Energy Recovery’s VorTeq – A Game Changer For The Fracking Industry (NASDAQ:ERII)

This is my update article on ERII. The first one you can read here.

Introduction to Energy Recovery

Energy Recovery (NASDAQ:ERII) is a fluid dynamics, materials technology and ESG company. ERII invented and dominates pressure exchanger technology (“PX”) that allows recycling of up to 40% expended energy in virtually any high pressure and hydraulic process. Large scale reverse osmosis desalination plants would not be possible without its pressure exchangers and as a result ERII has a 100% markets share in desalination PX coupled with 70% margins. Demand for fresh water is projected to grow substantially as entire regions of the world face acute water shortages.

Recently, ERII is expanding its core PX technology into other verticals. First vertical – VorTeq, to be commercialized this year, is expected to disrupt the oil and gas industry by lowering fracking break evens by estimated $5-10 a barrel. VorTeq and three other verticals are expected to be unveiled within the next 3 months and promise to increase ERII’s revenues multiple fold over the next several years.

Q2 Results Summary

Energy Recovery delivered a solid set of results in the second quarter. Diluted EPS were $0.30, partially reflecting the gain on terminating the Schlumberger (NYSE:SLB) agreement. The Company reaffirmed guidance of 20-25% growth in Water Segment revenues for 2020 over 2019 and 2021 preliminary guidance of flat to 5% growth. At the same time the company reported the largest ever order backlog for large projects for 2021. “We have much higher order book than we had at this time last year” management reported on the call. “For the first time ever we have orders for two years ahead”. Based on those statements, we believe that the guidance is very conservative. The backlog is at a record, despite COVID-19 disruptions. The company should achieve 70% gross margins in the Water Segment which translates into operating earnings of about $0.50 per share. Adding $1.75 per share in net cash and a conservative multiple of 22x operating EPS (Xylem (NYSE:XYL), Flowserve (NYSE:FLS) and other water comparisons trade at 30-40x P/E despite having lower growth and lower margins) we get value of about $12 per share for the Water Segment alone (without any other verticals).

We also got a lot more visibility on VorTeq in the Oil & Gas Segment which is ready to test in the field by October at the latest. Based on estimated $6mn savings generated by the technology per fleet per year, likely 33% share of the economics, projected 250 fleets operating in the US alone exiting 2022 and (conservative) 75% market share, ERII will generate additional $375mn in revenues. At 2 times revenue (gross margin is expected to be over 50%), VorTeq represents additional $13 per share value for a total value of $25 per share in 2021, 200% upside from here.

Quarter Highlights:

