Author’s note: This article was released to members of the CEF/ETF Income Laboratory on March 8, 2022.
Value stocks have outperformed year-to-date as investors reassess frothy tech valuations in the face of rising interest rates, soaring inflation and geopolitical risk. Growth offers the best potential long-term returns, but when times are tough, cash is king and investors flock to cheap, cash flow-generating companies. This is where the Pacer US Cash Cows 100 ETF (BATS: COWZ) Between.
COWZ invests in US stocks with above average free cash flow returns. Cash cows, basically. COWZ’s underlying holdings are relatively cheap, which should lead to strong, above-market returns when valuations normalize. This has been the case since the beginning of the year and the trend should continue. In my opinion, at least. The fund is a buy, and particularly suitable for investors looking for value funds. As COWZ only yields 1.4%, it is not an efficient income vehicle, nor particularly suitable for income investors.
The basics of the COWZ
- Investment Manager: ETF Pacer
- Expense ratio: 0.49%
- Dividend yield: 1.41%
- Total returns 5-year CAGR: 16.93%
COWZ is an equity index ETF. It is a relatively simple fund, investing in the 100 companies with the highest free cash flow yields within the Russell 1000 Index, a broad-based US equity index. It is a cash flow weighted fund: the higher the cash flow, the greater the weighting. Weightings are capped to ensure minimum diversification. Both the fund and the Russell 1000 index have several other criteria for inclusion, centered on liquidity, size, etc., but nothing particularly impactful. COWZ is a simple fund, investing in US equities with strong free cash flow yields. A brief summary of the fund’s index/stock selection.
COWZ is a surprisingly well-diversified fund, with exposure to the most relevant industry segment. The fund is overweight energy and materials, two sectors with relatively low valuations.
COWZ’s holdings themselves are reasonably well diversified, with the fund investing in 100 stocks, and the top ten of them representing only 21% of the fund’s value.
In broad terms, COWZ is only slightly less diversified than a broad-based equity index fund like the S&P 500. As such, the fund could be a relatively large holding in an investor’s portfolio. .
COWZ’s focus on cash flow is relatively rare among value funds, and a benefit to the fund and its shareholders. Earnings can take a beating, book values are rarely in line with true market prices, but cash flow doesn’t lie (easily) and is generally a more accurate measure of a company’s financial performance. Although this is the case, few value funds consider, let alone to concentrateon cash flow when building their portfolios, but COWZ does.
COWZ’s focus on high cash flow yielding companies results in a fund with a relatively cheap valuation. According to fund filings, COWZ has a free cash flow yield of 9.8% compared to only 2.9% for that of the Russell 1000 index, a very large and significant difference. COWZ’s PE ratio of 10.1x is also significantly lower than said index’s 27.9x. Although not shown above, and consistent with fund filings, COWZ boasts a PB ratio of 3.0x, also lower than the index’s 4.2x PB ratio. COWZ is also cheaper than other broad-based U.S. stock indices, including the S&P 500.
COWZ’s cheap valuation is the fund’s most prominent feature and core investment thesis, and provides investors with several significant advantages.
First, and most importantly, cheap valuations could lead to strong, above-market returns, should these normalize. This has been the case since the start of the year, with the fund outperforming most broad equity indices, and by quite a significant margin. The outperformance was due to the normalization of valuations, supported by rising commodity prices, inflation fears, the prospect of higher interest rates and geopolitical risks.
COWZ is also one of the few value funds to have outperformed US equity indices since inception, albeit by a small margin. Still, these are positive results overall, especially given the recent outperformance of technology and growth. COWZ has performed reasonably well even in difficult industry conditions, a plus for the fund and its shareholders.
Valuations are heavily dependent on investor sentiment, particularly in the short term, and sentiment looks poised to continue to reward cheap value stocks over more expensive growth and technology stocks. This is partly because markets continue to fear rising inflation, the possibility of higher interest rates and continued political risk, and partly because growth stocks large-cap stocks remain significantly overvalued relative to the market and their historical averages. In fact, according to JP Morgan, large-cap growth stocks remain 65% overvalued relative to their historical average, a very significant percentage.
On a more negative note, and as can be seen above, large-cap value stocks are also overvalued relative to their historical averages, although by far less. Conditions are such that most US equities should post losses if valuations were to normalize, but those should be significantly lower for value stocks. This has been the case since the beginning of the year, with clearly underperforming growth, but stable value. As mentioned earlier, valuations are such that the stock looks likely to outperform going forward, but the possibility of significant gains seems quite low. The value just doesn’t offer enough value to important wins to be all that is likely, in my opinion at least.
Second, cheap valuations serve to somewhat reduce the possibility of large losses, at least under current conditions. Remember that growth stocks are significantly overvalued relative to their historical averages, while value stocks are only slightly overvalued. Deterioration in economic conditions or market sentiment should
Finally, cheap valuations help make returns less dependent on volatile market sentiment. Cash-intensive companies can still choose to distribute that cash to shareholders, either in the form of dividends or share buybacks. Both of these, especially dividends, drive returns and don’t rely on investor sentiment to do so. COWZ’s underlying holdings generate just under 10% cash, per year, after CAPEX. Underlying COWZ holdings could elect to distribute this cash to shareholders, guaranteeing a 10% return / return to shareholders without given the possible growth of dividends, capital gains, etc. Those returns would be solid, all things considered. Most companies and stock indices, including the Russell 1000, have much lower cash flow yields and therefore rely on capital gains and investor sentiment for their returns.
COWZ’s strong free cash flow yield is the fund’s most important benefit and core investment thesis.
Stocks and value funds could outperform if valuations normalize, as they have since the start of the year. COWZ is a large-cap, equity-focused U.S. value fund with above-average free cash flow returns, and offers investors a particularly strong way to benefit from continued value outperformance. COWZ is a buy, especially suitable for investors looking for value funds.