This article was published on Dividend Kings on Monday, June 26.
My family is dealing with a medical tragedy involving my grandmother, who is now facing her sixth cancer recurrence.
We believe in never giving up and always trying to harness tragedy to inspire triumph. That is why my family’s charity fund, based around the Dividend Kings’ ZEUS Income Growth Portfolio, is planning on donating $80,000 to Helen Keller International this year.
- One of GiveWell’s top 4 effective charities in the world
- $3,500 to save a child’s life via Vitamin-A supplementation
- The lowest cost life-saving charity you or I can donate to
My family plans to donate the last of our final $25,000 on Giving Tuesday when Helen Keller is having an annual match campaign.
- $1,750 to save a child’s life
- Almost as good a deal as Bill Gates gets!
- $25 per life-year saved!
- 5.2X more cost-effective than the 2nd best charity (Against Malaria)
The Charity Fund That May Change The World
The basic design of any ZEUS portfolio is 33% ETFs, 33% hedges, and 33% individual stocks.
- ZEUS = Zen Extraordinary Ultra Sleep Well At Night portfolio
I’m constantly researching the best world beater blue-chip ETFs and companies.
Today I wanted to share with you the results of my research into the best dividend ETFs.
Specifically, two Buffett-style ETFs you won’t want to miss.
Buffett’s Favorite Valuation Metric: Free Cash Flow Yield
Warren Buffett is the greatest living investor, having studied under Ben Graham at Columbia. His mentor taught him about deep value investing, and that’s how Buffett became a legend and was able to buy Berkshire in 1965.
- Specifically, the Salad Oil Swindle of American Express
- He earned 50% annual returns for five years after investing 40% of his partnership’s capital, buying AXP after it fell 50%
In 1984 Buffett wrote in the Berkshire annual letter about his favorite valuation metric, owner earnings. This is his personal version of free cash flow which includes the investments needed to maintain the moat.
Free cash flow is effectively the same thing as owner earnings because free cash flow is defined as the money left over after running the business, including maintaining the current business and investing in future growth.
Investing enough to maintain the current business implies investing enough to maintain the moat.
Today Buffett doesn’t base his decisions on free cash flow yield but rather on “wonderful companies at fair prices.”
But do you know why Buffett used to invest based on free cash flow yield? Because it works.
Free cash flow/enterprise value (market cap – debt) has, for the last 30 years, been the single most successful valuation metric.
The average annual return was over 16%, and 84% of years generated positive returns. That’s compared to 11% average annual gains for the S&P with positive returns in 76% of years.
Let me share two FCF yield-based yield ETFs that are the ultimate Buffett-style ETFs, deep value bargains you won’t want to miss.
Pacer US Cash Cows 100 ETF (COWZ): The Perfect Value ETF
COWZ was the original FCF yield ETF that kicked off a family of ETFs that now numbers eight.
Morningstar rates COWZ five stars silver meaning its historical returns are in the top 20% of its peers, and Morningstar is confident it will continue outperforming long term.
COWZ’s tax-adjusted returns offer the last five years are in the top 1% of mid-cap value funds.
What’s the secret to such incredible outperformance?
How about a near-perfect strategy for screening for quality deep value.
COWZ starts with the Russell 1000, America’s 1,000 biggest companies, themselves world-beater blue chips.
Then it takes the top 10% by free cash flow yield, which also is a quality screen, and then weights by free cash flow yield while applying a 2% max risk cap.
The result is a portfolio that’s high quality, diversified, and trades at a valuation that makes Japanese value stocks look expensive by comparison.
What COWZ Owns
Let’s make a comparison of COWZ’s top 50 holdings to VTV, the gold standard value ETF from Vanguard.
COWZ is unlike most value ETFs that use more traditional metrics like book value or PE ratios.
COWZ isn’t for the faint of heart; no deep-value ETF is.
This is a concentrated cyclical portfolio that can be very volatile at times.
The benefit of such a dedicated deep value strategy is unspeakable great valuations. I’m talking 3.3X cash flow, and Morningstar’s analysts think this ETF will deliver 14% to 17% long-term returns.
- Compared to 16.3% for the last 30 years (strategy)
Historical And Expected Future Returns
COWZ’s strategy had delivered average annual gains of 16.3% since 1993. Morningstar’s analysts think it can do close to 17% based on what it owns now.
That would be one of the best investment strategies you could buy.
Total Returns Since 2017
COWZ ran circles around VTV and almost kept up with the S&P in a period when growth clobbered value.
