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Deep Dive: This cash-cow stock strategy is attracting lots of money. Here are its top 10 picks.

The Pacer U.S. Cash Cows ETF has been a strong performer since the bull market for stocks ended. Read More...

Following a year in which a rapid rise in interest rates caused stock and bond prices to tumble, investors are focusing on quality. One way to do this is to look at free cash flow — and doing so might make for better long-term returns for growth investors.

The Pacer U.S. Cash Cows 100 ETF COWZ, has shined as the Federal Reserve has clamped down on excess liquidity by raising interest rates in an attempt to lower inflation. Sean O’Hara, president of Pacer ETF Distributors, discussed the exchange-traded fund’s approach to stock selection during an interview.

Let’s begin with four sets of total returns (with dividends reinvested) for the Cash Cows ETF against ETFs that track its benchmark, the Russell 1000 Value Index RLV, -0.07%, and the S&P 500 SPX, +0.14%.

ETF Ticker 5 years through March 7 2023 through March 7 2022 5 years through 2021
Pacer U.S. Cash Cows 100 ETF COWZ, 78% 3% 0% 113%
iShares Russell 1000 Value ETF IWD, -0.04% 40% 1% -8% 68%
SPDR S&P 500 ETF Trust SPY, +0.16% 59% 4% -18% 132%
Source: FactSet

The Cash Cows ETF has been the best performer over the past five years. You can see that it held up very well during the bear market of 2022 — and that for the five years through 2021, when interest rates remained very low and liquidity was elevated, the fund outperformed the iShares Russell 1000 Value ETF IWD, -0.04% but trailed the SPDR S&P 500 ETF Trust SPY, +0.16%.

Cash Cows has $12.9 billion in assets under management. That’s up from $2.6 billion a year ago.

O’Hara said that when the ETF was launched in 2016 and for several years after that, stock valuations relative to earnings were at very high levels. The idea for Cash Cows was to identify value stocks in a way better suited to the modern world.

Traditionally, stocks are placed in the “value” camp if they trade low relative to book value. But O’Hara and his colleagues at Pacer believe this measure doesn’t work very well, “because the vast majority of the stock market’s value today is based on intangible assets and not tangible assets,” he said.

He cited Google parent company Alphabet Inc. GOOGL, +0.42% as an example: The company’s market value is “based on the fact that they dominated search and figured out how to dominate it. Those are intangibles,” he said.

The broad stock-market indexes are weighted by market capitalization, so the largest tech names dominated during the liquidity-driven bull market. And even today, the largest five companies held by the SPDR S&P 500 ETF Trust — Apple Inc. AAPL, +0.84%, Microsoft Corp. MSFT, -0.18%, Alphabet Inc., Amazon.com Inc. AMZN, +0.40% and Nvidia Corp. NVDA, +3.83% — make up 20% of the portfolio.

“It makes sense, when you think about the change in the economy from manufacturing to consumption, technology, brands, the health-based economy — those things thrive on intangibles,” O’Hara said.

For Cash Cows, the rules-based stock-selection approach is based on trailing free-cash-flow yields. A company’s free cash flow is its remaining cash flow after capital expenditures. This is money that can be used to pay dividends, repurchase stock or expand organically or through acquisitions, or for other corporate purposes.

A company’s trailing free-cash-flow yield is the sum of its free cash flow per share for its past four reported quarters, divided by the current share price.

The Cash Cows portfolio is reconstituted and rebalanced every quarter. The screen begins with the full Russell 1000 Index RUI, +0.13% of the largest companies publicly listed in the U.S. Then all financial stocks are removed, since free-cash-flow yields aren’t typically available for the industry. Then there is a forward screen to remove any company expected to post any quarterly net losses over the following two years.

The remaining stocks are then ranked by trailing free-cash-flow yield, and the top 100 make the final list. These are weighted by free-cash-flow yield, with a maximum weighting of 2% for any stock.

O’Hara said free-cash-flow yields can be “a great predictor of what is going on in an economic cycle.”

Even before large technology companies were signaling slower growth rates, the Cash Cows portfolio had been leaning away from tech stocks, while companies in the energy, industrial, materials and healthcare sectors had “rotated in,” he said.

In addition to identifying undervalued stocks and moving with broad economic trends, this type of stock screening can point to trouble ahead if a company’s free-cash-flow yield is declining or if analysts expect net losses ahead. For example, Cash Cows held shares of Intel Corp. INTC, +1.76% from September 2020 until December 2021. Intel cut its dividend by 66% last month.

Here are the fund’s top 10 holdings as of March 8. Some have weightings above 2% because of share-price increases since the fund was last rebalanced in December.

Company Ticker % of portfolio net assets
Meta Platforms Inc. Class A META, +0.25% 3.1%
Nucor Corp. NUE, +1.21% 2.3%
LyondellBasell Industries NV LYB, +0.80% 2.3%
Marathon Petroleum Corp. MPC, -1.80% 2.3%
Dow Inc. DOW, +0.82% 2.2%
Valero Energy Corp. VLO, -3.06% 2.2%
Exxon Mobil Corp. XOM, -1.46% 2.1%
PayPal Holdings Inc. PYPL, +1.24% 2.1%
Cisco Systems Inc. CSCO, +0.41% 2.0%
Altria Group Inc. MO, +0.54% 2.0%
Source: Pacer ETFs

Click on the tickers for more about each company or ETF.

Read Tomi Kilgore’s detailed guide to the wealth of information available for free on the MarketWatch quote page.

Pacer has also applied the Cash Cows strategy to other groups of stocks, including the Pacer U.S. Small Cap Cash Cows 100 ETF CALF, +0.36% and the Pacer Global Cash Cows Dividend ETF GCOW, +0.33%.

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