Summary
- CALF selects 100 small-cap stocks based on free cash flow yield, but weights based on free cash flow dollars. This important distinction gives the portfolio a size and quality boost.
- Quality is a concern with most small-cap ETFs. However, CALF does it best. Its 8.03/10 Profit Score leads all peers, as does its rock-bottom 8.67x forward earnings valuation.
- For the second consecutive quarter, CALF's reconstitutions moved in the right direction. Rather than bargain basement hunting, several top holdings have excellent earnings momentum and positive sentiment on Wall Street.
- I've upgraded my rating on CALF to a buy. Volatility concerns remain, as with most small-cap funds, but it's worth the speculation.
Investment Thesis
The Pacer US Small Cap Cash Cows 100 ETF (CALF) recently emerged as a top performer, outpacing 90% of its small-cap peers over the last six months. The portfolio changes I documented in September proved beneficial. And after the latest reconstitution, I'm now in a position to recommend CALF because of its low valuation, high free cash flow margins and profitability, and strong analyst momentum. I look forward to explaining why in further detail next.
CALF Overview
CALF tracks the Pacer US Small Cap Cash Cows Index, selecting 100 small-cap companies with high trailing twelve-month cash flow yields. Constituents are weighted based on free cash flow dollars rather than free cash flow yield, meaning larger companies are advantaged. It's a simple but crucial distinction for small-cap companies especially. A free cash flow yield screen on small-cap stocks typically results in an overly risky portfolio.
The graphic below describes the selection process, which includes a 2% weighting on individual securities. The quarterly reconstitutions allow for less style drift, but frequent turnover is only sometimes advisable with deep-value stocks. In September, CALF had the twelfth-worst YTD returns in a peer group of 72, but it closed the back half of the year with the seventh-best returns. Conservative investors may frown on these ups and downs, whereas risk-takers see opportunity in each reconstitution.
This graphic also highlights the pitfalls of investing in standard small-cap Indexes. For example, the free cash flow yield posted for the S&P SmallCap 600 Index is -9.79%, suggesting poor quality. CALF's 13.53% figure, if nothing else, improves the chances that its selections are at least profitable. In my opinion, the screen is less valuable with large-cap ETFs like the Pacer US Cash Cows 100 ETF ( COWZ ).
CALF's expense ratio is 0.49%, so it's costly. However, I noted in my annual U.S. Equity ETF review that the small-cap segment is one where investors should consider higher-fee products. If a strategy is that much better, it's worth the money.
Sector Exposures and Top Ten Holdings
CALF is a very concentrated ETF with nearly 50% of its holdings in Consumer Discretionary and Industrials stocks. There's no exposure to Financials, Real Estate, or Utilities, and only 3.59% to Consumer Staples. This composition indicates high volatility, so it's most appropriate for risk-takers who view volatility as an opportunity.
Due to the mostly equal-weight nature, CALF's top ten holdings list isn't representative of the ETF. However, recent top performers include Signet Jewelers ( SIG ), Matson ( MATX ), and UFP Industries ( UFPI ). These aren't household names, but I will add more color soon by examining the fund at the industry level.
Performance History
The following table summarizes 1-5 year returns for the 30 largest small-cap dividend, value, and blended ETFs with sufficient history. The list is sorted by five-year returns, and CALF's 44.41% gain was fourth-best behind RWJ , XSVM , and DWAS .
Last year's 15.20% loss was mediocre, only the 17th best in this sample. However, as discussed previously, its six-month returns to finish the year were seventh-best in total and third-best in this sample, behind DWAS and VBR .
Added volatility is apparent when looking at long-term returns. Still, CALF's annualized standard deviation is similar to the iShares S&P SmallCap 600 Value ETF ( IJS ) and the iShares Core S&P SmallCap ETF ( IJR ). CALF's 7.68% annualized return mostly offset the higher risk, leading to competitive Sharpe and Sortino Ratios.
CALF Analysis
The last reconstitution swapped 27 companies, and I favor several changes. Oil & Gas E&P representation increased by about 2% to 6.70%, followed by Automotive Retail (6.19%), Semiconductors (4.74%), and Biotechnology (4.66%). Meanwhile, CALF reduced exposure to the riskier Apparel Retail industry, which now accounts for just 3.05% of the portfolio.
The results are stronger fundamentals, so I believe CALF is moving in the right direction. The following table summarizes several metrics, both pre-and post-reconstitution, and the bottom rows allow you to compare against IJS and IJR for benchmark purposes.
What makes CALF unique is its 8.03/10 Profit Score, derived using Seeking Alpha Factor Grades and the highest among all 75 small-cap ETFs I track. The previous portfolio scored a respectable 7.77/10, and both easily beat the 5.53/10 and 6.02/10 scores for IJS and IJR. Other quality-focused small-cap ETFs like KSCD, DGRS, SQLV, OUSM, and XSHQ have scores between 5.22/10 and 7.62. However, only some can match CALF's estimated 21.12% earnings growth rate and 13.66% free cash flow margins, and none can match its 8.67x forward earnings valuation. The 6.47x trailing cash flow valuation is further evidence that the current portfolio represents high quality at a low price, an approach I recommend when dealing with the small-cap segment.
Finally, I want to highlight CALF's improved 5.96/10 EPS Revision Score. Typically, value-oriented portfolios rotate into beaten-down stocks with each reconstitution, but this score proves that CALF works differently. Many top holdings had positive sales and earnings surprises last quarter. They also have double-digit expected sales growth, trade below 10x forward earnings, and have B+ or better Seeking Alpha EPS Revision Grades. Here are six examples.
Investment Recommendation
CALF has the highest profitability and lowest valuation of any small-cap ETF I track. Along with a solid long-term track record, a 21% estimated earnings growth rate, and high free cash flow margins, it's worth speculating. The fundamental improvements recently made without sacrificing quality were a pleasant surprise. And since this was the second consecutive positive reconstitution, I've decided to upgrade my rating on CALF to a buy.
For further details see:
Buy CALF: It's Moo-Ving In The Right Direction