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.