SPSM - CALF: Our Favorite Small-Cap ETF Can Continue To Outperform

2023-10-18 01:08:58 ET

Summary

• The Pacer US Small Cap Cash Cows 100 ETF features a unique free cash flow weighting methodology.
• The strategy has impressively outperformed benchmarks given the tilt toward fundamentally stronger companies.
• The fund can work as a core portfolio holding for exposure to small caps over the long run.

The Pacer US Small Cap Cash Cows 100 ETF ( CALF ) takes a systematic approach to investing in small-cap stocks by focusing on companies generating excess cash flow. The idea here is that "cash cows", as profitable companies with strong fundamentals, should offer shareholders higher return potential over the long run. Indeed, data shows that the strategy has worked, with CALF outperforming benchmarks over the last several years and up 17% in 2023.

In our view, the fund does a good job at screening for high-quality stocks which helps to balance the inherently higher levels of risk in this important segment. We are bullish on CALF and expect shares to trade higher into 2024.

What is the CALF ETF?

CALF technically tracks the "Pacer US Small Cap Cash Cows Index". According to the rules-based methodology, the security selection process starts with the S&P SmallCap 600 Index as the universe of eligible companies.

The top 100 stocks in terms of their free cash flow yield are included in the fund. From there, CALF utilizes a unique weighting methodology based on the highest 12-month trailing free cash flow yield with holdings capped at 2% of the overall weighting.

There is a long history of academic research suggesting free cash flow yield as a powerful valuation metric, which can highlight companies that are productive, reliable, and self-sufficient in terms of financial strength.

The result is a distinct fund profile tilted heavily toward companies seen as inexpensive relative to their cash flow as a valuation metric. Companies with a high free cash flow yield are seen as having financial flexibility, capable of moving forward with stock buybacks, paying dividends, or taking strategic corporate actions as investments toward future growth.

Going through the current portfolio, the sector breakdown is 34% in consumer discretionary names, followed by 21% in Industrial sector stocks, and a 15% weighting in energy as the sector breakdown.

Keep in mind that the strategy completely excludes financial sector stocks including banks, as free cash flow is not a relevant metric for companies managing money.

The table below presents the top 40 holdings within the CALF portfolio. CONSOL Energy Inc. ( CEIX ) is the largest current holding with a 2.4% weighting, next to American Eagle Outfitters, Inc. ( AEO ) at 2.3%, and Encore Wire Corp ( WIRE ) representing 2.2% of the fund.

The way we see it, the individual names here are not as important as their combined contribution to the strategy. Sharing the cash cow label, the stocks within CALF are noted as having an average free cash flow yield of around 13% and a price-to-earnings multiple of just 6x. By this measure, there is a clear "value" profile, however, keep in mind that many of the included stocks do not pay regular dividends. The overall fund yields a modest 1.3% with a quarterly distribution.

Another metric we are highlighting that stands out is the performance of the underlying names year-to-date, with an average return of 17%, consistent with the total fund performance.

One explanation here for the significant spread relative to other small-cap indexes and even the benchmark S&P 600 is in the context of the current market environment. Companies that are able to generate free cash flow have been rewarded this year by the market as a segment of safety and relatively isolated to rising interest rates.

This dynamic of tilting towards "high quality" stocks is also evident when we go back to the sector breakdown. Beyond the exclusion of financial sector names, CALF does not hold utilities or even real estate stocks given their capital-intensive operating models that often limit free cash flow generation. Both sectors have been particularly pressured this year, and help explain how the CALF fund has been on the right side of the trends.

What's Next For CALF

What we like about the Pacer US Small-Cap Cash Cows 100 ETF is that the fund can represent both a defensive strategy during a period of market volatility, while also well-positioned to capture the upside during a period of stronger market momentum.

With interest rates at a near two-decade high and mixed signals toward the strength of the economy, the expectation is for continued market volatility over the near term. The cash cows with the CALF portfolio should continue to perform well given their relative fundamental strength and ability to absorb financial shocks.

While we don't believe the sectors that are systematically underweight in the free cash flow yield approach including utilities and real estate will also underperform forever, the fund's ability to rebalance means that it can always be invested in stocks that offer good value as a catalyst to participate in broad market rallies.

On the upside, in a scenario where macro conditions evolve more favorably, we also expect the CALF portfolio to participate in a broader market rally based on improving sentiment towards small caps overall.

Final Thoughts

Our take here is that this systematic free cash flow yield approach can replace a more passive indexed strategy in this particular market segment of small caps. CALF is a good option for investors as a core holding for long-term small-cap equity exposure.

In terms of risks, we have a bullish view on stocks and a general level of optimism toward economic conditions but also recognize CALF would not be immune to a deeper macro deterioration. A scenario where consumer spending reverses lower sharply would likely result in renewed financial market uncertainty and open the door for a deeper correction in equities as an asset class.

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