ETF Expert Corner

MarketGrader’s Carlos Diez & Brady Lipp Spotlight Barron’s 400 ETF

March 29th, 2016 by ETF Store Staff

MarketGrader’s Carlos Diez and Brady Lipp spotlight the Barron’s 400 ETF, including discussing the recent rebalancing of its underlying index.



Transcript

You can listen to our interview with Carlos Diez & Brady Lipp by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: The ETF we're Spotlighting this week is the Barron's 400 ETF. The ticker symbol is BFOR. Joining us via phone to discuss this ETF is Carlos Diez, CEO and founder of MarketGrader Capital, and Brady Lipp, managing director at MarketGrader. MarketGrader developed the index that Barron's 400 ETF tracks. Gentlemen, great to have you both back on the show.

Brady Lipp: Thanks for having us.

Carlos Diez: Thanks Nate. It's great to be here.

Nate Geraci: I want to start with the back story on this ETF. Carlos, as I understand it, the editorial team at Barron's discovered your firm. They learned about your investment philosophy, and they wanted to partner on developing this ETF. Take us from there, how did this ETF go from concept to creation?

Carlos Diez: Absolutely. I'll start actually with how the research process started because that's the first place that we collaborated with Barron’s. They learned about us in the early to mid-2000s, and we started providing some of our fundamental research, which is really what we've done for a long time, to their clients on their website. We created a section on the Barrons.com website called StockGrader with our fundamental ratings ... and that eventually led to the idea of creating a broad index that had the best rated companies based on that fundamental perspective that we provide, broad market index and that was the genesis of the Barron's 400.

Nate Geraci: Well Carlos before we get into the Barron's 400 ETF, you mentioned your fundamental research ... Can you talk in a little bit more detail about MarketGraders overall investment philosophy, and investment process itself ... What are some of your firm's core investment beliefs?

Carlos Diez: Our firm has been around since 1999 and our focus has always been fundamental analysis, and more specifically we have always focused on GARP, growth at a reasonable price. So we analyze every company under coverage, and it’s been more than 6,000 North American companies for the better part of the last 16 or 17 years. And we grade them across four fundamental categories; growth, value, profitability, and cash flow. We use six distinct indicators for each one of those, for a total of 24 indicators. So you can have a company that scores very highly in growth, but very poorly in value, and its unlikely to have a very good score, or the other way around. Profitability and cash flow are always important factors that we take into account, so we actually use those 24 indicators in one final numerical rating between 0-100 and that gives you our overall score. To give you an idea ... historically about 15 to 16 percent of our coverage universe has been rated buy, and about 15 or so hold and the balance of that rate itself. So it's a very strict fundamental system, and like I said before GARP is the focus of the analysis itself.

Nate Geraci: So the ETF is the Barron's 400 ETF, the ticker again is BFOR. MarketGrader again developed this index, and this is the index the ETF tracks ... Carlos, as name implies this ETF holds 400 stocks. These are all U.S. stocks, and as you mentioned, they're selected based on fundamentals, or 24 indicators you track, as you said across growth, value, profitability, and cash flow ... Can you walk us through some of these indicators in a little more detail? And help us understand the types of stocks we should ultimately expect to find in this ETF.

