Distillate Capital Executives Share Their Insights on Value Investing and Their Newly Launched ETF

ETFdb.com: Please tell me about yourselves, and the trajectory that led you to Distillate Capital.

Thomas Cole (T.C.): The three of us were together at a traditional, active, value-oriented investment firm here in Chicago. I was chief investment officer there, Jay was head of strategy as well as a sector analyst, and Matt was an analyst covering healthcare and then a senior member of the portfolio management team. We didn’t start together or at the same firm, but we all have a legacy as fundamental investors. I started at Brinson Partners and stayed until it was ultimately called UBS Global Asset Management, almost 28 years in total, and had a number of roles in research and portfolio management and ultimately was running the U.S. Equity business based in Chicago. Matt and Jay were at the competing firm in town, Institutional Capital (ICAP). I joined ICAP in 2012.

When I joined ICAP it was one of those periods like we are in now where there were a lot of headlines about value, as a strategy, not working. And there was reason to wonder, as the valuation model I had used at UBS and the one I adopted at ICAP were both struggling to identify stocks that were more likely to outperform. The value benchmarks were also struggling. But that didn’t make intuitive sense. The market wasn’t divorced from fundamentals as it had been in the late 1990s, and there was a large and growing body of work that showed markets were far from perfect, and that human behavior leads people to quite often make bad investment decisions. So instead of saying it was a phase in the market and simply waiting for a resurgence in value, we set off on a project to reconsider the valuation equation.

And instead of starting where we had left off, we backed up and said, what is bedrock that we can count on with certainty to measure value and consider risk? We set aside a lot of the convention wisdom and points of emphasis on Wall Street and went back to a couple of bedrock principles. One is that the value of any asset is the value of the cash that asset will produce in the future. The second is the presumption that stock prices ultimately reflect fundamentals. With that in mind, we started down the road that is now Distillate Capital.

Jay Beidler (J.B.): Soon after joining ICAP, Tom came to Matt and myself and said, basically, behavioral research says that value investing should still be working, so why is it struggling? That’s kind of where we started digging into some of the accounting distortions, the issues that we think are leading people to mistakenly think that value isn’t working and why we think it’s just not getting properly defined.

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ETFdb.com: What are some of the drawbacks of traditional value-based strategies?

T.C.: We’ve written a paper that’s on our website that highlights our views in some depth, it is called Accounting for Value in a Changed Economy. But basically, the economy has changed a lot in recent years. It has moved away from a world where companies put physical assets in the ground or bought machines. We moved into a world that’s more about research and development (R&D), and creating intellectual property. That is important, as the accounting for each type of activity is quite different. Physical assets are purchased, capitalized and written off slowly over time, while R&D spending and the development of intellectual property is written off as it is incurred.

As a result, what used to be comparable across industries and across companies became less comparable. Earnings and EPS became less comparable. The accumulation of earnings that shows up in book value became less comparable. Metrics like the price-to-book, which if you go way back in time was a pretty valuable metric in the context of indicating where there might be relative value opportunities in the market, became less comparable. So making accurate comparisons to find stocks that offer better value has gotten more difficult.

But it’s even a little more complicated than that. Accounting conventions, in general, have become more complicated. Warren Buffett suggested in a recent letter to shareholders that the earnings per share figure at Berkshire Hathaway would become completely meaningless due to the requirement to report unrealized gains and losses from equity investments in net income. I think he said the measure was “useless.” So comparing Berkshire’s PE to another company’s PE becomes meaningless. So for several reasons, accounting-based valuation metrics have become very difficult to use. So, we developed a cash flow–based valuation metric that we believe gives us a much better measure of relative valuation across the market.

J.B.: I think value for a lot of strategies in its current definition really measures physical asset intensity rather than the price you’re paying in relation to the future stream of cash flows. In a world that’s shifting more and more towards intangible assets, this mismeasurement of value is getting worse and worse. We think there’s a tremendous opportunity to redefine value and capitalize on that distortion.

