Category: COWZ

Pacer Paves The Way

Pacer’s US Cash Cows 100 ETF (BATS:COWZ) leads the herd in low-cost, profitability-based, retail-accessible, indexed investment vehicles. This ETF with a provocative name has amassed $12.8 B in assets over its short tenure, and has certainly not been lacking in its investment returns: 12.76% since inception compared to the S&P 500’s 12.25%. Pacer proudly advertises COWZ’s impressive free cash flow (FCF) yield over the competition as the main reason it’s able to beat the market.

Pacer correctly argues that the free cash flow-enterprise value ratio (FCF/EV) has been among the best-performing stock screens since the end of 1991. From an academic pricing factor standpoint, it’s sort of a hybrid metric that targets both the Fama-French profitability (via FCF) and value (via EV) factors. Conveniently, both profitability and value have direct ties to the discounted cash flow model. A two-pronged approach to increase discount rates (i.e. your expected return) is surely a good thing.

However, Pacer’s choice of axes is a bit misleading. I don’t want to copy the table without permission, but The Novel Investor identifies (from 2000-2020) that despite higher returns, the top decile of FCF yield stocks suffered hideous drawdowns compared to more “average” stocks. You may have fewer negative years, but the negative years are worse than usual. As we expect from an efficient market, there are no free lunches. And that includes COWZ.

This isn’t FCF yield’s only drawback, however, and it’s important to understand all of them. As Pacer admits, only 15% of analysts consider FCF yield when valuing companies, which is even less than dividend yield (and as we know from Miller and Modigliani, dividend yield is irrelevant).

Let’s be honest with ourselves – if FCF yield was such a good metric, then why isn’t everybody using it?

The Problems With COWZ’s Strategy

Free cash flow isn’t a “pure” metric. By definition, it is equal to cash flows less capital expenditures (CapEx). By looking only at FCF, CapEx is getting swept under the rug.

Why does this matter? Because the best way to have a high FCF is by having a very low CapEx. If your company has, say, $100M in FCF, wouldn’t you want to invest it back into the company? A company that spends all of its money growing the business would have the same FCF as a company that makes no money, just because the growing company has a high CapEx.

You may not want to grow your company because you’re committed to giving back to your shareholders. Pressure to pay investors is real, and is one possible reason why FCF/EV is such a strong strategy – executives don’t want to take risk with their excess cash and just pay investors.

Alternatively, you may not want to grow your company because there’s no more room for growth – you’re at your peak, and it’s all downhill from here. Or, there’s something seriously wrong with your business or your industry, and investors discount your stock accordingly.

For example: do we think that the behemoth of cash cows, Apple (AAPL), has a high FCF yield? Of course not. Earlier this year, Seeking Alpha analyst Frederik Mueller correctly identified AAPL as a buy when it had an FCF yield of 5.13%, which is much lower than COWZ’s average 12.05%. COWZ does not own Apple shares. Ironically, this is because Apple invests in itself with its free cash flows.

I would hazard that all of these rationales are at play in COWZ’s stock selection. A Fama-French 5-factor regression suggests that there are certainly some well-to-do conservative companies, i.e. the real cash cows, but there are also a lot of “mad cows” – heavily discounted value stocks that incidentally have high FCF/EV numbers.

Of course, these factor loadings are impressive even for dedicated factor ETFs; COWZ even managed to pick up some (statistically insignificant) alpha. Which leads us to the next issue: concentration. It is difficult to maintain such a high FCF/EV ratio without high concentration, which requires frequent turnover.

Only 100 stocks are in the ETF, and the top 10 holdings constitute 22% of assets by weight. Not to mention, with a turnover of 114%, the stocks are hardly held for a long duration. (I would not think turnover costs are significant – all of the constituent stocks are very liquid – but it’s definitely not desirable.) One would hope that these profitable mid-caps are wonderful businesses, but as discussed earlier, one cannot be sure that these are not cigar butts.

My main issue with this ETF is that it’s screening only employs one single metric. We would expect a consortium of metrics to outperform any individual metric, and one single metric to be inadvertently short some other metric. As an analog, consider the Invesco S&P SmallCap 600 Pure Value ETF (RZV). RZV gets away with deep value exposure, but struggles with significant negative momentum – and RZV even considers multiple metrics.

