With Class and Old Fashioned Realism
John Hancock Classic Value Fund
Richard S. Pzena
Author: Jana Tchinkova
Last Update: , :
|With an in-house dedicated research team of 11 analysts and a proprietary computer modeling system, Richard Pzena and John Goetz have been managing this traditional value portfolio for nearly a decade now.
John Hancock Classic Value remained a consistent top-quintile performer over the past 5-year, 3-year, and 1-year periods. Pzena spoke to Ticker about their best quality picks and worst disappointments.
||John Hancock Classic Value Fund|
Q: Can you go back in history for a while? At the end of 2002, Pzena Focused Value was acquired by John Hancock Funds, and consequently was renamed and re-organized. Now, Pzena Investment Management still sub-advises the fund. What changed during this transition in terms of strategy and research?
Nothing has changed in terms of strategy or research. In fact, one thing that defines our firm and, I think, made us so attractive to Hancock Funds is our intense commitment to a research-driven investment process, disciplined strategy and deep-value investment style. Our approach has produced strong long term results and we’re committed to it.
I guess the only noticeable change since our association with Hancock, beyond a major increase in the fund’s assets, has been an effort to ensure that the fund is categorized as a large-cap value fund. We changed the focus from a universe of the 1,000 largest companies to the 500 largest companies. Previously, we weren’t quite as sensitive to where we would be categorized; at times the portfolio would have been considered large-cap and at times it would have been mid-cap. We clearly are large-cap now and are categorized that way by Morningstar.
Q: So, this is the only difference?
Yes, the portfolio is still mostly the same. If you think about the average market capitalization of the 500 largest companies, it’s about $3.5 billion. We pick the companies for our portfolio from that pool.
Q: Do you have more restrictions or resources available since John Hancock took over?
We have no restrictions, but more resources. We joined forces with Hancock Funds for the marketing resources and access to the market they could provide.
When they rebranded the fund and took over distribution, we had $20 million in assets and it had taken us seven years to reach that level. Over the past 18 months or so, with our strong performance and Hancock’s marketing and distribution resources behind us, we’ve gone from $20 million to about $200 million.
Q: What does ‘classic value’ now stand for? How do you determine value?
We are “classic” value investment managers, trying to find good businesses when they get very depressed in price relative to their long-term earnings and cash flow generating capability. That is an old fashioned definition of value and we approach it with a fairly healthy dose of realism. The realism being that we acknowledge that we don’t get to buy the best businesses with the fastest growth rates, the wonderful management teams, the high margins, and all of these characteristics that everybody wants in their portfolio because that is not what sells for a low price. If you are focused on buying something at a low price typically there will be some issues associated with it that make it cheap. There is no free lunch.
Q: What is your research process? How many people do you have internally on your research staff? Do you rely also on Wall Street research or independent research?
Our 11-person team is not your typical research staff. We think of ourselves as private equity kind of investors who happen to be operating in the public markets. We are buying businesses for the long term, not picking stocks for the short term.
Our team of analysts is way more focused on understanding businesses and their long term prospects and they are the right type of people for this kind of investment process. For example, John Goetz, our research director ran a billion-dollar global plastics business. We have two former McKinsey consultants, a former private equity analyst, a former chemical research engineer, even a former lawyer.
Since we have at most 40 stocks in the portfolio, and we average about a three-year holding period for our investments, we only make 10 to 15 investments a year in the fund. With 11 analysts, we have the luxury of really being able to get to know the companies that we are buying in-depth. It doesn’t mean we always get it right but it does mean that when we make judgments of whether we like a business, we know we have studied it carefully enough and have the information we need to make that judgment.
Q: You use a proprietary computer model to screen equities. Can you tell us more about this system that you have in place?
We have developed our model over a long period of time to forecast earnings based on history. It is conceptually very simple. We look at average margins, average growth rates to come up with future earnings. The implementation, however, is relatively complex, because we have data issues and capital structures that are different, and this model accounts for all of those.
The model is very important, but it also is really just the first part of the process. It helps us figure out where to focus our research efforts. It doesn’t substitute for doing the thorough analysis and judgment that our analysts do on a company by company basis.
The model ranks companies on the basis of their share price to what the earnings would be if the histories were held into the future. At the top of the list are companies that sell for a low price relative to what their history suggests they should be earning in the future.
The point is they are generally not earning what their history suggests they should be. Something is wrong and the company is earning less than its historically demonstrated pattern. It then becomes a candidate for us to look at and we assign it to a research analyst to review.
Q: Do you have a cutoff number where you stop and the rest of the companies are eliminated? Also, how often do you run this computer model?
We run the computer model every day and the team formally looks at the results once a week. The model breaks the market into five quintiles. Only companies in the cheapest quintile are considered.
Every week, a couple of companies creep into the list of cheap stocks so we assign an analyst to take a quick look at each one for a week or two. They read everything they can get their hands on, including the company’s own propaganda, Wall Street research, news articles, trade journals, government studies, whatever we can find. We speak to the investor contact, we speak to some of the analysts and we build a simple financial model showing what went wrong and what has to go right to get the company back on track and then we make a decision whether we want to do the intensive research study.
At this point, we actually reject about 75% of the companies. We reject them because the histories may not be relevant, because the business has changed, or we conclude that the business isn’t any good, there is a structural flaw, or even that we can’t figure it out.
On the other 25% we do an intense, in-depth analysis and we generally visit the company at the end of that process. We are as knowledgeable as we possibly can be about the company before we visit so that we can have an intelligent discussion with the company’s management and not simply get their standard pitch.
Q: One of the reasons that you said can make you get out of or trim a certain position is reaching fair value? Can you define fair value in the context of your fund and can you talk about other factors that come into your sell decisions?