  • the tone of the quarterly call was confident and factual, unlike some of their previous IR efforts. ERII’s CEO, Robert Mao, committed to R&D, cost and return discipline, focusing only on the highest IRR projects and setting fixed timeframes to get new verticals to profitability. The company will not pursue projects that have lower than 50% gross margins as not to dilute its impressive financial metrics.
  • ERII confirmed what Liberty Oilfield Services (NYSE:LBRT) said on their quarterly call on 7/29/2020. LBRT reaffirmed its full support of the VorTeq technology, adding that field testing is imminent. Importantly, Liberty’s clients are open to disruptive technologies, especially since VorTeq has been integrated to its technology seamlessly.
  • Cost savings estimated together with Liberty amount to over $6mn per fleet per year, a number higher than we initially thought possible. This does not include additional “soft” savings that the frackers and their clients are able to achieve. Savings would be considerably higher when centrifugal pumps are introduced, potentially double or more, but to be conservative, we will not account for them yet.
  • There will be 3 new verticals announced on the 3Q results in late October 2020. From what we can gather, one can be water related with two others being in completely new segments. Given the timing indicated on the call – new verticals have to meet high margin, returns and limited R&D requirements. The “sandbox” in which these new verticals will be is around 3,000 PSI. We believe that the revenues from these verticals will eventually at least double ERII’s revenues from Water and Oil & Gas.
  • Inaugural ESG report will be unveiled in September. ERII is an outstanding candidate for environmentally conscientious portfolios based on the 40% plus energy savings achieved thanks to its technology. Given that estimated $2 trillion follow ESG investing principles and shareholder list does not appear to have many ESG focused investors, this can be a significant catalyst by itself. The company plans to market extensively in Europe which is particularly focused on ESG investments.
  • Given the material effect that the VorTeq will have on transforming ERII by adding another revenue driver in the next 3 months, lets “drill” little deeper into what we know about VorTeq.
  • Hydraulic fracking has been a game changer for the global oil and gas markets. United States, after years of declining oil and gas production, returned as one of the largest oil producers. It went from an energy importer to an energy exporter within a span of a decade. As we have seen in previous oil cycles, skeptics and competitors have succeeded in slowing the shale growth temporarily, before the American entrepreneurship, capital markets and innovation drove a rebound and more growth. The latest effort by OPEC+ to derail its competitor will fail again, despite creating a lot of damage in the oil patch. Although the number of frack fleets went from around 400 to 130 at the trough in Q2 2020, it is expected that in 2021 the number will be above 200 and increase from there. This is US market only, Argentina’s Vaca Muerta shale formation and many others represent further opportunity to grow in the future. Moreover, these fleets will likely be more efficient, so the numbers are unlikely to be “apples to apples” comparisons.
  • The process of extracting oil and natural gas from shale rock has gone through substantial technological evolution but is about to change again. ERII’s VorTeq will be one of the key drivers. Cost savings that this technology is going to generate will reduce the fracking break even initially $3/barrel with eventual total savings potential of $6/barrel. How can a small research company do something where giant companies have failed? The answer is the breakthrough PX exchanger technology that Energy Recovery already uses to capture 100% market share of large scale desalinization projects for more than a decade. Effectively, it is able to recycle energy already expended back into the process.
  • The magic breakthrough of VorTeq innovation lies in its ability to separate the slick water from clean water and protect the pumps, the weak spot of the process. Currently, the pumps used in fracking are required to withstand one of the most aggressive environments on the planet – pressures of between 10,000-15,000 PSI while pumping liquid with sand and other sediment in it. Average pump lasts hours, has to be constantly repaired and parts replaced, while maintaining spares. The cost and capex invested is, as you can imagine, substantial. By protecting the pumps, VorTeq can extend the lives of the pumps used to THOUSANDS OF HOURS from less than 12. The process is described in more detail by ERII’s partner Liberty, a technological leader in fracking:

VorTeq progress

Liberty Oilfield Services calls VorTeq “A Game Changer in the Pressure Pumping”

Source: Liberty Oilfield Services

VorTeq 1.0

Source: Fearnleys Research

VorTeq 1.0 cost about $2mn to produce and was the size of a Mack truck. Caterpillar’s (NYSE:CAT) Kemper division, a highly specialized manufacturer, was supposed to produce it, a process that was expected to take 3-4 months. Under the old Schlumberger contract, ERII was getting paid $1.5mn fixed fee per year per fleet with expected savings of $3-5mn annually for the fracker to divide with the oil company. When the contract was signed, we believe, Schlumberger had around 80 fleets, a number that has likely been reduced to single digits in 2Q 2020.

VorTeq 2.0

VorteqSource: Energy Recovery

Developing VorTeq 2.0 has been a long process, as is to be expected when creating such breakthrough technology, but is 99% done. The idea was to lower the cost, increase durability and reduce complexity. That has been achieved and you can see the difference between the two versions for yourself. VorTeq 2.0 costs less than a quarter to manufacture (estimated to be $400-500k per unit), there can be multiple manufacturers at the same time, not just Kemper, and it is modular to increase flexibility depending on the frack job. VorTeq 1.0 was required to be able to handle 10,000 PSIs and 1-2 pounds of sand per minute, VorTeq 2.0 is able to go potentially above 12,000 PSIs and process 4-6 pounds of sand per minute. Thus, it can increase the range of fracks and the SPEED/EFFICIENCY of fracking, driving further savings, than just increasing the longevity of the pumps. So, 25% of the cost + 2-4x in throughput increase + increased flexibility = a win for ERII shareholders.

VorTeq Value Creation

What is this worth? If we use the initial estimates of base savings of $6mn per fleet per year, it is clear that ERII’s share can be substantial. Moreover, it is not limited to $1.5mn per year and only two providers (Liberty and Schlumberger) as in the previous contract, but can potentially be higher since there is no exclusivity and it is hard to imagine any fracker in the world that can afford NOT to use this technology. In our valuation we estimated that ERII will capture 33% of the savings. It is obvious that the savings will fluctuate depending on a number of variables that are changing constantly, but we believe that this is a fair estimate at the moment.

