Large Cap or Value? You can’t be both!
You can learn a lot about a large-cap value product just by looking at the average market cap of the portfolio. While the category may be called large-cap value, there is an inherent conflict in trying to be both large-cap and value. Few of the largest stocks are cheap, and the cheapest stocks mostly fall toward the smaller end of the large-cap universe. So, if a large-cap value product has an average market cap over $50 or $100 billion, it is likely compromising value for the sake of market cap.
3Q 2024 Update Webinar Replay
Original broadcast details
Date: Thursday, October 10, 2024
Executive Summary
3Q24 was a great quarterOur CS composite produced an 11.8% net return, outperforming all our benchmarks. We outperformed the S&P 500 by 5.9 percentage points and the S&P 500 Value by 2.7 percentage points.
Mega-cap growth stocks underperformed
The mega-cap growth stocks that propelled the market for six quarters since the start of 2023 became a drag on market performance this quarter. The Magnificent Seven reduced the S&P 500 returns by about two percentage points, and more broadly, the S&P 500 underperformed the S&P 500 Equal Weight by 3.7 percentage points.
Our non-U.S. portfolios also performed well
Our Global and GIVES portfolios substantially outperformed the MSCI World Index by 3.7 and 7 percentage points, respectively, this quarter while our International portfolio performed in line with the MSCI EAFE Index.
Internationally, equal weighted indices outperformedAs with the U.S., since the start of 2023, global markets have been led by the mega-cap stocks. In this quarter, that prevailing trend reversed, and the equal-weighted indices outperformed.
Our valuation spread relative to the S&P 500 remains extremely wideThe P/E multiple of the S&P 500 expanded this quarter, rising to 21.7x, which is 36% above its average since our inception, and is 76% higher than our CS portfolio. Given the superior growth profile of our portfolio, we believe it should not trade at a discount to the S&P 500, and that over time the valuation spread should compress and drive substantial outperformance in the process.
3Q23 International Strategy Update
Our international strategy underperformed in the third quarter. The portfolio was down 6.7%, compared to the MSCI EAFE which was down 4.1% and the MSCI EAFE Value, which was up 0.6%.
Warning Signs
In the second quarter of 2024, the S&P 500 outperformed the S&P 500 Equal Weight by almost seven percentage points. This was one of the widest differentials on record. While this is clearly good news for the S&P 500 for the quarter, we believe it is also a clear warning sign of potential significant underperformance for the years ahead.
Q2 2024 Update Webinar Replay
Original broadcast details
Date: Tuesday, July 16, 2024
Executive Summary
Returns of the S&P 500 in 2Q24 continued to be propelled by a few mega-cap growth stocks to the exclusion of almost everything else. Despite not owning any mega-cap growth stocks, our value stock portfolio outperformed the S&P 500 in both 2023 and 1Q24. But in 2Q24, we could not keep pace.
Lyrical CS underperformed the S&P 500 by 10 percentage points. Performance wasn’t about anything going wrong fundamentally, but instead about our not owning mega-cap growth stocks. While some of our stocks experienced material price declines, it was all multiple compression, as earnings estimates increased for all five of our worst detractors.
Warning! The S&P 500 outperformance over the S&P 500 EW was historic. The S&P 500 EW trailed by 690 bps, and 75% of S&P 500 constituents underperformed in the quarter. This was the 6th best 3-month period for the S&P 500 relative to the S&P 500 EW. Be wary, since after each of the 30 best 3-month periods, the S&P 500 significantly underperformed for the subsequent 3- and 5-year periods.
International markets also benefited from outsized gains in the largest stocks.
Our International and Global portfolios underperformed their cap-weighted benchmarks due to our underweight of the largest stocks. Our average market cap and our performance has been inline with the equal-weighted index.
Our GIVES value approach to impact investing outperformed the style benchmark.Many richly priced impact-themed stocks have suffered serious declines, which we avoided given our valuation discipline. Year-to-date, GIVES has outperformed the MSCI ACWI Sustainable Impact Index by 990 bps.
Our valuation spread relative to the S&P 500 is now historically wide.
We continue to believe that the spread will eventually narrow, given our portfolio has demonstrated faster earnings growth and has no greater economic sensitivity. By the metrics, our portfolio deserves a premium, not a discount.
We expect the valuation spread to narrow, driving outperformance.
We expect the spread to narrow from 100%+ to ~30%, the average spread in our first decade. Even if the valuation spread remains around 100%, our faster expected EPS growth should still drive some outperformance. But, if the spread narrows, outperformance could be vastly greater.
Q1 2024 Update Webinar Replay
Original broadcast details
Date: Thursday, April 11, 2024
Executive Summary
The story of 1Q24 was mostly a continuation of the trends from 2023.
The S&P 500 followed its 26.3% return in 2023 with an additional 10.6% return in 1Q24, the best start to a year since 2019. Also like in 2023, in 1Q24 the S&P 500 return benefited from outsized contributions from a few mega-cap growth stocks.
Our LAM-CS composite outperformed the S&P 500 by +110 bps and the S&P 500 Value by +360 bps.
We outperformed despite not owning any of the mega-cap growth stocks that made outsized contributions to the S&P 500.
International markets also benefited from outsized gains in the largest stocks.
Our International and Global portfolios underperformed their cap-weighted benchmarks due to our underweight of the largest stocks, but they outperformed the equal-weighted versions of those benchmarks.
GIVES’ differentiated approach to value-style impact investing returned 9.3% as the MSCI ACWI Sustainable Impact Index lost 3.2%.
Many richly priced, impact-themed stocks suffered serious declines. We avoided these, given our valuation discipline. Price matters, even in impact investing.
Our portfolios remain attractively valued, even after strong returns.
In the U.S., even after our significant gains in 2023 and 1Q24, our LAM-CS forward P/E ended the quarter at 11.7x, only about half a point above its average since inception. Meanwhile, the S&P 500 forward P/E was 21.2x, 36% above its average over that same period.
The spread between our valuation and that of the S&P 500 remains extremely wide.
The valuation spread of our LAM-CS Composite relative to the S&P 500 was 81% at quarter-end. We continue to expect that this spread will compress and drive substantial outperformance. Based on earnings growth, it appears our portfolio should be valued at a premium to the S&P 500, not a discount.
We have been waiting a few years for the valuation spread to compress.
It can be hard to be patient, but outperforming by a little has been a pretty good way to pass the time, while we wait to outperform by a lot. Perhaps the waiting may be over, given our 39.7% return and 980 bps of outperformance over the last 12 months.
Obvious Valuations for Non-Obvious Impact Stocks
2023 was a challenging year for impact and sustainable investment strategies. The MSCI ACWI Sustainable Impact Index underperformed the MSCI World Index by about 2,000 bps. This poor performance was tied to severe multiple compression in several high valuation stocks with obviously impactful businesses. Since impact can be hard to find, the largest impact funds tend to crowd into the same obviously impactful businesses and therefore suffered similar performance woes as the index. Startlingly, 25 stocks are commonly owned by at least one-third of the 15 largest actively managed “Sustainable” or “Impact” funds, according to eVestment. In Lyrical’s Global Impact Value Equity Strategy (GIVES), we do not own any of those obvious impact stocks and we avoided much of the performance pain suffered in 2023.
There is a lot to like about obviously impactful businesses; not only do they improve the world, they also typically benefit from secular growth. However, overpaying for any business, even an impactful one, should eventually lead to poor returns. We believe prime examples of this are the popular and expensive alternative energy companies, including Enphase and SolarEdge.
The alternative energy companies had attractive fundamentals, but they were expensive. In 2023, these companies had fantastic earnings growth of 28%, handily beating the 15% growth of the electrification suppliers, as you can see on the left side of the chart below. However, the alternative energy companies had an average return of -14%. Their problem was not growth; it was valuation. As investors questioned the long-term pace of renewables adoption, this group of companies saw a de-rating of -34% in 2023, as you can see on the right side. Even after this multiple decline, these stocks still ended the year at a lofty 26x earnings.
