employees I understand how important it is to engage a PBM you actually have no choice. And the margin structure has been very flat over 40 years in the business is grown and grown and grown and grown and grown and you can buy them for single digit multiples of earnings because they're cheap so health care is one area small caps another area. I would broadly say the companies that people have doubts about because of AI is another area things like information technology services businesses that were the ones that the big companies outsourced to to upgrade systems to to hand to engage to transform their businesses to take advantage of new technology like moving to the cloud the whole more the whole effort of moving to the cloud was a was a bananza for these companies and now everybody saying well we don't need anybody because chat GPT is just going to do it or the AI is going to do it and so their valuations have come way in. And we suspect that companies when they move full force into in to adapt adopting AI are going to seek advice on doing this just like they've sought advice on every other technological change in business so there's some there's cheap stocks there too. I can keep going but those are some examples great what about value traps that can come up sometimes I think it value investing how do you navigate that challenge from a portfolio construction perspective that something appears inexpensive and then in the end you know maybe it was inexpensive for a reason and it's not going to come back. Yeah I always I never give a satisfying answer to that question but I'll make my provocative answer I don't think you can be a value investor if you try to avoid value traps because you have no idea which are the value traps you just don't. And so the whole effort of trying almost precludes you from being a true value investor you have to say to yourself I'm going to buy at a low enough price so that the ones that turn out to be value traps don't detract from my performance because the ones that worked were so good. And that's why most people don't they engage they add overlays like a catalyst value with a catalyst or you hear that all the time. The problem is if you wait for a catalyst to appear you really missed the opportunity to buy at a very cheap valuation because once the catalyst is obvious it's too late. And the idea that you're going to all know the catalyst but not no one else is going to know the catalyst is unreasonable so I think you have to accept and I think the only way to be successful as a value investor is to accept that you're going to get some things wrong. Now I would say there things that you can be careful of like access financial leverage is one example or long term lousy return on capital employed or I'll just add one more a declining business declining business are very tough or value investors because most public company executives can't handle the idea of a declining business. Private investors know how to do this beautifully they they just milk the business they're not worried about the share price they don't worry about any what anybody thinks they're worried about maximizing the cash flow stream over the remaining life of the business public company management teams say I'm going to try something else and usually that's a bad idea. So we would avoid businesses that are in decline and maybe that's a better answer I mean that to the value truck question but I but I really think that you don't know which are the ones that are going to work and which are the ones that are that's why they're so cheap because it's not possible to know and if you try and convince yourself otherwise you're you're going to you're going to be playing a different game. What about when you're actually have the position on and maybe the thesis isn't playing out exactly as you would have hoped what's the process you go through the thought process and maintaining conviction versus the decision to sell and move on. There's a lot of ways that people do this none of which makes sense to me most most of which don't make sense to me like some people would stop loss orders it say if I lose 25% I'm out to me that means you had no idea what you're getting yourself into and then it didn't work so you can you approve that you didn't know what you're doing so you get out. But then there are other value investors with the opposite they just think they're always right and they double down every time it goes down like that both of those make no sense to me the fact that you lost money has no impact on what you should do today you should. Reunderwrite the investment start over again sometimes that means giving it to a different analyst to look at but the job of a really true value portfolio manager is to be obsessive worrying about everything that goes wrong all the time I'll give you one recent example in our portfolio. Charter communications we bought charter communications I don't know 18 months ago something like that got cheap had some financial leverage but not threatening financial leverage and we all knew that video was done right no they don't make money on video anymore they were they were pricing it to break even but broadband data. Was a big growing business and two things were key to that premise one is that it's very expensive and difficult for a second competitor to come in and lay the infrastructure like Verizon Fios would have been one of those competitors laying a second alternative to the cable network. And Verizon Fios started a business grew it to something like 18 million subscribers and then stopped because they were not making enough money to justify the investment so sort of prove that case and then you had the wireless companies that were offering fixed wireless meaning that you could. Set up a little receiver in your home and using a cell signal get internet service and they were way under pricing the cable operators but are studying to prove not to be correct either was that they were limited and how much capacity they could take how much market share they could take before they started undermining the high margin cell phone