IWB - VFLO: My Balanced Take On Victory Capital's Free Cash Flow Yield ETF

2024-01-18 01:54:48 ET

Summary

• VFLO is Victory Capital's answer to COWZ, the most popular free-cash-flow-yield ETF on the market. Since my August review, VFLO has outperformed by 3%.
• VFLO's use of forward-looking metrics is important. This approach considers new information analysts have about current markets, and although estimates can be flawed, I believe it's a net positive.
• After last month's reconstitution, VFLO offers nearly the same estimated EBITDA growth as the Russell 1000 but at a fraction of the cost. On paper, VFLO looks great.
• Still, diversification is extremely poor, with only 50 stocks and 73% of assets in three sectors. Moreover, two of those sectors have had the worst risk-adjusted returns over the last decade.
• VFLO is an exciting ETF, but the number of pros and cons means a hold rating is most appropriate.

Investment Thesis

Since my initial review on August 1, 2023, the VictoryShares Free Cash Flow ETF ( VFLO ) has attracted $75 million in new assets and outperformed its chief rival , the Pacer US Cash Cows 100 ETF ( COWZ ), by 3.04%. Last month, VFLO reconstituted again, and the ETF now features 12.40% free cash flow margins, 9.22% expected EBITDA growth, and an extremely attractive 11.78x forward earnings valuation. On paper, VFLO looks tough to beat, but this balanced review also considers VFLO's weak diversification and high concentration in sectors that have not performed well historically. I ask readers to evaluate VFLO's strong fundamentals with these potential flaws in mind and, like COWZ, be prepared to handle bottom-quartile performance in some years. I reiterate my "hold" rating on VFLO and will compare it fundamentally with COWZ, FLOW, and COWS in more detail below.

VFLO Overview

Strategy Discussion

VFLO tracks the Victory US Large Cap Free Cash Flow Index, selecting stocks with high free cash flow yield and higher growth characteristics. This objective covers three main factors: quality, value, and growth, and if these can be achieved, we're off to a great start. The Index weights constituents by a modified free cash flow yield calculation, which I believe is an improvement over COWZ, which only considers trailing metrics. The steps are as follows:

1. A group of approximately 1,000 large-cap stocks form the starting universe, which excludes Financials and REITs.

2. Selections must have positive trailing and forward one-year historical free cash flow, plus positive average forward two-year and trailing one-year historical earnings per share.

3. Free cash flow yield is calculated for the top 500 companies by float-adjusted market cap. A company's average forward and trailing twelve-month free cash flow is divided by enterprise value.

4. Growth scores are calculated based on sales and EBITDA trends and long-term EPS growth. The top 75 companies with the highest free cash flow yield are selected, with the list narrowed to 50 based on growth score.

5. Free cash flow yield is capped at 15% and individual security weights are capped at 4%. Furthermore, sector weights are capped at 45%, or 20% above the starting universe weight.

6. Reconstitutions are quarterly and effective on the third Friday in March, June, September, and December.

A key feature is step #2, where forward-looking metrics are considered. The Index provider considers this an improvement, as do I, given my long-standing criticism of COWZ's methodology. An average makes sense and acknowledges new information analysts might have about current market conditions.

50 Stocks And A Strong Sector Bias

But it's a mistake to assume VFLO is better than COWZ because it's just one feature change. A drawback of VFLO is that it only holds 50 stocks compared to 100 for COWZ. As I wrote in August, creating a fundamentally strong portfolio is easy when you don't have to select very many stocks. To illustrate, when I apply a 10% minimum free cash flow margin screen and a maximum 20x forward P/E to the Russell 1000 Index, the list is cut to 124 stocks, with the sector breakdown as follows:

• Consumer Discretionary: 22
• Industrials: 22
• Technology: 22
• Health Care: 21
• Communication Services: 13
• Energy: 13
• Consumer Staples: 6
• Materials: 5

I could buy these stocks, but that's a lot of emphasis on only a few sectors. The breakdown is even more stark when screening the Russell 1000 Index for trailing free cash flow yield. The average yield is 3.79%, according to Pacer ETFs , and companies exceeding twice that figure are few and far between:

• Consumer Discretionary: 21
• Health Care: 14
• Materials: 8
• Industrials: 8
• Communication Services: 7
• Technology: 7
• Energy: 7
• Consumer Staples: 5
• Utilities: 1

The common denominator is Consumer Discretionary and Health Care, which comprises 49% of VFLO. Energy takes the total to 73%, while stocks in defensive sectors like Consumer Staples and Utilities are unlikely selections. From a risk-adjusted returns perspective, this isn't the ideal setup. Consider the ten-year Sharpe Ratios below for nine of Invesco's S&P 500 Equal Weight ETFs (excluding Communication Services and Real Estate due to insufficient history). While Health Care ranks high at #2/9, Consumer Discretionary and Energy are #8 and #9, respectively. Consumer Staples and Utilities are in the middle and offer solid downside risk-adjusted returns (Sortino Ratio). Investors shouldn't ignore them, but VFLO does, and more importantly, will continue to do so.

This criticism is not unique to VFLO. It also applies to COWZ, the Global X U.S. Cash Flow Kings 100 ETF ( FLOW ), and the Amplify Cash Flow Dividend Leaders ETF ( COWS ), with combined exposures of 48%, 45%, and 44% to Consumer Discretionary and Energy. But VFLO seems the least diversified, and COWZ's bottom-quartile results from 2018-2020 might serve as a proxy for what's to come for VFLO.

