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Richard Pzena and Kunal Kapoor

Standing firm against falling returns and assets, Richard Pzena stockpiles beaten-up financials. His is a conviction few share.

Morningstar Advisor, 06/17/2008

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To say that Richard Pzena has been put through the wringer may be an understatement. While many of his peers won't touch beaten-up financial stocks, Pzena has steadfastly added to the likes of Freddie Mac FRE, Fannie Mae FNM, Citigroup C, Bank of America BAC, and others in the past six months.

But as the myriad headlines have made abundantly clear, that simply hasn't been the right thing to do. Not yet, anyway. The John Hancock Classic Value Fund PZFVX, which Pzena manages, fell more than 14% in 2007 and was down double digits for a brief period in early 2008 again. Pzena Investment Management PZN, which went public in 2007, has seen assets under management decline from a high of more than $30 billion to less than $25 billion recently. Meanwhile, the firm's stock fell from more than $20 to less than $10, before bouncing back modestly.

It's enough to make most investors pack it in, but Pzena is sticking to his guns, convinced that others are massively overreacting to the problems facing many financial companies. He is convinced that stock prices for many notable financials already reflect some very negative news, so his firm recently went as far as to launch a financials-only portfolio for institutional accounts.

Such conviction has served Pzena well in the past, and he's certainly expecting the same again. In fact, he isn't shy about comparing his current malaise to what he went through during the Internet heyday. This time, however, the company he's keeping is more modest, with many notable value managers positioned quite differently. Why is he standing firm? To find out, we visited him on March 6 at his New York offices. Kunal Kapoor is president and chief investment officer of Morningstar Investment Services.

Kunal Kapoor: You've said that you look for good businesses experiencing temporary problems that should be earning more than what they're currently earning. What are some things that you look for to determine whether you think the firm can correct its issues and move forward?

Richard Pzena: First, is it a good business? A good business is a business where you can identify one or more reasons why it should, in the long run, earn a good return on its invested capital base. It could be anything: a competitive cost structure, physical assets or location, a customer base that's difficult for a competitor to unseat, a brand or a franchise or a technology--something that makes us think that even if the current management fails in its efforts to restore the earnings back to normal, someone else is going to want to try.

Then, we have to make a judgment, and this is the hardest part, because the judgment is, will the management's plan likely cause the earnings to rebound? Obviously, we buy before we know if the plan's going to work. So it's a judgment. We're making an assessment.

But sometimes, it's industry conditions, like with what we're experiencing today with financials, consumer cyclicals, and housing and housing-related. These are all businesses that are currently impaired, and they're impaired by industry conditions more so than any company-specific situation. The questions are, how permanent are these, and is there any industry data that you can look at to convince yourself that they're not permanent? PAGEBREAK

KK: Do you place a premium on management?

RP: It's an interesting question, because we are relying on the management to execute a plan to restore the earnings power. On the other hand, very often it's the management that got them into the place they're in. Obviously, we're not looking to invest in companies that we think are ineffectively managed, but we recognize that the people running these companies are human beings and that people make mistakes. The standard Wall Street view of what is a good management is one that has a good record. As soon as something goes wrong, the management is bad. We're much more focused on the characteristics of the business. Because the reality is, if the business has good characteristics and the person running it fails, he or she is going to be replaced. The business isn't going away.

KK: There are a number of other good value managers out there. Where do you feel like you get your edge when you sit down and look at some of these names?

RP: A lot of value investors look for a catalyst. The unfortunate reality of value investing is what creates value is deterioration. It's unfor¬tunate because we all know that if a business is deteriorating, it's usually a bad idea to buy a stock. The problem is, if you wait for the "turn," or the "revisions," or the "catalyst," or the "momentum," or whatever Wall Street word you want to use, you rarely get a cheap price. I think you optimize the risk-reward trade-off by paying attention to the valuation and buying before the turn, or before you know when the turn is going to be. That's very, very difficult for most people.

It's the art of all of this. We like to take advantage of an environment like we're in today, particularly with financial stocks, where it's more fear than fundamentals. Because you can do all the downside sensitivities you want, and the answer is you don't really know how bad things are going to get.

KK: Are you oversimplifying just a little bit by saying it's more fear than fundamentals? There are fundamentals involved, too.

