Pzena Investment Management, Inc.
Q3 2021 Earnings Call Transcript

Published: 20 Oct 2021

[Operator:]

Hello and welcome to the Pzena Investment Management Reports Results for the Third Quarter of 2021. My name is Charlie, and I'll be coordinating your call today. I will now hand you over to your host, Jessica Doran to begin. Jessica, please go ahead.

[Jessica Doran:]

Thank you, operator. Good morning and thank you for joining us on the Pzena Investment Management third quarter 2021 earnings call. I am Jessica Doran, Chief Financial Officer. With me today is our Chief Executive Officer and Co-Chief Investment Officer, Rich Pzena. Our earnings press release contains the financial tables for the periods we will be discussing. If you do not have a copy, it can be obtained in the Investor Relations section on our website at www.pzena.com. A replay of this call will be available for the next two weeks on our website. Before we start, we need to remind you that today's call may contain forward-looking statements and projections. We ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from today's comments. Please note that we do not undertake to update such information to reflect the impact of circumstances or events going forward. In addition, please be advised that due to prohibitions on selective disclosures, we do not, as a matter of policy, disclose material that is not public information on our conference calls. Now, let me turn the call over to Rich, who will discuss our current view of the investing environment.

[Rich Pzena:]

Thanks, Jessica. We human beings are irrational decision makers. It's not just my opinion. Decades of behavioral economics research and several Nobel Prizes have been handed out in support of this conclusion. We simply tend to make biased judgments. Sometimes out of recent experience, sometimes out of a hard-wired predisposition towards loss of version. The evidence is powerful. We, humans, are simply irrational economic actors. The truth is effectively the path platform upon which value investing is built. Value investors capitalize on the realization that human biases impede rational decision making, and the resulting mix/priced assets are available for those willing to systematically override their biases and apply rational economic analysis for their decisions. Let's consider the choice of which asset class offers the most attractive future return profile today. Using our estimated normalized earning yield as a metric, the cheapest quintile of the 2000 largest global stocks offers a yield of more than 13%. Compare that to the estimated normalized earnings yield of the full universe of global stocks at just over 6%, and treasury bonds and Eurobonds each offering yields of just 2% or less. And yet, current sentiment, investment literature, stock price momentum all would have one believe that the better choice is to be found among assets with lower projected earnings yields. The rational actor would obviously prefer the double-digit return opportunity embedded in the cheapest stocks. Let's consider one of the most common current arguments for avoiding the cheapest stocks today. Namely, I prefer quality - or - okay. So let's look at the facts. The cheapest quintiles of both U.S. and non-U.S. stocks have 10-year average revenue growth rates of 6% and 8% and 10-year average returns on equity of 17% and 13% respectively. By any analytic frame, I think it's fair to say that this is a fertile hunting ground for quality businesses. Let's also consider the near-term projected earnings of the cheapest stocks. Wall Street analysts are projecting value stocks to grow their earnings at more than 20% compounded annual growth rate through 2023, a higher rate than projected by analysts for growth stocks. And we can buy these growing high-quality value stock businesses for prices at 60% or more discounted to their growth gathering. A message in conclusion is clear. We think the value cycle is still in its early stages. There will, no doubt, still be bumps in the road ahead as there always are but to ignore the data is to fall prey to the irrational decision maker spate of suboptimal outcomes. You can count on us to always stay true to our value discipline and therefore offer a counterbalance to this all - to human reality. Let me close with a few comments about our business. We closed the quarter with assets under management at nearly $51 billion. We had net outflows of $1 billion for this quarter but this comes after positive net flows last quarter of $2.2 billion as we have remarked over the years, our flows can be lumpy. I'd like to offer as evidence that the marketplace rewards our value discipline. We still have positive net flows for the year and if this holds, we will achieve our fifth consecutive calendar year and eight of the last 10 years with positive net flows. We are awaiting approval from the Irish Regulatory officials to open our first European office in Dublin, which will offer us the ability to offer EU clients access to our strategies in whatever form they prefer. I look forward to answering your questions. I'll now turn the call back over to Jessica.

