Why Investors Should Like ETFs

In this podcast, Motley Fool host Ricky Mulvey and analyst Jim Gillies discuss:

• A difficult stretch for small-cap stocks.
• Costco's new healthcare offering.
• One piece of Costco's valuation that's often forgotten by investors.

Plus, Motley Fool personal finance expert Robert Brokamp and host Alison Southwick find out how Fools use ETFs in their portfolios.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Sept. 26, 2023.

Ricky Mulvey: It's not very fun being an investor right now, is it? Motley Fool Money starts now. I'm Ricky Mulvey joined today by Jim Gillies. Jim, thanks for being here.

Jim Gillies: Thanks for the invite, Ricky.

Ricky Mulvey: It's a little bit dreary for stock investors right now. In the United States, inflation's about eight percent. The medicine from interest rates really hasn't kicked in on home prices or inflation. Your beloved small caps are down about six percent right now looking at the Russell 2000. We're long-term investors, but it's really not fun putting money in the market today.

Jim Gillies: That is correct. I wrote a little piece last week for the members of Hidden Gems Canada, basically saying, boy, it sucks right now, doesn't it? I went through much of what you talked about showed at the time, the S&P 500 was down about four percent for the month as of I think last Thursday. Spoiler, it's gone lower since. The Nasdaq was running at close to six percent down, the R2k was over six percent probably getting worse. The reasons I think because we're seeing all of these wonderful headlines. Inflation rate hikes, more rate hikes coming the phrase higher for longer has entered the Lexicon. The Canadian economy, which is where I live it contracted last month. You guys at least don't have that to play along and I think both countries have got we'll say some nascent housing problems to probably have to deal with. I further went through, and I broke up the year, the last almost four and a half decades. It broke it up by returns per month. We always hear about, oh, the stock market returns about 11 percent a year, 10, 11 percent a year, on average. Not every year obviously, but on average. But I broke it down into a monthly just to try to give the members a little bit of a hey, we acknowledge, it sucks right now. But September is really bad, actually September, if you were to break out the last, since 1980, you break out the monthly returns, returns by month and just average them. The only negative month has historically been September, with an average of about down, 0.9 percent.

Spoiler this month is going to contribute to that average make it worse, frankly. But I said, the other thing is if you were to chain Lincoln, look at the returns in aggregate for all the other months. They're all positive, some barely, but some pretty good. The next three or four months, October through January, tends to be a very good period for the market. If all those people who did sell in May and went away and they start coming back, it tends to be pretty good. Then the other thing I want to encourage people to remember is that the environment sucks. However, you want to be a buyer to steal from Buffet. You want to be a buyer, you pay a high price for a cheery consensus. We've gotten two things this past month, whether the September doldrums extend or not, we've gotten two things this month. We don't have particularly high prices and we do not have cheery consensus across the board pretty much. Paradoxically, I like those environments even though pretty much anything I've bought in the past few months or recommended is probably not up just because it's a crap market right now. But remember, these things do not persist and we are long term.

Ricky Mulvey: I think there's still. At least one worry that I'm thinking about is that the housing market has had a stick poked at it and it really hasn't moved and that's a problem in the US, and I know it is a problem in Canada where you're dealing with a lot more of those variable rate mortgages.

Jim Gillies: Yeah. Exotic mortgages. Hey, our American friends and cousins. Do you have any advice on situations where a country piles into exotic style mortgages? I feel that you guys have got a pretty good example for us. It's a problem in Canada certainly, but this is not really a Canadian audience show, so it's fine. But my take on it, the other little piece of data I'll throw out is the ratio of the small cap environment. You referenced the small caps earlier where I do play most of the time. The valuation, just the ratio of small caps in aggregate to large and mid caps in aggregate. That valuation ratio is actually over the past 50 years, we are at a low that has been seen once in the past 50 years. We're there again and the last time we saw this was in the wake of the run up to in the wake of the tech bubble bursting. Again, I think people were, again, you pay a high price for a cheery consensus. What were people buying in 99 in early 2000? They were chasing anything with tech and Internet on it, this or that and so yeah, small caps got forgotten at that point in time. Today, we've had a little bit of that in 2021 and bursting in 2022. We've got a little bit of the pay, any price for these great growth stocks are going to change the world. Maybe less of an implosion in some of the larger caps, particularly large cap tech, they're certainly down. But the valuations generally, if you're looking at something like an Apple or Alphabet, or Microsoft, they're not low. But they're not unreasonable in my opinion. But I do like the fact that we have a nice set up for small caps in terms of valuation and the last time this happened, Ricky, so I mentioned that it's only happened once in 50 years, we've gotten to this low ratio, small cap valuations to large and mid-caps. In the decade after we hit that low valuation, the large and mid-caps struggled. In fact, I think the next decade was basically flat. Small caps outperformed rather substantially. I like the set up for the next decade here.

