Commentary 4q08

Pzena Commentary Fear and uncertainty have driven equity valuations to an extreme across a broad range of industries. Our message: don’t panic, think long term, and take advantage of the opportunity. A World of Extremes Events of the past year have created an environment where it seems everything is at an extreme – uncertainty, emotions, volatility, valuations. These are not easy times to navigate, particularly when it comes to portfolio decisions. Our objective in these pages is to provide a perspective on what we believe to be the outsized return potential now available to equity investors (and value investors in particular), how these opportunities stack up against fixed income alternatives, and the conditions that led to these valuation distortions. Our message is simple: don’t panic, think long term, and take advantage of the opportunity.

The Environment – Volatility Abounds We have just lived through one of the most volatile periods in stock market history. This past quarter, the VIX Index (a measure of market volatility) averaged 58.6, hitting an all-time high of 89.5 during the trading day on October 24th. The index has averaged 19.7 since inception in 1990. In addition, the S&P 500 experienced moves of greater than 2% on over 60% of the trading days during the fourth quarter (39 out of 64). The S&P 500 fell by 21.9% and MSCI World, net by 21.8% during this period, leaving these indexes down 37.0% and 40.7% for the year, respectively. What, then, can we observe about valuations that have resulted from this turbulent period?

S&P 500 Overvalued Normal Range

0% -30%

S&P 500 Undervalued

-60% ‘80

‘85

‘90

‘95

‘00

‘05

Source: San ford C. Bertstein & Co., Pzena Analysis

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HEADLINE: DIN2: BOLD 8.5toPTBook Value vs. S&P 500 Figure Price

HEADLIN

40% Value black Opportunity RULES: Stroke 0.25Limited PT, 100%

RULES: S

Price to Book of Cheapest Quintile of 500 Stock Universe to S&P 500

60% 30%

Clearly, the experience of the past year has been painful. But resulting from that pain is a level of valuations, for the market in general and value stocks in particular, that is compelling. We regularly track the value of equities versus 10-year treasuries using a dividend discount model, and have not seen this deep a discount to fair value for equities (56%) in almost 30 years (see Figure 1). The next-most-attractive discount for equities was 37.4% in September 2002, followed by a 34.5% discount in August 1986. Although the past is not necessarily prologue, cumulative returns for the S&P 500 for the following three year periods were 58.9% and 62.2%, respectively. Even if we adjust the 10-year yield to 4.5% (from 2.2% at December 31, 2008) to account for a possible “treasuries bubble,” exacerbated by investors’ flight to safety, equities would still appear to be 40% undervalued. Put another way, risk premiums are at their widest point in the 28 years of data we maintain on the subject. Today’s equity risk premium, or the expected return on equities less the risk free rate, is 13.3%. This compares to an average over the 28 year period of 2.7%, and the next-highest reading prior to 2008 was 8.0% achieved in September 2002. This is a clear sign of risk aversion in the markets. So what about our portion of the investment world…value stocks? Again, we look to the historical data. On a price-tobook basis, there has only been one period in the past 43 years where the spread between the cheapest quintile of stocks has been wider than at present, and that was at the end of the internet bubble, when the magnificent overvaluation of the S&P 500 was the main contributor to the outsized spread. Today, the cheapest quintile of the largest 500 U.S. listed companies (our

% Discount to S&P 500

Premium (Discount) to 10 Year Bonds

Figure 1: S&P 500 Valuation Relative to Bond Market Assuming Normal Equity Risk Premium

Valuations – A Silver Lining

PZENA QUARTERLY REPORT TO CLIENTS | FOURTH QUARTER 2008

Y AXIS: DIN50% REGULAR 7.5 PT, track -25, right aligned

Y AXIS: DI

SIDEWAYS:60% DIN REGULAR 7.5 PT, track -25, center aligned

SIDEWAY

X AXIS: DIN REGULAR 7.5 PT, track -25 70%

X AXIS: DI

GRAPHIC: Use 100% black or blue for bars, curves, dotsSignificant Value Opportunity 80% ‘65 DIN‘70 ‘75 7.5‘80 ‘90 track ‘95 -10‘00 ‘05 COLOR LEGEND: REGULAR PT, 10 ‘85 PT leading,

GRAPHIC

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

SOURCE: DIN REGULAR 7.5 PT, track -25

FOR FINANCIAL PROFESSIONAL USE ONLY

COLOR LE

SOURCE:

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large cap universe) sells for a 68% discount to the S&P 500 on a price-to-book basis, 13% points more than on average. As you can see in Figure 2, this discount is higher than at any other period of wide spreads, excepting the height of the internet frenzy in 1999.

Opportunities Broaden Spreads began to widen during the third quarter of 2007, led by sharp declines in the financial services sector, followed shortly thereafter by consumer discretionary stocks. The second major event took place during the second half of this year, as sectors that were perceived as being shielded from a U.S. slowdown by strong emerging market economies started their precipitous decline. This included energy, materials, and industrial cyclicals, some of which are now sporting valuations that have pushed them squarely into the cheapest quintile of our investment universe. Our opportunity set has thus broadened. Not only are valuations attractive, but they are now available across a wide variety of sectors, giving us the ability to add attractively valued holdings while also adding to the diversity of our portfolios.

