FTCS - As FTCS Disappoints Again Let's Discuss The Factor Story

2023-09-11 12:25:41 ET

Summary

• Tracking the Capital Strength index, FTCS adheres to the highest standards of quality, representing cash-rich companies with strong capital efficiency.
• Alas, FTCS has significantly underperformed the S&P 500 index since the previous note.
• Analyzing how the portfolio has changed since March, I noticed that quality has improved, but valuation characteristics have weakened.
• Unfortunately, there will be no upgrade for FTCS today, as valuation remains its main vulnerability.

The First Trust Capital Strength ETF ( FTCS ) is obviously a success story. By saying so, I mean that this investment vehicle has been consistently delivering on the 'capital strength' front, building top-quality concentrated equity mixes. Also, investor attention to the fund has been rather strong, as can be deduced from $8.68 billion in assets under management accumulated since its inception in 2006. The problem here is that, as I discussed in my previous articles, with the most recent analysis published in March, top-quality stories the fund was aggregating did not always secure market-leading performance in the past.

Today, I would like to reassess the FTCS portfolio once again, as a substantial share of its holdings have been replaced, to arrive at a conclusion about whether the factor story beneath the surface has finally become supportive of a Buy rating.

A Quick Investment Strategy Recap

As comes from its name, the lynchpin of the fund's philosophy is the concept of 'capital strength.' This phenomenon is reflected in the name of its passive strategy's basis, the Capital Strength index. Let us quickly summarize the methodology description from the investor guide :

1. First, the constituents of the Nasdaq US Benchmark Index demonstrating "a minimum 3-month average daily dollar trading volume of $5 million" must have no less than $1 billion in cash or short-term investments.
2. The next metric assessed is the Long-Term Debt/Market Cap ratio, which cannot exceed 30%.
3. After that, capital efficiency is measured using the Return on Equity, which must exceed 15%.
4. Finally, 50 names with the lowest volatility are selected.
5. Holdings are assigned equal weights, with the nuance that, as described on the fund's website , a single industry cannot have a weight above 30%.

The Portfolio Composition: A Fresh Take on Factor Exposures

As of September 8, FTCS had a portfolio of 50 stocks, with weights distributed rather evenly thanks to the equal-weight schema. To corroborate, the group of the key ten names, with Eli Lilly and Company ( LLY ) being the key holding, had a weight of just 21.6%, while those ten at the bottom accounted for 18.6%.

A quick comparison of tickers in the respective datasets showed that since my previous note, the fund has removed a fairly sizable cohort of stocks that were no longer satisfying the strict criteria of 'capital strength.' More specifically, the fund has replaced about 35.88% of its portfolio, which means 18 stocks it is currently long were absent as of March 22; the exact same number was removed, so FTCS remains a 50-strong portfolio. Among the positions added, Accenture plc ( ACN ) is the most notable name, sporting a 2.1% weight. At the same time, Trane Technologies plc ( TT ), the fund's primary holding back in March, failed one of the index's tests and was subsequently removed.

With such a substantial share replaced, it is wise to anticipate some, perhaps rather meaningful, shifts in factor exposures. Truly, there is something of interest here, as the basket has become even more expensive, but with a few advancements on the quality front as well. To provide a better illustration of how the fund's portfolio has evolved, I compiled the following table:

Calculated using data from Seeking Alpha and the fund

1. First and foremost, the weighted-average market cap has almost doubled. There is no complicated story behind this improvement; the key reason is that Apple ( AAPL ) has finally qualified, so its contribution has pushed the figure substantially higher.
2. I called valuation the "blind spot" of FTCS' strategy in my first note published in July 2022. In fact, this point remains valid. As the market cap surged, the earnings yield shrank, now resembling the one offered by the iShares Core S&P 500 ETF ( IVV ), or 4.48%. At first glance, this is an adequate level, especially assuming there are no loss-making companies in this mix.
3. Nevertheless, a more reliable indicator is the share of stocks with a B- Quant Valuation rating or higher. And this parameter clearly illustrates that FTCS is priced too generously, as the figure is now standing at only 7.6%.
4. A pleasant surprise is an improvement in growth characteristics, with Arch Capital Group Ltd. ( ACGL ) and General Electric Company ( GE ) being the key contributors to the forward EPS growth rate.
5. Quality remains top-notch, as 48 stocks out of 50 have an A (+/-) Quant Profitability grade. Besides, the weighted-average Return on Assets has risen to 10.9%, with a significant contribution from AAPL. Nevertheless, an almost 2x increase in ROE is not to be perceived as a meaningful improvement, as the figure is skewed because of Home Depot ( HD ), a stock that the fund has added since March. HD has an overinflated ROE directly connected to its four-digit Debt/Equity ratio.
6. Regarding cash and cash equivalents, FTCS' holdings' total cash pile has risen to $457.2 billion, with the top contributors being AAPL and UnitedHealth Group ( UNH ). The median has also grown materially, touching $4.11 billion. The corollary here is that its holdings should have enough flexibility to withstand the ripple effects of tighter monetary policy (which are obviously yet to work their way through the economy), with the potential to weather a recession (in the event one is finally triggered) mostly unscathed.

Performance Review: Disappointingly Languishing Amid Tech Rally

In short, FTCS has not delivered alpha since the March note. It seems I was right when I said that "quality and value are essential" when navigating the market, explaining why the fund's unimpressive valuation characteristics weighed on the rating despite its profitability and capital efficiency credentials.

Alas, I was right for the wrong reason. Most likely, the fund's inability to keep pace with the U.S. market flagship index was connected to its rather weak growth characteristics together with minuscule tech exposure and, hence, limited options to benefit from swiftly increasing AI premia that were pushing share prices of tech names like NVIDIA ( NVDA ) into the stratosphere.

For a broader context, below is the comparison of FTCS' returns to the performance of IVV over the July 2013–August 2023 period. The period was shortened intentionally to account for the fact that the fund changed its index in 2013.

Created using data from Portfolio Visualizer

Unfortunately, over the long run, FTCS significantly lagged IVV, most likely owing to its fees . The silver lining is a lower standard deviation; at this point, the fund is also positioned to deliver lower volatility as its weighted-average 24-month beta is just 0.75, as per my calculations.

Investor Takeaway

Tracking the Capital Strength index, FTCS adheres to the highest standards of quality. The flip side is the permanent relative expensiveness of its portfolio, manifested not only in a market-like earnings yield, but also in a diminutive share of stocks with attractive Quant Valuation grades. Another problem is triple-digit turnover resulting from quarterly reconstitution and rebalancing of the index.

Unfortunately, there will be no upgrade for FTCS today, as valuation remains its main vulnerability. The recent oil price rally on the back of the extended production cuts adds to the thesis of higher inflation for longer, thus increasing risks for high-multiple stocks that are most sensitive to the Fed's decisions. Also, we have seen how nervously the market has reacted to Apple's issues in China , which illustrates that investors are once again reevaluating growth premia, something that is directly connected to interest rates. All in all, I believe the fund is a Hold.

For further details see: