XOUT: An ETF With Unique Investing Style

In this episode of Industry Focus: Wild Card, Motley Fool's Emily Flippen chats with Will Rhind, the CEO of GraniteShares and owner of XOUT U.S. Large Cap ETF to find out more about its unique style of investing. Rhind shares some examples of how this strategy works and what metrics decide the choices management makes. He shares some companies that are X-ed out and the reasons behind those decisions.

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This video was recorded on Feb. 26, 2020.

Emily Flippen: It's a Wild Card Wednesday, a day where anything goes here in the studio. And I'm your host, Emily Flippen. I'm excited to have a really special guest joining us today to talk about a style of investing that many people may have never considered before; I definitely know I haven't considered it myself. Joining me is Will Rhind, the founder and CEO of GraniteShares, who, among other things, is the owner of XOUT, a U.S. large-cap ETF. Will, thanks for joining today.

Will Rhind: Thank you, Emily, very nice to be here.

Flippen: Yeah, so let's talk a little bit about this XOUT ETF, because when I first heard about it, honestly, I was really intrigued and somewhat surprised by its investing style. So maybe just talk to us about XOUT and what makes that investing style unique.

Rhind: Sure. So XOUT is an ETF that we offer, a completely differentiated way of investing, as you rightly pointed out. And in its simplest form, what we're trying to do is exclude or X out losers, instead of pick winners. So what does that mean? Well, traditional philosophy in investing would have us all think about picking winners, that's what we've been trained to do, that's what everybody in the market is trying to do is we outperform by picking winners. And, obviously, over time, we've come to realize that that's incredibly difficult to do. So tons of academic research supports that fact that active-management picking winners is very, very hard, just statistically over time.

So what the index and ETF crowd largely did was actually, instead of picking winners, we understand that that's too hard to do, so let's just buy the market, let's just buy every stock in the market and we will, by definition, take the average. And so what XOUT is trying to do and what we, GraniteShares, believe is that actually there may be a better way to do it, which is instead of just holding all the companies in the market, regardless of whether they're good or bad, why not try and leave the bad companies out and then, by definition, you should have a portfolio that may be able to outperform over time.

Flippen: So there are a lot of mutual funds out there that may be focused on specific industries, to your point, trying to pick good companies in these industries, while at the same time excluding bad ones. So what made GraniteShares interested in pursuing this type of investment strategy? Because it really is kind of the first of its type.

Rhind: No, that's exactly right. I think there's some really good research that came out relatively recently -- and by that, I mean in the last couple of years -- that basically, sort of, said, "Over the last 100 years, the vast majority of stock market returns can be attributed to just a handful of stocks." So if we think about any kind of large index, particularly, obviously, a large U.S. index, we all know that it's just a handful of stocks that are driving the majority of that performance. And those stocks people already own, so for the most part, they're going to be the Amazons, the Googles, the Facebooks, the Apples, etc. And so what we thought was, well, we'll actually -- knowing that and understanding that only a small number of these companies are contributing to the performance of the market, well, there must be plenty of companies that are actually pulling down or detracting from that performance, and maybe it's actually easier to identify a company that's in secular decline or a company that's not thriving, or a company that's been disrupted, than it is to identify the next Google. And so that's the genesis of XOUT. And so far, indeed, that thesis seems to be true, that it's actually easier to identify losers. We exclude those from the portfolio. We're focused on the forward-facing risk, which is technological disruption, and that technological disruption, we want to identify companies that are not thriving.

Flippen: So you said the thesis has so far been playing out. How long has XOUT been around? How long have you been doing this?

Rhind: So the fund officially launched in October of last year, so that's 2019. So it's very new in terms of a strategy, but one thing I will point out is that a similar strategy was actually running in a private fund before that. So the strategy was being run as a private fund and then was conceived as an ETF for purposes of making it accessible to the broader market. So the fund itself has been running for a limited period of time but is doing well in terms of not just the performance, in terms of the total return, but the number of assets and the sort of feedback that we've gotten from the market.

Flippen: Yeah, you kind of hit my next question on the head there, which was, there is a lot of options when you set the fund, and your ETF in particular with XOUT, has a relatively low expense ratio, and that's a notoriously hard business to get into. So why did you go the ETF route? Obviously, I selfishly enjoy it, because I think it makes your style of investing and your process way more accessible to the average investor, but surely there must be a business reason behind it too, right?

Rhind: Well, selfishly, or to sort of disclose my own bias, we're an ETF company, so ETF is what we do, that's what we love, that's what we're passionate about. And so we always -- you know, we try and do everything as an ETF because that's our DNA, the throes of the company, that's the experience that we have and the passion that we bring to the market.

So there was no doubt, no question in my mind that we wanted to do this as an ETF. And the ETF is just -- it is the weapon of choice, if you will, in investing today for the vast majority of people.

