Animal Spirits Podcast - Talk Your Book: Elimination Alpha – How to XOUT Your Portfolio Losers

Episode Date: December 2, 2019

On this edition of Talk Your Book we chatted with Will Rhind and David Barse about the new GraniteShares XOUT U.S. Large Cap ETF and thinking about finding winners by avoiding losers in your portfolio. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Granite Shares. For more information, go to granitechairs.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritthold's wealth management. This podcast is for informational purposes only and should not be relied upon for

investment decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. I wrote a post fairly recently called So Many Losers. And the gist of the article was the work that Hendrick Bessimender has done on stock market returns, talking about how the winners or the veterans, or the vent, majority of the wealth creation has been concentrated in the hands of the few. So basically, Pareto on steroids, quintessential capitalism. So companies like Microsoft and Apple and Google and

Amazon, things like that are responsible for all of the wealth created. And yeah, one of the things that people don't understand about the way the stock market functions is that the losers tend to outnumber the winners by a large margin. Right. But because of the nature of market kept waiting, the winners more than offset all of the losers. So as a random example, foot locker could go to zero and the S&P 500 would have blink. I don't even know if foot lockers in the SCP 500, but just as an example. So was one of the titles of these papers, do stocks beat treasury bills? Yes, that was one of them, where they looked at the fact that cash actually outperforms a large number of stocks. So the implication, I guess, being that, you know, market

cap weighted indexes are really hard to beat, or if you don't hold market cap stocks, then, you know, if you miss the biggest winners, I guess essentially you're in trying to Now, if you do the old Charlie Munger invert line of thinking, what if there was a way to hold the stock market and potentially eliminate, obviously you can't eliminate it all, but what if you can eliminate the losers? And that is what this product X-Out tries to do. One of their approaches is to turn the concept of alpha generation upside down, this is a quote, surmising that the best way to be at a passive index is by focusing not on what companies

to own, but what companies not to own or exclude. against a backdrop of Disney technological change. This idea makes a lot of sense to me. So this is the Granite Shares X-out U.S. large-cap ETF. And we've talked to Granite Shares founder, Will Ryan, before. He was actually on the show. We did an early talk your book. And he was on stage with me, actually, at the recent conference we had for wealth stack.

And this is an interesting idea. So in your post, you wrote about how the fact that O'Shaunice gave you some numbers and it was looking at an equal weighting portfolio of global stocks. And global stocks since 1994 have done like 8% a year. If you took out the 10% of the worst performers, your annual returns would jump to 14% a year. If you took out the 25% of worst performers, you would jump to 22% a year. So it is kind of the weird Charlie Munger inversion thing where instead of trying to pick the winners, let's just get rid of the losers and whatever is left over is bound to do really well for us.

So, again, in theory, this idea makes a lot of sense where the rubber meets the road is, well, how do you X-out the losers? And that's what they are trying to do with this product. And we'll get into that right now. We are sitting here with David Barr's CEO and founder of Exout Capital and returning champion Will Rind, founder and CEO of Granite shares. So X-Out's main investment premise is that it is easier to exclude losers than to pay. pick winners. Explain what you mean. So I'll talk about this is David Bars. I'm the founder and CEO of Vexout. I came from this endeavor from the opposite side of the world. Active management, concentrated positions in select portfolios with a value bent and found that that was a very difficult strategy to execute on in the post-financial crisis timeframe. And as asset flows

continued to prosper into the passive indices, it occurred to me that wouldn't it be an easier way of going about this to simply exclude losers than to try and identify who the winners are going to be in that paradigm? And I had grown a firm for 25 years trying to pick winners and getting beaten by passive benchmarks year and year out. That was the genesis for the idea. Just simply, it's easier to exclude losers than pick winners. I think that makes a lot of sense. So you had this idea. What were the steps involved in terms of, okay, I have this idea.