Ricky Mulvey: Let's move on to a bit of a cheerier story. Costco expanding its presence in healthcare. It is linked up with Sesame, a direct-to-consumer healthcare marketplace. They're setting virtual primary care visits at just $29 health check ups, so basically a standard blood test and a follow up at 72 bucks, and an online mental health visit for $79. Jim, I know you're in Canada, so you're used to not spending a ton of money on healthcare. But for us Americans is this is a really big deal. We'll focus on the business though. Costco operates pharmacies that has independent optometrists in the store. How important is healthcare to the business of Costco?

Jim Gillies: I do love, as you've alluded to, you're asking the Canadian about the American healthcare system. Thank you for that. I'm just going to do a little bit of background here. Healthcare, they have independent pharmacies. You say the gas stations in some places, the optical stuff, the food court, the famous $1.50 hot dog, hearing aids, tire installation. All of those things fall into a category for Costco, a revenue category called the warehouse, ancillary, and other businesses, and you also get E-commerce, business centers, travel and whatever else in there. As to how important it's going to be? Warehouse ancillary in the most recent full fiscal year, fiscal year 2022, which by the way, I believe Costco reports after hours today. This information I'm able to give you is precisely a year out of date. But whereas ancillary was approximately 21 percent of total revenues for fiscal 2022. That's all, that's gas, pharma, optical. As far as how important this deal will be, it probably not much in the near term as a percentage of revenue. However, as an ongoing piece of Costco, taking an ever larger share of the consumer dollar, especially with the perception of low cost or buy and bulk. Although it's hard to buy mental health visits and bulk. Although probably some people should. This is probably not your typical bulk sale, but you are getting almost bulk pricing. I would argue you're getting a better deal because they Costco, they are buying a bulk and it's adding more fuel to Costco, taking an ever larger piece of your consumer dollar fire. I like that and the other thing too, is that Costco is still a pretty good growth story. Fiscal 2022, again, this is a year out of date. But fiscal 2022 grew total revenue 16 percent. Fiscal 2021, that grew total revenue 17.7 percent. The warehouse ancillary has actually been getting better, it's taking a larger chunk.

Jim Gillies: It went from 16.5% of total revenue in fiscal 2021 to 20.9% of total revenue in fiscal 2022. That is a near 47% growth rate that year. They are trying to make Costco front of mind for all of these and Solari-type things. When you're going for your 10-gallon tub of mayonnaise, you can also get your hearing aids and your eyes checked.

Ricky Mulvey: In the next couple of weeks, we're going to do a deeper dive on Costco, which I don't know if you know this, Jim. There's new food court items. Mango smoothie, [laughs] roast beef sandwich included, chicken Caesar salad. If you have thoughts on any of them, email us. Our email is [email protected], that's podcasts with an S @fool.com. Maybe we'll include your review on the show. But last question. Costco always seems expensive as a stock, especially when you compare it to other retailers. As a cash flow nerd, how do you square that?

