ETF Edge - Sell-off Strategies & Top Inflation Beneficiaries

Episode Date: July 19, 2021

CNBC's Bob Pisani spoke with James Davolos, Portfolio Manager and Research Analyst at Horizon Kinetics – along with Tom Lydon, CEO of ETF Trends. They discussed today’s sharp sell-off on Wall Street as Covid fears flare up again despite a number of relaxed restrictions all across the globe. Plus, a hot new inflation fund that’s poised to benefit from higher inflation. In the ‘Markets 102’ portion of the podcast, Bob continues the conversation with Tom Lydon from ETF Trends. Hosted by Simplecast, an AdsWizz company. See https://pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds, you are in the right place every week. We're bringing you interviews and market analysis, breaking down what it all means for investors. I'm your host, Bob Pisani. We're keeping a close eye on today's sharp sell-off on Wall Street. COVID fears flaring up again despite a number of relaxed restrictions.

all around the globe, plus owning in on a hot new inflation fund that's poised to benefit from higher inflation. Here's my conversation with James DeVolos, the portfolio manager and research analyst at Horizon Kinetics, along with Tom Leiden, CEO of ETF Trends. Tom, I want to start with you. We see the market sort of down 800, 850 points or so, no real bounce in the middle of the day. And the markets are having a difficult time today. I think the problem is we all want to live in a post-COVID world, but the virus is not going away. We're also seeing some very heavy volume in some ETSs.

So to bring us up to date where we are with ETS today. No, absolutely. I think the Olympics are going to be a great litmus test, Bob, and that's starting on Friday. If we can get through that without any major disruption, that will be really good. In the middle of the summer, when everyone's enjoying coming out, It's really disheartening to see what's going on. But as you point out, we're seeing redemptions and selling across the board, whether it be high technology or also quality, momentum, large cap to small cap.

All those ETFs are being affected. The positive aspects today are obviously treasuries. We're seeing the 10-year dip below 120, that TLT is up almost 2% today, which is great. And then as we mentioned earlier, these reopening companies are being hit. But those COVID-type companies that did well, the Zooms of the world, the Pelotons of the world, the Kathy Woodstocks of the world are actually holding up pretty well. Yeah, and James, what seems to be happening here is what we call degrossing, what hedge fund guys call degrossing. They're just taking down exposure. The overall market is down 2%. As Tom points out, I see quality names.

of the big tech names down. I see high beta names. I see momentum names, banks down, almost across the board, we're down about 2%. This seems like people are just taking down some exposure overall. Yeah, I think it's hard to know what people are doing on a day-to-day basis. People have a lot of different constituents, timeframes, performance goals, but I think that the long-term trend remains pretty clear. I think the tenure going back to 120, below 120, no pivots from the Fed policy. I think the long-term trend still points to a pretty strong reflation, ultimately shifting into inflation. James, I want to talk to you about this new inflation ETF that you started because it's a very interesting idea, but it seems hard to execute to me. How do you decide what stocks are going to benefit from inflation and give us an idea of three or four stocks that are in this, particularly the commodity type names?

Sure. So the first thing we want to do is we want to identify an end market that we believe is inflation. which we broadly refer to as hard assets, so a tangible, finite asset that can benefit from pricing pressures. But then the most important part is we overlay a capital-like business model where we want to emphasize businesses that don't put a lot of the balance sheet at risk and don't spend a lot of capital in order to earn their returns. And then finally, we overlay a valuation framework where we're not just going to overpay for a good business and a good vertical. Yes, so I want to just bring up some of these companies. So you have here, Texas Pacific land, for example, Archers Daniel Midland, Wheat and Precious Metals, Franco Nevada. These are all commodities stocks. Texas Pacific land, for example, they own a lot of land. What do they do? Sure. So Texas Pacific is truly one of a kind where they benefit from owning royalties on the oil and gas production of any number of companies operating in West Texas, whether it be Chevron, Exxon, EOG.