VFLO Analysis

Sector Snapshot

The following sector snapshot provides helpful information on where VFLO gets its features, namely its 7.60% trailing free cash flow yield, 9.22% estimated EBITDA growth rate, and 11.78x forward earnings valuation.

Here are some top-level observations:

1. Consumer Discretionary, Energy, and Health Care have free cash flow yields above 7.50% and taking into account their solid historical sales and forward EBITDA growth rates, their high allocations make sense.

2. Free cash flow yield for the Industrials sector is low at 3.74%, so solid 12.68% forward EBITDA growth must be the reason for its 9.35% allocation.

3. The Materials sector has a terrific 12.69% free cash flow yield but only a 4.26% allocation in VFLO. The likely reason is the selections' negative sales and EBITDA growth rates, and this is a perfect example of where VFLO and COWZ differ. COWZ has 12.01% exposure to this sector because it only considers trailing metrics.

4. VFLO's Technology selections have a 7.65% free cash flow yield, but weak estimated sales and EBITDA growth limit exposure to 8.16%.

5. Only two Utilities stocks qualified: Vistra Energy ( VST ) and NRG Energy ( NRG ), with free cash flow yields of 3.02% and 10.58%, respectively. VST's low free cash flow yield figure is balanced by strong one-year historical and estimated sales growth (18.20% and 11.02%), while NRG's high free cash flow yield is balanced by weak one-year historical and estimated sales growth (-2.81% and 2.66%).

Fundamentals By Company

Next, I want to highlight selected fundamentals for VFLO's top 25 holdings, which total 66.72%, the most compared to COWZ, FLOW, COWS, and the iShares Russell 1000 ETF ( IWB ). I've also included summary metrics for the VictoryShares Small Cap Free Cash Flow ETF ( SFLO ), launched on December 21, 2023. SFLO shares many of the same features as VFLO but also seems well-diversified at the company level.

As mentioned earlier, VFLO's strategy is to select stocks with high free cash flow yield and higher growth characteristics. Based on this analysis, VFLO delivers on the valuation promise, evidenced by its 11.78x forward earnings valuation and 8.52x trailing cash flow valuation. While the other three free-cash-flow-focused ETFs offer slightly better valuations, their expected EBITDA growth rates are only a fraction of VFLO's.

Ultimately, VFLO appears poised to perform well in both growth- and value-favored markets, and since style trends tend to be secular, the goal is worth pursuing. Large-cap growth stocks have the edge today, with five-year annualized rolling returns 8% better than large-cap value. However, large-cap value stocks were superior for most of the 1980s and 2000s decades before dot-com stocks took over in the late 1990s.

VFLO's weighted average free cash flow margin is 12.40%, much better than what the Russell 1000 Value Index features, but not the broader Russell 1000 Index, which has 16.60% margins. Your takeaway depends on what you believe is the most appropriate benchmark, but I think VFLO opens the door to IWB comparisons since its strategy seeks stocks with "higher growth characteristics." So, while I'm satisfied it's a high-quality value fund, it's no better than what IWB offers. The same is true on growth, but with a market cap that's 1/10 the size of the broader Index, it's evident there is limited exposure to mega caps. You might view that as a positive feature, especially if you feel overexposed to the Magnificent Seven.

A surprising find is VFLO's strong 7.00 Momentum Score, which I derived using Seeking Alpha Factor Grades. However, I doubt this advantage will persist because there isn't anything in the methodology to suggest that VFLO's Index assesses recent price changes. Furthermore, there's a mix among the top holdings, with stocks like Cigna ( CI ) and PulteGroup ( PHM ) near their 52-week high prices but others like Bristol-Myers Squibb ( BMY ) and Humana ( HUM ) near their 52-week low prices. It could be linked to VFLO's EPS Revision Score, which is much better than the disastrous scores for COWZ and FLOW. Regardless, it's a bonus and a possible reason for more success in the future.

Still, in the end, it's a balancing act. Questions I would ask include:

1. How important is diversification? If VFLO is only one small complement to your well-diversified portfolio, my concentration concerns might be irrelevant.

2. Which factors do you value most? Compared to the other three free-cash-flow-focused funds, VFLO slightly sacrifices quality and value for substantially better growth potential.

3. How much do you rely on forward growth estimates? I like the balance between trailing and forward free cash flow estimates, but analysts can't predict the future, especially with the highly volatile Energy sector where VFLO derives much of its estimated earnings growth.

Investment Recommendation

VFLO better balances the factor mix compared to rivals COWZ, FLOW, and COWS. By selecting securities by free cash yield first and then growth score, VFLO achieves a comparable estimated EBITDA growth as IWB but at less than half the forward earnings valuation. On paper, it's a fantastic combination. However, I'm also mindful of the general composition of the U.S. stock market, where defensive sectors like Consumer Staples and Utilities, which have solid risk-adjusted returns, have no place in VFLO. Instead, preference, at least currently, is given to Consumer Discretionary and Energy stocks, the two sectors with the worst risk-adjusted returns over the last decade. Furthermore, I reiterate that it's easy to create a fundamentally strong portfolio of just 50 stocks, so the hidden cost of VFLO's weak diversification, however small, should be considered. Given these pros and cons, I believe a "hold" rating is most appropriate, and I look forward to providing more updates as the fund reconstitutes. Thank you for reading.

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