Given that ERII has $95mn of cash on balance sheet and zero debt, the company can lease the VorTeq 2.0’s to the frackers without raising any dilutive financing. Obviously, the company can finance the units at today’s ultra-low interest rates as contra parties such as Halliburton (NYSE:HAL), etc. are easily financeable. Adding all this together, we are talking about potential $400mn plus in additional revenues in several years. Although margins may be a bit lower than the current 70’s% in terms of its desalinization technology, we think that 60% range is highly achievable. $400mn additional revenues is a lot of growth when current revenue run rate is around $100mn. It is not difficult to imagine that with oil market normalizing as the world economy recovers to see ERII earn $1.50-$2.00 three years out.

VorTeq 3.0

As appealing of a value proposition as VorTeq 2.0 is, the savings generated by the VorTeq technology can be considerably higher. Why? The answer lies in the current pump design. They are built to withstand the most severe conditions anywhere on the planet, save the bottom of the ocean. Solution is VorTeq 3.0 – replacing the expensive pumps needed in current environment with considerably cheaper and more efficient centrifugal pumps. While under development currently, we estimate that this can save additional millions of dollars annually, savings that can be at least partially captured by ERII in the future.

Further Verticals

Given that fracking is one of the most difficult operating environments, mastering this one allows ERII to utilize it in other verticals that are much easier. Besides current uses in chemical plants, pipelines, etc. we can envision other uses where high pressure or hydraulics are present. This represents further substantial optionality for Energy Recovery investors and can more than double Desalinization and VorTeq revenues again. More on the size and specifics of the three new verticals will be revealed in October 2020.


ERII is a PX company. They manage to dominate the desalination with their technology. We believe that just their Water business is worth USD 12 per share, 50% upside from current levels. ERII is now working on importing their technology to fracking. If VorTeq is successful, the share price should more than triple to USD25. On Q3 call ERII will disclose further information on three other verticals they are now working. One of these should be substantially larger than VorTeq. If that is right, there is substantial share appreciation ahead.

Disclosure: I am/we are long ERII. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Givaudan: Sticky Player In A Niche Industry (OTCMKTS:GVDBF)

Investment Thesis

It is quite exciting to find a niche market with several secular tailwinds and top players’ rational behavior. In my opinion, Flavors & Fragrances (F&F) is such a type of niche industry. Top 4 players consist of more than half of the market share with trends of continuing consolidation. In addition to that, the sector has substantial barriers to entry that keep protecting incumbents.

Leading player in the industry is Givaudan (OTCPK:GVDBF) (OTCPK:GVDNY), along with International Flavors & Fragrances (NYSE:IFF), Symrise (OTCPK:SYIEF), and Firmenich (private company). In my view, Givaudan is the best-managed company for long-term exposure based on its fundamentals and business model.

Heritage Over 250 Years

Givaudan is the world’s leading flavors and fragrances manufacturer with a legacy that stretches back over 250 years. Today, the Company has a leading market share and 73 production sites worldwide. It has two business divisions: Fragrances and Flavors. The Company also engages in research and development activities into perfumery raw materials, both synthetic and natural.

Industry Overview

F&F companies occupy a strong position in the value chain because their products make up only a small portion of the final product cost, but play a decisive role in the consumer’s purchasing decision. According to the Givaudan presentation, the share of F&F ingredients in customers’ COGS represents 4-6% in fine fragrances and 0.5-2% in flavors and consumer fragrances. On the other side, scent and taste largely determine the customer purchase decisions. Therefore, the F&F companies are in a sweet spot in the value chain, because they represent only a small portion of production costs, but a critical buying criteria.

Several megatrends support the organic growth of the industry. For instance, health & wellness, middle-class boom & urbanization, naturalness & sustainability, vegetarian/vegan/halal/kosher food, traceability, etc. In addition to that, the industry has a strong connection to population growth and disposable income, with little dependence on cyclical economic trends.

