In this episode of The Acquirers Podcast Tobias chats with Andrew Wellington, Co-Founder and Managing Partner at Lyrical Asset Management. During the interview Andrew provided some great insights into:
- Analyzability – Triaging Your Best Ideas
- Never Rebalance & Rarely Trim!
- The Future For Value Investing
- How To Truly Diversify Your Portfolio
- Characteristics Of A Good Business
- VQA – Value, Quality, Analyzability
- How To Screen For New Ideas
- Only Analyze Good Businesses
- Even God Would Get Fired as an Active Investor
- Founding Analyst At Pzena Investment Management
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias: Hi, I’m Tobias Carlisle. This is The Acquirer’s Podcast. My special guest today is Andrew Wellington of Lyrical Partners. He’s a deep value investor with a focus on quality and analyzability. We’re going to talk about how he constructs a portfolio, how he thinks about value, how he identifies value traps, and where he sees the future of value, right after this.
Tobias: I’ve heard of Lyrical quite a few times. What do you do at Lyrical? You have a value fund. Do you have a fund of funds as well?
Andrew: Yes. People get a little confused by that. Lyrical Asset Management, which is the business I cofounded, and I cofounded it with my longtime friend, Jeff Keswin. Jeff and I go back to when we were undergrads at University of Pennsylvania. We both were in a small dual degree program there called management and technology, which is where you graduate with a degree from Wharton and a degree from the School of Engineering. We were good friends in college. When we both got job offers to start working in New York City, we were roommates for two years. Jeff started out as investment banking analyst at Bear Stearns. This is 1990. I don’t think he liked that very much after a year. He got a job at an investment firm called Siegler Collery. A short while later, they hired another analyst. And then a few years later, he and that other analysts left and started their own hedge fund. They called it Greenlight Capital, and the other analyst is David Einhorn.
David and Jeff built that business into a very successful hedge fund. I’m not going to have the numbers exactly right, but after roughly 8, 10 years together, they split up. Jeff sold out of his half of the business. He started something called Lyrical Partners, a year or so later, which was his– It’s not a good word for it, but you can think of it as a family office, a business office, Jeff pursued a wide range of pursuits, including venture investing, and giving seed capital to other hedge funds. It also included a fund to funds. Around that time, I had been a portfolio manager running the mid-cap value strategy at Neuberger Berman. And this is the early 2000s, when for the older listeners out there will remember that’s back when value work.
Andrew: I was putting up some really great returns, and Jess said, “You’re a better stock picker than my friends that run billion-dollar hedge funds. Why you being an idiot and working for some big mutual fund company, you should quit your job immediately and start your own hedge fund.” I wasn’t really ready to make the leap at that time. As I was approaching my 40th birthday, at the end of 2007, it was before the financial crisis, but value stock starts to get cheap way before away. I was seeing a lot of opportunity out there. A lot of the things that hadn’t lined up before were now lining up. In late 07, and then really officially in ‘08, I decided to start my own firm. I knew I could pick the stocks, I knew I could run the portfolio, but run the business, run the office, the legal, the accounting, and most of my clients had been very, very large institutions that would never invest in a startup manager, where Jeff had a great Rolodex of clients and customers.
We got together and Lyrical Partners was still in existence, and it had a fund to funds and he was doing some things in real estate and he was still giving money to venture businesses, under that umbrella, I always joke, I wanted to call it Wellington Capital Management.
Tobias: It’s a good name.
Andrew: It turns out that name was taken.[chuckles]
Andrew: We came up with the next best thing, which is Lyrical Asset Management. Lyrical is kind of the label you could think of as Jeff Keswin’s alter-ego in business. If you really get to know the firm Lyrical is a great name for it because, well, it’s hard to put in precise words, it gets to the culture of the firm about– Jeff says Lyrical comes from– he wants to just do things with people after he left the hedge fund industry. Just do things with people, and that is kind of what Lyrical broadly is all about.
Founding Analyst At Pzena Investment Management
Tobias: You started though– before Neuberger Berman, you were at Pzena. You were a founding analyst at Pzena?
Andrew: I was, which is a very pompous way to say that I had spent five years in management consulting, knew absolutely nothing about investing. Therefore, I was cheap, I think.[chuckles]
Andrew: Rich Pzena, who came from Sanford Bernstein, I think, knew that he could take good people and train them to be good analysts. And so, yes, I was one of the original employees, retired to be at the founding. There were two analysts at the firm, neither one of us had worked at as equity analysts at the time. But, yes, I can claim to be a founding member of that firm. I really stumbled into an incredible opportunity. I didn’t know anything about investing, other than what I learned in my classes at Wharton. Asset Management wasn’t really a popular career path in the late 80s, and I was at Wharton, so if it was going to be popular somewhere, it was going to be popular at Wharton. A decade later, everybody wanted to go work for a hedge fund. In the late 80s, and I graduated in 1990, nobody was going there. It was all consulting and investment banking. I chose consulting, nobody even watched CNBC back then.
