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Commentary,

An Economy Rebalanced: Q2 Top 10 Market Eliminations by the XOUT Strategy

Originally Posted May 14, 2020

Ryan Giannotto, CFA, Director of Research

Ryan Giannotto, CFA, is the Director of Research at GraniteShares. He can be reached via email: ryan.giannotto@graniteshares.com.

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The response to novel coronavirus has emerged as one of the most economically disruptive events in human history.  With the physical economy all but tossed asunder, COVID19 has aggressively intensified the drumbeat of digital disruption impacting all industries. A rapid bifurcation in the market is underway, between companies with adaptive ties to the virtual economy and those that are reduced to bailout dependency—no one is immune.

The latest XOUT rebalance gives fresh insight to the pronounced market schism, with the strategy aiming to eliminate companies falling behind in the race to innovate effectively.  While cutting losers has always been investing best practice, COVID19 lends a renewed imperative to this endeavor. The unpopular, yet unequivocal, reality is that not every company will survive this maelstrom—entire swaths of the economy will be subject to irretrievable impairment. This problem may the chief focus of the XOUT index, as owning potentially clear stock market losers is a luxury investors may no longer afford.

XOUT Q1 2020 Recap

Source: Bloomberg data, market cap as of 4/16/20, (*) indicates a new XOUT this quarter

Instead of trying to pick the winning stocks, XOUT flips the investing paradigm by seeking to identify companies likely to underperform, and to exclude them from the portfolio. Over the strategy’s Q4 rebalance cycle, the 10 largest X’ed OUT companies together underperformed the market by a whopping 7.85% as indicated in the chart below,[i] adding to the 5.49% underperformance achieved in Q4 2019. 

Collectively, these 10 cross-sector stocks were responsible for erasing over $670 billion in shareholder wealth, with Wells Fargo, the most egregious of last quarter’s losers, seeing its share price decrease by yet a further 45%.  With a market cap of only $110B, the San Francisco based bank suffered too steep a decline to reprise its role on the Top 10 XOUT list for this upcoming quarter, replaced by Comcast.

Quite simply, eliminating companies at risk of long-term secular decline may be an easier way to outperform the market than trying to chase the winners.  Cumulatively, the XOUT Index outperformed the market by 7.31% since fund inception (October 7th, 2019), with 4.98% of that outperformance accrued over the latest Q1 rebalance cycle. 

As depicted in the chart below, XOUT continued to outperform in both rising and falling market cycles, experiencing an attenuated drawdown as well as a stronger recovery through these unprecedented market conditions. Perhaps the story is best told by comparing the XOUT Index’s positive return since fund launch (+3.15%) against the market’s negative total return (-4.16%) over the relevant period, from 10/7/20 to 4/16/20.

Source: Bloomberg data, 10 largest eliminations from the XOUT Index from 1/16/20 to 4/16/20.

XOUT Breakdown for the Upcoming Quarter

Drawing on the latest available data, here are the 10 largest stocks X’ed OUT for the upcoming quarter—they inhabit a multitude of sectors (even Information Technology), and encompass both oil majors.  Other notable eliminations include Starbucks, both United and Delta to now exclude all airlines, Goldman Sachs and Norwegian Cruise Line, while the likes of Snapchat, Clorox and Campbell’s were added.  These determinations are not subjective, but arrived at through quantitative scoring across 7 metrics—revenue, employment growth, R&D investment, gross profitability, earnings expectations, buybacks and management. XOUT uses these inputs to evaluate who may be the biggest losers of the COVID era.

1) Walmart (WMT) Walmart is out single largest eliminated name- and this immediately causes controversy. Many investors will instinctively look to Walmart as company that has made valiant strides to counter the rise of digital commerce, pointing to the acquisitions of Jet.com and Flipkart. Why is this responsive company eliminated?  

The intractable problem for Walmart is that the companies cannot even grow revenues at the pace of inflation— on a real basis, the company’s sales are actually going backwards.  If you already sell half a trillion a year in goods, how can you sell an additional $30 billion each year? This is a question Walmart has been unable to answer, with its forays into the digital space yet to move the needle after years of efforts.  Moreover, what these growth initiatives have resulted in is a steady, but meaningful decline to profitability, roughly 80 basis points per quarter- the toll of competing against more technologically adaptive enterprises.