Indeed, using the Fama-French 4-factor model, we can see that COWZ has been negatively impacted by price momentum with a p-value of about 0.04. It would not surprise me if a competitor ETF were released that addresses this issue, for example through patient trading or less naïve fund construction.

Other Seeking Alpha analysts similarly note that COWZ’s main drawback is its use of historical FCF/EV instead of forward-looking FCF/EV, which makes it susceptible to chasing past performance (i.e. buying up previously well-performing stocks in cyclical sectors that are due for a correction). I’m not sure if forward-looking FCF/EV is the solution (because anything forward-looking suddenly becomes speculative), but evidently, there is room for improvement.

To summarize, it’s important to recognize that profitable stocks trading at value levels are not a free lunch. It means the market is pricing in tremendous risk, for example, to future cash flows. On one hand, taking that risk is where you get your return. On the other hand, it’s unclear whether COWZ is taking those risks in an efficient manner. The markets are too complex to employ single-metric screens and hoping it pays off, even if your metric is half-decent.

What COWZ Gets Right

Certainly, there are some redeeming qualities for this fund, which is why I cannot advise to sell it at all costs.

Pacer is steadfast in its commitment to bringing its investors all the advantages of indexing. Accordingly, it comes with a relatively low expense ratio: 0.49%. COWZ’s expenses are certainly much higher than a regular S&P 500 index fund, but the expense ratio is still tolerable. Importantly, if you want to stick to the strategy, you do not want to turn over 114% of your portfolio every year on your own. It’s easier if you pay someone else to do it. Thanks to the ETF structure, you’re also unlikely to pay capital gains taxes on this turnover.

At least for now, I like COWZ’s exclusion of mega caps. (I’m an acolyte of the size premium.) COWZ does have a slight preference for smaller caps, which I’m happy about, but I don’t think it needs to go smaller. While factors are observed to be stronger in small caps (not to mention the much-maligned size premium), this is less of a story with the profitability factor, where it only makes sense that large firms have the widest profit margins. Moreover, if we’re turning over 114% of our portfolio, we’d prefer to do it in large caps where frictional trading costs are lower.

Generally, I like the holdings. These are probably not market-cap-stable companies, but they have been and will be around for a while. I trust in their longevity.

Alternatives To COWZ

For me, COWZ is too extreme. I’d rather diversify among hundreds of more stocks and target multiple metrics instead of just one. This obviously comes at the cost of expected returns, but if your goal is to minimize “going to zero” tail risk, then broad diversification, beyond 100 stocks, is mandatory. Accordingly, the Avantis US Small Cap Value ETF (AVUV) is what I use in my portfolio, though there exist similar ETFs.

Because COWZ appears to be a differently-branded mid-cap value fund, the Alpha Architect US Quantitative Value ETF (QVAL) could be an alternative as a concentrated multi-factor ETF. According to the ETF Research Center, COWZ has a 30% holdings overlap by weight with QVAL, which similarly targets a handful, 50, of value stocks. QVAL is actively managed, but then again, COWZ is de facto actively managed too (it makes its own index).

Verdict: COWZ Requires A Leap of Faith

If you believe in stock picking using only an FCF/EV screen, then go for it and hope you didn’t join in right before the coming recession. You’ll be hard-pressed to find a more courageous ETF. COWZ markets this niche phenomenally, but I think it’s just that: marketing.

You’d be disillusioned to think that you’re investing in a basket of blue-chip low-beta stocks (even if some of them are). It’s clearly a volatile product, and it has high expected returns because of the compensated risk being taken, not because the cash cows (or “mad cows”) make money. A factor regression confirms that past performance has largely been influenced by exposure to known risk factors (mostly above-average market beta), and not the inherent superiority of FCF/EV to deliver market-beating returns. On the contrary, these compensated factor risks are probably not being taken in an efficient way because FCF is a sort of synthetic metric that is strongly affected by company-discretionary variables (i.e. CapEx). Moreover, because COWZ relies on the past performance of this one single metric, I think it’s not a smart product. I do not own any shares. But, for sure, the ticker is probably “going up”. Index funds are cash cows in the long run.

Final thought: I would not want to tell my family that our life savings are in an ETF called COWZ.

