Many moons ago I wrote a long old book on stock screening – based in turn on a regular newsletter about stock screening run by the Investors Chronicle. Rather amusingly that book is now out of print and allegedly costs hundreds of pounds to buy second hand. Sadly, I have only a few copies left, otherwise, I’d be treating friends to a nice slap up dinner on the proceeds of selling those last few copies of the book.
This interest in stock screening sparked my lifelong interest in quantitative-based investing, by which I mean using systematic strategies to try and screen out behavioral bias. I found myself drawn to the ideas of Ben Graham and Joseph Piotroski and for decades I’ve regarded myself as fundamentally a value-focused, contrarian investor. I still can’t quite stop myself looking down the list of stocks hitting the 52 week low and thinking “are these a bargain”. The answer is probably not because the downside of all good contrarian strategies is that most of the ‘target’ stocks are genuine rubbish. And crucially, you only make a profit in this form of distressed investing if you are
- Willing to be bloody patient and
- do it systematically, by ignoring your own cognitive biases.
Over time I’ve tended to stay away from stock picking – leaving the development of systematic stock strategies to the likes of Stockopedia, who do a great job. By contrast, I’ve taken those ideas and tried to apply them to the world of ETFs. Rather than using stock screening strategies to identify individual stocks, why not use the same ideas to identify big baskets of stocks? Thus, smart beta has merged into factor-based investing and ended up in ETFs.
But if I’m honest, when I look down the list of stocks in most ‘value’ ETFs I tend to feel a tad disappointed. Sure, by the quantitative measures used, these ‘value stocks are a bit cheaper than the main market, but they aren’t what I traditionally understood to be ‘value’ stocks.
Yet in truth true deep value investing is itself largely dead, except perhaps in Japan. Archetypal Ben Graham Net Net stocks, for instance, are almost non-existent and what we’re left with are what I would call ‘anaemic’ value stocks i.e they are just a bit cheaper than the average.
I’d also argue that the sophistication of many quant driven value strategies used in ETF land is a tiny bit underwhelming. In reality, most strategies simply focus on the PE ratio, price to book and perhaps the dividend yield. The incredible sophistication of Piotroski like points scoring systems has been junked for simplicity.
But value investors also need to recognise that their traditional methodologies are increasingly redundant. The traditional focus has been on hard assets, yet we are midway through an epochal change in capitalism towards a system built on Intellectual property and brands. Thus, most traditional value investors ignore a huge part of the modern capitalist economy.
More ‘progressive’ value investors such as Gary Channon at Phoenix have reacted by adopting their philosophy to one which is more quality in style terms but with a touch of growth at a reasonable price or GARP. This in turn reflects the shift in thinking of sage value types such as Buffett and Munger, who’ve had to change their stock selection strategies in order to buy real-world businesses..
So far, much of this evolution in thinking about value hasn’t found its way into mainstream value based smart beta – we’re still stuck in Value Indices Vs 1. But last week I saw an announcement of a new ETF by a Chicago based firm called Distillate Capital which I think could be the start of something much more interesting. If they deliver on their promise, it could be a more useful, modern version of value investing that might actually work.
Here’s the blurb on the new ETF…
“The Distillate U.S. Fundamental Stability & Value ETF (NYSE:DSTL) seeks to distill a starting universe of the roughly 500 largest U.S. companies by market cap into only the stocks where quality and value overlap. To accomplish this, Distillate Capital begins by redefining and updating industry definitions of value and quality for the 21st century, drawing on the team’s extensive experience as fundamental value investors. DSTL then utilizes these rationally-defined measures of value, quality, and risk to weight its constituents with the goal of providing investors with superior compounded long-term returns.”
The key point here is to properly define what value means in our modern era. Does it mean lots of empty factories that can be turned into flats ? Or cash on the balance sheet ? No.
Value 2.0 means properly focusing on things such as the value of the brand and IP which are caught by the auditors but only in passing – and usually inaccurately. To give one example – research & development is typically treated as an expense whereas physical assets such as factories are usually treated as assets.
As Distillate remind us “the economy has shifted to a sufficient degree, from physical to intellectual assets, that traditional comparability is significantly impaired. For example, companies such as Apple or Johnson & Johnson, whose most valuable assets tend to be their intellectual property and research & development, often appear expensive using traditional valuation metrics, and may not compare favourably with more “physically-based” companies that own large factories or refineries.”
So, what exactly do these new look screens actually focus on? As you’d expect there’s really only top line detail at the moment, but the issuer seems to focus on something called the “distilled cash yield that is intended to offer a truer, more consistent gauge of valuation across the market. This measure restores comparability between older, more physical-asset based companies and newer, more research and development-oriented ones. For quality, DSTL emphasises long-term fundamental stability over short-term price-based metrics and also incorporates a financial indebtedness measure that adjusts for off-balance sheet leases or other calls on capital that may not be picked up by traditional measures. “
I intend to dig around a bit more into this, but in theory ,this is exactly what smart beta needs – a strategy informed by active stock picking using traditional stock screening techniques, but updated for the passive era. And with hopefully lower costs and better results!