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Pzena Investment Management Inc (PZN)
Q3 2020 Earnings Call
Oct 21, 2020, 10:00 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good morning, and welcome to the Pzena Investment Management, Inc. Announces Third Quarter 2020 Earnings Conference Call. [Operator Instructions]
I'd now like to turn the conference over to Jessica Doran, Chief Financial Officer. Please go ahead.
Jessica R. Doran -- Chief Financial Officer and Treasurer
Thank you, operator. Good morning, and again, thank you for joining us on the Pzena Investment Management third quarter 2020 earnings call. I am Jessica Doran, Chief Financial Officer, and with me today is our Chief Executive Officer and Co-Chief Investment Officer, Rich Pzena.
Our earnings press release contains the financial tables for the periods we will be discussing. If you do not have a copy, it can be obtained in the Investor Relations section on our website at www.pzena.com. A replay of this call will be available for the next two weeks on our website.
Before we start, we need to remind you that today's call may contain forward-looking statements and projections. We ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from today's comments. Please note that we do not undertake to update such information to reflect the impact of circumstances or events going forward. In addition, please be advised that due to prohibitions on selective disclosures, we do not, as a matter of policy, disclose material that is not public information on our conference calls.
Now, let me turn the call over to Rich, who will discuss our current view of the investing environment.
Richard S. Pzena -- Chairman, Chief Executive Officer and Co-Chief Investment Officer
Thank you, Jessica. Ride the winners. That's always been obvious investment strategy favored at the end of every cycle. These are really just select the few dominant technology masters of the universe that everyone loves, sit back and enjoy the multiple expansion. Meantime, valuation spreads between cheap and expensive have reached all-time highs all over the world. Further, the volume of questions about whether value will ever work again or whether there is a new definition of value have been -- have become commonplace.
This is reminiscent of the late 1990s Internet bubble, when Michael Lewis' 1999 book, The New New Thing, described it all you needed to know. Investors then like investors today, were mesmerized. But values day is coming, paying less than the present value of future cash flows remains a winning strategy for long-term investment success, and the environment today makes this path even more attractive than normal. We would argue that the seeds for unwinding today's extremes are right in front of us, especially as our COVID dominated world has led us into a recession, that history shows it's the key marker for the shift.
Considering the following four possible catalysts that could already be signaling that a shift is upon us. First, the recession is in place and the path toward economic recovery is becoming clear. We examined recessions in the U.S. over the last 100 years and in Japan over the last 45 years, and the evidence is compelling. The U.S. experienced 14 recessions during the past century. I'm looking at the five year returns, measuring from the beginning of the recession, the value outperformed the broad market by an average of 5% per year.
Second, interest rates stop falling, bringing multiple expansion from growth stocks to an end. Interest rates have been in structural decline for the past 40 years. The trend has led us to a world where you can buy value stocks at PEs of 10 just like at any time in the past 70 years, while average growth stock multiples have doubled from 30 times to 60 times earnings. Even if rates don't rise, the tailwind enjoyed by growth stocks should dissipate.
Exuberant growth expectations for the technology masters of the universe revert to normal. Consider the math using Microsoft as an example. Microsoft's stock price is up ten-fold during the past 10 years. That's 25% per year, helped by strong growth in cloud technology replacing on-premises hardware demand. This has led to 8% annual growth in operating income. To get an 8% annual stock price appreciation going forward given Microsoft's high multiple would now require 20 years of 10% operating income growth. Possible? Maybe. But considering that, market analysts estimate that public cloud penetration of data needs has reached 30% to 35%, and that the possible maximum penetration for the public cloud would be approximately 70%. We're about halfway to saturation. So where will 20 years of growth come from? We have yet to see.
And finally, the conventional wisdom that technological change comes entirely at the detriment of the existing franchises proves to be mistaken. Let's consider the case of electric cars and Tesla versus VW. Conventional wisdom and stock price suggest that the answer is obvious, Tesla will win. But even if Tesla grows, does it make sense that VW has to shrink? Tesla's stock is one of the darlings rising over ten-fold during the past five years. VW's stock on the other hand has barely changed in the same period. But there are ultimately only two ways to win an auto manufacturing. One, charge higher prices. In other words, maintain a brand premium or two, manufacture at lower costs. It seems inevitable, but these truths will apply to electric vehicles and that VW will succeed importing their brands strengths, think Porsche and Audi and scale advantages into the electric vehicle competition. In fact, VW leads all competitors in the number of new electric vehicles that will be introduced over the next several years.
Turning to the business front, we finished the quarter with approximately $1.1 billion in net inflows. For the previous 12 months, we had net positive flows of approximately $2.1 billion. In fact, we have had positive net flows for each of the last three calendar years and six of the last eight years. No small feat in a world questioning the efficacy of value investing.
I'll now turn the call back over to Jessica Doran.