RP: Sure, there are. There were some loose lending standards and credit spreads that were too narrow. That has obviously now unwound. Housing prices are in a decline, and people now want to bail out of financials. They want to bail out independent of the fundamen¬tals. They want to bail out because they know there's something wrong. There's no doubt that there's something wrong. But when they start ignoring the valuation with the only objective of exiting, that's when you can get yourself in some extraordinary opportunity sets, like what we're seeing today.

We have data that housing prices are declining. We have data that there is unusually high defaults, particularly in subprime mortgages. What we don't have data on is what the ultimate losses are going to be in those pools. When no one knows what the ultimate losses are going to be, people make up numbers. When you're making up numbers and all you see is the pricing declining and the delinquencies increasing, you tend to make up some wild numbers.PAGEBREAK

KK: It can't be easy for you to get your head around some of those situations.

RP: It's easy to try to come up with a downside understanding, I think. You never know the ultimate bottom, but you can take things like where the market is pricing subprime mortgage-backed securities, and back in to the loss rates that you have to assume in the subprime pool in order to get those trading prices. And they're extreme. The loss rates inherent in the subprime ABX index for the '06 and '07 vintages imply loss rates in the high 20s. That's possible but extremely unlikely, because when someone defaults on a mortgage, you get the house, and you get to sell the house. The recoveries so far on subprime first mortgages have been running in the 65-cents-on-the-dollar range-so 35% losses when you foreclose. To get to a 28% loss rate for the whole pool implies 80% default.

Now, I can sit here and say that seems ridiculous. The concept that 80% of the people who bought houses in '06 and '07 are going to mail the keys back to the bank because their house price went down seems far-fetched. Even though the media likes to write about the housekeeper buying an $800,000 house in California, we ignore that most of the borrowers in the subprime pool are mostly lower- to moderate-income people who had $225,000 mortgages, on average. They live in the house and weren't planning on flipping it. They put some real money down, not zero down. If they get kicked out of their house because they don't make the payments on their mortgage, they still have to move somewhere else. So the idea that you're going to walk away from your life savings to save a few hundred dollars a month, or to avoid a situation where you may have negative equity in the home, seems to me unlikely. More people will do it than has been the case historically, no doubt about it, but the idea that you're going to get to 80% of borrowers doing it seems ludicrous.

KK: What's it going to take to turn things around?

RP: It's going to take one of two things, which are the two things that every single player is looking for, so you're not going to be able to beat it. Either the rate of deterioration of home prices slows down or the rate of delinquency on mortgages slows.

KK: Which do you think is most likely?

RP: I think they're both likely. All the natural corrective mechanisms--for home prices as well as excess home inventories--are working as you would expect. The number of new homes being built right now is so far below the population growth that we're going to work off all the excess, and we're going to be in a housing shortage situation. When you do the simple arithmetic on the numbers, it's not that far away. PAGEBREAK

KK: Some people have the opposite opinion--that it's going to take a number of years to work off some of the inventory.

RP: It depends on what you mean by inventory. If you mean inventory of people who decided to put their house on the market, that's one thing. But those people have to move somewhere else once they sell their house. You have to be looking at vacant homes, and vacant homes are the homes that were built and are unoccupied or sold and unoccupied. That number grows when you build more homes than the population growth, which is what we did for about three or four years. We've been undershooting population growth, or normal demand for housing, for the past 18 months. Right now, at about a million units a year, we're shorting what you need by 600,000 or 700,000 units a year. It doesn't actually show up in the data because people are, I believe, deferring home purchases. The household formation is growing at a slower rate than population-meaning people are living with their parents, or whatever they're choosing to do, to avoid buying a home and waiting until they get the best price.

I believe there's some pent-up demand, so I'm now not looking at the inventory data. I'm looking at the normal level of demand. How much cumulatively did we build in excess of that normal? How much cumulatively are we shorting the normal? When you do that, you're less than 18 months away from equilibrium. If you go beyond 18 months, theoretically you're in a housing shortage.

The other things that go on is income levels continue to grow, housing prices continue to fall, and if interest rates--which are key to this discussion--fall, affordability moves back into line, such that the median income earner can afford the median home, which we got out of whack on. Those are the three ways to correct the problem, and all three are working in favor of correcting it.

