As a value manager focused on impact businesses, we’ve managed through an unfavorable period in 2023 and 2024. It may feel like the dominating performance of U.S. mega-cap growth stocks will go on forever, but the data lead us to expect otherwise. Historically, whenever the cap-weighted index has outperformed the equal-weight index by the widest margins the following five years experienced a reversal, with the equal-weight index substantially outperforming. Furthermore, in those same environments, value stocks outperformed by even more.

As for our portfolio of select value impact stocks, we believe we are attractively positioned with a historical EPS growth rate of around 8%, more than two percentage points faster than that of the MSCI World. Despite this better growth profile, the portfolio ended the year at a P/E ratio of 11.8x, while the MSCI World P/E was 62% higher at 19.1x. This valuation spread is incredibly wide by historical standards. Given our EPS growth, we expect that spread to compress, driving outperformance in the process.

OBVIOUS IMPACT FAILS AGAIN

The importance of valuation within the sustainability space has become clear over the past two years with the MSCI Sustainable Impact Index returning -5% cumulatively. Prior to 2023, the more obvious impact stocks had earned expensive valuation multiples, driven by enthusiasm about the future of everything from electric vehicles to smart grid technology. Then, as concerns mounted about the rate of change slowing, the valuation multiples of these same stocks compressed. Our portfolio focused on impactful businesses with cheap valuations managed to buck the trend, generating a much better +23% cumulative return.

Many of our peers in the impact space did not fare so well because they had crowded into similar, more obvious impact businesses despite their high valuations. To show how crowded the space has become, we used the eVestment database to look at the holdings of the largest 15 actively managed sustainable and impact funds that had less than 100 holdings. These funds may be actively managed, but we found that they look awfully alike. As shown below, 21 stocks were found in five or more funds, and the most common company, Microsoft, showed up in 10 of the 15 funds.

Of the most common impact stocks above, Lyrical only owns one company, Aptiv, which is highlighted in blue.

As one of the largest providers of electrical wiring and components, Aptiv is a key supplier in the electric vehicle ecosystem. It is an obvious impact company, and it previously was overvalued. Back in 2021, the stock traded for more than 30x earnings and wasn’t close to being cheap enough for Lyrical to consider, even as we very much admired the company. Fast forward to 2024, and Aptiv’s valuation had dropped to near 10x P/E, a victim of the selloff in obviously impactful businesses. This is when we purchased Aptiv - only when its valuation was as convincing as its positive impact.

VALUATION MATTERS

There’s a lot to like about obvious impact businesses like Aptiv. Not only do they improve the world, they also typically benefit from secular growth. However, overpaying for any business, even an impactful one, will generate a poor return.

To understand this dynamic better, let’s look at the performance in 2024 of two groups of companies aligned with the energy transition. First are the popular and expensive alternative energy companies, including companies such as Enphase and SolarEdge. Second, we have the cheap and less popular electrical suppliers, including three companies we own: Johnson Controls, Wesco, and Rexel.

In 2024, the alternative energy companies suffered both deteriorating fundamentals and valuation compression. As shown below, in 2024 these companies had earnings growth of just 3.8%. Questions were raised in 2023 about the long-term pace of adoption of renewables, but these companies still grew earnings at a heady near-30% pace in that year. In 2024, those growth concerns became reality as earnings growth slowed. As a result of this slowing growth, this group of companies saw a valuation de-rating of 20% in 2024, with their P/Es declining from 24.9x to 20.0x by year end.

While the more popular impact companies faced headwinds in 2024, our more ignored electrical suppliers continued to grow impressively, notching 24% earnings growth in 2024. They started the year at a cheaper valuation of 17.9x and ended the year at 21.1x. The alternative energy companies are now cheaper than the suppliers, something that would have been unthinkable a few years ago. This creates opportunity for GIVES to own businesses that were recently out of reach - like Aptiv.

In GIVES, we look to benefit from the secular growth available to companies serving the energy transition, but we only invest in companies with attractive valuations. Of all the companies studied above, we own only three of the electrification suppliers, Johnson Controls, Wesco, and Rexel—which trade at an average P/E of 13.4x.

ENGAGING WHERE IT MATTERS MOST—CLIMATE CHANGE & NET ZERO

The companies we own are making a clear positive impact on the world. But, sometimes, these nonobvious impact companies need a helpful push when it comes to setting net zero targets. Oftentimes they have not begun the challenging process of estimating scope 3 emissions, or they have simply not been educated on how and why to align with SBTi. At Lyrical, we are laser-focused on guiding our companies to set and adhere to net zero targets.

We aim to have 75% of GIVES’ portfolio companies (other than those with immaterial GHG emissions) develop SBTi-approved net zero targets by 2030, and we take an active role in pushing our companies to comply. As with our investing and research, we accomplish this by managing a structured process. When we initially invest in a business, we share where they are positioned within the table below. This exhibit shows our GIVES companies and where they stand on SBTI alignment, from immaterial emissions on the left to having long-term approved SBTi targets on the right.^[1] We explain to management that our job is to move them to the right on the table below, insisting that they develop SBTi-approved net zero targets.