service which is really what they're in business for so we bought it. And it started off good it looked like their law their losses stabilized the stock went up. They're good for maybe one quarter or they started to go in down again and it was clear that we misjudged how big fixed wireless could be Verizon announced that they were going to restart their their capital spending program. And so what do you do you know our analyst wants to look at it and say you know I want to study this because I'm sure it doesn't make sense that Verizon is going to do this and we said they said they're going to do it why do you want to study it anymore so that's the job of the portfolio manager right to say we got it wrong we should exit so you do and you should either exit when when something comes goes against you or you should say we got it right and we should double up. But you shouldn't automatically do either one so to me it's you start over again and do it over and do the analysis over again and shifting into sort of more market. I've discussion here anything you know surprised you particularly to the upside or downside this year overall in the stock market and how do you think about heading into next year how do you think the market set up for next year. Well I'll ask through that from my portfolio perspective because you know it's been a particularly good year for financial services and this is in the value world right we're not invested in the big tech names that have gone through the roof for. So I'll report this in two ways one is that these companies have done so well and have started reaching their fair values after being undervalued since the financial crisis ended 15 years 16 years ago. And they've been generally really good investments during that 16 year period but now you have to pay a full price for many of them some of them are still okay we haven't exited all of them. But that's been a nice pleasant surprise going into all the Trump trade war issues the consumer has remained strong as continue to spend and has continued to have strong credit with no deterioration in credit mechanism the credit metrics. And I think that's surprised everybody in the stocks were good have been good performers as a result. I mean I would say I'm surprised by the relatively small impact that all the tariff stuff has had on companies it's had more impact on stock prices so companies that are exposed to tariff issues. Have remained cheap for the most part even though because we all keep fearing that eventually it's going to hurt their businesses or their margins. But it's clearly hurt their share prices and technology you spoke on at the beginning of our discussion here. The fact that you know there's a handful of technology stocks that are significant percentage of the S&P 500 is that and in contrast also to the internet bubble right with that was a big part of the market. Is this the new market regime that we're heading into because technology trends are so strong or at some point there potentially is a shake at all people will reassess you know the dominance of these companies. Well I mean there's no good value investor that wouldn't answer the latter we look at these multi trillion dollar valuations that companies have and and you think what do you have to believe. To get those to be a reasonable price and the answer is you have to believe growth rates and valuation and earnings margins that have no precedent. So we're always skeptical about believing that doesn't mean it can't happen. It can and it's gone on for a long time. We today the AI is we have the winners in the prior generation like Microsoft and Google and meta that have money and so they can pour tens or hundreds of billions of dollars into building out data centers to host their AI offerings. And then you have the startup companies that have raised tens or hundreds of billions of dollars and now are engaging in all these crazy transactions with each other that make you as a pure value person looking in from the outside saying I don't know how they ever pay for any of this stuff. But if AI lives up to its expectations and has a major impact on labor productivity if you can take out 10% of your workforce you can pay for all of this stuff and so it's not an unreasonable perspective. I think it's unreasonable to have it be a third or more of your portfolio and or you know in some cases in the growth stock world all of your portfolio. It's why it's our offering to the world look we can still find interesting good stuff we don't have to pay giant prices for it we can pay the prices we've always paid. And get you a double digit return and getting a double digit return starting at multiple multiple trillion dollar valuation is not a trivial exercise. And do you think it's a talk about investment information technology as an opportunity or there are a lot of when you're in the value world there are a lot of always sort of derivative plays of what might be a big trend going on that you can find someone down the line. They're sure but they're controversial right so down the line would be let's take a. We don't even own this one but let's take an Accenture or a company that historically has has been the partner of companies when they've waited into new technology. That's not happening right now so they're multiple has compressed dramatically if it turns out that their revenue start to accelerate because they're helping companies get into the AI world they can they can take off. So there are those kinds of businesses out there anything that has gotten AI in its framework. You wouldn't put in the category of being cheap these days it's the ones where people think the AI is going to be displacing the companies where you may have an opportunity just riskier than the way that you ask the question. And I touched on some of the tariffs on macro issue anything else that sort of you I mean that you think it might be worth being a concern employment the Federal Reserve stands inflation they're all sort of. Headline risks in your world when you look at investing how much do you how much way to give to macros at