Jim Gillies: Well, first off, sometimes you should be willing to pay a premium for a high-quality business. This is a high-quality business. For the longest time, because I'm a bit of a pest for the longest time. Whenever I would go to Costco, and I try to avoid going on weekends. I'd nip out at lunch hour or whatever. I would always take a photograph from random place on the inside and text to my colleague [inaudible] , and I would just say, I don't own enough Costco, we should make this a recommendation, a stock advisor candidate. He finally listened to me, thank goodness. But you should be willing to pay a premium for something because it's always busy and everyone's, you look at the size of the carts and what they are putting in the cart. You go in for some milk and eggs and you walk out with 250 bucks of stuff you didn't know you needed. Then another little trick to their valuation is their valuation overstates the value of the business. Because the thing about Costco is they own, I don't have the number completely off the top of my head, but it's about, I believe, 80-85% of the land and buildings for their stores. That asset value is not contributing to earnings or cash flows quarter to quarter, but if they had to, they could do a giant sale-leaseback and you'd get a significant value. The way I always try to put it to people is imagine you own a paid four-million-dollar house.

That million-dollar house is paid for, it is not costing you, well, it's not contributing anything to your bottom line. In fact, it is costing you. You're paying property taxes, you might be paying HOA fees in America. You of course, got your maintenance expense. But if you need to realize funds from that million-dollar house, you can either put a HELOC on it and take some money out. You could sell the place entirely. Now all of a sudden, boom, you get a million bucks. There is an asset-added value here that is obscured in the valuation ratios that people usually quote, they'll talk, oh, Costco's trading at 30 or 35 or 40 times earnings. Yes, it is, but it is missing a rather large piece of the puzzle that I think you do need to include. Again, just as a premium business and there's still many more growth avenues, many more warehouses they can open, both in North America as well as in certain other places if they so choose. Eventually, I think Costco will, once it hits what it perceives to be a saturation type situation, which is similar to Home Depot about a decade ago. They'll just turn it into a cash flow engine, because everything is too, is the cash flow right now. A lot of it's going into building new warehouses. At some point that will stop. I don't think it's going to stop and immediately drop the total cash. People will abandon Costco at that time. I think when it drops, much like Home Depot, when they did it, they will probably turn into a giant cash flow engine, and then start returning that capital to shareholders.

Ricky Mulvey: Jim Gillies. As always, I appreciate your time and your insight.

Jim Gillies: Thank you, sir. 

Ricky Mulvey: Sure, we like stocks at the Motley Fool, but we've got no beef with ETFs. Alison Southwick and Robert Brokamp caught up with Bill Mann and a couple of other Foolish investors to learn how they used exchange-traded funds. 

Alison Southwick: At the Motley Fool, there is nothing we love more than discovering a beautifully run publicly traded company, investing in said company, and then watching the value of our shares go up and up and up over the long run. Isn't that right, Bill Mann?

Bill Mann: You know, that is the way that we draw it up.

Alison Southwick: It sounds easy enough, pick the stocks that go up into the right. But as Peter Lynch famously quipped, in this business, if you're good, you're right six times out of 10. You're never going to be right nine times out of 10. These are tough odds. But luckily, we live in a world where ETFs exist, which can easily help you diversify your holdings and spread out your risk. Today, with the help of a few Foolish analysts, we're going to talk about how you should think about using ETFs in your portfolio. Now bro, for our listeners who might be newer to investing, can you give us just a brief explanation of what an ETF is? Should I make it hard on you by not allowing you to say, basket of stocks or bonds?

Robert Brokamp: I think I can do it without saying that.

Alison Southwick: Okay.

Robert Brokamp: Let's start with the fact that ETF stands for Exchange Traded Fund. Let's start with the fund part, which just means that it's a way to buy many investments with just one purchase and receive at least a degree of professional management in the process. In that way, an ETF is like a traditional mutual fund. However, the difference is that exchange-traded part. The prices of ETFs change throughout the trading day. You can buy or sell any ETF anytime the market is open, and you'll usually get a price that's pretty close to what you see when you pull it up on your screen. That's different from a traditional mutual fund because that only gets priced once a day after the market closes. When you put in your buy or sell orders, you actually don't know exactly the price you're going to get. In other words, an ETF is a mutual fund that trades like a stock.

Alison Southwick: How should you work ETFs into your investing strategy? I asked Motley Fool analyst, Kirsten Guerra, before the show how she uses ETFs and here's what she had to say.