Let me look at the research. Oh, maybe there's something here. Let me launch an index and an ETF. What did that look like? So the ETF decision was a long storied road because originally the idea was to do it in a private fund as a long only strategy by simply excluding losers and to do it with a number of different broad-based indices, not just the largest 500 companies in the U.S. And scaling that kind of business is a real challenge because a lot of folks who invest

in private investment vehicles, what's called them alternative funds, wondered why I wasn't doing a long, short strategy. Instead of just excluding losers, take out the losers and short them. And shorting is a really, really difficult business. There aren't a lot of firms out there that have real assets under management in their short strategies. And I would say that even if they're successful at it, it's ultimately a poor tax strategy, right? It's all short-term capital gains and you have to be excellent on market timing. So getting to the ETF, as I said, was a little bit of a road, but it naturally happened. I attended a few conferences. I learned about the product. I came again from outside this industry. So learning about it was a chore, if you will, and there are some

interesting characters in the space. You guys probably know a lot more of them than I do. But I would tell you that when I discovered how structurally sound the product was for the kind of investment process that I was trying to embark upon, it became a natural fit. And then I got to meet granite shares. And that just opened the door for me. Can you explain to us kind of the universe here? Because no one ever brags about my portfolio succeeded because I avoided all these losers. Everyone wants to talk about what they won. And so what do the buckets look like? How many losers are there in a typical year or cycle or whatever? How many stocks are you guys trying to get rid of? Yeah, so the fund currently, this is Will Ryan speaking, the fund currently

excludes 250. So it takes the 500 largest names in the US and excludes the 250 that the index feels most likely to underperform. And the basic reason behind 250 is if you exclude, say, 10% or 10 names, 20 names, it's probably not statistically big enough to create the kind of alpha that would be meaningful, we think is meaningful for the strategy. So the bottom line is coming back to like why think about this strategy, why do something like this? I mean, what was fascinating to me, you know, coming from the passive world, kind of all my career, kind of opposite to David, is that much as we love passive investing, there's one just obvious flaw in indexing, which is you buy every company indiscriminately, regardless of whether it's a good company or bad. And there's a number of

examples that we can talk about, which would be completely nonsensical when you sort of say, hey, do you realize that this is in your portfolio? And people would go, well, why would I ever own that stock? But you do just because or by virtue of the fact that you're buying the market. And to me, the active world and the criticism of active management that we on the passive side have lived with for decades is right in a sense of it's just incredibly difficult to pick winners to find the next Google is just infinitely harder than identifying a company that is already underperforming or in secular decline. And so that is the basic premise that this is built on. So I disagree with you on the market cap stuff, but we're not here to argue. So let's talk about

some of what X out does. Would you say that the losers share more similar characteristics than the winners? So we know it's really difficult to identify the Amazon's and the Googles of the world. What makes you think that we can identify the losers? How does it work? So the index methodology applies nine, we group three of the nine into one, but nine individual financial metrics that we think help identify what those losers might be. They're fairly straightforward as you think about it, revenue growth, acceleration, how that company has surprised the street on a quarterly basis, looking back 20 quarters, whether they're profit. whether they're hiring people, whether the analyst community is saying something positive or negative about them. How is the CEO done since he's come into office, he or she has come into office and measure that against the other 499 CEOs in the index? And what is the company

doing with its capital? Is it making investments in its own business? Is it making investments in its stock? And is it doing that with cash flow as opposed to borrowing to do that? So you aggregate these factors together and you get a score. And the bottom 250 on that score of that aggregate factor is an indicator for us to say, get it out. Have you done any research to look at what would have happened if you went long with those 250 stocks that you're excluding? Do they do really poorly?

I would imagine they do, but... Well, I think the first thing to say is it's not a permanent exclusion. So this is a strategy that rebounds every quarter. So every quarter, according to the metrics and the scoring that happens, you're going to get these scores for every company in the index. So as David said, you exclude the bottom 250. There's nothing that is against some of those companies being re-eligible for the index if, of course, their performance improves. And so I think in terms of a permanent exclusion, we've never tested sort of that because the whole idea is that we're just trying to identify companies that are

underperforming. But if a company turns itself around, it can very well get back in the index. I guess we have been living, some people would say, in a bizarre world where, I mean, there are periods of time where the junkie stocks do really well. So I would imagine there are periods of time where the 250 that you exclude do better and the 250 that you include do worse. I mean, obviously this strategy is not going to out from all the time. But you said that this is mostly a business screen. So you're screening out companies with lousy fundamentals based on the attributes that you just spoke about. Is there any sort of price or technicals involved at all? Is there any momentum measures or anything like that?

