Tom Cole, CFA, Co-founder of Distillate Capital, joined Julie Cooling, Founder and CEO of RIA Channel, at the GTE Wealth Forum to discuss how the evolution of the US economy requires a change in metrics for value investors.
Distillate Capital was founded in 2017 by a seasoned investment team. The team has taken a fresh look at value investing, mindful that the value style has frustrated many investors in recent years. Historically, the U.S. market listed capital-intensive companies, but today’s market leaders add value through R&D and intellectual property. The two types of companies cannot be directly compared using traditional accounting measures, such as price-to-book, return on equity (ROE), or return on assets (ROA). Cole notes that value investing is alive and well when stocks are evaluated using free cash flows, allowing old-economy and new-economy companies to be directly compared.
Distillate has raised $2 billion in three ETFs: Distillate U.S. Fundamental Stability & Value ETF (DSTL), Distillate Small/Mid Cash Flow ETF (DSMC), and Distillate International Fundamental Stability & Value ETF (DSTX). The investment process uses free cash flow as a measure of value, with a different way of evaluating risk and quality. Companies with capital-preservation characteristics tend to have conservative debt loads and the ability to generate significant cash flows. The holdings in the ETFs are the least expensive stocks that meet the quality criteria.
The only time markets were more expensive than today, on a free cash flow basis, was during the technology bubble of 1999 and 2000. There are stocks trading at reasonable valuations in today’s market, but investors have to decide when to rotate into those names. Even value indices are not inexpensive today, as traditional sectors such as industrials and utilities have been bid up due to the growth of data centers and artificial intelligence. In the two years following the market’s 2000 peak, the S&P 500 was down around 28%, while the smallest 200 stocks in the index had rallied by as much as 50%. The situation is similar in today’s market, with smaller stocks generally offering greater value than larger stocks.
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