Q: What is the background of the company and the fund?

Lyrical Asset Management is a partnership between Jeff Keswin and myself. Jeff and I have been friends for over 25 years, since our college years at the University of Pennsylvania. Back in 1996, Jeff co-founded Greenlight Capital and later sold his stake in the business in 2002. He’s been an entrepreneur and a builder of businesses his entire career. I have a 20-year investing career, which includes long periods at both Pzena Investment Management and Neuberger Berman. 

Our firm was founded in 2008 and we began managing money for clients in 2009. Today, Lyrical Asset Management has $4 billion in assets under management, including more than $750 million in the Lyrical U.S. Value Equity Fund, which was launched in February 2013. Prior to 2013, we were mostly running managed accounts for institutional clients. 

Q: How would you define your investment philosophy?

Over the course of my career as a value investor I have developed and refined an investment approach that tries to incorporate the best elements of deep value investing and its returns, while minimizing some of the negatives. I felt confident that if we executed our strategy well, we could deliver a “best in class” level of performance.

Our strategy is based on three key stock selection criteria: value, quality, and analyzability. We believe that valuation is the most important element of any investment we make. If you take the best business in the world and pay a fair price for it, you only achieve an average return. The only way to generate a premium return is to buy a business for less than it is intrinsically worth. And the bigger the discount, the bigger the return you generate when you are right. The tricky part is getting it right. 
Among the undervalued stocks, we only invest in the good businesses. Companies must meet minimum standards of profitability and return on invested capital. We also stay away from companies that have too much debt. When we avoid low quality businesses we get more of the stocks right. Because we avoid low quality companies, it keeps us out of certain parts of the market, like deep cyclicals, basic materials, airlines, and regulated utilities.

We also look to invest in companies that are easier to analyze. It makes sense that the easier it is to analyze and understand a business, the easier it is to get it right. Analyzability means we avoid businesses such as banks, complex financials, pharmaceuticals and biotech, social media, and hi-tech. It also means we avoid companies that have big problems to solve, like a retail chains facing online competition. 

The benefits of this approach show up in our stock-by-stock batting average and our returns. Since our inception, about two thirds of the stocks we have owned have beaten the market. That is an exceptional batting average, and it’s driven by sticking with good businesses that are simpler to analyze, and buying them at a discount providing a large margin of safety.

Q: What kind of value are you seeking?

The typical value stock is not a good business, or it is complicated or it is facing big problems. We don’t want to own the typical value stock; we want to look for the exceptions. They are admittedly few and far between, but there are enough of them to enable us to fill a concentrated portfolio.

While our approach is very basic and sensible, and perhaps may not sound distinctive, we believe our portfolio is different and unique. We have done an overlap analysis between our holdings and the universe of other managers and we have found that no other firm’s portfolio materially overlaps ours. Out of more than 2,700 institutions that report their portfolio to the SEC, our highest overlap with another firm is only 10% to 15%.

Q: Are these opportunities easy to discover?

There are two challenges to pursuing this investment approach. First, such opportunities are hard to find, so you need a systematic way to screen through what is a very large universe to identify these rare value situations. The second challenge is patience. Our stocks tend to be mis-valued, not because there is an obvious concern about the businesses, but more out of benign neglect. These are companies that have perhaps underperformed. Their earnings have performed well but their stocks have been ignored or overlooked. And so, over a multi-year period, their multiples have slowly and steadily compressed. 

Although each is a good business, is easy to understand, and is attractively valued, it is not an interesting investment to the typical investor because there is no catalyst present to make that stock go up in the near future. We do not care about catalysts. We simply look for good businesses at attractive prices. If we think the business has enough upside to fair value, we will buy it. We never know how long it will take to see the discount go away and the company revalued, but these stocks are deeply undervalued, with 40%, 50%, or even more upside, so even if it takes five or ten years, we earn a great annualized amount of excess performance.

Accordingly, we feature a very low turnover in our portfolio. Our average holding period of an investment is longer than six years. We turn the portfolio over about 15% to 16% a year. With 33 stocks in the portfolio, we have historically replaced an average of five of them per year. 