The total F&F market size is around USD26bn and is growing by an average of 4% per year in the long run. More than 500 companies are active worldwide, but the four largest producers have a market share of more than 50%. The F&F market is characterized worldwide by high barriers to entry (regulation, intellectual property, innovation, scale, global presence, preferred supplier lists, the complexity of supply chains, local taste preferences).

Recent Results & Outlook

Givaudan had a strong start to the year. In the first half of 2020, Givaudan recorded sales of CHF3.2bn, an increase of 4.0% on a like-for-like basis. The Fragrance division grew 4.5%, and the Flavors division grew 3.6% on a like-for-like basis. When we look deep into the top-line performance, we can see the relatively good performance of those parts of the portfolio which are not impacted by COVID-19. On the other side, Fine Fragrance, Fragrance Ingredients, and Active Beauty were down by 16.4% and 0.1% on a like-for-like basis respectively.

The Company had the right balance between mature and growth markets, with 58% of sales coming from mature and 42% of sales from growth markets. All regions were contributing to the growth on a like-for-like basis. The only market which was almost flat was India, given that the country has been heavily affected by the COVID-19 crisis.

EBITDA increased by 11.3% to CHF734m, while the underlying margin was remaining stable at 23.7%. At the bottom line, net income amounted to CHF413m or an 8.8% increase compared to the same period last year. Free cash flow was at the level of CHF178m or 5.5% of sales compared to 4.8% in 2019.

Balance sheet wise, the Company has a net debt (incl. pension obligations) of CHF5.2bn at the end of the first half of 2020. The weighted average effective interest rate for is 1.43%. The leverage range of 3.0-3.5x seems sustainable for a consumer goods company like Givaudan, given the free cash flow generation (CHF787m in 2019). But for future shareholders, the Company has already trod some of its flexibility.

Despite the higher debt than what it would be desirable, the maturity profile is quite favorable. Within the next 2-3 years, there is a need for refinancing of around CHF1.3bn.

The Company aims to outpace the market with 4-5% sales growth and free cash flow of 12-17% of sales, and both measured as an average over the five years. In 2016-2019, it grew sales by 5.1% and had a free cash flow margin of 12.5%.

Since 2014, the Company made 14 acquisitions, which contributed CHF1.5bn of annualized revenues. On the other side, the Company paid for M&A growth of CHF3.6bn. The strategy is to continue to grow through acquisitions by being opportunistic, disciplined, and diligent. Also, it is very assuring the Company is not going for size at all costs, rather opportunistic acquisitions. We can see from the list below that the Company strategically picks what best fits into its business model.


Since the Company has delivered its outlook in H1 2020, I will keep it as a proxy for the next five years in my valuation model. It isn’t straightforward to model potential acquisitions, so I will not include them in my model.

For 2020, I used lower bound estimates for revenues and FCF, while for the rest of the projection period, I used mid-bound forecasts of 4.5% for top-line growth and 14.5% for FCF. For the terminal growth rate, I used 3%, which is consistent with world economic growth. I set a discount rate at 6%, but if someone uses 5% or 7%, the intrinsic value is CHF4,797 and CHF2,109, respectively.


Putting all the pieces together, we can conclude that Givaudan is in an attractive industry with a strong tailwind. But at the same time, we can see that these companies are trading at a higher price than my model indicate.

Therefore, it would be wise to wait for a better entry point because I don’t see a margin of safety at this valuation level. Putting all pieces into perspective, the Company would be on my list, but I would wait for a better entry point.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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How Tesla defined a new era for the global auto industry By Reuters

© Reuters. FILE PHOTO: Tesla Inc CEO Elon Musk walks next to a screen showing an image of Tesla Model 3 car during an opening ceremony for Tesla China-made Model Y program in Shanghai


By Edward Taylor, Norihiko Shirouzu and Joseph White

FRANKFURT/BEIJING/DETROIT (Reuters) – Tesla Inc’s (O:) rapid rise to become the world’s most valuable carmaker could mark the start of a new era for the global auto industry, defined by a Silicon Valley approach to software that is overtaking old-school manufacturing know-how.

Tesla’s ascent took many investors by surprise. But executives at Daimler AG (DE:), the parent company of Mercedes-Benz, had a close-up view starting in 2009 of how Tesla and its chief executive Elon Musk were taking a new approach to building vehicles that challenged the established system.