Investment Thesis

It’s been one year since I reviewed the Pacer US Cash Cows 100 ETF (BATS:COWZ), arguing that using trailing instead of estimated free cash flow was a critical flaw in the selection process. It took time for the thesis to play out, but COWZ ETF has been slow to unwind some of its riskier commodity-related holdings. Meanwhile, several low-cost value and dividend funds were safer bets as the market declined. Today’s article provides an updated thesis and a past performance analysis of over 30 alternative ETFs. COWZ continues to look strong on the profitability and valuation metrics it screens for but needs to improve its growth, concentration, and volatility metrics. Therefore, I urge readers to be careful with COWZ. Otherwise, they’ll risk giving back some of its extraordinary gains over the last five years.

COWZ Overview

COWZ tracks the Pacer US Cash Cows 100 Index, selecting Russell 1000 securities based on free cash flow yield. Its fact sheet provides a compelling reason for investing based on this metric, defined as a company’s total free cash flow relative to its enterprise value. As of December 31, 2022, the Index’s free cash flow yield was 12.48% compared to 3.64% for the Russell 1000, so selections typically trade at low valuations.

Financial securities, except for REITs, are excluded, and rebalancing occurs quarterly on the third Friday in March, June, September, and December, leading to high portfolio turnover. I previously determined that the initial selection universe is based on projected free cash flows and earnings over the next two years, with companies removed should they have negative average projected cash flows or earnings. However, despite the availability of forward-looking information, I was surprised to find out that selections are based on trailing twelve-month free cash flow (not free cash flow yield). Others disagreed with me at the time, reasoning that frequent rebalancing meant the Index would quickly change gears if necessary. Nevertheless, Energy exposure increased above 35% after last week’s rebalancing. U.S. inflation cooled to its lowest level since September 2021, resulting in relatively poor recent returns.

COWZ has $12.5 billion in assets, an incredible achievement in just over seven years for one of the lesser-known providers. It’s Pacer’s own cash cow, and I could only find three ETFs with better growth rates over that period:

1. JPMorgan Equity Premium Income ETF (JEPI)
2. Dimensional U.S. Core Equity 2 ETF (DFAC)
3. iShares ESG Aware MSCI USA ETF (ESGU)

In addition, COWZ has a 0.49% expense ratio but is liquid with a minimal 0.02% median bid-ask spread. These features help attract investors who want something closer to active management. For context, the average expense ratio is 0.62% for the nearly 200 actively-managed U.S. equity ETFs I track, so COWZ’s fees aren’t a deal-breaker. If it can deliver, then the fees are justified.

Performance Analysis

I initially covered COWZ at the request of a few readers, and after looking at COWZ’s track record, it was easy to understand the interest. For the one year ending March 2022, COWZ’s 23.55% gain ranked first-best among 170 U.S. large-cap blend and value-focused ETFs. For the period ending March 29, 2023, COWZ’s 5.14% decline ranked #34. That’s still an excellent result considering SPY’s 9.62% loss. However, the wheels are starting to come loose. COWZ’s latest one- and three-month returns ranked only #135 and #112. If inflation continues to fall, I expect more of the same moving forward.

COWZ’s selection universe is a large-cap blend Index, but its holdings are more value-oriented. Therefore, I want to benchmark its returns against both using the SPDR S&P 500 Value ETF (SPYV) and the SPDR S&P 500 ETF (SPY).

The above graph highlights COWZ’s 12.72% annualized return since January 2017, 3.72% and 0.97% better than SPYV and SPY. The disadvantage was higher volatility, but this feature is sometimes positive. Many investors consider it an opportunity, like those who bought into the strategy after the Q1 2020 crash.

However, pay attention to COWZ’s poor performance up until its recovery began in April 2020. Through March 2020, COWZ’s annualized 1.32% loss was 2.36% and 7.85% worse than SPYV and SPY. Therefore, I’m reluctant to assign credit to the free cash flow yield strategy. COWZ held stocks in the right sectors at the right time. Other ETFs, like HDV, DHS, and FDL, also did well because they overweighted Energy stocks, so the key is understanding overall market conditions first.

The following table highlights historical returns for 34 large-cap ETFs with at least $5 billion in assets and a five-year track record, including COWZ. Figures exclude the last two days of March but should be sufficient for these purposes.