Tobias: Same as today.
Andrew: It’s harder for people to remember.[chuckles]
Andrew: After five years of consulting, I got this opportunity to join Rich Pzena, as he was starting Pzena investment management. It just seemed a really great fit this career path of analytics have it. It had a lot of the things I liked about consulting. It didn’t have a lot of things I didn’t like about consulting, like client handholding. Which now this year is seems to be all I’m doing.
Tobias: When Rich Pzena’s hiring for his firm, it must have been a conscious decision not to get guys who had a background in investing as his analyst. Why do you think that was?
Andrew: Well, if you go back to where he came from, Sanford Bernstein. At that time, Sanford Bernstein hired a lot of people at a consulting. A lot of the research department, there were former McKinsey and I was at Booz Allen. I think that was a labor pool he was used to recruiting from. The bad part of hiring a consultant is they don’t know anything about investing, but the best part about hiring a consultant is, they don’t know anything about investing. Now that I’ve been doing this for 25 years, and I met with people that have been investors at other firms as possible employees to hire, breaking– let’s not call them bad habits, but it’s difficult to change somebody’s style of investing. If it doesn’t match up with the way you want to invest, that can create a lot of problems. I think that’s why he looked for ex consultants to be his first analysts.
Tobias: Pretty good business analysts, consultants, that’s a lot of consultants have a lot of experience doing business analysis, but not so much the financial analysis. Is that part of the attraction, do you think?
Andrew: I think so. I’ll say I learned a lot of great things in management consulting, it provided me a fantastic toolkit of skills that have really helped me in the years afterwards. It’s a different kind of analysis, but it’s close enough. We’re talking five years, I’d worked as a management consultant, which if you do the math at graduate college, it means I was still 27. When I was 27, I thought I knew a lot. Now that I’m in my 50s, I realized how I didn’t know anything at 27. You’re still so early in your career, but, yeah, you come in with a lot of the core skills, you just are applying them in a slightly different way to the task of equity research. Fortunately, Rich Pzena was a great guy to learn how to be an equity analyst, how to apply those skills to the sphere of investing and value investing in equity research and analysis.
Tobias: When you shift from– you go to Pzena, to Neuberger Berman, and then you set up Lyrical, what is the investment style at Lyrical? What’s the philosophy? How do you characterize what you do? What do you take from say Pzena and Neuberger Berman?
VQA – Value, Quality, Analyzability
Andrew: We say the Lyrical way is VQA, stands for value, quality, and analyzability. I think of each of those jobs added one of those letters. At Pzena, it starts with value. That’s where I learned how to be a value investor. We are first and foremost value investors. Our goal at Lyrical is to generate the highest returns we possibly can. The way we know of to do that is through value investing. The way you generate high returns is to buy a business at a discount to what it’s worth. We don’t want to be just value investors, we want to be deep value investors, because the bigger that discount, the bigger the return you generate, if you’re right. So, that’s where value comes from.
When I went to Neuberger Berman, I’d spent five years at Pzena and I felt I learned a lot, enough that Neuberger was willing to hire me and make me a portfolio manager. That really was the appeal there of getting a chance to have, at that time a billion-dollar pool of capital and run it the way I wanted to. That’s where quality came in. What I noticed as an analyst at Pzena was that when I was analyzing a bad business that was volatile or had low returns on capital, I was wrong a lot. When I analyzed a good business, I was right a lot. It didn’t matter how hard I worked. What matters was, I’m right on the good businesses and wrong on the bad businesses. So, I didn’t want to work on the bad businesses anymore. It was liberating to the job I got at Neuberger Berman was to run the mid-cap value strategy.
One of the great things about mid-cap is there are no important stocks in the benchmark. In a large-cap, I mean, look at how much the five largest stocks in the S&P 500. They’re 20%, 25% of that index, they a huge factor in determining, so everybody’s focused on those five at the expense of the other 495. Mid-cap, no one stocks important.
So, you start with a totally clean sheet of paper, you just own what you want. You don’t have that other– those big components to distract you. I built a valuation screen, which I still use today. As I went through it, I noticed that say, in the auto industry, on my screen, we had back then Johnson Controls was in the automotive seating business, and you had them who had grown their profits for 15 straight years, had positive revenue for something like 45 years.
