CALF: Underappreciated Small-Cap Factor Fund Focusing On Free Cash Flow

seekingalpha06-18

Large caps are outperforming small caps since last December, bringing trouble to diversified portfolios.High free cash flow firms are also outperforming, primarily among large caps, and small-cap ...

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Seiya Tabuchi Perusing the Goldman Sachs US Weekly Kickstart report, I noticed that US large caps are now at multi-decade highs versus small caps. Diversified investors likely feel this full well. Both the Russell 2000 and the S&P SmallCap 600 indexes have posted weak returns so far in 2024 while the SPX is higher by about 15%, dividends included.  High free cash flow companies are outperforming, too. That trend is seen primarily, however, among large caps. These two factors, small companies and high free cash flow firms, come together in one ETF that has gained tremendous volume in the past 12 months. I have a buy rating on the Pacer US Small Cap Cash Cows 100 ETF (BATS:CALF). While currently out of favor in terms of absolute and relative performance, its current valuation is attractive, and the allocation is more diversified from a sector point of view compared to the large-cap version of the strategy: the Pacer US Cash Cows 100 ETF (COWZ). Large Caps Beating Small Caps Since Last December   Goldman Sachs High Free Cash Flow Firms Outperforming   Goldman Sachs According to the issuer, CALF is a strategy-driven ETF aiming to provide capital appreciation over time by screening the S&P SmallCap 600 for the top 100 companies based on free cash flow yield. Free cash flow is the cash remaining after a company has paid expenses, interest, taxes, and long-term investments. It can be used to buy back stock, pay dividends, or participate in mergers and acquisitions. Small-cap companies offer a variety of opportunities, including exposure to companies with higher growth that are often under-researched. CALF is a growing ETF, now with $9.1 billion in assets under management as of June 14, 2024. The fund’s annual expense ratio is not cheap, though, at 0.59% while its trailing 12-month dividend yield is modest at just 1.2%. Share-price momentum is also lackluster given a nearly 9% decline, in total return, year to date.  Making matters worse are risk characteristics that are troubling – the ETF’s standard deviation is above 21% while its annualized volatility is just slightly lower at 18.6%. A strong quantitative aspect of CALF is its high liquidity rating – average daily trading volume is more than 1.6 million shares, notably higher compared to just a year ago while its 30-day median bid/ask spread is tight at just 0.01%, per Pacer ETFs. Zooming in on the portfolio, the 4-star, Bronze-rated ETF by Morningstar plots along the very bottom of the style box. There is also a significant allocation to the value style – more than half of its assets are considered small-cap value. That area of the US stock market is notoriously associated with economic strength – i.e., when the domestic GDP rate is on the rise, small-cap value should outperform.  But that has not been the case during this cycle thanks to rising interest rates, which disproportionately affect small-sized companies reliant on debt financing. The way I see it, now that market yields have steadied since October 2022, companies within the CALF fund should be better positioned to withstand prevailing macro conditions.  What makes CALF particularly compelling today is its very low 11.6 price-to-earnings ratio, while its long-term earnings growth rate is high at 12.3%. That results in a PEG ratio of less than one – hard to find among diversified equity ETFs today. COWZ: Portfolio & Factor Profiles Seeking Alpha While there is some diversification with CALF, there is risk in the sense that nearly half of the allocation is invested in just a pair of sectors: Consumer Discretionary and Industrials. Energy is a significant overweight, while the Information Technology sector is an underweight by about 20 percentage points versus the S&P 500. So, I expect CALF to perform significantly apart from the SPX. COWZ: Holdings & Dividend Information Seeking Alpha Seasonally, right now is a favorable calendar stretch for the fund. But volatility has historically been apparent from August through the middle of October. Prospective investors should weigh seasonal risks, but it’s a secondary indicator when I go about analyzing markets and ETFs. COWZ: Bullish Early-Summer Seasonal Tendencies Seeking Alpha The Technical Take With a low earnings multiple, an economically sensitive portfolio, and a disciplined management approach, CALF’s technical view is not encouraging today. Notice in the chart below that shares recently fell below what was key support in the $44 to $45 range. With highs notched above $49 early in Q2, that results in a downside measured move price objective to about $41 based on the height of the previous range. What's more, there was a notable bearish RSI divergence, evidenced by a series of lower highs in the RSI momentum oscillator.  Making matters worse for the CALF bulls is that there’s now a very high amount of volume by price between $45 and $49 – that will likely turn out to be a thick area of overhead supply on rally attempts. With the ETF now trading under its flattening long-term 200-day moving average, further downside is probable according to my chart reading. It would be a solid buy around $41 with $39 – the low from October 2023 – acting as potential support. CALF: Bearish Rounded Top Triggers a $40 Price Target, $39 Further Support Stockcharts.com Risks Continued underperformance among small caps is an obvious risk with CALF, but so too is the chance of further relative weakness among Consumer Discretionary stocks. Also, if there's growing interest in non-profitable tech companies, such as Cathie Wood ARKK-type names, then CALF may lose some of the interest that built up earlier this year. Finally, geopolitical risks could hit CALF's cyclical portfolio harder than other more blue-chip large-cap funds should they arise. The Bottom Line  I have a buy rating on CALF. 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