COWZ ranked better than average in this sample of the most popular large-cap funds over the last year. The WisdomTree U.S. Dividend Growth ETF (DGRW) was the top performer with a 1.67% decline, and Dividend Aristocrat ETFs like SDY and NOBL also performed well. Also worth noting is how the VanEck Morningstar Wide Moat ETF (MOAT) soared over 11% this year. I got that call wrong last September, viewing its additional volatility as a negative, given poor market sentiment at the time. As a result, I didn’t see the January tech boom coming, and Energy stocks also proved beneficial.

My pessimistic view on volatility is also a critical risk to my thesis. There’s every chance I’m wrong on inflation and the Energy sector, and the fund will return to its winning ways. Still, staying within your risk tolerance and avoiding funds with questionable strategies is essential. I’ll identify COWZ’s limitations shortly, but first, let’s look at its composition at the sector and company level.

COWZ Analysis

Sector Exposures and Top Ten Holdings

The following table summarizes sector exposures for COWZ, SPYV, and SPY. I also included the Invesco Russell 1000 Dynamic Multifactor ETF (OMFL) based on the comments of another article. Another Seeking Alpha contributor recently covered OMFL for the first time, and I will try to provide some additional color to this exciting fund.

COWZ has 35.80% exposure to Energy stocks, followed by 18.86% and 13.38% in Health Care and Materials. That concentration alone makes it a risky offering. According to the SPDR Sector Tracker, these sectors fell out of favor over the last quarter. Energy and Health Care are down 5.78% and 6.56%, while the S&P 500 Index is up 4.64%.

SPYV, SPY, and OMFL look more balanced, making them more appropriate for passive buy-and-hold investors. COWZ can work but requires more attention, as you can’t expect it to react swiftly to changing market conditions. To illustrate, consider that COWZ’s allocation increased to 35.80% from 31.70% in January, primarily due to rebalancing to target weights rather than any new additions and deletions. I reiterate that the Index relies too heavily on historical information.

COWZ’s top ten holdings are listed below, totaling 21% of the portfolio. The maximum weighting per stock is 2% at each rebalancing, so names like Cisco Systems (CSCO), AbbVie (ABBV), and Occidental Petroleum (OXY) represent some of the better-performing stocks over the last two weeks. The most significant Energy change was a 0.72% exposure increase to HF Sinclair Corporation (DINO). Treat this as a straightforward “buy the dip” move after the company missed Q4 earnings expectations.

COWZ Fundamentals

The following table highlights selected fundamental metrics for COWZ’s top 25 industries, updated to reflect the latest GICS changes. I also included summary metrics for SPYV, SPY, and OMFL.

I want to highlight how all four ETFs have different features. COWZ’s 1.28 five-year beta reflects the higher volatility described earlier. SPYV moved closer to SPY on volatility after its December reconstitution, and OMFL is a low-volatility ETF, at least momentarily. I don’t see COWZ as an alternative to either choice, but more of a compliment when conditions warrant it.

COWZ’s fact sheet illustrates how well its selections look on a free cash flow yield basis. Therefore, it’s no surprise that COWZ trades at just 11.93x forward earnings and 6.41x trailing cash flow, 12 and 23 points cheaper than SPY. Pacer is no different than any fund provider as they highlight the metrics that make the fund most attractive. Free cash flow yield is important but only covers two broad categories (profitability and valuation). The ones listed above are also worth considering.

For instance, COWZ’s constituents increased sales by an annualized 15.84% over the last five years, but analysts expect 4.73% growth over the next year. SPYV, SPY, and OMFL’s expected sales growth rates are also lower but not nearly the same magnitude. COWZ has 28% exposure to Oil & Gas E&P and Services stocks, and expected sales growth is roughly half what it was before. It’s concerning that these Energy stocks drive the already weak overall sales growth factor. Oil prices are unpredictable, and there needs to be more growth potential elsewhere to balance the portfolio. Nearly every other industry listed has low-single-digit or negative expected sales growth. The exceptions tend to be volatile industries like Hotels, Resorts, and Cruise Line stocks like Booking Holdings (BKNG) and Expedia Group (EXPE). The same logic applies to EBITDA growth, of which COWZ’s 6.39% rate is the weakest.

I also want to highlight COWZ’s 9.44/10 Profitability Score, derived using individual Seeking Alpha Factor Grades. It’s a terrific feature, but the average profitability score for the 170 large-cap funds referenced earlier is 8.98/10. Given how the initial screen for large-cap stocks addresses profitability already, I question the additional benefit of the free cash flow screen. Its benchmark Index, the Russell 1000, scores 9.13/10, and OMFL’s multi-factor approach resulted in an even better 9.66/10 score. In the end, COWZ seems mostly a deep-value but highly volatile play.

