2023-08-01 21:18:03 ET
Summary
- VFLO is a newly-launched free cash flow yield ETF that incorporates forward-looking metrics estimates into the selection process. Fees are 0.39%, and AUM is up to $54 million.
- Trailing and forward free cash flow figures combine to generate expected free cash flow. Like COWZ, VFLO's valuation metrics are excellent. It currently trades at 11.88x forward earnings.
- However, VFLO only holds 50 stocks compared to 100 for COWZ and FLOW, another free cash flow ETF just launched by Global X.
- By selecting just 5% of stocks from its universe of 1,000, VFLO has an easier time than COWZ at creating a fundamentally-strong portfolio. No buffer rules may also lead to unacceptably high turnover.
- I'm pleased with some modifications to the selection process, but disappointed in others. I plan to watch and report on VFLO's changes each quarter, but don't recommend readers buy VFLO just yet.
Introduction
On June 21, 2023, Victory Capital launched its latest Index ETF, the VictoryShares Free Cash Flow ETF ( VFLO ). VFLO selects highly profitable stocks with high free cash flow and growth features and is a direct competitor to the Pacer US Cash Cows 100 ETF ( COWZ ). It was only a matter of time before competition heated up in the free cash flow space since COWZ is a massive success for Pacer. However, the question remains: is VFLO better than COWZ? Given how VFLO has no track record, it's not an easy call. But based on my initial evaluation of its strategy and fundamentals, there are some positive and negative takeaways, and I look forward to sharing them with you in more detail below.
VFLO Overview
Strategy Discussion
VFLO tracks the Victory US Large Cap Free Cash Flow Index , selecting large-cap U.S. stocks that "exhibit high free cash flow yield and higher growth characteristics." Constituents are weighted by a modified free cash flow yield calculation, different than COWZ's free cash flow weighting scheme. I've summarized the entire selection process below, as detailed in the Index methodology document .
1. According to the ICE Framework, The Index selects from a group of 1,000 large-cap stocks and excludes Financials and REIT securities.
2. Selections must have a positive trailing and forward one-year historical free cash flow.
3. Selections must have a positive average forward two-year and trailing one-year historical earnings per share.
4. Free cash flow yield is calculated for the top 400 companies by float-adjusted market capitalization. The free cash flow yield calculation is the average of the company's forward and trailing 12-month free cash flow divided by the enterprise value.
5. Growth scores are calculated for all remaining companies based on sales and EBITDA trends and long-term EPS growth.
6. The top 75 companies with the highest free cash flow yield with a growth score are selected. The top 50 companies with the highest growth score are chosen from that group.
7. Free cash flow yield is capped at 15%, and each constituent's weight is capped at 4%. Sector weights are capped at 45%, or 20% above the starting universe weight.
8. The reference date for the factors is the close of the first Friday in March, June, September, and December. Rebalancings occur two weeks later, and the weight dates are six days before rebalancing dates.
A key feature is the Index's use of free cash flow estimates and historical free cash flow figures to arrive at what Victory Capital calls "Expected" free cash flow, illustrated in the graphic below.
I'm pleased with this change because I first discussed this flaw in a March 2022 review of COWZ. The result will be an ETF that better reflects current market conditions. Still, it's hard to know what all this means without evaluating some actual data. Therefore, let's jump into the fund's composition, starting with the sector exposures and top holdings.
Sector Exposures and Top Holdings
The following table highlights sector exposures for VFLO, COWZ, and the newly-launched Global X U.S. Cash Flow Kings 100 ETF ( FLOW ). FLOW is another free cash flow ETF I plan to initiate coverage on later this year and leads with a 0.25% expense ratio compared to 0.39% and 0.49% for VFLO and COWZ, respectively.
All three fall into Morningstar's "Mid Value" equity style box, but the key difference is that VFLO underweights Energy and overweights Health Care. I've been critical of COWZ for its high exposure to Energy and predicted it would be slow to unwind its Energy holdings as inflation declined. That said, overweighting Health Care isn't necessarily better. VFLO is concentrated at the company and sector levels, so it's best to consider it a satellite rather than a core holding.
VFLO's top ten holdings are below, totaling 33% of the portfolio. CF Industries ( CF ) and Expedia Group ( EXPE ) look like their weightings were initially capped at 4%, and both have excellent free cash flow margins above 20%. They also trade at 9.84x and 12.62x forward earnings; you can expect these metrics with VFLO and its competitors.