ETFdb.com: Let’s get into your newly launched ETF. The Distillate U.S. Fundamental Stability and Value ETF. How do you think that this ETF is circumventing some of the shortcomings that you just mentioned of the traditional value approaches? If you could discuss specifically with respect to the value and quality that would be great.

T.C.: I think the primary difference versus what’s available in the marketplace now is starting with the valuation thought process that we just laid out. We still see the majority of offerings out there starting with the price-to-book measure as their primary measure of valuation. A lot of times, there are multiple factors that go into the measure of valuation, but those, again, we think are somewhat tainted, given the accounting issues that impact comparability.

J.B.: On the value piece, we really start with free cash flow for the reasons that we described. We then draw on our long history in fundamental analysis across a variety of sectors to make a number of adjustments to free cash flow that we think are necessary to really make it comparable across companies and across the market.

Matthew Swanson (M.S.): Let me expand on the quality or risk component of our process. While the industry generally leans pretty heavily on near-term price volatility to define risk at the security or portfolio level, we think of that as at best an incomplete proxy for risk.

To Tom’s earlier point, we backed up to bedrock principles and defined risk in a very different way, looking at fundamental stability, cash flow stability, and also the level of debt on a company’s balance sheet. If you believe cash ultimately determines value, then the likelihood of getting that cash should be your primary point of concern. We think fundamental stability is much more important than stock price volatility.

T.C.: We’ve also broken away from the tradition of market cap weighting you see in many ETFs. Market cap weighting was an innovation in 1923, but we think there’s a much smarter way to weight the holding in our portfolio. Our proprietary measure of cash flow is the primary determinant of how securities are weighted in DSTL.

The fact that we can offer our strategy in an ETF makes it particularly appealing to the high-net-worth and family office markets, and probably to a lot of registered investment advisors, because there are certain tax advantages that go with ETFs that certainly differentiate them from the mutual fund market that offers competing value-based strategies.

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ETFdb.com: Would you also talk about some of the companies that are held in your ETF?

T.C.: Apple (AAPL) is the largest holding at the moment. Another paper that we’ve written that is posted on our website covers the FAANG stocks. We’ve taken a look back at those companies and their valuations in the context of the way we measure relative value. Apple is obviously one of the A’s in FAANG.

The market’s been pretty fixated on FAANG leadership and questioning the valuations there. When you put things on our measure and look at the cash flow dynamics of those businesses against the prices paid, you see that the levels where they trade versus the market averages are not nearly as egregious as some of the accounting metrics might make you think at first.

It’s very interesting to look at Amazon (AMZN), which isn’t a current holding but would have been a holding over the course of the history of the index that we’ve created. It was really no more expensive than a lot of other retailers. It’s a classic case of where an old economy stock and a new economy stock were pretty difficult to compare unless you were able to put them on an equivalent footing and look at the cash flow dynamics against the market cap of the enterprise.

Back to Apple, the cash flow is obviously tremendous and despite the stock’s volatility, the underlying fundamental stability is high. And they have a balance sheet with more cash than debt.

The portfolio currently has some other technology companies in the top ten. That includes Microsoft (MSFT) and Intel (INTC), and then there are some other companies more associated with branding, like P&G (PG). In all cases, they have very strong balance sheets and display considerable fundamental stability.
 

ETFdb.com: When you look at the sector exposures of your ETF as also noted in the summary prospect, the ETF has a significant exposure to information technology, healthcare, industrials and consumer discretionary, and not much exposure to real estate, utility and energy. Is the ETF diversified enough? How should investors interpret the sector exposures? Should they look at it from a security level?

T:C: The portfolio does come together at the security selection level, and the industry or the sector weight is a function of the compilation of underlying stocks. That said, the portfolio holds 100 different stocks and remains very diversified, and that’s true historically. It’s also very dynamic, so as the market moves around and the opportunity set moves around, the sector weightings change. You’ll see that the technology weighting has been low at times and it’s also been very high. That’s true of healthcare as well.

