Andrew Wellington — Working Hard to Find Easy Investments

Winter 2015

Andrew Wellington co-founded Lyrical Asset Management (LAM), a New York-based boutique investment manage- ment firm, where he serves as the firm’s Chief Investment Officer and Managing Partner. Lyrical began investing client capital at the start of 2009. Over the six years ended December 31, 2014, LAM’s U.S. Value Equity-EQ strategy returned 323.7%, net of fees, more than doubling the S&P 500 total return of 159.4%.

Mr. Wellington has been involved with active portfolio management for almost twenty years. He was a founding member of Pzena Investment Management, where he was the original equity research analyst, and later became a principal and portfolio manager. He then went on to Neuberger Berman where he became the sole portfolio manager for their institutional mid‐cap value product, growing it from $1 billion to $3.3 billion in AUM, and earning a five- star Morningstar rating. He was also a managing director at New Mountain Capital, where he played a key role in establishing and managing the $1.2 billion New Mountain Vantage Fund, a value‐oriented, long‐only, activist hedge fund. Early in his career, Mr. Wellington worked as a management consultant at Booz Allen & Hamilton and First Manhattan Consulting Group. Mr. Wellington graduated summa cum laude from the University of Pennsylvania’s Management & Technology Program, earning both a Bachelor of Science from the Wharton School and a Bachelor of Science from the School of Engineering.

Graham & Doddsville (G&D): Tell us about your background prior to Lyrical.

Andrew Wellington (AW): I graduated from the University of Pennsylvania’s Management and Technology Program in 1990 and first started my career in management consulting. Investment management wasn’t even on my radar at that point. It was a different world back then — hedge funds were rare and nobody was watching CNBC yet. I spent five years in management consulting before I started to look more seriously at investment management.

In late 1995, I met Rich Pzena, who had just left Sanford Bern- stein where he ran their domestic equity portfolio. He was starting his own firm, Pzena Investment Management, and I joined Rich as his research analyst. Rich’s business partner in that venture was Joel Greenblatt. I worked with them for over five years. I couldn’t ask for two better people to learn value investing from.

The firm had a great deal of success both in terms of in- vestment performance and fundraising. It grew from basically nothing to over $1 billion around the five-year mark.

Toward the end of my time at Pzena, I was promoted to be a portfolio manager and a princi- pal, but I still wanted more autonomy to make my own decisions. I left in early 2001 to join Neuberger Berman. It was a co-portfolio manager role with Bob Gendelman in their institutional mid-cap value

fund. I was co-PM in 2002, and then I became the sole PM in 2003 when Bob left to start his own hedge fund.

G&D: What is your investment philosophy and has it changed over time?

AW: Throughout the almost 20 years I’ve been investing, the style and philosophy has always been similar. First and foremost, there is a focus on value. I am a deep value investor. By deep value, I mean I look for the companies that are trading at the biggest dis- counts to intrinsic value that I can find. The bigger the dis- count to intrinsic value, the bigger the return you generate when you’re right. No matter how great a business is, no matter how well you know it, if it’s not undervalued, you can’t make a superior return investing in it.

Then there are two things I’ve settled on that improve the odds of success — quality and analyzability.

The emphasis on quality is the Joel Greenblatt influence rubbing off. Amongst the cheapest stocks, I only want to invest in those that are also fundamentally good businesses. Good businesses have flexible costs, stable sources of demand, rich margins that provide more of a gap between cost and revenues. When things go wrong, a lot of times you don’t even notice because good business- es are able to offset it. On the other hand, when little things go wrong with a bad business, it tends to result in disproportionately big problems. Analyzability is important because the simpler the business is, the more transparent it is, the smaller the problems it’s facing, the easier it is to accurately determine future earnings. If you get the future earn- ings right, you get the investment right.

There are no style points in investing. We don’t get extra percentage points for making money on a stock that’s really difficult to understand. If you make a huge return on a really simple stock, that still counts.