Jessica R. Doran -- Chief Financial Officer and Treasurer
Thank you, Rich. We reported diluted earnings of $0.16 per share for the third quarter compared to $0.13 last quarter and $0.19 per share for the third quarter of last year. Revenues were $33.9 million for the quarter and operating income of $15 million. Our operating margin was 44.1% this quarter, increasing from 36.4% last quarter and decreasing from 46.3% in the third quarter of last year.
Taking a closer look at our assets under management, we ended the quarter at $33.3 billion, up 5.7% from last quarter, which ended at $31.5 billion and down 7% from the third quarter of last year, which ended at $35.8 billion. The increase in assets under management from last quarter was driven by net inflows of $1.1 billion, as I've just mentioned, and market appreciation including the impact of foreign exchange of $0.7 billion. A decrease from the third quarter of last year reflects $4.8 billion in market depreciation, including the impact of foreign exchange, partially offset by net inflows of $2.1 billion.
September 30, 2020, our assets under management consisted of $13.3 billion and separately managed accounts, $18 billion in sub-advised accounts and $2 billion in our Pzena funds. Compared to last quarter, separately managed account assets increased, reflecting $0.4 billion in market appreciation and foreign exchange impact, partially offset by $0.1 billion in net outflows. Sub-advised account assets increased, reflecting $1.3 billion in net inflows and $0.3 billion in market appreciation and foreign exchange impact, and assets in Pzena funds decreased slightly to $0.1 billion in net outflows.
Average assets under management for the third quarter of 2020 were $33.1 billion, an increase of 11.1% from last quarter and a decrease of 8.1% from the third quarter of last year. Revenues increased 12.7% from the last quarter and decreased 8.4% from the third quarter of last year. The fluctuation in revenues primarily reflects severance [Phonetic] and average assets under management over the period as well as the impact to performance fees and fulcrum fees recognized.
During the quarter we did not recognize any performance fees similar to last quarter when compared to $0.3 million recognized in the third quarter of last year. The third quarter also reflects a reduction in the base fees of certain accounts related to the fulcrum fee arrangements of one client relationship. These fee arrangements require a reduction in the base fee if the investment strategy underperforms its relevant benchmark or allows our performance fee if the strategy outperforms its benchmark.
During the third and second quarters of 2020, we recognized $1 million reductions in base fees related to these accounts compared to $0.5 million reduction in base fees during the third quarter of 2019. These fees are calculated quarterly and compare relative performance over a three year measurement period. To the extent that three year performance record at this account fluctuate relative to its relevant benchmark, the amount of base fees recognized may vary.
Our weighted average fee rate was 41 basis points for the quarter compared to 40.4 basis points last quarter and 41.2 basis points for the third quarter of last year. Asset mix and the impact of swings in performance fees and fulcrum fees are all contributors to changes in our overall weighted average fee rate.
Looking at operating expenses, our compensation and benefits expense was $15.8 million for the quarter compared to $15.6 million last quarter and $16 million for the third quarter of last year. G&A expenses were $3.2 million for the third quarter of 2020 compared to $3.6 million last quarter and $3.9 million for the third quarter of last year. The decrease from last quarter and the third quarter of last year, primarily reflects a reduction in travel costs and professional fees. Other income was $0.5 million for the quarter, driven primarily by the performance of our investments.
Looking at taxes, the effective tax rate for our unincorporated and other business taxes was negative 6.8% this quarter compared to a positive 4.1% last quarter and negative 5.1% in the third quarter of last year. The negative effective tax rate this quarter and in the third quarter of last year reflects the benefit associated with the reversal of uncertain tax position liabilities and interests due to the expiration of the statute of limitations. We expect the effective rate associated with the unincorporated and other business taxes of our operating company to be between 3% and 5% on an ongoing basis.
Our effective tax rate for our corporate income taxes, ex-UBT and other business taxes, was 26.5% this quarter compared to our effective tax rate of 26.6% last quarter and 24.4% for the third quarter of last year. The fluctuation in these effective rates reflects certain permanently non-deductible expenses. We expect this rate excluding these items to be between 23% and 25% on an ongoing basis.
The allocation to the non-public members of our operating company was approximately 78% of the operating company's net income for the third quarter of 2020 compared to 77.7% in the last quarter and 74.5% in the third quarter of last year. The variance in these percentages is a result of changes in our ownership interest in the operating company.
During the quarter through our stock buyback program, we repurchased and retired approximately 102,000 shares of Class A common stock for $0.5 million. At September 30, there was approximately $10.7 million remaining in the repurchase program. At quarter end, our financial position remained strong with $49.2 million in cash and cash equivalents as well as $70.3 million in short-term investments. We declared a $0.03 per share quarterly dividend last night.
Thank you for joining us. We'd now be happy to take any questions.
Questions and Answers:
Operator
[Operator Instructions] Our first question will come from Sam Sheldon with Punch & Associates. Please go ahead.
