Pacer US Cash Cows 100 ETF: Time To Plan An Exit Strategy (BATS:COWZ)

Cash cow with dollar sign

Enes Evren/iStock via Getty Images

Investment Thesis

Several readers requested I look into the Pacer US Cash Cows 100 ETF (BATS:COWZ), which uses free cash flow yield to select the top 100 securities in the Russell 1000 Index. The reason for the request is obvious: COWZ ranks highly no matter what category you place it in. Consider its five-year total returns through February 2022 compared to others in my U.S. Equity ETF Database:

  • 1/22 for all large-cap value ETFs
  • 20/ 64 for all large-cap blend ETFs
  • 2/19 for all large-cap dividend ETFs

FactSet places COWZ in the blend category, while Morningstar places it in the value category. But I’m less interested in the category and more interested in the quality of its constituents, the accuracy of analysts’ forecasts, and the way Pacer selects its components, which I find troubling. With a 10.48 forward P/E ratio and 17.79% forward EPS growth, COWZ seems to offer the ultimate combination of value and growth. However, this is only true if inflation remains high. COWZ overweights commodity-driven stocks that are notoriously difficult to forecast, and a reversal could be in order in the near or mid-term. Therefore, buy or hold COWZ today to fight inflation, but don’t look away for too long. Understand that this ETF was weak pre-pandemic, and there’s every chance it will eventually return to its roots.

ETF Overview

Strategy and Fund Basics

COWZ tracks the custom-built Pacer US Cash Cows 100 Index, screening Russell 1000 securities based on their free cash flow yield. Its fact sheet describes this calculation as follows:

COWZ Free Cash Flow Yield Definitions

Pacer ETFs

The Index excludes Financial companies (except REITs) and rebalances quarterly on after the third Friday in March, June, September, and December. Frequent rebalancing leads to high turnover, which sometimes is beneficial but often isn’t with value ETFs. The reason is that value investing requires long holding periods. To delete a stock simply because another stock became even cheaper (through price depreciation) goes against my portfolio management philosophy. In effect, it ignores sector allocations and is anti-momentum in a way, but it could be a good way to temporarily deviate based on changing market conditions.

The order in which Pacer screens constituents is crucial. According to its summary prospectus, the initial universe is based on projected free cash flows and earnings over the next two years. A company is removed if they have negative average projected cash flows or earnings. If no forward year free cash flow or earnings data is available, they remain. However, final selections are made based on trailing free cash flow yield. In addition, weights are determined based on trailing free cash flow (not free cash flow yield) and capped at 2%. I don’t know the reason for this, especially since the selected constituents’ projected cash flow and earnings data are available. Perhaps Pacer feels the data isn’t reliable, or they’re using it to counter the anti-momentum factor I described earlier. Either way, I’m skeptical and will be discussing the potential impact later.

Finally, I’ve listed some key statistics below for COWZ as of March 28, 2022. The 0.49% in annual fees Pacer charges is high but potentially is worth it for what’s arguably an actively-managed ETF.

  • Current Price: $50.53
  • Assets Under Management: $3.05 billion
  • Expense Ratio: 0.49%
  • Number of Holdings: 100
  • Launch Date: December 16, 2016
  • Trailing Dividend Yield: 1.41%
  • Five-Year Beta: 1.35
  • Portfolio Turnover: 104%
  • Assets in Top Ten: 21.15%
  • Tracked Index: Pacer US Cash Cows 100 Index

Sector Exposures and Top Ten Holdings

After the recent reconstitution, COWZ primarily invests in Health Care (23.13%) and Consumer Discretionary (17.99%) stocks. Materials, Technology, and Energy stock exposures are in double-digits while Real Estate and Utilities have negligible allocations. Again, I’d like to highlight the absence of Financials stocks, which are screened out. Large-cap financials have been underperformers since COWZ launched, so their absence has benefitted investors.

COWZ Sector Exposures

Pacer ETFs

I’ve listed the top ten holdings below, many of which you’ll recognize, like Moderna (MRNA), Meta Platforms (FB), and Pfizer (PFE).

COWZ Top Ten Holdings

Pacer ETFs

Performance Analysis

Earlier, I described how COWZ had excellent five-year returns regardless of its categorization. I want to expand on this, as Morningstar’s table below suggests COWZ wasn’t always a top-performing ETF.