Our process is to first sift through the statistically cheap- est stocks, just on the numbers. We find that most of those stocks are either not very good businesses or they’re complex. But there are exceptions, usually a handful of stocks, that don’t have any major problems and aren’t very complicated that we can go research and analyze in more detail. If you have a small, concentrated portfolio, you can fill it with just these exceptions. Because they don’t have major problems and be- cause they are good business- es, you can get a high percent- age of them right.

One metric we track is our batting average — how often we get something right. For us to be “right,” the stock has to outperform the market. We’re able to track this because we don’t do any trading around positions. 65% of the investments we’ve made at Lyrical have outperformed the market over their life. This is a fairly high batting average, but it is not because we are much better analysts than everyone else. Rather, we have a high batting average because we invest in stocks that are relatively easier to get right. When we see businesses that are difficult to get right, we skip them and keep looking. As I like to explain it, we work really hard to find the easiest investments.

G&D: How would you describe your research process? What do you focus on?

AW: Our research and analysis is really about immersing ourselves into the history of a company — seeing how it per- formed quarter after quarter after quarter, looking at what past long-term objectives were and how they were realized or not realized, and examining what caused the under or out- performance. Then, you can build a deep qualitative under- standing of the business. You see how that matches up with the financials so you can make a quantitative forecast of future earnings.

Modeling is an element of what we do. To value a business, we need to estimate its future earnings and so we need a model. But a model is simply a tool. The critical part is using the correct assumptions. If you get the sales growth right and

you get the margins right, you’re almost all the way there. You don’t need to build a complicated model. A complicated model with the wrong margin assumption is not going to do you any good.

G&D: What is your process for replacing a stock in the portfolio?

AW: At a high-level, this is how our process works. First, we start with a valuation screen on the top 1,000 US listed stocks. That screen is where we generate all our investment ideas.

We pick one company at a time from our screen to re- search, analyze, and investigate, and typically spend about a month on it. At the end of the research process, we will come to a conclusion on quality, analyzability, and valuation of the stock. If it meets all our criteria, then it goes onto our bench. Through this process, we end up with a handful of stocks on our bench.

We’re always looking at what are the best names on our bench versus what’s already in the portfolio. When we think the portfolio would be materially better by replacing a name, we make the switch. It has to be overwhelmingly better, hit- yourself-over-the-head kind of better. Replacing a 30% upside stock to buy one with 40% upside just doesn’t make that much of a difference on a 3% position. We employ a “one-in, one- out” philosophy and keep the number of names in the port- folio constant, which enforces a certain discipline in our process. So what typically happens is we patiently wait until one of our stocks appreciates and approaches fair value. Normal- ly, we look to replace a stock when it has 5–10% upside to fair value. But we will replace it before then if the new opportunity is significantly better.

We also sell if we ever lose conviction in the fundamental thesis. There’s no room in a concentrated portfolio for stocks you don’t really believe in.

G&D: How did you determine that 33 is the optimal number of holdings? Buffett’s famous quote is that no one gets rich off their sixth-best idea. Have you considered more concentration?

AW: Well, the sixth-best idea we’ve owned is Jarden Corp (JAH). We’ve made 827% on that, which goes to show you can do ok on your sixth-best idea. But to address the question, the 33 comes from a few things. An academic statistical study shows that when you get to the 30s, you’ve captured almost all the benefits of diversification. So there is definitely a risk mitigation benefit of 33 versus six or eight.

I also believe our returns are higher with 33 stocks than they would be with six or eight. This gets into the psychological and behavioral aspect of investing. Let’s play a game. We’ll flip a coin and if it’s heads, you win $500, but if it’s tails you owe $100. That a 5:1 payoff on a 50/50 bet. I would hope everyone knows that’s a good bet. Now let’s make one change. Heads you win $5 million, tails you lose $1 million. It’s the same risk/ reward but the size of the bet is huge now, and you start to focus more on the 50% chance you lose $1 million and you probably don’t take the bet. There are fantastic risk/reward opportunities that you are willing to do at 3% of your portfolio that you might be unwilling to do at 10%. When a position gets that big, you look for perfection and there’s no such thing. You become overly sensitive to the downside, re- mote as it may be. And for every unit of downside you eliminate, you tend to sacrifice multiple units of upside and, over the long the run, end up with lower returns.

