ETFs Tracking Companies With High Free Cash Flows Could Be a Better Value Play

Exchange traded fund investors should consider a strategy that captures the benefits of high free cash flow yield companies, the “cash cows,” as well as how to spot and evaluate these attractive stocks.

In the recent webcast, Can You Milk More Out of Value with Free Cash Flow Yield?, Sean O’Hara, president of Pacer ETFs Distributors, pointed out that the value style has been stuck in a rut. Over the last ten years, value has rallied only twice. The last ten years have seen the worst returns ever for U.S. value stocks versus growth — this was even worse than during the dotcom bubble. In the last three years, value has given up most of its gains relative to growth since the year 2000.

O’Hara believed that this underperformance in value may be associated with the way many investors traditionally categorize the value style. Specifically, the price-to-book ratio remains a key input to all major value indexes that value investors rely upon. O’Hara noted that 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. More recently, the P/B has ceased to be as effective as the economy shifts toward intangible investments that are not captured.

The old metrics of defining company values are less pertinent in today’s market environment where more emphasis is placed on intangible assets. Consequently, O’Hara argued that traditional book value makes less sense in an economy driven by intangibles such as patents, licensing agreements, proprietary data, brand value, and network effects.

“In the 1960s, companies engaged in large manufacturing footprint-producing activities and investments in physical infrastructure to build cars, extract and refine oil, and produce chemicals or steel. These companies required tangible investments to produce tangible products,” O’Hara said.

“Now, more companies provide services or products that are differentiated by their design, innovation, and their significant research, development and intellectual property,” O’Hara added.

Instead, companies’ value and ability to generate free cash flow mostly is a result of their intangible assets.

“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?” O’Hara asked.

“Traditional book value (assets minus liabilities) ignores many of the resources that are most important to companies today. Market leaders such as enterprise software firms generate cash flows in ways not easily recognized by conventional valuation metrics,” O’Hara added.

Rather than assuming that value investing might not work, it may simply be that the most frequently used measure of value has become less relevant in a changed world, O’Hara explained. While book value or other accrual-based accounting measures may still be useful in comparing companies engaged in physical activities, they are less meaningful for the increasing number of companies engaged in intangible activities.

Alternatively, O’Hara believes that measures of free cash generation are likely to provide a truer valuation comparison between firms. More free cash flow is tied to the intangible assets mentioned. Using free cash flow yield to measure the sustainability of a company may produce potentially higher returns and more attractive upside/downside capture overtime.

“Looking at free cash flow in relation to enterprise value puts companies on more equal footing and presents a more comparable picture of valuation,” O’Hara said.

Investors interested in the free cash flow metric now have several ETF options to choose from. For instance, the Pacer Global Cash Cows Dividend ETF (NYSEArca: GCOW), the Pacer US Cash Cows 100 ETF (NYSEArca: COWZ), the Pacer US Small Cap Cash Cows 100 ETF (BATS: CALF), the Pacer Developed Markets International Cash Cows 100 ETF (BATS: ICOW), the Pacer Emerging Markets Cash Cows 100 ETF (NasdaqGM: ECOW), the Pacer US Cash Cows Growth ETF (BUL), and the Pacer Cash Cows Fund of Funds ETF (HERD) all implement free cash flow yield screens to narrow their investing universes.

O’Hara also highlighted Pacer’s recently launched dividend strategies for investors seeking higher income potential. Investors can look to two new unique, dividend-focused ETFs that are now available on the New York Stock Exchange. The first fund is the Pacer Metaurus US Large Cap Dividend Multiplier 400 ETF (QDPL), which seeks to provide cash distributions equal to 400% of the S&P 500 dividend yield in exchange for modestly lower exposure to the price return performance of the S&P 500. The second, the Pacer Metaurus US Large Cap Dividend Multiplier 300 ETF (TRPL), seeks to provide cash distributions equal to 300% of the S&P 500 dividend yield in exchange for modestly lower exposure to the price return performance of the S&P 500.

Financial advisors who are interested in learning more about free cash flow yield can watch the webcast here on demand