Daimler (OTC:), which bears the name of the man who invented the modern car 134 years ago, bought a nearly 10% Tesla stake in May 2009 in a deal which provided a $50 million lifeline for the struggling start-up.  

That investment gave Mercedes engineers an inside view of how Musk was willing to launch technology that wasn’t perfect, and then repeatedly upgrade it, using smartphone style over-the-air updates, paying little regard to early profitability.

Mercedes engineers helped Tesla develop its Model S luxury sedan in exchange for access to Tesla’s partially hand-assembled battery packs, but in 2014 Daimler decided to sell their stake amid doubts Tesla’s approach could be industrialized at scale.

Tesla would go on to pioneer new approaches in manufacturing, designs in software and electronic architecture which enable it to introduce innovations faster than rivals, leaving analysts to draw comparisons with Apple (O:).

Three people directly involved with the Mercedes side of the collaboration said the brief partnership highlighted the collision of old and new engineering cultures: the German obsession with long-term safety and control, which rewarded evolution, and the Silicon Valley carmaker’s experimental approach which embraced radical thinking and fast innovation.

“Elon Musk has been walking on the edge of a razorblade in terms of the aggression with which he pushes some technologies,” said a former Mercedes engineer who worked on the partnership.

By contrast, Mercedes and other established automakers are still not comfortable about releasing a new technology, such as partially automated driving, without years of testing.

Tesla did not respond to requests for comment.

Investors favor the Tesla model, in an industry undergoing fundamental and dizzying change even though the U.S. carmaker will face an onslaught of competing electric vehicles from established automakers during the next few years.

They are putting their money on Musk and his company, even though Mercedes-Benz alone sold 935,089 cars in the first half of 2020, dwarfing the 179,050 delivered by Tesla in the same period.

Today, Tesla is worth nearly $304.6 billion, more than six times Daimler’s 41.5-billion-euro ($47.7 billion) market capitalization. See GRAPHIC:


Daimler and Tesla began collaborating after Mercedes engineers, who were developing a second-generation electric Smart car, bought a Tesla Roadster. They were impressed by the way Tesla packaged batteries, so arranged a visit to Silicon Valley to meet Musk in January 2009 and ordered 1,000 battery packs.

The collaboration expanded. At a joint press conference in the Mercedes-Benz museum in Stuttgart in May 2009, Tesla said the partnership would “accelerate bringing our Tesla Model S to production and ensure that it is a superlative vehicle”.

For its part, Mercedes wanted to use Tesla’s batteries to power an electric version of its compact Mercedes-Benz B-Class. The Tesla Model S would hit the road in 2012. An electric B-Class, arrived in showrooms two years later.

Despite having batteries supplied by Tesla, the Mercedes had a shorter operating range after Daimler engineers configured the B-class more conservatively to address their concerns about long-term battery degradation and the risk of overheating, a second Daimler staffer who worked on the joint projects told Reuters.

German engineers found that Tesla engineers had not done long-term stress tests on its battery. “We had to devise our own programme of stress tests,” the second Daimler engineer said.

Before starting production of a new car, Daimler engineers specify a “Lastenheft” – a blueprint laying out the properties of each component for suppliers. Significant changes cannot be made once the design is frozen.

“This is also the way you can guarantee that we will be profitable during mass production. Tesla was not as concerned about this aspect,” the second Daimler source said.

Daimler’s engineers suggested the underbody of the Model S needed reinforcing to prevent debris from the road puncturing a battery pack, the first Daimler engineer said.

To quash doubts about safety and security, following a series of battery fires, Tesla raised the ride height of its vehicles, using an over-the-air update, and a few months later, in March 2014, said it would add a triple underbody shield to new Model S cars and offered to retrofit existing cars.

Musk was able to make adjustments quickly thanks to Tesla’s ability to burn through more cash during development.

“At Mercedes you can make such adjustments every three years at best,” the engineer said.

The Model S, a four-door electric sedan would go on to outsell the flagship Mercedes-Benz S-Class in the United States in May 2013, and outstrip S-Class deliveries globally by 2017.


Musk’s relentless focus on innovation explains, in part, why he has disrupted the traditional auto world. In an interview at the 2020 Air Warfare Symposium, published on YouTube, he was asked about the importance of innovation among his employees.