No, we don't use any of the pharma French methodology. And I think that in my mind was one of the things, again, that I think is really important with this, is that what we're looking at is fundamental metrics. In essence, the same metrics that an active manager would look at in terms of screening stocks. But we're not screening stocks to try and identify the winners. It's to identify companies that are going to lose or going to most likely underperform. And I think when you think about that lens, the bigger picture here is we're trying to identify through the lens of technological disruption, companies that are just fundamentally. disadvantaged. And looking forward, this is a forward-facing risk that is affecting all investors. And so as we think about this particular methodology, we're trying to identify companies that through the lens of technological disruption just are fundamentally challenged. And yes, there are going to be periods of time where certain junkie companies will do well, etc. But over the long run, we feel like good companies will continue to be good companies and bad companies will underperform and will be screened out. And there's no

sort of sector constraints. So there could be an entire sector that, to your point, could be facing disruption and a whole sector could be gone, basically. That's exactly right. So look at the way that information technology or telecommunications of the S&P has changed radically over the last 10 years, started off being a weight of around 10 percent, now is under 3 percent. And so that's exactly what we're trying to do. And again, through the lens of just fundamental analysis, we're not trying to make any kind of tilts. There's no value or growth bias. It's just about good companies and bad companies. So this, so the portfolio can load to different factors. It could be quality, it could be value. I guess it could potentially be growth. Have you done any sort of

regression analysis to see what does this look like? Is it a Buffett portfolio sort of, for lack of a better word? Where does it shake out? I mean, at the moment, there's no statistical sort of significant correlation to any particular factor. That would be more of a coincidence than not. What I can tell you is that when you take 500 names, remove 250 and reweight market cap, you obviously get, for example, tech would have a higher weighting in X-Out fund today than it does in the S&P 500. And obviously, some sectors will be either completely eliminated or drastically reduced. But there's no sort of tilt or significant tilt to any kind of factor. So in one of your papers, you said that in the 1950s, the average age of a company in the S&P 500 was 60 years.

And that recently slipped below 20 years, which is pretty remarkable. What are the implications of this exactly? And how does your business metrics screen out for the incumbents that might be disrupted, like the general electrics of the world? That's the secret sauce of what we're trying to accomplish. We're trying to anticipate all those companies that used to be in the S&P and get them out of our index today before they're out of the index entirely. And so that's likely to happen one or two ways.

Either a company's going to get merged out of existence, or it's going to simply deteriorate to the point where the indices decide to drop that company because it isn't the largest 500 company anymore. So GE alone, just by having that security eliminated from our index, contributed something like 122 basis points in the past in the last couple of years of performance, just from one security. Now, will GE ultimately disappear from the index? I doubt that in its current form.

but we're trying to at least deal with this forward-facing risk of technological disruption because that's clearly what's happened to them. And without forecasting it on an individual company-by-company basis, deal with these metrics that we think are indicators of disruption. I know that this is obviously more of a quantitative fund and you're not bottom-up stock picking, but are there any companies that hit the screen and get put into the sort of losers' pile that would surprise people at the moment. Disney comes up, okay.

How dare you, sir? Disney? Disney. Wow. And look, it's a great one to talk about because historically, in recent history, right, they're spending a ton of money on, so one of the metrics, CapEx.

They're spending a lot of money. They're buying content. They're creating content. They're really investing in their business to keep up with the disruptors. And so at the current state of its historical financial performance, it doesn't meet the screen. Next quarter, might it? Yeah.

And good for them if they do. It's a great story to tell and people want to get into individual stock selections like that. That's not what we do. But it's a perfect example of something where it's a headliner. Everyone talks about it in the financial media. It's a darling for what they're doing. But right now, if you dig into it. to the financial performance, it just doesn't cut the score.

So that's interesting. Two data points that I think are worth talking about. So most people are familiar, or listening to this, are familiar with Hendrik Bessonbender's paper. I think you started it in 2017, showing that 4% of all listed stocks are responsible for all of the wealth creation ever in the stock market. Another stat is that two-thirds of all stocks underperform the index. So two implications there that I think market cap champions will use myself included is that

well, that's why market cap waiting works is because you're guaranteed to own the biggest winners de facto. So you're saying that it's a bad thing that you might own the biggest losers, but there tend to be a smaller piece of the pie. I guess if you invert that or pick on the two-thirds, doesn't that make the case for what you all are trying to do that, yes, market cap waiting obviously has its place and whatever. But maybe people shouldn't stop spending time focusing on the winners, which is really difficult to identify. And let's focus on the losers, which is potentially possible. Look, I think you just made the case.