KK: Let's talk about financials. What's the overall weighting in the portfolio for financials?

RP: It's around 42%.

KK: Please talk about Freddie Mac. It was your largest position as of Dec. 31.

RP: I'll discuss Freddie and Fannie Mae, because they're pretty much the same story. (On the day of this interview, March 6, Freddie and Fannie closed at $20.14 and $21.70 per share, respectively.) These are businesses that have enjoyed a fantastic franchise. They almost describe the definition of what a good business is. They do something that no one else can do. They can hedge a mortgage portfolio with long-term instruments that are typically callable debt, so they can basically hedge the interest-rate risk of holding a mortgage. They tend to attract competition only during periods of time when there's a steep yield curve or when somebody wants to play an interest-rate betting game, because most others can't effectively hedge the holding of an interest-rate instrument.PAGEBREAK

So over very long periods of time, they've earned very high returns. If you look at them as almost a hedge fund, their portfolio of holdings has done quite well long term. At the same time, they're an insurance business. They do both: They insure mortgages held by others, and they hold mortgages for their own portfolio. Because they have this sort of quasi-monopoly position with implicit government backing, they've earned over 20% aftertax return on equity over their history.

It's a good business, and today, the good business has gotten so much better, because there is no competition right now. If you think of the insurance part of the business, it's very similar to how other insurance companies work. When there's some kind of catastrophe, in this case the subprime mortgage crisis, what happens? Rates go up. This is exactly what's gone on here. Fannie and Freddie have dramatically raised their guarantee fees and tightened their lending standards such that the business they're writing today is about as good as it gets. Probably the best it's ever been in their entire history. Meanwhile, the spread between their borrowing costs and their yield on a mortgage has widened to about as good as it ever gets.

This is the best situation you can imagine if you didn't have a historical portfolio or balance sheets to worry about. The unanswerable question is, how bad is that historical balance sheet?

So, we can observe a few things. One is that Fannie and Freddie typically make good loans. They make the kind of loans that you would be the least concerned about: fixed rate, with lots of money down. Their loan-to-value ratios, even at the end of the year, were around 60%. Versus appraised value, after whatever declines we had through year-end, there was 40% equity in the homes. You'd have to have massive deterioration before there are losses in this portfolio.
Second, their delinquency rate has ticked up, but these are not subprime borrowers or no-money-down borrowers. We're talking about delinquency rates that are under 1%. They're not 20%. Big, big difference. The history is that they've done a spectacular job in making credit decisions.

Now, we're in a situation where you don't know what's going to happen, so you have to stress test. I'll tell you that in a stress test on credit it's hard to drive them over the edge. The assumptions you would have to make are unbelievably extreme.

KK: Such as?

RP: A national home price decline of 20%, combined with an employment decline of 10%--about as bad of an environment as you could possibly imagine. I don't think credit gets them. I think that there are capital issues that come from having to mark to market their portfolio. You know the spread widening that we talked about? While that's a good thing theoretically for the business you're writing today; it's a bad thing if you had to sell any of the paper that's already on your books. The spread widening requires an accounting writedown. That accounting writedown says nothing about your ability to collect the money; it just says that if you had to sell that loan today, you wouldn't get par value for it.PAGEBREAK

KK: Is it fair to say they've accelerated the rate at which they've been taking those markdowns?

RP: Well, the whole accounting scheme for them has substantively changed as they've negotiated with OFHEO (Office of Federal Housing Enterprise Oversight) and come out of the accounting scandal that they were involved in the last couple of years. So the answer is yes.

First of all, we haven't had an environment where people have gotten panicked about high-quality mortgages. So the idea that the spreads have widened this much and that you have to actually take an impairment on your balance sheet, and that the regulators then use that balance sheet to determine whether you need more capital or not-this is the risk of Fannie and Freddie. This is why nobody wants to own it. And the accounting is complicated. You look at their books, and they have fair value accounting and GAP accounting, and now Freddie introduced another accounting mechanism.

KK: A lot of people who don't own the stocks often say that they're just too opaque; it's not even a question of being complicated.