We do not do any other trading besides that. We are investors, not traders. If a stock dips down, we do not buy more. If it runs up, we do not trim it back. We put on our positions and we leave them alone until it is time to make a replacement. We then sell the full position of whatever we are looking to replace and we buy a full position of the new stock. This has had the added benefit of making our fund tax-efficient.

Q: How do you quantify what represents an opportunity?

We start with a quantitative screen that estimates the fair value of all of the 1,000 stocks in our investment universe. It generates five-year projections based on historical and estimated future earnings. We sort this list based on price to estimated five-year forward earnings, and then manually sift through those on the top of that list to select which look like good businesses that are analyzable and easy to understand.

It may sound time-consuming, but with more than 20 years of experience, we know the vast majority of the stocks in our universe well enough to gauge what is worth investigating and what is not. We also look at other financial metrics, such as historical returns on capital, balance sheet health, and earnings consistency. That initial screening is how we first identify good businesses trading at cheap prices.

However, that screen is merely an initial filter, a crude estimate, and we do not rely on it for our investment decision-making. Once we filter out those names, we proceed through a fundamental research process. 

Q: What drives your research process?

Once we identify a potential investment opportunity, we perform a classic Benjamin Graham-style fundamental analysis of the business. The objective of the research process is to develop a deep and thorough understanding of the business. We analyze the history of the business, evaluate its strengths and weaknesses, and assess threats and opportunities. We spend a lot of time reviewing the historical financial statements of the business and parse through past investor presentations and earnings call transcripts. 

Once we feel that we understand a business well enough, we build our own model to estimate its future earnings. As a result of this diligent research process, if we believe it is a good business, and we have confidence that we can estimate its future earnings well, and it looks attractively valued based on those future earnings, then and only then does it become a candidate to add to the portfolio. 

To evaluate quality, we believe the best single measure is return on invested capital, ROIC. As an investor, if a business only generates a 5% return on capital, then how can we expect anything but a 5% return on our investment over the long run? You have to have a high enough return on invested capital.

Quality is more than just a number, though. You need to understand the business. You need to know how flexible and adjustable it is. You need to know how it performs over a full economic cycle. We look at how resilient it is to competition. These factors enable good businesses to earn good returns on their invested capital.

Part of our research is to avoid companies that were historically good businesses but are becoming bad. That is why we do research and due diligence to avoid these mistakes. Sometimes we find value opportunities by identifying a business that has been historically bad but has now changed and is much better. Most often, though, businesses that are historically good tend to stay good, and most of our investments have a long history of generating attractive ROIC. 

The intrinsic value of any business is the present value of its future earnings. As a practical matter, we value companies based on their five-year-forward normalized earnings and look to pay the lowest multiples on those five-year-forward earnings that our investment universe is offering. Obviously, we do not know what the future earnings will be so we have to estimate them. For some businesses, that estimation is very difficult to get right. They can be complicated, the industry volatile, or they face emerging threats. Other businesses are far steadier and more stable, more predictable, and so they are a lot easier to estimate. 

If we get the future earnings right, we get the investment right. When we do make mistakes, it is because our estimate of the future earnings was significantly wrong. That is why analyzability is so important to us. We look for companies that are easier to accurately estimate their future earnings.

Q: Do you like to meet management?

We do not spend time visiting companies. In fact, I have not gone to visit a company in over a decade. We feel we can get the best, most objective data through their financials and the transcripts of their presentations and conference calls. Earlier in my career I would visit companies as the final piece of my due diligence process—you normally do all your research and analysis and then go and visit the company. But that was back in the days when written transcripts of earnings calls did not exist, so we lacked access to that critical information. 

I have come to believe that meeting management teams can be just as misleading as it is informative. I would rather we base our decisions on facts rather than on how well a company’s management can sell themselves. When I reflect back on all the companies I once visited, I cannot think of a single case in my entire career where a company visit made us decide to not invest.

Q: Can you provide an example of a stock you discovered?

We recently added our first stock of this year: Tenneco Inc. They are in the automotive industry, and their Clean Air division is one of the world’s leading producers of emissions systems. The Clean Air division is 70% of the company, and the other 30% is suspension systems: shocks and struts. It has attractive valuation, attractive financial characteristics, good returns on capital, and a healthy balance sheet. 