Kirsten Guerra: I'm an analyst and I spend all day, every day looking at businesses. That's where I prefer to focus my investing energies on individual companies. That's just what interests me. ETFs are boring to me, but something like half of my portfolio is in ETFs, and that's just because I allocate the asset classes that are most boring to me into ETFs. For me that means I have ETFs for bonds, or tips like inflation, protected bonds, emerging markets, equity, real estate. I either don't want to think about those things, like the bonds, or I don't think I have any specialized knowledge to help me beat an index fund for emerging markets where most of my equity knowledge is pretty domestic to the US. Some stuff is boring to me and I don't want to think about it, but I've decided I want exposure to it in my overall portfolio. Then for that, I've got an ETF.

Alison Southwick: Let's hear from another analyst, Jason Moser, on how he uses ETFs.

Jason Moser: I think ETFs are wonderful instruments for most investors. Particularly when it comes to industries or markets that are a bit more difficult to fully understand. Cybersecurity strikes me as one such industry. Threats and technology are just constantly changing, which makes determining the winners and losers just more difficult proposition. The broad diversification of the ETF in this case could make more sense than trying to pick just one or two winners. One ETF investors might want to dig more into is the Nasdaq First Trust, CTA, Cybersecurity Index, and its ticker is C-I-B-R. This ETF consists of 35 different holdings today, all companies that are focused on the cybersecurity market.

Alison Southwick: Using ETFs to gain exposure to sectors you either aren't interested in or feel are too complex to fully understand. It sounds like a good approach to me, but what do you guys think? Bill, I'll start with you.

Bill Mann: We think of ETFs as being plain vanilla. There are actually more than 8,700 ETFs to choose from on the US stock market. Yes, while it seems they may be ways to get exposure to broader areas of the market, a lot of people use them to hedge for example, if they want to pick a couple of stocks, they can use an ETF, like a broad index fund and play an index plus a few strategy. I love that sort of thing because we tend to think of the market as being, you know, kind of an average return. Most people manage to underperform the market. The ETF itself gives you right out of the gate, a very easy, cheap way to get broad exposure to the market.

Alison Southwick: Bro, how do you think about ETFs in your portfolio?

Robert Brokamp: It's similar to what Bill said. I like to think of it as advisor diversification. If I'm picking my own stocks, I don't want my future retirement riding on my abilities. I can buy a collection of index-based investments that invest in large caps, small caps, international stocks, real estate so that I have a portion of my portfolio diversified across different ideas on what will be the best-performing asset class from between now and the time I die.

Alison Southwick: Bro, you mentioned how ETFs and mutual funds are very similar. How do you decide between choosing an ETF versus a mutual fund?

Robert Brokamp: Well, part of it is what's available to you. A lot of reasons people have regular, old mutual funds is because that's what's in their 401K or that's within their 529 plan, so you stick with that. I think that's perfectly fine, especially for any tax-advantaged account. One of the big reasons that use an ETF over a regular index fund, I should say like a traditional open-end mutual fund, is that they tend to be more tax efficient. Not always, but generally speaking. If you are in a situation where you're buying within just a regular brokerage account, it's generally better to choose the index-based ETF versus a traditional index fund.

Alison Southwick: ETFs can be active or passive. Now when I think of active, I think of a manager who's picking and choosing what's going to go into the ETF. Then I guess a passive one, I'm thinking it somehow just follows an index. First off, do I have that right, Bill?

Bill Mann: More or less, you have that right. A lot of passive ETFs are so narrow in their scope that they are actually some form of active. But literally, the best way to think of a passive ETF is that there is some process that once the fund has been launched that is not really guided by humans, but you could set the parameters up ahead of time. It is the next best thing to actively managed. Whereas, for an actively managed one, it is the same as the overwhelming majority of mutual funds. In that there is a manager who is making decisions under whatever the parameters of the fund is.

Alison Southwick: Now, active ETF seem to be much more popular right now and I believe they are outperforming passive, obviously it depends on what time frame you're looking at, I assume. But can you talk about why you would choose one versus the other?

Bill Mann: For me, I would almost necessarily default to passively manage ETFs. One of the reasons that you want to gain exposure to an ETF, and Robert used this term earlier calling it, what was the term? Advisor?

Robert Brokamp: Advisor diversification.

