Chicago-based Distillate Capital, an asset manager focused on fundamental equity analysis, has launched its first ETF, the Distillate US Fundamental Stability & Value ETF.
The firm’s founders, Tom Cole, Jay Beidler and Matt Swanson have extensive experience in fundamental equity analysis and their ETF is designed to distil a starting universe of the roughly 500 largest US companies by market capitalisation into only the stocks where quality and value overlap.
Cole says: “We started developing a new valuation platform, then launched Distillate a year and a half ago and we believe we have developed a unique offering in the value space, offering a different way to think about value in today’s economy.
“Our measure of valuation works where a lot of the legacy accounting-based valuation metrics have stopped working.”
The firm also has taken a different tack on risk. “We use measures of fundamental stability and balance sheet quality instead of relying on stock price volatility when we consider risk. We also think you cannot separate the price you pay from the conversation about risk. Paying too much for the perception of safety, as an example, creates a large potential risk for many investors.”
The launch saw good inflows, consistent with their expectations. Cole says: “The client base over time will broaden out, but high net worth individuals and family offices are a natural fit and certainly some of the wealth advisers are good candidates.
“There is lots of money going into passive investing and many investors are frustrated with value as a concept as a lot of active value managers have failed to meet their return objectives. But few people have asked why is value not working?”
Distillate took it back to the bedrock concepts of value, that the value of any asset is the present value of the cash that asset will produce in the future.
“This was the genesis of what we could use to accurately compare value across companies,” Cole says. “We think about value being a function of cash generation, and we think about risk being a function of that cash actually materialising. For long-term investors, fundamental stability and financial leverage should be more important than short-term stock price variability in judging risk.”
Matt Swanson says: “When we bottom-line our thinking about risk, we see two ways for investors to lose money: either paying too much for a cash flow stream or when the cash flows expected do not materialise. Debt is also a contributing factor for risk. When fundamentals change to the negative, debt can magnify the losses.”
“We are bringing a measurement of value and risk together in one product that we think is unique in the context of the offerings that are out there where Price to Book remains a well-used metric.”
The primary metric that is identified with value, Cole says, is price to book value. “If you are a company that develops energy or builds cars or is a classic manufacturing business, your assets are capitalised and then depreciate over time. But if you are a tech company, you spend money on R&D and despite building value in your company, all the R&D is immediately expensed and you don’t have assets on your balance sheet. This creates a comparability issue between companies with physical assets and those that rely more on R&D and branding. And companies that rely on R&D and branding are a much larger part of our economy than they were historically.”
“Not only are the incomes different but accumulated book values are not comparable either – that lack of comparability is at the heart of systems that make people think price to book value helps them find value.
Distillate’s fund is not a market cap weighted fund. “Market cap weighting was an innovation in the 1920s but it hasn’t innovated much since then and a market cap weighted index buys too much of things that are over-priced and too little that is under-priced so we have taken a different tack with our portfolio – we are looking at the cash flows of companies within the portfolio to weight our holdings.”
“We have drawn on a lot of knowledge having been fundamental analysts since the 1980s. Our methodology is based on industry and accounting knowledge gleaned over the decades as value investors.”
Cole says: “We compete in a rare sport where age is an asset and we have seen a lot of things and have been testing our methodology in numerable ways. It’s an evergreen concept and not set to answer whatever is in vogue. We are not feeding the ducks while they are quacking.”