In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Andrew Wellington discuss:
- Deep Value Investing with a Quality Growth Edge
- Lessons from Rich Pzena: Mastering Value Investing
- Why Price Matters More Than Quality
- Is Value Investing Still Alive? The Reality of Rerating and Market Patience
- The Flawed Construction of ‘Value Investing’ Benchmarks
- Why Do Some Stocks Stay Undervalued?
- Balancing Diversification and Concentration
- Why You Should Avoid Cyclical Stocks
- Why the S&P 500 Equal Weight Index Signals a Potential Shift
- AI CapEx Boom: Will Big Tech’s Spending Deliver Returns?
- The Power of Carbon: Innovation, AI, and the Hidden Chemistry of Growth
- Global vs. U.S. Investing: Market Inefficiencies and the U.S. Listing Premium
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: This meeting is being livestreamed. That means it’s Value: After Hours. Somehow the stream is working. Never know how it’s going to work. I’m Tobias Carlisle. Joined as always by my co-host, Jake Taylor. Our special guest today is Andrew Wellington of Lyrical– Lyrical Partners, Andrew?
Andrew: Lyrical Asset Management.
Tobias: Lyrical Asset Management. I had Andrew on when we were doing the recorded ones. You haven’t been on the live one. So, welcome to Value: After Hours.
Andrew: It’s good to be here. I’m an avid listener.
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Deep Value Investing with a Quality Growth Edge
Tobias: I like to hear that. Let’s discuss very quickly. Can you talk a little bit about Lyrical, and perhaps, your focus and how you may differ from other firms?
Andrew: Yeah. Lyrical Asset Management is a classic value investing investment boutique. We’re based in New York. We manage just under $8 billion. Our longest product is our US value portfolio. We’re now in our 17th year managing that product. And in 2009, we expanded what we do and we applied the exact same process we’ve been running in the US to the developed markets outside the US. So, for the last five plus years, we’ve also been running an international combined with our US portfolio as our global portfolio.
We also have one other variant which is a subset of our global stock portfolio. Our companies that are also making a positive impact from an environmental, an ESG perspective. And so, we have this even more concentrated product we call GIVES, Global Impact Value. That again, it’s a subset of our global stocks that are making quantifiable provable impacts. It really is the only value style product that we can find out there in that impact investing space.
Tobias: How do you characterize your process or your strategy? What are you looking at that distinguishes you from other people?
Andrew: So, I think what really distinguishes Lyrical from all of our peers, and maybe take a big step back, we’re still, what I would call, deep value investors. I know that’s a dirty word these days. People are running away from that label. [Tobias laughs] We will gladly be the last people out there labeling themselves as deep value. The average PE of our portfolio at year end was 12. That’s about 10 multiple points less than the S&P 500. That’s real value. Not one of these value and name only products out there that’s really more GARPy. But what’s really– [crosstalk]
Jake: I know. That’s a good one. I have heard that.
Andrew: [chuckles] VINO, VENO
Jake: Yeah. Yeah.
Andrew: What’s really different about us versus our other deep value peers though, is what we call, our uncommon combination of both deep value but also having quality growth. So, if you look at the growth profile of the stocks in our portfolio, you look over the last economic cycle, the companies we own, even though they have just a 12 PE, they’ve compounded their earnings on average at 9% a year. Now, that may not sound that impressive to a growth investor, but the S&P 500 has only done seven, and the value index has only done five. So, we have found companies, we call them the gems amid the junk, companies with earnings growth as good or better than the S&P 500, but still trade at huge multiple discounts.
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Why Do Some Stocks Stay Undervalued?
Tobias: Why do you think they trade at those discounts? Why do they tend to? Why do you get the discount?
Andrew: Yeah, that’s the billion-dollar question. There’s a lot of reasons why companies trade at discounts. They have problems. Ours mostly don’t have problems. They’re just unpopular. The best explanation seems to be they’re ignored. They’ve slipped through the cracks. They may be misunderstood. Some of them have controversies swirling around them, but they’re controversies about what might happen in the future, not really anything bad that’s happening today.
The typical value stock does have bad things happening today. It does have depressed earnings. Those are good investments too, but we find the better investments are the cheap stocks that don’t have anything wrong with them that are just misunderstood or ignored. As anyone that’s been in the value space, there seems to be a lot of that out in the market today of companies that nobody cares about their fundamentals.
Jake: Andrew, do you feel like that that is often like exclusion from indexes part of the equation of being ignored?
Andrew: Yeah, I think that contributes to things. But our universe is mostly in an index, either the Russell1000 or even the S&P 500. Now, with so much weight in the Magnificent Seven, anything outside of that has a pretty low weight. But one of the things we found, it’s not what we look for. But when we look at all the stocks we’ve owned over the years, one of the things we find they tend to have in common is they’re peerless.
I mean that in the literal sense. They don’t have a good peer. And so, I don’t think the market really knows how to value businesses. It takes shortcuts. It doesn’t really know how to take a cash flow, and do a DCF and come up with a number. So, the market tends to take shortcuts.
And so, you look at this company versus its peers, and so what are other companies that do the same thing, how do they trade. Or, when that’s not there, you look at the history. Well, if the stock’s been cheap for five years, the history will give you a false reading, and you’ll think of it as being undervalued. But we own a lot of companies.
So, just off the top of our head, one of the stocks we’ve owned for a really long time is Ameriprise. Very simple business, wealth management and asset management. There are certainly many competitors out there that also do wealth management. You’ve got Morgan Stanley, you’ve got Merrill Lynch, you’ve got UBS.
Merrill Lynch doesn’t exist as a stock. It’s part of Bank of America. When you buy Bank of America, you’re not really getting wealth management. It’s a tiny piece. When you buy Morgan Stanley stock, you’re only getting a tiny piece of wealth management. So, there are no real comps, even though it’s a pretty simple business that everybody knows.