[1] Notes: Ayvens and Konecranes targets are pending SBTi-approval. Companies in red collectively comprise approximately 88% of the portfolio’s reported Scope 1-3 emissions (on an unweighted basis). Flex has near-term SBTi-approved targets but does not have a mitigation plan for its Scope 3 emissions, which are the highest in the portfolio.

This clear and simple net zero framework helps us focus on where engagement is most needed and where we can affect the most change.

MOVING COMPANIES IN THE RIGHT DIRECTION

As expected, we sometimes get pushback from our companies on setting these targets. Even if a company is helping the world with its products, it can seem daunting to measure and set targets on scope 3 emissions.

This was the case with Wesco in 2024, a clear impact leader but one that struggled with scope 3 emissions analysis. Wesco is towards the left in the table above because it has not set SBTi-approved near-term or net zero targets even though we estimate the company will make a massive difference. We estimated the company’s efforts will result in about 30 million tonnes of avoided carbon by 2026 by lowering its Scope 3.11 emissions (use of sold products), primarily through promoting energy efficient products. The challenge for Wesco comes from measuring and reporting these Scope 3.11 emissions, since the company sells ~1.5 million products from 30,000 suppliers.

When we first asked Wesco to estimate Scope 3 emissions, they were unsure about reporting accurate figures.

We own Rexel, which is a similar business that excels at measuring Scope 3 emissions and has set an SBTi-approved net zero target. Over the past few years, we have met with Rexel several times to better understand their Scope 3 emissions measurement process. Through friendly, long-term engagement, we discovered that Rexel took a phased approach to Scope 3 measurement and moved from measuring GHG emissions, using a spend-based approach, to using product-level lifecycle assessments, which is a more intensive process.

In May 2024, we traveled to Pittsburgh, Pennsylvania to meet with Wesco senior management at their headquarters, specifically to discuss Wesco’s Scope 3 strategy, in the context of Rexel’s measurement process. Wesco has taken Lyrical’s net zero feedback earnestly and has asked Persefoni, a third-party verification service, to begin a Scope 3 emissions inventory using the spend-based approach.

Wesco is moving in the right direction, with Lyrical’s support.

We met with the company again, virtually, in November 2024 and learned that Persefoni had completed its initial analysis. Wesco is conducting a follow-up in 2025 to help ensure data accuracy and said it will disclose Scope 3 emissions by 2027 at the latest. After the second meeting with Wesco, Lyrical contacted the CDP to help expedite Wesco’s Scope 3 disclosure process and sent Wesco resources on recommended emissions verification standards and providers.

Through focused engagement like with Wesco, we have seen our companies make significant strides towards net zero.

24 MONTHS OF MAGNIFICENT SEVEN

In 2024, our performance may have stood out within the impact space, but it wasn’t enough to keep up with the MSCI World Index, which is dominated by mega-cap U.S. stocks. The Magnificent Seven is the popular nickname for the seven U.S. mega-cap growth stocks that drove much of the returns of the MSCI World in 2023 and 2024. Specifically, the seven are: NVIDIA, Meta, Apple, Amazon, Microsoft, Alphabet, and Tesla.

We have not owned any of the Magnificent Seven, which makes sense given that we are both disciplined value and impact investors. As you can see from the P/Es on the right in the table, these expensive stocks do not fit in the value category. The priciest of the seven is Tesla at over 125x forward earnings. Four have P/Es in the 30s, and Meta and Alphabet have P/Es in the 20s. Furthermore, we do not think any of these companies qualifies as creating positive impact (even though Microsoft was the most-owned company in our peer analysis of active sustainable funds mentioned above).

Without the Magnificent Seven, the MSCI World return since 2023 would have been 31.5%, but the impact of mega-cap stocks in general extended beyond the Magnificent Seven. The MSCI World Equal Weight return was an additional 5.8 percentage points lower at 25.7%.

WEIGHT MATTERS

The performance of the MSCI World relative to the MSCI World Equal Weight has been extraordinary over the last two years. To illustrate this, we present the bar graph below which shows the year-to-year performance of the MSCI World relative to the MSCI World Equal Weight back to 1995, when the equal-weight index track record begins.

In 2024 and 2023, the MSCI World outperformed the MSCI World Equal Weight by 11.0 and 7.1 percentage points, respectively. These are the third and fourth largest outperformance years in this 30-year record. With the effect of compounding, these two years combined for 21.2 percentage points of outperformance.

The only other period in this record that resembles the last two years is the Tech Bubble years of 1997, 1998 and 1999, when the MSCI World outperformed by 20.7, 11.9 and 7.0 percentage points, compounding to 53.8 percentage points.

Following those two Tech Bubble years, the MSCI World went on to cumulatively underperform the MSCI World Equal Weight by 79.4 percentage points over the next seven years from 2000 to 2006.

A WARNING SIGN

Historically, after periods when the MSCI World has outperformed the MSCI World Equal Weight by the most, that trend has reversed, and the MSCI World has gone on to significantly underperform in the years that followed.

The table below chronicles the three-month periods when the MSCI World outperformed the MSCI World Equal Weight by the widest margins.