Finally, COWZ’s 5.49/10 EPS Revision score is slightly above the 5.41/10 category average. I use this as a leading indicator for market sentiment, and it helped me identify high-dividend and value stocks as the safest funds last year. Still, excessive Oil & Gas E&P exposure is now a burden rather than a benefit. Consider the following Seeking Alpha Factor Grades for COWZ’s top ten holdings in this industry.

On the other hand, OMFL looks solid on most metrics relative to COWZ except valuation. I also like that it’s less volatile, and its total 10% Energy exposure is sufficient. It’s high enough to help counter inflation but is manageable.

Investment Recommendation

COWZ’s flaw is its use of trailing free cash flow metrics rather than forward-looking ones. As a result, COWZ continues to double down on Energy stocks even as inflation recedes to its lowest level since September 2021. It’s evidence that confirms how frequent reconstitutions are insufficient if forward-looking metrics differ so much from historical ones. Regardless, 35% Energy exposure is too much and contributed to relatively poor returns over the last quarter. That’s the danger of investing in a concentrated and volatile fund.

This article compared COWZ’s fundamentals with SPYV, SPY, and OMFL. The former two are passive options that reconstitute just once annually, so there’s a solid chance this analysis may be valid later this year. I am less familiar with OMFL, but its Index is reviewed monthly and targets low volatility, momentum, quality, size, and value factors. I like this multi-factor approach more in uncertain environments and suggest COWZ shareholders reconsider the risks of this previously poor-performing ETF. Thank you for reading, and please feel free to leave a comment below to continue the discussion.

Author’s note: This article was released to CEF/ETF Income Laboratory members on February 1st.

I last covered the Pacer US Cash Cows 100 ETF (BATS:COWZ), an index fund investing in U.S. stocks with above-average free cash flow / FCF yields, in early 2022. In that article, I argued that COWZ’s cheap valuation could lead to strong, market-beating returns moving forward, making the fund a buy. COWZ has significantly outperformed relative to the S&P 500 since, as expected.

COWZ’s holdings remain incredibly cheap, and so the fund remains a strong investment opportunity, and a buy. On the other hand, COWZ is currently overweight the volatile energy industry, which increases risks, and might prove to be a deal-breaker for more conservative investors or energy bears. With a 1.9% dividend yield, the fund is an ineffective income vehicle.

COWZ – Basics

• Investment Manager: Pacer ETFs
• Expense Ratio: 0.49%
• Dividend Yield: 1.87%
• Total Returns CAGR 5Y: 12.24%

COWZ – Overview

Strategy and Holdings

COWZ is an equity index ETF, tracking the Pacer US Cash Cows 100 Index. It is a relatively simple index, which includes in the 100 companies with the highest FCF yields within the Russell 1000 index, a broad-based U.S. equity index. Weights are dependent on FCFs themselves, not yields. Weights are capped at 2.0%, to ensure a modicum of diversification. COWZ the Russell 1000 index both have several other inclusion criteria, centered on liquidity, size, etc., criteria, but nothing particularly impactful.

A quick summary of the fund’s index / security selection.

COWZ’s largest holdings are as follows.

COWZ’s largest holdings all generate significant amount of FCF in dollars, as per the fund’s weighting scheme. FCF yields tend to be quite strong too, with some exceptions. These include Meta (META), the fund’s largest holding. Meta is one of the largest companies in the world, and so generates significant FCF in dollar terms with a normal, even below-average, FCF yield. It might have been simpler to use a standard market-cap weighting scheme, but this is how the fund works right now.

COWZ’s focus on cash flow is relatively rare amongst value funds, and, in my opinion, a positive. Earnings can be massaged, accounting book values rarely conform to actual market prices, but cash flow doesn’t (easily) lie, and is generally an accurate measure of a company’s financial performance. Most value funds focus on accounting earnings and book value, both of which are easy to game, while COWZ focuses on better, more informative FCF metrics.

