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Among the myriad of metrics used to evaluate publicly traded companies – and there are plenty – free cash flow (FCF) is one of the most important.
Put simply, free cash flow is what’s left over after subtracting capital expenditures from cash flow from operations. Though not infallible, FCF can help investors gauge a company’s financial health and it “signals a company's ability to pay down debt, pay dividends, buy back stock, and facilitate the growth of the business,” according to Investopedia.
FCF provides investors with a cleaner view of a company’s overall financial health and its ability to fund growth and shareholder rewards than simply looking at earnings per share. Again, FCF isn’t the perfect metric and it’s not a promise that company with strong related traits will generate impressive returns. However, there is compelling evidence on that front.
“Companies generating high free cash flow yield have the ability to grow dividends over time and produce better earnings. In the chart below, free cash flow yield has the highest return with the fewest periods of negative twelve month returns,” according to Pacer ETFs, an issuer of exchange traded funds rooted in free cash flow principles.
(Image: Pacer ETFs)
Look at LCOW
Pacer is relevant in this conversation because earlier this month, the firm launched the Pacer S&P 500 Quality FCF Aristocrats ETF (LCOW). The rookie ETF follows the S&P 500 Quality FCF Aristocrats Index, which is something of a cousin to the popular S&P Dividend Aristocrats indexes.
“The S&P 500® Quality FCF Aristocrats Index measures the performance of companies in the S&P 500 that have had positive free cash flow (FCF) for at least 10 consecutive years and simultaneously have high FCF margin and high FCF return on invested capital (ROIC),” according to S&P Global.
Index methodology is always pertinent when evaluating ETFs and that’s particularly true in the case of LCOW. Consider the following regarding the S&P 500. As of last month, the index’s FCF margin was 18.5% and its FCF ROIC ratio was 16.9%, but when trimming that universe down to the companies with at least 10 years of FCF growth, those percentages increase to 21.3% and 22.5%, respectively, according to Pacer data.
Moreover, when accounting for LCOW’s capping and weighting methodology, those percentages swell to 27.6% and 27%, respectively. Bottom line: there’s efficacy in the LCOW methodology because it has the potential to generate superior risk-adjusted returns.
(Image: S&P Dow Jones Indices)
LCOW Details
Strong FCF traits are sector-agnostic, but that said, some groups are simply better than others. So it’s not surprising that technology stocks account for 41.20% of the LCOW roster. Upon rebalancing, LCOW holdings are capped at 5% and sector weights are limited to 40%.
Financial services, healthcare and communication services names combine for another 40% and three of the 11 GICS sectors – materials, real estate and utilities – aren’t represented in the new ETF. The weighted average market cap of LCOW’s 100 components is north of $830 billion.
The new ETF charges 0.49% per year, or $49 on a $10,000 stake.