VFLO Analysis
Fundamentals By Company
The following table highlights selected fundamental metrics for VFLO's top 25 holdings, totaling 65.51% of the portfolio. Summary metrics for COWZ and FLOW are in the bottom rows.
One thing I like about VFLO is how it mixes high- and low-risk stocks, similar to how a barbell strategy works. AbbVie ( ABBV ), Bristol-Myers Squibb, and CVS Health ( CVS ) offset riskier Energy holdings like Marathon Petroleum ( MPC ), Valero Energy ( VLO ), and Chevron ( CVX ). The weighted-average five-year beta for the current portfolio is 1.12, and although VFLO likely will experience high turnover, just like COWZ, I appreciate less risk.
As mentioned, VFLO has high free cash flow margins. On average, the figure is 14.48%, slightly less than COWZ and FLOW but still in line with the 15% offered by the SPDR S&P 500 ETF ( SPY ). I previously complimented COWZ for its high 9.32/10 Seeking Alpha Profit Score, but VFLO improved on that without sacrificing valuation. VFLO trades at 11.88x forward earnings, or 1.10x points cheaper than COWZ, though it's more expensive on trailing cash flow (8.02x vs. 6.63x).
One of the more interesting metrics is VFLO's 15.03% five-year annualized sales growth rate. Analysts expect just 5.86% growth over the next twelve months, so if you're searching for why these stocks' valuations are depressed, this is it. VFLO's 5.19/10 EPS Revision Score reflects the weaker growth picture for VFLO's constituents, and although COWZ and FLOW are no better, I want to emphasize that these stocks trade cheaply for a reason.
Finally, this is for informational purposes only, but I ran a three-year backtest on VFLO's current portfolio to August 2020 and made an interesting observation. VFLO's holdings outperformed COWZ last year and kept pace in 2021-2022. One interpretation is that VFLO's selections are mostly top performers but temporarily out of favor. That's the hope, at least, and interested readers can click here to analyze the backtested returns further.
Diversification Risk
Earlier, I presented what I consider a fundamentally-strong ETF. Third-party sites like Morningstar feature something similar. VFLO's harmonic P/E and growth rates are below the category average (large value). The 3.63% yield figure is incorrect, as the gross dividend yield is 1.87%, and then you have to factor in fees, but that's beside the point. VFLO looks excellent on paper, and you might justify an investment based on this table alone.
Still, you should always include diversification when evaluating an ETF's fundamentals. The reason is that anyone can build a fundamentally-strong paper using stock screeners. Seeking Alpha has one (webinar here ), and I found seven U.S. stocks with A+ Profitability and Valuation Grades with market caps above $10 billion. An equal-weight portfolio trades at 8.61x forward earnings and 5.18x trailing cash flow and has a 9.89/10 Profit Score.
But would a prudent investor mindlessly implement this portfolio? Of course not. They might add stocks from different sectors and industries to spread out the risk, sacrifice profitability and valuation for more growth potential, and screen for factors not emphasized, like price and earnings momentum. Neither of the free cash flow ETFs does this exceptionally well, which is why they're best used as a satellite holding. However, VFLO is the most aggressive, with just 50 holdings, so it's crucial investors consider how VFLO might complement their existing portfolio.
Investment Recommendation
VFLO does an excellent job targeting companies with high free cash flow yields. This single metric combines simultaneously hits on the value and quality factors, and I believe VFLO's incorporation of free cash flow estimates is an improvement over COWZ's methodology. The negatives are that it's highly concentrated, with 56% of assets in two sectors and 66% allocated to the top 25 holdings. VFLO selects just 50 stocks or 5% of its starting universe, making generating a portfolio that looks great on paper easier. For this reason, I ask readers not to rely solely on the fundamental metrics provided in this article and on third-party sites like Morningstar.
Instead, see how it complements your existing portfolio, and understand that free cash flow yield ETFs predominantly hold stocks that trade at low valuations for a good reason. VFLO might also substitute these stocks too often, as I couldn't find any mention of a buffer rule that would relax the screening criteria for existing constituents, as is common with rules-based ETFs. Therefore, I don't see any reason to rush into buying VFLO, but I will commit to quarterly updates to track the changes over the next year. Thank you for reading, and I look forward to continuing the discussion in the comments below.
For further details see:
VFLO: Is This New Free Cash Flow ETF A COWZ Killer?