Free cash flow (FCF) is defined as what a company has left over accounting for maintenance and operational expenses and it’s a revered investing metric for a simple reason: shares of companies that area prolific generators of free cash flow typically outperform those that are not.
That holds true at the industry- and sector-level. Likewise, understanding why FCF is meaningful is easy to comprehend. In fact, some experts argue that FCF is more important than earnings per share because the former signals a company’s ability to initiate or grow dividends, potentially buyback shares and reduce debt. Coincidentally, those are the three cornerstones of shareholder yield.
Then there’s cash on hand, which simply put, is the amount of capital a company has at its disposal to finance acquisitions, debt reduction, expansion and shareholder rewards, among other things. Companies with substantial cash reserves and/or favorable debt/equity ratios often outperform their financially flimsy rivals over time.
The good news for investors is they don’t need to spend hours scouring financial reports in an effort to identify strong balance sheets and prodigious generators of FCF. Some exchange traded funds, including the following, do the heavy lifting for market participants.
Pacer US Cash Cows 100 ETF (COWZ)
The Pacer US Cash Cows 100 ETF (COWZ) is a $19.77 billion behemoth that turned seven years old last December. COWZ screens the Russell 1000 Index for attractively valued stocks with elevated FCF yields, making the Russell 1000 Value Index a relevant barometer for this ETF’s success.
COWZ has been up to the task. Over the past three years, the ETF is higher by 52.6%. Said another way, combining the returns of the Russell 1000 and Russell 1000 Value indexes over that period would result in a sum that still slightly trails the returns offered by COWZ.
COWZ also offers investors a diverse portfolio as none of its 101 holdings exceed weight of 2.34%. The ETF could also be solid idea for technology-heavy portfolios because that sector accounts for just 9.45% of the fund’s roster. Energy and consumer cyclical names combine for over 48% of the COWZ lineup.
VictoryShares Small Cap Free Cash Flow ETF (SFLO)
Following its December debut, the VictoryShares Small Cap Free Cash Flow ETF (SFLO) is a new kid on the free cash flow ETF block, but its objective is compelling because investors rarely associated FCF with small-caps. The conventional wisdom is that many small firms aren’t profitable, so FCF is an unattainable luxury.
SFLO proves the opposite is true. The rookie ETF follows the Victory U.S. Small Cap Free Cash Flow Index, which “aims to select high quality small/mid cap companies from the universe by applying profitability screens. It then selects companies with the strongest free cash flow yield that exhibit higher growth. Higher free cash flow gives companies the ability to reinvest cash, pay dividends, or repay debts,” according to the issuer. SFLO attempts to beat the Russell 2000 Value Index, an objective the ETF accomplished in January.
The VictoryShares ETF allocates approximately 65% of its weight the energy, consumer discretionary and industrial sectors compared to a combined allocation of 34.6% to those groups in the Russell 2000. SFLO already has $39.48 million in assets under management, indicating advisors and investors like the pairing of FCF and small-caps.
Global X U.S. Cash Flow Kings 100 ETF (FLOW)
The Global X U.S. Cash Flow Kings 100 ETF (FLOW), which debuted last July, features an approach that’s similar to what’s found with the aforementioned COWZ. FLOW follows the Global X U.S. Cash Flow Kings 100 Index – a gauge that’s a collection of domestic large-caps with above-average FCF yields relative to the broader market.
Like COWZ, FLOW is energy and consumer cyclical heavy, but the fund also features substantial allocations to healthcare, materials and technology stocks. Over time, FLOW could bring further confirmation to the notion that FCF investing is efficacious.
“Relative to a broader U.S. equity index, the Russell 1000, companies with high levels of free cash flow currently exhibit a higher level of return-on-equity, another quality factor measurement of profitability,” according to Global X research. “In addition, high free cash flow yielding companies have grown their earnings at a much faster rate, a growth style characteristic, than the same broad market index. All while demonstrating historically lower price-to-earnings ratios, an alignment towards the value factor.”
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.