Indexing is essential. Using forensic accounting screens makes it even better, Ranger’s John Del Vecchio says.
John Del Vecchio, forensic accountant and co-portfolio manager of the Ranger Equity Bear ETF (NYSEArca: HDGE), has a new book out that puts indexing in a favorable light, but with a few important twists.
Del Vecchio told IndexUniverse.com Correspondent Cinthia Murphy that owning swaths of the market is the only way to preserve returns in a world full of vagaries that can torpedo the most established of companies. But that doesn’t mean he buys into traditional market-capitalization-weighted methodologies.
After all, Del Vecchio helped create the Earnings Quality Index that will underlie a forensic accounting ETF that went into registration last month. He discusses the key concepts behind that fund in his book “What’s Behind The Numbers?”, arguing that applying forensic accounting and focusing on earnings quality allows him to find value stocks while excluding accidents that are waiting to happen.
Murphy: Right off the bat in your book you make the argument that most stocks will lose money even in a bull market. If that’s the case, stock-picking is a losing proposition any way you slice it. It sounds to me like a big pro-indexing statement.
Del Vecchio: That’s fair. For a buy-and-holder or a dollar-cost-average investor, the only way to really invest is to do it in the index space, and not through individual securities. To make this statement more realistic, imagine we were talking in the late 1970s; we would be talking about Kodak, Polaroid and General Motors, companies that back then were stars, but 30 years later were all bankrupt. Fast-forward to the 1990s, and the same can be said about Microsoft, Intel or even Cisco. Today you have Apple and Google. The reality is that from one generation to the next, in the stock market, the leaders don’t carry over. The only way to get sustainable returns is to own an index.
Murphy: I can’t help but to link this to the argument Rob Arnott recently made about the problems with chasing big companies. There’s no such thing as a safe bet, as in a too-big-to-fail stock that investors should own, right?
Del Vecchio: Think about it this way: Enron was an $80 billion company when it spiraled downward and into bankruptcy eventually. There are many others like it. The market capitalization or even the revenues of a company have really nothing to do with what’s going to happen in the future. Every company experiences a bump in the road; there’s no company that’s going to have just a clear straight trajectory of growth. But how the company withstands the bump in the road will have a lot to do with its management, and with its ability to sell its product. At the end of the day, a company’s earnings quality is the most crucial metric here.
Murphy: And your book talks about diving deep into those earnings numbers and isolating the companies that show red flags. What should investors do with that?
Del Vecchio: Our book is not about shorting stocks—which is what I do for a living—but it’s about avoiding a big loss. It’s really applicable to everyone in the market rather than just to those who are looking to short positions as a hedging strategy. The reality is that if you take a big loss, it just takes you that much more in gains to make up for that.
When a 2008 comes along, or a huge market storm comes along, it can have a pretty significant impact on your retirement, and getting back on track is tough. So we are looking to help people avoid a big loss. If you are going to own stocks, you need to pay close attention every quarter to the red flags that show that a business is not doing as well as management wants people to believe it is, or even Wall Street. And you have to be prepared to sell. You can’t be emotionally attached to that position and reluctant to accept that you were wrong.
Murphy: Aside from shorting a stock, what’s the process here that you think investors need to take to heart?
Del Vecchio: We look at combining short-selling with value on the long side. You have to be a value investor and buy $1 worth of assets for 50 cents; there has to be an embedded margin of safety for that value to be realized. Being a growth-stock investor, where you are just paying ridiculous valuations, is very dangerous.
Take the technology sector, for instance, where a lot of people get easily seduced by fancy, glossy stocks. The truth is that the higher the multiple you pay for revenue, the lower your returns are. If you are going to pay big multiples, the more money you lose. We show in our book that combining short protection with value investing on the long side outperforms, even in volatile times, like during the 2007-2009 period.
Murphy: Are we talking about a long/short strategy as the best way to mitigate risk and capture returns?
