The Future For Value Investing | The Acquirer's Multiple®

During his recent interview with Tobias, Andrew Wellington, Co-Founder and Managing Partner at Lyrical Asset Management discussed The Future For Value Investing. Here’s an excerpt from the interview:

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.