Right below that on the screen was Ford, or General Motors, which didn’t have anywhere near that kind of success. I would look at this, and why would anybody want to own Ford or GM, when they can own a much better business in Johnson Controls? That there were these good businesses amongst all the cheap stocks. They both have the same upside according to the model, so why don’t we analyze the good one, and have a better chance of being right, then look at these bad ones?
One thing that bad ones often had going for them was much larger market cap. If you’re going for returns and not trying to– we’re trying to maximize returns, not maximize weighted average market cap. And so that’s where quality came in. Then, I was forming Lyrical during 2008, which only a contrarian value manager would quit their job early and start their own firm in the middle of a financial crisis. Where everyone else saw terror, I saw opportunity. I didn’t know if we were going to raise a dime of capital, but I knew since inception returns were going to be really, really good.[chuckles]
Characteristics Of A Good Business
Tobias: How do you characterize a good business?
Andrew: We say the word quality, and I think quality means different things to different people, but it’s just a good label. I can say, it’s not important what your definition of quality is. For us, specifically, what we look for as the primary quantitative measure of quality is return on invested capital. It was two reasons why we look for return on– two rationales why we look at return on invested capital. One is, if a business invests money in itself and generates a poor return on that, then what kind of returned can you hope to achieve as an investor in that business? There is some logical connection between your return as an investor in a business and its return on invested capital.
Now, you could take a higher ROIC business, pay three times too much for it and still have a bad result. It’s really hard and you could buy something cheap enough that if it has terrible returns, you can do okay, but there is this linkage between ROIC, the returns the company generates on itself and what you hope to generate as an investor in that business. The other thing is the inverse of ROIC, which is capital intensity.
I’ve found what really helps being right as an analyst is investing in resilient businesses. Flexible businesses. When you have a lot of capital employed in your business, that makes you very rigid, your costs are rigid, your supply is rigid, you’re not very adaptable. When you do this for a long time, what you notice is that companies have high ROIC, not because of the numerator, but mostly because of the denominator. It’s capital like businesses that have high ROICs. It leads you to capital like businesses, which are more flexible, are more resilient. As the future unfolds differently than you expect, which happens all the time, every time. The business adapts, and it ends up that the change in results of the company are far lower or mitigated compared to the change in expectations.
Long-winded way of saying we define quality as return on invested capital, and somewhat related to that is you also want to avoid companies with excessive leverage on their balance sheet. Those are the two primary things we can quantify that we look for.
Tobias: You gave a presentation to the CFA Society where you were talking about value traps. You contrasted in the first instance, AerCap with UAL, which I thought was very interesting, because it’s not a comparison that I’ve seen before, but it makes complete sense. You show that UAL has these various years where it has hugely negative, it’s obviously very cyclical, whereas AerCap is not particularly cyclical at all. It doesn’t seem to move around much. Is that one of the things that you’re looking for, is that resilience? Or is that sort of an average ROIC over cycle? How are you thinking about that?
Andrew: Yeah, so that comparison, I like a lot because AerCap leases airplanes to airlines around the world. When we look at how the stocks reacted in the COVID pandemic, especially earlier this year, the market treated them the same. Yet, you look at the results, and they’re night and day. United Airlines earnings, I think are down something like 300% this year, they’re going from making money to losing 2X, or 3X of what they were supposed to make. While AerCap did just take a charge, it’s a non-cash charge, it’s basically a present value of an expected reduction in future earnings. Still, their book value is going to be basically flat this year. We’ve had the greatest crisis to ever hit the commercial aviation industry by a magnitude of 3X or 4X what the worst recession ever in history was, and their book values flat this year.
Tobias: Yeah, extraordinary.
Andrew: That’s a pretty– [crosstalk] If this didn’t do it, what the heck’s going to lower their book value? If you look back over the last economic cycle, their book value grew like 14% a year during the financial crisis. You got to really worry if the airlines are going to survive and make it. If all the airlines go bankrupt, that will definitely have a negative impact on AerCap, but they’re so insulated from that, that it will take a crisis, many times worse than what we experienced this year, to really negatively impact them. And yet, they have the same stock reaction pretty much, and AerCap still is trading at a fraction of book value. If this year didn’t lower the book value, what’s going to do it?
Tobias: When you implement your strategy, you have long-short portfolios, and long-only portfolios. Is that true? Am I characterizing that correctly?
Andrew: We don’t do long short. We’re just long-only. Long, short, maybe something, we looked at in the past, maybe something we look at into the future. Honestly, the world doesn’t seem to want long-short anymore.
Tobias: It’s tough out there for short.