Flippen: That's really interesting. And I know you talked a little bit about its performance. I mean, you've only had it, at least as an ETF, since October, so that's a relatively limited time frame that's publicly available to us, but how do you think about correlation with the overall market. So you talk about outperformance, but do you find any less volatility, I guess? Are you limited to downside at all as a result of this strategy?

Rhind: I wouldn't think of it too much like that. That we're correlated very closely to the market, because really what the strategy actually does, is kind of build out a little bit, as we take the 500 largest companies in the U.S. by market cap, we score all of those companies on the basis of seven fundamental criteria that generates a score, best to worst, and we exclude the 250, so 250 stocks with the worst score.

Flippen: That's a lot. I mean, that's half of the market right there.

Rhind: That's right. Exactly. So it's a lot of companies. And by doing that, you end up with a portfolio that's still highly correlated with the market, which has basically a beater of one to the market. And so you're getting a portfolio that is very much correlated to the market, but we think that by excluding these stocks, which are detracting from performance, you have a higher probability of being able to outperform over time.

Flippen: So maybe just talk us through your investing process. You talked a little bit about technological disruption, but what makes a company or an industry uninvestable to you? What makes you choose for it to be part of that 250 that are X-ed out?

Rhind: So it's such a great question, because it gets to the core of why we think this strategy makes sense. So what a lot of tech funds, obviously, do is they're focused on identifying tech companies, and their genesis for that is that tech companies are the ones that are winning. Well, again, this comes back to this philosophy of when you're picking winners, you're crowding or herding that strategy into a few companies. If you flip the thesis on its head and say, "Well, actually, which companies are being disrupted by technology?" Well, now you're opening yourself up to every single company in every single sector. In other words, there's no sector that's immune from technological disruption or disruption more broadly.

And so when you start to think about it from that perspective and you reverse or flip the thesis, that's when things start to get really interesting, because you can look at the different metrics. In our case, we look at simple things or fundamental things, such as, revenue -- so is a company increasing its sales? Employee growth -- is a company firing instead of hiring people? R&D investment -- is a company investing in itself through share buybacks, and are those buybacks being done out of free cash flow, or does the company have to borrow money to do that? Profitability -- can the company make money. Earnings forecast -- is it expected to make money? And then management score.

So we're evaluating these things. And as you kind of probably try to identify, there's no one factor that we can identify that elicits technological disruption, but what we think is that by blending these together, we got a good formula for identifying companies that are being disrupted or are likely to underperform and we want to get those out of the index.

Flippen: I love hearing that, because it sounds very similar to the way that we here at The Motley Fool go about a lot of our investing processes. Obviously, everybody has their own process, but in an inclusive instead of exclusive way. So it's interesting to take those same drivers and put it in the context of X-ing out companies. But there's one aspect that, personally, whenever I look at companies, I always think about, which is, the opportunity for change in the future. So business models, they might seem outdated, but new management, new business initiatives, investments into technology, these are sorts of things that can rapidly change a business. So maybe just talk to us a little bit about turnover. So how do you reevaluate companies that may have been X-ed out that maybe have changing business models now?

Rhind: Yeah, again, great question. So one thing I want to make sure that everyone understands is, this is a dynamic strategy. So we rebalance the portfolio every quarter. So that means we're scoring every company, as part of our process, every quarter. And then based upon that scores -- best to worst score -- again, we're leaving out the 250 with the worst scores. So as you rightly pointed out, a company could quite easily turn itself around, quite easily improve its score by, obviously, improving on certain metrics that we look for. And therefore, it could conceivably be the case that a company could be out one quarter and then come in the next quarter.

Turnover in the portfolio is still relatively modest, about 40%. So that's a relatively modest turnover. We don't want to have a strategy with a high turnover. But I think what makes XOUT different is that unlike, say, some strategies that exclude on a permanent basis, what we have is something dynamic. In other words, we don't care whether the company -- you know, we're not trying to exclude or discriminate against any in particular. All we're saying is that if a company is disadvantaged from the index perspective, it's going to be left out, but if it turns itself around, it's coming back in.

Flippen: Yeah, I agree with that general strategy, and I like how dynamic it is as opposed to identifying broad sectors and completely ignoring them. And I left our listeners, I think, waiting long enough at this point. To the extent that you can tell us, what are some of the companies or industries that your ETF has decided to X out of your fund?

Rhind: Yeah. So in terms of the latest quarter of the fund, the top X outs, top 10 holdings that are X-ed out or eliminated. You can see on our website and the fact sheets that we have available for the fund, every quarter, we're going to publish the top holdings and the top X-ed out holdings. So in this particular quarter, JPMorgan Chase is actually the largest X out in the portfolio, followed by Visa and followed by Walmart. And we have a list of 10. So within that 10, I could broadly say to you that in terms of sectors that are represented, you have banks or financials, you have telecommunications, and you have some retail or energy companies as well. So those are sort of the three sectors, I would think, at a general perspective, but obviously, there are 10 individual companies that make out that top 10 list.