There are no utilities in our portfolio and there haven’t been any in the underlying Distillate FSV index in a fairly long period of time. We keep going back to the accounting metrics, but the way a lot of value indexes are put together right now, to Jay’s earlier point, concentrates on the price-to-book measure, which is more accurately a measure of the intensity of physical assets on a balance sheet. A lot of value benchmarks are very heavily weighted towards energy and financials, where there are substantial physical and accounting assets. When you look at cash flow dynamics, you don’t see that there’s nearly as much value in a lot of those sectors with high physical asset intensity. Those sectors have not tended to be a large weight in our index over time.

M.S: The historical makeup of our index tends to be underweight [in the] energy [sector], compared to value benchmarks or even broad market benchmarks. Examining it a little further, you see that there is pretty high cash flow volatility in terms of what those companies generate over time. That tends to screen them out of our process.

What we’ve found is that even in good times – say, when the oil price was near $100 a barrel – those companies, generally, weren’t producing a lot of free cash flow. They were putting it all back into investments to find additional resources. As former fundamental analysts, when we look at companies like that, that do not produce any cash flow, even in good times for the industry, those are the things that we are fine not owning.

It’s probably also worth mentioning that our valuation metric is one that is forward-looking. In a case like the energy group, if you were backward-looking and if you were simply making valuation decisions based on backward-looking cash flows, you might not catch a big change in the fundamentals that occurs with the change in the commodity price. It’s another one of those things that we’ve corrected for where we see others make mistakes.

J.B.: Our current model, as Tom said, shifts around the industry weights over time to where there are undervalued stocks. Currently, the underweight relative to utility companies is an interesting one from a risk point of view. A lot of utility stocks screen very attractively on traditional risk metrics looking at price variability or relative price variability.

With respect to fundamental metrics, though, a lot of them do not have a lot of fundamental stability. They tend to have a lot of leverage and not have attractive valuations on a cash flow basis.

We don’t think something is truly a safe investment if you’re paying a very high price for it and it has a lot of leverage and not a great deal of underlying stability. We think risk gets mismeasured. We would much rather own a tech or healthcare company that has very stable underlying fundamentals, a very attractive price and very little debt, relative to a utility company that offered the opposite in terms of fundamentals, but with a more stable stock price.
 

ETFdb.com: Next, I would come to expense ratio. In the last few years, there’s been so much focus on fees and expenses, and we have seen fund flows disproportionately going to funds with low expense ratios and fees. Your fund’s expense ratio is 0.39%. How does it compare with other similar ETFs?

M.S.: Looking at it from a competitive point of view, we’re certainly not trying to compete with market cap–weighted indices that can be had for a very low fee, if not for free. We think there are issues with market cap weighting. Market cap–weighted indexes own more of what just went up and less of what just went down. That’s sort of the opposite of our value approach and our background and our philosophy that we tried to apply here.

When you look at what we call first-generation smart beta products that have deep roots in the academic factors that have been identified rightly or wrongly over the last few decades, we’re certainly more expensive than they are. We think some of those approaches suffer from the accounting shortfalls that we discussed at the top of this interview. Even some of those are market cap–weighted. They might do well with the factors, but are suboptimal given the influence of being weighted by a company’s market cap.

As we looked at the marketplace, we fit in more with the second generation of smart beta, where firms use customized definitions of value if they have a value criteria, or risk if they have a risk criteria. We looked at that space and the ones we identified there were in the 40-basis-points range. Relative to those funds, we think we offer a very fair offering.

 
ETFdb.com: I did a quick check this morning, just to see where the expense ratio stands. I looked up the average of the other value-focused ETFs, the way we categorize them on our website and I found even your expense ratio was around the average of those ETFs.

M.S.: I think there’s probably a wide range around that average, but that consists of what we saw too.

J.B.: That would probably include what Matt was referring to – first-generation ETFs based on pure academic factors or value factors. Some of those large value funds are really price-to-book driven and often market cap–weighted.

