FTCS - FTCS: Finally This ETF's Style Is Timely!

2023-12-14 05:52:38 ET

Summary

• FTCS is an $8.5 billion ETF that somehow flies under the radar. It shouldn't.
• The market is likely to again reward capital strength over sheer stock size, which bodes well for FTCS in 2024.
• I recently bought it in one of my investment accounts, and rate it Buy here.

First Trust Capital Strength ETF (FTCS) and capital strength as a stock market "factor" has lagged the largest S&P 500 badly this year. In fact, that multi-year underperformance is toward the upper end of its recent historical range. This may or may not be primed for immediate reversal. But it has caught my attention. So much so that I bought this ETF in one of my accounts very recently.

FTCS has been on my watchlist for a long time, but this is the first time I've owned it. And while I do treat all equity ETFs as "rentals" rather than "own it long-term" types until we either get a true market "clearing" to the downside, or I'm convinced the threat of a renewed bear cycle is greatly diminished, I see alpha potential in FTCS versus the broad stock market right now.

As a reminder, this is exactly why I repeatedly urge investors to follow a process that includes maintaining at all times a watchlist of ETFs that they might consider using "when the time is right," however their investment regimen defines that. Frankly, FTCS caught me a bit by surprise. In my technical ranking system, it was not off the radar, but it was not as likely as some other equity ETFs to be at a buy point for me. But in the same way that a horse can win a race at odds of 5-1 when the favorite is "even money (1-1)," until the time arrives to pull the "buy" lever, anything on the watchlist is a consideration. What changed things for me was a combination of a sharp upturn in the market's willingness to reward quality over sheer market capitalization, and of course a confirmation of this "story" in the chart pattern.

Capital strength. What is it, and why now?

What truly distinguishes FTCS's approach is the specific degree to which it defines what types of company quality features construe the concept of capital strength. It is hard to go an hour watching financial television without some market guru waxing poetic about "quality."

So it is refreshing to have it defined and carried out on a more regimented basis as this ETF does.

FTCS's screening process looks for stocks of companies with strong cash positions, low levels of long-term debt, and high return on equity. That's "capital strength."

More specifically, stocks must have at least $1 billion in cash or short term investments, a long term debt to market capitalization ratio less than 30%, and an ROE greater than 15%. The ETF manager then ranks eligible stocks by short-term (3 months) and long-term (12 months) realized volatility. The 50 companies with the best total scores on that systematic process make it into the index. FTCS caps industry weights at 30%.

The current sector mix is not nearly as tech-heavy as the broad market, and industrials are nearly 3 times their weighting here as in SPY. Energy and Basic Materials have very low weights as they do in SPY, which should not come as a surprise to investors familiar with stock screens for quality, and the typical profile of stocks in those 2 sectors.

As the title of this article implies, the market does not always reward capital strength. However, with interest rates potentially "higher for longer," companies that don't have to rely heavily on the debt markets to continue growing (or even existing, in the case of many small caps) stand a better chance to move higher if and when the market gets selective about the credibility level of companies they reward.

Why didn't FTCS look as attractive earlier? Because the market appears to finally be ready to reward higher quality companies after a year (2023) where the main attraction for investors could be summarized by the famous slogan "size matters." Here's a look at how FTCS has lagged QQQ in a historic manner this year.

Yet a longer look back (chart below) indicates that when comparing the type of stocks FTCS targets with the success of companies that were simply the largest (XLG is the top 50 within the S&P 500 by size), again capital strength has been as dismissed by investors as international and small caps stocks.

FTCS: it's been hiding in plain sight! Here's why.

This is a 17-year-old ETF with $8.5 billion in assets. Yet, it is in the basement in terms of investor interest on the Seeking Alpha platform. There has been virtually no one looking it up for the past few months. First Trust, the fund's parent, tends to have sticky relationships with certain financial advisors, and thus FTCS is not a household name to self-directed investors. But I think that should change, so this was the ideal time to bring it to the attention of Seeking Alpha's sophisticated audience.

This also answers a riddle I often ask myself: what is an "undiscovered ETF?" which is a big focus of my research work on this platform. Well, it is obviously not all about AUM. FTCS is the case in point for that.

This is an equal-weighted, 50 stock portfolio, both features I am very friendly to. I like to know what I own inside the ETF, so 50 names is an OK number. And equal-weighted ETFs could be on the verge of a long-awaited shift from laggards to leaders, given that the Magnificent 7 stocks are starting to get more attention for having reached valuations that their future earnings cannot justify for much longer.

The ETF's benchmark is one that contains 500 Nasdaq companies, yet here's something to note: all 50 holdings are in the S&P 500.

So FTCS is what I'd refer to as an "S&P 500 subset" ETF, though with the added twist that this fund does not implicitly start its filtering process with the S&P 500 stocks. But it gets to a similar spot, given the strong presence of Nasdaq-listed names that are also in the S&P 500. FTCS is reconstituted and rebalanced quarterly.

The components of this ETF have been solid businesses, built to last in a recession. But until very recently, to borrow and old phrase (and thus give away my Baby Boomer generation age), "that and a nickel gets you a cup of coffee." While we wait for my fellow Starbucks regulars to stop laughing at that one, I'll close with this timely thought: I believe we are nearing one or possibly even in one in some segments of the economy, which means that what FTCS represents may take on added significance in 2024. For all of the above reasons, I rate it a Buy in the usual context that I believe it has a strong chance to outperform the S&P 500 over the next 6-12 months or so.

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