Advisors flock to ETF that upends traditional value investing metrics

All it took was a subtle tweak to traditional value investing for a relative newcomer in the ETF space to come up with one of the hottest funds on the market.

While value investing purists remain fixated on price-to-book formulas, Pacer ETFs zeroed in on free cash flow metrics and commissioned Russell Investments to carve out an index of 100 companies from the Russell 1000 Index with the highest free cash flow yields.

The Pacer US Cash Cows ETF (COWZ) launched in December 2016 and quietly grew to a few hundred million until two years ago, when the economic environment, including rising interest rates and high inflation, laid the foundation for a value investing run.

COWZ crushed the growth-oriented S&P 500 Index over the past two years, gaining 42.6% in 2021, when the S&P was up 28.7%, and 20 basis points last year, when the S&P was down 18.1%.

The ETF has seen its assets swell to nearly $13 billion.

“The genesis for the strategy is basically that we had this notion that with the way the stock market is constructed today, valuations are mostly based on a company’s intangible assets, and the traditional value approach to investing is low price-to-book value,” said Sean O’Hara, Pacer ETFs president.

A problem with that traditional valuation modeling, O’Hara explained, is that it overlooks the value of intangible assets, especially at companies like Uber and AirBnb, which have very little in tangible assets.

“The free cash flow yield a company generates is divided by its enterprise value, and the enterprise value is the market cap plus the debt, minus cash,” he said. “It’s really simple. But nobody thought of this strategy because the framework and hierarchy has been in place all along, and there’s so much entrenched usage.”

Essentially, there’s nothing new about a focus on free cash flow, but it is unique to use it as a primary metric.

In addition to its standout performance against the S&P 500, COWZ has been running away from the broader Russell 1000 Index. In just over six years since it was launched, COWZ has generated an annualized return of 14.3%, which compares to an 8% annualized gain by the Russell 1000 over the same period.

At $23 billion, Pacer ranks as the 16^th largest ETF provider in the country and is enjoying unique success for a company founded just seven years ago.

Todd Rosenbluth, director of research at VettaFi, credits COWZ with having a distinct strategy that is well-suited for the current environment.

“COWZ is a cash-flow-generation and high-quality strategy, and such a strategy is in demand when earnings and market volatility heats up,” he said. “But it is rare for funds from smaller firms to break out like this.”

At $13 billion, COWZ represents more than half of Pacer’s total assets, but the company offers seven other ETFs focused on free cash flow. And, as Sumit Roy of ETF.com reported, Pacer is likely to ride this horse for a while.

O’Hara admits that it isn’t just the unique valuation metric and recent performance that's attracted so much money to COWZ over the past two years.

“We have 79 external wholesalers focused on wirehouses, bigger RIAs, smaller RIAs, insurance companies and banks, and we’re on every major platform there is,” he said. “The primary reason we’ve had success is we spend our time with the financial advisors, and there’s a little bit of explanation needed to understand what COWZ is. You must understand cash flow yield and why it works in certain environments.”

COWZ is up 5% so far this year, which is basically in stride with the S&P 500. O’Hara said the value-oriented strategy should stay competitive until the market enters another strong growth phase.

“The data we have would lead us to believe it would do well off the bottom, because the market will have to go through a capitulation phase,” he said. “During a massive growth phase, we would probably lag growth, but we would do well versus traditional value.”