Since 1995, we have 358 rolling three-month periods to observe. The top period when the cap-weighted index outperformed the most was from 1999, at the peak of the Tech Bubble. In those three months, the cap-weighted index outperformed the equal-weight index by an astonishing 12.1 percentage points. While this chart is dominated by the Tech Bubble, with 19 of the top 30 periods coming from that era, the second most frequent is the recent AI era, which has five occurrences (shaded in blue), including three from 2024.

In addition to the relative performance in these three-month periods, the table includes the performance of the MSCI World relative to the MSCI World Equal Weight in the subsequent one-, three- and five-years. Notice all the numbers in red, indicating MSCI World underperformance.

In the short run, the acute outperformance of the MSCI World over the MSCI World Equal Weight has not always led to a reversal. There are several one-year periods where the cap-weighted index continued to outperform. However, as we extend the time horizon to three years, performance reversal became more common, occurring 64% of the time.

When we extend the time horizon even further to five years, performance reversal became nearly inescapable, with only one observation in this time frame where the cap-weighted index continued to outperform. On average, the next five years produced 31.9 percentage points of MSCI World underperformance compared to the MSCI World Equal Weight.

Admittedly, some of the periods in this table are too recent to have one-, three- and five-year subsequent returns, and it always is possible this time will be different. However, the consistency and magnitude of underperformance presented here is a damning historical record. It seems extremely unlikely that the cap-weighted index, and the mega-cap growth stocks driving it, will continue to outperform the average stock over the coming three to five years.

EQUAL WEIGHT GOOD, VALUE BETTER

As good as the case is for the MSCI World Equal Weight, we believe there is something even better to consider, namely value stocks. The table below is like the table above with the one change being that the subsequent returns are for the MSCI World relative to the cheapest quintile of the top 2,500 global stocks, rather than relative to the MSCI World Equal Weight. It shows that historically what has been a good environment for the equal-weight index has been an even better environment for value stocks.

Looking at the subsequent one-year returns for these 30 periods, the cap-weighted index underperformed the cheapest quintile by 2.8 percentage points on average. That’s 2.4 percentage points more outperformance than the equal-weight index, which averaged 0.4.

Over the subsequent three years, the cheapest quintile outperformed the MSCI World by 20.4 percentage points. That’s 13.6 percentage points more outperformance than the equal-weight index, which averaged 6.8 percentage points of outperformance.

And, over the subsequent five years, the cheapest quintile outperformed the MSCI World by 84.4 percentage points. That’s 52.5 percentage points more outperformance than for the equal-weight index, which averaged 31.9 percentage points of outperformance.

So, if you want to diversify away from the high valuation of the MSCI World, the MSCI World Equal Weight has been a good choice, but the far better choice has been a portfolio of the cheapest stocks, like what we construct in GIVES.

OUR UNCOMMON COMBINATION – VALUE, QUALITY, GROWTH

In addition to being deep value, our stocks also have quality growth. This uncommon combination is the signature feature of Lyrical’s portfolios. Shown in the bar chart below on the left is a summary of our current valuation, as well as the valuations of our benchmarks. Valuation is important, but it isn’t everything. What matters in investing is not just what you pay, but also what you get, specifically the future earnings.

Shown in the line graph below on the right is the growth profile of our portfolio and the benchmarks. The lines at the top show the EPS growth history of our current GIVES portfolio, while the lines below them show the EPS growth of the MSCI World and the MSCI World Value.

From 2007 to 2024, the MSCI World has had an annualized EPS growth history of 5.5%. By contrast, our current portfolio has a growth history that is more than two percentage points faster. This growth profile is why we continue to believe the wide valuation spread justifiably deserves to narrow.

CONCLUSION

We have performed well in a period that has been tough for sustainability-focused indices and stocks. Our valuation discipline helped us avoid commonly owned and expensively priced stocks that collapsed in the past two years. With GIVES outperforming the MSCI Sustainable Impact Index by 27.9% over the past two years, we believe we have proven the merits of an impact investing strategy that is deeply rooted in value investing.

In addition to our solid financial performance, we have established a strong net zero framework and stewardship program. As long-term shareholders (our average holding period at Lyrical has been 7-8 years), we are able to effect change as shown by our recent work with Wesco.

While we outperformed sustainability-linked indices, we lagged an MSCI World that has been boosted by U.S. mega-cap tech stocks. It may feel like this will go on forever, but history suggests just the opposite and that a value-focused, equal-weight approach will succeed in the future.

As for our portfolio, most years our companies report earnings in line with our expectations, with a few positive and negative surprises. Our mix of earnings outcomes in 2024 was not materially different than in any other year. We continue to find excellent new opportunities even in this rich market. During the year we added three new impact stocks to the portfolio with P/Es below and expected growth rates above the MSCI World Index. As a group, the three new additions had an average P/E of only 12x, much cheaper than the MSCI World Index with expected EPS growth faster than the MSCI World Index.

Our portfolio is attractively valued, and the secular trends behind positive change remain in place, which should bring long-term earnings growth for our companies.

We greet 2025 with great optimism.