And so, I don’t think the market really knows how to value it, or at least it– Now, just because you don’t have peers it doesn’t mean you have to be misvalued. You could just as easily be misvalued too high or too low, but I do think that contributes to stocks getting misvalued is if they don’t have clear comps or peers to compare themselves to.
Jake: Yeah, it makes sense too, if the less– The number of analysts, the number of names that they have to cover now has gotten pretty diluted. So, if you just have to take a lot of shortcuts in order to cover a ton of names, you can see how these things would just get thrown into these big baskets and lumped together. And now, those all trade at this PE.
Andrew: Yeah, just another one that popped in my head. We own a really interesting company in the insurance phase called Primerica. On the one hand, what they do is incredibly simple. It’s very low-end term life policies to the lower middle class mostly. But they don’t really retain any of the risk. Almost all of it’s reinsured. It’s mostly a distribution business. It’s mostly about originating the contracts. There’s no other business model like this at all in life insurance.
So, they’re not getting a huge amount of money from their investment portfolio. They’re not doing huge policies. And so, it just doesn’t look like any other life insurance company. It’s got far better economics. It’s much less capital intensive. It’s got way better growth. But I think one of the things depressing its multiple, is that all of its peers are much worse businesses. And so, it’s hard for the market to see through that. That’s how you get a company that’s compounded its earnings at over 15% a year for 15 years at a low PE.
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Balancing Diversification and Concentration
Tobias: Andrew, when you are constructing your portfolios, how do you think about diversification and concentration? How big do you like a position to be or how do you look at sector and industry concentration and so on?
Andrew: Yeah. Most of the things we do, we’re really bottom up in the way we think about that. We never want to get something big wrong. The only way I can absolutely guarantee we never get something big wrong is you never make anything big. [Tobias chuckles] I haven’t figured out how to not be wrong part.
Jake: The math checks out.
Tobias: Yeah, that’s how I do it too.
Andrew: So, we look for these value opportunities where it’s a really good business with good growth at a cheap price. We start with a universe of a thousand stocks. What we look for is incredibly rare. There’s not 100 of these. There’s not even 50 of them. We struggle at times to find 30 or so of them. And so, what we don’t want is to have–
Right now, everything related to the auto sector is really cheap. We want this to be the Lyrical Value Fund. We don’t want this to be the Lyrical Automotive Fund. And so, if there is a great opportunity in the automotive sector, we’ll own one, we’ll own two. If they’re different enough, maybe we’ll even own three. But that’s our hard ceiling. We never want to have more than three stocks that are exposed to the same driving factor that are from the same industry. And so, we end up with a portfolio that typically has 33 stocks and typically has represented in it maybe 26 to 28 different industries.
Again, we don’t want to overweight anything too much. So, our max position size at cost is 5%. We want to look for good companies at cheap prices, but beyond that, we want to own as many different kinds of good companies at cheap prices as the market opportunity set gives us.
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Why You Should Avoid Cyclical Stocks
Tobias: You mentioned your deep value, but does that mean– Do you look at cyclical industries? Do you look at oil and gas, for example, which I think that looks cheapish to me at the moment?
Andrew: A lot of it looks cheap, but you’re not really sure, because the earnings are all over the place. That’s the problem with cyclical industries. So, this is now my 30th year being a value investor. I look back over the hundreds of investments I’ve made over those 30 years. A lot of them have worked out, that’s why I’m still here today, but a whole bunch of them haven’t worked out. Every single one of those stocks for 30 years was cheap when I bought it. The thing that separates, the only thing that separates the successes from the failures is down the road we get the earnings about right. If we got the earnings about right–
We didn’t have to get it exactly right. We had a big margin of safety. If we thought the earnings are 5 today and we think they’re going to 10– If we’ve got 10, that was great. If we got 9, good enough. 8, still good enough. You get 2, it wasn’t cheap enough. I guarantee you that. [Jake laughs] Nothing’s cheap enough for 2. And some of them you get two or even worse. So, you got to get the earnings right.
Now, when something’s really cyclical, it’s really hard to get the earnings right. If the earnings fluctuate from 1 to 10, you can’t just say like “Oh, 1’s the low, 10’s the high. We’re going to value it on five and a half.” That’s not good enough. And so, we tend not to invest in things where the earnings are wildly cyclical. Yes, in a recession, their earnings go down for a year or so. That’s not quite the same thing as cyclical. And so, we do tend to stay away from all those basic materials.
The other thing is when something’s really cyclical, it tends to be a lower quality business that has bad long-term growth. So, all those other bad things tend to come along with being cyclical, and so we avoid those kinds of stocks completely.
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Why the S&P 500 Equal Weight Index Signals a Potential Shift
Tobias: Have you seen with the most recent outperformance to all of the very biggest names in the market that there is a pronounced discount now as you get towards the smaller end of the market?
Andrew: Not even the smaller end of the market, just outside the top 10. So, one simple way to do this is just look at the PE on the S&P 500 Equal Weight Index. It’s all the same names, just each one gets, what, 0.2% instead of whatever the cap weighted weights are. And at year end, the S&P 500 was what, 21 times, I think and the Equal Weight Index was 16.5, which seems really reasonable for the overall market. So, there’s so much skew. It is the Magnificent Seven, but it’s way bigger than that. It goes far beyond that.
Jake: Talk a little bit about your letter about the– What it would mean if the market cap weighted was to go back to where the equal weight is today and what that would mean then for returns? I thought that was rather sobering the way that you calculated that.
Andrew: So, right at year end, the S&P 500 PE was about 32% higher than the Equal Weight Index. And people say, “Well, maybe that’s deserved,” because I’m sure the Cap Weighted Index has had much better earnings growth with the Magnificent Seven, and Nvidia and all these amazing stocks. The Cap Weighted Index has to have grown faster. But when you actually look at the earnings history, it hasn’t.
So, we had 15 years of data on the earnings growth of the Equal Weight Index, and we split it up into two halves. And for the first seven and a half years, the Equal Weight Index grew about 2% points a year faster than the Cap Weight Index. Even with that, they had about the same PE, the entire time. But even then, there was a little bit of PE multiple compression where the Cap Weighted Index went from a 2% discount to an 8% premium. But for the most part, they had about the same PE, even though the Cap Weighted Index grew more than 2% points a year slower for seven and a half years.
Then we look at the last seven and a half years, and it’s a little better for the Cap Weight Index, but only because it’s grown exactly the same rate as the Equal Weight Index. So, there’s been no better earnings growth at all. But it went from basically parity to a 32% premium. It’s multiple, not earnings, better earnings growth.
Well, maybe the market’s looking forward. It should be looking forward. But even then, when you pull up the consensus estimates, they do have the Cap Weight Index growing faster, but only about 1% a year faster for the next couple years, and who knows if that will be right. So, there really isn’t a fundamental case that supports the Cap Weighted Index being such a high premium over the equal weight.
So, we ran the math. What if they converged? Over the next five years, what if we ended up both at the same place, 16.5? When you do that– I think that the number came out to be around almost 40 percentage points of cumulative underperformance, about 600 basis points a year of underperformance for them to end up if they had the same earnings growth and the same PE at the end of this period.
Now, that seems like a huge amount of underperformance. But then, we went back and looked at every other time when the Cap Weighted Index had outperformed the Equal Weight Index by that much. And if anything, that history says, it’s usually a little bit more than 40 percentage points. So, it all looks really bad for the Cap Weighted Index. That said, what’s most likely to outperform tomorrow? Probably the Cap Weighted Index. Momentum is way more powerful in the short run. But things that cannot go on forever don’t. Although, we as value investors know they often could go on far longer than we like.
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Tobias: Do you think that that’s a product of that flows? Does that appeal to that argument, the passive flows to the Cap Weighted Index?
Andrew: That’s the most common thing I hear, but I put on my math hat and it doesn’t seem to make sense. Why are the seven biggest stocks outperforming the next seven stocks by so much? You should see much more uniformity across the biggest names in the S&P 500, if it was just flows into passive.
Tobias: That’s a good point.
Andrew: The big seven mostly have an AI story, and so there’s a lot of enthusiasm about that. Somehow the market says, “They’re all going to be winners and there’ll be no losers in all this.” That doesn’t typically happen. But no, I don’t think passive is–
Jake: [crosstalk] to all of the other ones, and yet they’re in competition as far as profit pools and yet somehow, they’re all going to win?
Andrew: That’s what it seems to be in the stock prices, but it makes no sense to me that I don’t know which ones will win. But I don’t think it could be all of them.
Tobias: JT, you got a little buzz in your microphone there. Can you maybe turn on, turn off again, restart.
Andrew: It’s not just the Magnificent Seven either. I’m sure you guys have looked at– I mean, have you seen Walmart or Costco?
Tobias: Yeah.
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Why Price Matters More Than Quality
Andrew: Walmart’s multiple is just exploded upwards. It’s a great company, but what have they done lately? For the last 15 years, they’ve grown their earnings, what, 5% a year? That’s slower than the S&P 500. Costco has been a better company. It’s grown its earnings like 12% a year, but its multiples exploded into the 50s, and you just can’t make that work.
There’s been a defensive shift and you look at some of the food companies or Staples. They’ve got higher than market multiples and they haven’t had any growth for the last 10, 15 years. Procter & Gamble and Coca Cola barely grown their earnings at all and are trading at market premium. So, again, this mega cap phenomenon goes– Magnificent Seven is the bulk of it, but it’s bigger than just the Magnificent Seven. There’s a lot of froth in that space.
Jake: Andrew, what would your counter argument be to the hypothesis that you really want to own quality, especially if maybe you’re going into a downturn economically, which you hear pretty often?
Andrew: So, whenever you say you really want to own quality, as a value investor, you don’t want to think about quality first. It’s always about price. I think Costco is a really high-quality company with really good growth, but I don’t think it’s a good investment at 50 times earnings. So, got downturns. Lots of thoughts about downturns because as a fundamental analyst, as a long-term investor, you got to think about downturns.
I would think we probably think about it more than most other investors, because our average holding period is over seven years. And so, the odds of there being a recession next year aren’t that high. The odds of there being a recession over a seven-year period start to get to be over 50%. So, we’re thinking about downturns from before day one of owning the stock.
Jake: I’m sure you predicted nine of the last five– [crosstalk]
Andrew: [chuckles] Exactly. So, one, if you do the DCF math on a downturn, downturns are actually pretty irrelevant to intrinsic value. That’s not the way the market reacts. Let’s say, a stock’s got a 15 PE and you lose a whole year’s worth of earnings, for one year, earnings go to zero and then they come back. Well, the right value for that should now be 14 times earnings. You just take one point off the multiple. And so, that’s a pretty small change in the valuation of the business and maybe even less.
Earnings don’t usually go down 100%, the financial crisis earnings fell by 30%. So, now, you’re talking about going from 15 to 14.7. That’s again even saying like, was that not even considered? Maybe 15 is the right number, because it would be 15.3 without that.
So, one, market reactions to recessions are way overblown. Our stocks are really unpopular. And so, we do find sometimes they react more severely in the marketplace to a downturn. But if we actually look at how the companies have behaved, our portfolio is less economically sensitive than the S&P 500. You can look at how the companies we own today, of the ones that were public in 2008, 2009, their earnings went down way less than the market’s earnings did. Again, we don’t own those deep cyclicals. We stay away from those things.
We can look at the COVID period, not your typical recession. But even there, we weren’t any more economically sensitive. But you get these knee jerk reactions in downturns. There’s no way to know what the market’s going to overreact to. So, we tend to take the point of view, anything that’s temporary doesn’t count. We just think like, “Okay–” Again, five years from today, if $5 of earnings gets to be $10, we don’t know what path it takes. But as long as they get to $10, we’re okay.”
