Free Cash Flow May Help Investors Avoid Unprofitable Small Caps

A significant portion of small caps are unprofitable, making it essential for investors to fully understand the composition of their small-cap exposure.

40% of small caps in the Russell 2000 Index are unprofitable, according to an article from Kiplinger’s published earlier this year, and very few small-cap companies generate meaningful free cash flow. Free cash flow serves as a premium valuation metric, particularly in the small-cap space, as it can spotlight operational efficiencies and strength on balance sheets.

Free cash flow is the company’s remaining cash after accounting for operating expenses and capital expenditures. It represents a company’s ability to grow its business, pay dividends, or pay down debt. The value of a company is the present value of its future free cash flow.

Additionally, with higher interest rates, companies may be forced to increase leverage. Small caps can be particularly negatively impacted as they could be forced into variable-rate debt as opposed to fixed debt.

Furthermore, since small caps seldom generate significant free cash flow, these companies are also often required to take on debt to fund operations.

Avoid Unprofitable Small Caps With SFLO

The VictoryShares Small Cap Free Cash Flow ETF (SFLO) serves as a solution for investors looking to invest in the compelling growth potential of small caps while weeding out unprofitable names.

See more: “VictoryShares’ Small-Cap Free Cash Flow ETF Enhances Exposure

SFLO tracks the Victory U.S. Small Cap Free Cash Flow Index, which screens companies for historical and projected free cash flows. It then goes a step further by eliminating the slowest-growing companies to seek better outcomes in both growth and value markets.

SFLO’s underlying Index uses the VettaFi US Equity Mid/Small-Cap 2500 Index1 as the universe of eligible securities. Compared to other small-cap funds, this effectively expands the universe by including both small- and mid-cap companies.

Importantly, small caps that succeed in generating high free cash flow tend to exhibit higher quality and lower valuations.

For more news, information, and analysis, visit the Free Cash Flow Channel.

VettaFi LLC (“VettaFi”) is the index provider for SFLO, for which it receives an index licensing fee. However, SFLO is not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of SFLO.

1/ The VettaFi US Equity Mid/Small-Cap 2500 Index consists of market cap weighted U.S. small- and mid-cap stocks.

Disclosure Information

Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. To obtain a prospectus or summary prospectus containing this and other important information, visit Read it carefully before investing.

All investing involves risk, including the potential loss of principal. Please note that the fund is a new ETF with a limited history. The Fund has the same risks as the underlying securities traded on the exchange throughout the day. Redemptions are limited, and commissions are often charged on each trade. ETFs may trade at a premium or discount to their net asset value. The Fund invests in securities included in, or representative of securities included in, the Index, regardless of their investment merits. The performance of the Fund may diverge from that of the Index. Investments concentrated in an industry or group of industries may face more risks and exhibit higher volatility than investments that are more broadly diversified over industries or sectors.

Derivatives may not work as intended and may result in losses. Large shareholders, including other funds advised by the Adviser, may own a substantial amount of the Fund’s shares. The actions of large shareholders, including large inflows or outflows, may adversely affect other shareholders, including potentially increasing capital gains. Investments in mid- and small-cap companies typically exhibit higher volatility.. In addition to the normal risks associated with investing, investing in companies with high free cash flows could lead to underperformance during periods when such investments are unpopular, and fluctuations in market conditions, industry disruptions, or company-specific factors may jeopardize the generation of free cash flow.

The value of your investment is also subject to geopolitical risks such as wars, terrorism, environmental disasters, and public health crises; the risk of technology malfunctions or disruptions; and the responses to such events by governments and/or individual companies.

Additional Information

The Victory U.S. Small Cap Free Cash Flow Index aims to select high quality companies from its starting universe by applying profitability screens. It then selects companies with the strongest free cash flow yield that exhibit higher growth. The Index is rebalanced and reconstituted quarterly. This Index calculates free cash flow yield by dividing expected free cash flow by enterprise value. Expected free cash flow is the average of trailing 12-month FCF and next 12-month forward free cash flow. Enterprise value (EV) measures a company’s total value, often used as a more comprehensive alternative to equity market capitalization. The information in this article is based on data obtained from recognized services and sources and is believed to be reliable. The securities highlighted, if any, were not intended as individual investment advice.

The Russell 2000 Index is a market cap weighted benchmark for measuring the performance of 2,000 small-capitalization companies in the Russell Index.

Distributed by Foreside Fund Services, LLC (Foreside). Foreside is not affiliated with Victory Capital Management Inc. (VCM), the Fund’s advisor. Neither Foreside nor VCM are affiliated with VettaFi.