This ETF Proves Value Investing Still Works in an Asset-Light World

For years now, many have claimed "value investing is dead". This claim peaked during 2020 and 2021 as this was a time when tech stocks were soaring, and traditional businesses faced challenges due to pandemic-induced stay-at-home measures.

Distillate Capital, a firm with a focus on value investing, challenged this notion, asserting that the fundamentals of value investing remain effective. They believe, however, that it requires adaptation to stay relevant.

The core challenge here is the nature of tech companies: they're often asset-light with minimal capital expenditure, resulting in low book values. This makes traditional value metrics like low price-to-book (PB) ratios less effective, as these companies typically have higher PB ratios due to their lower denominators.

However, it's not that tech companies lack assets; rather, their assets are largely intangible and harder to quantify. Take Facebook's platform, for example. Its immense influence and revenue generation potential aren't adequately reflected in financial statements.

For a deeper understanding, I recommend the book Capitalism Without Capital (affiliate link.) It dives into the nuances of this transition in the investment landscape.

Distillate Capital pointed out that even using the PE (price-to-earnings) ratio for comparisons might not be equitable. For instance, a traditional business might show higher net earnings compared to a tech company, but this doesn't always paint a complete picture.

Consider this: a traditional business might incur substantial capital expenditures, like purchasing costly equipment, which is then depreciated over, say, ten years on the income statement. This spreads the cost out and results in higher reported net profits.

In contrast, a tech company might not have significant capital expenditures but could have high operational expenses, such as salaries for top-tier programmers. These costs are expensed in the year they occur, potentially making the company's profits look smaller.

As such, comparing PE ratios and profit margins has become less meaningful. Even within the same industry, fair comparison requires similar depreciation schedules.

Distillate Capital suggests an alternative: focusing on free cash flow, which they see as less prone to distortion. They use a valuation metric based on the ratio of free cash flow to enterprise value, also known as the free cash flow yield.

Some of you may recognize the concept of free cash flow yield, as I've previously discussed the Pacer US Cash Cows 100 ETF (COWZ), which employs the same metric.

Distillate Capital, however, takes it a step further by tailoring their free cash flow measure. They normalize capital expenditures and fluctuations in working capital, along with making several adjustments to circumvent the distortions. Distillate Capital’s ETF also made my list of the Best ETFs for 2024.