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AI CapEx Boom: Will Big Tech’s Spending Deliver Returns?
Tobias: Whether it’s the seven or some subset of the seven have these plans for enormous. CapEx expenditures over the next several years. I think the aggregate number that I saw was something like $300 billion which just– I don’t know how they’re going to deploy that over that period of time. And then, I saw yesterday, I don’t know how impactful this actually is, but Microsoft seems to be scaling back some of its data center investments. Do you have any view on whether that CapEx is likely to result in returns that they have seen historically, and what Microsoft’s little move there might be forecasting?
Andrew: Not really, but I’ve seen good work by other people. So, it might have been our mutual friend and your recent guest, Dan Rasmussen. It might have been him or it might have been someone else on Twitter I saw. So, my apologies if I’m not giving the right person credit. He looked at all this CapEx, and then you backed into well, like, that CapEx, what kind of margin do they need to earn on that and what percentage of the data center is all that?
They backed into what is the revenues you need from AI for that to be as profitable as their existing businesses. It was some extraordinary number that were at less than 10% of the way there. So, it sure sets an awfully high bar. And then, the multiples are high on these companies. So, if they get all of that, you’re just paying a fair price today. So, the odds are stacked against you.
Now, we’re not long short. We don’t have any negative bets about these things, but they don’t appear as attractive as the boring companies we own. Many of them growing as fast as some of these Magnificent Seven stocks. They’re just trading at 12 PEs instead of 30 PEs.
Tobias: Yeah. I thought it looked a little bit like the late 1990s in the sense that it was a market that was more concentrated and large in growth, rather than a– We think of the late 2000s being a dot-com, but really it was large growth. And similarly, now, we think of it as being Mag Seven, but really it’s large growth. It’s funny that it’s the same Walmart again, Costco, those same characters, like they don’t really fall into the tech story. They’re just large growth companies.
Andrew: What does Warren Buffett publicly talk about– One of his biggest regrets was not selling Coca Cola when it was 60 times earnings. I’d say, if you’re a real value investor, you should have been long gone at 30 times earnings, let alone 60. [chuckles] Coca Cola with 60 times earnings, how can soft drinks possibly grow fast enough to justify a 60 PE? So, yeah, it was a tech bubble. That’s what people remember. I lived through it.
As a value investor, I have the scars of being basically flat in 1999, as everything else was going to the moon. We couldn’t get fired fast enough, and then just see everything change and then value mattered again for the next decade after that. But it was way bigger than just a tech bubble. That’s a convenient label for things. And tech was absolutely insane, some of the valuations being given there. But it was a NIFTY 50 bubble too. Today, rhymes, it’s always a little different. It never plays out exactly the same, but there’s speculative excess sure seems likely.
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Jake: In fairness to the old man, I think he’s clipping something like 40% of his original cost basis in dividends a year out of Coke still. So, [chuckles] he’s doing okay.
Andrew: Yeah. But what if he sold it and bought something better?
Jake: Yeah, sure. It could have been.
Andrew: It could be 45%.
Jake: Yeah.
Tobias: He’d have a few billion dollars more in cash, probably.
Jake: Yeah. They didn’t have Fartcoin though, back then, so we’ve got a lot more better options.
Tobias: Do you think that’s where a lot of the speculation goes into those coin offerings?
Andrew: I know even less about that than–
Tobias: Yeah. We’re the wrong three guys to be discussing that, so everybody’s coming here for the crypto discussion. Let me just give a quick shoutout to the folks who are playing at home. Johnny Airport in Mendocino, California. Boise, Idaho. Brandon, Mississippi. Tallahassee. Helsinki, Finlandia. Mac’s in Valparaiso. Tampa, Florida. Jupiter, Florida. Congrats, Sam, you’ve won again. Thessaloniki, Greece. Waipa, Australia. Is that real? Weipa. Toronto, Oregon City. Bellevue. Tampa. Toronto. Savonlinna, Finland. Dubai. Gothenburg, Sweden. There’s got a little jump there. Sorry.
Jake: Don’t read anything on the teleprompter, guys.
[laughter]Tobias: Ligmaa’, Portugal. Sure, that’s a real place. Lausanne, Switzerland. London. Someone in the 51st state. Gothenburg, Sweden. Did I say that? Torino. Vancouver. Jupiter, Florida. Where are you coming from, Andrew? You’re in New York City, NYC?
Andrew: New York City. Close to Columbus Circle. That’s where our headquarters and offices are.
Tobias: Yeah. What’s it like working out of New York as a value guy?
Andrew: The only thing I’ve ever known. It’s the world capital of finance. This is where everybody is. So, I don’t know any different. I grew up in the suburbs of New York City, out in New Jersey. So, this has been my home for all of my life, except for four years, I went away to college.
Tobias: How’d you get started?
Andrew: And even then, I was only about 100 miles away, so I’m not exactly– I haven’t traveled as far from my home as you have, Toby.
Tobias: [chuckles] How’d you get started? How’d you get into the business?
Andrew: I got into the business through dumb luck, which is– It’s a great way to get into it, but it’s not a repeatable approach. [Tobias laughs] I was toiling away as a management consultant at Booz Allen Hamilton. That’s what I had spent the first five years of my career after college was in management consulting. I got a headhunter call about an analyst job at Sanford Bernstein. It really appealed to me. There were a lot of things about consulting I liked and a lot of things I didn’t like.
The equity research job had a lot of– The things I liked about consulting without a lot of things I didn’t like. Namely, in consulting, you think you’re right and then you have to convince your client to do what you say they should do. In investing, you think you’re right, and then you just put your money where your mouth is, and the market tells you whether you really were right or not down the road.
