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A Unique Geographic Position Makes Allete An Attractive Utility

Summary Midwest utility holding company ALLETE has encountered substantial share price volatility in 2015 so far due to broader utilities volatility and its own diversification efforts. Concerns about the company’s exposure to coal mining and coal-fired electricity have risen in recent months as the federal government has proposed to crack down on power plants’ carbon emissions. In the short term, ALLETE is insulated from commodities volatility since its major electricity customers supply the strengthening U.S. auto manufacturing sector. In the long term, the company is positioned to translate carbon restrictions into rate base growth and new projects for its clean energy development subsidiary. The company’s share valuation and dividend yield are already attractive. Given its recent volatility, however, potential investors will likely be able to get rock-bottom valuations by waiting a bit longer. Midwest utility holding company ALLETE, Inc. (NYSE: ALE ) has experienced an abnormally high amount of share price volatility in 2015 to date. The company’s share price set a new all-time high early in the year before shedding 24% of its value in seesaw action that has persisted until now. While some of this volatility can be attributed to the uncertainty that has impacted the broader utilities sector regarding future interest rate movements, ALLETE’s heavy exposure to coal and coal-fired electric generation assets has caused investors to turn bearish given the current federal U.S. regulatory environment. Furthermore, the company differs from most of its peers in that its primary customer base consists of a handful of large industrial facilities rather than a large number of small, residential homes. This article evaluates ALLETE as a potential long investment opportunity in light of these factors. ALLETE at a glance Headquartered in Duluth, Minnesota, ALLETE Inc. is a utility holding company that comprises six wholly-owned subsidiaries in addition to an 8% stake worth $115 million in the broader regulated venture American Transmission Co. Minnesota Power is the most important of these subsidiaries and, as a regulated electric utility, it provides electricity to 144,000 residential customers, 16 municipalities, and several large industrial customers in northern Minnesota. It generates sufficient electricity to meet the demand of its 26,000 service area via multiple sources, the largest of which (62% of the total) is coal. Another 29% is derived from power purchase agreements, of which a large fraction is also generated from coal, and hydro. In all Minnesota Power has a total generating capacity of 1723 MW. Minnesota Power operates within a relatively favorable regulatory scheme that includes a 10.4% allowed return on equity, cost and fuel price riders, and a $2.6 billion rate base. More than 50% of its electric sales are attributable to industrial customers, including five large producers of taconite, an important iron-bearing rock that is an important raw material input in the steel industry. The industry in the company’s service area has remained buoyant of late and the company expects new industrial customers to increase demand by up to 600 MW. Furthermore, the state of Minnesota borders states that have some of the most abundant wind resources in the country, and the subsidiary expects to meet at least some of this demand via investments in new wind capacity in North Dakota. Minnesota Power expects to average roughly $250 million in annual capex through 2018 in part to meet this demand growth, providing support for future rate base increases. ALLETE’s non-regulated subsidiary BNI Coal, which operates closely with Minnesota Power, owns and operates a lignite mine in North Dakota. This mine yields roughly 4 million tons of coal annually that is sold to electric coops in the area that in turn have power purchase agreements with Minnesota Power. Under ordinary circumstances, it would appear to be optimally placed, thanks in large part to the fact that its “cost plus” contracts run through 2037, to benefit from growing demand for electricity (and thus generation fuel) in Minnesota Power’s service area. This would be true if its name was “BNI Gas” instead of “BNI Coal.” Given coal’s rapid fall from grace in the eyes of federal regulators, however, the subsidiary runs the risk of becoming a burden on ALLETE’s balance sheet over the next several years. To the company’s credit, ALLETE responded to the unpopularity of fossil fuels in general and coal in particular by forming ALLETE Clean Energy in 2011. This non-regulated subsidiary is responsible for the development and acquisition of wind, hydro, solar, biomass, and shale gas (hence its use of the word “clean” rather than “renewable” in its name) projects. Recognizing the existence of a broad resource nexus between energy and water, ALLETE also acquired U.S. Water Services, which is a small water management firm based in Minnesota, in February 2015. Finally, ALLETE owns a number of smaller subsidiaries that operate in different sectors. Superior Water, Light, & Power is a regulated electric, water, and natural gas utility that operates within a service area consisting of Superior, Wisconsin and the immediate vicinity. This subsidiary utility has an attractive allowed return on equity of 10.9%, although both its rate and customer bases are only a fraction of those of Minnesota Power, making it a small contributor to ALLETE’s consolidated earnings. ALLETE Properties is a subsidiary that owns three property developments in Florida. The incongruous nature of its operations and generation of losses of late have prompted its parent company to investigate gradual sales of the subsidiary’s assets that will allow it to exit the property sector while maximizing returns. ALLETE is also a participant in the CapX2020 initiative, which is focused on the upgrading of transmission lines. ALLETE’s consolidated operations are ultimately strongly influenced by the regulated utilities sector. Its regulated utilities operations were responsible for 88% of its consolidated revenue in FY 2014. Furthermore, with the exception of ALLETE Properties, its non-regulated subsidiaries operate closely within the regulated utilities sector, complementing ALLETE’s consolidated revenues and earnings. This has allowed the parent company to report a respectable EPS CAGR of 6.7% CAGR since 2010. Its dividend has increased by 15% over the same period even as its payout ratio has declined from 76% to 65%. Nor is ALLETE exposed entirely to Minnesota, as its regulated operations now encompass North Dakota, South Dakota, and Wisconsin as well while its clean energy operations reach as far afield as Oregon (hydro) and Pennsylvania (shale). Q2 earnings ALLETE reported Q2 consolidated revenue of $232.3 million (see table), up by 24% YoY and beating the consensus analyst estimate by $20.3 million. The increase and beat were mostly attributable to the inclusion of full quarter results from US Water Services and Clean Energy for the first time. The revenue number was also aided by the presence of a cost recovery rider and the commencement of a new power sales agreement in June 2014. The company’s retail numbers came in low, with retail electric sales in terms of kWh sold falling by 9.7% YoY, although the consolidated sales number increased by 7.2% over the same period due to power purchase agreements. The average price of regulated electricity increased by 7% compared to the previous year, offsetting the negative impact of lower retail sales volume on revenue. The presence of a fuel cost rider kept regulated revenue from increasing, however. ALLETE financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 323.3 320.0 290.7 288.9 260.7 Gross income ($MM) 179.6 187.9 203.3 200.0 177.1 Net income ($MM) 22.5 39.9 32.9 41.6 16.8 Diluted EPS ($) 0.46 0.85 0.72 0.97 0.40 EBITDA ($MM) 87.3 100.6 95.0 101.7 69.1 Source: Morningstar (2015). ALLETE’s cost of revenue increased by 72% YoY to $143.7 million due to the aforementioned subsidiary additions. Gross income remained relatively flat at $179.6 million YoY due to this increase despite the much stronger revenue result. Net income came in at $22.5 million, up by 33% from the previous year. Diluted EPS came in at $0.46 versus $0.40 YoY, missing the consensus estimate by $0.02. The EPS included acquisition fees of $0.02, without which the consensus estimate would have been matched, as well as dilution equal to $0.07. EBITDA increased from $69.1 million to $87.3 million YoY. Finally, ALLETE’s dividend in Q2 represented a 3.1% increase over the previous year. Outlook ALLETE’s management announced during the Q2 earnings call that it was increasing its FY 2015 guidance up to $3.20-$3.40 despite the Q2 earnings miss to account for proceeds from the sale of a wind farm that its subsidiary ALLETE Clean Energy is constructing. This result would represent its strongest annual earnings in more than a decade while also continuing a multi-year trend. The company’s current year earnings are due in no small part to the resilience of Minnesota’s taconite producers in the midst of a very bearish global steel market. While falling demand for industrial materials in the developing world in general and China in particular has pummeled steel indices (steel ETF prices are hovering around their early 2009 lows), Minnesota’s taconite producers mainly supply domestic steel producers that in turn supply U.S. automakers. ALLETE’s management has reported few signs of weakness among its large