SPGP - COWZ: This Buffett-Style Value ETF Could Change Your Life

2023-04-19 07:30:00 ET

Summary

• Free cash flow is the purest form of valuation, and helped make Ben Graham and Warren Buffett legends.
• Pacer US Cash Cows 100 ETF is a value exchange-traded fund that uses free cash flow/enterprise value, the single best single metric investing strategy of the last 31 years.
• The COWZ ETF owns 100 world-beater companies that best free cash flow minting, Buffett's "Owner earnings" in any given year.
• It has historically delivered 16% annual returns since 1991 (strategy), 16% returns since 2017, and Morningstar thinks it will generate 17% returns long term. If you want market-beating returns with very low valuations, COWZ is a potentially great choice.
• If you want the closest thing to a Buffett-style deep value ETF, COWZ is it. This is why I'm adding it to my family's $2 million hedge fund, as a 5.5% allocation.

This article was published on Dividend Kings on Monday, April 17th.

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Warren Buffett started out his career as a student of Ben Graham, the founder of value investing and securities analysis.

His career was made by such incredible returns as earning 400% on American Express Company ( AXP ) during the "Great Salad Oil Swindle" of 1963.

• 49% annual returns on a world-beater blue chip everyone had heard of.

What if I told you that there was an exchange-traded fund, or ETF, that was literally as close to a Buffett-style value fund as you buy today?

There is, and it is called the Pacer US Cash Cows 100 ETF ( COWZ ).

Let me show you why this ETF is the best value ETF I've ever seen. In fact, it's so impressive that I'm adding it to the Dividend Kings ZEUS Income Growth Portfolio, which is my family's $2 million hedge fund.

Dividend Kings ZEUS Income Growth Portfolio

Why am I planning on buying COWZ for my family fund? And why should you consider doing the same? Because this is old school Buffett-style investing at its finest.

COWZ: An ETF Harnessing The Purest Form Of Value Investing

There are many ways to value a company: earnings, cash flow, book value, dividend yield, discounted cash flows, sales, etc.

But ultimately, Buffett considered one kind of metric his favorite, and what he called "owner earnings," free cash flow.

Free cash flow is what's left over after running a business and investing in all future growth.

It's what pays dividends, funds buybacks, pays down debt or can be used for acquisitions.

Ultimately free cash flow is the purest form of valuation because it's the cornerstone of true intrinsic value.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.” – Warren Buffett’s 2000 Annual Letter.

Everything else about a company ultimately doesn't matter. Its patents? If they don't ultimately generate free cash flow they are worth nothing.

A company's moat? It exists purely to protect and grow free cash flow.

Sales? If a company never generates free cash flow, then no amount of sales make it worth a darn!

A company's brand? Only because strong brands provide strong pricing power and superior free cash flow are brands worth paying attention to.

Good management? Ultimately, free cash flow is the best measure of profitability (with certain exceptions for some sectors), and profitability is Wall Street's favorite proxy for quality companies, including wonderful management.

In other words, if you asked Ben Graham and Warren Buffett, what's the single best measure of quality and moatiness? They would probably tell you free cash flow ("FCF") or "owner earnings" is a great metric to look at.

In fact, if you were to try to construct a single metric ETF that had the best returns over the last 31 years, FCF/EV outperformed all of them.

And this is where COWZ is so impressive. Its elegance is its simplicity, but as Davinci said, "Simplicity is the ultimate sophistication."

How COWZ Works And Why I Want To Own It

Morningstar's star ratings are based on historical returns vs. peers, and its bronze, silver, and gold ratings are based on how a fund is constructed.

In the case of COWZ, it's a 5-star fund that has run circles around other value funds, and Morningstar thinks it will continue to do so.

Top 1% Of Its Peers For The Last 5 Years

Out of 364 value ETFs, COWZ was only beaten by three of them over the last five years.

And here's why.

COWZ starts with the Russell 1000, a world-beater index, and then screens for positive free cash flow yield. It then sorts by 12-month trailing free cash flow yield and weights by it, using 2% max risk caps.

In fact, COWZ uses FCF yield as measured by enterprise value, meaning market cap + net debt.

• to screen for reasonable leverage.

The result at the end of 2022 was a spectacular 13% free cash flow yield and a P/E of less than 7.

For context, the average private equity deal is at 11X earnings, and the average Shark Tank deal in the first 10 seasons was at 7X earnings.

Want to find Shark Tank/Private Equity/Deep Value Buffett-style deals?

Well, this ETF lets you invest in 100 of them with one ticker!

Here is the result of the quarterly rebalancing on March 17th.

The cash flow yield actually went up to 13.5%, and the P/E ratio stayed the same, at an anti-bubble/Shark Tank-like 7.