I mean, to me, and just to be clear, I'm not saying that market cap is a bad strategy. What I'm saying, because obviously X out is a market cap weighted index. What I'm saying is exactly what you just said, that if you assume that 4% of companies attribute all the performance, everybody owns those companies anyway. So that doesn't change. So therefore, if you want to outperform or try and outperform that index,

what are you going to do? you're going to weight or overweight those companies, probably not because market cap weighted would have them at a high weight anyway. So therefore, logic would dictate that by getting rid of the companies that are not contributing to that performance, that is a better strategy in order to outperform the classic market cap weighted index. That is the whole point of what we're trying to do. So maybe this isn't your role to determine, but when you're talking to advisors and people that are using this product, where do you see this fitting inside of a portfolio? Is this to complement maybe their large cap exposure is just to replace it? How do you see people using it? Well, I think, I mean, ultimately it's to replace it. I mean, this is an alpha strategy, if you will. I mean, obviously it's completely rules-based. But the whole point here is that I think this is a better way to hold large-cap equity exposure. And coming again from the active side, people obviously hold large-cap funds on the active side. They own hedge funds. There are multiple sort of traditional factor-based products.

all of which are designed to outperform in a traditional sense. Now, we can argue about whether that works or not, but I think for us, this is simply a way of saying this is a better way to get that large cap core exposure. So very much a replacement, but of course can be a compliment as well. It doesn't have to be one or the other. In your research, you talked about how you have these nine sort of signals that you look at to suss out the losers, was there anything that you found that would be kind of surprising where you ran some numbers and thought this surely will work in it,

and it really didn't do a great job of picking out the losers. There are thousands of fields in Bloomberg that anyone can get access to. This isn't rocket science to explore that. It's taking the thousand and figuring out which are the nine that work. And so there were a lot of factors that we studied and measured and back tested, and we're sort of surprised. For instance, what's glaringly missing from my nine debt, some form of leverage. Why isn't that a test that should indicate that companies with high levels

of debt? And by the way, from my background, I was very focused on debt, debt levels, clean balance sheets. These were important characteristics of value investments. Guess what? That didn't really indicate much for us in terms of helping contribute to alpha that we were trying to generate. And I was sort of surprised by that, to be honest with you. So I'd be curious to hear your thoughts on maybe this diverting a little bit, but just did technology disrupt value investing, or is it just temporarily out of favor? What's your opinion there? If you talk to most value investors, they'll tell you they're really growth investors in disguise. Meaning what? Meaning that they use different metrics for trying to find value, however they wanted to find value. But ultimately, if they're successful,

the investment they're making should be a growing company. They're just not paying for it. So whether you call it growth at a reasonable price or some other marketing term that was used to fashion for an asset class that's been in difficult times for 10 years running right now. But ultimately, I don't think it's tech-disrupted value. They're arguably the largest company in the index right now. Apple is a value stock, isn't it? I mean, how can anyone not say it is with the kind of balance sheet that it has? It's still, by a lot of different firms' metrics, a cheap stock. but it's hard for people to just get their hands around it when it just keeps appreciating like

does, right? I think what's really interesting, and this is actually something that was addressed in one of the white papers written about this strategy is that one thing that has changed, I think, is the way that people look at valuing companies. So obviously, to take a somewhat silly example, but back in the day, people would count assets of a company being like the number of steam engines a company had or whatever, and that would be one of the major factors. Contributable assets. Now, if you look at the S&P, the amount of value that's

ascribed to the major companies in the form of intangible assets, so things such as number of patents, IP, technology, things that are not these tangible assets. That is like a fundamental shift that's happened over the last of 20 years. And there's a strong argument to say that that isn't properly priced into the market. And that as a function of technological disruption has disrupted value investing. So like things that book value wouldn't capture. Yeah. Like brand, for instance, or something like that. Exactly. The value of someone's IP, their brand, goodwill, you know, the patents, things that traditionally don't fall within traditional valuation metrics. So maybe the sales pitch for you guys, maybe you can correct me from wrong,