Sam Sheldon -- Punch & Associates -- Analyst
Good morning, Rich and Jessica. Thanks for taking my questions. Maybe you could start by giving us a sense for the pipeline of new opportunities that you see for your business and how that might compare to the opportunities that you had coming into 2020?
Richard S. Pzena -- Chairman, Chief Executive Officer and Co-Chief Investment Officer
Sure. Sam, this is Rich. The pipeline stays fairly comparable to where it was when we were coming into 2020, which is somewhat below where it was at the peak and averaged significantly better than average versus where it's been -- was over the last, call it, four or five year average. So I'd describe it this way. There is not a lot of value searches going on, number one. Number two, where they are going on, we still tend to get included. And really we've been in a prolonged period of anti-value, but in particular, the last three years.
And so the only people that are aggressively searching for a value -- for deep value kind of managers right now, you would call the early adopters. So I described it as saying our pipeline is -- given the performance of value, the pipeline is good. Given the last five years, the pipeline is above average, but it's not as strong as it was pre-2018.
Sam Sheldon -- Punch & Associates -- Analyst
Okay. That's helpful. And if you were to characterize outflows that you have experienced in recent quarters, how much of it is attributable to clients throwing in the towel on value versus sort of shifting funds to other areas like passive or a private equity?
Richard S. Pzena -- Chairman, Chief Executive Officer and Co-Chief Investment Officer
Again, we don't really know, we know what they tell us. And I would tell you that there is a range, there is some that have thrown in the towel, but not a lot. And the ones that have thrown in the towel where there -- where there's significant -- where they were significant, has been particularly in the sub-advisory channel have been where they just made a complete redetermination of an overall strategy. More of the outflows have been within our sub-advisory channel. The gross outflows have been within our sub-advisory channel where the ultimate customer has become disheartened by value performance and is behaving more in reaction to the performance. That's mostly been rare on the institutional side and the flows have been more net positive on the institutional side. Obviously, we won one very large new sub-advisory mandate during the quarter that was funded during the quarter that skewed the numbers favorably.
Sam Sheldon -- Punch & Associates -- Analyst
Okay. And with some of these headwinds, can you give us a sense for how much pressure you're feeling on fees. You guys have done a nice job. Looks like the weighted average fee is essentially flat over the last year at 41 basis points. But can you give us a sense for how much pressure you're feeling on the fees?
Richard S. Pzena -- Chairman, Chief Executive Officer and Co-Chief Investment Officer
The fee pressure feels very, very similar to the -- what the fee pressure has been for the last few years. There are clearly trends toward lower fees in the institutional world, but we haven't seen any real pressure here that you would tie specifically to recent investment performance. So I would say the fee pressure state is real. We have always been committed to treating all of our clients fairly and equally. So we won't cut fees for one client without doing it across the board and we've maintained that discipline, and I think our clients understand and that, that's how we operate. So -- and we've been firm on that. So that as long as we're fair and reasonable and in line with the markets, we are OK. And so I would say this is the same fee pressure that we've seen for several years.
Sam Sheldon -- Punch & Associates -- Analyst
Okay. One last question for me. You guys closed a mutual fund in the quarter. Can you talk about that decision and how you're feeling about the remaining mutual fund business today?
Richard S. Pzena -- Chairman, Chief Executive Officer and Co-Chief Investment Officer
Yeah. We closed a long-short mutual fund. And if you -- the strategy was in a simple way of putting it long value and short growth. And so the performance was pretty poor. We actually still believe that that's a smart way to do so. We're -- we've still continued on a separately managed basis to manage some of our own money in that way. But once you -- in something that's long-short that you're expecting to preserve capital by being hedged. The idea that we could ever make a go at that particular fund was low probability. So we closed it.
On the mutual fund in general, the mutual fund business in general, our commitment remains very high. We are -- we have actually more -- we've increased resources rather than decreased them. And in a world where investment performance is what it is, we don't expect a lot of near-term success. But having said that, there are a number of intermediaries that consider or use our fund that are all thinking about what should they do if value reemerges.
And so we're in a lot of these kind of long drawn out conversations that we sort of feel they're not ready to pull the trigger to put their funds on their -- put our funds on their recommended lists or on their model managers or portfolios put that -- they want to know that they really understand us and know us, so that when they decide to pull that trigger, they could do it in a much more expedited fashion. So I'd call it -- I'd say, we haven't learned anything about whether we can be successful in this given the performance, but we're certainly not giving up.
Sam Sheldon -- Punch & Associates -- Analyst
Okay. Thank you for taking my questions.
Richard S. Pzena -- Chairman, Chief Executive Officer and Co-Chief Investment Officer
Sure.
Operator
[Operator Instructions] I'm showing no further questions at this time.
[Operator Closing Remarks]
Duration: 23 minutes
Call participants:
Jessica R. Doran -- Chief Financial Officer and Treasurer
Richard S. Pzena -- Chairman, Chief Executive Officer and Co-Chief Investment Officer
Sam Sheldon -- Punch & Associates -- Analyst
