CALF: Mostly Undervalued, Grossly Profitable Small-Size Equities With Caveats (BATS:CALF)

Pacer US Small Cap Cash Cows 100 ETF (BATS:CALF) is a smart-beta ETF offering exposure to cash-rich U.S. mid- and small-size companies with value characteristics. Since its inception on 16 June 2017, the fund has amassed ~$856 million in net assets. Its expense ratio of 59 bps seems a bit too high, though justified given the complex strategy.

CALF has a strong tilt toward the value factor coupled with solid quality, which is a positive surprise given that small-size companies tend to deliver lower margins and weaker capital efficiency compared to larger counterparts. However, the fund’s strategy is not completely flawless, which justifies the Hold rating. More on that is below in the article.

The investment strategy and the portfolio

According to the summary 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, which is tracked by the iShares Core S&P Small-Cap ETF (IJR). I dissected the IJR portfolio in December 2021, assigning it a Hold rating due to softer quality and the interest rates risk.

From that pool, only companies with FCF and earnings forecasts for the next two fiscal years can proceed to step two, where one hundred of those with the highest trailing twelve months Free Cash Flow/Enterprise Value ratio (the FCF yield) are selected for the portfolio and weighted using FCF.

As I pointed out in my January article on the Pacer US Cash Cows 100 ETF (COWZ), the FCF yield (or the EV/FCF multiple) not only allows to find truly underappreciated cash-rich companies but also somewhat immunizes a portfolio against the “enterprise value problem,” a phenomenon when a company is trading with below-average and at times even rock-bottom Price/Earnings, P/Cash flow, or P/FCF, but with lofty EV/EBITDA or EV/Cash flow, which points to the fact it has a high balance sheet risk and investing in such a “value stock” is a suboptimal choice.

Of course, the metric has substantial limitations as the financial sector simply cannot be screened for value stocks using it given the concept of FCF is meaningless for banks, insurance companies, and the like. Rather expectedly, neither CALF nor COWZ has exposure to financials.

As of May 16, the fund had a portfolio of 100 stocks, with the key ten holdings having around 21.6% weight. Though CALF is tilted towards small-caps (below $2 billion market value), with a ~62% allocation, its exposure to mid-caps is also rather larger; a ~$4.3 billion Asbury Automotive Group (ABG) is one of the examples, with a ~2.1% weight.

The portfolio is extremely heavy in consumer discretionary stocks that are sporting an over 44% weight, which makes it distinctively different from COWZ, which is overweight in healthcare and energy; sizeable exposure to the latter has likely allowed it to deliver positive total return and outperform CALF this year, which has just ~5.8% of its portfolio invested in E&P, midstream, oilfield services players, and the like.

Most of the consumer discretionary names in the CALF equity basket are grossly underappreciated; more specifically, 29 out of 39 stocks from the sector have an at least B- Quant Valuation grade pointing to the fact they are trading at a discount to their 5-year averages and/or sector medians.

Besides, the positive surprise is that all the companies either have high-quality characteristics (a B- Profitability grade or stronger) or are more than adequately profitable, with a C (+/-) rating. The corollary here is that their lower multiples are principally the consequence of the small-size factor, not a discount stemming from paltry margins, weak or even negative returns on capital, inability to deliver sufficient cash flow, etc.

The table below summarizes the Quant data for the fund’s top 20 investments in the consumer discretionary sector. As you can notice, the only Achilles heel is the growth factor as a few companies in the set are either growing anemically or tackling sales/earnings/cash flows contraction.

Industrials are the second-largest sector, with an almost 18% weight. Relative inexpensiveness and decent quality can be observed in its case too. Interestingly, even a few GARP plays can be spotted, like ArcBest Corporation (ARCB), which has both value and growth characteristics.

Overall, around 63% of the fund’s net assets are allocated to value stocks, which is a result worth respecting. Quality is not totally flawless, with an ~76% allocation, but rather adequate for a small-size fund, more likely thanks to the EV/FCF and earnings screen used by the index managers quarterly.

Taking a closer look at FCF yields

Using the data from Seeking Alpha and my own computations, I assessed the EV/FCF multiples of CALF’s current holdings. The key takeaway is that it would not be fair to say all the fund’s investments have either large or even positive FCF yields. Some are trading at a premium or cash-burning, hence, their yields are negative.

For example, Ultra Clean Holdings (UCTT), Tredegar (TG), Fossil Group (FOSL), and Kelly Services (KELYA) are FCF-negative; FOSL and KELYA outspent net operating cash flow.

Meanwhile, iTeos Therapeutics (ITOS) is a peculiar example of a stock with a negative FCF yield of (317)% caused by negative enterprise value, while its FCF is nothing short of exemplary and accounts for almost 98% of the net CFFO.

However, it should be noted that for 83% of CALF’s holdings, the EV/FCF multiple is below 15x, while stocks trading with a single-digit multiple account for over 57% of the portfolio, which once again reinforces two points that 1) the fund has comparatively strong quality, 2) most of its holdings are substantially undervalued.

What returns the strategy was capable of delivering

Unfortunately, the returns CALF has delivered since its inception are broadly disappointing, though there are a few bright spots. Surely, it underperformed the iShares Core S&P 500 ETF (IVV) during the July 2017 – April 2022 period, also finishing behind its larger counterpart COWZ.

More disappointingly, CALF outperformed IJR only marginally, with a return just a few bps better. In my view, one of the culprits here is the burdensome expense ratio of 59 bps. Anyway, this highlights the limitations of the cash-flow-focused strategies over relatively short periods.

Another issue is the Sharpe and Sortino ratios being the weakest in the selected group, which implies its risk-adjusted return was completely unsatisfying.

However, there is a silver lining. For example, CALF beat IVV and IJR in 2021, finishing only behind COWZ and delivering a staggering ~37.4% total return, more likely undergirded by the capital rotation to value. 2020 was also fairly strong, with an ~16.6% return, only ~2% weaker than IVV’s 18.4%. IJR and COWZ did worse.

This year, despite its value tilt, CALF has been in the red, though it has been less afflicted than financials-heavy IJR and tech-heavy IVV. COWZ, contrarily, has been shining.

More likely, the returns small-caps have delivered YTD are so lackluster because investors are of the opinion higher cost of equity bolstered by interest rates climbing higher will take its toll on the small-cap echelon which is more vulnerable to the looming capital scarcity; I highlighted this risk in my December note on IJR.

Final thoughts

CALF eliminates the ingrained issues of conventional passive value investing by moving away from P/E and P/B to the free cash flow yield, thus also adding a quality ingredient to its investment mix, which is of greater importance for small-cap portfolios. Certainly, this is worth appreciating.

However, elevated turnover (123% as of the summary prospectus), comparatively burdensome expenses, and lower quality compared to large-cap-focused ETFs are the primary downsides worth paying attention to. Returns, including risk-adjusted, are another disappointment. Besides, the risks that I discussed in the December note are still relevant. That being said, I am skeptical of CALF, assigning this fund a Hold rating.