In studying the business we learned that its clean air division, which comprises the majority of the company, is doing very well. Emissions standards and government regulations are increasing around the world, which is creating a strong demand for their products. A lot of engineering and regulatory expertise is required, enabling them to earn attractive returns on their invested capital.

Tenneco is a great example of value hidden in plain sight. There is nothing special that we expect to happen in the company that the industry has not already been talking about for years. Yet, despite the solid fundamentals, the stock is priced at a very attractive multiple of earnings. A shorter-term, less patient investor might see this lack of recognition as a negative and move on. We, on the other hand, see the opportunity to earn a great long term return.

Q: How did your view on the company differ from the market?

We probably share a similar view with a lot of other analysts and investors on Tenneco as a company, but we have a very different view of Tenneco as a stock. 

We first discovered Tenneco in late 2014, when our screen showed it to be significantly undervalued with attractive quality metrics. Our research process, which typically takes about one month, confirmed that it was a good opportunity. We decided that it was something we would put in our portfolio. But we stick to a discipline of one stock in and one stock out. If I wanted to buy Tenneco, I had to find something in my portfolio to sell, and there just wasn’t anything that I was willing to sell at that time. 

So, we put Tenneco on our bench and it sat there for several months, until April of this year. At that point, one of our existing holdings had appreciated significantly and no longer looked materially undervalued. Instead, it looked like it was close to fair value, so we decided to take it out of the portfolio, and in its place we added Tenneco.

Q: What is your portfolio construction process?

We manage a fairly concentrated portfolio of 33 stocks, selected from the universe consisting of the 1,000 largest U.S. stocks. We own 33 stocks because we find that number is a good balance between being concentrated enough so that you can be incredibly selective in what you own, but also broad enough that you get the risk mitigation benefit of diversification.

We are pure bottom-up investors, driven only by stock price and company fundamentals. We do not have a market or macro view that influences our investment choices. We also do not look at any benchmark as an investment guide. While our clients may use the S&P 500 Index or the Russell 1000 Value Index as benchmarks for us, we remain indifferent, and just simply seek to own the best 33 stocks that we can find. If we do our job well, we should be able to beat either benchmark. 

We do not conviction-weight our portfolio, meaning we don’t put more weight in our favorite names. We have gone back and analyzed my historical returns from a prior firm and discovered that, as well as I had done, my returns would have actually been a bit higher if I had equal-weighted my portfolio. With that realization in mind, I stopped using conviction weights in portfolio construction.

We manage our exposure risk very tightly. We do not put too much capital in any one stock, and we do not allow more than three stocks in the portfolio to be from the same industry, no matter how great that industry might be. Our goal is to create the most diversified, concentrated portfolio we can. 

We accept that we make mistakes. We’re human. We know that despite our best efforts at research and analysis we will still make mistakes. The best thing we can do is to make sure that no mistake is ever very big. That is why we have strict limits on stock weights and industry concentration.

Q: What does risk mean to you and how do you manage it?

Risk to us is a permanent loss of capital; it is not a day-to-day volatility. If a stock goes down 1% in a day that is not risk. Even if it goes down 20% in a year, if it eventually recovers and goes on to be up another 20% that is not risk. Risk is not stocks that go down, it is stocks that go down and stay down.

Risk happens when we get the future earnings significantly wrong. We manage risk at the stock level through our three key criteria: valuation gives us a margin of safety; by sticking to quality businesses, we decrease the chance of the future earnings being significantly wrong; and by sticking to analyzable businesses, we get more of the future earnings estimates right.

The risk in our portfolio lies in the companies that are not doing well. But they really take care of themselves. Because we do not add more to positions if they go down, it means that if these companies do poorly and their stocks underperform, they just become a smaller and smaller percent of the whole over time.

Even with all our risk management, we know we are still going to get some things wrong, so we make sure we do not put too many eggs in one basket. We do not put too much weight in any one stock and we do not allow too many stocks to derive from the same industry.

The only risk you can really truly manage is your exposure risk. I cannot control if tomorrow somebody chooses to sell the stock off 10%. I cannot control how volatile a stock ends up being. But I can completely control how much of my portfolio is in any single investment.