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Pzena Investment Management, Inc. Q2 2010 Earnings Call Transcript

All of these fears led to a broad decline in world equity markets as witness by a 12.7% decline in the MSCI world index and a flight from risk assets. The real question though is do these fears have any real impact on the long-term profitability of commercial business enterprises or are they simply a giant price discount that investor should pounce on.

I’m sure you can guess our view. The one constant fact that seems to be perennially ignored by investors is that companies are run by people and the people react to changing economic situations. If there is inflation, they manage for inflation, if there is economic slowdown, they manage for economic slowdown. And although unanticipated changes in economic factors can cause an earnings dislocation, it is rare that fully anticipated changes will cause a problem.

The current economic sluggishness has been widely and universally anticipated. Accordingly, companies are prepared. Operating margins and earnings are at or near record levels despite revenues which are significantly below recent peaks. Corporate leverage is below normal with many companies cash-rich and valuations are compelling.

History tells us that companies can manage through almost any economic situation as long as they don’t have too much financial leverage and funding risk. Over the course of the last 50 years, the return on equity for the S&P 500 has fluctuated around a very flat trend line. Companies have averaged a 13.5% ROE during economic booms and economic buffs, during high inflation and low inflation, during high tax environments and low tax environments, during high interest rates and low interest rates.

There is certainly no reason to believe that they won’t do it again. So the increase in volatility from this uncertainty has once again created a compelling opportunity for the value investor. As is usually the case, this opportunity is coming exactly on most investment committees and boards are demanding that the portfolios they oversee be structured to avoid another 2008.

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