These aren't dying companies; they aren't "cigar butts." They are thriving companies, some of the best in the world. Consider their growth rates over the last year:

• 24% sales growth
• 52% earnings growth
• 55% cash flow growth.

They might not be the widest moat companies in the world, but 82% of them have some kind of moat.

And for a portfolio trading at single-digit earnings and cash flow, B- financial health and profitability are very good.

What kind of companies does COWZ own this quarter?

COWZ isn't perfect, but this ETF is hard to beat if you want companies firing on all cylinders that are minting free cash flow.

COWZ Top 50 Holdings

OK, so COWZ has quality, deep value, and strong growth. But here's why I'm really impressed.

Historical Returns: Doing What No Value ETF Can Do

Back-tests from 1991 show that a 100-stock portfolio built around maximizing FCF/EV (what COWZ does) delivered the best annual returns and positive returns 84% of the time.

• including the tech bubble of the 1990s
• the lost decade for tech in the 2000s
• and the raging tech bull market of the 2010s.

OK, but what about the value bear market? There has been no bear market as far as COWZ is concerned.

Total Returns Since 2017

How many value ETFs were able to beat the S&P over the last six years? About 1% or 4 of them, and COWZ was one of them.

What were the historical annual returns for COWZ's FCF/EV strategy since 1991? 16%.

What was the historical annual return since 2017? 16%.

What do Morningstar's analysts expect from COWZ in the future? 17%.

While past performance is no guarantee of future results, COW's strategy returns since 1991 provide a 97% statistical probability that this ETF is the real deal, a Buffett-like ETF that's doing what quality value has done for over 50 years: outperform.

Risk Profile: Why COWZ Isn't Right For Everyone

No ETF is perfect, and there are a few things you might not like about this ETF.

First, it uses trailing 12-month FCF yield and doesn't use forward-looking data. That means that cyclical sectors like energy can become heavily overweight for up to a year, even after they stop generating the best free cash flow yield.

Note that energy is now up to 35%, and in a recession, that could really hurt COWZ. Its historical volatility is about 25% higher than rival value ETFs like VTV for this reason.

COWZ Isn't As Undervalued As It Might Seem

(Source: FactSet Research Terminal.)

Next, we have the fact that this ETF isn't actually historically undervalued. At least not compared to its historical 9.7 median P/FCF.

But doesn't this kind of historical valuation have no meaning since COWZ rebalances quarterly? Kind of, but this brings us to another negative.

COWZ has over 114% annual turnover. That means a bit higher tax bill, and you can't know with confidence what you'll own next quarter.

• COWZ, (OMFL), and (SPGP) are core "strategy ETFs." = fantastic and proven strategies for wonderful returns
• (SCHD), (VIG), and (SCHG) are core company ETFs = fantastic and proven portfolios of world-beater companies that remain relatively stable over time

Dividend Consistency Is Hurt By High Turnover Though Long-Term Growth Is 10%

Vanguard's Value ETF has a lot more consistent holdings, resulting in the dividend incomes being more dependable.

COWZ, like any high-turnover ETF, can have wildly variable pay-outs in any given year.

• dividend growth since 2017: 10% CAGR vs. 9% VTV.

And finally, we can't forget that the 0.49% expense ratio is much higher than many popular value ETFs.

• COWZ: 0.49%
• VTV: 0.04%
• SCHV: 0.04%.

Is COWZ worth the extra 0.45% per year in fees? I would say so, given that the historical outperformance of VTV and SCHV is about 5%.

But since past performance does not guarantee future results, some investors are uncomfortable paying a 0.5% fee.

Bottom Line: This Buffett-Style Value ETF Could Change Your Life

Value investors have spent over a decade wondering if value would ever start working again.

Well, guess what? The purest form of value investing has been working for 31 years.

Since 1991 FCF/EV has been the best single valuation metric to use for valuation, and since 2017 COWZ has been delivering its historically great returns.

• 16% returns since 1991 (the strategy)
• 16% annual returns since 2017 (actual annualized results)
• 17% Morningstar long-term total return consensus.

In an era when investors were yelling "to hell with value, long live tech," just like the tech bubble, COWZ was beating the red-hot market.

Will that continue in the future? Morningstar's analysts think so, and given its dedication to the purest form of value investing, one that both Graham and Buffett espoused and became legends using, I tend to agree.

That's why I'm looking forward to taking a 5.5% position in COWZ.

Is it a perfect ETF? There is no such thing. There are plenty of reasons why some people might not want to own this ETF.

But if your goal is world-beater companies firing on all cylinders and minting cash? There are few better ETFs that you can buy today.

For further details see:

COWZ: This Buffett-Style Value ETF Could Change Your Life