- Just 1% of value ETFs did better than COWZ
Boom! There are your 14% to 17% returns right there. Smooth out the bear markets by looking at rolling returns, and you can see that COWZ’s historical returns match its backtest and future expected returns.
While running circles around VTV and consistently beating the S&P.
Why Not Everyone Will Like COWZ
COWZ is far from perfect.
For one thing, it uses trailing 12-month free cash flow yield. For cyclical companies, this can mean going big into sectors like energy when energy prices are at their peak and about to crash.
On average, COWZ is a high turnover strategy ETF, owning a stock for five months.
Some people dislike high turnover strategies because they want to know what they own.
- consider splitting half your ETF bucket into core and high turnover strategy ETFs
- if that makes you more comfortable
And some people just don’t like paying a 0.49% expense ratio when Vanguard Value offers:
- 5% turnover
- 0.04% expense ratio
Is that extra 0.45% in expenses worth it? How about the higher turnover? Doesn’t that mean higher taxes?
- Tax-adjusted annual total returns since inception (Jan 2017): 10.7% for COWZ vs. 7.3% for VTV
6.5 years of historical returns might not be enough for some people (it’s about 50% statistically significant) but given 30 years of strategy historical data that COWZ is matching in the real world?
Given that Morningstar’s analysts say its portfolio is likely to deliver similar returns in the future?
This is sufficient evidence for my family charity fund to go all in on COWZ.
- All in defined as a 4.17% allocation in the future
Pacer US Small Cap Cash Cows 100 ETF (CALF): The Perfect Small Cap Value ETF
Historically, Small caps outperform larger companies and tend to trade at lower valuations.
So what happens if you apply the proven FCF yield strategy to small caps?
You get a four-star silver-rated fund. The expense ratio is 0.1% higher than COWZ, and the yield is about half as much.
CALF has been around for six years, and in the last five years, its tax-adjusted returns were in the top 6% of peers.
But impressively, the lowest ranking it gets across any time frame is the top 15%, with a range of the top 6% to the top 15%.
This tells us that the CALF strategy is one of the most consistently wonderful ways to invest in small-cap value.
CALF starts with the S&P 600 small cap index, then takes the 100 companies with the highest FCF yields and weights by FCF yield with a 2% risk cap.
The valuations are even better than COWZ, a mind-blowing 5.4X earnings at the last rebalancing.
How cheap is 5.4X earnings?
The average Shark Tank deal in the first ten seasons was 7X earnings.
The average private equity deal closes today at 11.3X.
Private equity likes to think of itself as “smart money,” and CALF lets you get a deal twice as good as theirs.
You’re buying a quality company cheaper than Mark Cuban did on Shark Tank!
These are valuations that Buffett waxes nostalgic about from the 1970s.
Except that you can buy them in 2023 with this ETF.
What CALF Owns
These are definitely a very different portfolio than what most value ETFs own.
CALF is just as concentrated in certain sectors, but the sectors it’s overweight are different than COWZ.
2.2X operating cash flow and a 7.5 PE, truly mind-blowing value.
The downside is Morningstar analysts think this portfolio is capable of just 10% long-term returns.
10% long-term returns are hardly what I would like from a small-cap value ETF.
Total Return Since July 2017
The returns for CALF have been lackluster, possibly due to how young it is and a severe 40% crash.
BOOM! 13% to 14% average rolling returns. Now we’re cooking with gas.
Why Not Everyone Will Like CALF
CALF is an even higher turnover than CALF, and taxes are guaranteed; returns aren’t.
And the expense ratio is also higher at 0.59%.
Some investors refuse to pay an extra 0.55% in expenses for an ETF that has yet to beat VTV in absolute terms.
Bottom Line: These Are 2 Buffett-Style ETF Bargains You Don’t Want To Miss
Deep value investing isn’t for everyone, not if you don’t realize what you’re getting into.
These tend to be cyclical companies, and the volatility of these kinds of ETFs can be high.
However, if you’re looking for the ultimate Buffett-style ETFs, there’s no purer form of value investing than FCF/EV.
It’s the best historical strategy. It’s Buffett’s favorite strategy, and it’s the strategy that has delivered remarkably consistent good to great returns since 2017.
Am I going to buy CALF and add it to ZEUS Income Growth personally? No, since I don’t personally care if I own small-cap value (I already do via other ETFs).
If CALF could prove itself to be superior to COWZ over time, then I certainly would add them to the portfolio.
COWZ is the gold standard of value ETFs. CALF is the gold standard of small-cap value ETFs.
This is a strategy that I believe in and want to own, and I think as a part of a diversified portfolio, most people would benefit from doing the same.