I’m bullish on the relatively new VictoryShares Small Cap Free Cash Flow ETF (NASDAQ:SFLO) based on its rigorous investment process, diversified portfolio of stocks with attractive characteristics, and sensible focus on free cash flow. Plus, analysts see upside potential of nearly 30% for the ETF.
What Is the SFLO ETF’s Strategy?
According to VictoryShares, SFLO seeks to give investors “exposure to high quality small-cap companies, trading at a discount with favorable growth prospects.”
The ETF focuses on free cash flow and “considers a company’s expected FCF” in addition to its trailing FCF, which it feels is a better approach. SFLO “focuses on companies with high FCF yield and the highest expected growth rates.”
What Is Free Cash Flow?
Free cash flow is the cash a company has left after it pays for items, including expenses, interest, taxes, and long-term investments. This leftover cash can then be utilized to create value for shareholders by paying out dividends, repurchasing shares, paying down debt, or even making strategic acquisitions.
How About Free Cash Flow Yield?
SFLO specifically focuses on small-cap stocks with a high free cash flow yield. Free cash flow yield is calculated by taking the company’s free cash flow per share and dividing it by the share price. Stocks with high free cash flow yields are considered to be more attractive than stocks with low free cash flow yields.
Why Focus on Free Cash Flow?
This is a wise metric to focus on because companies that convert a significant portion of their revenue into free cash flow are likely doing a good job of efficiently managing their operations and expenses.
Furthermore, some investors believe free cash flow is a superior metric to earnings because earnings can be distorted by accounting adjustments or non-cash items (such as amortization and depreciation). These investors believe that focusing on free cash flow provides a more accurate view of the actual cash the company can reinvest or return to shareholders.
Stringent Investment Process
SFLO utilizes a stringent investment process to try to create an attractive portfolio of stocks with high free cash flow yields and decent growth prospects. It looks at a company’s expected free cash flow, not just trailing FCF, and uses a growth filter to filter out companies with high free cash flow but low growth prospects.
The fund starts with a universe of over 2,500 small-cap stocks and eliminates the 10% of these stocks with the lowest liquidity. SFLO also excludes REITs, financial stocks, and companies with negative projected free cash flows or earnings.
The fund managers then select the 300 stocks with the highest free cash flow yields from within this universe (focusing on both trailing and expected free cash flow).
Next, they then run a growth filter to narrow this list down to the 200 stocks with the best “growth scores,” which VictoryShares says include sales growth, EBITDA growth, and long-term earnings growth.
These remaining 200 holdings are then weighted by their free cash flow — specifically “based on the size, yield and trailing 90-day average liquidity of a company.”
This rigorous process of starting with a broad universe of 2,500 small-cap stocks and winnowing it down to the 200 remaining names included here creates a strong group of holdings. For example, as of the end of the most recent quarter, SFLO’s starting universe of potential investments had a free cash flow yield of 4.3%, but the final 200 selections feature a far higher free cash flow yield of 9.9%. The remaining 200 stocks also have significantly more favorable growth prospects than the universe as a whole.
SFLO’s Portfolio
So, what does a portfolio created with this extensive screening process look like in practice?
SFLO holds 200 stocks, and its top 10 holdings account for a minuscule 13.3% of assets, so there are no concerns about concentration risk (the portfolio being dominated by a handful of large holdings) here.
Below, you’ll find an overview of SFLO’s top 10 holdings using TipRanks’ holdings tool.
Many of these small-cap stocks are unlikely to be household names to investors. But what I like about this portfolio is that it features a more attractive group of stocks than its benchmark, the Russell 2000 Value Index, based on multiple metrics.
For example, as of May 31, SFLO’s holdings trade at just 11.9 times trailing 12-month earnings, while the Russell 2000 Value Index trades at a considerably higher 25 times trailing 12-month earnings. They also exhibit far superior earnings per share growth of 33.9% over the past three years versus 14.6% for the benchmark. Additionally, SFLO’s holdings sport a much better return on equity of 18.6% versus just 5.4% for the benchmark.
No matter which way you slice it, SFLO’s holdings look far superior to the broader universe of the Russell 2000 Value Index as a whole.
Lastly, the fund is fairly well-diversified across sectors, although it’s worth pointing out that it has a fairly high exposure to the Energy sector, with a weighting of 30.7%. Energy is followed by Consumer Discretionary, which has a weighting of 19.6%; Industrials, which has a weighting of 16.6%; and Health Care, which has a weighting of 12.8%. Technology makes up a relatively small 8.6% of the fund.
This positioning makes SFLO a nice counterweight to broad-market S&P 500 (SPX) funds, where Technology has a much larger weighting thanks to the dominance of large-cap tech stocks. For example, the Vanguard S&P 500 ETF (NYSEARCA:VOO) has a 30.6% weighting towards Technology and just a 3.9% weighting towards Energy.
Historical Performance
The fund only launched in December 2023, so there isn’t much of a long-term track record to judge its strategy yet. However, it’s worth noting that another fund from VictoryShares with a similar focus on free cash flow (albeit on large-cap stocks as opposed to small-cap stocks), the VictoryShares Free Cash Flow ETF (NASDAQ:VFLO), has been around for a bit longer and put up a strong 27.7% gain since launching last June.
The Pacer US Cash Cows 100 ETF (BATS:COWZ), another popular ETF focusing on free cash flow, has returned an impressive 16.2% on an annualized basis over the past five years as of June 30.
How High Is SFLO’s Expense Ratio?
SFLO features an expense ratio of 0.49%, which is on the higher end but not egregious for a fund with a complex strategy. This means that an investor with $10,000 in the fund would pay $49 in year one.
Is SFLO Stock a Buy, According to Analysts?
Turning to Wall Street, SFLO earns a Moderate Buy consensus rating based on 139 Buys, 58 Holds, and four Sell ratings assigned in the past three months. The average SFLO stock price target of $32.59 implies 22.6% upside potential from current levels.
Go with the Flow
I’m bullish on this new ETF based on its sound fundamental focus on free cash flow and FCF yield and its rigorous investment process. These create a strong, diversified portfolio of stocks that screen well on a variety of metrics. SFLO’s exposure to small-cap stocks and sectors like Energy give investors differentiated exposure versus the typical S&P 500 fund, making it an interesting counterweight to the broader market.
Furthermore, sell-side analysts believe the ETF has upside potential of nearly 30%, adding to my bullish stance.
