Value investing gets another outing and a different look with Distillate Capital’s Value Investing 2.0 approach.
Founded in 2017, the company launched its first ETF DSTL in late 2018 and is now launching DSTX. Distillate’s Tom Cole, co-founder along with Matt Swanson and Jay Beidler, established the Distillate platform having met at Institutional Capital (ICAP).
The team believes that popular value investing metrics such as Price/Earnings and Price/Book ratios can be useful for evaluating ‘old economy’ companies, which possess largely physical-assets like factories and machinery, however, these traditional metrics are not effective when it comes to evaluating companies, whose most valuable assets are intellectual property and assets built via R&D, which now dominate.
Cole says: “We developed a fresh look at valuation. Our first ETF was a domestic large cap strategy but our methodology is first-principles based and works across geographies and market caps.”
Despite operating over a ‘fairly turbulent three-year period’, as Cole describes it, the first ETF added value each year, performing in line with the firm’s expectations.
“The world’s use of accounting metrics for the purpose of valuation was complicated by changes in the underlying economy as investing activities today in R&D, which is a huge driver of many companies, are accounted for differently than investing activities in physical assets, which used to dominate,” Cole says. “At Distillate we moved to a free cash flow metric to measure valuation that is free of the distortions from accounting, and using it, we found that paying less for assets, or a value strategy if you will, is still a very viable way to invest.”
Cole believes that the firm’s approach to risk has also enabled them to create a product that works and allowed them to be at the top of the competitive rankings.
“We take a different approach at risk versus the vast majority of people in our business,” Cole says. “Risk is usually measured by thinking about stock price volatility and ultimately we think that stock price volatility is a poor proxy for risk and often leads you to the wrong investment decisions for your clients.”
Cole cites an extreme example as when good companies sell-off indiscriminately during a drawdown, so their volatility spikes, triggering the risk models to push investors away from purchasing good companies when they are least expensive.
“For us, risk is about the stability of the cash flow that a company generates. And then we consider the financial leverage within companies as well.”
The firm’s methodology starts with a global universe of companies, and then utilises a process eliminating from consideration those companies that are the least stable cash generators. The process takes out the highly leveraged companies as well, and then utilising a metric of free cash flow against enterprise value to judge valuation, the strategy owns the least expensive stocks that remain.
Initial investors in the ETFs have been family offices and registered investment advisers who are committed to ETFs for all the usual reasons of liquidity, transparency and tax advantages.
“The average investor characteristically has a value orientation but has struggled with how value has performed for them,” Cole says. “Our answer to value’s shortfall has been logical and helped them understand their options better, and the performance we have generated fits with their thinking of how value should work.”
With their institutional background, Distillate hopes to expand into the institutional market as assets grow. The firm currently has around USD220 million under management.
“The ETF vehicle makes an enormous amount of sense to us. It is a superior vehicle to mutual funds,” Cole says. “Our only frustration is that transparency in terms of who owns it is not what we are used to from the institutional side. We would love to be able to communicate directly with our clients and the ETF makes it a bit more difficult.”