Andrew: It is. Our original product is a concentrated US value portfolio, large-cap value portfolio. And then over the last years, we’ve developed and applied our US process to a universe of non-US stocks. And so, we look at the 1000 largest US and the 1500 largest non-US. What comes out of that is a global portfolio, which you can have either just the US version or the international version, or both. We’ve been doing US the longest, that’s where most of our assets are.
How To Truly Diversify Your Portfolio
Tobias: Let’s talk about concentration, diversification. What’s your definition of concentrated? How do you think about diversification in that context?
Andrew: Diversification is the best risk management tool. It is truly the only free lunch in finance. You want to take advantage of that because investing is about making predictions about the future. When you make predictions about the future, you’re wrong a lot. That’s just the nature of it. How do you protect yourself against it? You diversify.
It is a tricky balance. You don’t want to diversify. One way to answer that is we want to own as many stocks as we can that meet our acceptable criteria for investment. You don’t want to own things that don’t meet your criteria to get more diversified. There’s nothing out there that exists that we have to own for the sake of diversification. It’s not about what we don’t own. It’s about making sure we don’t know too much of any one thing that we do own.
The academic literature and the math will tell you that if they’re sufficiently different, as long as you have 30 something stocks or more, you’re pretty much achieving all the benefits of diversification that you get with 100 stock or several 100-stock portfolio. We’d like to own about 30 something stocks, which is what we do own. You’re okay at 25, but you start getting below that, you lose a lot of benefits of diversification.
Owning 33 different banks isn’t diversified. Wo we look at it from the industry point of view, we would like to have 33 stocks from 33 different industries. Our investment criteria are too difficult, too tough for us to actually find 33 stocks in 33 different industries, but we still end up with something like 27 or 28 different industries out of 33 stocks, and there’s some things we may own to have. Then, we have a hard rule, under no circumstances, no matter how great it looks, we will never own more than three stocks that do the same thing or exposed to the same thing.
When you get things wrong, when you get one thing wrong, you like to have one thing wrong. You don’t want to get one thing wrong, and have it be 10 stocks in the portfolio that suffer because of that.
How To Screen For New Ideas
Tobias: Right. When you are looking for ideas, how are you sourcing? How are you filtering? How are you validating?
Andrew: I believe the most important step in the investment process is idea generation. Everything comes from that. If you generate mediocre ideas, and you give it to the best equity analysts in the world, it’s going to be a mediocre stock that you know a lot about. If you give a great stock to a mediocre analyst, they may not do good work, but it still is a great investment. You’re only as good as the ideas that you can generate. I think it’s really important that you generate your ideas through– we think screening is the way to do it.
Otherwise, you don’t come up with– You mentioned a little earlier AerCap versus United Airlines. Well, you’re not going to find AerCap anyway, but screening, that’s not really written about in the papers, nobody’s talking about it. We think the best way to generate ideas is to screen, and screening is a skill. I think we have a really good screen, but it’s just a tool. If I gave that screen to 10 other investment firms, they would generate different ideas from it that we would because it’s how you use it, how you look at it. I like to joke, our screens like Roger Federer’s tennis racket. In fact, when I play tennis, I use the same model he did, it just didn’t work the same with my hands, it did in his.
Andrew: It is an effective tool. You can’t play tennis without the racket, but it’s how you use it that matters. You can use that screen and skip over all the ideas that we happen to find out of it. You can get stuck on the names all the way at the top that may be bad data or bad businesses and missed the one that’s on line 17 because you got busy with lines 1 through 10.
There’s a lot in how to use it, but without that screen, we couldn’t generate good original ideas and find– we could get into this more. Our goal of managing the portfolios, we want to own the 30 something best stocks we can find. When we find one that’s better than what we already own, then we sell one and we buy another, and that’s kind of how we manage the portfolio, and you’re not going to find the best ideas unless you have some good tool to do that. I think screening is just critical.
Tobias: I’ve seen AerCap in David Einhorn’s portfolio and it comes up in my screens to funnily enough. I think it’s one of the better opportunities out there. Right now, it’s certainly been popping up in screen. So, I agree with you. I think that as a deep value guy in mid-cap, it’s likely that we overlap pretty frequently on some of these names. Once you find these ideas on the screen, how do you then move forward to the validation process? What’s the difference between what’s in the screen and what’s in the portfolio?
Analyzability – Triaging Your Best Ideas
Andrew: It’s iterative process. I like to do triage. There’s some things that look good on the screen. After a little bit of work, you can quickly dismiss them because you see something like asbestos lawsuit, the research notes. Number one on our screen for a while was Pacific Gas and Electric. Obviously, screen wasn’t taking into account that they set the state of California on fire and might be liable for that.