COWZ Historical Returns - Morningstar

Morningstar

Note how COWZ ranked in the third quartile from 2017 to 2019. In 2019, 75% of peers outperformed, but relative performance substantially improved in 2020, 2021, and YTD 2022 through February. So what changed? Inflation. As I’ll describe later in my fundamental analysis comparing COWZ with the iShares Russell 1000 ETF (IWB), COWZ holds a lot of stocks that have benefited tremendously from rising commodity prices. Furthermore, forecasting commodity prices is often a fruitless effort, and remember that Pacer selects constituents by trailing free cash flow yield. Once inflation gets under control, commodity-driven stocks will only get more attractive as their stock prices fall (and yields rise). It may take several quarters for the trailing twelve-month free cash flow figure to reflect this reality.

My cautionary note doesn’t take away the success COWZ experienced overall. Against IWB and the iShares Russell 1000 Value ETF (IWD), COWZ outperformed by an annualized 0.87% and 6.61%, respectively. But the graph below makes it clear that up until the market crashed in March 2020, its returns-to-date were only as good as IWD. The higher standard deviation is likely due to the volatile nature of commodities and because its weighted-average market capitalization tends to be on the lower end of the large-cap scale.

COWZ vs. IWB vs. IWD Performance History

Portfolio Visualizer

Finally, I’ve compiled a list of comparators in the large-cap value categories and sorted them based on their five-year returns. I’ve also included each ETF’s five-year return to risk ratio, which is the annualized return divided by the annualized standard deviation. This ratio is similar to the Sharpe Ratio, excluding the risk-free rate for simplicity.

Large-Cap Value ETF Performances

Author

COWZ tops the list, but the Fidelity Value Factor ETF (FVAL) has better risk-adjusted returns and performed relatively well pre-pandemic. The SPDR S&P 1500 Value Tilt ETF (VLU) and the Vanguard Mega Cap Value ETF (MGV) also look good and offer better diversification at the sector level.

VLU vs. FVAL vs. MGV vs. COWZ Sector Exposures

Morningstar

Fundamental Analysis

Key Attractions

The free cash flow yield method results in stocks with strong value and growth characteristics. It’s the ultimate combination for growth-at-a-reasonable-price investors and a strategy that resonates with me. The following table, which highlights selected metrics for COWZ’s top 20 industries, confirms this attractive setup.

COWZ Fundamental Analysis

Author

A few high-level points I’d like to make:

1. COWZ is more concentrated than IWB because it holds only 100 stocks versus over 1,000 for IWB.

2. As discussed previously, its five-year beta of 1.35 is elevated due to its relatively low $63 billion market capitalization.

3. Sales for COWZ’s constituents have grown at a 16.12% annualized rate over the last five years compared to 13.49% for IWB. It makes sense since increased sales ultimately drive increased cash flows. Analysts expect roughly the same level of growth for the following year.

4. COWZ’s cash to total debt ratio is 11.22% lower than IWB’s. I found this surprising, and I ensured an apples-to-apples comparison by excluding Financials stocks in IWB (this ratio is less useful for banks, in particular). Although this is operating and not free cash flow, my interpretation is that COWZ’s constituents hold more debt than the average Russell 1000 security.

5. Valuation is the main attraction. COWZ has a forward price-earnings ratio of just 10.48, 16.02 points less than IWB. COWZ looks deeply discounted, which has been a theme the market has favored in 2022.

Potential Negatives

While the numbers look mostly positive, let’s not forget what’s driving them. Keep in mind that sector and industry allocations usually drive returns rather than specific stock selection decisions, and I’ve noted the following differences between COWZ and IWB from an industry allocation perspective:

  1. Biotechnology: +7.68%
  2. Oil & Gas Exploration & Production: +6.63%
  3. Steel: +5.90%
  4. Commodity Chemicals: +5.80%
  5. Systems Software: (5.28%)
  6. Semiconductors: (4.97%)
  7. Health Care Services: +3.73%
  8. Oil & Gas Refining & Marketing: +3.42%
  9. Interactive Media & Services: (3.20%)
  10. Internet & Direct Marketing Retail (3.16%)

Biotechnology

COWZ holds six biotechnology stocks as follows:

  • Moderna (MRNA)
  • Regeneron Pharmaceuticals (REGN)
  • Bristol-Myers Squibb (BMY)
  • Gilead Sciences (GILD)
  • Biogen (BIIB)
  • United Therapeutics (UTHR)

Using the iShares Biotechnology ETF (IBB) as a proxy, it’s clear why these stocks qualified for the Cash Cows Index. IBB is down 15.95% YTD, but the graph below suggests a rebound isn’t necessarily imminent. Biotechnology stocks hadn’t had a solid year since 2015, when they ended their five-year win streak over the SPDR S&P 500 ETF (SPY). In the last five years, it’s underperformed SPY by an annualized 10%.