A key driver of success in value investing, besides making judgments about businesses, is to realize that nothing’s perfect. There are risks with everything. You need to be able to tolerate uncertainties and potential downside.

With 3% positions, I can be completely analytical and dis- passionate about everything. We make better decisions because we’re able to stay unemotional about them and that leads to better risk/ reward in the portfolio.

G&D: On a related topic, why is every position a 3% weight? Why not adjust position sizing based on conviction?

AW: I don’t have equal conviction, but I’ve learned that my conviction does not add value. I did not start out with the idea of running an equal- weighted portfolio. I looked back at the three and a half year period I managed a fund at Neuberger Berman. Over that period of time, I outper- formed the U.S. equity markets by about 1000 basis points per year. I went back and analyzed what my performance would have been if I had equally weighted my portfolio, thinking that the analysis would show how much extra alpha I creat- ed with my judgments about conviction weights. Instead, I discovered that my weighting decisions had cost me 70 basis points per year. Since that original analysis, we have expanded it to look at all mutual fund managers. What we found was that we’re not the only ones that don’t add any value with conviction weighting. Contrary to conventional wisdom, most funds would generate higher returns by simply equal weighting their portfolio.

G&D: How actively do you trade in your portfolio?

AW: Our turnover is around 17% per year, which implies a six-year average holding peri- od. Some stocks we’ve held for as a little as a year. There have been a lot of stocks we’ve held for six years and counting. The bigger the discount to intrinsic value, the more patient you can be. If the upside in your investment is only 5%-10%, you better realize that gain quickly. But if you’re upside is 60%+ and it takes you five years instead of two or three, that’s okay because that’s still a substantial amount of outper- formance per year.

We’ve realized it’s impossible to determine how long it will take for a stock to work. We might be able to estimate what the earnings will be but you have no idea how long it might take the market to recognize those earnings.

Goodyear Tire (GT) is an in- teresting example. Over the six years we’ve owned it, GT is up 370%. That’s 210 percent- age points better than the mar- ket. Yet it’s still at 9x earnings. They’ve done a great job growing earnings and reported record margins but it’s still cheap because the market is slow to accept that this level of profitability is sustainable. It’s been a great investment in part because of how cheap it was in the past and also their fundamental success in improving profitability.

The tougher ones are where you expect the company to improve but there are bumps along the way. Part of what separates great investors from less good ones is the ability to sift through the noise and figure out if the company will ever get things right. We don’t trade around positions. When our stocks aren’t doing well, we don’t add more. When they are doing well, we don’t trim them back. The only trades we do in our process are when we sell a position in its entirety and replace it with a new position at full weight.

It’s contrary to the way every other manager I know in the business operates but we have tested both methods and found our way actually per- forms better.

G&D: What valuation meth- odology do you rely on?

AW: One fundamental law in economics is that the value of a business is the present value of its future earnings. But in the real world, there are all kinds of problems with the traditional DCF formula, in- cluding figuring out terminal growth rates, discount rates, etc. We take that same con- cept but apply it in a more practical framework. Our approach is to value com- panies on their five-year for- ward normalized earnings. The multiple we use comes from the history of the market.

While we know the market has historically been valued at about 15.5x one-year forward earnings, our analysis of histor- ical valuations suggests the market is valued at about 9x five-year normalized forward earnings. Sometimes the mar- ket is at 10x like it is today. In other periods, such as in 2008 or 2009, the market could be below 6x. But the market has always reverted back towards 9x over time. We don’t use different multiples for different businesses or industries because we hope to capture everything that might make one company or industry better than another in the future earnings number. There’s elegance to the framework that allows us to compare different companies from different industries with different stories and still have one absolute valuation paradigm.