Del Vecchio: Exactly. Our view is that it has to be long value, and short companies that have fundamental deterioration or aggressive accounting. On the long side, it’s not just picking stocks that have low P/E, but those where there is some catalyst we see for the value to be realized, which is different for each company.
Murphy: Is a growth investor more of a risk taker than a value investor?
Del Vecchio: I don’t know that they take more risks, but the more expectations that are embedded in a stock, the lower the returns, because the smaller the margin for error that management has to work with on delivering those expectations. There’s no company that has seen a smooth trajectory in growth. You can get away with it for years, but eventually you are going to hit that bump in the road. The odds just are not in your favor.
Murphy: As far as bumps in the road, is inflation the next big bump?
Del Vecchio: What really matters is the 20- to 25-year period when you are in your highest earning years, your highest saving years, building your nest egg for your future. That’s really the time frame that holds the key for how well you will do. You could end up in an inflationary period and be down significantly or you could luck out.
Right now, there’s no question in my mind that in the future we are going to see serious amounts of inflation. The government may tell you that that’s not going to happen, but food and energy costs are going up. The Federal Reserve cannot remove the liquidity that they have put out there over all rounds of quantitative easing without triggering inflation. Even if they raise interest rates, reducing the size of the balance sheet won’t be a linear unwinding, so we will have massive amounts of inflation.
Murphy: What are you telling your clients to do to prepare themselves for that environment?
Del Vecchio: I still advocate the long/short approach. I think our clients who buy HDGE understand the value of the hedges. In my opinion, brokers that are using alternative investments and hedging might not be making as much money on the upside when everyone is giddy, but they are not getting hit as much on the downside, so they are coming out ahead with a smoother equity curve.
Just talking to people in that space who buy our funds, we know that their clients—who are mostly wealthy individuals—are not interested in huge returns; they are interested in preservation of capital and a reasonable return on top of inflation. They are looking for 6 to 7 percent returns, and not the 15 percent everyone else wants. In that scenario, protecting on the downside is as important as it is capturing the gains on the upside.
Murphy: That’s where indexing comes in, right? In your book you also talk a bit about the pitfalls of indexing. Is your gripe really with market-capitalization-weighted strategies that dominate the ETF space?
Del Vecchio: That’s exactly right. There are two issues that I think are a problem with traditional indexes. First, it’s the market-cap-weighted strategies that put so much emphasis on the big companies. If you look at the S&P 500, the top 100 stocks are about two-thirds of the index weight, and obviously Apple is the biggest company. You also have others like Exxon Mobil, Johnson & Johnson, etc. If you could have predicted these companies would be where they are now, you’d have done really well, but you can’t. Market cap isn’t the best strategy, again because you can’t predict who will be on the top and the winners don’t carry over from generation to generation.
The other thing goes back to my first point, and that is that most stocks underperform even in bull markets, so traditional indexes have all the best companies, but they also have all the bad ones too.
In our process, we score the stock based on earnings quality and instead of shorting it, we exclude it from the mix. When we did that, we found that over time it gave us better returns. It’s an index that takes advantage of a short-selling methodology but without actually shorting any stocks. We are trying to exploit the few problems that we see: Market-cap weighting is a flawed strategy, so we look at earnings quality, and we try to exclude some of the losers; that way, you can enhance traditional indexing.
Murphy: So traditional indexing, if you will, has its pitfalls, but fundamental indexing is a viable alternative?
Del Vecchio: I’m still not a big fan of fundamental indexing that includes all the losers. Indexes like the S&P 500 that are dividend-weighted, low volatility-weighted, etc., those are fundamentally weighted indexes that still have problems because they still include the stocks that are dragging down the index. We are trying to change the nature of indexing by excluding companies that we perceive to be losers. If you weight by earnings quality and exclude losers, you can improve your returns in a rules-based process.
Murphy: What’s the main takeaway you want people to get from your book?
Del Vecchio: You need to focus more on losses. Winners take care of themselves, but it’s the losses that can make all the difference. People are afraid to take a loss, but you have to admit that you were wrong and take a small loss so that you live to invest another day.