“We certainly need those that do advanced engineering to be innovative,” Musk said. “The incentive structure is set up … such that innovation is rewarded. Making mistakes along the way does not come with a big penalty. But failure to try to innovate at all … comes with a big penalty. You will be fired.”

Established automakers are playing catch-up to Tesla, designing their own software operating systems and dedicated electric cars.

Mercedes will release its EQS next year – a four-door limousine built on a dedicated electric vehicle platform, with an operating range of 700 km. A new version of the Mercedes S-Class, which will have combustion and hybrid powertrains and semi-autonomous driver assistance systems, is due this year.

From an investor perspective, traditional players face billions of dollars in restructuring costs as they transform product lines and factories to move away from internal combustion technology

“No one is going to give an OEM (established automaker) a five-year window to say … you can totally retool your business, and I am going to buy in and fund this journey,” said Mark Wakefield, co-leader of automotive and industrials practice at consulting firm AlixPartners.

Start-ups, however, get time from investors to learn, make mistakes and grow, he added.

Investors are betting on Tesla’s ability to scale up manufacturing just as they once backed Toyota Motor Corp (T:), which defined the auto industry’s last era with its mastery of highly efficient, high-quality lean production.

Toyota overtook the market capitalization of former industry leader General Motors  (N:) in 1996, though it wasn’t until 2008 that it sold more vehicles than its Detroit rival.

The Japanese giant also cultivated ties with Tesla, with the U.S. startup helping it design an electrified RAV4 compact sports utility vehicle under a 2010 deal.

Toyota was impressed by the speed with which Tesla came up with the new design, but ultimately decided Tesla’s methods were not suitable for mass production by a mainstream manufacturer when Toyota’s standards for product quality and durability were applied, two company insiders familiar with the partnership said.

Toyota said the joint project involved cooperation on the development of electric cars, parts and production system.

“Toyota accomplished what the project set out to achieve, and it ended in October 2014 after Tesla delivered roughly 2,500 electric powertrain systems over three years” for an electrified RAV4 crossover SUVs, a spokeswoman said.

Both the Toyota and Daimler collaborations were agreed before the Volkswagen (DE:) emissions-cheating scandal in 2015, which prompted a global regulatory backlash and forced carmakers to step up investments in electric cars.

“That was all before dieselgate, which changed the economics of electric and combustion-engined cars,” a senior Daimler manager said. “Tesla has a lead. Let’s see if they can scale up.”

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Meet the man who’s been behind nearly every evolution of the fund industry for two decades

To call him financial services’ Forrest Gump might be a stretch, but Carlos Diez has been behind the scenes of just about every big fund-industry pivot for the past two decades. At the height of the dot-com boom, he saw the business opportunity of a growing consumer class interested in investing, then, a few years later, anticipated the future in indexing.

He’s had some crummy timing, though: It took so long to get his firm, MarketGrader, off the ground that the dot-com bubble popped and the U.S. entered a bear market. Several years later, an asset manager launched a suite of funds based on MarketGrader indexes. That was in October 2007 — just as the cracks were starting to form in the global financial system, and at the very peak of that market cycle.

Diez says he’s learned from the downs as well as the ups, and he’s humble about it: The funds were closed in March 2009, just as the longest bull market in history was starting up. In the following decade, those indexes outperformed their benchmarks, returning 374%, compared to 318% for the S&P 500


MarketWatch spoke with Diez about his career starting new things, and then starting again, as well as what he’s thinking about now. The interview that follows has been edited for clarity.

MarketWatch: Could you share your biography?

Carlos Diez: I actually started the company right out of college. I went to college in California and graduated in 1999, so I went through all the dot-com experiences as a student. A lot of buddies of mine in college were, quote-unquote, investing in the stock market. I remember teammates on my soccer team would come and say, “I bought this or that,” and I would say “what do they do?” They would say “I have no idea, but they’re up 30%.”