They also own the land. So if you want to develop pipelines, if you need access roads, if you need power, if you need water, you need to pay them in easement. And the most important variable here is that they spend virtually no money to earn their revenue because they're earning a cost-free royalty on oil and gas production or a cost-free easement on somebody crossing their land. So they can benefit from this inflationary cycle without committing all of that capital. And you have some metals companies, gold companies, Franco-Nevada Corporation, for example. What do they do? And why would they be an inflation holding? Sure. So Franco-Novada's main business is streaming or royalties in precious metals,

where they have a very similar, low-cost, very capital-efficient way of benefiting from the gold and silver mining activity of other companies. So I believe that gold is ultimately going to have a bid, especially as you're going to, you see pressure on the dollar, inflation expectations tick up. Franco Nevada has a very low break-even cost by virtue of these streams and royalties so they can benefit from a rising gold price without having to put more and more money back into the earth because, as I mentioned, other people are spending the money to extract the gold and silver. You also own Archer Daniels Midland now.

This is, I mean, obviously, it's a grain company. They've processed grains. but there's an inflation play here that I never really understood or realized, actually. Can you explain what the inflation play is with owning ADM? Sure, and I love this company. They basically crush or mill a lot of the world's flour and corn into starches and sweeteners and flowers as well as seed oils. But basically what they earn is called a crushing margin.

So if you have inflation in soybeans, corn, wheat, all of these input costs, It goes into their grain elevators. It goes into their crushing facilities. And they earn a fairly defensible, if not rising, margin on processing that throughput. Then they sell the end products to the end customers where they push on all that inflation. But they're earning a margin on these inflationary forces or inflationary end markets without really needing to commit any more capital themselves. Yeah. You know, Jim, or rather Tom, commodities are on fire this year.

I was looking at it. I think it's probably the biggest commodity ETF here. Investco's optimum yield, diversified commodity strategy, ETF. They own futures contracts, I think 13 or 14 futures contracts. And they've had a great year so far this year. They're up about 25%. It's down rather noticeably today, of course, because there are concerns about the COVID variance. But this would have been a great investment earlier in the year. Yeah, absolutely, Bob. And there are a couple key points here. As you point out,

at futures base. So there are positives and negatives that go on with that. We're not going to get into the details, but they've seen almost $3 billion come into this ETF this year, where GLD has seen about $7 billion in redemptions. At the same time, kind of what James is pointing out, there are some companies that you can invest in, royalty companies, where they're almost getting a rent payment

every month. And they're not having to man up for that. They're not having to increase their labor costs. And that's nice and steady, especially with metals prices where they are today. The final point is, historically, when you look at inflationary times, gold tends to be a second half player. We've seen so far in the last 12 months that the base metals and the food and the energy have been where most so the performance has been where gold's been somewhat flat. If we actually do see inflation tick up here, you can expect that gold will kick in, and with that, it'll be better for these companies as well.

Yeah, James, you own a few unusual items, and I wonder if you could explain me. You own exchanges, for example. So you own ICE Intercontinental Exchange, which owns the New York Stock Exchange, where we are right now. You own Deutsche Boris. What do owning exchanges have to do? do with inflation? If you were to think about the ripple effects of what inflation would cause

throughout the broader economy, but also for individual businesses, it impacts currencies, interest rates, soft commodities, hard commodities, and the Intercontinental Exchange, Deutsche Bors, the CME, they operate very large derivatives exchanges, which allow people to both hedge and speculate on all of this instability and volatility that might arise as a function of inflation. But if you were to step back and look at what these businesses are, they're basically financial supercomputers matching buyers and sellers. So if there's a couple trillion dollars more notional derivative volume, the exchange has spent very little money to basically earn that revenue and a lot of that converts into operating income.

Yeah. I wonder, you were talking earlier about this concept of capital light as a way to look at inflation. I wonder if you can explain that. You seem to be emphasizing companies that are doing outsourcing. This is sort of another branch that you're investing in, and that that's going to save money. And once you get revenues up, once you have inflation, revenues go up

and the company's benefit because they don't have a lot of spending in the middle. The goal goes to the bottom line. Explain this capital light model. And I'm wondering we put up that full screen so that'll help explain this. The number one problem with betting on a direct binary bet on inflation or commodities is

that, let's say you were to look at the upstream of copper or oil or gold. They spend a lot of money to earn their returns, and they lever it up with a lot of balance sheet debt. And so when the cycle, if you're early, or if you're late, or if you're wrong, you can impair a tremendous amount of capital going into these capital-intensive businesses. So we focus on businesses that have a very asset-light,

highly scalable, operating-leverage type of business model. And as you mentioned, some of these do provide outsource data, contract research, research services, where because of their extensive libraries of data, their facilities and their staff, they can do it more inexpensively and better than a lot of the incumbents can do it internally. Yeah. You know, Tom, we used to have a word for this, operating leverage. It's where essentially companies would cut costs in the middle.

