Worried About An AI Bubble? Consider The Pacer US Cash Cows 100 ETF (BATS:COWZ)

Introduction

Per its Prospectus, the Pacer US Cash Cows 100 ETF (BATS:COWZ) (the “Fund“) is an exchange-traded fund (“ETF“) that “seeks to track the total return performance, before fees and expenses, of the Pacer US Cash Cows 100 Index” (the ‘Index‘).

With a 5-Star rating from Morningstar, the Fund charges a 0.49% expense ratio. Assets under management exceed $20 billion, which, to me at least, is convincing evidence of this ETF’s success since its inception in December 2016.

I own shares of the Fund, believe it is a BUY, and I am buying more on pullbacks for a number of reasons, including the following:

First, I am attracted to the Fund’s focus on companies with strong cash flows that trade at a discount. Second, while I am not calling for an end to the AI-related bubble (and, yes, I do think it is a bubble), the Fund is a nice diversifier for investors overly allocated to the AI/technology high-flyers. For instance, when the Nasdaq & S&P 500 were both crashing in 2022, the Fund actually churned out a slight gain. Third, the Fund’s high allocation to the energy sector (above 25%) provides an avenue for investors to tip toe back into the inexpensive energy sector, which I think will do well after the U.S. Presidential election as political incentives to suppress the price of oil decrease. OPEC also seems committed to maintaining production cuts. Fourth, since its inception, the Fund has demonstrated that the methodology used to create its portfolio can perform well in both up and down markets.

The Portfolio Methodology

Per the Prospectus, the Index utilizes a rules-based methodology that provides exposure to large and mid-capitalization U.S. companies with high free cash flow yields. The Index starting point is the Russel 1000 Index. Those companies in the Russell 1000 Index are then screened based on their average projected free cash flows and earnings over the next two fiscal years. Companies with negative projections for free cash flows or earnings are removed from the Index universe, as are financial companies (excluding REITs).

After the above vetting process is completed, the remaining companies are ranked by their trailing free cash flow yield. The 100 companies with the highest free cash flow yield are then included in the Index, and they are weighted in proportion to their trailing 12-month free cash flow, with individual company weightings capped at 2% (at the time of each rebalance).

A visual summary of the process from the Fund’s website is shown below.

This data included in the visual, which is from the recent December 2023 rebalancing, shows the portfolio of the Fund achieving a very low price to earnings ratio (roughly 10) with a free cash flow yield north of 8.50%. The fact that the Fund’s holdings tend to be trading at a discount should provide the Fund with a margin of safety in the event of a market downfall.

The Index is rebalanced quarterly on the 3rd Friday of March, June, September and December. Upon each such rebalancing, as noted above, the individual company weightings in the Index are capped at 2%. For further information about the Fund’s portfolio construction, see the Prospectus.

Top 10 Holdings

Per Seeking Alpha, the Fund’s top ten holdings are as follows as of February 29, 2024:

AbbVie Inc. 2.29%

Qualcomm Inc. 2.25%

Lennar Corp. 2.23%

DR Horton Inc. 2.11%

Nucor Corp. 2.09%

Valero Energy Corp. 2.07%

Marathon Petroleum 2.07%

Phillips 66 2.03%

Booking Holdings Inc. 2.03%

Cencora Inc. 2.03%

Total 21.16%

Notably, the Information Technology sector constitutes just under 10 percent of the Fund’s holdings. Meanwhile, oil refiners are well represented, with three such companies among the Fund’s top 10 holdings. According to the Fund’s website (linked earlier), Energy-related companies comprise 27.52% of the Fund, Consumer Staples comprise 21.37% of the Fund, and Health Care companies comprise 14.36% of the Fund (as of March 1, 2024), giving the Fund an overall defensive posture, which should cause it to hold up reasonably well if (and when) the AI bubble bursts.

Performance

The table below compares the performance of the Fund to ETF proxies for the Nasdaq & S&P 500 for the past five full calendar years.

Click to enlarge

And here is the aggregate performance of those same ETFs over the five-year period.

As can be seen from the above tables, the Fund has clearly lagged the technology-focused Nasdaq (and what non-tech ETF hasn’t!), but it has held its own against the S&P 500 over the five-year period, even though the S&P 500 has a heavy weighting of large-cap technology companies (roughly 31% as of March 3, 2024). In my view, the Fund’s performance is impressive, and its diversification benefits are notable. For instance, in 2022, the Fund managed to eke out a small gain compared to large losses for both QQQ and SPY (-32.58% and -18.17%, respectively).

Year to date (as of March 1, 2024), the fund is up nearly 5%. It continues to churn out solid returns, and I expect those returns to continue.

The Fund has paid a consistent dividend since its inception in 2016 and the current dividend yield is approximately 1.83% per Seeking Alpha as of March 3, 2024. Significantly, the trajectory of the dividend over time is up, even if not up in a straight line. In its first full calendar year, 2017, the Fund paid $0.57 in dividends, while in 2023, the Fund paid $1.00 in dividends.

Risks

The Prospectus (linked earlier) lists risks associated with investing in the Fund. In the short term, the biggest risk, from my perspective, is that technology and “growth” companies continue to dominate the return landscape and the Fund’s value approach remains out of favor (at least on a relative basis). That said, since its inception, the Fund has performed very well, a testament to its focus on the best cash flow generators in the Russell 1000 universe. Nonetheless, past performance is not a guarantee of future results and investors should do their own due diligence. There are also several competitors in the space now providing fundamentals-based indexing, which could eat away at gains from the strategy.

Conclusion

The Fund’s Index is constructed in a manner that ensures that the Fund is populated with quality, high-cash-flowing companies. It also provides returns that are not highly correlated with the S&P 500 (adding diversification and defense to a portfolio) and, if we [ever] enter into a period of significant outperformance by value-oriented stocks, the Fund should perform very well. Until then, the Fund has shown that it can grind out strong returns on par with the S&P 500 (over the full investment cycle), while still maintaining a healthy margin of safety and providing growing dividend payments. Don’t be afraid of the AI Bubble, BUY this Fund and diversify instead. Cheers