In 2015, the U.S. Value Equity-EQ and U.S. Value Equity-CS composites produced gross returns of -5.0% (-5.7% net) and -5.1% (-6.3% net), respectively. Comparatively, the S&P 500 and Russell 1000 Value produced total returns of +1.4% and -3.8%, respectively.

 

 

For only the second time in our seven year history, we did not outperform our benchmarks for the year. It was a difficult year to outperform given the narrowness of the market. The 50 largest stocks in the S&P 500 outperformed the index by the widest margin since 2008. Furthermore, the S&P 500 would have finished the year down 1%, instead of up 1.4%, if just four stocks were excluded (AMZN, GOOG, MSFT, FB). When so much return comes from so few stocks, it is particularly difficult for active managers to outperform. It is possible to outperform in these markets, but in 2015 we did not succeed. Our performance was more in line with the Russell 1000 Value, and was within the general range of expected outcomes for any given year. We do not know when the value we see in our portfolio will be recognized by the market, but we do expect that when this happens, as we have seen in our past, the returns will be exceptionally attractive.

 

In analyzing our portfolio’s performance attribution, we find it helpful to examine both the investment success rate and the skew in the distribution of returns. In 2015, 46% of our investments posted gains, and 43% outperformed the S&P 500. This is the first year that either the absolute or relative success rate was below 50%. We attribute the low success rate to the narrowness of the S&P 500. Since inception, 79% of our investments posted gains, and 62% outperformed the S&P 500.

 

Skew was also a negative factor in 2015. Typically, our skew is positive by over a two-to-one ratio. Since inception, our outperformers outperformed by 39% annualized while our underperformers underperformed by 18% annualized. However, in 2015 our outperformers outperformed by 13% while our underperformers underperformed by 22%. This negative skew is exemplified by the fact that we had one stock up over 40%, but had four stocks down more than 40%. While there were several big decliners in the portfolio, many of those stocks actually had solid fundamental results in 2015, leading us to believe the losses will be temporary, and to expect these stocks to recover and advance.

 

Portfolio turnover in 2015 was 7.4%, and stands at 15.5% annualized since inception. During the year, we sold two stocks which approached fair value. For both stocks sold, we added a compelling replacement from our inventory of researched investments. Most of our turnover is driven by stocks approaching fair value. Thus, in a flat or down year like 2015, we expect to have less than normal turnover.

 

With solid fundamental results and a decline in stock prices, the portfolio valuation became even more compelling. The P/E ratio for our portfolio on forward consensus earnings estimates was 11.9x at the end of 2015. The S&P 500 had a valuation of 16.1x on this same basis, a premium of 35%. Historically, the average premium of the S&P 500 to our portfolio is ~25%. The current premium of 35% is near a historical high. The only time the premium has been greater was at the end of 3Q11, 2Q12, and 3Q12. After each of those periods, over the following twelve months, the LAM-EQ net returns outperformed the S&P 500 by 582 bp, 2,045 bp, and 2,130 bp, respectively.

 

We used eVestment’s database and examined the returns of all Large Cap, Mid Cap and All Cap Value products. While not all of these products are our true peers, we wanted to cast a wide net in capturing the performance data. In total, as of January 25, 2016 there are 555 products in those three categories that reported returns for all years since our 2009 inception. Lyrical Asset Management’s U.S. Value Equity-EQ ranks as the product with the highest return for that period in that assembled, superset universe. Additionally, our U.S. Value Equity–CS product ranks as the next highest returning product (second only to EQ) in the Large Cap universe, and in the top 1% of that superset universe over the same time period.

 

For 2015, the U.S. Value Equity-EQ and U.S. Value Equity-CS composites ranked in the 70th and 71st percentiles of 507 products in the database, respectively. (Note that eVestment uses gross performance for such rankings.)

 

In 2015, the Russell 1000 Growth index outperformed the Russell 1000 Value index by 9.5%, the widest spread since 2008. Since 2009, the Russell 1000 Value index has underperformed the S&P 500 by 27.2% (163.0% vs. 135.8%), or 180 bp per annum (14.8% vs. 13.0%).

 

At Lyrical, we do not regard the Russell 1000 Value index as a real value index. Russell forces every stock of the base index into either the Growth or Value index, thus diluting the impact of the “real” value stocks in the Value index with many more that are at or near market multiples. For us, a better benchmark for tracking the performance of a “real” value approach is an equal weighted index of the lowest price‐to‐book (P/B) companies. While the Russell 1000 Value index has 35 years of history, we have been able to get our hands on a 55 year history of a Low P/B series. Looking at the returns of this Low P/B series helps put “real” value investing results in a better historical context.

 

Since 2009, the Low P/B index has actually outperformed both the Russell 1000 Value and the S&P 500. Low P/B has returned 186.9%, 23.9% more than the S&P 500 and 51.1% more than the Russell 1000 Value. On an annualized basis, Low P/B has returned 16.2%, 140 bp more than the S&P 500 and 320 bp more than the Russell 1000 Value.

While this outperformance is good, it is still well below the 55 year history of the data series. Since 1960, Low P/B has returned 17.0% per annum, 520 bp better than the 11.8% annualized total return of the S&P 500. Even after recent woes, “real” value investing has clearly been a superior long term proposition.

 

Low P/B has significantly outperformed over the long term, but there have been several periods where it has temporarily underperformed. The chart below plots the relative performance of Low P/B versus the S&P 500. The long term trend of the chart is undeniable. Low P/B outperformance is persistent over the decades.

 

Source: Sanford Bernstein; Lyrical analytics

 

The short term trend of the chart is also undeniable. The performance of “real” value investing has been in a slump. The Low P/B series returned -9.1% in 2015, 530 bp worse than the Russell 1000 Value, and 1,050 bp behind the S&P 500. This past year was a continuation of a trend that started in July 2014, when the relative performance of Low P/B versus the S&P 500 peaked. Since then Low P/B has cumulatively underperformed the S&P 500 by 2,000 bp.

 

The current underperformance of “real” value is not a unique event. Over the last 55 years, there have been seven other periods where Low P/B has experienced a significant run of underperformance. The table below summarizes the past down cycles for Low P/B relative performance, and we make several observations.

 

One thing we notice is that these down cycles have lasted in duration from sixteen to twenty-six months. The current down cycle has already lasted about eighteen months. If the past is any guide for the future, the turn for the next up cycle should occur sometime in the next few months.

 

At Lyrical, our investment approach is more sophisticated than just creating an equally weighted portfolio of low P/B stocks. We manage a concentrated portfolio of carefully selected stocks that are deeply undervalued based on their expected future earnings and also are relatively easy to analyze and understand, quality businesses. The benefits of this approach are apparent when comparing our net returns to that of the Low P/B series.

 

When value is out of favor and Low P/B underperforms, our product has also underperformed, but by a smaller margin. By muting the underperformance during value style down cycles, we believe we have taken some of the “potholes” out of “real” value investing.

 

Furthermore, our product has also been able to capture more upside in the recoveries. In the first recovery period starting in March 2009, after 36 months we outperformed Low P/B by 900 bp. In the second recovery period starting in August 2012, we outperformed Low P/B by 3,880 bp.