[Jessica Doran:]

Thank you, Rich. Looking at our results for the quarter, we reported diluted earnings of $0.27 per share for the third quarter compared to $0.25 last quarter and $0.16 per share for the third quarter of last year. Revenues were $61.6 million for the quarter and operating income was $28.4 million. Our operating margin was 55% this quarter remaining relatively flat from 54.9% last quarter and increasing from 44.1% in the third quarter of last year. Taking a closer look at our assets under management, as Rich mentioned, we ended the quarter at $50.8 billion, down 4.3% from last quarter, which ended at $53.1 billion and up 52.6% from the third quarter of last year, which ended at $33.3 billion. The decrease in assets under management from last quarter was which driven by net outflows of $1.4 billion and market depreciation, including the impact of foreign exchange of $0.9 billion. The increase from the third quarter of last year reflects $17.3 billion in market appreciation, including the impact of foreign exchange and net inflows of $0.2 billion. At September 30, 2021, our assets under management consisted of $18.8 billion in separately managed accounts, $29.3 billion in sub-advised accounts, and $2.7 billion in our Pzena funds. Compared to last quarter, assets under management decreased in each channel with separately managed account assets reflecting $0.9 billion in net outflows and $0.3 billion in market depreciation and foreign exchange impact. Sub-advised account assets reflecting $0.5 billion in market depreciation and $0.4 billion in net outflows and assets in Pzena funds reflecting $0.1 billion in net outflows and $0.1 billion in market depreciation and foreign exchange impacts. The decrease in assets under management primarily occurred towards the end of the quarter, resulting in average assets under management of $62.4 billion, an increase of 1.7% from last quarter and 58.3% from the third quarter of last year, revenues increased 1.5% from last quarter and 62.1% in the third quarter of last year. These increases from last quarter and the third quarter of last year reflect the average assets under management. Our weighted average fee rate was 39.4 basis points for the quarter compared to 39.5 basis points last quarter and 41 basis points for the third quarter of last year. Asset mix across our strategies and distribution channels as well as performance-based fee are generally the primary contributors to changes in our overall weighted average fee rate. However, changes in asset levels may also impact our fee rates as the majority of our separately managed account pay us management fees pursuant to the schedule in which the rate we earn on AUM declines as the amount of AUM increases. Our weighted average fee rate for separately managed accounts was 53.4 basis points for the quarter compared to 53.3 basis points last quarter and 54.9 basis points for the third quarter of last year. The decrease from the third quarter of 2020 primarily reflects an increase in assets due to market appreciation. As the rates we are in, the majority of our fee schedules decline as the assets increase. Our weighted average fee rate for sub-advised accounts was 27.6 basis points for the third quarter of 2021, compared to 27 basis points for both the second quarter of 2021 and the third quarter of 2020. The increase from the second quarter of 2021 and the third quarter of 2020 reflects the shift in assets to strategies that typically carry higher fee rates. Certain accounts related to one client relationship have fulcrum fee arrangements. These fee arrangements require a reduction in the base fee if the investment strategy underperforms its relevant benchmark or allow for a performance fee if the strategy outperforms its benchmark. During each of the third and second quarters of 2021 and the third quarter of 2020, we recognized $1 million reductions in base fees related to these accounts. These fees are calculated quarterly and compare relative performance over a three-year measurement period. If the extent of three-year performance record of these accounts fluctuate relative to their relevant benchmark, the amount of base fees recognized may vary. Our weighted average fee rate for the Pzena funds was 69 basis points for the quarter, increasing from 68.1 basis points last quarter and from 68.7 basis points for the third quarter of last year. The increase from the second quarter of 2021 reflects the shift in mix toward products and strategies that typically carry higher fee rate and the increase in the third quarter of 2020 primarily reflects a reduction in expense reimbursements paid. Looking at operating expenses, our compensation and benefits expense was $18.9 million for the quarter compared to $19 million last quarter and increasing from $15.8 million for the third quarter of last year. The increase in compensation and benefits expense from the third quarter of 2020 was primarily driven by an increase in compensation and the market performance with strategies tied to the company's deferred compensation obligations. G&A expenses were $4.3 million for the quarter compared to $3.9 million last quarter and $3.2 million for the third quarter of last year. The increase from the second quarter and the third quarter of last year primarily reflects an increase in professional fees and data and systems expenses. Other income was $0.4 million for the quarter, driven primarily by the performance of our investments. Turning to taxes, the effective rate for unincorporated and other business taxes was negative 5.4% this quarter compared to a positive 3.6% last quarter and negative 6.8% in the third quarter of last year. The negative effective tax rate this quarter and in the third quarter of last year reflects the benefit associated with the reversal of uncertain tax position liabilities and interest due to the expiration of the statute of limitations. We expect the effective rate associated with the unincorporated and other business taxes of our operating company to be between 3% and 5% on an ongoing basis. Our effective tax rate for our corporate income taxes, ex-UBT, and other business taxes were 24.2% this quarter compared to our effective tax rate of 24.8% last quarter and 26.5% for the third quarter of last year. The fluctuation in these effective rates reflects certain permanently nondeductible expenses. We expect this rate excluding these items to be between 24% and 26% on an ongoing basis. The allocation to the nonpublic members of our operating company was approximately 78.8% of the operating company's net income for the third quarter of 2021 compared to 78.4% last quarter and 78% for the third quarter of last year. The variance in these percentages is the result of changes in our ownership interest in the operating company. During the quarter through our stock buyback program, we repurchased and retired approximately 234,000 shares of Class A common stock for $2.6 million. At September 30, there was approximately $44.4 million remaining in the repurchase program. At quarter end, our financial position remains strong with $70 million in cash and cash equivalents as well as $7.3 million in short-term investments. We declared a $0.3 per share quarterly dividend last night. Thank you for joining us. We'd now be happy to take any questions.

