CALF: Mostly Undervalued and Largely Profitable Small Stocks with Caveats (BATS:CALF)
Pacer US Small Cap Cash Cows 100 ETF (BAT: CALF) is a smart beta ETF offering exposure to cash-rich US small and mid-sized companies with value characteristics. Since its inception on June 16, 2017, the fund has raised approximately $856 million in net assets. Its expense ratio of 59 basis points seems a little too high, although justified given the complexity of the strategy.
CALF has a strong tilt towards the value factor associated with strong quality, which is a welcome surprise given that smaller companies tend to offer lower margins and lower capital efficiency compared to their larger counterparts. However, the fund’s strategy is not entirely flawless, which justifies the Hold rating. More on this below in the article.
Investment strategy and portfolio
According to the simplified prospectus, CALF tracks the Pacer US Small Cap Cash Cows Index, which is reconstituted and rebalanced in March, June, September and December.
The selection universe encompasses the constituents of the S&P SmallCap 600 index, followed by the iShares Core S&P Small-Cap (IJR) ETF. I dissected the IJR portfolio in December 2021, assigning it a Hold rating due to lower quality and interest rate risk.
From this pool, only companies with forecasts of FCF and earnings for the next two fiscal years can proceed to the second stage, where one hundred of those with the highest Free Cash Flow to Enterprise Value ratio over the last twelve months (the FCF return) are selected for the portfolio and weighted in FCF.
As I pointed out in my January article on the Pacer US Cash Cows 100 (COWZ) ETF, the FCF yield (or EV/FCF multiple) not only finds truly undervalued cash-rich companies, but also to somewhat immunize a portfolio against the “enterprise value problem”, a phenomenon when a company trades with prices/earnings, P/Cash flow or P/FCF below average and sometimes even at most low, but with a high EV/EBITDA or EV/Cash flow, which indicates that it has a high balance sheet risk and that investing in such a “store of value” is a suboptimal choice.
Of course, the metric has significant limitations as the financial sector simply cannot be screened for value stocks using it since the concept of FCF does not make sense for banks, utilities insurance, etc As expected, neither CALF nor COWZ are exposed to financials.
As of May 16, the fund had a portfolio of 100 stocks, with the ten key holdings having a weighting of around 21.6%. Although CALF is biased towards small caps (market value less than $2 billion), with an allocation of around 62%, its exposure to mid caps is also rather larger; A ~$4.3 billion Asbury Automotive Group (ABG) is one example, with a weighting of around 2.1%.
The portfolio is extremely heavy in consumer discretionary stocks which have a weighting of more than 44%, which clearly differentiates it from COWZ, which is overweight in health care and energy; significant exposure to the latter likely enabled it to generate a positive total return and outperform CALF this year, which has invested only around 5.8% of its portfolio in players in the E&P, midstream, oil services, etc.
Most of the consumer discretionary names in the CALF equity basket are grossly undervalued; specifically, 29 of the 39 stocks in the sector have a rating of at least B-Quant indicating that they are trading at a discount to their 5-year averages and/or sector medians.
Further, the positive surprise is that all companies either have high quality characteristics (a B- or better profitability rating) or are more than adequately profitable, with a C (+/-) rating. The corollary here is that their lower multiples are mainly the consequence of the small size factor, and not a discount linked to derisory margins, low or even negative returns on capital, an inability to deliver sufficient cash flow, etc.
The table below summarizes the quantitative data of the fund’s top 20 investments in the consumer discretionary sector. As you can see, the only Achilles heel is the growth factor, as a few companies overall are either experiencing anemic growth or tackling shrinking sales/profits/cash flow.
Industry is the second largest sector, with a weight of almost 18%. Relative low cost and decent quality can also be observed in his case. Interestingly, even a few GARP games can be spotted, such as ArcBest Corporation (ARCB), which has both value and growth features.
Overall, approximately 63% of the fund’s net assets are allocated to value stocks, a result to be respected. The quality isn’t entirely flawless, with an allocation of around 76%, but quite adequate for a small fund, most likely thanks to the EV/FCF and earnings screen used by managers. indices each quarter.
Focus on FCF returns
Using data from Seeking Alpha and my own calculations, I evaluated the EV/FCF multiples of CALF’s current holdings. The main finding is that it would not be fair to say that all investments in the fund have significant or even positive FCF returns. Some trade at a premium or burn money, therefore their returns are negative.
For example, Ultra Clean Holdings (UCTT), Tredegar (TG), Fossil Group (FOSL), and Kelly Services (KELYA) are FCF-negative; FOSL and KELYA exceeded net operating cash flow.
Meanwhile, iTeos Therapeutics (ITOS) is a particular example of a stock with a negative FCF return of (317)% caused by negative enterprise value, while its FCF is simply exemplary and accounts for almost 98% of the CFFO net.
However, it should be noted that for 83% of CALF’s holdings, the EV/FCF multiple is less than 15x, while stocks trading at a single-digit multiple make up over 57% of the portfolio, further reinforcing two points that 1) the fund has a relatively strong quality, 2) most of its holdings are significantly undervalued.
What the strategy was able to deliver
Unfortunately, the feedback CALF has delivered since its inception has been disappointing overall, although there are some positives. Admittedly, it underperformed the iShares Core S&P 500 (IVV) ETF over the July 2017 – April 2022 period, also finishing behind its larger counterpart COWZ.
More disappointingly, CALF only marginally outperformed IJR, outperforming by a few basis points. In my opinion, one of the culprits here is the onerous expense ratio of 59 basis points. Either way, it highlights the limitations of strategies that focus on cash flow over relatively short time frames.
Another issue is that the Sharpe and Sortino ratios are the lowest of the selected group, implying that its risk-adjusted performance was completely unsatisfactory.
However, there is a silver lining. For example, CALF beat IVV and IJR in 2021, finishing only behind COWZ and delivering a staggering total return of around 37.4%, most likely supported by capital turnover in value. 2020 was also quite strong, returning around 16.6%, only around 2% less than IVV’s 18.4%. IJR and COWZ did worse.
This year, despite its value bias, CALF has been in the red, although it has been less affected than the financial-heavy IJR and the technology-heavy IVV. COWZ, on the contrary, shone.
More likely, year-to-date small cap returns are so lackluster because investors believe the higher cost of equity supported by rising interest rates will wreak havoc on the echelon. small caps which is more vulnerable to the impending capital shortage; I highlighted this risk in my December note on the IJR.
CALF eliminates the ingrained problems of conventional passive value investing by moving away from P/E and P/B in favor of free cash flow yield, thus also adding a quality ingredient to its investment mix, which is of greater importance for small cap portfolios. Certainly, it is worth appreciating.
However, high turnover (123% according to the simplified prospectus), relatively heavy expenses and lower quality than large-cap ETFs are the main disadvantages to pay attention to. Returns, including risk-adjusted, are another disappointment. Moreover, the risks I mentioned in the December note are still relevant. That being said, I’m skeptical of CALF giving this fund a Hold rating.