G&D: How do you assess the quality of management?

AW: In terms of management skill and running a business, what I’ve learned over the years is it’s really hard to tell how good management is. Some businesses you can tell they’re great because you can see how much better their business is performing relative to peers. We look for a high level of competence. If we were to grade management, we would want to grade them with an ‘A’ or a ‘B’. We wouldn’t want to own a company where we would give them a ‘C’. In some businesses, there are more capital allocation decisions to be made. You want to be able to rate those management teams an ‘A’. We own AerCap (AER), an aircraft leasing company, for example. I would not want to own an aircraft leasing company with ‘B’ management. Fortunately, I think AerCap’s management is an ‘A+’.

One major factor we analyze is capital allocation. If the company generates a lot of free cash flow and the management team proceeds to waste it, that free cash flow has no value to investors. Capital allocation doesn’t have to be perfect or optimal. I just don’t want to see it wasted.

Acquisitions are the biggest way a company can blow itself up. When companies do acquisitions, you want to make sure that they’re buying at an attractive price and realizing synergies. Otherwise you’d like to see the excess cash eventually returned to shareholders.

Our preference is for companies to employ cash for stock buybacks because we believe every stock we own is under- valued. A dividend distribution may not be optimal, but it’s hardly a bad thing, so we don’t get too worked up over that. If they want to leave some cash on the balance sheet for strategic options or for safety, that might be sub-optimal but I don’t have a problem with that either.

G&D: Do you also look at businesses or industries that reach potential inflection points? For example, a situation where significant capacity came out of an industry?

AW: We look for quality, analyzable businesses at significant discounts to intrinsic value.

Sometimes a company is undervalued because there is an inflection point and the future is expected to be much better than the past, but those are rare exceptions. Most of our stocks are undervalued be- cause they are benignly neglected by the market. There is nothing going on today that is different than what was occur- ring last year or the year be- fore, but because of random ups and downs in the market or through earnings growth outpacing price appreciation, the stock has become under- valued.

We do own a few stocks which are beneficiaries of consolidation, such as Avis (CAR), Hertz (HTZ), and Western Digital (WDC). Consolidation is one element of the thesis, but consolidation by itself isn’t enough to make the invest- ment attractive. We own them because they are quality, analyzable businesses at significant discounts to intrinsic value. The airline industry is benefit- ting from consolidation but we will not be investing in any airlines.

It’s really interesting to com- pare the differences between the car rental and the airline business because they have very similar sources of demand. The biggest driver of demand for car rental is deplanements. People go on air- planes and when they land, they rent cars. But these two business are structurally very different. One business we love, the other business we won’t touch. Even with the benefits of consolidation, air- lines are still not a good business to us because the cost structure is fixed. If your business earns only a 10% margin, and there’s a 10% fall in demand with most of your costs being fixed, you can get a 100% fall in earnings.

Contrast that with car rental. In the car rental business, 70% of costs are variable. They’re able to right-size their business. They don’t need the economy or demand to return. They could shrink to current levels of demand over a few quarters and get back to profitability. That’s a much better business structurally. It’s a much more robust business to the ups and downs of what can happen in the future. You can afford to take more risk be- cause the resiliency and flexibility of the business is risk- mitigating.

G&D: You recently launched a long/short fund. What was the rationale for doing so?

AW: My business partner, Jeff Keswin, co-founded Greenlight Capital. He has substantial experience in the long/short world so even though we decided to initially focus on long- only at Lyrical, we thought there might eventually be an opportunity to manage a long/ short fund as well. Betting on ourselves, we started our long/ short fund in early 2013, initially with just internal capital.

