Talk Your Book: Investing in Free Cash Flow

0:00Today's Animal Spirits Talk Your Book is brought to you by Victory Capital. Go to victoryShares.com to learn more about the VictoryShares. VictoryShares Free Cashflow ETF and the VictoryShares Small Cap Free Cashflow ETF. That's VFLO and SFLO. Again, that's VictoryShares.com to learn more. Remember, all investing involves risk. VictoryShares ETFs are distributed by Four Side Fund Services, LLC, and you can visit VictoryShares.com for details and prospectuses. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching.

0:38All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:59Welcome to Animal Spurs with Michael and Ben. on today's show, we're talking about how to build a portfolio using free cash flow as the underlying metric. Then a lot of the traditional value research in the academic world was focused on the price to book factor. Book value is essentially the net asset value of the company. The first time that I saw free cash flow, which is I guess like the modern day book value, The first time that I think I saw that was Michael Mobison, who spoke about how using free cash flow as a metric would have screened or you would have using free cash flow to value Amazon would have showed you, yeah, this company on a gap basis is losing money for the last 37 quarters in a row or whatever it is.

1:53But if you make some adjustments and you look at free cash flow, because there's a lot of capex involved, which we get into in the show. But if you look at the free cash flow, what is available for the company to put back into the business, to distribute? If you look at that metric, Amazon looks like a pretty healthy, sustainable, growing business. Right. The traditional valuation metrics for Amazon were saying it's overvalued forever, which is why you tried to short it in like 2011, probably, right? Actually, that's exactly right. Yeah. So you had to make some changes. is it, I was getting some flashbacks from the CFA hearing about this stuff.

2:27So we talked to Michael Mack, who's an associate portfolio manager at Victory Capital. He helps run the Victory shares, free cashflow ETFs. And yeah, I was getting, I had the three ring binders of equations and stuff from the CFA. And I was thinking through like, take this out, add this back in, subtract this. Yeah, bind us full of equations. Me too. that's true so anyway this is and to your point like the whole value thing a lot of it it's same thing with dividends a lot of it depends on how you define this thing there's not there's not one group of this and this is this is how you do value uh because i thought the most interesting thing about looking at victory shares free cash flow etf is if you look at compare it to the sectors in the russell 1000 value index and it's nothing like it yeah right it has way more energy way more healthcare, way more consumer discretionary.

3:14And it's a totally different way of looking at it. So value is not just this one thing. It's kind of in the eye of the beholder. Anyway, really interesting conversation. Here's our talk with Michael Mack from Victory Capital.

3:32Michael, welcome to the show. Thanks, Mike. All right. So today we're going to talk about the Victory Shares free cash flow strategy. And you guys have had a heck of a run I'm talking about in terms of investment appetite or investor appetite. So you started the year, the ticker is VFLO, the Victory Shares Free Cashflow ETF. You started the year at just around$125 million in assets. And now you're up to nearly$900 million. And the performance has been fine. It's roughly in line with the index. Talk about typically flows follow performance, and that's not the case here. So I'm super interested to hear about what is it in the story that is resonating with investors?

4:18Yeah, we've had the advantage of having a tight experience with free cash flow strategy. So kind of know the market, know the client base. I think the real challenge for people is for years on the value side, you've had a lot of value investors just shouting into an echo chamber, right? Like you see that article, it's like value is underperformed by 15 years. And some articles just stop there. But I think a lot of investors are tired of being told the same things with value investing. They're looking for new answers. And I think the advantage of free cash flow yield is how it finds value, how it tends to be more resilient in a growth market while still doing well in a value market.

4:56I think the concept of free cash flow is really timely, especially in a world where MAG7 is dominating returns and people are trying to find sources of return outside of those names. So Michael and I both have our CFAs, not to brag, but some people in the audience might not be familiar. Why don't you just tell us how you define free cash flow? Yeah, it's a good question. It's the cash that's left over after a company's reinvested in its business. So if you think of, it includes a lot of things, right? All the company expenses, your interest on your debt, your taxes, and most importantly, reinvesting in your business.

5:32And so when a company has free cash flow, that's cash that's left over to do what we think is a lot of shareholder-friendly things like buybacks, pay and grow a dividend, pay down debt. And then what's interesting about free cash flow is we think about it as a profitability or a quality metric. We turn this into a value metric by taking the free cash flow over the enterprise value and making it a yield. And when you do that, if you think of like for the everyday person, if you think of like a rental property, two questions you ask, right? How much will I pay and how much will I rent it out for?