COWZ provides investors with exposure to most relevant industry segments. The fund is currently significantly overweight energy and materials, while being underweight tech. COWZ’s industry exposures are normal for a value fund, but much more aggressive than average. The fund’s 31% allocation to energy is particularly aggressive, and means fund performance is moderately dependent on the performance of said industry / oil prices. Most equity index funds, including those focused on value stocks, have much lower energy allocations, in the 5% – 15% range.

From the above, it seems clear that COWZ is a reasonably well-diversified fund. COWZ invests in 100 companies from all relevant industry segments, and with the top ten of these accounting for around 20% of its value. Diversification reduces risk, volatility, and the probability of significant losses and underperformance, all important benefits for the fund and its shareholders. On the other hand, broader equity indexes, including the S&P 500, are a bit more diversified, with investments in hundreds of companies.

FCF Yield and Valuation

COWZ focuses on companies with above-average FCF yields, which results in a fund with an incredibly cheap valuation. COWZ itself sports an FCF yield of 12.7%, an incredibly strong figure on an absolute basis, and almost 4x that of the S&P 500. COWZ’s 6.6x PE ratio and 2.5x PB ratio are also significantly lower than average, with the S&P 500 sporting a PE ratio of 20.6x, and PB ratio of 2.5x (PB ratio figure taken from ETF.com).

COWZ’s cheap valuation is the fund’s most important characteristic and core investment thesis, and provides investors with several important benefits.

Cheap valuations could lead to significant capital gains and market-beating returns, contingent on valuations normalizing. Valuations are dependent on many factors, including company fundamentals, broader economic conditions, and investor sentiment. Higher inflation, rising commodity prices, and increased interest rates have caused valuations to normalize since early 2022, with most value equity indexes, including COWZ, outperforming since the same. Outperformance took the form of significantly reduced losses, not gains, but returns could turn positive once economic conditions settle and sentiment improves.

COWZ’s cheap valuation led to outperformance in the past and could, potentially, lead to further outperformance in the future.

COWZ’s cheap valuations has other benefits too. Specifically, cheap valuations are indicative of ample earnings and cash-flows, which serve to reduce the possibility of significant losses, and the magnitude of any losses experienced.

As an example, we have Marathon Petroleum (MPC), COWZ’s sixth-largest holding. MPC sports a 21.3% FCF yield, an incredibly strong figure. If MPC’s stock price goes down, the company can use its massive cash-flows to fund a massive dividend or stock buyback program, which would increase demand for the company’s stock, leading to a higher share price. Losses would be reduced, and, perhaps, even turned into gains. MPC engaged in a massive stock buyback program in 2022, buying more than 30% of shares outstanding. Stock prices soared as a result.

Companies with cheap valuations, like MPC, can always choose to combat declining share prices with massive dividend hikes or stock buyback programs, which reduces the magnitude of said share price declines.

Importantly, companies with frothy valuations can’t do the above. As an example, we have Tesla (TSLA), with a measly 1.0% FCF yield. Although Tesla does generate some cash, it generates little for a company of its size / market-cap. In the event Tesla’s stock price goes down, the company could use said cash-flows to fund a dividend or buyback programs, but these would be small, almost inconsequential. Investor demand would increase, but only marginally so: investors would care little about a 0.0% – 1.0% dividend yield, or from a similar-sized buyback program. Tesla would almost certainly have to endure a collapse of its share price without support from a dividend or buyback programs, so losses could mount. Tesla’s share price has declined by 65% in 2022, and there was no dividend or buyback program announced, as expected.

COWZ’s cheap valuation could lead to market-beating returns and reduced the probability and magnitude of significant capital losses, two important benefits for the fund and its shareholders. These two benefits are somewhat mediated by investor sentiment, so their impact might be muted, although that has not been the case in the recent past.

Performance Analysis

COWZ’s performance track-record is outstanding, with the fund consistently outperforming broad U.S. equity indexes and narrower U.S. value equity indexes, both by very healthy margins. Outperformance was particularly strong in 2022, a good year for value stocks and funds, but returns were strong in other time periods too. COWZ did underperform from 2019 to 2021, but only moderately so, and returns were still strong on an absolute basis. In general terms, COWZ’s performance has been strong since inception, without any significant periods of weakness.

COWZ – Looking Back

Finally, a quick look at how COWZ’s fundamentals have evolved since my last article on the fund.

