Large-cap tech stocks are in the spotlight, but investors can also win with small-cap stocks, as demonstrated by the Pacer US Small Cap Cash Cows 100 ETF (BATS:CALF).
The ETF has quietly been a hit with investors, taking in record inflows in January 2024, which was remarkably its 46th-straight month of inflows. According to Bloomberg Senior ETF analyst Eric Balchunas, no other small-cap ETF has taken in more cash over the past 12 months. CALF is quickly becoming a major player in the world of ETFs, as it now has $8.7 billion in assets under management (AUM).
I’m bullish on this small-cap ETF based on its winning track record, its inexpensive holdings, and its unique strategy, which we’ll discuss in depth below.
What Is the CALF ETF’s Strategy?
According to the fund’s sponsor, Pacer, CALF “aims to provide capital appreciation over time by screening the S&P SmallCap 600 for the top 100 companies based on free cash flow yield.”
This focus on free cash flow and free cash flow yield makes CALF stand out from your run-of-the-mill small-cap ETF.
Free cash flow is simply the cash a company has left over after paying for expenses, interest, taxes, and long-term investments. This cash can be used to create value for shareholders by making share repurchases, paying dividends, or even making acquisitions.
Free cash flow yield is derived by taking a company’s free cash flow per share and dividing it by its share price. Generally speaking, the higher the free cash flow yield, the more attractive the stock looks.
Pacer explained, “The ability to generate a high free cash flow yield indicates a company is producing more cash than it needs to run the business and can invest in growth opportunities.”
While Pacer has another fund focused on free cash flow yield called the Pacer U.S. Cash Cows 100 ETF (BATS:COWZ), an additional benefit of taking this strategy and focusing specifically on small-cap stocks is that it can offer “exposure to companies with higher growth that are often under-researched.” Pacer says that this focus gives investors exposure to a part of the market where “high-quality stocks are trading at a discount.”
So how does CALF select these high free cash flow-yielding stocks that it invests in? Let’s take a look at its investment process.
CALF’s Investment Process
CALF starts out by looking at all 600 stocks in its investment universe, the S&P Smallcap 600 Index. It then screens these companies for the top 100 names based on their free cash flow yield over the trailing 12 months.
Screening for these top 100 companies creates a portfolio of holdings that is significantly cheaper, and that produces a much higher cash flow yield than the initial 600 stock universe. As of CALF’s last quarterly rebalance, the 600 stocks in its initial investment universe had an average price-to-earnings multiple of 15.0 and an average free cash flow yield of 4.3%. But by screening for the top 100 stocks by free cash flow yield, this new list has an average price-to-earnings ratio of just 10.0 and a free cash flow yield of 13.2%.
CALF then tips the scales further toward value and higher free cash flow yield by weighting these 100 holdings by cash flow, creating a final portfolio with a slightly lower average price-to-earnings ratio of 9.3 and a slightly higher free cash flow yield of 14.4%. Note that to maintain a well-rounded portfolio, CALF caps these position sizes at 2% when it rebalances each quarter.
What type of results does this elaborate investment process generate? It turns out that it has produced a pretty impressive track record over time, as we’ll discuss in the next section.
How Is CALF Performing?
As of the end of the most recent quarter, CALF generated an annualized three-year return of 17.3% and an impressive annualized five-year return of 17.4%.
These are excellent returns that beat both its benchmark and the broader market over both time frames. For comparison, using the same timeframe, CALF’s benchmark, the S&P SmallCap 600 Value Index, returned 10.2% on an annualized basis over the past three years and 11.3% on an annualized basis over the past five years. These are solid returns, but CALF soundly outperformed them over both timeframes.
Similarly, as of the most recent quarter, the Vanguard S&P 500 ETF (NYSEARCA:VOO), a good proxy for the broader market, returned 10.0% over the past three years and 15.7% over the past five years, meaning that CALF outperformed it over both time frames.
A Balanced, Inexpensive Portfolio
So, what does CALF’s portfolio look like? As mentioned above, CALF holds 100 stocks, and because it caps positions at 2% when it rebalances, its top 10 positions make up just 21.9% of assets. Below is an overview of CALF’s top 10 holdings using TipRanks’ holdings tool.
While these are small-cap stocks that may not be household names to many investors, the fund’s top holding, Abercrombie and Fitch (NYSE:ANF), demonstrates why its strategy of focusing on companies that produce high free cash flow yield can be effective. After being undervalued for a long time, Abercrombie and Fitch is up 300% over the past year.
CALF’s largest exposure is to the consumer discretionary sector, with a weighting of 37.3%. Its second-largest exposure is to industrials, with a weighting of 17.2%. While you won’t find any of the market’s hottest large-cap tech stocks in the fund, given its small-cap focus, information technology is present here and has a weighting of 10.6%, the fund’s third-largest sector exposure. Lastly, energy is the final sector with a double-digit weighting of 10.5%.
What Is CALF’s Expense Ratio?
CALF’s expense ratio of 0.59% means that an investor will pay $59 in fees on a $10,000 investment in CALF annually. While this is a bit high, CALF has produced excellent, market-beating results over a multi-year time frame, meaning that it is likely worth it.
Is CALF Stock a Buy, According to Analysts?
Turning to Wall Street, CALF earns a Hold consensus rating based on 48 Buys, 44 Holds, and 10 Sell ratings assigned in the past three months. The average CALF stock price target of $50.75 implies 7.2% upside potential.
The Takeaway: A Different Way to Win
CALF is a great ETF that has used its unique strategy of focusing on small-cap stocks with high free cash flow yields to beat its benchmark and the broader market over the past three and five years.
I remain bullish on the ETF based on its unique and effective investment process, which is proving itself over time, the long-term track record it is generating, and the attractive valuations of its holdings. While large-cap tech and growth stocks are deservedly in the market’s limelight, CALF shows that there is more than one way for investors to win in the market.
