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Investors Business Daily
Investors Business Daily
Business
MARIE BEERENS

These ETFs Help You Invest Like An Owner, Not A Speculator

Investing in stocks with the mindset of a company owner is what's given some of Distillate Capital's best ETFs an edge over some of its competitors.

The Chicago-based company was founded in 2017 by three partners with a background in value investing. From the start, Distillate's funds have been designed to weather all conditions. This methodology stems from a holistic approach to equity research, as well as the shedding of some of the traditional valuation and risk metrics.

Instead, the team prefers to focus on cash flow, just like a company owner would.

"Cash is fact, earnings are an opinion," says Thomas Cole, Distillate's co-founder and CEO. This matters especially if you're going into a downturn. "Free cash flow provides a much more accurate way to assess the valuation opportunities in the market. And that doesn't depend on the timing or the economic environment that we are in."

Building A Family Of ETFs

The firm only has three ETFs. Its largest, the $896 million Distillate U.S. Fundamental Stability & Value, has grown assets exponentially since its inception in 2018. Distillate Capital as a firm now manages a total of $925 million in assets. That includes separately managed accounts.

Cole has been in the industry since 1985. His trajectory includes a focus on value stock analysis, and he has held senior positions at UBS Global Management and Institutional Capital. He shared with IBD the specific methodology Distillate uses to pick stocks. He also discussed the performance of the funds and what differentiates them from other ETFs.

IBD: What is Distillate's mission?

Thomas Cole: Distillate was launched with two things in mind. First, value as a strategy was still a very viable way to add value for clients and that investors need not abandon equities as a place to add value to their portfolios.

Second, we believed our approach was a bit unique in that we did not see a similar competitive offering. We have now been ahead of the S&P 500 each calendar year since we began, and we will again (in 2022). And as a result our competitive ranking is very high. All of which suggests we are beginning to build a pretty nice proof statement that we were correct in both of our starting assumptions.

Separating From The Pack Of Best ETFs

IBD: How do you differentiate yourselves from other ETF issuers?

Cole: We are different in that we don't make use of the conventional valuation metrics, things like P/E and Price-to-Book ratios, because we think they're pretty unhelpful given what has happened in our economy over the last 30 years. We rely on free cash flow instead to much better assess the underlying economic performance of the businesses we might own. We think like owners ... a concept Benjamin Graham wrote about in "The Intelligent Investor" now over 70 years ago.

And on the risk assessment side, we come at things thinking again about the value of any asset (stocks for Distillate) being a function of the future stream of cash flows it will generate.

IBD: Why are P/E's and Price-to-book ratios flawed, as you suggest?

Cole: Our economy is now largely driven by R&D, rather than physical assets and traditional capital spending. That is important because when the accounting rules were written and put in place, our economy didn't have much R&D spending. Businesses were instead built with factories and machines and other things you could see and touch.

The reason that matters is that the accounting for those two activities, either building assets with physical stuff, or building assets by way of intellectual activities, is completely different. What that leaves you with is earnings figures, often used in P/E ratios, that are not comparable. The same is true if you think about accounting book values. Those numbers across industries are no longer comparable either. So identifying the cheapest stocks in the market became more difficult using traditional measures we were all trained to use.

Picking Stocks For ETFs

IBD: What is your specific methodology for selecting stocks?

Cole: We start with a beginning universe that for our U.S. large cap strategy approximates the S&P 500. We then look at each company's legacy of generating excess cash and what expectations exist for cash generation as well. We create a comparable score for each company and then eliminate from consideration those companies that have the least stable businesses.

To the extent that the screen does not eliminate some highly leveraged businesses — companies carrying a lot of debt — we eliminate those from consideration as well. Of what meets our quality criteria, we buy the least expensive stocks on the basis of their forward looking "normalized" free cash flow, measured against enterprise value. We do that work each quarter, and rebalance the portfolio each time.

Pinpointing Strategies

IBD: Please briefly describe your three funds?

Cole: Our three strategies include a U.S. large-cap product, Distillate U.S. Fundamental Stability & Value ETF. (Our) international equity product is Distillate International Fundamental Stability & Value ETF. And (our) U.S. small midcap strategy is Distillate Small/Mid Cash Flow ETF.

With those three offerings, we cover most of the investable equity universe. All of them work with the same underlying philosophy and rebalancing periods, with only some modest adjustments in implementation. Across our product set, we put a high priority on capital preservation, and we get there a little differently in each offering.

Our U.S. large cap strategy has held up much better than the market (in 2022), protecting capital as we would have expected. So as of today, DSTL is down a little less than 10% and the S&P 500 is off 17%, so we feel good about the opportunity.

Parsing Small-Cap Benchmarks

In the U.S. small midcap strategy, we have noticed that the small-cap benchmarks have become more financially levered over time and that there are a meaningful number of benchmark constituents. In the Russell 2000 indexes in particular, but also in the S&P 600, where cash flow estimates going forward are negative. That isn't a good combination. Our strategy's valuation is meaningfully better than the benchmark, but at the same time avoids the leverage and all the companies that are not expected to generate positive cash flow.

On international, we use the All Country World Index ex US. It is a group of companies that, compared to the U.S. using the S&P 500, is more levered, less fundamentally stable and they have enjoyed a slower rate of growth. Roll the clocks back 10 to 12 years, and not only all that, but the U.S. was less expensive on the basis of the free cash it was generating as well. That U.S. stocks did better for the last decade then is no wonder. But now, the starting free cash flow yield on the international benchmark is better than it is on the S&P 500, perhaps giving international stocks a good point from which they may do better.

Where Heading Next?

IBD: What is your strategic view for the future of your firm: Will you keep launching more ETFs? Individually managed accounts?

Cole: We are somewhat agnostic on the vehicles our investors choose. We offer separate accounts today, as well as model-only arrangements. (And) we believe in focus, and we won't try to be everything to everyone. We might find slightly different ways to apply our "value plus quality" investment philosophy, but the three strategies we've launched to date are likely to remain our core.

IBD: What would you advise investors to do in today's market?

Cole: We are not tactical investors. For the vast majority of people, staying invested is important, actually critical. Most investors chase performance, and that is a losing game. Supporting that, and perhaps providing some comfort for the current situation, when we look at valuations currently, we are starting now with the S&P 500 generating a free cash flow yield against market cap of between 5% and 6%. Think of it as a bond. Our strategy has a better yield than that, but it is important to note that 5% to 6% is not a low level versus history.

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