RP: The businesses are unbelievably simple. The accounting is complex. I wouldn't say opaque. The business is not opaque. They charge a guarantee fee, and if somebody defaults on their mortgage, they pay for it. That's the business. It's not that hard. They tell you exactly what their fees are. Every quarter, you know what their fees are, and every quarter, you know how much is delinquent. What else is there to know?

KK: Has your estimate value for Freddie and Fannie changed at all?

RP: It has. We've raised it since we initiated the positions, because we didn't anticipate the market being as good as it is for the new business they're writing. Now, what I'm going to say is not a fair statement, but if they marked all of their business to the current margins that are available in the market, and they didn't lose anything on the historical book, each of these companies would be earning around $10 a share, and each of the stocks are around $20 a share. You never ever see that.

KK: What do you think is a more normal earnings level for them?

RP: $6 or $7 a share. Obviously, you don't apply the current good environment, but you also don't apply the really terrible environment from two years ago when their spreads were very narrow, because everybody else was competing with them to buy these mortgages. If you put it somewhere in the middle, you get around $6 or $7 a share. And that is a conceptual earnings power, because each quarter the accounting requires them to mark to market. So you have to assume that spreads return to normal and stay normal. Then, that's how they earn that kind of money.PAGEBREAK

KK: What about Citigroup? Has your valuation changed there much since you bought it?

RP: It has; it's been impaired due to dilution, though not deterioration in earnings power. (Citigroup closed at $21.17 on March 6.)

KK: Do you think Citigroup's earnings were inflated by the housing boom?

RP: They weren't players in the housing market.

KK: But clearly they benefited from that one way or the other.

RP: A very, very small percentage of their earnings. Citigroup doesn't derive its earnings from fancy financial structuring transactions.

KK: Is the international franchise more valuable?

RP: The whole franchise is intact. You have the credit-card business. Credit card has nothing to do with this. There wasn't any excess in credit-card issuing in the past five or seven years. A lot of the business is outside the U.S., which is a really valuable franchise, because they tend to be in markets where there's very limited competition, and they make a lot of money in those markets. In the U.S., there's only three or four credit-card companies that make any money, because it's a scale business. That's about a quarter of their earnings.

Then, you have the New York City retail banking network that they make some money off of. That's not impacted by this. They have Smith Barney, which is a wealth management platform, not impacted by any of this. They have foreign currency trading globally. They have interest-rate swaps.

The percentage of their earnings that came from structuring CDOs, which is where they got caught up, was minuscule. It was probably about 5% of their earnings. Assume that's gone. The beauty of investment banks is that they go to wherever the money is to be made. They never make money the same place they did five years ago. They're going to be doing work on restructuring and distressed and workout situations. They were doing none of that two years ago. That'll replace the earnings that they had in selling all these fancy instruments.

KK: What would you like the new management at Citi to focus on first?

RP: You know, the world acts as if there was something massively broken at Citigroup. The reality is Citigroup suffered for the last couple of years from a slope in the yield curve, which is a case of where even the best management in the world wouldn't have been able to have a different outcome. They probably need an upgrading of risk controls; they probably have to review their assets. They've clearly had blowups in various areas in the past. But structurally, the idea that they should break up the company, to me, seems silly. Maybe in the future, but not when.

KK: You don't want a fire sale.

RP: Why would you sell something today? It makes no sense. And if you add up the pieces and value them separately, that wouldn't be good, either, because nobody likes any of the pieces.

KK: You've also dipped into the insurance area. What's your thesis with Allstate ALL?

RP: Allstate is a great franchise that went through a cycle improvement over the past four, five years, and its earnings rebounded nicely. Its share price has never really reflected the good market conditions. We're sitting here earning a very high return. The book value's growing very nicely, and it's selling for as low a multiple of book as it ever has sold for. (Allstate closed at $46.71 on March 6.)

KK: What are your least favorite stocks today?

RP: Anything tied to the whole China story. To the extent that you could get out of China completely, that would be my recommendation.

Postscript: A month after this interview, Pzena confirmed that he still very much likes the stocks mentioned in this article, despite their recent rebound.

Kunal Kapoor is president and chief investment officer of Morningstar Investment Services (www.mp.morningstar.com). Kapoor owns shares of FNM and C.

See more of this conversation on our Videos page.

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