macro specific to a company in general or is it something different basically. You know for us where we tend to invest through a cycle rather than predict the macro you can this I broadly characterize it as there are two kinds of investors. The ones who try to guess what's going to happen next and you can use see the words I'm choosing and position their portfolio accordingly. A lot of top down investors there are a lot of people who are very skilled at that and then there are those who react to the macro environment so for example everybody is afraid of tariffs so any company that might have to pay them gets killed. But you know that the management has ingenuity and they can modify they're this they're not stuck in in the present so that's more what we do. We don't so much as worry about the macro as much as we do. Understanding if the business franchise is strong enough to handle a period of adversity so that they can modify their businesses to come out clean on the other side the two different ways of thinking about the same thing. We more are focused on long term competitive threats so crypto being a good example you know I don't look at crypto to see if I want to invest in it. I have more look at the technology underlying crypto to say is there a threat to the banking system because somebody's figured out a better way of doing this. And now that we have all these stable dollar coins that are being you know popularized and that can take the risk currency risk out of the equation and actually facilitate cheaper transactions. You have to try and figure out if there's a threat to exit to the incumbents and and so that's what I don't have an answer to that when the heavy duty thought process about that because the banks the big banks have all invested tens of billions of dollars in blockchain technology to try and preserve their business franchise and become more efficient. To some extent their ability to accept deposits in a way that is our viewed as safe and secure gives them advantage in that regard but we'll see. And artificial intelligence you know the applicability to the investment management industry is that you know we've heard from some people say well that helps me write my investment letters and things like that. How is that being applied today to think and what's the potential there for being helpful for the industry. Today it's mostly applied and I would conclude us and that in making your your team more efficient. So it makes the research team more efficient not only the marketing teams and the writer the writing teams it also you can use it to shorten the time that it takes to gather information. The analysis of that information we haven't turned over to AI at this point the analysis because what AI is very good at is observing the present. Making inference about the future is way more difficult because mostly the market is behavioral rather than you know I can see that this business is growing faster than you think it's growing because I have all this data to prove it. That's kind of a momentum strategy and it's very helpful for momentum type investors I think less helpful for someone who's trying to find the thing that AI wouldn't like but doesn't mean you don't we're not experimenting so I would say we're we're far away from turning over the thought process to to AI. A new product development for firm like yours is that an ongoing opportunity set that you're always sort of think of their new products we can get into it or sort of a core 27 strategies. Our core I mean for us we pretty much have our strategies are what are that all value and every way you could slice and dice it from US small mid and large. We have concentrated and not concentrated we have global we have regional we have emerging markets there's not a lot more ways you can do it we we've recently incubated and now have a three year record on a credit strategy which is. Think of as value investing in credit when the pricing of credit doesn't make sense and and it tends to be on the more first lean kind of credit where you're where you're not looking at a total loss in a distressed situation so it's very promising it's not highly liquid marketplace but it's very promising but I would say mostly we have the ability to search down value anywhere in the world. And and we'll see what what evolves in credit I would say more we've our product development has not been on new investment strategies as more on new formats to go to market like ETFs would be a good example. And lastly here for for non professional investors looking to pursue a value approach to their investing style you know what what are the initial sort of due diligence checklist things you think they need to look at for people just don't do it on professional level when they but they have that bias they want to find inexpensive stocks. And the reality is the quantitative stuff works right you can buy low price to book stocks you can screen on low price to book and you have a having a universe that you could start with and and if you screened on low price to book and then eliminated the ones that have excessively leveraged balance sheets. It's a good starting point the checklist that I would say beyond the screen is where the interesting part comes in it depends how much work you want to do but you could dig into what's going wrong with the business and read what the company says they're going to do to fix it and say does that make sense or not make sense. You can look and say it's the history of this company a 20% return on capital employed over the last 25 years or a 5% return on capital employed and so if I can find a 25% that selling at a low price where it sounds sensible what they're doing it's a very good start to to without having a giant team of research people but it's not work free. Rich, thank you for joining us today and for sharing your perspective and valuable insights into our listeners. Thank you for tuning into compound insights from CFA Society New York. I'm Gary Farber and we look forward to bringing you more conversations with leading voices and finance. We'll see you again soon.