[Operator:]

We have a question from Sam Sheldon of Punch and Associates. Your line is open. Please go ahead.

[Sam Sheldon:]

Maybe you could start by giving some color on the pipeline and interest trends that you guys are seeing on the sub-advised and separately managed sides of the business?

[Rich Pzena:]

Yes, I mean I'll give you a little bit of color, Sam. The pipeline has been relatively stable for maybe up a little bit, but I'll call it mostly stable over the last 12 months and it continues to be fairly widely scattered over all of our strategies. There are chunkier searches that come and go. They come and we win some of them, we lose some of them. We always hopeful that we're going to win them, but the opportunity set to remain reasonably stable. I think it is the best way to put it. When we do our own projections of what might have them, we see enough of a pipeline continue to feel comfortable about positive flows. But I would say not enough to see big, big growth rates.

[Sam Sheldon:]

Okay, that's helpful. And maybe how you're feeling about the mutual fund business today? Do you plan on adding additional resources or funds there? I guess would you expect that to be the sort of last account type to benefit from improved sentiment towards value as maybe retail kind of chases returns?

[Rich Pzena:]

Yes, I mean we did add a fund this year. I don't know if it was in the last - I don't remember when it started. Started in the quarter. So, we added an international value of mutual funds. Obviously, it's very early. It has a small amount of assets in it and we added another salesperson. We're actually still looking to expand our investment a little further. We continue to believe that being very out there and aggressive on the message about value investing. We'll pay dividends when and if we believe it's when. I hate to use the word if but it's fair to use it. There is a big flow of funds into value. We've started to see a little bit of it but we clearly are investing ahead of our belief that this is going to happen.

[Sam Sheldon:]

I've got a question on performance fees. It looks like you haven't recorded significant performance fees year to date, but the performance in your strategies has been pretty strong recently. Based on what you see today, where do you think that is going in the next few quarters?

