Pzena Investment Management Third Quarter Commentary

From Wall Street to Main Street, from the City to the Bourse, investors are panicked. This crisis of confidence has claimed victims that one year ago would have seemed laughable. Bear Stearns, Lehman, Merrill Lynch, Fortis, Bradford & Bingley, AIG, Wachovia, Fannie Mae, Freddie Mac, just to name a few. Unfortunately, we have been caught with some of these positions in our portfolios as we sought to exploit the fears, rather than hide from them.

Our approach of exposing the portfolio to the cheapest stocks has often protected our investors from the downside risks to the market, although that has not been the case for much of this cycle. Nevertheless, some interesting changes to market leadership are afoot. The value/momentum cycle appears to have begun to turn. While the current volatile market has been driven by emotion, the turn may actually be justified by the fundamentals for the two sectors at the heart of the cycle - commodities and financials. Historically, these turns come before the data is completely clear or consistent. But once the data is available to the market, the investment opportunity will have passed.

Momentum/Value Cycle Has Shifted
Equity investment returns have historically been dominated either by momentum or by value. Both styles are supported by long-term academic research, and coincidentally both have generated similar levels of excess long-term returns over the broad market. Momentum flourished in the most recent cycle as investors fell in love with the "Chindia" story and the fantasy of decoupling. As inevitably happens as each momentum cycles ends, the "story" collapses - in this case the sharp fall in commodity prices signaled the shift. In fact, it may surprise many that the best performing sectors for the third quarter were Consumer Staples, Health Care, Financials, and Consumer Discretionary. An underweight in the cheapest stocks (Financials and Consumer Discretionary) would have been costly for the quarter, despite all of the failures within the financial services industry.

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