While I was waiting to hear back from Sanford Bernstein, I get a call from a guy I never heard of out of the blue. His name is Rich Pzena, and he says, “I just left Sanford Bernstein, and I found your resume in the reject pile. And I was wondering, would you like to come talk to me about a job at my brand-new firm?” I ended up becoming his first equity analyst back in January of 1996, 29 years ago. He’s been a great friend and mentor for those 29 years. But that’s how I got into this. I feel very fortunate. I just really enjoy what I do. It fits with the way my brain works. Now, it’s hard to imagine how I could have been doing anything else.
Jake: That’s so cool. It’s a fake joke, but supposedly, at Goldman, there was this giant stack of resumes. There’s two guys there and they’re trying to figure out how the hell are we going to sort through all of these to decide who we want to hire. One guy goes, “I got an idea,” and he takes it, and he grabs half of the pile and he throws it in the garbage. And then, the other guy’s like, “Why’d you do that?” He said, “Well, I wouldn’t want to hire anybody who’s unlucky.” [Andrew laughs]
Tobias: I think you took yours off the top of the pile.
Jake: Yeah. [crosstalk]
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Lessons from Rich Pzena: Mastering Value Investing
Tobias: They were going to hire and then just said, “You’re going to be rejected.” What did you learn from Rich?
Andrew: From Rich, I learned all the fundamentals. I knew about business. I’d gone to The Wharton School of Business as an undergrad. I had the raw tools, but I had never done research and analysis. So, at the core of what we do, as I mentioned before, you got to get the earnings right. So, that is about how do you research a company and ultimately convert that to a forecast of future earnings that has a chance of actually being right.
Anyone can build a model. Building a model that’s right is a lot trickier. And so, that’s a learned skill, how to think about businesses that are currently having problems, and what kinds of problems are temporary and fixable, and in you’re modeling, what should the margins be in the future? How do you think about that? How do you break down income statements, balance sheets, cash flows, build models that work.
It’s amazing how many models I see on the sell side that don’t add up. They have all these profits for years and then the balance sheet, no debt gets paid off, no cash accumulates. It all has to fit together. So, it’s not exciting stuff, but it’s crucial table stakes skills you have to learn and develop if you ultimately want to be successful as an investor.
The other thing was learning how to be a value investor, which is different than being analyst. And in a way, it didn’t feel like it at the time, but I’m blessed that I was there for the years leading up to the tech bubble, through the tech bubble and then for a year on the other side. So, got to be there to see our beliefs get questioned, see everything go against us, see how holding firm paid off and then ultimately get that payoff and see how everything was right.
And then, I Left there in 2001 for the chance to run my own value portfolio at Neuberger Berman, but the core foundation on which everything else in my career has been built was established in those years at Pzena. It was a really small firm at the time. It was roughly zero dollars and zero cents in assets on day one. It was a little over a billion by the end of year five when I left. But I got a lot of one-on-one time with Rich. Very humbling in the early years, trying to figure things out. He’s just so smart and such a good analyst. I’m very lucky. I got trained really well.
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Tobias: Yeah, I was sad to see that stock get taken private. I thought it was too cheap too when it went private. Somebody in the comments suggested that you got RFK spasmodic dysphonia, JT. [chuckles]
Jake: What the hell does that mean?
Andrew: Make America value again.
Tobias: That voice box is very robotic. Andrew, take us through that most recent letter of yours. You looked at some interesting things. One of the things we were talking about was the indices. Just the value indexes. You said, one of your favorite things to do is just to show what’s wrong with the value indexes. So, what’s wrong with value indexes?
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The Flawed Construction of ‘Value Investing’ Benchmarks
Andrew: Yeah. As an investor in the large cap value space, we are both blessed and cursed with having, perhaps, the dumbest indices ever created. And so, we’re blessed, because it sets a really low bar for us to be compared to and it makes us look smarter, because our index is so poorly constructed. The negative side of it is the index has done so poorly for so long that so many investors and client prospects have lost interest in the category altogether. Because you read stories about how value’s performing in the Wall Street Journal or they’ll talk about it on CNBC and they’re talking about the value index. The value index is not value stocks.
So, when I think of value stocks, I think of stocks with low price to something multiples. We focus on earnings. So, low PE stocks. Our best proxy for how’s value doing is how’s the cheapest 20%, a Fama and French approach, but using earnings instead of book value, how’s the cheapest 20% by PE performing? We can go back in time and look at how that cheapest quintile has done. If we go back to 1979 and we pick that odd year, because that’s when Russell and S&P created their value and growth style indices, that’s how far back their track records go.
So, since 1979, it’s been 45 years, if you own the cheapest stocks, the cheapest 20% just every quarter, but half a percent in the cheapest 200 of the top 1000 lather, rinse, repeat, you would have outperformed the S&P 500 over this 45-year period by 350 plus basis points per year. You compound over 45 years at that and it results in a huge, I mean, more than an enormous. difference in wealth.
Yet, over this same exact 45-year period, the Russell 1000 Value Index has underperformed the S&P 500 by about 60 basis points a year. So, it didn’t just outperform by less. It’s not just diluted. It managed to fail when value stocks had been incredibly successful. Probably, no one’s given value a better name than Warren Buffett, and probably, no one’s given value a worse name than the large cap value indices. One of the biggest–
Tobias: What’s wrong with the index? How are they constructing them?
Andrew: I think one of the most eye-opening facts about the index– So, you’ve got the Russell 1000. Russell divides that and puts half the market into growth and half the market into value. So, how many stocks are in the value index?
Tobias: Less than half.