Carlos Diez: Absolutely, so in the growth category we're looking at top line and bottom line growth ... we're looking at net income growth, operating income growth, revenue growth ... both over the long term and the short term. And we're looking at EPS growth very closely. In value we're looking at traditional valuation multiples, we're looking at price earnings, price book, price sales, price cash flow ... And in profitability we look at margins very close, we look at return equity, the growth of shareholders equity, things like that ... Lastly in cash flow, we look at a company’s, their free cash flow. If they have any debt, their ability to service that debt without impairing growth ... So when you combine all those things, you get a very good assessment of a company's fundamental health. The index itself ... the objective was to have an index that serves as a benchmark for investors seeking capital appreciation from U.S. equities. So we try to identify the companies based on the formula that I just described, that are constant creators of economic value. Because we believe those companies are typically the best creators of future shareholder value, that's where you want to be. The top companies that you find, the index itself builds mostly mid-caps, right now about 56 percent or so of the index constituents are in the 1-10 billion dollar segment in market cap, and the balance or the other 45 percent or so is pretty much evenly listed between large caps and small caps. So it's not at all a small cap index, but it behaves very much like a mid-cap index. And it typically has about 80 to 95 companies that overlap the S&P 500. Of course the companies are not always the same, the index gets re-balanced twice a year. It actually just went through its latest re-balance earlier this month. Every time we do that, we pick the top 400 companies again, in our system - rating system. We remove the ones that no longer make the mark and we reconstitute the index and return it to equal weights. So it's a pretty dynamic index and it has about 38 to 40 percent turnover every six months, every time we do this process. The ETF itself is very helpful for concerns over so many constituents because it's the most tax efficient way to take advantage of that methodology ... and in terms of companies you get a lot of GARP, a lot of growth at a reasonable price. The sectors fluctuate based on who is doing well and who is reporting good earnings. Lately we've been picking up pretty good value in mostly industrials, financials, and technology here in the U.S. of course. We also have had a very good amount of consumer discretion companies for the better part of the last four or five years or so.

Jason Lank: Carlos, this is Jason Lank. You mentioned that this ETF is equal-weighted. Most investors are familiar with, for example a market capitalization weighted product, but this is equal weight ... Why did you choose that as opposed to any other methodology? And what does it add to the party, so to speak?

Carlos Diez: We chose equally-weighted because we wanted to give every company that we picked, based on its fundamentals, an equal opportunity to contribute to the index performance. And there's a lot of very good companies that we see, especially in the mid cap segment of the U.S. market that maybe don't get a fair shake, so to speak, in the larger benchmarks simply because even if they do very well they account collectively for a very small weight in the overall index. So if you take the S&P 500 for example, the top 20 names or so account for more than a quarter of the weight of the index. So it doesn't really matter what the bottom half or bottom quarter of the companies in that index do, or other similar benchmarks do. They really don't sway the index and have very little influence on its performance, simply because its dependent on what the large names do. So we wanted to break that connection, to break that link and allow companies to contribute to that long term capital appreciation focus based on their fundamentals. And doing it equally weighted allows to do just that.

Jason Lank: One further question on the equal-weighting philosophy. This fund ETF tends to hold medium sized companies, of course we know those aren't quite as liquid as the larger companies are. Have you ever run into any liquidity problems trying to equal weight with small to medium sized companies?

Carlos Diez: No, actually not at all because we apply two liquidity filters in selecting the companies. Number one, Dow Jones Indexes former sister company were very much a part of this process when we were developing the index. They wanted to make sure that the companies were very liquid, should there be in the future, like there is now, a product that products attracted, that could be investible to make a significant amount of assets. We use a minimum market cap of 250 million dollars on a float adjusted basis, so anything below that on a float adjusted basis is ineligible for index selection number one. Number two and far more importantly, we use a three month average trading volume of 2 million dollars per day on average. That's a pretty high hurtle to clear ... So once you have those two filters in place, anything above them makes companies eligible for it. So we have never had any issues with any companies being illiquid or anything like that. They're all pretty fairly liquid and in the ETF itself that's what matters the most - the liquidity of the underlining constituents.

Nate Geraci: Again, we're visiting with Carlos Diez and Brady Lipp of MarketGrader Capital. We're spotlighting the Barron's 400 ETF ... Brady I know you've been waiting patiently on the other line ... the tagline for this ETF is that investors can access some of Americas highest performing companies in a single share. As Carlos mentioned there is a fairly sizable mid and small cap allocation within this ETF. Where does this fit in a portfolio? Should this be viewed as sort of a total U.S. stock market replacement?

