If you’re expecting traditional value stocks to outperform growth stocks, you ‘are going to wait forever,’ this fund manager says

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You may be seeing headlines describing a “rotation to value stocks” as technology stocks as a group are trading at all-time highs.

But investors who are waiting for a recovery of performance for traditional value stocks against growth stocks “are going to wait forever,” said Thomas Cole, CEO of Chicago-based Distillate Capital and co-manager of the $237 million Distillate U.S. Fundamental Stability & Value ETF

Cole argues that investors should focus on free cash flow rather than traditional measures of price to earnings or book value.

During an interview, Cole, who was formerly head of U.S. equities at UBS Global Asset Management, said Distillate’s process is to select 100 stocks for the ETF portfolio based on estimates of future free cash flow and current enterprise valuations. (A company’s free cash flow is its remaining cash flow after planned capital expenditures.)

Further analysis is done on the consistency of past cash flows and debt levels. Stocks in the portfolio are weighted, in part, by cash-flow analysis, “with some reflection of the size of the business,” Cole said.

Cole said value measures based on earnings and book value have become essentially meaningless. GAAP earnings are subjected to myriad — and inconsistent — adjustments by companies trying to make the best cases to investors.

Among the S&P 500 Index all but 15 companies reported adjusted earnings per share (in addition to the standard GAAP EPS) in their most recent announcements of quarterly results, according to FactSet. That shows how difficult modern accounting rules can be for investors trying to understand what is really going on with a company’s business.

“If I am sitting with a group of analysts and we’re comparing relative valuations, I don’t know which EPS number to use anymore. Book values have long past being useful,” Cole said.

Here’s a 10-year chart comparing the performance of the $334 billion SPDR S&P 500 ETF — dominated in recent years by rapidly growing technology giants — against the $44 billion iShares Russell 1000 Value ETF which takes a standard approach to tracking large-cap and mid-cap value stocks based on price-to-book ratios:

The 10-year chart speaks for itself. Now let’s look at a two-year chart for the same ETFs, this time adding the Distillate U.S. Fundamental Stability & Value ETF, which was established in October 2018:

The Distillate U.S. Fundamental Stability & Value ETF even led during 2020 with a 19% return, compared with 18% for SPY and a tepid 3% for IWD. And that success was despite not holding most of the best-performing stocks in the S&P 500 during 2020, including Amazon.com Inc. which soared 76%. (Tesla Inc. rocketed 743% in 2020 but wasn’t added to the S&P 500 until Dec. 21.)

Cole said his strategy “doesn’t go for the home runs,” because those are “situations with a lot of risk.” On the other hand, the strategy also avoids “a lot of losers,” he added.

In his annual letter to shareholders in February 2019, Berkshire Hathaway Inc. CEO Warren Buffett wrote that when he referred to earnings of the conglomerate’s subsidiaries, he really meant earnings that remained “after all income taxes, interest payments, managerial compensation (whether cash or stock-based), restructuring expenses, depreciation, amortization and home-office overhead.”

That comes pretty close to actual cash flow.

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While he was careful to say that he was “not throwing the accounting profession under the bus,” Cole said he and his colleagues are focusing on cash “as the ultimate common denominator.”

“If I can use that as the ultimate valuation metric, I don’t need to reconcile it,” he said.

Cole said that to “make an apples-to-apples comparison” of companies and stocks, the Distillate team makes many of its own adjustments. But he added that free cash flow “is undoubtedly a better starting point than using price-to-book or price-to-earnings.”

The largest holding of the Distillate U.S. Fundamental Stability & Value ETF is Alphabet Inc. which is Google’s holding company. The ETF holds the Class A shares. Alphabet’s class C shares are also widely held and traded.

A comparison of Alphabet and Apple Inc. helps explain why Cole sold the ETF’s holding of the iPhone maker during the third quarter. (Apple’s shares were up 25% for the first half of 2020, up 59% though the third quarter and up 82% through the end of the year).

Alphabet’s Class A shares closed at $1,880.07 on Jan. 20. Analysts polled by FactSet estimate the company’s free cash flow per share for calendar 2023 will be $111.53. So if we divide the estimated FCF by the current share price, we have an estimated free cash yield of 5.93%.

Apple’s shares closed at $132.03 on Jan. 20, and its consensus estimate for calendar 2023 free cash flow is $4.74. That makes for an estimated free cash flow yield of 3.59%.

We could also divide the share prices by the free-cash-flow estimates, for a valuation (based on calendar 2023 estimates) of 16.9 for Alphabet and 27.8 for Apple.

Much more goes into Distillate’s analysis and quarterly rebalancing of the portfolio, but this is enough to illustrate the point. Until the third quarter, Apple had been the largest holding of the Distillate U.S. Fundamental Stability & Value ETF from its inception and the largest holding of the strategy since it was originally funded in 2017, Cole said.

“It went from being one of the cheapest names available to us, to being one of the most expensive, and largely tech has done that,” he said.

In their year-end letter to shareholders of the Distillate U.S. Fundamental Stability & Value ETF, Cole and Distillate Capital co-founders Jay Beidler and Matthew Swanson wrote that although the Distillate U.S. Fundamental Stability & Value ETF outperformed the S&P 500 during 2020, “Amazon’s 76% gain alone subtracted almost 2% from relative performance for the year.” They added that the performance of these stocks “combined to detract another 2 percentage points versus the S&P 500.”

So the fund’s approach makes it diversified from the S&P 500’s tech-growth-heavy weighting, but the strategy has been a success so far.

The letter also included a fascinating comparison of Tesla’s current valuation to free cash flow to that of Cisco Systems Inc. in March 2000. At that time, Cisco’s stock had risen 1,300% over the previous three years and its share price of $77 was about 120 times its trailing 12-month free cash flow. “This optimism was not unfounded as free cash flows increased 450% over the ensuing 20 years,” the Distillate founders wrote.

But Cisco’s stock closed at $45.34 on Jan. 20, 2021 for a decline of 41% over a period of more than two decades.

The Distillate team explained the terrible long-term performance of Cisco’s stock.

“[T]he multiple paid for free cash flow contracted by 90%, providing a stunning example of the risk over overpaying for the shares of a good business.”

Ironically, Cisco is now the sixth-largest holding of the Distillate U.S. Fundamental Stability & Value ETF.

And now to Tesla — the stock closed at $850.45 on Jan. 20 and traded for 532 times the consensus estimate of $1.60 a share of free cash flow in 2020, according to FactSet.

“Similar to Cisco in 2000, this valuation does not leave any cushion or downside protection and the risk of valuation compression over time will be a substantial obstacle for growth to overcome,” the Distillate team wrote.

They added that the timing of the stock’s addition to the S&P 500 (it was up 731% for 2020 before being added to the index on Dec. 21) was something for investors in index funds that track the S&P 500 to think about: “We doubt that many investors would be happy with a manager who announced to the world their intention to buy a substantial amount of a stock in several months’ time and then after the stock went up significantly on the news, bought that much more of it.”

Here are the top 10 holdings of the Distillate U.S. Fundamental Stability & Value ETF as of the close on Jan. 20:

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