6:07That's really what free cashflow yield is solving for. So it's not just the companies that have the most free cashflow. Quite frankly, that would mostly be the MAG-7 because they are the beachfront properties, if you will. It's the companies that have the most cash flow relative to their enterprise value. So maybe if I bought a property Bayside, I could only rent it out for half as much, but if it costs me a fourth of what the beachfront property is, that's a better deal. It's always about trying to find the most value for your dollar invested. And that's what free cash flow yields for. Ben, it's funny you mentioned the CFA because my mind went to the same place.

6:43I remember back in the day in my bed, I had like a whiteboard and I had all of these free cash flow formulas. And there was free cash flow to equity and free cash flow to firm. And you could start with notepad or EBIT or all these sort of things. So yeah, fun times. What's the difference between net income and free cash flow? Yeah, it comes down to, there's a couple of things. One, it's net of the investments, right? CapEx is taken out of free cash flow. I think where it really becomes meaningful today, If you read a good article on why value investing struggled, they've talked about accounting earnings not being as relevant and biasing gross stocks, in particular tech.

7:23And the reason for that is the way earnings count for R &D, they expense it 100 % immediately. So if a business is investing in R &D, it's hitting their bottom line. Whereas if a business is investing in CapEx, they're only depreciating a small part of it. So where in earnings, you look better if you're spending more on CapEx and you're kind of punished if you spend more on R &D. In this case, it just deducts them both. So it's a level playing field. It looks at all the cash expenses, nets them out, and it's the cash that's left over. You mentioned something interesting about how free cash flow has been like a value-ish metric that has held up better in a growth environment.

8:00I'm wondering if value, really traditional valuation metrics, really make a comeback. do you think a free cashflow might go out of favor? Oh, we don't because I think of at the end of the day, it's the value of a business. It's kind of going back to the source, the value of, if I could dust off your textbook again, the value of a business, it's the present value of the future free cashflow. Yeah, sure. So you're aligning with what drives it. It should be, right? So I'm curious if this whole strategy is quantitative or if there's any qualitative measures that you put on top of the free cashflow yield that you're looking at.

8:34Yeah, it is all rules-based. So that's a key part of it. It's funny, a little background. I was at a hedge fund. That's where I first started kind of focusing on free cash flow right out of college was everything was through the lens of free cash flow. But we had a quant model where the number one factor was free cash flow. And it was interesting. The PM there, we had two sleeves he ran. The first he ran was his own free picks. He was allowed to pick whatever he wanted, unconstrained kind of alpha. that did well. But when he picked from the model, that did poorly. And I think one of those things he realized is, right, part of the alpha and free cash flow is keeping it unemotional.

9:13You're buying into weakness. It's hard for someone to apply a fundamental overlay. It's almost one of those things of don't outthink it. If the price dips, the free cash flow goes up, systematically add to it, vice versa, lighten up when the yields drop, and you'll create better returns through those rebalances over time. It is funny how the best ideas portfolios never work out. It always sounds great in theory. We have this screen that gives us 500 stocks, but we're going to pick the best 50 or 100. And you're right. The tests always show that rarely ever works. I don't know, maybe because of the emotions or it's just hard to pick the winners.

9:46Remember Joel Greenblatt's book, The Little Book That Beat the Market? Yeah. And he told a story about this, that they screened for these stocks quantitatively, and then the PMs picked the stocks. And almost inevitably, they underperformed. Exactly. And unemotionally. And I mean, if you look at the best name, this one of the best names in terms of high free cashflow stocks, it was a utility that became an AI play. Like, I don't know who had that one on their bingo card going into the year. Well, you've got another one in here that I want to mention a little bit. But before we get to some of the individual names, let's talk more about the process.

10:18So what is your investable universe? How do you screen it down? And how do you ultimately select stocks? We start from a large cap universe. We define it as the top 400 profitable companies. You can essentially think of it as it's going to pull from the Vetify 1000 universe, but it's going to be similar in exposure to like the S &P 500. We originally kind of did our studies on the S &P. The reason we get the question a lot, should we do large and mid or just large? What we found is you can get similar returns with large cap without the risk that comes with mid cap. So So that's the first part.

