Tom Cole says you should toss out the old fundamentals, like book value, and look at a different one more attuned to the 21st century. Works for him.
What is the measure of a company’s worth? If you are like most investors, you look first to book value, earnings and dividends. Take those three metrics with a grain of salt, says Chicago money manager Thomas Cole. He says you’re better off appraising, instead, how much loose cash a business generates from its operations.
With help from two partners, Cole has turned the simple statistic of free cash flow into a rapidly successful stock picking operation. In a little over four years their Distillate Capital Partners has attracted not quite $1 billion to its main fund while comfortably outpacing the market average.
Free cash flow, as Distillate sees it, is cash from operations minus outlays for capital expenditures. That this is one good way to look at profitability is scarcely a novel concept. Warren Buffett has been trumpeting the idea at least since 1986, using the phrase “owner earnings.” What he means by that: The owner of a business cares not much about net income but a lot about the quantity of cash that can safely be extracted without impairing the business.
Necessity is the mother of entrepreneurship. Cole, now 61, Jacob Beidler, 41, and Matthew Swanson, 46, created Distillate after New York Life pulled the plug on a research boutique where they were working. “We knew going into it that the world didn’t need another money manager,” Cole says, but they didn’t want to abandon the work they had already put into their alternative way of evaluating stocks. Cole, elder statesman with four decades in asset management, is the chief executive, but the three own equal shares.
Balance sheets, defined for an era of steel making, are hopelessly antiquated for an economy of intangible assets like drug patents and software.
The insurance company missed out on a nice little venture. Since inception in 2018 the Distillate U.S. Fundamental Stability & Value exchange-traded fund, which focuses on large companies, has averaged a total return of 13.4% a year, against 10.1% for the S&P 500. Two recent additions to the product line, one a fund holding foreign stocks and one small U.S. stocks, account for 4% of Distillate’s assets and are off to a mixed opening, with the foreign stocks behind and the small stocks well ahead of benchmarks.
Distillate’s obsession with free cash flow emerges from a skepticism about corporate accounting. Net income can all too easily be doctored or artificially smoothed out, Cole says, citing acerbic comments from Buffett in this year’s letter to Berkshire Hathaway shareholders.
Cole goes on: Balance sheets, defined for an era of steel making, are hopelessly antiquated for an economy of intangible assets like drug patents and software. “There’s been an underlying shift from [an economy] being driven by physical capital to one driven by intellectual capital,” Cole says. The failing of generally accepted accounting principles: They calculate book value, the excess of assets over liabilities, to include the value of factories and warehouses, since these get capitalized on the balance sheet. But book does not include the accumulated value of research and development, which gets written off as soon as the expenses are incurred.
Cole considers himself a value investor, which is to say someone who instinctively prefers a slower-growing company trading at a low multiple of its earning power to a fast grower trading at a steep multiple. “Value investing has worked for a long time,” he says. “It is intuitively appealing.” But see how the notion of value gets turned around in his hands.
A traditionalist, following the precepts of that 20th century bible of value investing, Benjamin Graham and David Dodd’s Security Analysis, would sooner buy a stodgy utility like American Electric Power than a Silicon Valley stock like Alphabet, the parent of Google. The utility can be bought at 1.9 times book value; Alphabet goes for 4.5 times book.
Take a look at the cash flows, says Cole. The utility has a habit of consuming all its net income and then some in building new power plants and transmission lines. It covers its hefty dividend by borrowing money.
Dividends are real but archaic: The modern way to disburse cash to shareholders is via share buybacks.
Alphabet, in contrast, generates plenty of cash that does not have to be plowed back into the business. By Cole’s reckoning, the web search company is priced at 15 times this year’s expected free cash flow, the utility at 140 times. Distillate U.S. Fundamental owns Alphabet, Apple, Visa and Broadcom; it doesn’t own any utilities.
Alongside net income and book value, dividend payments make up a classic triad of Graham and Dodd valuation. What about them? Surely they are real things, not easily manipulated like earnings or irrelevant like book value?
Dividends are real but archaic: The modern way to disburse cash to shareholders is via share buybacks. The way to finesse this change in corporate habits, Cole says, is to be indifferent to whether cash is spent on dividends, buybacks or debt paydowns. He is happy to include in the portfolio stocks like Adobe and AutoZone that don’t pay a dime.
One might wonder how, at a time when Buffett is a celebrity and every annual report includes a statement of cash flows, there could be room to beat the market using cash flow valuations. Answer: While many investors have adapted to post-industrial values, many have not. The iShares Russell 1000 Value ETF, built off an index in which book value plays a large role, has $50 billion in it.
Cole holds out the hope that pockets of irrational exuberance will remain for Distillate to exploit. “During the pandemic the work-at-home stocks like Peloton and Zoom had people declaring that value as a style is dead,” he says. “There’s always something going on.”
What Cole and his partners accomplished seems almost too easy. They created an asset manager using off-the-shelf back-office services and zero hired help. Despite a fairly high 78% annual turnover, they don’t need a trading desk; ETF market makers do most of the buying and selling. They don’t need analysts because they get all the data they need off a subscription to FactSet. They don’t need a shareholder servicing department because, unlike mutual funds, ETFs don’t interact with their customers.
“What we’re doing now we couldn’t have done 20 years ago,” Cole says. The streamlined format of an ETF is a bargain for investors; the 0.39% annual fee on Distillate U.S. Fundamental is half what the average actively managed mutual fund costs. And yet that fee is quite lucrative to the fund’s creators. They are probably pocketing well over half the $4 million a year it brings in. Free cash flow indeed.
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