I thought I could build a tool that would help investors understand what they’re buying. That was the genesis of MarketGrader. It took a little bit longer than I thought to get all the pieces together. And there was a big bear market that affected our launch plans. When we launched, in 2003, we started research for some institutions, some sell-side, some investment banks, and in parallel to that we started building our indexes. It was accidental, if you will. We were putting out ratings on companies in the U.S. and Canada and only 15% of companies were a “buy,” and people said, what’s going on here? So we said, let’s build a model portfolio of the best companies in MarketGrader. We didn’t want to overweight the largest companies because we saw what happened in the late 1990s and early 2000s. So it was the 40 best companies in MarketGrader, equally weighted, and we rebalanced every six months. Dumb luck had it that that happened to be a banner year for stocks, so we did very well. This was well before smart beta and things that are so hot today.

We had built a good relationship with (asset manager) London & Capital and plowed head-on into the ETF space. I had always thought ETFs were going to be the next big thing in the space. We launched our first ETFs in October 2007 at the very top of the market. We rode the 2008-2009 market down and eventually the company (closed the funds). That was a big hit to our business.

Concurrently, we were developing a relationship with Dow Jones. We met the editors of Barron’s in 2004. At the time, Barron’s online was a novel product. Barron’s wanted to find a tool that rated stocks like we did to complement their writers’ analysis. We built a tool called StockGrader to go alongside the new that launched in 2005. And because we were having success in the index business, we met with Dow Jones Indexes in 2007 and created the Barron’s 400. (MarketWatch note: an ETF based on the index, the Barron’s 400 ETF

, launched in 2013.)

About six years ago, we really started focusing on building out our company globally. We were particularly focused on Asia, specifically China. I started visiting China in 2004-’05, and we built a family of A-share indexes there. CSI (China Securities Index Co.) is owned by the two stock exchanges which are, by extension, owned by the state. We co-created two indexes that they started publishing and eventually we licensed one to VanEck in Australia, which has been doing really well. That was the beginning of our global expansion. VanEck in New York converted two of their ETFs to use MarketGrader benchmarks, one on China and one on India.

Related:The man behind Case-Shiller on why the housing index has no Houston and why that’s no problem

MarketWatch: Can we go back to the October 2007 launch, and could you just talk a little about your feelings about being at the mercy of timing?

Diez: A few years ago, that was a big source of frustration for me personally and professionally. I felt like we were on our way and things happened that we couldn’t control, not just a huge market event, but the fact that our client decided to exit the business. It was very frustrating. But now in hindsight, it was actually a good experience. I know that might sound masochistic, but we learned a lot. We learned about how to get involved and when not to get involved in the development of products, and how important it is, if someone goes out to offer an investment product to a client, it’s as important for the provider of that fund to know there’s a match between the two as it is for the seller of the fund. If you sell someone a long-term capital appreciation strategy but the client is maybe focused on making money in the next couple of weeks or jumping on a bandwagon that might be doing well, it’s bound to wind up disappointing the client. We learned a lot about that process. We’re not a product provider but we’ve try to work very closely with them — London & Capital, VanEck and ALPS (the distributor of the Barron’s 400 ETF.)

From a company-specific perspective, to be honest, in those early years we were doing fairly well and growing organically and thought that could continue, so we never sought a bigger partnership or more capital from a larger institution, we thought we could do it alone. In hindsight that was a mistake. It’s important to have the capital and the right partners. We were flying on our own.

MarketWatch: Has that changed?

Diez: We have taken on more capital from our existing investors, not from a larger institution. But that’s something that might happen at some point. In China specifically, we are making a concerted effort to find a partner, because for us to have success in China, although we’re fairly well-known, for us to go it alone in China is very difficult, almost impossible… All the negative things you hear about, in terms of access for foreign firms, those are all very real.

MarketWatch: You didn’t mention this much, but I’ve heard from other people that you were pretty early to the idea of smart beta, even though some other companies, like Research Affiliates, have gotten a lot more attention for their work on it.

Diez: It was partly accidental, but we did feel that it was important to offer investors something different than what was out there, meaning purely market-cap-weighted stocks in indexes. At the time, people thought stock selection in passive strategies was anathema. They’d say, “oh, it goes against our creed.” But I thought our process was transparent and it worked well, and you could call it an index because it was not one person selecting stocks. It was just an index that behaved differently.

We had latched on to London & Capital and we were a small company, growing, and they were opening up opportunities for us. Why not ride that opportunity while it lasted? So obviously things played out differently and that’s why people don’t know about us being in it early. Rafi has a very strong product. Very shrewdly and very smartly, rather than becoming a product company, they said, we’re going to license this and you can brand them your own thing, whether Pimco or Schwab or whatever. I think that was genius. I attribute a lot of their success as much to that as much as to the methodology.

