Pzena Investment Management (NYSE: PZN) has had a strong year, rising 85% year to date. More strong performance could be on the way, though, as Pzena's funds continue to outperform benchmarks, gather assets, and accrue performance fees.
The financial crisis was tough on Pzena. In the years leading up to the crisis, the company was winning new money, but it ran into capacity limits on its biggest funds, limiting the upside from the boom. When the crisis hit, Pzena moved into financials. These companies met Pzena's "deep value" investment style, but as we know, they turned out to be value traps. Performance suffered, and Pzena is still down 48% from the IPO price in 2008, despite its impressive performance this year.
Performance has picked up significantly the dark days of 2008; 2009 and 2012 were strong years. 2013 has been the best year in a decade on both an absolute and relative basis. The poor performance of 2007 and 2008 has just about rolled off the key performance periods. Over one-year, three-year, and five-year periods, Pzena has outperformed the benchmarket indicies strongly.
Deep value strategies are clearly back in vogue. Value cycles have historically lasted six years, and we seem to be about halfway through the current one, according to management. Further upside seems quite possible. Pzena has invested heavily in "old tech," particularly HP, and financials. The firm clearly has a great deal of confidence diving back into the sectors that burned it so badly in the past. This return to financials is justified internally by an improved investment process paying greater attention to the appropriate amount of leverage. Whether this new process really represents a significant change or not, the value cycle has turned, and Pzena should continue to outperform.
The evidence of this is that over three-year and five-year periods Pzena is now starting to show strong performance, and sales of funds have picked up considerably. Year-over-year assets-under-management growth of 33% shows that investors have readily embraced this turnaround in Pzena's performance. In 2005, the company's win rate at prospect meetings was around 75%. Through the crisis it fell to zero but has picked up to around 30% now. As performance continues to improve, so this momentum in sales will build.
Gains in the sub-advised fund area have been particularly important in this sales growth. From August last year, Pzena managed 28% of the Vanguard Windsor Fund. The relationship with Vanguard is building to more small mandates. Pzena manages the Pzena Europe Fund for ABN Amro. This relationship could build in the same way as Vanguard. Investors are still hesitant to invest, so these relationships have really done a lot to build Pzena's reputation. A sign of this is the company's decision to start building a presence in London.
If we are thinking about growth, capacity is clearly an issue. Here, Pzena has certainly learned from the crisis. The new Expanded Value Fund aims to build on the success of the flagship Large Cap Value Fund. Rather than being limited to about 40 stocks, the Expanded Fund will hold about 80. The Large Cap Fund ran into limits at about $20 billion, so the Expanded Fund has a lot of room left to grow.
Pzena has also been trying to move into new areas, most notably with the Emerging Market Value Fund. This is something of a niche and has had particular success overseas. More recently, a long/short strategy has been tested. With only a year-long record, this is unlikely to affect near-term performance -- assets will only build with a three-year record -- but this is also another unique product that may find some early success with investors.
As performance improves and sales increase, performance fees and margins will improve too. Roughly 5%-6% of Pzena's AUM earns performance fees. These fees amount to 15% of returns in excess of the benchmark over the past three years. Going forward, as Pzena rolls through better periods of returns, this could add as much $0.05 to EPS. Pzena's cost base is also more fixed relative to competitors, leading to significant operating leverage as AUM continues to grow. Pay at Pzena is top-quartile, but it is less variable regarding markets and company profitability. In 2007, margins were as high as 69%. In 2012, they averaged 49%, so there's clearly a lot of scope to grow.
Pzena currently trades on forward earnings of 20 times, but even conservative projections suggest that the multiple three years forward is close to 15 times. If we include the company's cash balance of $2.88 per share, this valuation starts to look pretty reasonable, especially given the fairly predictable nature of growth and margin expansion on offer, here. Pzena also pays out 80% of its earnings as dividends, a proportion that may rise in the future and that would lead to a substantial yield above 5%.