industrial customers as a result, with only one customer idling its facility. ALLETE’s earnings are highly sensitive to electricity demand from taconite producers, with a 1 million ton per year change to taconite production having an impact of $0.03/share on the company’s diluted EPS. In fact, ALLETE’s heavy exposure to Minnesota’s taconite production could continue to be a boon in coming quarters. Petroleum prices fell sharply in Q4 2014 and Q1 2015 and, while they have rebounded a bit from their 2015 lows, they remain well below their earlier highs. Consumers have responded by buying new, less fuel-efficient vehicles, driving demand. This month’s auto sales are expected to be the highest for October since 2001, while 2015’s numbers are expected to be 5% higher than 2014’s. Cheap petroleum should therefore support ALLETE’s earnings via Minnesota Power by keeping taconite demand high. While I do expect crude prices to rebound, especially as the finances of OPEC members are squeezed ever tighter, it will take several quarters for any reduced demand for U.S. steel to be felt by ALLETE. In the longer term, ALLETE’s earnings have the potential to be substantially impacted by the Clean Power Plan that was recently unveiled by the U.S. Environmental Protection Agency [EPA]. This new regulation requires each U.S. state to achieve predetermined reductions to the carbon intensity (greenhouse gas emissions per kWh of electricity generated) of their respective power plant sectors. Minnesota must achieve a large 24.5% reduction by 2024, while Iowa and South Dakota must achieve still larger reductions. While the EPA’s plan will not benefit all utilities, ALLETE is uniquely positioned due to the abundant wind resources near its service area and its new ALLETE Clean Energy subsidiary, the latter of which is already developing a reputation as a wind farm construction firm. ALLETE itself will need to shift away from coal towards renewables and, if this move is done properly (i.e., by building its own capacity rather than relying on power purchase agreements), it could support future capex. Beyond that, however, ALLETE Clean Energy should become a steadily larger contributor to consolidated earnings as utilities in the surrounding area also rely upon it to develop new renewables capacity. BNI Coal will suffer from weakening coal demand under this scenario, of course, and ALLETE itself could incur asset write-downs if it is required to send some of its coal-fired generation capacity into early retirement, but on balance, I expect the company to benefit under the Clean Power Plan. Valuation The analyst consensus estimate for ALLETE’s FY 2015 EPS has increased over the last 90 days in response to the resilience of its industrial customers and recent asset sale while the FY 2016 EPS estimate has remained relatively flat. The FY 2015 estimate has increased from $3.11 to $3.26 while the FY 2016 estimate has been revised slightly lower from $3.39 to $3.37. Based on a share price at the time of writing of $50.36, the company’s shares are trading at a trailing P/E ratio of 16.3x and forward ratios of 15.4x and 14.9x for FY 2015 and FY 2016, respectively. While the trailing ratio is in the middle of its historical range, both of the forward ratios are near the bottom of their respective 5-year ranges, having actually been at the bottom as recently as last month. Conclusion ALLETE’s share price has been all over the place in 2015 to date in response to the combination of a bearish sentiment in the broader utilities sector and its own diversification efforts. This latter move is the one that investors will want to pay the most attention to since it has the potential to provide the company with the type of growth options that are not available to most of its peers. The company’s heavy exposure to coal mining and coal-fired generation is a concern at a time when both activities are attracting the ire of regulators. This disadvantage is more than offset by the company’s twin advantages of close access to abundant wind energy resources and a subsidiary that contributes to consolidated earnings by developing and selling wind farms. Meanwhile, the EPA’s Clean Power Plan will support the company’s future rate bases while driving demand for ALLETE Clean Energy’s services. ALLETE is an attractive long investment opportunity at present due to its 4% forward yield and relatively low valuation. Given the volatility that has characterized utilities in recent months, however, I would encourage potential investors to wait for the company’s share price to provide an additional margin of safety by trading at 14x FY 2016 earnings, or $47.18 based on the estimate available at the time of writing, before initiating a new position. Initiating a short put position could be an attractive strategy here at this time.

Don’t Bother With Small-Cap Growth ETFs – Invest In The Internet Instead

Summary I compared a highly diversified small-cap ETF with an Internet-based ETF. The Internet has not finished permeating our lives, yet we have no need to fear another Internet stock bubble. Going forward, a portfolio or ETF of Internet stocks should outperform both the market and small-cap growth stocks. Source: Wikipedia Commons Through my daily random analyses of stock prices, correlations, and whatnot with R software, I occasionally find something interesting. I especially enjoy looking for patterns in ETFs, as such patterns can give us an idea of where the economy is at and headed. Today I was looking at how Internet-based companies have performed in respect to other industries. Let’s start with the facts: Some investors like small-cap stocks in developed countries because of the huge upside associated with growing companies. Small-cap stocks of developed countries grow in strong economies with few restrictions on business. This makes them good stocks for speculation and for diversification into the “growth stock” sector. However, in these countries, many small-cap companies are heavily reliant on the Internet to run their businesses. In contrast to large-cap stocks that began prior to the time of the Internet, many of these small-cap companies would likely go under if they lost the power of the Internet to transcend geographics, save on communication costs, and monitor the habits and demographics of their clients. When I began looking into the correlation between Internet-based companies and small-cap stocks I found – unsurprisingly – that said correlation was quite high. Of course, not all small-cap stocks are Internet companies. However enough are to show a strong correlation between the two industries. In my analysis, I looked at the following ETFs: PowerShares NASDAQ Internet ETF (NASDAQ: PNQI ) iShares MSCI EAFE Small-Cap (NYSEARCA: SCZ ) The first is a portfolio of NASDAQ Internet companies. The included companies are large-cap growth stocks. The second is a portfolio of small-cap companies in developed countries, mainly the Europe and Japan. After importing the data from these two ETFs, I checked the correlation coefficient: an astounding 0.97! Yes, some of this correlation is due to an overall correlation with the general market, but below I’ll be showing some charts that show how these two ETFs differ from the market as a whole. Also realize that these portfolios have little overlap in actual securities: One is U.S.-centric (over 80%); the holds less than 1% of U.S. stocks. One is small-cap; the other large-cap. One is growth-only; the other mixes in some value stocks (I’m speaking of SCZ). Yet these two ETFs are almost perfectly correlated! It’s as if the NASDAQ Internet companies are working in tandem with small-cap companies. Or perhaps small-cap companies are gaining their business from NASDAQ Internet companies? Instead of speculating, let’s take a look at how the stocks move in respect to each other. I want to do this for multiple periods. I’ll explain why in a second: The Past Year: (click to enlarge) When you look at the first chart, it looks like PNQI and SCZ are pretty similar. It might appear that PNQI has done better in the past few months. But overall, these two ETFs look like the perform roughly at the same quality. Since the Existence of Both ETFs: (click to enlarge) Now we see a significant difference. Though these two ETFs are highly correlated, PNQI outperforms SCZ. That is, if you switched out small-cap growth stocks for large-cap Internet companies, you’d have realized a gain of over 200%. Sticking with the small-cap “growth” stocks, which are supposed to outperform during a bull market (the time period we are currently looking at), you would have underperformed – the SPDR S&P 500 ETF (NYSEARCA: SPY ), during this time, realized gains of 50%, while SCZ only grew 10%. The Past 3 Months: (click to enlarge) So here’s where things get interesting. While the previous two charts showed PNQI to be the better choice, in this chart, we see SCZ higher than PNQI. Notice that both these ETFs are in negative territory, so one explanation might be that PNQI is a risky ETF. However, to say that PNQI is risky simply not true, unless you believe that SPY is risky: both ETFs are down 4% in the past three months. Yet as we have seen in the chart going back to 2008, PNQI has outperformed SPY by 150%. That is, PNQI appears to have much more upside than both SCZ and SPY yet the downside is the same as that of SPY. Is SCZ an Outlier? To check if SCZ is an outlier, I checked other EAFE funds’ correlations to both SCZ and PNQI. The quick answer is that SCZ is not an outlier; the result holds for other EAFE small-cap and growth funds. For instance, SCZ and the iShares MSCI EAFE Growth ETF (NYSEARCA: EFG ) are 99% correlated. EFG is also 94% correlated with PNQI, showing a unique connection with EAFE small cap companies and Internet companies. Likewise, Vanguard MSCI EAFE ETF (NYSEARCA: VEA ) shows 0.99 and 0.94 correlations to SCZ and PNQI, respectively. The Future of Internet Companies The Internet bubble of the 90s taught us to be weary of investing too much in Internet-based companies. But unlike other bubbles (e.g., the housing bubble), we were dealing with a new invention in the 90s (Internet-based business). Today, we have a much better understanding of how Internet companies work. Thus, I don’t see PNQI’s extreme returns as a bubble but as the result of a legitimately good business model: putting your money where business is booming – online. The Internet has and will continue to permeate our lives (how are you reading this article right now?). And the last three months has shown that Internet companies don’t hurt more than the general market when a correction comes. Internet traffic is growing and bandwidth requirements are increasing for current users. One reason for this is the transition to video, which comes from two sources: A preference for consuming content in video form. A shift to streaming entertainment (e.g., Netflix (NASDAQ: NFLX ), which PNQI holds). By 2017, 70% of Internet traffic will be directed toward video, according to Cisco. The Internet is also changing how people shop. Today, consumers are using an omnichannel shopping method, which essentially means that they are browsing multiple sites at once to find the best deal. Such an activity would have been time-consuming and gas-consuming in the era where one had to drive store-to-store for price comparisons. Look at some of the holdings in PNQI to appreciate the fund’s appreciation of the growth of the omnichannel shopping preference: Amazon (NASDAQ: AMZN ) Priceline (NASDAQ: PCLN ) EBay (NASDAQ: EBAY ) Expedia (NASDAQ: EXPE ) Tripadvisor (NASDAQ: TRIP ) This is where the real growth is at. PNQI also has holdings in Chinese Internet companies, such as Baidu (NASDAQ: BIDU ), which PNQI first bought in 2008. To this, they’ve added other important Chinese Internet stocks, such as… JD.com (NASDAQ: JD ), an online “mall” for electronic products (omnichannel shopping). Ctrip.com (NASDAQ: CTRP ), an airline and hotel booking service (omnichannel shopping). NetEase (NASDAQ: NTES ), an IT company known for being the largest email service provider in China. …and anything else they can get their hands on via NASDAQ. Yet, investors looking for “growth” often turn to these investing concepts: “Invest in small-cap stocks.” “Invest in foreign countries; U.S. stocks are overpriced.” “Diversify among many growth stocks.” Investors agreeing with such statements would find SCZ the perfect ETF. SCZ does not hold more than 1% of its portfolio in a single stock – the maximum weight to any given stock is less than half a percent. And SCZ’s holdings are all over the place: Switzerland, the U.K., Japan… In contrast, PNQI attaches close to 10% of its portfolio. AMZN, PCLN, Facebook (NASDAQ: FB ), and Alphabet Inc (NASDAQ: GOOG ), all individually occupy more than 8% of the PNQI portfolio. PNQI also certainly doesn’t see U.S. stocks as overbought, as the vast majority of its portfolio is in the U.S. In other words, PNQI is virtually the antithesis of SCZ. Conclusion The two ETFs we just looked at correlate… but only one consistently outperforms. And I believe that PNQI will continue to outperform both SCZ and SPY, at least until the next big thing (can something possibly surpass the Internet?). We are not repeating the bubble of the 90s because the Internet is no longer a mere novelty but an integral part of culture in the developed world. The demand for the stocks PNQI holds will increase as long as the companies behind those stocks are continually making improvements in our lives (or finding ways to addict us to their products – FB, I’m looking at you). In addition, PNQI’s exposure to the Chinese Internet market shows a stark contrast to what I see in SCZ management sa being more of a “spray-and-pray” shotgun approach to a growth portfolio: Invest a little in everything and hope we keep attracting clients; no portfolio manager every gets fired for diversifying. I am assigning a strong buy rating for PNQI going into 2016 and an underperformer rating to SCZ. I would recommend, based on the most recent chart comparing PNQI to SCZ, that SCZ holders sell their shares now, while SCZ is above both the market and PNQI. Once sold, take the capital that was in SCZ and put it in PNQI, while it’s at a relative discount. Request a Statistical Study If you would like for me to run a statistical study on a specific aspect of a specific stock, commodity, or market, just request so in the comments section below. Alternatively, send me a message or email.