The screen is a very good tool, but an imperfect one, and so you do a little bit of work and some of the names immediately and just keep– in some sense, you just keep doing work until you can’t dismiss it anymore. You keep looking for a reason not to own it. At some point, you’ve turned over every rock and stone and you can’t find a good reason. That’s a little bit of a simplification, but we have a team of four people, including myself, and we all go through the screen, and we all look for ideas. We will do a little bit of work and we’ll talk about what ideas look interesting, and we’ll agree on one name. That’s our top priority. Then, we actually all independently do our homework on it.
Some of the work will share, you don’t need for people to create the same spreadsheet. We’ll divide and conquer a bit. It’s hard to describe, but it’s traditional old-fashioned research, you study up on the business, you figure out what are the things I got to worry about? You try to build a financial model and think about what are the important stuff, you got to get right to get that right.
If the model says, it’s got good future earnings, and you can buy it at a low price. Most importantly, we haven’t talked about this yet, a concept we call analyzability. I can put numbers into a spreadsheet to come up with future earnings for any business, but for lot of them, I’m not going to believe it I could build a model on Citigroup. I’m now finally old enough, wise enough to know not to believe it, because they’re just numbers in a spreadsheet you’re making up, you actually can’t forecast it. You take something else.
One of the simplest businesses we have in the portfolio is a company called Crown Holdings, and they make beer cans and soda cans, you can model that. You can get that business right. You’re not going to get it right to the penny, but take bets, which stocks earnings do you think you’re going to get right, five years from now crown holdings, or Citigroup. Just one is inherently more analyzable, it’s easier to get right. It’s simpler, it’s more transparent.
That’s I think, a key thing that separates Lyrical. A lot of people have done a lot of work to study on what works in investing. As I was talking about earlier with stuff like quality, we’ve put a lot of thought into what works in research. The thing that works in research is analyze easy businesses, and you’ll get more of them right.
There’s a certain bravado in value investing that wants to tackle the really hard one with the most complicated financials. The more complicated is the harder the task, perhaps there’s more value hidden. Also, you’re much less likely to actually get it right. If you just look a little harder, screen a little harder, what you’ll find is there’s something just as cheap, with just as much upside, that’s a whole lot easier to figure out.
We’d rather work really, really hard to find easy investments. They’re harder to find, but when you find them, it’s a lot easier. You’ve still got to do the good fundamental research and figure out how the business works, what drives it, and get those assumptions roughly right. Again, the easier a business is, the greater your chances of getting it right.
Tobias: You say you’re looking for tractability, it needs to be understandable, no tail risks, so no asbestos liabilities, or liabilities [unintelligible [00:27:53] California a lot. Then, high returns on invested capital or higher than average returns on invested capital and [crosstalk] low price.
Andrew: I would just correct. It’s not high returns invested capital, it’s about avoiding low returns on invested capital. It’s about having a floor, our absolute floors 10%. Our preference is 15. I’d rather own a cheaper company with a 16% ROE than not cheap, not that cheap company with a 60. There really isn’t that much of a difference between 60 and 16. So, it’s more about avoiding the bad than it is about seeking the great.
Never Rebalance & Rarely Trim!
Tobias: Okay, that makes sense. You’ve got a position in the portfolio, it grows pretty rapidly relative to the rest of the portfolio. How do you handle that? Do you trim them back? I saw that in one of your notes, there was no rebalancing?
Andrew: Correct. We don’t rebalance. It’s because the data tells us not to. Right now, the data says not to, but it’s by a small margin, what we find is– we don’t rebalance, but we can test, what would our returns be if we did monthly rebalancing because we know all the stocks. We’re just changing the weights. Well, what if we did semiannual rebalancing? Or what if we did annual rebalancing? We tested all those. What we basically find out is, our returns end up the same. Within a very small range. Now from year to year, we’ve been around for 12 years or so. From year to year, some years rebalancing our returns would be one or two points higher, some years one or two points lower. Over 12 years, it’s almost entirely canceled itself out. Except the best scenario of all those by a small margin is the don’t rebalance at all.
Tobias: You don’t get taxed to, if you do that.
