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Pzena Investment Management

Third Quarter 2013 Commentary


The emerging markets offer a superior value advantage across identiable cycles. A bottom-up investment approach can be highly effective in identifying opportunity and avoiding value traps.
The emerging markets have attracted considerable investor interest, both as a way to tap into large, rapidly growing economies and, more recently, as potentially a good place to nd value as hyper-growth decelerates and stocks correct. As such, we felt this an opportune time to take a step back and offer a long-term perspective on value investing in the emerging markets. In this article we review the empirical evidence for the value advantage in the emerging markets, examine some of the reasons this advantage exists, present our research on whether there are observable value cycles in the emerging markets, and discuss where we currently stand. The Value Advantage Academic evidence of the global value advantage is well documented. Fama and French conducted the seminal research in this area, rst in their 1992 article The Cross-Section of Expected Stock Returns1 which identied the value advantage in the U.S., followed by their 1998 article Value versus Growth: The International Evidence.2 Their 1998 work examined both developed and emerging markets, and found the value premium, dened as the return differential between low and high price-to-book stocks, was 7.68% per annum in developed markets and 16.91% in emerging markets. Other researchers conrmed Fama and Frenchs observation of the value advantage in emerging markets, including Rouwenhorst3, Barry, Goldreyer, Lockwood and Rodriguez4, and, more recently, Marjo-Ritta Elisa Pitkanen5 who studied the period 2001 through 2011. Studies have also identied a value advantage in individual countries as diverse as India, Malaysia and China. We conducted our own research into the global value advantage, examining the return difference between low price-tobook stocks and the broad market over the period 1988 through 2013. As can be seen in Figure 1, we were able to conrm a value premium in both the developed and emerging markets, as well as the signicantly higher premium for value stocks in emerging markets. Not unexpectedly, this premium has narrowed in more recent years as emerging markets become broader in country representation and market capitalization. Still the value advantage is substantial. Why Value Works True believers in the efcient market hypothesis would postulate that this value advantage cannot exist. They would argue the stock market is forward-looking, determining a companys value based on future earnings and cash ow. With thousands of market participants, and relatively equal access to information, stock prices in theory should reect an unbiased, well-informed view as to the intrinsic value of a business. Yet, the history of investing is that valuation distortions are common, observable, and exploitable. Although the research we cited earlier identied and quantied these anomalies, cognitive psychologists have provided the most compelling research into why they exist. Amos Tversky and Daniel Kahneman of the Hebrew University conducted ground-breaking work into how the emotional responses of people inuence their view of the future. They observed that people develop rules of thumb to judge the probability of an event, and that these judgments are highly inuenced by the recency of the event. In other words, when an event has recently occurred, people tend to overestimate the likelihood of its recurrence. This recency bias can be exacerbated by the events severity, which makes it even more memorable. But memories eventually fade, and expectations normalize. At the extreme, fading memories can lead ultimately to complacency and underestimation of risk. It is likely that these forces, in conjunction with the ebbs and ows of the economy and corporate performance, form the underpinnings of valuation anomalies through investment cycles. And nowhere

Figure 1: The Value Advantage in Emerging Markets: 1988 - 2013 Annualized Excess Return of Low Price-to-Book Quintile vs. Broad Market Index* 25 20 15 10 5 0 1988 - 2013 Emerging Markets 2000 - 2013 Developed Markets

*MSCI Emerging Markets Index for Emerging Markets and MSCI World Index for Developed Markets Source: Sanford C. Bernstein & Co., Morgan Stanley Capital International, Inc., Pzena Analysis

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are the desperate rush towards, and the panicked ee from risk more apparent than in the emerging markets. Value Cycles in Emerging Markets In previous articles we presented our research on value investing cycles in the U.S. dating back to the 1960s. Studying periods when a portfolio of low price-to-book stocks either outor under-performed the market index - in this case the S&P 500 - we found that there are discreet periods to values relative performance. Yet over full cycles, which tend to last almost ten years on average, value outperforms the broad market by approximately 4.8% per annum. Recently, we extended our research to see if similar cycles exist in the emerging markets. We examined data back to 1993, and were able to identify cycles over which value had distinct periods where it lagged and outperformed the MSCI Emerging Markets index. On average, value outperformed the broad market by 8.0% per annum over the entire cycle (Figure 2). Where We Stand Today As shown in Figure 2, we are currently in the anti-value portion of the emerging markets value cycle that started in April, 2011. A nave low price-to-book strategy has underperformed the MSCI Emerging Markets index by 10.8% over the last 30 months, a period punctuated by knock-on effects of the European recession, slowing emerging markets growth, and the

