By Philip van Doorn
The largest holding of the Distillate U.S. Fundamental Stability & Value ETF is Alphabet Inc. /zigman2/quotes/202490156/composite GOOGL +0.90% , which is Google’s holding company. The ETF holds the Class A shares. Alphabet’s class C shares /zigman2/quotes/205453964/composite GOOG +0.90% are also widely held and traded.
A comparison of Alphabet and Apple Inc. /zigman2/quotes/202934861/composite AAPL +2.02% . helps explain why Cole sold the ETF’s holding of the iPhone maker during the third quarter. (Apple’s shares were up 25% for the first half of 2020, up 59% though the third quarter and up 82% through the end of the year).
Alphabet’s Class A shares closed at $1,880.07 on Jan. 20. Analysts polled by FactSet estimate the company’s free cash flow per share for calendar 2023 will be $111.53. So if we divide the estimated FCF by the current share price, we have an estimated free cash yield of 5.93%.
Apple’s shares closed at $132.03 on Jan. 20, and its consensus estimate for calendar 2023 free cash flow is $4.74. That makes for an estimated free cash flow yield of 3.59%.
We could also divide the share prices by the free-cash-flow estimates, for a valuation (based on calendar 2023 estimates) of 16.9 for Alphabet and 27.8 for Apple.
Much more goes into Distillate’s analysis and quarterly rebalancing of the portfolio, but this is enough to illustrate the point. Until the third quarter, Apple had been the largest holding of the Distillate U.S. Fundamental Stability & Value ETF from its inception and the largest holding of the strategy since it was originally funded in 2017, Cole said.
“It went from being one of the cheapest names available to us, to being one of the most expensive, and largely tech has done that,” he said.
In their year-end letter to shareholders of the Distillate U.S. Fundamental Stability & Value ETF, Cole and Distillate Capital co-founders Jay Beidler and Matthew Swanson wrote that although the Distillate U.S. Fundamental Stability & Value ETF outperformed the S&P 500 during 2020, “Amazon’s 76% gain alone subtracted almost 2% from relative performance for the year.” They added that the performance of these stocks “combined to detract another 2 percentage points versus the S&P 500.”
So the fund’s approach makes it diversified from the S&P 500’s tech-growth-heavy weighting, but the strategy has been a success so far.
The letter also included a fascinating comparison of Tesla’s current valuation to free cash flow to that of Cisco Systems Inc. /zigman2/quotes/209509471/composite CSCO +0.35% in March 2000. At that time, Cisco’s stock had risen 1,300% over the previous three years and its share price of $77 was about 120 times its trailing 12-month free cash flow. “This optimism was not unfounded as free cash flows increased 450% over the ensuing 20 years,” the Distillate founders wrote.
But Cisco’s stock closed at $45.34 on Jan. 20, 2021 for a decline of 41% over a period of more than two decades.
The Distillate team explained the terrible long-term performance of Cisco’s stock.
“[T]he multiple paid for free cash flow contracted by 90%, providing a stunning example of the risk over overpaying for the shares of a good business.”
Ironically, Cisco is now the sixth-largest holding of the Distillate U.S. Fundamental Stability & Value ETF.
And now to Tesla — the stock closed at $850.45 on Jan. 20 and traded for 532 times the consensus estimate of $1.60 a share of free cash flow in 2020, according to FactSet.
“Similar to Cisco in 2000, this valuation does not leave any cushion or downside protection and the risk of valuation compression over time will be a substantial obstacle for growth to overcome,” the Distillate team wrote.
They added that the timing of the stock’s addition to the S&P 500 (it was up 731% for 2020 before being added to the index on Dec. 21) was something for investors in index funds that track the S&P 500 to think about: “We doubt that many investors would be happy with a manager who announced to the world their intention to buy a substantial amount of a stock in several months’ time and then after the stock went up significantly on the news, bought that much more of it.”
Here are the top 10 holdings of the Distillate U.S. Fundamental Stability & Value ETF as of the close on Jan. 20: