Then, everything changed on Monday, February 24th. Starting that day, the market began one of the steepest selloffs in history. Over the next 3½ weeks (just 18 trading days) the S&P 500 fell 28%. Low P/E stocks were punished much more severely, falling 48%. Lyrical’s portfolios, which are also filled with many of the lowest P/E stocks, were also severely punished, falling a gut-wrenching 51 and 53%.

 

*Please refer to Notes for important details regarding data presented herein

 

We cannot explain why our stocks fell so much. Prior to adding each stock to the portfolio, we had carefully underwritten each business for how it should behave in an economic downturn. While the COVID pandemic created an economic crisis like no other, we had good reason to believe that, on average, there was no more risk from the pandemic in our portfolio than in the overall market. On that basis, our stocks should have been down the same as the market, or probably even less due to their lower valuations. This is not how the market reacted at the time, even though our assessment of our portfolio fundamentals proved to be correct, if not conservative.

 

After March 18th, the underperformance ended for low P/E stocks in general, and Lyrical stocks in specific. The S&P 500 bottomed a few days later, on March 23rd. Since our bottom, we have enjoyed one of the best performance runs of our careers. On average, our companies’ earnings were less impacted by the pandemic than the S&P 500’s. Based on the fundamentals, our stocks should not have sold off as much as they did, and the market slowly began to recognize this. Beginning on March 19th, our portfolio produced a triple digit return, far outpacing the S&P 500, the S&P 500 Value, and even the cheapest P/E stocks.

 

The recovery over the final 9½ months of the year was strong enough to raise our YTD returns from a low of down over 50% on March 18th to a final return of up over 12% at year end, outperforming our style benchmark, the S&P 500 Value, by over 1,000 bps.

 

We also outperformed the cheapest quintile by over 1,700 bps. We are especially proud of this result. There is a very high correlation, over 90%, between the cheapest quintile returns and Lyrical’s returns. It is unusual for us to differ so starkly from the cheapest quintile’s performance, as we were up more than double what the cheapest quintile was down. We do have a history of outperforming the cheapest quintile by 270 bps per annum over our 12-year history, but this degree of differentiation was unusually good. We think this shows that we have executed our stock selection process well and have done a good job of picking out the “gems” amongst the “junk”.

 

One might think that our recovery from the March 18th bottom had to be Lyrical’s best performance period. Well, not quite. The last 9½ months have certainly been outstanding, but they still are not as outstanding as what Lyrical produced back in 2009. The circumstances are quite different today with a global pandemic compared to then with a global financial crisis, but the return pattern off the bottom is quite similar. Our EQ composite net return was over 130% off the bottom this year but was over 150% after the same amount of time off the bottom in 2009.

 

 

We believe the biggest driver of our outperformance since March 18th is the partial recognition by the market that the selloff of our stocks was unwarranted. The basis for this view is the 2020 consensus estimate revisions for our current portfolio compared to several major market indices.

There has been a narrative that value stocks went down more this year because they are more economically sensitive. That narrative rings true for the S&P 500 Value, whose 2020 EPS estimates fell 35% during the year, more than 1.5x the 23% negative revision of the S&P 500. However, this narrative was not true for our value portfolio.

The data in the chart below clearly show that our stocks have been less impacted by the events of 2020 than the S&P 500 or even the NASDAQ. Those two indices have seen their 2020 estimates cut by 23% and 24%, respectively. By contrast, the stocks in our portfolio experienced only a 16% and 19% estimate reduction for our EQ and CS constructions. That is a 20-30% lower impact for our portfolios than for those indices.

 

*Please refer to Notes for important details re data presented herein

 

As indicated by the revision analysis, the economic sensitivity of this crisis was directionally in line with the last one. From 2019 to 2020, the average earnings decline for our stocks was only 10-12%. By comparison, the S&P 500 earnings fell 17.5%, which is 45-75% more than our portfolios’ earnings fell. The S&P 500 Value index was again even worse, as its earnings fell by 28%, 60% more than the S&P 500 EPS decline and well more than double Lyrical’s decline.

 

 

Not only have our stocks historically been less economically sensitive, but, more importantly, they have grown their earnings faster. Over the last economic cycle and the recent crisis, the EPS of our companies have compounded at 6.5% and 7.2%, depending on the portfolio construction we use. The S&P 500 has only grown its earnings at 4.9%, and the S&P 500 Value at a meager 2.4%.

 

One would think that you would have to pay a premium for a portfolio with earnings characteristic superior in both long term growth and economic sensitivity. That would be a rational expectation. The reality is that you can now own our portfolio at a substantial discount to both these indices.

 

At the end of 2009, after a year of tremendous absolute and relative performance, our portfolio had a NTM P/E ratio of 13.7x. The S&P 500 had a slightly higher NTM P/E ratio of 15.6x, a 14% premium. At the end of 2020, even after our double-digit gain for the year, and triple-digit gain off the bottom, our portfolio has a NTM P/E ratio of just 11.3x. So, on this simple metric, our portfolio is 18% cheaper today than 2009. The same cannot be said for the S&P 500. The NTM P/E ratio for the S&P 500 was 22.6x at year-end 2020, 45% higher than 2009.

 

With the combination of our multiple being lower, and the S&P 500 multiple being higher, the valuation spread has blown out to extraordinary proportions. Instead of the 14% spread we had at the end of 2009, we have a 100% valuation spread at the end of 2020.