And we saw this during COVID. They cut real estate costs, cut firms that are out there. there, cut expenses overall, and once the revenues go up, you see the move, it all goes to the bottom line here. It's called operating leverage, and he's sort of describing this to a certain way, although capital light means essentially you eliminate a lot of these middle costs by outsourcing. Right, and in two cases here, the renters, if they're going to have to get more gold out of the ground, it's on them to produce the capital and also the people. And then the other things like trading and commodity futures, if that happens to increase, it's all about leveraging

technology. So some great companies to think about, I think the bottom line here, as we continue to look at the Fed and what the Fed is signaling regarding inflation, most advisors don't believe it. The number one fear that advisors have today is inflation followed closely by high stock valuations. So they're gearing up to protect their clients from inflation and looking at these types of options in commodity ETFs. I want to go back to this capital light model because I was looking, James, for some examples here. I think your biggest holding is Charles Rivers Labs. And there's a good example of essentially the Capital Light model. I wanted you to explain that. Charles River essentially does lab work for pharmaceutical companies. How does that fit in with

with this concept of capital light and inflation? Correct. And think about all of the arguments about, is inflation real? Have you experienced inflation? I think two areas that you'd be pretty hard pressed to argue against being inflationary over the past decade are higher education and health care. And within health care, it's really hard to access this and play this

because of the capital intensity, because of the complexity of the health care payment system. But Charles River Lab, they basically, are a contract resource organization where they streamline the very early stage safety assessment and discovery processes. And they can do it more cost effectively and they can do it more rapidly than even the largest pharmaceutical, biotech, academic, and government agencies out there. And so in an inflationary world where there's price pressures all throughout the health care

ecosystem, A, there are a very low component of the overall cost structure. But B, they have the facilities in place, they have the networks, they have the databases, where it doesn't cost them very much to put a lot more throughput through their existing system. So labs have all... Healthcare companies have all these fixed costs. And to the extent that you can outsource some of them, for example, lab work to a company like Charles River, that obviously reduces that middle part of all the expenses. And that is going to benefit once people have revenues.

who's higher. I mean, I'm trying to connect the dots here to the inflation story. So let's say that Pfizer, just to throw out a mega cap by a pharmaceutical company, if it's getting more and more expensive to hire people to do your internal safety assessment and discovery, if to get the data is becoming more and more expensive, if getting the lab equipment is getting more and more expensive, it's that much more beneficial for you to outsource this to the industry leader. And to the extent that there's more and more demand in an inflationary environment, Charles River is going to benefit both through higher volume and higher pricing, kind of having that one-two punch, to your word, operating leverage on the upside.

Yeah, and there you see Charles River, which has had a spectacular year, partly obviously on COVID and additional needs for more medical research, but also perhaps partly on that inflation story, that they're the beneficiary of outsourcing in the pharmaceutical industry. Yes, and pricing pressure flowing through the system. They're a nice place to kind of capture that inflationary pressure without having too much risk. Now it's time to round out the conversation with some thoughtful analysis and maybe some perspective to help you better understand ETFs. This is the Markets 102 portion of the podcast. Today we'll be continuing the conversation with Tom Leiden from ETF trends.

And Tom, thanks for joining us. I just want to comment on what we're seeing here today. I've been saying all day that the real problem we're having right. now is everyone wants to believe that we're living in a post-COVID post-vaccine world, but the virus is not going away. And I was talking to half a dozen of my friends that own restaurants this week. In the last few weeks, they've said the same thing. Business is fabulous, and they can't get enough help.

