There has been much debate over whether value investing is dead, but it seems that this year has shown that value investing is still very much alive. In late 2020 and some parts of this year, there have been periods in which value stocks have outperformed versus growth stocks.
Lyrical Asset Management Wins Big With Value And Growth
However, what if you could buy value stocks that also have growth characteristics? That’s what Lyrical Asset Management does, and they’ve found great success with this strategy. The fund has returned 19% gross and 18.3% net for the first three quarters of the year, compared to the MSCI EAFE Index’s 11% return and the MSCI EAFE Value Index’s 11.4% return. For the third quarter, Lyrical Asset Management returned 1% gross and 0.8% net, compared to the MSCI EAFE’s -0.4% return and the MSCI EAFE Value’s -1% return.
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Lyrical’s Global Impact Value Equity Strategy (GIVES) is up 21% gross and 20.2% net for the first nine months of the year. The MSCI World Index is up 19.4%, while the MSCI World Value Index has returned 18.9%.
However, these indices do not take into account ESG or impact investing, like Lyrical’s GIVES portfolio does. The GIVES portfolio was up 1.6% gross and 1.4% net for the third quarter, compared to the MSCI World’s flat return and the MSCI World Value’s -0.8% return.
Dan Kaskawits and John Mullins, co-portfolio managers at Lyrical International and for Lyrical’s GIVES fund, shared their strategies with ValueWalk in an interview via email. They discussed their international deep value fund.
Value Indices Are Broken
In their 2020 letter to investors, Kaskawits and Mullins argued that value isn’t dead and that it’s the value indices that are a problem. They noted that the EAFE Value Index has significantly underperformed the MSCI EAFE in 10 of the last 14 years. Kaskawits and Mullins pointed out that comparing the MSCI EAFE Value Index to the performance of the cheapest stocks in non-U.S. developed markets reveals that they have outperformed the index in 10 of the last 15 years.
In their interview with ValueWalk, they explained that they want to maximize the future cashflows they purchase for every dollar invested. However, MSCI and other index providers focus on other things when building their value indices. They zero in on stocks with low growth to select the stocks for their value indices.
“Here is how it works,” Kaskawits explained. “For each constituent in the EAFE Index, MSCI assigns a value score and a growth score. Stocks with high value scores and low growth scores go into the value index. Stocks with high growth scores and low value scores go into the growth index. But what about stocks that have a high value score and a high growth score? These are some of the best opportunities and where we spend most of our time sourcing ideas – cheap stocks with high growth.”
He added that these stocks confuse MSCI’s algorithm, so they are included in both the value and growth indices at partial weights, diluting their influence. Kaskawits and Mullins define value stocks as the cheapest quintile within their universe of 1,500 stocks outside the U.S. in developed markets based on five-year forward earnings power.
“We don’t just buy all the cheapest stocks though,” Kaskawits said. “Our goal is to perform better than the cheapest quintile, which we have been able to do thus far. Since inception, we have generated a return of +46.5%, net, compared to the cheapest quintile, which was up 39.3%.”
How The Lyrical Team Selects Stocks
Kaskawits and Mullins said their portfolio trades at 11 times forward earnings, compared to the MSCI EAFE benchmark’s multiple of 15 times. They look for stocks within the cheapest quintile of their universe because that part of the market has delivered the longest-running source of alpha at more than 400 basis points annually, dating back to 1975 in non-U.S. developed markets.
However, the Lyrical team noted that there is a problem with the cheapest part of the market because most of the companies in that part of the market are cheap for a reason. Nonetheless, the cheapest part of the market has outperformed despite its fundamentals, as the companies in that part of the market typically lag the market significantly in earnings growth.
Kaskawits and Mullins sift through the cheapest stock in search of gems among the junk. They pointed out that the MSCI EAFE Value Index hasn’t grown its earnings since 2007, and while their fund trades at the same P/E multiple, it’s made up of companies that have grown their earnings per share by over 7% over the same period.
“We think most investors believe that growth stocks are expensive stocks,” Mullins clarified. “Our goal is to combine both growth and value by hunting for compounders in a part of the market ignored by many of our peers. With our bottom-up approach, we’ve found several cheap companies in sectors of the market favored by more traditional growth investors.”
He used Nintendo as an example, as it trades at about nine times forward earnings excluding cash and investments, compared to peers like EA, Take-Two or Bandai Namco, all of which trade at a multiple greater than 20 times. Kaskawits and Mullins noted that the Nintendo Switch is in its fifth year and believe that many investors are worried about the potential end of the console cycle.
However, they believe Nintendo has transformed itself into a recurring, high-margin business. Kaskawits and Mullins pointed out that video games have long been considered a cyclical business, and console cycles have historically lasted about five to seven years.
Nintendo no longer plans to release new hardware every five to seven years, instead choosing to release newer versions of its Switch console on a regular basis, similar to how Apple launches updated versions of the iPhone every year. The Lyrical team believes this new method suggests there will be no cyclical decline in console and game sales but rather a steadily growing level of games sold to a growing base of users on a stable platform.
For nine times earnings, Lyrical gets a business with a 30% return on capital and a capital-light, software-centric business and plenty of cash in a growing industry. Nintendo trades at a significant discount versus its peers, but Kaskawits and Mullins believe it has some of the best games and franchises in the business, including 20 of the top 25 best-selling games of all time. They think Nintendo’s success is predictable and that it’s worth 75% more than what it is trading at today.
The Importance Of Analyzability
Kaskawits and Mullins have always been deep value investors, but their investing process has changed slightly over the years. One investment that had a significant impact on how they invest was the oil and gas sector, which they owned before starting Lyrical.
The Lyrical team owned several lower-quality exploration and production companies. Their thesis was that the marginal cost to produce oil was much higher than the market price at the time. They believed that the companies were exceptionally cheap based on a “more normal oil price.”
Now that oil is above $80, Kaskawits and Mullins see that they were right, but it took years for their thesis to play out. Additionally, they failed to appreciate how long U.S. shale producers would drill at uneconomic prices.
“You can make a lot of money buying bad businesses at cheap prices, but it’s very hard to do repeatedly,” Kaskawits explained. “Things that can go wrong, tend to go wrong for bad companies. It pays to keep it simple. Today, if we don’t think we can get the earnings right for a business, within a reasonable band, looking five years into the future, we pass. By holding a strict bar for quality and analyzability, we sleep better at night and happily delivery better returns to our clients.”
The Lyrical team has found that investing in high-quality businesses improves their odds of success. They only invest in companies with durable competitive advantages and an expected return on invested capital of at least 10%, but preferably above 15%. Additionally, they have found that the easier it is to analyze a business, the greater the probability of success.
Their Biggest Mistake
Kaskawits and Mullins said their biggest mistake in their current fund is Babcock, which has plunged 22% since they bought it in June 2019, although they still own it today. They bought the engineering and construction company because it is different from the other companies in its sector. Typically, the Lyrical team doesn’t like engineering and construction companies because they provide a commodity service with limited earnings visibility.
However, Babcock is a highly specialized engineering company that provides mission-critical services to government agencies, which means it does not provide a commodity. Kaskawits and Mullins explained that Babcock is the only company that can service the U.K.’s submarines because it has unique ports, personnel and clearance. Babcock also has a return on invested capital of more than 30%. Its business is more predictable than that of other companies in the sector because its revenues come from government budgets. Its costs are also easy to predict. However, that doesn’t mean there weren’t any problems with Babcock.
“Unfortunately, a bad management team can hurt even a good business, like Babcock,” Mullins explained. “The previous management team made a bad acquisition and then started to get behind on their earnings targets. They started booking contracts in a generous way to inflate earnings. There was nothing fundamentally wrong with the business itself, but the accounting margins were overstating normalized levels and needed to be reset.”
Although Babcock was a mistake initially, he expects things to turn around, enabling Lyrical to still win on the investment. He said the problematic management is out, and the new management has a track record for turning around mismanaged assets. The Lyrical team sees more than 50% upside from Babcock’s current price.
Their Biggest Winner
Lyrical’s biggest winner was Ashtead, which generated a return of 215% in USD, compared to the MSCI EAFE’s return of 35% over the same period. Kaskawits and Mullins said the primary driver of that return was a rerating in the multiple, which rose from 9.1 times forward earnings per share when they bought it to 28 times forward earnings when they sold it.
“Ashtead is a good example of value hidden in plain sight,” Kaskawits said. “The business continued to chug along, as it always had, during our holding period. But the market took notice and rerated the stock, which is a critical part of our expected return because we buy stocks for significantly less than what we believe they are worth.”
The U.K.-based Ashtead is North America’s number two tool rental equipment company, primarily operating under the Sunbelt brand. It has 936 locations and is one of only two companies in the industry with a national market presence alongside United Rentals. The Lyrical team explained that scale in the industry makes a big difference, and Ashtead has better technology than smaller players, enabling it to provide superior service, like by remotely monitoring equipment.
When asked about their newest, high-conviction idea, Kaskawits and Mullins turned to Samsung Electronics Co Ltd (KRX:005930), an industry leader in Device Solutions like memory chips and semiconductor foundries, Consumer Electronics, and Information Technology and Mobile Communications.
They believe Samsung’s crown jewel is its Device Solutions business, which accounts for about 70% of its operating profit and is expected to grow its revenue in the high single digits. The company’s other businesses are also steady, with solid market positions and GDP-like growth. The Lyrical team noted that Samsung had generated a 20% return on tangible capital over the last 10 years.
They pointed out that Samsung is widely considered to be the best-in-class memory producer with a leading portfolio and efficient manufacturing operations. Kaskawits and Mullins believe Samsung protects its competitive advantage by spending more than $16 billion on research and development, which is more than its two biggest competitors combined.
Samsung is also one of only three operators that can produce high-end outsourced semiconductors to companies like NVIDIA Corporation (NASDAQ:NVDA) and QUALCOMM, Inc. (NASDAQ:QCOM). Kaskawits and Mullins noted that Samsung has over $80 billion in net cash and a history of intelligence capital allocation through share repurchases and M&A.
They acquired Samsung shares for about 8.5 times 2022 earnings per share, adjusted for net cash and investments. The Lyrical team expects the company to grow its earnings per share by 12% annually, in line with its historical average, and they see about 50% upside to fair value.
“Samsung is a good example of how our long-term viewpoint gives us a competitive edge,” Mullins said. “Most Wall Street commentary is focused on short-term results and weekly memory chip pricing, which can be volatile. Over the longer-term though, memory demand and industry profits are expected to grow at a healthy rate. By taking a step back and focusing on the long-term opportunity, we can take advantage of the short-term noise.”
This post first appeared on ValueWalk Premium