Impact companies can be found without splurging on high valuations. Consider electrical suppliers providing the materials needed to support electrification. Electrical suppliers grew earnings by a strong, albeit slower 15%, but they started the year at a lower valuation, which allowed for multiple expansion of 28% during the year and a positive average return of 32%.
Gems Amid the Junk™
The simplest way to summarize our investment approach is that we seek to own the gems amid the junk. It is all about getting more for less. More quality and earnings growth for lower valuations.
To our core, we are value investors. We seek to own the cheapest stocks in our universe, because the cheapest stocks historically have had the highest returns. Incredibly, in the U.S. the cheapest stocks have outperformed the S&P 500 by nearly 400 bps per annum over the last 40+ years. Over that same period, the cheapest stocks outside the U.S. did even better, and outperformed the MSCI EAFE by over 400 bps per annum.
While cheap stocks have been strong performers, they are often junky companies with low quality characteristics and low earnings growth. Despite these weaker fundamentals, the cheapest stocks still have outperformed over most time periods, and by a wide margin.
This counterintuitive outperformance is driven by the cheap stocks being too cheap. Yes, most of these stocks deserve lower valuation multiples than the rest of the market, but they are so unpopular that their multiples become too low. Over time, these stocks see their multiples expand from “too low” to appropriately low, and that expansion is what has driven their strong performance.
While most of the cheapest stocks are junk, within that junkyard there are gems waiting to be discovered. These gems are companies that have the quality and growth characteristics of pricier stocks, yet their valuations are in line with the cheapest stocks. Undeniably, these gems are rare exceptions that take effort and skill to discover, but they do exist. Given that the cheap junk has outperformed over time, we expect these cheap gems to outperform by even more.
By owning the gems amid the junk, we have built portfolios with the uncommon combination of both deep value and quality growth characteristics. This combination is quantifiable and demonstrates our investment proposition relative to our peers. Compared to most of our peer group, especially those that closely track the value benchmarks, our portfolio not only has a lower P/E valuation, but also a superior earnings growth profile.
Finding gems amid the junk. Getting more for less. That is our formula for success.
The Lyrical Challenge
Lyrical’s portfolios look very different from the S&P 500, and even very different compared to our peers. A big reason for that is our uncommon perspective, and one example of that perspective is something we call The Lyrical Challenge.
The Lyrical Challenge is inspired by the old Pepsi Challenge commercials. Starting in 1975, Pepsi began running television ads where they showed ordinary people participating in a blind taste test between two colas: Pepsi and Coke. At Lyrical, we do our own blind test, but of stocks instead of colas, and of earnings records and valuation multiples instead of taste. The results of these blind comparisons can be surprising, as the perception of a stock can be very different from the reality. In this piece, we present one of the more interesting Lyrical Challenges we have encountered.
2023 Global Impact Value Equity Strategy (GIVES) Review
Our Global Value Impact strategy returned 16.4% in 2023, outperforming the MSCI ACWI Sustainable Impact Index by 1,150 bps and the MSCI World Value by 490 bps, and underperforming the MSCI World index by 740 bps.
While it was satisfying to significantly outperform our style benchmarks by so much, it was frustrating to lag the MSCI World, which benefitted from an outsized contribution from the Magnificent Seven U.S. mega-cap growth stocks. As both value and impact investors, we did not own these seven stocks that accounted for about half of the total index return in 2023. If we compare ourselves to the MSCI World excluding these seven stocks, we would have outperformed by 30 bps.
2023 was a tough year for sustainability investors with the MSCI Sustainable Impact index returning only 4.9% or 18.9 percentage points behind the MSCI World index. A slowdown in the forecasted growth of electric vehicles (“EVs”) and renewables penetration caused a sell-off in many stocks aligned with sustainability trends. Many of these stocks traded at high valuation multiples and fell significantly.
We’ve long advocated for a value-disciplined approach to impact investing. 2023 was a proof point for why. The long-term trends toward EVs and renewables promise of significant growth, caused companies obviously aligned with these trends to trade for sky-high multiples. While many of these obvious impact stocks collapsed in 2023, our value stocks held up while delivering positive change including more than 3 million tonnes of portfolio-weighted emissions avoided.