Flippen: [laughs] So maybe talk us through those. I feel like I can hear listeners scratching their heads now, because JPMorgan, Bank of America, Visa, Walmart, these are companies that are kind of cornerstones of American consumerism. And I was actually just going through some data from the S&P. And they report their earnings beat for their different industries, and a lot of these are financial companies. And the No. 1. best-performing industry for them in terms of beating on the bottom line over the last quarter has been financials. So what's the thinking that's going in behind X-ing out what many people see to be attractive opportunities?

Rhind: So again, we're looking at seven fundamental metrics and those seven metrics we weigh, that creates a score, the worst companies get kicked out from that score. So particularly, let's take JPMorgan, for example, the top XOUT. So probably the two biggest factors that lead to that being X-ed out: a lack of growth in terms of deposit rates -- and deposit rates for a bank, you know, think of that as being somewhat analogous to subscribers on the social network platform, in that that's the lifeblood of where the bank gets its capital. And so if that deposit base is slowing down or is shrinking, that's not necessarily a good sign.

The other thing, particularly with that stock, that reflected badly in terms of the model was stock buyback. So stock buybacks funded from borrowed money as opposed to out of free cash flow, which is something that scores negative. So that was something that was specific to JPMorgan.

I think Walmart is another one you mentioned that we get a lot of questions about, because the company, obviously, has made strides to try and insulate itself from disruption. So it bought Jet.com and did other ostensibly good things. The challenge with Walmart, in particular, from our model's perspective is just so big that the actual sales, when you look at sales growth -- sales, when you index for inflation, are actually moving backwards rather than going forward, and it's just the sheer size of the enterprise that makes it difficult to accelerate its sales, earnings, profitability, etc., in a way that perhaps other companies and other industries can do.

Flippen: Are you concerned at all about the process of X-ing out companies that have strong cash positions if and when there is some sort of market pullback?

Rhind: No, because, again, that's not what we're trying to do. So what we're trying to identify is companies that are at risk of technological disruption, and we're trying to leave those out of the portfolio. So therefore, I suppose, by definition, the companies that would remain in would be those that are least likely to be disrupted from a technological perspective. And therefore, from that perspective, there are companies that presumably, hopefully, you would want to own anyway. So that's the thesis behind it. That's the model. And we think that by owning these good companies or these companies least likely to be disrupted over time, that's the strategy that ultimately allows or gives investors the highest probability of being able to generate sustainable performance.

Flippen: Will, you've definitely already given us a lot to think about, but before I let you go, I do, kind of, want to ask a question is, you know the average person listening to this podcast, there may be people who haven't gotten invested yet, who are looking to get invested just average retail investors, business connoisseurs, lots of different people. So for the average listener out there, what do you think is maybe the biggest misleading opportunity that a lot of people maybe could go out of their way to reasonably X out of their life?

Rhind: Well, in terms of this particular strategy, one example I always give to people is take a company, like GE, General Electric. So General Electric, one of the most revered companies in America, so much sort of history and legacy behind it. If you just left out GE from the S&P 500 in 2016-17, you would have outperformed by 1.22%. So just leaving that company out of the market alone, one decision, or made one decision, you would have been able to outperform in a significant way. So extending to a broader portfolio of companies, is obviously what we're trying to do with XOUT.

I think, the one thing that probably people should do, it may sound obvious, but still not enough people do it is, just do the basic due diligence on a fund. So when you're thinking about making investment, you make sure you understand what the management fee is, what the charges are, what's in the portfolio. And, again, the beauty of ETF is it's all transparent. So you can go on to our website, GraniteShares.com, you can look at the fact sheet. The fact sheet will tell you all sorts of interesting things about the fund. And then, clearly for those that are interested in reading a bit more, there's a prospectus, there's all sorts of [...] that people can really do their homework on the strategy. I wish people would do more of that, but I think if I have any one top tip for people, that's always just to make sure that you do your homework on whatever investment or fund you're going to buy.

Flippen: I love that kind of end note there, because I think it's so meaningful for the average listener. And hopefully this is, for the person listening out there, they are part of their due diligence process when thinking about investing in companies.

Will, I know you're calling in from London, so I really appreciate you taking the time out of your day to come, sit, talk with us about XOUT. I look forward to seeing where it goes.

Rhind: Thank you, Emily. Thank you so much for having me on the show, and thank you everybody, for listening.

Flippen: Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out, shoot us an email at [email protected] or tweet us @MFIndustryFocus.

As always, people on the program may own any companies discussed on the show, and The Motley Fool may have formal recommendations for or against any companies mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for his work behind the glass today. For Will Rhind, I'm Emily Flippen. Thanks for listening, and Fool on!