Andrew: Rebalancing has a lot of negatives when you do it. You incur trading costs, you have the potential for trading errors, it’s less tax efficient. There should be some provable positive that you are going after to offset all those negatives. I would say the data clearly shows that for us, at least, I don’t know about every strategy, but for our strategy, the data shows there’s no return benefit from rebalancing. Now some of that has to do with what we’re dealing with. We have a mostly equal-weighted portfolio of 33 stocks. When everything starts at around three, if it gets really big, what is it? Five? We’re not talking about–
Andrew: Well, let’s say it got doubled in size, it got to six. Now trimming something from six to three sounds like a big deal, doesn’t it? On the day you trim from six to three, 97% of your portfolio doesn’t change. How much is it going to really impact the returns. I think that’s why the data comes out he way it does is, when you look at this rebalancing, you really– it looks like you’re moving around a lot at the position level, but at the portfolio level, it just doesn’t add up to enough of the portfolio to really make a difference in returns. We choose not to do it.
Now, if something gets to be 10%, then we get nervous. We get nervous when you get to two digits of position weight. If it gets to 10, we trim it to 9. It goes up more and gets to 10, we’ll trim it back to 9. We just found through the numbers, I know philosophically, in a way it doesn’t make sense. Wait a minute, you had it at 5% when it was $10 a share, now it’s $20 a share, and it is bigger. Why do you own more of it when it’s less cheap? I don’t have an answer for that. Other than the data says it doesn’t change my returns. This is something we could very easily quantify and test. Let’s not waste time on all this rebalancing, let’s focus on getting as many of these 33 stocks right as possible.
Tobias: What about the opposite scenario where something goes against you, will you keep on buying to bring it up to equal one?
Andrew: We don’t trim things when they go up, and we don’t buy more when they go down. One, we get the best test of that because that is what rebalancing is just in a systematic way. Every time something goes down, you buy more, and every time it goes up, you trim it, that’s rebalancing. There are stocks in the past, we would have done better if we bought more, and there are stocks in the past if we bought more, we would have done worse. The rebalancing analysis shows that if we do this long enough, it’s going to end up with probably no difference at all. It also just, again, makes the job of being a decision-maker easier. We have one decision to make, in or out. Waiting is off the table and we just focus on– Do we still think this is one of the 33 best stocks we can own or not? If it is, it stays in.
When I was at Neuberger, I used to trade around my positions all the time. I’d look at my sheets every morning, and I’d say, “Oh, this one’s only two and a half. Maybe I’ll make that three.” Then I put in the order, and then I’d be watching the stock all day to see how did I do, did I buy it the low of the day? Then, I’d be tracking it for the next few weeks, like was it good to add there? When I did all this analysis, to see how much of a difference this stuff made, and found it made no difference at all, or actually probably was a slight negative. I took it out of the process and then what I found is, it was about lunchtime, and I was done with all my work for the day.
Andrew: Because I wasn’t wasting all this time thinking about trading, thinking about the order, tracking it. It’s a huge distraction. It just makes us– You don’t realize it, I didn’t realize it at the time how– if I estimated how much time it took my mind, I would have grossly underestimated it. It was only till I took it out of the process that I saw how much time it freed up. That’s time we now have to focus on just making sure the stocks we own are the right stocks to own, look for new investments and focus on the more important things.
The Future For Value Investing
Tobias: You’re a deep-value guy in the mid-cap space. It’s been a mixed bag for deep value and for value in the States in particular. The first decade of the 2000s was absolutely spectacular for value. The last decade has been quite tough. I think probably value and quality would have done quite well through to say 2018. The very beginning of 2018, and then it’s been a long grind lower since then. Do you have any view on what it would take for value to turn around or if value turned around already?
Andrew: Let me correct you on one thing. We’re not a mid-cap manager. I would describe us as a large-cap manager. I did run mid-cap at Neuberger, but our investment universe is the 1000 largest US stocks. So, I would say that is the large-cap and mid-cap universe. What will it take for a value to turn around? Right now, it looks like what it takes for value to turn around is the calendar to flip from March 18 to March 19. Right now, that looks like the bottom. You have the correct timing about value. If you looked at the value indices, it looks like they haven’t worked for 14 years, but if you look at what we think are better measures of value, like how did the lowest PE stocks perform, they outperform by quite a large margin from 09 through 17. Value is only been underperforming for about two years, 18, 19, and then a pretty nasty downturn in February, March of this year as the pandemic erupted.
Then, they bottomed on March 18. By our calculation, the lowest PE stocks in the US are up over 80% since March 18, that’s almost 30 percentage points better than the S&P 500. They’re in a big hole, so they haven’t completely dug their way out, but going up 80% in nine months is a good start. To my point earlier about the value indices, while the lowest PE stocks are up 80% and have outperformed by almost 30 percentage points, the large-cap value indices have underperformed the S&P. This isn’t new. The large-cap value indices underperformed the S&P over those nine years from 09 through 17, when the lowest PE stocks outperformed. Those indices aren’t great at capturing what value really is. It’s a shame because it’s turned a lot of allocators off of investing in value stocks, thinking it’s broken when it’s the indices that are broken, not value investing.
