High-Quality Stocks on the Cheap in These New ETFs

It’s generally best to avoid new funds, simply because they’re so hard to size up. But occasionally you find exceptions. I’m investing in two fledgling, actively managed exchange-traded funds: ValueShares U.S. Quantitative Value ETF (symbol QVAL) and ValueShares International Quantitative Value ETF (IVAL).

Manager Wesley Gray is little known, but I’ve spent enough hours talking with him and reading his book that I’m comfortable putting both my clients’ money and my own in his ETFs. Gray and his team eight self-described “quant geeks” are good enough, in my view, that they could be running a hedge fund, for which they could charge wealthy clients annual fees of 2%, plus 20% of profits—the standard (and outrageous) pricing structure for such vehicles.

But that’s not the kind of guy Gray is. While studying for his doctorate at the University of Chicago under Nobel laureate Eugene Fama, Gray took four years off to join the Marines and fight in Iraq. His ETFs each charge 0.79% annually. That’s pricey for an ETF, but the fees will decline as assets grow.

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The funds are off to decent starts. Since its inception on October 22, the U.S. fund has gained 11%, beating Standard & Poor’s 500-stock index by 0.8 percentage-point. The foreign fund, launched December 31, has gained 8.3%, compared with 7.4% for the MSCI EAFE index, which tracks stocks in developed foreign markets. (Returns are through June 16.)

But Gray isn’t crowing about the funds’ short-term results. “We have been on a lucky run,” he says. “Our approach should work over five to 10 years. But in the short run, we could look like the biggest idiots on the planet.”

When Gray was growing up, he learned about investing from his grandmother. He began managing money for friends and family while still doing graduate work. He started an investing blog, which he and his colleagues continue at www.alphaarchitect.com, and he co-authored Quantitative Value, a book about what he calls the “evidence-based investing” his ETFs employ. He still teaches finance part-time at Drexel University, in Philadelphia.

The crux of Gray’s strategy is to buy the most undervalued, highest quality stocks that he and his team can find. Says Gray: “We are true value investors. We focus on cheap first. Then quality is second.”

Academics, including many at the University of Chicago, pioneered the notion that the market is efficient at taking into account all publicly available information and, thus, impossible to beat except by luck. But they subsequently uncovered several anomalies. Most important to Gray: Stocks that trade at low prices relative to earnings, assets or sales tend to beat the market over the long term. So do high-quality companies. Gray and most academics believe investors make psychological errors in evaluating stocks and that such errors allow those anomalies to persist.

The ValueShares process is computerized, but judgment goes into most of the factors the Gray and his colleagues employ. To simplify their methods a bit, they start with large and midsize companies, excluding financials and real estate investment trusts. Next they compute each company’s operating earnings—essentially, profits before taxes and interest payments. They then divide that number by the sum of the stock’s market capitalization (the share price times the number of shares outstanding) and the value of the company’s outstanding bonds. In equation form, this calculation is expressed as EBIT/EV, with EV standing for “enterprise value.”

Finally, the team looks for companies with superior, historical long-term growth in earnings, sustainable competitive advantages and high profit margins.

Currently, the U.S. ETF owns 40 stocks, and the foreign fund holds 48. The ETFs now own mostly midsize and large-company stocks; as assets grow, Gray says, the funds will shift more toward large companies.

Instead of trading every day, the managers, for regulatory reasons, reconstitute the portfolios quarterly. Gray expects annual turnover of about 100%, meaning that on average every stock will be replaced over the course of a year. You might expect that to result in capital gains distributions, which could result in an unwelcome tax bill. But ETFs are typically able to avoid making those distributions.

The funds are too new to have meaningful risk measures, but Gray expects them to be as volatile as their respective benchmarks—or a bit more so. The relatively small number of stocks in each portfolio is one reason to expect above-average volatility. Moreover, Gray and company pay no attention to sector diversification—one reason he predicts that the ETFs will suffer stretches of lousy performance relative to the broad market indexes. The U.S. fund currently has more than 25% of its assets in both energy shares and stocks of consumer durable companies (makers of long-lasting consumer products). Those allocations are, respectively, more than double and triple the S&P 500’s weightings. The foreign fund has 40% of its assets in consumer durables and 20% in industrials—almost quadruple and double, respectively, the weightings in the EAFE index.

A few words of caution: Although you may not be familiar with the EBIT/EV ratio, just about everyone on Wall Street is and, like Gray and his team, either uses high-powered computer screening or works with someone who does. But, in my view, Gray exhibits a singular combination of brilliance, passion and discipline that I’ve found only in first-class fund managers.

Steve Goldberg is an investment adviser in the Washington, D.C., area.