 

As we showed above, after the tremendous absolute and relative performance of 2009, we continued to outperform over the next eight years until the end of 2017. Entering 2021, the valuation spread is 86 percentage points wider, and the absolute NTM P/E is 18% lower. Therefore, we would expect the next eight years to be potentially better on an absolute basis, and substantially better on a relative basis. Given these characteristics, would you want to bet otherwise?

 

Let us start by looking at recent history and comparing the S&P 500 Value performance to our preferred proxy of value stock performance, the cheapest P/E quintile of our 1,000-stock universe. Since the March 18th bottom, the cheapest quintile has returned 84.4%, 25.6 percentage points more than the S&P 500. The S&P 500 Value index has had the opposite experience, returning 45.0%, or 13.8 percentage points less than the S&P 500.

 

 

It is not just 2020. If we go back to last decade, the cheapest P/E quintile of stocks had a great nine-year run of performance from 2009 to 2017. They produced an annualized return of 19.4%, 410 bps per annum better than the S&P 500. Did the S&P 500 Value outperform, too? No, sadly it did not. That index had an annualized return of 13.7%, 160 bps per annum worse than the S&P 500.

 

 

It is not just the last decade. We have 23 years of NTM P/E data going back to 1998. These 23 years include some tough times for value stocks, including: the tech bubble, the global financial crisis, and the recent FANG era and growth stock boom. Even with all those tough times, the cheapest P/E quintile had an annualized return of 10.5%, 200 bps better than the S&P 500. Again, over this long period, the S&P 500 Value returns were disappointing. That index had an annualized return of 6.7%, 180 bps worse than the S&P 500.

 

We can even go back to the inception of the S&P style indices in 1979. Since we do not have NTM P/E data that far back, we use LTM P/E as far back as we have it, and then use P/B for the earliest years. In each case we still measure the performance of the cheapest quintile by each measure. Can you guess the outcome? Over the full 42-year period, the cheapest P/E quintile had an annualized return of 15.7%, 360 bps better than the S&P 500, and the S&P 500 Value returns disappointed. That index had an annualized return of 11.4%, 70 bps worse than the S&P 500.

 

When people proclaim that “value is dead” they often cite as evidence the underperformance of the large-cap value benchmarks like the S&P 500 Value. As the data above show, these value indices do not track the performance of value stocks. For more insight into what might be behind the problems with these indices, please see our 2019 Review Letter.

 

Our portfolio does not look like the S&P 500 Value. It more closely resembles the cheapest quintile, except our companies have much higher earnings growth, and our net returns have been higher by 270 bps per annum over our 12-year history. Since we do not look like the S&P 500 Value, we have had high “tracking error” relative to that index. While this is true, we take offense to the term “tracking error.” The word error implies that we have done something wrong by differing from the index. From our point of view, though, given the poor performance record of the S&P 500 Value over multiple long, time horizons, the real “ error” would be for us to “ track” the index.

 

We do not mean to single out the S&P 500 Value index for criticism. If you calculate the returns of the large-cap value indices from Russell or MSCI, you will find that they all perform about the same as the large-cap value index from S&P. This is not an issue unique to S&P, but a common problem for all the large-cap value indices from the major providers.

 

2020 was a year we will remember for a long time, even though most of it we would like to forget. The selloff tested the mettle of investors, but we held firm to our investment process. Our decisions were guided by our fundamental research, avoiding the influence of price action. Over the course of the year, as the financial impact of the pandemic became clearer, our assessment of our portfolio fundamentals proved to be correct, if not conservative, and our discipline was rewarded.

 

We now believe March 18th to be the end of the value downcycle that began in 2018. Since then, low P/E stocks in general and Lyrical stocks in specific have had an incredible recovery. We believe this was driven by the partial recognition by the market that the selloff in many value stocks was unwarranted. The triple-digit recovery in our stocks was strong enough that we finished the year with a double-digit gain, and more than 1,000 bps of outperformance over the S&P 500 Value index.

 

We have great expectations for our future returns. Our portfolio companies have shown themselves to be less economically sensitive than the S&P 500 and have also produced better historical growth. Despite these superior earnings characteristics, our portfolio has half the multiple of the S&P 500. We believe our better earnings and lower valuation will fuel many years of outperformance, as good or better than the many years of outperformance we experienced in the aftermath of the Global Financial Crisis.

 

As always, we are bullish on value stock investing. However, we cannot be confident in the large-cap value indices, like the S&P 500 Value. Value stock investing has a long track record of delivering market beating returns in decade after decade. Unfortunately, indices like the S&P 500 Value have an equally long record of underperforming despite the success of low multiple stocks.

 

Active management is not justified everywhere, but we believe that 2020 shows the importance of active management in value investing. We think the lowest multiple stocks outperform over time because of behavioral reasons. Human nature is to overreact and push some stock multiples too low. Blindly buying the lowest multiple stocks captures that overreaction and benefits when it unwinds. As active managers, we can do better than just blindly buying the lowest multiple stocks. While many low multiple stocks are “junk” deserving of their low multiple, some are “gems” that are truly mispriced. We seek to collect these “gems” in our portfolio, which has resulted in an uncommon combination of both value and growth. This approach has served us well, delivering outperformance over the S&P 500, S&P 500 Value and the cheapest quintile over our 12-year history, and we expect it to continue to serve us well in the years to come.

 

 

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Andrew Wellington,

Founder

Chief Investment Officer

 

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