But this weekend, for the first time, half of them said they're a little concerned. concerned about these COVID variants and ask me about it. Now, that's a change in attitude. Something's happened here where there's a little more heightened awareness and probably correctly so. But you see the situation here today. We're seeing reopening stocks notably on the weak side. And as you've noted, Tom, some big ETFs have a lot of volume. Yeah, Bob, you're right. I mean, on the West Coast here, we've seen the same thing in Los Angeles. They just implemented a new rule that inside you've got to wear men. I think you're hitting the nail on the head. For those that are vaccinated, we're enjoying the summer.

We're getting back to the way things were before. But two things. We're seeing those that are not vaccinated, we're seeing a bit of a spike in COVID cases, number one. And we're starting to see some people that are vaccinated actually get the virus. So that's concerning as we go into the fall and we start to be in closed environments again for sure. I think as we look towards the Olympics and that's all starting on Friday, we've started to see some indication that their case is there. If that goes smoothly,

hopefully that'll be a good precursor to what might be coming. But man, if you are a restaurant and you're back full and your place is packed after a real tough year, it would be terrible to look to the fall to have to go through those same problems again. Yeah. I want to move to the 10-year yield here. Everybody's trying to figure out what exactly is trying to tell us.

But what's amazing to me is just when you're at 1.3% on the 10-year yield, I'm wondering, you know, who exactly is buying this thing. I mean, I know there's a lot of international buyers who have 0% on their 10-year. So there are Japanese pension funds that are certainly buyers. But I'm wondering about, you know, you and I have talked about the 60-40 portfolio, the 60% stocks, 40% bond portfolio. I'm wondering how you could possibly have that kind of portfolio with 10-year yields at 1.2% and inflation at 2.5%.

It doesn't make any sense. That's a crazy transaction. Yeah, it's all about keeping everything safe. I mean, there's $5 trillion in money market funds right now, Bob, that are paying next to nothing near record highs. So you're right, that 40% in the $60,000, many people are feeling is somewhat dead in the next two to three years. So what do you do?

You keep it safe. You keep it short duration. In the ETF space, there's a lot of money in the fixed income side that's moving towards active, where there's some really good managers out there that are able to show their worth. And then they're also looking at alternative income strategies. Folks like JP Morgan have this JEPI or Nationwide Newsie have options over. strategies that are kicking out 7 to 8% yields. A very small allocation for your fixed income allocation there can really help boost that overall

yield for your clients. Yeah. And let me just ask you about flows because you were mentioning active here. It seems to me there's three big trends going on so far this year in terms of where the money is in ETFs. Number one, a lot of money continuing to flow into the plain vanilla passive. indexed ETFs, the S&P 500s, the Russell 2000s, that's continuing. And we're having probably a record year on that.

But two other trends, number one, more actively managed ETFs being created. And secondly, mutual fund conversions to ETFs, the biggest one so far, which is dimensional fund. So you put flows into plain vanilla, passive, you put more actively managed ETFs, coming into existence, you put some mutual funds converting into ETFs, and it's no wonder we've got, we're looking at a potential record year for flows. We are, and a couple other components to add to that is, you know, last year, more money went into fixed income than the equities. This year, we're only seeing about 25% of what we

saw last year going into fixed income. Again, back to the lack of, you know, comfort in the fixed income market, let's say. The other thing I'd say, Bob, is we're starting to see the money outside of the traditional S&P 500 be somewhat meaningful. I mean, the S&P 500 carried a lot of people for a long period of time coming out of the financial crisis. And as you know, it was a concentration of a bunch of fang stocks and a few more that really made a difference. I think with the thematic strategies, the disruptive and also active strategies, we're starting to. to see money diversify a little bit, as many people are looking for where the fang stocks or the next fang stocks might be coming from. Yeah, that's a good point. Tom, I'm going to have

to leave it there. I appreciate your thoughts, as always, and we'll forward to talking to you again very soon. Tom Leiden, of course, a dear friend of mine and one of the great experts on ETFs in the world. Everybody, thank you for joining us. InvestcoQQQQ believes new innovations create new opportunities. Here's to greater possibilities together. Learn more at Invesco.com slash QQQ, Invesco Distributors, Inc.