Why I Sold Berkshire Hathaway And Added Quality To My Portfolio

Summary Berkshire Hathaway may be a model for a quality company and merits a place in one’s portfolio on that basis. Berkshire Hathaway’s recent performance has been disappointing. Can an ETF focused on the quality factor replace it and improve returns as well as portfolio quality? I continue to review my holdings with an eye to what I want to keep and what’s not earning its keep. After a hard look, I decided Berkshire Hathaway (NYSE: BRK.B ) just wasn’t getting it done. Take a look at some stats for BRK.B and the ETFs tracking the S&P 500 and the NASDAQ 100. Annualized Volatility Beta Daily Value at Risk Max Drawdown Total Return (1 year) BRK.B 14.2% 0.91 2.1% -6.3% 4.4% SPDR S&P 500 Trust ETF ( SPY) 12.7% 1.00 1.9% -4.9% 9.5% PowerShares QQQ Trust ETF ( QQQ) 13.7% 0.99 2.0% -5.7% 11.8% Looking at these numbers, I asked myself “Why?” Why do I need something that I think of as high-quality but ultraconservative yet has greater volatility than the NASDAQ 100. And with that volatility comes barely a third QQQ’s return. It has greater volatility than the S&P 500 as well, and half of SPY’s return. Sure, the stock has had great years in the past, but when I ask what it’s done for me lately, I’m not getting an answer that tells me to hold onto it, especially since it’s a large holding for me. The question was, what do I replace it with? In looking for the answer, I asked myself why I was holding BRK.B. What came immediately to mind? Quality. When I bought the stock it was because I viewed it as the model for quality. So, while I was deciding to part ways with BRK, I had to decide how to fill the gap it would leave. I might have begun by considering other stocks, of course. But, another factor that entered into my thinking is that I have been moving away from individual stock holdings in favor of funds. That decision is the subject of another discussion altogether, but especially for places where a stock is occupying a structural role in my portfolio, I think it can make more sense to fill that slot with an ETF that does the same job. So, what I wanted was a fund that emphasized high-quality. What Asness et al., following the Fama-French factor terminology, called Quality Minus Junk in their 2013 paper on the subject. In that paper they define quality stocks as being “safe, profitable, growing, and well managed” and showed how the quality factor has outperformed. After BRK.B had a nice pop on Thursday and Friday, I decided it was time. I could have gone with one of AQR’s mutual funds, which are built on Asness’s rigorous research. But, even if the door was open to me, I’m not in a position to fork out the cost of entry. These funds have a nominal minimum purchase of $1-5 Million depending on share type. I have a large holding in BRK.B but not remotely that large. In addition there are fees that approach 2%, and the funds are generally available only through advisors. I’m sure you can get in for less than that nominal seven-figure requirement if your timing and brokerage are right. In fact I do hold an AQR mutual fund purchased this way despite its nominal $1M minimum. But most of them are closed to new or even current investors. A smart move by the funds’ management, keeping the funds something halfway between an open-end and closed-end mutual fund. I won’t argue the desirability of AQR mutual funds, but as I go through them, I don’t see enough to justify those barriers to me. What I went for was the iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ), which does what it says on the label: Emphasizes the quality factor. QUAL: Top Ten Holdings and Sector Distribution When I start to look at an ETF almost the first thing I do is look at the portfolio. (click to enlarge) I found that the top six positions in QUAL were also in my own portfolio: Microsoft (NASDAQ: MSFT ), Johnson & Johnson (NYSE: JNJ ), Apple (NASDAQ: AAPL ), Gilead (NASDAQ: GILD ), Berkshire Hathaway and Costco (NASDAQ: COST ). Four more of my stocks were in the top 20: Celgene (NASDAQ: CELG ), AT&T (NYSE: T ), Chevron (NYSE: CVX ) and Qualcom (NASDAQ: QCOM ). I hold a total of 14 individual stocks, and I look primarily for quality in my choices. So, I was struck by the convergence of my opinion and that of QUAL’s passive algorithm. I’m not sure I’ve ever looked at an ETF portfolio and found 70% of my portfolio’s stocks in the ETF’s top 20. And I’m certain I’ve never hit all of the first 6. I felt the algorithm validated decisions I’ve made over a period of several years, and this fund was a fit for my own approach to investing. Sector weighting also aligned with my own portfolio strategies. (click to enlarge) I have a modest allocation to a dual-momentum sector-switching strategy. For the past year and a half or so it’s been in information tech, healthcare, consumer discretionary most of the time it hasn’t been in the out-of-market position. The QUAL index has loaded the portfolio with 70% allocation to those sectors. Again, I felt I was moving along the same path. So, with the validation that my investment strategies and QUAL’s index algorithm were generating similar choices, it seemed clear that I had to look more closely. QUAL’s Strategy and