Andrew: People say, “All right, maybe five–” We’re defining value as the cheapest 200. If you take the bottom half, maybe you think there’s 500 out of a 1,000. But no, there’s 870 stocks in the Russell 1000 index. [Tobias laughs] So, it is not an index that focuses on the cheapest stocks. It is an index that owns everything, except for 13% of the absolute most expensive. It’s a core index that owns everything, but the most expensive stocks. It’s not a value index. So, exhibit one, 87% of the stocks are in the value index. That can’t be a style index–
Tobias: Is it market capitalization? Is that how they’re making a dividing line by it? So, it’s half the market capitalization in growth and– [crosstalk]
Andrew: Exactly. They want to put half the market cap into value and growth. When you’ve got trillions and trillions in the Magnificent Seven, it takes hundreds and hundreds of other stocks. So, yeah, the cheapest 200 are in the Russell1000, but then there’s 670 more.
Another thing is just cap weighting itself. Cap weighting, you look at the performance of Equal Weight Indexes versus. Cap Weight, and even with the last couple years where it’s gone the other way, Equal Weight tends to outperform Cap Weight. It tends to be even more significant in the value space than in more expensive stocks. And so, if it was just an Equal Weighted Index of those 870 stocks instead of Cap Weighted, about half of its underperformance would go away. So, Cap Weighting in the value index also has been really destructive.
There’re a few other things they do too that make it nonsensical. So, we like cheap stocks with high growth rates. What they do is they give everything a value score and they give everything a growth score. And so, if you’re really cheap, you get a high value score. But if you’re cheap with good growth, you also get a good growth score. And they say, “You know what? Well, let’s split you. Let’s put some of you in the growth index, some of you in the value index.”
So, if you added up the constituents in growth, plus value, you don’t get a 1,00. You probably get more like 1,350 because of the double counting. It’s not double counting. They split them. But they’re underweighting the very best value stocks, the cheap ones with good growth, and they’re overweighting the cheap stocks with bad growth.
And then, you have the other extreme. You have some stocks out there that have bad value scores, but they also have bad growth scores, like consumer staples. We talked about Coca Cola and Procter & Gamble. They have high PEs and low growth. So, because they have a bad growth score, some of that gets into the value index, even though they’re expensive. And so, that doesn’t help returns either.
That said, even a blind squirrel finds a nut every now and then. When real value’s out of favor, like 1999, like 2008, like 2018, if the value factor is really out of favor, the value index will, in a way, benefit by comparison by not being very exposed to value. So, in the worst years for value, it’s going to be tough to beat that index. But over the long run, it’s clear that, what we tell, you can be active, you can be passive, you can do value, you cannot do value. But the one thing you absolutely do not want to do is be passive in large cap value, because the options are really poor.
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The Power of Carbon: Innovation, AI, and the Hidden Chemistry of Growth
Tobias: JT, do you want to do your veggies? See if we can see how that microphone goes.
Jake: Sure. It’s okay.
Tobias: It’s got some dysphonia. It’s got that spasmodic dysphonia. Have a go.
Jake: All right. We’re going to be talking about carbon today. We’re bringing some science in, and we’re going to open today’s veggie segments with a scene from 1772. And this guy, scientist Antoine Lavoisier, who is often called the Father of Modern Chemistry. He stood in a courtyard in Paris. He’s squinting under a brilliant sun. And in front of him was a glass jar with a handful of glittering diamonds inside of it. Around this jar, he positioned several massive magnifying glasses, and they were focusing the power of the sun onto a single point inside the jar. Onlookers watched in stud disbelief as the diamonds eventually vanished without a trace, leaving behind just a faint trail of gas.
This novel experiment proved that diamonds were actually made of carbon, and contrary to popular belief at the time, they weren’t indestructible. Lavoisier, he forever altered our understanding of both chemistry and the nature of eternal jewels. [crosstalk]
Tobias: JT, do you want to try it without the headphones? Try it without the mic?
Jake: Sure.
Tobias: Give us a check one, two.
Jake: Is that better?
Tobias: Yeah, much better.
Jake: Okay. So, where were we in our story? So, he just melted these diamonds, made them disappear. It turns out that carbon is one of the universe’s most remarkable elements. It’s found in the air that we breathe, the construction blocks of our very cells and buried in diamonds beneath our feet. But it’s not just a building block for life. It’s the chemistry lessons inside of it can actually help us to think and create and be more innovative.
So, carbon forms the backbone of organic chemistry. But why is it carbon? Like, why are we made out of carbon and not, say, argon or neon or some other element? It’s rooted in carbon’s atomic structure. And with the atomic number six, it holds six protons and six electrons in its orbit.
So, if we remember back to our grade school chemistry class, the electrons fill two shells. So, the first shell, which is called the K shell, holds two electrons. And for carbon, that’s completely fill. And then, the second shell, which is called the L shell, holds the remaining four electrons, but ideally, it wants to hold eight electrons in total. So, that means there’s space for four more electrons in that outer shell.
Okay. So, that makes carbon very eager to want to bond with other things, because it has four and it’s willing to share. And rather than losing or gaining electrons outright, it tends to instead then share these electrons with others and then creates covalent bonds is what it’s called.
So, this flexibility is why carbon can be in everything from methane, which is CH4, to the intricate spirals of DNA that make up how we’re built to diamonds. It’s one of the most amenable elements to teaming up with other elements, which makes it this raw ingredient that then can form the wonders of the universe.
So, this complexity of carbon comes from the fact that it can do single, double and even triple bonds. Because it can bond in so many different ways, it can form chains, and rings and branches, and it allows for these incredible complex structures, and also simple. That’s what gives life to all of this diversity. And then, again, also, countless industrial applications that we have.
So, going a little further on this, one of my favorite writers, Matt Ridley, has described innovation as when ideas have sex. So, it’s like the combination of things that actually is what advances things. Some of history’s greatest breakthroughs are very accidental, and they’re the unlikely intersections of ideas.
So, the printing press was actually the pairing up of movable type with a winepress. The internet fused telecommunications and computing and decentralized information, the smartphone wasn’t doable until you had touchscreens, and tiny modems and wireless connectivity, pocket sized computing. And then, of course, there’s just putting wheels on a suitcase. I don’t know why that took so long, but we figured that one out.
