ETF Trends CEO Tom Lydon spoke about 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 strategy-oriented ETF The goal is to achieve capital appreciation over time by reviewing the Russell 1000 based on free cash flow rate of return for the top 100 companies.
The free cash generation will likely enable a more accurate valuation comparison between companies. Free cash flow is the money left over after a company pays expenses, interest, taxes, and long-term investments. It is used to buy back stocks, distribute dividends, or participate in mergers and acquisitions.
The ability to generate a high return on free cash flow indicates that a company is producing more cash than it needs to run its business, which can then be invested in growth opportunities. Free cash flow producing companies are generally characterized by three distinguishing features – they are productive, reliable and self-sufficient.
The companies generate more cash flow than they spend and can thus grow without outside financing. Free cash flow is a solid measure of profitability as the result that is subject to manipulation and accounting assumptions. Because companies are less dependent on the capital markets for financing, they will not dilute their issued company shares.
Using free cash flow rate of return to measure a company’s sustainability can lead to potentially higher returns over time and more attractive up / down tracking.
From 1926 to 2020 there were 16 periods of sustained value outperformance with an average duration of 39 months. In the past ten years the value has only recovered twice. For the past decade, US value stocks have seen the worst returns ever compared to growth stocks. That was even worse than during the dot-com bubble.
Rethinking Value Investing – There have been problems with traditional measures of value. The price-to-book ratio remains an important input factor for all important value indices. From 1960 to 1989, the cheapest 20% of stocks by P / B fared significantly better than the most expensive 20%. However, from 1990 to 2020, the relative performance of the cheapest P / B stocks was much more subdued.
P / B was then no longer as effective as the economy shifted to unrecorded intangibles. The traditional book value makes less sense in an economy driven by intangibles such as patents, license agreements, proprietary data, brand value and network effects. What is more valuable to a company like Google? The physical buildings and the network servers they contain, or the intangible algorithms that run on those servers?
The value and ability of companies to generate free cash flow now comes primarily from their intangible assets. Traditional book value (assets minus liabilities) ignores many of the most important resources for businesses today. Market leaders such as enterprise software companies generate cash flows in ways that traditional valuation metrics cannot easily detect.
More free cash flow is tied to the intangible asset. Because accrual accounting rules make free cash flow less distorted, free cash flow measurements are likely to provide a more accurate valuation comparison between companies. If you look at the free cash flow in relation to the company value, you represent the companies more equally and convey a more comparable assessment. Look at COWZ, Free Cash Flow Return = Free Cash Flow / Company Value (or Market Cap + Debt – Cash).