[Rich Pzena:]

Remember, almost all of our performance fees are three-year rolling average performance. And so when you look back three years, you're looking --you're including the beginning of the pandemic and you're also including this pretty anti-value environment that existed in the second half of 2018 and into 2019. So mostly, those will roll out over time. I don't think it's a quarter away, but I think it's a year away before the negatives on our - in our performance calculations are gone, and you'll see some of the more recent performance generate performance fees.

[Sam Sheldon:]

Okay. It looks like headcount is up around 10% over the last year. Just curious to hear how much of that is the opening of the Dublin office and what roles you're filling at the firm and maybe just broadly how retention has trended recently?

[Rich Pzena:]

Yes. So Dublin office will have - initially have four people in it and they're already employed, although I don't know that they were in the - I think they are employed in October, not in September. So they wouldn't be in that headcount number yet. And mostly, the headcount growth has happened in our - on the distribution side and it's in the support of marketing support. So it's in the RFP team. It's in the publication and content and distribution area, we did opportunistically at some research. We had actually had three research analysts that we hired in the quarter somewhat - couple were replacements but we took advantage of the ability to find some good talent which is, comes - that you come across that in a lumpy fashion, just like we come across our accounts in a lumpy fashion and we - so we're pretty - I mean we're completely fully staffed now on the investment side, although we've decided to continue to be more proactive and having a steady pipeline of investment talent rather than hiring in chunks like we've done in the last couple of years. So - but over the - biggest growth area for us in headcount over the last five years has been on client side and the sales and marketing side.

[Sam Sheldon:]

Okay. The last question from me is around the Dublin office. Can you just talk more about how that launch is going and maybe you could speak to the importance of Pzena having a formal presence in the EU? Thanks.

[Rich Pzena:]

We already have a big business in the EU. And free - this is a Brexit reaction. Actually, so the London registration and ability to passport that into the EU disappeared with Brexit. We had a temporary solution in place while we were figuring out what our options were. We decided being regulated in Dublin since we already had funds that were available and regulated by the Central Bank of Ireland, it was an easier process and that we believe that they're fairly reasonable to deal with. So the impact really is so that we cannot have a complicated process by which we offer various strategy. So we offer separately managed accounts. We offer , and other co-mingled vehicles, all of which have different kinds of regulatory requirements and we were using third parties to facilitate our ability to operate there and it's less than optimal. It does add a little bit of cost at the beginning. The start-up cost adds a little bit more ongoing expense, but that will be offset if the assets get bigger and that's what we hope. So again, this is just investing everywhere in the world that we need to invest to get access to markets and I don't think there's anything more to say unless you have any other questions.

[Operator:]

Our next question comes from Tom Brownell of Rock Point Advisors. Your line is open. Please go ahead.

[Tom Brownell:]

Great. Thank you, operator, and thanks for taking my question. Good morning, guys. I think the first question I guess we would pick up on Sam's first question around the pipeline in the market opportunity and Rich, which strikes me as I heard you answering Sam's question, it's interesting over the last, I guess two, three maybe even four quarterly calls, we've heard you talk about the inflection between growth and value strategies performance and the interest in those strategies and you had said that there has historically been a pretty solid sort of 12-month lag between the performance of the relative strategies and the interest, especially on the institutional side and it strikes me that now, I realize it hasn't. We haven't had - we didn't have a clean break last fall that has persisted, but if you pick last October, it is a little bit of the demarcation point here we are 12 months. Hence, I was wondering given your flows in the most recent quarter whether you would still feel and so there will be a large pickup in interest in activity anytime now or whether this time it feels different to you?

