There’s a saying, “revenue is vanity, profits is sanity and cash is reality.”
This means that while high revenue or profits may make a business look good on paper, what really matters is having enough cash on hand to pay bills and keep the business running in the real world.
Cash is the lifeblood of any business. Without it, even the most successful company can quickly run into trouble. Cash allows a business to pay suppliers, employees, rent, and other expenses, and to invest in new opportunities.
In evaluating a business, one of the most important factors is its ability to generate cash. This shows whether the company is financially sustainable and can withstand economic downturns or other challenges. Revenue and profits are important, but they are not enough on their own.
Warren Buffett’s use of owner’s earnings highlights the importance of focusing on cash flows rather than just accounting profits when valuing a company.
To calculate owner’s earnings, you start with the net income of the business and add back any non-cash expenses, such as depreciation and amortization. Then, you subtract any capital expenditures and working capital investments required to maintain the business. The result is the amount of cash that is available to the owners of the business.
Some businesses, such as airlines, require significant investments in capital equipment to keep the business running. For example, airlines need to maintain and replace planes on a regular basis, which can be very expensive.
Buffett focuses on the maintenance CAPEX, which refers to the amount of money a company needs to spend just to keep its current operations going. This helps him determine whether a company is generating enough cash to sustain its current level of operations.
In addition to maintenance CAPEX, there is also growth CAPEX, which refers to the money a company spends on expanding its operations.
Owners earnings is a guesstimate as Buffett doesn’t really do very detailed mathematical calculation when valuing a company. If a spreadsheet is needed, it means it is too complicated and the business is something that he doesn’t understand.
Hence, one would not find this owners earnings calculation easily. But we can use a proxy called free cash flow (FCF). The key difference is that free cash flow does not take into account the difference between maintenance and growth capital expenditures, while owner earnings does.
The Pacer US Cash Cows 100 ETF (COWZ) is an ETF that selects stocks based on high free cash flow yield.
This free cash flow yield is calculated by dividing free cash flow with enterprise value. The latter is used instead of purely market cap because it consider the amount of debt and cash in the company, which makes this single metric more robust. Companies with higher debt will cause the yield to go down.
Some may not believe that one single metric can pick good performing stock. But we have to know that the S&P 500 index is also based on one metric – traded market cap.
In fact, COWZ has outperformed the S&P 500 ETF (SPY) since it was incepted 7 years ago – COWZ returned 13% per year while SPY did 12%. But COWZ is more volatile as shown by its higher standard deviations and there were some years it underperformed SPY. Nonetheless, it is still impressive for an ETF to deliver above 10% annual returns. (This ETF also made my list of the Best ETFs for 2024.)
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While the S&P 500 is a widely used benchmark for the US stock market, the Pacer US Cash Cows 100 ETF (COWZ) actually uses the Russell 1000 as its universe. This index includes the 1000 largest stocks in the US, and there is some overlap with the S&P 500. COWZ selects stocks based on their free cash flow yield and includes the top 100 highest-yielding stocks in its portfolio.
The top 10 holdings were:
PXD: PIONEER NAT RES
Z: ZILLOW
MCK: MCKESSON
GILD: GILEAD SCIENCES
XOM: EXXON MOBIL
BKNG: BOOKING
CVX: CHEVRON
OXY: OCCIDENTAL
ABBV: ABBVIE
CSCO: CISCO SYS
These high free cash flow yield stocks tend to be mature companies that some may describe as a ‘boomer portfolio’. In fact, some of the stocks in the COWZ portfolio, such as McKesson, Chevron, and Occidental, are also holdings in Warren Buffett’s portfolio. This similarity suggests that the methodology used by COWZ in selecting stocks is not too far off from how Buffett values stocks.
By investing in the COWZ ETF, investors can gain exposure to a portfolio of high free cash flow yield stocks without having to pick individual stocks themselves. With an expense ratio of just 0.49% per year, the ETF is a cost-effective way to access this investment strategy.
Stocks with high free cash flow yields can be considered a type of value stock, as they offer a higher cash return relative to their market value. Other common value metrics include Price-to-Earnings (PE), Price-to-Book (PB), and EV/EBIT, among others.
Let’s compare the performance of different value metrics to see how they have historically fared in the market.
First, we can compare the performance of Vanguard Value ETF (VTV), which is the world’s largest value ETF by assets, tracking the CRSP U.S. Large Cap Value Index. This index uses a composite of value metrics, including book-to-price, forward earnings-to-price, historic earnings-to-price, dividend-to-price ratio, and sales-to-price ratio, to select its holdings.
On the other hand, we have Alpha Architect U.S. Quantitative Value ETF (QVAL), which uses EV/EBIT as its primary value metric. In addition, QVAL applies a quality filter to eliminate risky or lower-quality stocks from its portfolio.
Here are their performances in a chart:
COWZ has emerged as one of the best value ETFs. COWZ’s emphasis on free cash flow yield has helped it to deliver strong returns, even in an environment where growth stocks have been favored.
Another factor contributing to COWZ’s outperformance was its overweight position in the oil and gas sector. This allowed the ETF to benefit from the inflation-driven run in commodity stocks, which was a tailwind for the sector. However, it’s important to note that this overweight position may be cyclical and could potentially result in underperformance if the portfolio remains heavy in oil and gas while inflation eases or if the sector experiences headwinds.
A prudent way to minimize the cyclical effects of sector rotation is to pair COWZ with the VanEck Morningstar Wide Moat ETF (MOAT) that was previously mentioned. This approach ensures that the portfolio benefits from both growth and value strategies. MOAT will perform well when growth stocks are in favor, while COWZ will perform well when value stocks outperform. By combining these two ETFs, investors can achieve a more balanced and diversified portfolio that can weather various market conditions.