So, we thrive by connecting various ideas, just as carbon readily bonds with its neighbors. Not all elements are that social. So, take helium, for instance. It has two electrons. So, it already has a full outer shell, and it’s already satisfied with itself, and therefore, it remains inert. It’s floating around in its smug isolation.
I would suggest that when people or organizations refuse to collaborate or learn, they become like intellectual helium. They’re stable, but they tend to be stagnant. So, I think we should all try to probably be more like carbon intellectually and be willing to make new bonds, remain open, evolve in our thinking, share our intellectual electrons.
Actually, I’ve been thinking a lot like everybody about AI recently. I think there might be an apt analogy here, and that we make artificial diamonds. I’ll explain a little bit how we make artificial diamonds and why I think it’s a pretty good analogy for AI.
So, to make an artificial diamond, you start with a seed of a diamond, which is like a really small diamond. You put it in this specialized press, and alongside it, you put in a bunch of raw carbon, and then you put extreme pressure on it and searing heat, and the carbon then dissolves and then recrystallizes onto the seed, and it slowly grows into eventually a dazzling stone.
The pressure we’re talking about here is like 5 gigapascals to 6 gigapascals, which means you’re exerting five billion newtons of force every square meter. What it’s trying to replicate is actually like inside the earth, right in the mantle. And then, the high temperatures are over 1300 degrees Celsius.
So, I think that AI follows a similar analogy right now, at least in my usage of it. You begin with a seed, which is like your prompt and the context that you provide to the AI. And then, the LLM then is this raw data that it’s been trained on, which to me represents the raw carbon that’s available inside the pressure chamber to add to it. And then, you have this intense computational power, which is like the pressure of physics. And then, the repeated training cycles maybe are the equivalent of the heat. All of this stuff comes together and crystallizes as actionable insights from data that you otherwise wouldn’t have been able to understand on your own with just that little seed.
And so, I think we’re maybe potentially creating these artificial intelligence diamonds, if you will. We should try to strive to be more like intellectual carbon and less like helium. You think back to Lavoisier’s vanished diamond and that proof that carbon has this hidden force within it. In contrast, helium, it floats around in its perfect shell, detached from change. I think you’d rather be carbon forging these connections. Maybe you could start using AI creatively in the same way, and I think that there’s an apt analogy between diamonds and AI today.
Tobias: Did that one come from ChatGPT? That sounds like something ChatGPT would say.
Jake: It didn’t hurt to put some things together. No. But I’d say the original ideas might have come from– [crosstalk]
Tobias: Hey, I think it’s going to be great.
Jake: Yeah.
Tobias: Good stuff, JT. How was Tahoe?
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Jake: Oh, it was great. It was apparently in California. They have this thing called ski week in my area, where the kids are off for a week. After paying the lift ticket prices, I realized it’s probably like ski week brought to you by Vail Resorts,-
[laughter]Jake: -because they are taking their pound of flesh if you want to take your kids up and ski for a couple days. But it was a great time, beautiful weather, perfect sun. So, I was sad to– It seems like I missed quite a good episode.
Tobias: You missed all veggies.
Jake: Oh, I know. Very, very painful for me, but it was a worthwhile distraction to go take the kids to the snow.
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Is Value Investing Still Alive? The Reality of Rerating and Market Patience
Tobias: Good stuff. Andrew, David Einhorn says that value is dead in slightly different words. But what do you think about his comments, and what’s your view?
Andrew: Well, one, I don’t think he said it was dead. And if anything, he still is talking about buying cheap stocks. So, we don’t think it’s dead either. I think what his comments were about was how values are not being rerated as quickly as they have been in the past. That sure seems to be the case over the last five years, seven years or so.
The way we invest, we certainly do better when things get rerated faster. That’s a piece of our return. The way we look at things, what I would call the lyrical math, is we want to own companies whose earnings are growing as fast or faster than the S&P 500, but own them at a much lower multiple. And so, if they do achieve growth as fast or faster, then the multiple shouldn’t stay cheap– It should converge with the S&P and drive extra performance.
But as long as the earnings are growing as fast or faster, we can be indefinitely patient, because as long as that spread doesn’t widen, we’re not losing anything. We’re keeping up with the market, maybe even beating it by a tiny bit, if we’re actually getting 1% a year faster growth. So, that’s always what we look for. It enables us to be patient. If you get five points of rerating over three years, that’s better than getting it over seven years, all of them work though. And so, I guess, we’d never had good visibility as to when rerating will happen. If we could figure that out, our returns would be so much higher.
Here I am, year 30 of doing this, and I’m no closer at all to figuring out catalysts. I mean, we could get into another side conversation. The catalysts exist, we just don’t believe they’re forecastable, foreseeable. Any catalyst you could see and count on, it’s already discounted in the price of the stock. So, that doesn’t help.
So, we take this approach of we have both a margin of safety and valuation, but then we also look for this margin of safety and growth rate too. They’re not growth stocks, per se, but again, we want to own something that’s growing– It’s okay if it grows a tiny bit slower than the market. If the market’s growing seven, six is okay. You can still be patient. But you can’t have things growing two or three or four. Because every year now that is delayed, that multiple re rating, you may not make it up in the long run, because you’re losing on the growth rate.
And so, back to the core point. Yeah, it does seem like things are rerating a lot slower. That’s okay as long as we’re not losing on relative multiple. Now, sometimes you do lose on relative multiple. That’s what happened in 2018. But for the most part, if the relative spread stays where it is and you get the growth that’s as good or better than the market, then we can stay indefinitely patient with our stocks and we’ll get paid someday. We just don’t know when.
Tobias: Have you looked at the rerating question? Is that something you can tease out statistically and see if that’s actually the case, or you just think value underperformance illustrates that?
