Executive Summary


This article provides an overview of Preston and Stig’s interview with Wesley Gray, an Executive Managing Member from the asset management company Alpha Architect that specializes in Quantitative Value ETFs. This is the second half of the interview.
This article and podcast answers the following questions:

  • How do I estimate the intrinsic value of an ETF?
  • What is the investment philosophy behind Wesley Gray’s value ETF?
  • Ask The Investors: Can you apply principles from Growth Investing in Value Investing?

How do you estimate the intrinsic value for an ETF?

To estimate the intrinsic value of an ETF, Wesley Gray points out that you first need to look at the investment process. Is it a solid process that you expect to perform well in the future? This is an important consideration because when you buy into the existing portfolio, you are also buying into a fund that will move around its portfolio.

One can argue that the intrinsic value of an ETF is the net asset value of the stock since that’s the price the stocks can be sold for in the open market. Clearly, this would also be dependent on whether you think the underlying assets are worth exactly what the stock market has priced it at.

Wesley Gray has tested a variety of fundamental to predict the future return of an ETF. What he has found is that the earnings yield on a large portfolio of stocks is the best predictor after subtracting realized inflation. The earnings yield is simply the inverse of P/E. If the P/E is 20, the earnings yield is 1/20 = 5%.

What is the investment philosophy behind Wesley Gray’s value ETF?

Wesley Gray’s value investing process can be broken down into five sequential steps:

1) Identify Investable Universe: The investment universe consists of mid and large capitalization stock that ensures that a relatively large amount of capital can be employed without moving the market price. There’re typically around 1100 stocks in the beginning after the first step.

2) Forensic Accounting Screens: The second step involves statistical models that are applied to exclude companies that are likely to risk financial distress and financial manipulation. This process takes away 100 stocks. This is not to say that even a small part of the 100 stocks are prone to accounting fraud, but there are some indicators to show that there is a higher risk in this pool of stocks. Since there is no extra return obtained from these stocks, you should avoid them. This brings us down to 1,000 stocks in our pool.

3) Valuation Screens: Here the screener takes the 10% cheapest stocks measured on operating earnings compared to enterprise value. For more about this process, you’ll want to refer to our discussion with Toby Carlisle.

4) Quality Screens: This step boils it down to the half of the stocks with a higher quality. Quality is a large number of different key ratios including return on capital, free cash flow, and a general improved balance sheet. Now we’re down to 50 stocks.

5) Invest with Conviction In value investing, a large diversification is typically not recommended. Dependent on how you measure risk, many investors argue that there is no additional benefits holding over 20 stocks since you will incur extra cost and not gain significant benefits from diversification. The SEC has strict regulation to protect the investors when it comes to ETFs, and demands that not more than 25% of the portfolio is in a given stock or industry. While you can have fewer stocks than 40-50 in an ETF, it’s typically not recommended as you would have to rebalance a lot more than you otherwise would.

Ask The Investors: Can you apply principles from Growth Investing in Value Investing?

Basically, all types of investing are the same. You discount the expected cash flow from your investment back today and compare it to the current price. Here, you want to have the highest possible discount. The problem with growth stocks is that the current price needs to be justified by somewhat higher growth rates, which are harder to predict. Value picks on the other hand does not require high growth to justify the price.

Sometimes, we hear stories about investors making a fortune on growth stocks. Most often, these people didn’t invest in listed growth stocks, but rather founded the company themselves and took them public. Empirical evidence also shows that value investing performs better than growth investing. Fidelity looked at the historical returns from 1980-2010 and found that a large cap value outperformed with 1.7% annually, while value small cap stocks outperformed with 4.2%. That is a vast difference! Assuming that you invested $10,000 at the beginning of 1980, your investment would turn into $601,860 instead of $188,177 for the small growth stocks at the end of 2010.

Books and resources mentioned in this episode

Wesley Gray’s book, Quantitative Value – At his price

Toby Carlisle’s book, Deep Value – Read reviews of this book.

Daniel Kahneman’s book, Thinking, Fast, and Slow – Read reviews of this book.

Wesley Gray’s site, Alpha Architect

Wesley Gray’s white paper for his, US Quantitative Value ETF: QVAL

Historical return for growth, Growth Investing Vs. Value Investing

Videos that Support this Podcast

Wes presenting at the 2013 Nantucket Project Finance Forum

Wesley Gray – Quantitative Value

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