2) Visa (V) The story of Visa is illuminating of the broader XOUT philosophy; while past performance has been remarkable, our analysis identifies unmistakable signs of deceleration. While revenue growth remains impressive, the rate of increase fell by 9.9% over the past quarter, and significantly this pattern of decline pervades other statistics as well. Visa’s management score, while still strong, decreased by 48% over the past two quarters.  Yet it is on a forward looking basis where this downward trajectory becomes most pronounced, with expected earnings having declined 74% quarter over quarter, and 89% over the past two quarters.  

3) JP Morgan (JPM) XOUT kicked out JP Morgan over a quarter ago, and this caused some waves, but the stock has since lost over $120bn in market cap and the outlook has only gotten worse.  A quarter ago, we scored JP Morgan in the top quintile for expected revenue, and since then this metric has collapsed to the lowest quintile- this environment has rapidly turned against the banks as profit engines for the economy, and not even the largest and most popular bank is immune from this effect.

4) Verizon (VZ) Drawing from their duopoly status of the U.S. telecom market, the human bias enjoys comparing Verizon and AT&T to see which is the better of the two stocks. The real answer, however, is neither may be worth owning. Despite the attention 5G networks have garnered, Verizon’s revenue is increasing at an anemic 0.49% rate; imagine a transformative technology impacting an industry and yet revenues grow 85% slower than the overall market. Additionally, Verizon is a leader in divesting human capital, coming in the top 8th percentile in this category, and yet it continues to incur margin pressure. Even in an age of digital automation, human capital remains a key input for innovation, and tellingly Verizon is firing over 3 times faster than the market overall is hiring.  Nonetheless, the company enjoys management in the second highest quintile.

5) AT&T (T) Many of the challenges encumbering Verizon are only more acute for AT&T.  Similar to VZ, T is in the bottom 7th percentile for human capital investment, and the company’s margins are one third lower than those of Verizon.  In addition to inadequate attention to R&D, the company is blighted by management in the second lowest quintile, evaluated 54% less positively than that of Verizon.  Finally, its middle quintile revenue growth is achieved through its acquisition of Time Warner, and indeed is rapidly decelerating as this momentary bounce recedes.  In essence, AT&T typifies a company responding to technological change as opposed to one who is leading it.

6) Coca-Cola (KO) To what extent does sugar water provide opportunity for digital innovation? This inescapable challenge subsumes Coca-Cola as earnings expectations are in the bottom two percentile for the entire large cap ecosystem—only nine companies come in lower, and they are all under $25 billion in market cap. Furthermore, the current economic environment has uncovered the extent to which Coke relies on physical distribution networks, a factor emblematic of its inattentive management.  Specifically, company leadership is scored 45% below market average, which raises the question: although margins experienced slight improvement in recent quarters, what is the path forward?

Source: Bloomberg, market cap as of 4/16/20

7) Bank of America (BAC) The intractable problem for Bank of America is lackluster deposit growth, which overshadows the company’s relative successes in stock buybacks, historical earnings performance and human capital investments.  In particular, deposit growth has fallen to the second lowest quintile and 20% below the industry average. This deficit is substantial, as the core proposition for bank investment is sustainable balance sheet growth, akin to the subscriber growth for a social media platform. More problematic yet is the diminishing ability of the company to monetize this asset base, with earnings expected to decline from the second highest quintile to the bottom 12% of companies overall.

8) Exxon (XOM) Exxon enjoys the dubious distinction of being the largest destructor of shareholder value since the end of Q3 2019 in the S&P 500. By just not owning XOM, an investor would have outperformed the market by roughly 0.5% over the past 7 months with only change.  XOUT extends this concept to the entire portfolio, and indeed has never owned Exxon, which is plagued by unadaptive management, limited R&D and revenue contracting at increasingly negative rates. We score it in the bottom 5% of companies- a no go zone for stock ownership inhabited by the likes of GM, GE and Whirlpool. These are stocks everyone owns but with little connection to the digital economy, ones that may simply be left behind.