We’re doing shorts because we believe we can be as good on the short side as we’ve been on the long side. If I did- n’t think we could be, I wouldn’t be interested in diluting our reputation or degree of success. We really believe that we have a differentiated approach to shorting. What’s driven our success on the long side is looking for significant misvaluations in businesses where we have a high probability of getting the future earnings right. That’s exactly what we look for on the short side as well. We’re not short accounting frauds. We’re not short businesses we think are going to disappear.

We are short companies that are significantly overvalued and yet are very simple and easy to analyze but are often over- looked by traditional short sellers because there’s no catalyst. We believe we can be relatively accurate at estimating future earnings power and reliably identifying stocks that are significantly overvalued. Many people think you have to short bad businesses. In some cases, we’re short great businesses. These stocks often have high multiples for long periods of time. If a great business is worth $100 a share but the stock is at $150, that’s a good short. It doesn’t have to go to zero to be a good short. We aren’t short stocks such as Tesla (TSLA) and Netflix (NFLX) because I don’t know what they’re going to earn in five years. Those are new business models. No matter how expensive they are today, no matter how likely they are to be overvalued, if I don’t know with a high degree of certainty what their future earnings will be, then that’s not a very good investment for us.

For the first six months, we shorted ETFs as a placeholder until we could build a portfolio of single-stock shorts. We have been running single-stock shorts now for 18 months. It’s working exceptionally well. In fact, over that 18-month peri- od, our batting average on the short side is 75%, compared to 68% on the long side.

G&D: Lyrical has a smaller investment staff relative to many other funds. Why is that beneficial versus employing a larger team with coverage on specific sectors or industries?

AW: When you only buy, on average, five stocks a year, how many people do you need? That’s less than one eve- ry two months. I have a lot of titles at the firm, but my main job at Lyrical is Junior Analyst. If I pick the right stocks, every- thing else at Lyrical is easy. I think part of our edge comes from the fact that I, along with my co-portfolio manager Caroline Ritter, bring a lot of experience to analyzing business- es.On the margin, we make better decisions because we’re the ones listening to every earnings call. We’re the ones going through the financials and seeing it all first-hand as opposed to having junior staff do that, and then processing what they have.

G&D: Would you be willing to walk us through a current idea?

AW: It’s interesting that the second-best stock we’ve ever owned is AerCap (AER) and it still shows up as one of the cheapest stocks in our portfolio today. Even though it has appreciated 1,200% since we first bought it, AER trades at 7.9x this year’s earnings. When we first got involved in January 2009, AER was priced around $3 a share and had $2 a share of earnings. You don’t need a very sophisticated screen to identify stocks at 1.5x earnings. AER is in the business of renting commercial airplanes to airlines around the world. If you looked at airlines in the U.S. in 2008, you’d have a pretty negative view of businesses that rent airplanes to airlines. There are a lot of things wrong with that view though. First, airlines in America aren’t the same thing as airlines around the world. There are different trends in different regions. They are very healthy and growing in the Middle East and in Asia. Also, airlines around the world are often supported by their governments, so they don’t have the same financial stress.

While it sounds risky to rent an airplane to an airline, when you look at the business and the history of it, you see that losses are really minimal. With AER, what matters most is not if an airline goes bankrupt, but do they have the right planes, those in demand by most air- lines? If you own a 757 that people aren’t really flying any- more, and it is repossessed, it’s going to be hard to find some- one else to buy it. If it’s a modern, fuel-efficient 737 or A320 that everybody around the world uses and where there is a production backlog today, there is much less risk to the collateral. If AER’s customers go bankrupt, it can repossess the airplane and easily find someone else who wants to rent it. AER’s business was nowhere near as credit- sensitive as one might think, but back in 2008, it was priced that way.

AER earned $2.63 last year, and this year they’re projected to earn $4.95. That big jump was because year they acquired ILFC in December of last year from AIG and the deal was incredibly accretive. While the stock is up, it was cheap before the deal and the earnings power increased so much that, on a prospective P/ E basis, the stock still is incredibly cheap. It hasn’t been a good performer in 2014 even though they’ve executed on the integration of ILFC exceptionally well.