is the water has been muddied in between this growth and value, potentially in the last decade, especially. You're kind of saying, we don't want to really define that anymore. We're going to define it this other way. And hopefully the winners out of both of those camps fall into our whatever we've gotten rid of. All right. So again, the screens that you're using are revenue growth, higher in growth, capital deployment. Share repurchases. Are repurchases a good thing? They are. Okay. If they're used, if they're financed with cash flow, not by borrowing money to buy back. So there are secondary screens within, there's factors within these factors, I guess, for lack of a better word. You're looking at share repurchases, but you're doing something

like how they're financed. That's right. Okay. Profitability, earning sentiment. and management performance. So these seem to be the big key drivers of business fundamentals. And so we think that using this, excluding the bottom half or 250 names, should leave you with the winners over time. Yep. Yeah. And if you look at the fund, obviously, has been going for just about four weeks now.

And around the numbers, as of yesterday, there's been 58 basis points of alpha over the S&P 500 created. Now, obviously, we can't project that forward and say that's. going to last forever and usual caveats apply. But, you know, in four weeks, the strategy has produced alpha. And if you look at the index, since the index has been live, which was the beginning of July, it's 114 basis points over the S&P. So again, we're saying that past performance is not relative of future returns, all that sort of stuff. But the live fund performance has delivered alpha, it's something that is working and hopefully will continue to work. Four weeks is

a blip on a blip, but better be positive than negative. Anything to the sort of cap weighting, I guess I think Ned Davis has done some research in the past where they looked at the top 10 holdings by market cap and the S&P and then they've maybe gone on to underperform. Is there anything in your back testing that has shown that maybe this type of screen excludes more of those biggest names or is that not really the case? Not really the case. I think I'd go back to the way that the fund excludes is based upon these fundamental factors, which means you're either a good company or a bad company in the eyes of the index. And I think that with a market cap methodology means that only a small amount of companies are contributing all the performance.

And so there's a herding effect. There's a crowding effect within that if you put more of those companies or focus more, leverage more into that particular space. And so we're trying to avoid that on the assumption that everybody already owns those companies, what's better is or what's more important is what you leave out of your portfolio rather than what you have in. I would imagine you can't answer this off the top of your head, but do you know how many of the top 10 market cap companies are in the portfolio today? You exclude Berkshire. I believe that's a top 10. Do you have any sense or do you not know of the top of your head? I want to say it's seven. Seven of the top 10 are excluded? No. Included. Yes. That makes more sense. Interesting.

Anything that we left out? Yeah, look, I just think one of the most interesting, if there's two things to leave you with, that we think we're capturing here is this flipping of the investment process. Everyone in the business is trained to pick winners. They're evaluated based on it. Analyst from the earliest days in education are trained to research and fundamentally identify who is the winner. And we're saying, nope, let's just focus on the losers, and it's easier to exclude losers than

pick winners. So it's a simple thing. And so leave them out. And the second is technology is the single most important forward facing risk. And it's happening at a faster and faster pace. And as efficient as markets have become, they still can't figure that out. And so I am a believer that this will continue to go, that Moore's Law applies, and things will continue to happen at a faster and faster pace.

And we're going to find out years from now who are those Xed out of the index because they're gone. But at least we're trying to capture some of that along the way. We just think that will keep happening. This is a strategy for the long term. Great. Thank you so much for coming on. Thank you. Thanks.

Thank you very much to Will Rind and David Bars for coming on. I am going to keep my eye on this one. I'm ruining for this idea to work. I think, again, there is certainly validity in this line of thinking. It's a different idea, a new product, and hopefully it works out. It's also interesting to think about. We talked in the interview about which, stocks are being excluded at the moment, I think that's kind of an interesting thing to

watch over time, which stocks are being pushed out. And if it's certain stocks that are out of it for a long time, is that indicative of some sort of trend in an industry or a sector or a certain company? So I think that's an interesting way to use this ETF to think about individual stocks as well. So thanks again. Remember, go to granite shares.com if you want to learn more about this ETF. It's called X-Out. And thanks again to Will and Dave for coming on the show. Thank you.