Then there are value funds that are more customized and the next-generation value funds, which take a different view of value like we do. There are also funds combining different factors. Can you extract more excess return from the combinations of factors to exploit a behavioral bias that may be in the market? That may add another layer of complexity. We think we’re sort of in that next generation of value funds or of multifactor funds. Although, ultimately, what we’re trying to do is really sort of combine an active philosophy with a passive wrapper. We’re trying to draw on our knowledge as fundamental analysts rather than anything purely quantitative.

T.C.: We also thought about the fee in the context of the excess returns that we expect to generate and knowing well the frustration that the industry has with a lot of active value managers that have failed to meet expectations. We wanted to be sure that we are offering our investors a very compelling deal that they will feel very good about, knowing fully well the competitive pressures in the industry. We could’ve arguably set a higher fee but we thought that, to use the Wayne Gretzky analogy, we would rather be where the puck is going as opposed to where it is currently.

Being aware of risks and costs is important regardless of your ETF investing strategy. Read The Hidden Risks and Costs of ETFs to find out more.
 

ETFdb.com: Let’s take one last question. What do you make of the current markets? You’re seeing so much volatility. In your white paper on risk, you mentioned that you see risk as a combination of quality and valuation, and that’s where long-term investors should focus, instead of on the short-term price fluctuations.

T.C.: The current volatility doesn’t strike as anything out of the ordinary. We saw a bout of volatility back in February and March. But when you look back at this year’s volatility, if you looked at it in a 10-year plot of the S&P, you would hardly see the dips in the chart. You’re right regarding our paper. We think a lot about long-term investing and that how you view risk and volatility should relate to your timeframe. If you appreciate the long-term returns and the risks in that long-term lens, the currently volatility shouldn’t be terribly concerning.

When you look at long-term returns, the only time that you really get hurt, if you look at 10-year trailing returns, is when valuations are substantially exaggerated, like the late 1990s. I wasn’t quite old enough to be around for the Nifty Fifty, but that period and the late 90s were periods when valuations were notably exaggerated. Away from those few moments, investing in equity is arguably about as good an investment as you can make. And we don’t think we’re in one of those exaggerated periods of valuation right now. The market is certainly a lot higher than it was only 5 years ago, or whenever you’d like to start the clock, but corporate performance is way higher as well. Earnings are higher and cash generation is higher.

Going back to the FAANG conversation, a lot is getting written about FAANG leadership in the market and the suggestion that the market is quite expensive. We have written about that group of stocks not to make the argument that they are collectively inexpensive, but that when you look at them based on the economics that they generate rather than the earnings per share that they might generate, that you get a much different answer in terms of how relatively expensive they are or are not versus the market averages.

We are not making any predictions about where the market is going to go, but we don’t think we’re facing anything dramatic in here.

 
ETFdb.com: If you want to add any final words about the ETF or about Distillate Capital as a company, you can do that.

T.C.: We came at the decision to form Distillate Capital and offer an ETF very quickly in terms of the three of us pursuing this as a business. We have a very high level of conviction in what we’re doing. We’re bringing to the market a differentiated point of view on valuation, a differentiated point of view on risk, and a differentiated methodology as it relates to weighting our portfolios. That we can offer it in a low-cost ETF that provides a substantial tax advantage over mutual funds is like a cherry on top.

It’s certainly a very crowded market. We’re well aware of that. We’re industry veterans. We get the challenges that active management faces, and yet we have enough conviction that we quickly decided to pursue this business opportunity. We’re really quite excited, and happy to be able to talk to you to help us get the message out to the world. I think we’ve got something that will truly make a difference for a lot of people.

J.B.: I would just say we are, at the core, fundamental value investors. We think value investing is alive and well but the definition needs to get updated for the 21st century in a rational way.

The Distillate Capital team thinks that value investing is alive and well but the definition needs to get updated for the 21st century. That’s where Distillate U.S. Fundamental Stability and Value ETF (DSTL A-), which was launched on October 24, 2018, can help investors. It uses an objective, rules-based methodology to measure the performance of U.S.-listed, large-capitalization equity securities, selected based on certain fundamental factors.

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