Upon examination, 2021 was a great year for Lyrical International. Our strategy has now outperformed the EAFE Value in each calendar year since inception, and at the end of May will reach its three-year performance mark.

For 2021 we returned 16.1%, compared to the ~11% for the MSCI EAFE and EAFE Value. On a constant currency basis, our return would have been ~22%, as foreign exchange rates had a -600bps impact.

*Partial year, inception date of 5/31/19. Past performance is not necessarily indicative of future results.

Ex-US Returns by 5-Year Forward P/E Quintiles - 2021

Cheapest Quintile Return History Versus EAGE: 4.2% Annual Outperformance

Until 2021, it had been more than 25 years since we last saw a period of high inflation. The European Central Bank’s (ECB) main task is to maintain price stability, defined as a 2% inflation rate. The ECB’s key measure of inflation, the Harmonized Index of Consumer Prices (HICP) has now been running above 2% since May 2021, most recently reaching 5% in December.

Since it has been such a long time since inflation was a factor, we examined historical data to analyze the performance of value stocks during periods of inflation. Since 1975, there have been two distinct periods of elevated inflation in Europe. As shown in the table below, in each of those periods, value stocks (defined as the cheapest quintile) outperformed the EAFE, including 11 years of 3.7% alpha for value stocks during the “Great Inflation” period of the 70’s and 80’s when CPI was stuck near 10%.

 

 

While value stocks in general have a history of outperformance in inflationary times, it is the quality of our companies that gives us confidence in this environment. We have seen the impact of eight months of inflation so far and, on average, our companies have been able to mitigate or benefit from the inflationary effects. Since May 2021, our portfolio’s consensus 2021 and 2022 EPS estimates have been revised up 20% and 11.6% compared to 7.6% and 2.4% for the EAFE. Let’s take a closer look at how our companies have managed this environment.

In an inflationary period, it is important for a business to have pricing power. Without pricing power, rising costs will squeeze the margins of a business that cannot pass along those costs to customers. The companies we are invested in possess several forms of pricing power. Some can increase prices because they provide critical products that represent a small portion of total cost for their customers. We own SK Kaken, which controls more than 50% of the architectural paint market in Japan. The quality of paint determines the strength and permanence of the coat, but the paint itself only represents about 15% of the cost of a project. As such, contractors choose paint based on brand and technical capability rather than price. SK Kaken has grown its earnings at a 9% rate since 2000 and trades for only a 13x forward P/E, before giving the company credit for the 103% of its market cap that it holds in net cash. Yes, it trades for less than net cash!

Other companies we own derive pricing power from dominant local positions. Air Water is a top Asian provider of industrial gas distribution, delivering and managing dangerous gases for their customers. When Air Water signs a new customer, they co-locate onsite with 15 to 20-year contracts with full raw material cost pass-throughs and take-or-pay clauses that guarantee a minimum level of revenue each month. Air Liquide and Linde operate the same business in Europe and the U.S. with similar growth rates and yet trade for more than 24x earnings compared with Air Water at only 9x.

This bottom-up perspective along with the historical data lead us to believe inflation should be a positive factor for us.

FOLLOW THE FUNDAMENTALS

Our first example is TFI, one of our best fundamental performers over the last two years. TFI grew earnings 6.5% in 2020 followed by 47.5% growth in 2021, resulting in aggregate growth of 57%. When we bought TFI in August 2019, the company was valued like a commodity transportation business with a forward P/E of only 9x. We instead saw a specialty transportation and logistics business with a long history of generating high-teens returns on capital, led by a cash-obsessed owner-operator.

The majority of TFI’s trucking business provides specialty transport for items like volatile chemicals. This business comes with high barriers to entry from scale, relationships, and expertise. In 2020, TFI benefited from the leadership of CEO Alain Bedard, who owns about 5% of the shares. While sales fell 11% during COVID, Alain moved quickly to cut costs, resulting in 300bps of margin expansion and overall EBITDA growth of 7% in the year. The company used downtime during the downturn to make positive structural changes to the business that are difficult to complete in a normal operating environment. As Alain put it, “No one wants to miss a storm.”

In 2021, we saw the company again be opportunistic as TFI acquired an underperforming less-than-truckload business from UPS for $800 million, just 0.2x revenue. This business had been operating at breakeven under UPS, but TFI thinks this is the result of mismanagement rather than structural issues. By acquiring this asset so cheaply, TFI managed to nearly double its sales, while barely increasing leverage. This deal couldn’t have been timed any better; TFI made this acquisition in January of 2021, just before the transportation market tightened, leading to unusually good pricing. These firm pricing conditions give us even more confidence TFI will hit its margin target of 10% for the acquired assets, and indeed they are already well ahead of plan. We expect this deal to be 50% accretive to EPS by 2023. Even with the stock outperforming the EAFE by about 260% since our purchase, we see 25% upside to intrinsic value from the current price.

HIGHLIGHTED HOLDING: ELEMENT

Not every stock in our portfolio has exceled over the past two years. One company that has struggled is Element. It was one of our worst fundamental performers in 2020-2021, with a 15% earnings decline. Element, like TFI, is in the logistics industry and is the leading commercial vehicle fleet management business in North America. It handles all aspects of managing a vehicle fleet, so customers can focus on its core competencies. The company provides a critical service to a fragmented customer base, with no more than 3.5% exposure to any one specific industry. In total, Element serves over 5,500 clients, including Amazon, in over 700 industries, such as telecom services, electric utilities, pest control, and pharmaceutical delivery. Element’s outsourced services are sticky, recurring, and easy to understand. The nature of the company’s relationships with clients translates into high switching costs and very low turnover and a 98% retention rate. 60% of Element’s industry is still insourced despite the clear benefits of leasing from a scale player like Element. We see long-term secular growth for a durable business that generates a mid-teens ROE.

Part of why we like Element is its low cyclicality, and in this area the company shined in 2020 with earnings falling only 1.2%. The company has very low credit risk – both from residual value exposure and customer default risk. In North America, it takes no residual value risk on the assets it manages, including those on its balance sheet. Any asset gains or losses are contractually passed through to the client, creating a predictable and stable earnings stream. With respect to customer default risk, even in the company’s worst years, during the Global Financial Crisis, Element realized just 10 bps of annual credit losses (as a percent of finance receivables).

Element held up well in the crisis, but then lagged in the recovery with earnings falling another 3.5% in 2021. In the near-term, Element is a victim of challenging auto supply chains. Demand for the company’s services is higher than it’s ever been, but the company simply can’t buy enough vehicles to fulfill its record backlog. We see this as a temporary setback. As the supply chain loosens, we expect the company to work through its backlog and for free cash flow to improve by close to 40% over the next two years. We see more than 50% upside to intrinsic value, with the stock trading below 6x its five-year-forward earnings power.

LONG-TERM THINKING IS OUR EDGE

We believe our biggest advantage is our long-term time horizon, which is reflected in how we value companies. We measure long-term earnings, seeking to buy the cheapest stocks based not on their one-year earnings but on their five-year forward earnings.

We seek to maximize long-term value and because of that our near-term multiples might not always be as cheap as the indices. As shown below, while our portfolio trades at a big discount to the MSCI EAFE, it trades at a slight premium to the MSCI EAFE Value Index (based on 12-month forward P/E).