Sean O’Hara, President of Pacer ETF Distributors, joined Keith Black, Managing Director of RIA Channel, to discuss stock selection using the free cash flow yield factor.
Historically, many investors and index providers selected value stocks or defined value universes based on the level of each stock’s price relative to its book value (price-to-book). O’Hara explains that price-to-book is becoming less relevant over time as the US economy transitions from a manufacturing economy with high levels of tangible assets, such as factories, to today’s economy where 90% of assets are intangible, such as intellectual property.
In this economy based on intangible assets, O’Hara prefers to evaluate stocks using the free cash flow yield factor. Historically, stocks ranking in the top 10% to 20% of free cash flow yield have earned excess returns relative to the market. It is important for investors to avoid investing in stocks with negative free cash flow yield, as those can be a drag on portfolio returns. After eliminating stocks in the financial sector and stocks with negative earnings forecasts, The Pacer Cash Cows ETFs® hold the 100 stocks in each market index with the highest free cash flow yield.
These ETFs overweight the stocks and sectors with the highest free cash flow yield. Currently, energy stocks have a high weight, given the recent surge in oil prices and reduced capital expenditures in the sector. Historically, return attribution for the cash cows comes more from individual stock selection than from sector rotation. Stocks with high levels of free cash flow tend to have higher earnings growth and trade at price-to-earnings multiples lower than the broader market.
The Pacer US Small Cap Cash Cows 100 ETF, (CALF), recently passed $4 billion in assets under management. This methodology may be especially relevant in small caps, as 40% of the companies in the Russell 2000 small cap index are currently reporting negative earnings. Small companies with high free cash flow yield may find it easier to service their debt than companies with negative earnings. While the average small cap company is spending 30% of earnings on debt service at today’s higher level of interest rates, the stocks in the CALF ETF only spend 6% on debt service.
Resources:
Free Cash Flow Yield as a Proven Measure of Quality
Webcast: The Real Reason Free Cash Flow Yield Works