IBB vs. SPY Historical Performance

Portfolio Visualizer

Oil & Gas

COWZ holds ten oil and gas stocks as follows:

  • ConocoPhillips (COP)
  • Occidental Petroleum (OXY)
  • EOG Resources (EOG)
  • Exxon Mobil (XOM)
  • Valero Energy (VLO)
  • Phillips 66 (PSX)
  • Diamondback Energy (FANG)
  • APA Corp. (APA)
  • Marathon Oil (MRO)
  • Targa Resources (TRGP)

Here’s how an equal-weighted portfolio of these ten stocks, rebalanced quarterly, would have fared in the last ten years.

COWZ Oil and Gas Stocks

Portfolio Visualizer

The purpose of this chart is to highlight this portfolio’s volatility rather than its poor long-term performance. Indeed, adding energy stocks has been a significant source of outperformance for COWZ and other ETFs, especially in the high-dividend category. However, COWZ is doubling down on this exposure even as the Fed has made fighting inflation a top priority.

At the June 2021 rebalancing, COWZ maintained its near nil exposure to Energy stocks. Subsequently, in September 2021, it boosted exposure to nearly 6%. Then, in December 2021, it added 5% to Energy, with managers noting how “the current inflationary environment has led to elevated levels of free cash flow for sectors and companies with significant proportions of tangible assets.”

COWZ December 2021 Rebalancing Summary

Pacer ETFs

And now, in March 2022, Energy exposure sits at 16%. COWZ successfully picked up on the inflation trend, but I want readers to know that it may be a slow unwinding of Energy stocks as they peak due to its selection process of using trailing twelve-month free cash flows.

Steel

COWZ holds four steel stocks:

  • Nucor (NUE)
  • United States Steel (X)
  • Cleveland-Cliffs (CLF)
  • Steel Dynamics (STLD)

The price of steel has dramatically increased, leading to incredible cash flow growth. Take Nucor, for example. Operating cash flow more than doubled in 2021, and the stock gained 118.45% and is up another 38.08% this year.

Nucor Q4 2021 Investor Presentation

Nucor Q4 2021 Investor Presentation

In a nutshell, bullish talking points for U.S. steel stocks include:

  • relatively low natural gas costs
  • decreased Chinese production to curb emissions
  • the European Union banning finished steel imports from Russia

It’s impossible to project future cash flows and earnings in this industry, but Nucor management sought to manage expectations with Q1 2022 guidance that was lower than Wall Street’s expectations. Despite the four steel names above being cash cows at the moment, COWZ shareholders also need to manage expectations in the future and understand that recent strong performance is unlikely to repeat.

Investment Thesis

COWZ looks strong at the moment and is likely to continue being an excellent hedge against inflation. It trades at just 10.48x forward earnings and has an estimated 14.38% revenue growth rate and 17.79% EPS growth rate. Its outperformance began at the height of the pandemic around March 2020 and continued until it was the best-performing large-cap value ETF over the last five years. That’s quite an achievement, but it’s equally important to realize how COWZ did it. My take is that it successfully rode the high-inflation wave, doubling and tripling down on Energy and other commodity-driven stocks to beat the Russell 1000 Value Index by 22% post-crash.

However, Pacer’s use of trailing twelve-month free cash flow is a flaw. As commodity prices peak, trailing free cash flow figures will remain high for at least a quarter or two. Meanwhile, stock prices will decline, making free cash flow yield figures even higher if the denominator (enterprise value) falls faster than the numerator (free cash flow). I’d strongly prefer using projected free cash flows, but it is what it is. Therefore, I encourage COWZ owners to start planning an exit strategy. According to Morningstar, it was a poor performer from 2017 to 2019, so there are few reasons to hold onto it should the Fed succeed in controlling inflation. In summary, I don’t think COWZ is the diamond many think it is. Take your chances if you must, but I feel better options are available.

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