COWZ’s valuation has improved, with the fund’s FCF yield increasing from 9.8% to 12.7%, and with its PE ratio declining from 10.1x to 6.6x. Valuations have improved due to general market weakness, underlying holdings earnings growth, and a shift towards cheaply valued energy stocks (from around 10% to 30%).

As COWZ’s valuation has significantly improved these past few months, capital gains and returns could remain strong moving forward. Both are somewhat dependent on investor sentiment, but COWZ’s underlying holdings could always engage in massive dividend hikes or buyback programs if share prices start to lag. They have the cash to do so, and some of COWZ’s largest holdings, including Meta and MPC, have, in fact, done so.

On a more negative note, COWZ’s shift towards energy stocks moderately increases portfolio risk and volatility, and means fund share prices and returns are somewhat dependent on energy prices and industry conditions. Expect moderate underperformance if energy starts to lag, significant if energy prices and share prices crater. Although the fund has always been overweight energy, allocations spiked these past few months, so these are important issues to consider.

As an example, COWZ underperformed the S&P 500 by around 20%, in total, from 2017 through 2021. Energy lagged during said time period, and by a lot.

COWZ fared relatively well during the above. Add another 20% in energy, and performance would have been materially weaker, around 20% – 25% lower. COWZ did not seem significantly riskier than the S&P 500 in prior time periods; it does now with such a massive allocation to energy stocks.

Conclusion

COWZ invests in U.S. stocks with above-average free cash flow yields. COWZ’s cheap valuation and strong performance track-record make the fund a buy.

ETF Trends CEO Tom Lydon discussed the Pacer US Cash Cows 100 ETF (COWZ) on this week’s “ETF of the Week” podcast with Chuck Jaffe on the MoneyLife Show.

COWZ is a strategy-driven ETF aiming to provide capital appreciation over time by screening the Russell 1000 for the top 100 companies based on free cash flow yield.

The free cash generation is likely to provide a truer valuation comparison between companies. Free cash flow is the cash left over after a company has paid expenses, interest, taxes, and long-term investments. It is used to buy back stocks, pay dividends, or participate in mergers and acquisitions.

The ability to generate a high free cash flow yield indicates that a company is producing more cash than it needs to run the business, which can then be invested in growth opportunities. Free cash flow producing companies generally have three defining characteristics – they are productive, reliable, and self-sufficient.

The companies generate more cash flow than they spend, which allows them to grow without external financing. Free cash flow is a sturdy measure of profitability than earnings, which are subject to manipulation and accounting assumptions. Lastly, as the companies are less reliant on capital markets for financing, they won’t dilute their issued company stocks.

Using free cash flow yield to measure a company’s sustainability may produce potentially higher returns and more attractive upside/downside capture over time.

Value Investing

From 1926 to 2020, there were 16 periods of sustained value outperformance, on average lasting 39 months. Over the last ten years, value has rallied only twice. The last ten years have seen the worst returns ever for US value stocks versus growth. This was even worse than during the dot-com bubble.

Rethinking value investing – there were problems with traditional measures of value. The price-to-book ratio remains a key input to all major value indexes. From 1960 to 1989, the cheapest 20% of stocks based on P/B significantly outperformed the most expensive 20%. However, from 1990 through 2020, the relative performance of the cheapest P/B stocks was much more muted.

P/B then ceased to be as effective as the economy shifted toward intangible investments that are not captured. Traditional book value makes less sense in an economy driven by intangibles, such as patents, licensing agreements, proprietary data, brand value, and network effects. What is more valuable to a company like Google? The physical buildings and the network servers inside of them, or the intangible algorithms running on those servers?

Now, companies’ value and ability to generate free cash flow mostly is a result of their intangible assets.  Traditional book value(assets minus liabilities) ignores many of the most important resources to companies today. Market leaders such as enterprise software firms generate cash flows in ways not easily recognized by conventional valuation metrics.

More free cash flow is tied to the intangible asset. Because free cash flow is less distorted by accrual-based accounting rules, measures of free cash generation are likely to provide a truer valuation comparison between firms. Looking at free cash flow in relation to enterprise value puts companies on more equal footing and presents a more comparable picture of valuation. Looking at COWZ, free cash flow yield = free cash flow/enterprise value (or market cap + debt – cash).

Listen to the full podcast episode on the COWZ:

For more podcast episodes featuring Tom Lydon, visit our podcasts category.