9) Chevron (CVX) Chevron is the worst scoring mega-cap stock, falling to the bottom 2.5% of the model overall; no other company over $100 billion in market cap even approached this level of vulnerability to secular decline  Foremost, the oil major reported an appalling -11% year over year revenue contraction- only 10 stocks in the entire large cap space suffered a worse decline. While the company had offered respectable buybacks, Chevron witnessed one of the most extreme collapses in earnings expectations in the large cap ecosystem. Indeed, this metric fell from the second highest quintile to the bottom 5%.  CVX may truly be a stock to XOUT, with little to show for its piddling commitment to disruptive innovation.

10) Comcast (CMCSA) The only new addition to the top ten XOUT list, Comcast was eliminated this quarter primarily on a basis of its poorly financed buyback program.  Stock purchases outstripped free cash flow, thereby necessitating an unsustainable reliance on debt financing. Moreover, while revenue growth is strong, this emanates from the company’s acquisition of SKY and is decelerating rapidly (-28.5% from the previous quarter) and this effect also pans out to its investments to human capital. Compounded by the current economic environment, earnings expectations have decreased by a remarkable -122%, a byproduct of a heavy reliance on ad-based revenues in a market increasingly favoring Over The Top (OTT) content access.

Flipping the Investment Paradigm

The primary task for equity investors ahead may be to avoid companies that will not remerge from this pandemic, a division that will largely fall along lines of digital adoption.  Without warning, companies have found themselves in an environment where they must ask if they can survive on a digital basis alone.  We believe the businesses that cannot convincingly answer this question to the affirmative may never fully recover. 

The XOUT strategy was not designed as a pandemic panacea, but technological adaptiveness has served as an excellent proxy for survival in the COVID economy.  Rather than attempt to pick the winners from this unprecedented tumult, a greater potential may rest in the power of exclusion—the mantra of the XOUT investing philosophy.


[i] Based on a market cap weighted index of JP Morgan, Walmart, Visa, Verizon, AT&T, Coca-Cola, Bank of America, Wells Fargo, Exxon and Chevron.

Important Information

This material must be preceded or accompanied by a prospectus https://www.graniteshares.com/Documents/130/GraniteShares-ETFTrust-Form-485POS-Prospectus.pdf. Carefully consider the Fund’s investment objectives risk factors, charges and expenses before investing. Please read the prospectus before investing.

Investing involves risk; Principal loss is possible.

The XOUT U.S. Large Cap Index utilizes a proprietary, quantitative methodology developed by XOUT Capital, LLC designed to identify companies that have a risk of being disrupted and as a result could underperform their relevant sector. The companies identified are then excluded from the index selection.

The Fund is passively-managed and attempts to mirror the composition and performance of the Index. The Fund’s returns may diverge from that of the Index due to costs and expenses incurred by the Fund or its holdings may deviate from a precise correlation with the Index. The Index uses proprietary methodology to exclude certain securities and there can be no assurance this will result in positive performance. The Fund may concentrate its investments to the same extent as the index and it may be exposed to the risk of loss from adverse developments facing those industries. One cannot directly invest in an index.

The S&P 500 is a market-capitalization-weighted index of 500 of the largest U.S. publicly traded companies. The index is widely regarded as a benchmark for U.S. equity performance. The S&P 500 is not used in the methodology of XOUT fund or the XOUT index.

This information is not an offer to sell or a solicitation of an offer to buy shares of any Funds to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction.

There is no guarantee the index will be successful in excluding companies that are at risk of being disrupted or possibly underperform their relevant sector. Exclusion or inclusion of a security within the index is not a recommendation or solicitation to buy, hold or sell any security

The Fund is distributed by Foreside Fund Services, LLC, which is not affiliated with GraniteShares or any of its affiliates.

©2020 GraniteShares Inc. All rights reserved. GraniteShares, GraniteShares Trusts, and the GraniteShares logo are registered and unregistered trademarks of GraniteShares Inc., in the United States and elsewhere. All other marks are the property of their respective owners.

Ryan Giannotto, CFA, Director of Research

Ryan Giannotto, CFA, is the Director of Research at GraniteShares. He can be reached via email: ryan.giannotto@graniteshares.com.

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