Implementation Quality can be a nebulous concept. The most important question was: How does the fund define quality? According to the fund’s factsheet they use “three fundamental variables: high return on equity, stable year-over-year earnings growth and low financial leverage.” Not unreasonable indicators of Asness’s “safe, profitable, growing, and well managed” definition of quality. The MSCI index description expands this with the quantitative details: A quality score… is calculated by combining Z scores of three winsorized fundamental variables-Return on Equity, Debt to Equity and Earnings Variability. MSCI then averages the Z scores of each of the three fundamental variables to calculate a composite quality Z score… then ranks all constituents of the parent index based on their quality scores. Weighting is determined by the product of market cap weight in the index and quality score. Weights are capped at 5%. As an aside to stock-pickers, think about how high MSFT and JNJ must score on the quality scale to overcome AAPL’s market cap advantage in rising above it in the weighting here. It’s an approach that should lead to emphases on both fundamental value and momentum. I liked what I saw, and feel most would agree that these indicators do indeed reflect a concept of a quality company. They are clearly necessary components of quality, although perhaps not sufficient. I’m sure all of us could add metrics we’d like to see included. But I was satisfied with it at this level. QUAL’s History The fund has 27 months of history (July 16, 2013) and net assets of $1.2B. The total portfolio is set at 125 holdings. SEC 30-day yield as of September 30 is 1.94%. Its beta is 0.92. And its fee is only 0.15%. Returns since the fund’s inception are about a third better than SPY and twice what BRK.B has turned in. (click to enlarge) For longer term evaluation we have to go to the index. It’s always problematic to base decisions on a fund using the historical performance of its index, but it’s what we have. Here we have MSCI’s 15 year chart of the index vs. its USA index of domestic stocks. (click to enlarge) Morningstar’s Samuel Lee looked at the fund and its index about a month after it was introduced ( here ). He called it a “Buffett in a Box,” and ran up this analysis where he divides the MSCI Quality Index by the MSCI USA Index. On this chart positive numbers represent outperformance of the quality index relative to the domestic market index. For the 30 years prior to QUAL’s inception the index outperformed by 60%. What you really want to see in this chart, however, is the changes in slope because the positive slopes represent periods of QUAL’s outperfomance. During bull markets, quality lags, but during downturns it shows its breeding. (click to enlarge) Lee compared QUAL to the Vanguard Dividend Appreciation ETF (NYSEARCA: VIG ) noting the he’ll be watching it in comparison to VIG with an eye toward moving his VIG position to QUAL if the fund evolved as he anticipated it should. Here’s what he would have seen when he followed through: (click to enlarge) Trading for Quality So, near the close on Friday I sold my entire position in BRK.B and put the proceeds into QUAL. I started my project to replace individual stocks with funds by focusing on BRK.B for two reasons. First, it has been turning in disappointing returns recently, and second I have a large allocation to the stock, larger than I feel appropriate. There are two other stocks I’m holding at much lower allocations that I have been looking to trade out of as well: JNJ and T. I like having both of them for the same reasons I like BRK.B: stability and quality. But, like BRK.B there underperformance comes with opportunity costs. How do those opportunity costs stack up against what QUAL has been returning? (click to enlarge) What this is telling me is that I can jack up my returns with little, if any, sacrifice in portfolio quality by moving these allocations to QUAL as well. The biggest problem I have with QUAL is one of the things that attracted me to it in the first place. That is the extent to which it duplicates what I’m already holding. I’m not prepared to trade out of GILD, COST or CELG at this time. I think each of those has excellent prospects to outperform the market and their sectors. I also hold a large (my largest, in fact) position in AAPL that I’d like to cut back. I’ll probably do so after earnings this week if, as I expect, we get another positive report. But my other duplications I’m more ambivalent about. I like MSFT and it is certainly not underperforming (75% total return vs. QUAL’s 33.5% on the scale of the above charts) but if I had a quality substitute, I would not miss it. The other I replicate is CVX where I’m underwater but am willing to wait for the oil cycle to turn before I do anything there. Of course, most funds I own replicate some part of my portfolio, especially with AAPL and GILD among the top holdings of nearly every fund I find interesting. Bottom line on this exercise for me: I like QUAL, perhaps as much as any ETF I’ve looked at recently. For my purposes, it can serve the same role in my portfolio as individual stocks of quality that have been, and likely will continue to be, underperforming the market.