ETF investors should consider the benefits of cash cow stocks and how they can enhance their investment portfolios.
In the recent webcast, Cash Cows: A Simple Pacer ETFs Strategy for Complex Markets, Sean O’Hara, president of Pacer ETFs Distributors, explained that the way many investors traditionally categorize the value style may be too archaic. Specifically, the price-to-book ratio remains a go-to input for all major value indices that many value-focused investors rely upon. O’Hara pointed out 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.
“Now, companies’ value and ability to generate free cash flow mostly is a result of their intangible assets,” O’Hara said.
“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?” He added.
Alternatively, O’Hara believes that measures of free cash generation will likely provide a truer valuation comparison between firms. More free cash flow is tied to intangible assets. Using free cash flow yield to measure a company’s sustainability may produce potentially higher returns and more attractive upside/downside capture over time.
O’Hara explained that free cash flow yield has exhibited the highest return with the lowest periods of negative trailing 12-month returns from 1991 through 2021. Free cash flow yield is calculated as free cash flow to enterprise value, or the combined market capitalization and debt minus cash. This free cash flow yield has shown to be one of the best value metrics when comparing 5-year rolling batting averages, 5-year average outperformance, and 5-year rolling average underperformance.
Investors interested in the free cash flow metric can turn to something like the Pacer US Cash Cows 100 ETF (NYSEArca: COWZ).
Focusing on companies with steady free cash flow can be a better approach to security selection than alternatives. Free cash flow is the cash left over after a company has paid expenses, interest, taxes, and long-term investments. It is used to buy back stocks, pay dividends, or participate in mergers and acquisitions. The ability to generate a high free cash flow yield indicates that a company is producing more cash than it needs to run the business, which can then be invested in growth opportunities.
Free cash flow companies generally have three defining characteristics — they are productive, reliable, and self-sufficient. The companies generate more cash flow than they spend, which allows them to grow without external financing. The free cash flow is a sturdy measure of profitability, which is, unlike earnings, not subject to manipulation and accounting assumptions. Lastly, as the companies rely less on capital markets for financing, they don’t dilute their issued company stocks.
Looking at COWZ’s latest quarterly rebalance, energy exposure has significantly increased after the rebalance. Despite volatile commodity prices, the energy sector is still in favor and has record free cash flow along with cheap valuations, O’Hara said. In addition, healthcare also continues to be one of the top sectors as this segment offers growth and stability with attractive valuations.
When comparing valuation metrics from 2016 through 2022, the underlying Pacer US Cash Cows 100 Index strategy has exhibited a 25.25% annualized earnings growth rate, a 9.09% average free cash flow yield, and an average price-to-earnings of 12.86%. In comparison, the benchmark Russell 1000 Value Index has exhibited a 10.58% earnings growth rate, 3.58% free cash flow yield, and 17.90% P/E over the same period.
O’Hara also highlighted the potential for outperformance during periods of rising interest rates. Companies with high free cash flow yields tend to outperform the market during periods of rising rates, with the Pacer U.S. Cash Cows Index strategy up an average of 23.7% during rising rate periods, compared to the Russell 1000’s 13.4% gain over these same periods.
Along with COWZ, investors have several other ETF options to choose from, such as the Pacer Global Cash Cows Dividend ETF (NYSEArca: GCOW), 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), which all implement free cash flow yield screens to narrow their investing universes.
Financial advisors who are interested in learning more about the cash cows strategy can watch the webcast here on demand.