Bill Mann: Advisor diversification. It was such a good term, I couldn't remember exactly how he put it. When you're using ETFs either you're doing one of two things. You're either trying to get into a broad set of instruments, we think mainly companies in a very cheap way. Or you're trying to get access to an area that you might not otherwise have, and particularly with the international ETFs in places like India and Korea. You can go even more exotic than that. Those markets are almost impossible for us to gain access to. To me it is a form of access or it is a form of diversification and since you're talking about ETFs, my advice is just to simple and stick with passive.

Alison Southwick: Now, another trend over the last couple of years was the rise and fall of thematic or niche ETFs. Which are ETFs that have a very narrow focus and sometimes they get a little wacky. According to Bloomberg Intelligence, investors have pulled roughly 2.6 billion from niche or thematic ETFs so far in 2023. That's the worst year of outflows since 2001, I guess. Now, Bloomberg says that the Arc Investment Management and their innovation fund alone has seen outflows of 450 million this year. A lot of that is just due to people pulling out of one fund. Is there a lesson here, Bill? Are some firms better than others when it comes to ETFs? Or is the lesson here about thematic investing?

Bill Mann: I think the lesson here goes beyond ETFs, is that when you're talking about managers, we hope springs eternal for all of us. We all think we can find the hot stock or the hot manager. When you're investing in ETFs, I think you have to get into the mindset of, that's not the thing that I am trying to achieve here. I'm trying to gain some level of diversification. If you think about it, we as investors know about ourselves that as a group we're pretty bad at timing. Why would we go into an ETF and we try to time a hot ETF manager or active manager, who is they themselves are trying to time the market.

Alison Southwick: Well, thematic investing peaked, but maybe we can still get in. I know you just said it's a bad idea, but let's see if we can come up with a winning thematic niche ETF. I want to know Bill and Bro, if you could tie an ETF to the success of any musical genre, theme, band, or musician, who or what would it be? Bill, do you want to go first?

Bill Mann: I want Weird Al Yankovic.

Alison Southwick: Bro, wants to [laughs] see if answer, I can tell you that right now right now. Bro is changing his answer immediately.

Robert Brokamp: No, I already have an answer, but I do have a ticker idea. It'd be TT because then you would call it pair of Ts. [laughs]

Bill Mann: The beauty of Weird Al Yankovic is that he is not genre specific, he is a trend following artist and so therefore, as an investor, I want Weird Al Yankovic the pair T.

Alison Southwick: Yeah, so Bro, are you changing your answer to what Bill said? 'cause I know how Weird Al Yankovic is so near and dear to your heart.

Robert Brokamp: He is. But now, you know, Alison, I love my Christmas music, so I would definitely create one. The ticker would be XMAS of course, but it would be market weighted toward new music and of course, would have a heavy weighting in the album that is coming out in October from Cher and it's just called Christmas. I wish it were called Cherry Christmas, but it's not. But it is coming out in October.

Bill Mann: I feel like she left an easy one right on the table, didn't she?

Alison Southwick: All right. Here's my last one for you. Do you ever stop and think, I love what I'm eating so much, I wish I could invest in it. The question is if you could create an ETF based on a specific dish or meal, what would it be? Bill, you've been going first every time. Why don't you just go first again.

Bill Mann: I think it's got to be a barbecue ETF. You've got plenty of commodity exposure. You have very little in the way of trend following. I mean, if there's a food that's less trendy than barbecue, I'm not quite sure what it is. Maybe tang is less trendy than barbecue. But there are geographical implications. The places where barbecue is best are in the fastest growing part of the United States of America. I think that's how I'm going to go, and because I am a Western North Carolina barbecue aficionado, the most the ticker is WNC.

Alison Southwick: There you go. All right, Bro, how about you?

Robert Brokamp: Well, my wife and I have joined the millions of people who are not eating out as much because it's gotten so darn expensive. There was a lending treat survey last month that found that 67% of people saying they're dining out less. My ETF with short restaurant stocks, with heavier weightings toward the higher and dining. The ticker would be EATN, as in, eating in.

Ricky Mulvey: As always, people on the program may own stocks mentioned and The Motley Fool may have formal recommendations for or against. Don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey, thanks for listening. We'll be back to tomorrow.