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Disciplined Deep Value Investor
Pzena Mid Cap Value Fund
Interview with: John Flynn

Author: Ticker Magazine
Last Update: Aug 10, 9:39 AM ET
Investors are not always forgiving when established businesses undergo short-term problems. In situations like these, they would rather sell the stock first and ask questions later. John Flynn, portfolio manager of the Pzena Mid Cap Value Fund, explains how a patient investor can profit from these fundamentally sound businesses when they are out of favor in the market for temporary reasons.

ďWe do one thing and one thing only, and that is deep value investing. We are committed to it and I think the disciplined process along with the strong investment culture that we have here really allows us to exploit the opportunities available in the market.Ē
Q: How is your research team organized?

A: Our analyst teams are organized by global industries. For instance, our auto analyst covers the entire auto supply chain around the world, including China, Europe, and America. They understand every aspect of the global automotive industry, and they can bring that perspective to the mid-cap market. We also have an excellent research team with 25 professionals. Each member has specific research responsibility and even the portfolio managers have sector coverage responsibility.

One rather unique strategy we use is to rotate coverage responsibility every three or four years. When we are debating a new idea, oftentimes there will be multiple people in the room who have covered the industry. So, we get historical perspective as well as a fresh perspective. The core of the team has been together for quite some time and the culture that has evolved is an important part of our success.

Q: What is your sell discipline?

A: The number one sell driver is valuation. When a stock has reached the midpoint of the universe on a price-to-normalized earnings basis, it is sold out of the portfolio and we are trimming the position as it approaches the midpoint.

There are two ways a stock can reach its midpoint. There is the good way where the stock goes up, and then there is the bad way where the normalized earnings estimate goes down. But in either case, we maintain our disciplined strategy and once a stock is fairly valued we move on to the next compelling, deep value opportunity.

Q: What is your portfolio construction process? Does diversification play any role?

A: In our Mid Cap Focused Value strategy, our portfolio normally consists of 30 to 40 names. Our annual turnover is about a third, so we donít need to identify too many buying opportunities each year. Our maximum position size for any one name is 5% at cost, 7.5% at market. In terms of sector constraints, the maximum sector exposure we allow is 25%, except for the financial sector where we can go up to 45%.

We are very conscious of the drivers of our investment thesis. If we are getting a cluster of names that are centered around the same valuation and the same driver, like the same economic or industry factor, we take that into consideration. When looking at names of equal valuation, if one name replicates an exposure already in the portfolio and one diversifies, we will go with the diversifying name.

The cheaper the stock on a price-to-normalized earnings basis, the larger will be its position in the portfolio. We do take into consideration range of outcomes, leverage, and diversification, but the fundamental driver for the portfolio sizing is always valuation.

While most of our clients use the Russell Mid Cap Value Index as their benchmark, we do not manage our portfolio with a benchmark in mind. We seek to create a portfolio with the most compelling valuation opportunities over time and we think that our portfolio should beat the benchmarks.

Q: What are your views on being overweight in particular sectors in search of deep value?

A: To take advantage of value dislocations, you have to be willing to be concentrated in an industry or sector when it is under stress. Today, financials make up 37% of our portfolio. We are willing to expose ourselves where we identify value opportunities and if we donít see opportunity, we donít feel compelled to have exposure. For example, today we have virtually zero exposure to utilities, consumer staples, and REITs.

Q: How do you interpret valuations and deal with valuation fluctuations?

A: There are different styles of investing, like value and momentum, that over time have proven successful. To get the full benefit of any one style, you must be disciplined. Attempting to time opportunities when value is attractive versus not attractive is a good recipe for leaving a lot of return on the table.

So, we do one thing and one thing only, and that is deep value investing. We are committed to it and I think the disciplined process along with the strong investment culture that we have here really allows us to exploit the opportunities available in the market.

Q: How do you define and manage risk?

A: We define risk as a permanent impairment of capital. Our whole research process is really meant to mitigate risk by focusing on the cheapest opportunities and paying attention to downside protection. We aim for a portfolio which is skewed where we make a lot of money if we are right, but donít lose too much money if we are wrong.

We focus on long-term opportunity. Because we are investing with a three-to-five-year time horizon, we see short-term fluctuations in our portfolio as opportunities rather than risk factors.

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