G&D: You mentioned Good- year Tire (GT) earlier in our conversation. What makes it a good business?

AW: GT has not always been a great business. It used to be a lousy business that we would have never touched before. The company used to make low-end commodity tires and high value performance tires. Asian imports killed the low- end part of the business. With factories and unionized labor, it took GT the better part of the first decade of the 2000’s to exit that business. The whole US tire industry shut down the low-end business and the related plants. That takes a lot of time and ac- counting charges — you can’t just do that overnight. Along the way there were dis- appointments. In 2007, syn- thetic rubber prices spiked with oil. They were able to pass through the costs but it took several quarters. They were finally ready to start mak- ing good profits in 2008 but then the global recession hit.

With 80% of their tire sales being replacement, and only 20% to OEMs, the recession shouldn’t have had as big of an impact on the business. But OEM car production fell by 50%, enough to lower capacity utilization at their factories and hurt their overhead cost absorption. GT did some more restructuring, and earnings started coming back. I think people got frustrated with GT and moved on to other things. I passed over it on the screens a number of times. The truth was obscured by lots of noise. Investors just had to peel it back and sift through it. When you did, you saw a company that was positioned to do very well. They previously had peak earnings in 2007 of $1.66. They were sup- posed to make $3 a share this year, record earnings, record margins, and while the stock is up to $28, it’s trading at a modest valuation of just over 9x earnings. There’s a lot of institutional memory in stock valuation. Most of the time it’s right, but you can find exceptions. In our view, there’s nothing wrong with Goodyear. It’s cheap be- cause of an outdated view of what the business is. Today, it’s a good business and still significantly undervalued.

G&D: Is there a short you would be willing to discuss?

AW: We are short Coca-Cola (KO). Coke’s a great company. They make a great product.

But Coke trades at about 20x earnings. They’ve grown their earnings at only 5% a year for the last five years and they’re not expected to grow that much faster over the next five years. Why does Coke have a 20x multiple? Because Coke used to be worth 20x and investors have become anchored to that multiple despite fundamentals.

If you go back to the late ’90s, Coke was a global growth powerhouse. They produced double digit EPS growth year after year and penetrated emerging markets. But now, they have reached a certain maturity level. We are also starting to see some cracks in the business. Consumers don’t like carbonated soft drinks as much anymore and you’re seeing that category shrink.

We feel we can reasonably estimate the future earnings of a company like Coke. Margins are stable. Sales growth is pretty stable. Not a lot of catalysts that can dramatically move the earnings of a company of that size and scale and scope.

Coke is getting credit for continued high performance, but if things don’t go that well, there’s much more downside.

It’s been a very profitable short over the past 18 months for us. It has underperformed the market by 16% at this point.

Another successful short for us has been Whole Foods (WFM), a similar story to Coke. We expected them to continue to perform at the high level they had been per- forming but even if they did that, they were significantly overvalued. And now we may be seeing a negative inflection in the business with increased competition nipping away at their position. They still might be the best organic foods market, but their competitors are selling more organic foods and at lower prices. The stock is already down a lot but now the company is earnings less than we initially estimated. We believe it has further downside and still looks like a really attractive short here despite the fact that we think it’s a great company. The vast majority of the names we are short, I’d be happy to be long if they were at a significantly lower valuation. Any- thing we’re long, if it were at a significantly higher valuation, I’d probably be happy to be short. The difference in valuation is everything.

Interestingly, while we are long value, we are not short growth. The businesses in our short book don’t grow any faster than those our long book. They have high multiples because they grew really fast a long time ago. There’s a certain stickiness to multiples. We see that with Goodyear too. It still has to shake off that reputation of its past and continue to perform. On the flip side, you also see it with Coke. Multiples are slow to adjust. Over subsequent years, as the earnings come through, eventually the market catches on, and the multiples adjust to the right level.

G&D: Thank you for taking the time to speak with us.