Brady Lipp: There's really two ways that investors are using the fund. As Carlos mentioned, there's been a relatively high representation in the mid cap area and a lot of investors are looking at it as their mid cap allocation. Which I think is ideal, because when you compare this ETF to an open ended mutual fund for example, there's a couple very distinct advantages that this fund has over an open ended fund. Number one is that you have some real tax advantages because of the unique way that the redemption and creation process for ETF units, and we have not made any cap-gain distribution since we started the fund back in June of 2013. The other big advantage is that the overall expense ratio of funds like this, tend to be lower than what you would typically see in an open ended fund. For example, our fund has an expense ratio of about 65 basis points, which is probably close to half the price of what you would typically see in an open ended fund. Now having said that, if you take a look at the long term historical performance of the Barron's 400 index relative to the S&P 500, you'll find that there's a correlation rate of .96 which is very high, relative to the S&P 500. So we do see investors using this as sort of an alpha generating satellite type position within the context of a core U.S. equity holding ... I don't think there would be anything wrong with that, that's exactly how I use the fund. It really depends a little bit on the investors desire to not have too much of a tracking in relative to the S&P 500. Those are really the two primary ways that the fund is used.

Nate Geraci: Carlos, you mentioned that the ETF is re-balanced every six months, and I know just two weeks ago a little more than a third of the holdings were replaced during re-balancing. I'm just curious, what does the general composition of this ETF look like now? Just in terms of whether it be holdings or sector weightings.

Carlos Diez: Right, in terms of sectors there have been a few changes this month, from the prior re-balance which took place last September. The sector that had the biggest net gain in the number of names was technology, which had a net gain of 12 names. And it's now the fourth largest sector at almost 17 percent of the index ... the top three continue to be industrials, financials, and consumer discretionary. Industrial and financials have 20 percent a piece, and consumer discretionary is right behind at 19 1/2 percent ... one of the things I found most interesting about the re-balance was the fact that both industrials and financials reached their maximum cap of 20 percent pretty quickly in the selection process. So let me explain what that means. We also have a 20 percent cap or ending for the index as being the maximum allowed in any given sector during any re-balance to avoid having half of the index or so in a single sector. In the last couple periods, both industrials and financials have done very well and that correlates very closely to what we’re seeing in terms of earnings growth in the U.S. for both of those sectors ... which a lot of people would think is kind of counter intuitive of what the market has been doing lately, so if you think about the early market selloff, some of the names that suffered the most were financials and industrials but if you look at the company that the Barron's 400 owns in that space, they're very different from what you would think about. It does really own a lot in financials for example, doesn't really own a lot of the large mega cap banks, or the names people would associate with financials, B of A's, JP Morgan, and so forth. A lot of investment managers, a lot of financial services firms that are not necessarily the banks, a lot of regional and midsized banks that seem to be doing well ... for industrial the story is the same, it has the top five health care mix. From a market cap perspective, like I said before, a little bit over half is in the mid cap section, with the balance about 22 percent large caps and 21 percent small caps.

Nate Geraci: Well Carlos, on that note ... and by the way we have about two minutes left. Interestingly if you look at the MarketGrader score given to each company in the ETF, at the re-balance a couple weeks ago, the overall score of the companies held increased to 67.8 from 63.6 and obviously this shows the inclusion of stronger companies in the index. But can we take anything away from this, In terms of the overall health of the U.S. economy? Are companies as a whole looking better?

Carlos Diez: I think so, and I think they are trying to reflect that and again the U.S. economy or any given sector or any given index is really not a static metric, it's a collection of companies and they all have different fortunes. To expand on what I said before, for example going back to financials and industrials, right before the re-balance we completed our tally of fourth quarter earnings for 2015. We look at financials and industrials and how they did in terms of EPS gains relative to the same sector as the S&P. Both were the two highest growers with 10 1/2 percent year over year increase in earnings versus 1.2 percent for financials and the S&P and .2 percent industrial in the S&P. Point being, it depends what you're looking at. To summarize there is plenty of growth at a reasonable price, there's plenty of value and there's pretty good health and overall corporate earnings in the U.S. so yes its descriptive of a fairly good economic environment at least in the U.S.

Nate Geraci: Well on that note, we will have to leave it there. Gentlemen, as always we appreciate you joining us today!

Carlos Diez: Thanks for having us, our pleasure!

Brady Lipp: Thank you very much for having us Nate!

Nate Geraci: That was Carlos Diez and Brady Lipp of MarketGrader Capital. Again the ETF is the Barron's 400 ETF and you can learn more about this ETF by visiting barrons400etf.com