Stocks or Corporate Bonds? One of the perceptions circulating in the investment community is that bonds are more attractive investments than equities, as spreads have widened for bonds as well, and may have similar returns with less risk. Let’s examine this question from two perspectives: First, consider the expected return for debt securities versus the expected return to equity in comparable risk situations, and then look at the empirical evidence coming out of the 1990 downturn. Note the expected return on various classes of securities in

the following table shows data that seem intuitively correct— more reward for more risk:

Security 10-Year Treasuries AAA Bonds BBB Bonds Equities - S&P 500

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

We can also observe the spread between the expected return on equities versus treasuries and BBB corporate bonds over time in Figure 3, noting the massive widening of all spreads to peak levels during 2008. Not only can we observe superior expected equity returns by asset class, but we can also make similar observations using the following illustration. Compare three different specific opportunities. Johnson & Johnson (a high quality/low leverage company), Allstate (an insurance company that has some risk in its own investment portfolio and medium leverage), and Liz Claiborne (a retail business with fairly high leverage) to see what apples to apples situations look like. As can be seen in Figure 4, in each case the expected return on the firm’s equity far surpasses the expected yield (yield to maturity) on their debt. True, equity holders assume a higher degree of risk than debt holders, but those risks appear to be more than compensated for in their pricing and expected returns. We would specifically note that in the corporate bond arena, opportunities for truly outsized returns (e.g. LIZ), are associated

HEADLINE: DIN4: BOLD 8.5 PT Returns for Equities vs. Bonds Figure Expected

Figure 3: Expected Equity Return Spreads

Company Johnson and Johnson

Spread (% Points)

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vs. 10 Yr. Treasuries vs. BBB Corporate Bonds

10

Security Bond Stock

Expected Return* 3% 16%

Bond Y AXIS: Allstate DIN REGULAR 7.5 PT, track -25, right aligned Stock

5

8% 25%

SIDEWAYS: DIN REGULAR 7.5 PT, track -25, center aligned Liz Claiborne

0

Bond

X AXIS: DIN REGULAR 7.5 PT, track -25Stock

-5 -10 ‘80

28% 67%

* Expected for black bonds is based on yield maturity curves, for representative GRAPHIC: Use return 100% or blue forto bars, dotssecurities recently traded.

‘83

‘86

‘89

‘92

‘95

‘98

‘01

‘04

‘07

Source: Sanford C. Bertstein & Co., Pzena Analysis

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Expected Return 2.2% 5.1% 8.5% 15.5%

PZENA QUARTERLY REPORT TO CLIENTS | FOURTH QUARTER 2008

Expected return for stocks is based upon Pzena analysis of earnings power and a five year period for stock prices to return to fair value based on our price to normal earnings methodology. It also presumes the stock market overall returns to more normal valuation. This is not a guarantee of future returns.

COLOR LEGEND: DIN REGULAR 7.5 PT, 10 PT leading, track -10 Source: Pzena analysis

SOURCE: DIN REGULAR 7.5 PT, track -25

FOR FINANCIAL PROFESSIONAL USE ONLY

PZENA COMMENTARY | CONTINUED

with stock valuations that are massively discounted. LIZ is trading at just over $3 per share having been in the $20’s as recently as last year. Allstate’s stock should return as much as LIZ bonds and three times the return of the Allstate bonds. As for the observed outcomes from history, Empirical Research Partners examined the returns of junk debt versus value equities coming out of the 1990 financial crisis. In the three year period post-October 1990 (the trough of equity valuations in that cycle), junk bonds returned 96%, whereas value equities returned 182%, and the average equity was up 112%.

Conclusion We offer the following observations: 1. The expected return on equities at current valuation levels is higher than at any time in at least the past 28 years; 2. Valuation spreads are wide, an environment that favors the value investor; 3. We believe equity returns should surpass those of fixed income securities of equally rated issuers; and 4. Equity returns surpassed those of even junk bonds coming out of the last financial crisis in 1990. We have not addressed all asset classes in our comparisons. For example, certain distressed assets such as mortgage backed securities could offer a better return than our equities. We simply argue that deep value equities should feature prominantly in any asset allocation.

Implications for Pzena Portfolios Although expected returns on the equity of highly leveraged companies appear compelling, we have taken a cautious approach toward investing in non-financial companies with leverage. Our goal is to own businesses where viability is not in question and debt levels not excessive, yet they are very cheap. We have limited our portfolio’s exposure to the downside risk of leverage by investing in companies with strong balance sheets and solid business franchises that we believe will survive the recession, regardless of how long and deep, and prosper in the eventual recovery. As more of these opportunities outside of the financial sector have become available recently, they have become a larger percentage of our portfolios. We continue to have meaningful weight in financials, where leverage is inherent in their business model, as this sector continues to provide some of the most attractive valuations. We have, however, limited our financial positions to those situations where we believe there is compelling downside protection, whether through explicit gov-

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PZENA QUARTERLY REPORT TO CLIENTS | FOURTH QUARTER 2008

ernment support or in underlying assets. While fear grips the market, we have been able to find good businesses that we believe are likely to survive this recession (maybe even gain share as the weak disappear) trading at levels we have never seen. We have found numerous world leading companies at six times normal (we are featuring leading advertising companies later in this newsletter). In some cases we are buying companies for close to the price of the net cash on their balance sheets, paying almost nothing for the earnings power of the business. While we have no way of gauging timing, we are in the position at this point that further stock price weakness is just an even better opportunity in the medium to longer term. The universal market perspective today is that the near-term is bleak and there is not even a hint of pending recovery. History shows that opportunity is rarely obvious and even more rarely is it embedded in the short-term. The long-term perspective is difficult to embrace, requires patience and commitment and doesn’t work until it works. But the data sure says it’s worth the wait.

DISCLOSURES Past performance is no guarantee of future results. The historical returns of the specific 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 fluctuate over time. The specific 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, profitable.

FOR FINANCIAL PROFESSIONAL USE ONLY