Figure 2: Value Outperforms Over the Cycles in Emerging Markets Capitalization Weighted Low P/B Portfolios vs. MSCI EM Index
MSCI Low Price-to-Book Emerging Markets Difference Index ce 19.6% 109.1% 25.8% -66.2% 1556.9% 19.2% -11.4% 67.0% 11.3% -19.5% ? 15.1% 32.6% -0.1% 7.3% -50.9% 479.0% 11.2% -0.4% 15.4% 3.9% -8.8% ? -3.6% 7.1% -13.0% 109.3% 18.5% -15.3% 1077.9% 7.9% -11.0% 51.6% 7.4% -10.8% ? -4.7% 8.0% # Months 3 45 48 11 107 118 11 33 44 30 ? 30 240

impact of potential Fed tapering. We are not surprised by this result; the data in both developed and emerging markets suggest that value strategies typically underperform toward the end of an economic cycle, resuming their out-performance once the impact of an economic slowdown is discounted in valuations and investors start to look forward toward recovery. When we look at what is happening across emerging markets today, we see signicant pain in many industries, as evidenced by the underperformance of low price-to-book stocks. That said, when we examine the returns on equity in those businesses, despite precipitous declines over the last few years, returns appear to have returned to about average (Figure 3), with some industries still above levels we would expect in a normalized environment. In many cases where the returns are indeed below normalized levels, we are cautious about the path back to normal, as in many industries vast supply was added during the boom and, frequently, in so doing, so was leverage. As such, we continue to take a business-by-business approach to building our portfolios, as all cheap stocks are not created equal in such an environment. For example, while book values of commodity businesses have grown rapidly during the boom period, book value can be a poor indicator of intrinsic value. Thus, our focus on understanding earnings power can help us reduce downside risk versus a nave price-to-book portfolio. In addition, although some value strategies place a signicant emphasis on predicting macro country factors, it has been our experience that focusing research at the company level is effective even in the face of country-level headwinds. We construct portfolios in this manner, which is likely why our approach has worked well during this period of normalization, and why we believe it can continue delivering the value advantage in the future.

Mar. 2000 Emerging Balance Markets

Oct 93 - Dec 93 Jan 94 - Sep 97 Full Cycle Annualized Oct 97 - Aug 98 Sep 98 - Jul 07 Full Cycle Annualized Aug 07 - Jun 08 Jul 08 - Mar 11 Full Cycle Annualized Apr 11 - Sep 13 ? Oct 93 - Current

Figure 3: Emerging Market Return on Equity Normalizing MSCI EM Return on Equity 18% 15% 12% 9% 6% 3% 0% 1992 Average

Cycle-to-Date (Annualized) -8.3%

1995

1998

2001

2004

2007

2010

2013

Source: Sanford C. Bernstein & Co., Morgan Stanley, Pzena Analysis

Source: MSCI, Inc., FactSet, Pzena Analysis

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THIRD QUARTER 2013 | PZENA QUARTERLY REPORT TO CLIENTS

References Fama, Eugene F., and French, Kenneth R., The Cross-Section of Expected Stock Returns, The Journal of Finance, June 1992 2 Fama, Eugene F., and French, Kenneth R., Value versus Growth: The International Evidence, The Journal of Finance, December 1998 3 Rouwenhorst, K. Geert, Local Return Factors and Turnover in Emerging Market Stocks, The Journal of Finance, August, 1999 4 Barry, C.B., Goldreyer, E., Lockwood, L. and Rodriguez, M., Robustness of Size and Value Effects in Emerging Equity Markets, 1985-2000, Texas Christian University, May 2001 (subsequently published in Emerging Markets Review 3 (2002), 1-30) 5 Pitkanen, Marjo-Riitta Elisa, Value Investing in the Emerging Markets, Master Thesis, Copenhagen Business School, December 2011
1

DISCLOSURES
Past performance is no guarantee of future results. The historical returns of the specic portfolio securities mentioned in this commentary are not necessarily indicative of their future performance or the performance of any of our current or future investment strategies. The investment return and principal value of an investment will uctuate over time. The specic portfolio securities discussed in this commentary were selected for inclusion based on their ability to help you understand our investment process. They do not represent all of the securities purchased, sold or recommended for our client accounts during any particular period, and it should not be assumed that investments in such securities were, or will be, protable.

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