Andrew: Rerating happens at two different levels. There’s idiosyncratic and then there’s a more macro level, which is, what we would call the value cycles, that when value’s out of favor, multiple spreads are widening. And when value is in favor, generally multiple spreads are compressing. So, those are long waves, that happen about once a decade.
And then, even when value’s out of favor– Not every stock is out of favor. You still get strong enough news on individual companies that cause things to be rerated. We have the stock charts of everything we’ve owned. We could see for the ones that have worked exactly when the multiples began to inflect upward.
You can go back and look at all the news that happened right up to that point. We can’t tell any difference from the news then to what the news was one year before that, two years before that. We have perfect hindsight of when these inflection points happen, and we still can’t find, knowing exactly where to look, any evidence of what caused it. So, it still remains like holy grail.
If we could avoid two years of dead money before things worked out, then our returns would be just that much better. But we don’t know how to do that, and so we default to this view that, “Okay, if the earnings double, then the stock should at least double and then the multiple should go up, because it’s too low for a company whose earnings are doubling over five, seven years.”
Earnings growth as the market, but our multiple rises relative to the markets, that always has to work out to outperformance. Sometimes it’s 100 basis points and sometimes it’s the 1,000. Those are all good outcomes, 1,000 is better than 100. But we can’t control that part. So, what it really distills down to, is don’t pay too much and then get the earnings right as much as you can. Get as many right as you can and get as few wrong as you can, and it’ll all take care of itself.
Jake: Can buybacks be part of a catalyst, if you will– Maybe it’s not like an instantaneous, but you can just see the cannibalism– I think Buffett’s, probably a lot of his recent theses have been pretty buyback heavy.
Andrew: There are many ways to get to good earnings growth. Buybacks is a common boost to our earnings growth. So, you talk about, say, 10% per year earnings growth. GDP is not growing that fast. And so, the way you can get to 10% earnings growth though, is if you have a nominal GDP like top line growth. Some companies have some margin expansion, but you can’t do that forever.
But if you’re a low capital-intensive business, high free cash flow business, then most or a lot of those earnings are available at the end of the year to buy back stock. A company that’s got 6% operating income growth may with some financial leverage have 7% or 8% net income growth and then with stock buyback can be more like 12% earnings per share growth. And so, that all goes towards the formula. That’s how you compound at those– It’s one of the most reliable ways that you can compound at those rates.
So, it’s great for earnings growth to have a low capital-intensive business that generates free cash flow that you can buy back stock, and get higher EPS growth and operating income growth. But it’s not a catalyst to make the stock go up today. At best, it seems to be even. I’ve never really seen that be an effective short-term catalyst.
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Global vs. U.S. Investing: Market Inefficiencies and the U.S. Listing Premium
Tobias: What’s your impression running foreign or global portfolios versus running the US portfolios? Are the index returns make it easier to get over? Are there more opportunities, or have you found it?
Andrew: We stick to just developed markets. We stay away from the emerging markets. But there’s a few big differences. One, if we not talking global, just talking international, you lose all the Magnificent Seven. The average quality of companies, the average growth rate is lower outside the US than in the US
Now, it’s a big world and there’s lots of exceptions. So, we’re still able to build a portfolio with the same value and growth characteristics we have in the US, it looks even better compared to that benchmark. The benchmark overseas, like the IFA would have a lower PE but also a much lower growth rate than the S&P. So, one, there’s what you’re compared to looks a little different.
You start to see other kinds of anomalies that you wouldn’t know about just in the US. So, you’d think all that should matter in the stock price is the business itself and how it’s doing. But where you’re listed can have a big impact. The same earnings stream listed in a different country can result in a very different multiple. It becomes obvious. when you have a few companies around the world that are listed in different places, but have the same results.
We have a number of companies in our international portfolio that are peers of our US companies. They could have very similar years from an earnings point of view and they’ve had very different years from a stock point of view. So, just another weird market anomaly you observe by going outside the US.
These exceptions, what we again call the gems amid the dunk, they exist outside the US. Probably the US market is more efficient. They’re a lower percentage of them in the US. So, there’s some tradeoffs there. There’s probably less gems outside the US, but the market’s less efficient, so we still end up finding about the same number of them. So, we get there in a different way, but we end up in the same place outside the US as we do inside the US. The process still works the same way.
Tobias: I think Dan Rasmussen made the same point that once you controlled for everything– In fact, you can control for the listing– There’s a premium for listing in the US.
Andrew: Premium listing in the US. But even outside the US, different countries. So, when the Ukraine war broke out, Europe stocks took a big hit. But there’s a lot of global businesses based in Europe, and they didn’t have that much revenue or income necessarily coming from Europe. But because they were listed in Europe, they got really cheap. So, that’s some of the other ways you see that anomaly play out.
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Tobias: JT, any final words for Andrew?
Jake: No. I’ve been reading your writing for a long time, and it’s great to finally get a chance to meet you in person and get to chat.
Andrew: It’s nice. Zoom now counts as in person these days.
Jake: Yeah
Andrew: We’ve evolved a lot as a species.
Jake: Yeah.
Tobias: Yeah. Congratulations on 17 years in the business and 30 years as an investor. If folks want to follow along with what you’re doing or get in contact with you, what’s the best way of doing that?
Andrew: A few ways. So, we have our website, lyricalam.com. There’s a tab up at the top called Insights, which has all of our letters and other thought pieces we put out. You could always find that there. They also get published if you can follow us on LinkedIn, find Lyrical Asset Management there. Everything gets published on our website gets published there. And then, if you’re an institutional investor, you could always reach out to ir@lyricalpartners.com and get added to our mailing list.
Tobias: Good stuff. Andrew Wellington, Lyrical Asset Management, thank you very much.
Andrew: Welcome. Good to catch up, Toby.
Tobias: Yeah, likewise. We’ll see you, guys, next week, same time, same channel, and we’ll have Andrew back in the not-too-distant future.
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