CALF: Owning The Best Small Caps For An Impending Breakout

While we’ve seen some pretty epic moves in large cap stocks (and mega cap, in particular) in the past several months to new highs, the same simply has not been true of small caps. I’ve been bullish on small caps for months and that bullishness has not paid off just yet. I still believe it will, and that’s because the setup right now on small caps looks like a bullish consolidation.

Small cap stocks are cheap relative to their large cap peers, and I believe there’s some catching up that will come later this year in terms of small cap returns against large cap returns. There are lots of ways to express bullishness on small caps, but one of the better ways is through the Pacer US Small Cap Cash Cows 100 ETF (BATS:CALF). It’s a small cap fund that focuses on free cash flow generation, so it’s different than a typical index ETF. I like the fund’s strategy, and I like the chart, so I’m starting CALF with a strong buy.

What is CALF?

As I mentioned, CALF is a small cap fund that focuses on a fairly stringent screening process that seeks to find the best of the best small caps, and importantly, does not include any financials. All other sectors are represented, but you will not find any banks here. From an allocation perspective, the fund is agnostic to growth and value; it simply seeks the best small caps available.

How is “best” defined? In the case of CALF, it’s based upon free cash flow generation, as we can see in this handy guide from the fund’s fact sheet.

This data is as of the December rebalancing but the principles are what we’re after here. We can see the fund starts with the universe of 600 small caps in the S&P 600 index, then screens for the 100 companies with the best free cash flow yields. That metric is simply the free cash flow generation on a TTM basis divided by the market cap. The difference is striking in that the S&P 600 sports an average FCF yield of just over 4%, but CALF is more than triple that level. In addition, the P/E ratio of CALF is extremely low on both an absolute basis, and relative to large cap indices.

Out of the 100 stocks that meet the criteria above, CALF then rebalances once per quarter and caps holdings at 2% max per stock. That leads to tremendous diversification and avoids the concentration risk we see in some big cap funds where two or three stocks make up over half the fund; you won’t get that here.

From a sector perspective, it is fairly heavily weighted in consumer cyclical stocks at 29%, but no other group is more than 19%. Keep in mind this allocation moves around a lot during the year as the fund is rebalanced, meaning there are lots of buys and sells during the year, so it’s something to monitor if you’re looking for particular sector exposure, or don’t like high levels of turnover.

We can see the top 10 right now are those stocks that have outperformed the benchmark since the last rebalancing, as all of these would have been capped at no more than 2% weighting at that time.

Because of the construction of this fund, the top 10 isn’t relevant; there will always be at least 10 stocks with 2% allocations, so monitoring the top 10 isn’t helpful with CALF given its strategy.

If you like small caps, like I do, CALF’s strategy is quite appealing in that it should theoretically give you the best small caps in terms of profitability, rather than just owning the universe of all small caps. Let’s now dig into the technical setup and why I’m so bullish from that perspective.

Is the consolidation finally about to end?

That’s the big question right now, and the answer to that will determine the next big move in small caps, including CALF. Below we have the daily chart, and I’ve drawn in an ascending triangle pattern that if completed, would measure out a move to ~$58 or so to the upside. But first things first, let’s take a look at the chart.

Ascending triangles are probably my favorite pattern to trade, because the lines in the sand are clearly defined, and they’re pretty reliable. Nothing is guaranteed, of course, but I think this setup looks extremely bullish.

The lines in the sand here are the top at ~$48, and the up-trending blue line that makes up the bottom of the triangle. What we’re looking for is a decisive break of one of those lines, hopefully to the upside. I’ve circled a false breakout we saw several days ago where we had a close outside the triangle, but quickly saw a failure. Since then, however, we’ve continued to make higher lows, and as long as that persists, this pattern is still valid.

The PPO looks great as it’s making higher lows as well, up-trending above the centerline, so it really couldn’t look better for a potential breakout.

Finally, the bottom panel shows CALF’s performance relative to the small cap index Russell 2000, and that’s to illustrate that CALF has consistently been a better buy than simply buying a small cap index. It doesn’t always outperform, of course, but over time it’s been better. I think small caps are a great buy right now in just about any form, but CALF looks to be the cream of the crop here with the current setup.

One more note on the chart is that this consolidation is coming to a potential end with seasonality as a big tailwind for the next four months.

April through July is an extremely bullish period for small caps, and CALF in particular. If the fund is ever going to breakout, it certainly looks like now is the time.

Wrapping up

With CALF, you’re getting a fund that’s actively rebalanced four times a year into what should be the 100 best small caps available. It removes the numerous small caps that are unprofitable and don’t generate FCF, but it’s also available at extremely cheap valuations of 10X or 11X earnings. With the S&P 500 trading at more than double that level, for instance, the relative value is quite strong.

Seasonality should be a big tailwind for the next four months, and we have what I believe is an extremely bullish consolidation pattern that is quite near completion. Putting all of this together, I’m starting CALF with a strong buy.