We did have this really tough period from 18 and 19. The tech bubble was worse for me. That’s the vantage of experience I’ve lived– this is now the third period, where values underperform that I’ve lived through. The first being the tech bubble and the second being the financial crisis, and compared to those two, this was a piece of cake. The tech bubble was more severe in terms of growth outperforming value. The financial crisis was just scary for everything. I was starting to think, what am I going to do for a living because I can’t be an investor in the stock market, that’s going away. Those are much scarier times than this.
Also, by far of this period, the worst performance was in 2018 for value. It was actually the best year for company earnings in Lyrical’s 12 year history. It was difficult to put up with the market action, but there really wasn’t much doubt that we own the right companies. Our companies were growing, they were growing faster than the S&P 500, just when their earnings went up, their multiples went down, and the stocks underperform. They weren’t facing any existential threats. It was easy to know as an analyst, you had gotten the right stocks right. It was just very trying for the business as clients grew frustrated with performance and things like that, to deal with that side of it
Tobias: Do you have any thoughts on what caused it?
Andrew: Caused the downturn?
Tobias: Just that little air pocket that value saw 2018, 2019, and a little bit of this year?
Andrew: Yeah. No idea at all. I’ve been thinking about this for 25 years, and I’m still no closer to finding why does value go through cycles? It is a mystery. It always seems to be. I think it’s a two-step process, I think. There’s the initial thing that happens, that gets value to underperform for a bit of time. That’s different every time. It could be economic fear, it could be falling in love with the internet for the first time. Something gets value to underperform enough that the second thing happens, which is the positive feedback loop of momentum. It’s a different trigger every time, which is why it’s hard to find a systematic cause, but something pushes value to the certain point where people start to give up on it. And that causes it to underperform some more, which causes more people. So, it’s a compound effect.
Something gets the ball rolling, so you got this boulder perched at the top of a hill. What gets it rolling is different than what keeps it rolling. What keeps it rolling is gravity or momentum, but what gets it rolling is just a really strong wind or just a slight little tremor, just something seems to happen. It’s not regular enough that you could actually trade around it, but if you go back and you study the performance of low value stocks, this happens about two years every 10 years. You got eight years of outperformance, in two years of underperformance. Sometimes it’s 12 and 1, sometimes it’s 7 and 2.
If you zoom out, we see this recurring pattern over the last 60 years that you get value outperformance for a while and then you get two years of retrenchment, and then it outperforms, and it’s okay because if you just held– the good years and the bad years all put together, you still end up with close to 500 basis points of outperformance over a full cycle. The down cycles tend to be more acute. The annualized returns are more negative then, but it’s just two years. And then you get very good positive returns over eight years. Eight years of compounding overwhelms those two bad years, but two years is enough to shake some people loose. That’s the challenging part of value investing. I don’t know why it goes through these cycles, but it clearly does.
Tobias: One of the things that I’ve observed, and I don’t know, it’s not necessarily quantifiable, but I think that value tends to sell off first. I think that in 2007, that was certainly true that I think value started dipping first. I think it’s longer bow, but I do think the late 1990s was value selling off.
Then there was a very big sell-off for the market and for the tech stocks, where value is doing quite well through that period, value just being long-only, you could be going up while the rest of the market was going down. I don’t know that we’ve seen the end of the cycle yet. Or maybe we have, but I thought that we’d seen– I think we’d seen a couple of years of sell-off before the market kind of woke up. I just wonder if it’s value investors being a little bit more disciplined about what they prepared to pay in the sense that they just the bid goes away for value when the market gets very frothy, so value starts retrenching.
Andrew: I think that might be right for one cycle. When you go back and look at these cycles, it’s always a different set of circumstances. It’s really hard to come up with one reason. You might be able to figure out what caused it this time. Although this time is the hardest one for me to figure out. I know value underperformed in 07 and 08, I know what to label that, that was a global financial crisis. Value underperformed in 98, 99, and I know what to label that, that was the tech bubble. I don’t know what label to put on this.
What happened in 18 that was different than 17. I still don’t know. I mean, you have the FAANGs, but this was way bigger than just the FAANGs. You take the FAANGs out of the market and you still saw it happen. I’m not really sure what was behind it this time. I don’t know what label to put on it. This one’s still a head-scratcher. Maybe it’ll be clearer in hindsight, but I doubt that too. We’re never going to know more about– we’re not going to remember 2018. It just really came out of the blue.