[Rich Pzena:]

Well, I'll say that the flows in the quarter were more - the outflows that we had were caused by a couple of things. One then the biggest is the fact that we had been up around 50% over the prior year and there was just rebalancing. So this benefits us obviously when we underperform. It hurts us when we outperform. That's the existing account. We also had one reasonably large sub-advisory relationship and this is in Canada and they decided to bring in-house and terminated a lot of managers. So we had kind of to - what I'm hoping will be big outliers on outflow side. The inflow side is where in the long run the growth will have to come from obviously. And so what if we had. We've had kind of - I'm going to call a normal pattern of new account openings. It has not picked up along the lines value would say if there was truly a 12-month lag period, are we seeing that. Now, what do I make of that, even as recently as - if you look at the performance in the third quarter, this was a very unusual quarter where I would say and obviously this is a little bit of an exaggeration but it was almost like every other day, we outperformed the market. The market was very much saying this is a growth market to value market. It is a growth market. It is a value market. So we haven't seen that clear, clear idea that we're in this cycle. So when you get that kind of behavior, the fear of missing out on a value rally or the looking in the rearview mirror and saw that you have missed out. It just hasn't yet materialized. Will it, I hope. October is off to a good start for us from a performance perspective globally. It doesn't feel like it did in the third quarter. It feels more like it did earlier this year and late year, but I don't know the environment - I don't have good words to explain it. It's obviously not there yet, but we haven't lost the hope or the belief that this is yet to come. It's probably the best way of putting it.

[Tom Brownell:]

Right. But - so not a material pickup and interest from that institutional sort of gatekeepers yet I think - hearing?

[Rich Pzena:]

Correct.

[Tom Brownell:]

It's super helpful. Thanks. Thanks for going through all that. My next question was going to be additional color on the redemptions and thanks for your helpful comments on that. Next question would be on the buybacks. Jessica, I think I heard you say in your prepared comments something like you did buy back some shares in the third quarter and I think I heard you say you have $44 million remaining on the authorization is that open-ended or is it - is there an end date to that authorization?

[Jessica Doran:]

It is open-ended. It is open-ended and there is an end date - there is not an end date to that authorization.

[Tom Brownell:]

Okay. Was it originally?

[Jessica Doran:]

Originally - when we originally went through the buyback program in 2000, I want to say - we started with $10 million in the beginning and we have added the buyback program twice since that point in time. In second quarter of last year - excuse me, in the second quarter this year, we added another $40 million to the buyback program.

[Tom Brownell:]

Perfect. And can you talk a little bit about your strategy around the buyback program and the implementation of that. How do you think about potential dilution to public shareholders as a result of some of the programs you have as part of your incentive components?

[Rich Pzena:]

I can answer that question. We've tried to buy back as much as we can when prices are reasonable to offset the dilution. We've always sort of had this view and have been operating pretty much that way that on average we're going to add 1% or 2% to the share count because this is a talent business and aligning the next generation of investment talent and leaders by using equity as a part of the compensation. It's critical to our business plan. So now obviously our - the liquidity of our share base - of our shareholder base is not enormous, so we can't buy enough stock so totally offset but we do think that the benefits that we receive through our modest annual dilution obviously get equally diluted. In my opinion having investment talent that is completely aligned from a business perspective is the best way to implement the investment strategy and the business strategy that we have. It's also been a spectacular retention tool for the senior people in the organization.

[Tom Brownell:]

Yes. To completely understand totally get it and that actually is - I'm glad to ask the question because I haven't really heard and I'm not suggesting you hadn't said that. You probably have that I just missed it but that's helpful to think about that 1% to 2% increase in share count sort of as a steady-state year in and year out. And so is a helpful data point to have in the back of our mind. So thanks for sharing that. I appreciate it. And that's. I'm good. No more questions from me. Thanks a lot.

[Rich Pzena:]

Okay. Great.

[Operator:]

There are no further questions on the lines at this time. So I'll hand the call back over to the team.

[Jessica Doran:]

Thank you everyone for joining us on today's call. We look forward to speaking with you next quarter.

[Operator:]

This concludes today's call. Thank you for joining. You may now disconnect your lines.