MarketWatch: One of the biggest issues in the ETF ecosphere has to do with intellectual property. How do you think about that?

Diez: Long and hard. (Laughs.) I think about that often and I think, more than someone taking your idea and replicating it, there’s also the risk, especially nowadays, of someone taking your message and taking ownership of it, even if the underlying exposure isn’t as good as yours. In the early days of an ETF launch, the perception is just as important as reality. A lot of companies have the resources to go out and blast out a message that maybe might not be as much a part of their DNA as it is yours. At the end of the day, what matters is the perception from investors. That’s the biggest challenge for us, the ability to communicate is what allows people to try you out and test what you’re offering.

I spend a lot of my time helping my clients. VanEck is the perfect example. They’re a very good client to work with, and there’s a lot of overlap between our views and theirs, especially on emerging markets and on China. They see the value that MarketGrader brings to the table but they’re big enough that they have the resources to do things their way. But they don’t want to have another me-too product out there. They’d rather have something that they think is unique, and I’d like to think that’s what they see in us.

MarketWatch: We talked a lot about your interest in China, but what’s the next-next thing?

Diez: From a country-regional perspective, I think what’s happening in China will continue to be front and center for some time. We’ve made a strong case for investors having a good exposure to China, being there for a long time. It would be a mistake not to, in our opinion. But separate from that, based on what’s happened geopolitically, there’s been a clear separation of economies and markets which will continue. I don’t think there is going to be a full disengagement between the U.S. and China, but we’re starting to see some countries pushing back on some of the things China has done. India (which just banned dozens of Chinese mobile apps), for example. The U.K. announced Huawei (will be excluded from its 5G wireless network).

That will have repercussions for investors. I think there will be an opportunity to build exposures around those themes. I feel strongly about growth in some Asian countries besides China, and I think investors may choose to invest in those. I think the indexes and products out there still leave room for companies like us to build products that are differentiated.

Read next:Coronavirus was the perfect storm for tech innovation, and this fund manager made out

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Will Vanguard step on the SPDR? This technology ETF just dethroned the industry leader

In mid-May, assets in the Vanguard Information Technology ETF

overtook those in a competing fund from the company that’s long dominated exchange-traded fund sector investing, the SPDR suite from State Street Global Advisors.

It was a small industry shift that perhaps only an ETF enthusiast would have noticed, yet it may speak volumes about how the investment-management world is evolving.

The Sector SPDRs were the first ETF products to track the S&P 500’s sectors — groupings of companies according to their business activities — and remain the industry giants, in large part because their scale enables institutional investors to use them to make big trades, said Todd Rosenbluth, head of ETF and mutual fund research for CFRA.

If Vanguard’s assets are catching up to State Street’s, it means one of two things, Rosenbluth told MarketWatch: either institutional investors are starting to get comfortable enough with Vanguard to rely on it as a trading tool — or that individual investors, who have traditionally comprised most of Vanguard’s customer base, are turning to “tactical” ETF strategies.

Vanguard cut its teeth in what the fund industry calls “core” products — simple index funds that track the overall S&P 500
for example. But individual investors are getting increasingly comfortable with exchange-traded funds, and increasingly using them to express more targeted views.

The attached chart shows 10 fund pairings of the currently existing 11 sectors. The 11th sector, real estate, was created in 2016; SPDR launched a fund to track the sector shortly before that. In contrast, Vanguard’s original sector lineup, which dates from 2004, has always included real estate. That fund has nearly $29 billion in assets, compared with $4.1 billion in the newer SPDR fund.

It’s only fair to point out that Vanguard’s footprint in the other sector funds remains quite small, compared against the corresponding SPDR funds. Next to real estate

and technology
health care

is the sector in which it has the largest presence, and there, its assets are still less than half those of the SPDR fund.

But Vanguard’s explosive growth rate is a story unto itself. The firm, once considered a financial-services underdog, now has more assets under management than its next three competitors combined. That’s thanks largely to individual investors.

See:Three fund managers may soon control nearly half of all corporate voting power, researchers warn

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