This year has seen a pivot back to value stocks as inflation and rising rate environments have investors reconsidering high valuation companies. In today’s market environments, the best measure of a company’s actual value may be a strong, stable free cash flow yield, and Pacer ETFs discusses the benefits of investing in high free cash flow companies — cash cows — in a webcast moderated by Tom Lydon, CEO of ETF Trends.
Sean O’Hara, president of Pacer ETFs, explains that the biggest fears advisors are currently expressing to them are inflation, rising rates, global turmoil, and valuations. The Pacer US Cash Cows 100 ETF (COWZ), which invests in large-caps, and the Pacer US Small Cap Cash Cows 100 ETF (CALF) offer investment solutions for a rising rate environment and have seen enormous inflows in the last year.
“Whether you look at MSCI, S&P, or Russell, the three big benchmark companies out there, they all have value indexes in their suites across multiple size categories and multiple jurisdictions,” O’Hara says. “The predominant metric is low price-to-book. This is important for us to understand because if we buy cheap beta ETFs that track benchmarks, we are going to own essentially nothing but low price-to-book stocks.”
Value investing has changed over time because the components of market value have changed; in 1975, 83% of a company’s value and ability to generate free cash flow came from tangible assets, whereas in 2020, 90% of their value and free cash flow generation are now derived from intangible assets (patents, brand value, licensing agreements, etc.).
Strategies for Cash Cows
Pacer ETFs has identified a strategy to better invest in value companies today that is based on a company’s free cash flow and free cash flow yield, which is calculated as the free cash flow of a company divided by its enterprise value (debt plus the market cap value of a company), O’Hara explains. Pacer ETFs believes that since free cash flow isn’t as distorted by accrual-based accounting rules, measuring the free cash generation is a better indicator of value for and between companies.
COWZ begins with the Russell 1000, which had a free cash flow yield of 2.93% and traded at 27x earnings as of the last rebalance. Companies from the financials sector are eliminated next, as well as companies with negative earnings forward-looking, and then the top 100 securities are selected from the remaining pool that have the highest free cash flow yields. Securities are then weighted in order of their free cash flow in dollars, capped at 2%.
“The ending portfolio would be 100 stocks with a 9.7% free cash flow yield and trading at 10x earnings; so three times the current return in dollars for one-third the price,” explains O’Hara.
In a rising rate environment, companies with larger free cash flows are better able to absorb rising costs, making them better-positioned in terms of performance.
“We love the strategy for what’s going on,” says O’Hara. “Our U.S. large-cap strategy COWZ is up 4% year-to-date; the rest of the market is down almost double digits based on this fear that inflation is going to be a problem and that rates are rising.”
Why Investing in Energy Makes Sense
Simon Lack, CFA, managing partner at SL Advisors, discusses the Pacer American Energy Independence ETF (USAI), which seeks to offer exposure to U.S. and Canadian companies deriving most of their cash flows from midstream energy infrastructure. The companies are not dependent on the price of oil or gas but instead on the volume of oil and gas that is moving.
“Energy, over the last several years has had three big headwinds which have all become tailwinds in the last year or so,” Lack says. These include the shale revolution, the energy transition, and COVID-19.
The U.S. is positioned very positively to be a leader in liquid natural gas exports, and Lack discusses the importance of natural gas over crude oil. USAI has been a strong performer in the last three years, and with energy increasing its weight in the S&P 500, it is bringing more investors to the space.
“You get a real sort of inflation protection explicitly in the contracts that these companies have; around 60% of the pipeline industry has inflation escalators built in,” Lack explains. The combination of the inflation protection and tailwinds means that the energy sector has a lot of room for growth.
Financial advisors who are interested in learning more about cash cow strategies in rising rate environments can watch the webcast here on demand.