November, Thanksgiving 2017, we’re ahead of the market again. We get into 18, and low PE stocks underperform almost every single month of 2018. I think it was like 10 out of 12 months, they underperformed. It was just brutal. Our companies were beating earnings. Then, we had the best year. The highest percentage of the portfolio outperformed earnings expectations that year, is just one simple metric. In every other year companies in our portfolio that beat earnings, on average outperform by, something like 1000 basis points. That subset of the portfolio. Unfortunately, it’s never 100% of the portfolio. In that year, they underperformed the first time in our 12-year history.
Tobias: And so, they beat, and then underperform the market.
Andrew: Yeah, we disaggregated it. There’s a something in psychology called a feature positive effect, it’s hard to see what isn’t there. When you have a bad year, everyone wants to blame it on, “Oh, well, look at these bad stocks you own.” I say, “Yeah, but look at 2009, we had a great year, and look at all these bad stocks we own. We have bad stocks every year. We outperform most of those years.”
So, it’s not the bad stocks. What do we have compared to normal, and what we noticed was, we had a normal number of bad stocks, and they did a little worse than normal bad, but what really hurt our returns in 2018 was, we had an abnormally large number of good stocks from an earnings point of view. They did abnormally bad. It wasn’t the losers in a way that hurt us. It was the total absence of stock winners, even though they were earnings winners. I still can’t explain why that– I can tell you very precisely exactly how much that happened in the numbers behind what did happen, but the why is still a great mystery.
Tobias: In one of AQRs papers were the guys who would look at value investing, it’s not Cliff Asness, but some of his colleagues had looked at this and they just they create this system to test the relationship between fundamentals and performance. The way that they do it is they give it forward earnings a year in advance. It’s explicitly cheating to do this. Then they look at the performance, and if you get those results, you get a spectacular Sharpe and sorting out for the entire period, but there are two notable periods where it doesn’t work, and if anything, the sign is the around the other way. It was 98, 99, and it’s been 2019 and 2020 have been– the relationship is just not– it’s a negative relationship. So, the closer you’re tied to fundamentals, the worst you do.
Andrew: Yeah, I mean, that certainly is what it felt like. Wes Gray did a great paper a few years ago, I think he called it like the God Portfolio, or even God would get fired as a hedge manager, where he actually looked forward and said, “Who had the best earnings growth over the next five years? Let’s own those five years early, and even they had huge years of underperformance. The aggregate returns were insane.
He even pointed out that you couldn’t– even if you were God, you couldn’t invest in this strategy, because you’d fall out at such a high rate, you’d be bigger than the entire stock market. It was a great exercise to just so show that if you were perfect, you owned the 10 best earnings grow, even then you had bad years in that. I guess you could say quite provably the market does get it wrong from time to time.
Tobias: Yeah. Andrew, we’re coming up on time. If folks want to follow along with what you’re doing, or get in contact with you, what’s the best way to do that?
Andrew: Yeah, well, our investor relations contact email is firstname.lastname@example.org. We have a website lyricalam.com, where we have some of our investor letters and things like that. I will say most of our content is for our clients. We’re mostly an institutional investment firm, and also have a very significant portion of our assets come through the wealth management channel. We work very closely with wealth managers. We don’t put a huge amount out there. We don’t have a big Twitter presence or things like that, but some stuff is posted on those websites. If you are interested in some of that– we do a quarterly webcast update call for our clients. Some of that content is available if you contact the IR email box. Again, I don’t write as much as you do publicly.[chuckles]
Andrew: I’m glad you do, because this podcast, I love following your Twitter feed, you’re a great resource to follow to see what everybody else is saying in value land. It gets lonely in years like 2018. It’s great to see, “Oh, good, Cliff Asness is going through the same trouble we are.” He’s really smart, so he’s having trouble. I feel okay that we’re having trouble.
Tobias: There are fewer and fewer guys who want that deep value or value tag on them. Everybody’s just– I’m just an investor now, I’m no longer a value investor.
Andrew: Yeah, deep value, it’s a tough term. I’d say, we’re not your grandfather’s deep value, because we have quality. Amazingly, the companies we own have grown their earnings faster than the S&P 500 over the last economic cycle, even though they’re less than half the price. If things keep going the way they have been going since March 18, and especially these last few months, the markets always slow to come around to it, but it won’t be long before everybody’s going to want value again, and it’s going to be the hot topic. The hot thing to be just like it was in the first decade of the 2000s coming out of the tech bubble.
Tobias: Yeah, I certainly hope so. Andrew Willington, Lyrical Partners. Thank you for your time.
Andrew: This was fun.
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