10:52We're going to exclude real estate and financials just because in the case of real estate, sometimes one-off acquisitions or disposals can skew it. And then if you think of banks, they're really not conductive to, one, measuring free cash flow. And then on the enterprise value side, we don't think you can probably systematically kind of capture their derivative exposure or whatnot. So it's hard to get a free cash flow yield in those spaces. So we exclude them knowing that when those sectors tend to do well, value will do well during those periods as well. From there, we screen for free cash flow yield.

11:27We do it a little bit uniquely, we think, in that we don't just look at their trailing. We'll also look at their forward estimates. So we average the two together to come up with our free cash flow yield. And then from there, we apply a growth filter. So we go from 75 down to 50 based on a company's growth score. And then from there, that 50 stock universe, we weight it by their size and their yield, their free cash flow yield. And we rebalance it quarterly. So I'm curious how cheap you're finding some of these areas. Because you see these charts that show the S &P 500 is overvalued or the large cap universe is overvalued.

12:06But if you take out some of the big tech names or just the MAG-7, whatever it is, the market looks more reasonably priced. So I'm curious how cheap you're finding your current universe to be these days. You really do need, you can't just be in a broad value fund. You're probably leaving a little on the table right now where like, you think of like the Russell 1000 value, it owns 850 stocks. So it's going to trade at 17 times earnings where if you really screen down and get a focused value exposure, the valuations are some of the widest we've seen, probably closer to 2000 levels than they were before.

12:37Michael, let me give you some numbers and then you could talk about this. So I'm looking at from your website, I'm looking at some fundamental data. So your EPS growth of the last three years is 20 % compared to the benchmark that I'm seeing as a Russell 1000, 14%. So 20 % EPS growth the last three years versus 14%. Price to book is roughly in line. Price to earnings, you guys are 15 and change. The index is 21. And then the return on equity is 23 versus 16. So higher ROE, lower price to earnings, and a higher EPS growth. That's a pretty nice recipe for stock selection, at least in theory. I mean, we think free cash flow yield does a really good job at multi-factor investing.

13:21If you think about like the Fama French stuff, right? At first, it was book to price, right? That was value. And then it's interesting, the two elements they've expanded on is they've added profitability, one, and then they've added low investment. Well, when you think about that, they're basically trying to get the free cash flow through a multi-factor lens, right? We think free cash flow kind of being the source is the ideal place to go. And as a byproduct, you'll get those favorable factor exposures. You mentioned that there was a utility stock that was kind of surprising you. What sectors are showing up as cheapest on your screens now?

13:52And I'm curious if you have any sector constraints that you put a ceiling on these things if it gets too high. Utilities did see there was a couple names. You're typically not going to see a lot of value in utilities because they're regulated. The companies that have done well happen to be the ones that aren't regulated. In terms of where we're seeing, and I'll take a step back to historically, free cash flow has found value in technology, healthcare, and consumer. So we talked earlier, like, why does it do well in some of those growthier markets? Well, it's able to find value in some of those growthier sectors.

14:24But today, where it's finding value is, again, In healthcare, as usual, what is different is energy. And energy is something where there was horrible free cash flow generation for about 20 years. Then 2020, they kind of got religion. They're now comped on being profitable. And the mantra at a lot of these energy companies has went from profitability at any price, or sorry, growth at any cost to now profitability at any price. So we've seen energy screen in at a level it's never in the past in terms of free cash flow generation and some of the quality metrics we look at? One of the stocks in the ETF that I'm looking at that I wouldn't think of as synonymous with high free cash flow is Zoom.

15:08Zoom has been a horrific stock for, I don't know, a couple of years. I don't know what the drawdown was. I'm guessing it was 70 % plus, at least probably a lot more. But then I pull up my Y charts and I look at Zoom's free cash flow. And yeah, sure enough, It's at an all-time high. So I think this goes to the unemotional aspect of using the rules-based screens as opposed to Zoom is probably not a stock that most people want to own, hence value. I think most companies don't want to be value stocks. And that's probably why it ends up working is because there's a human bias that makes people want to avoid these names.

15:43That's it. People tend to focus too much on price and lose track of the fundamentals of the business or the earnings or the cash flows. And so that can lead them to confusion. Oftentimes, you can see a life cycle. And we saw this with Microsoft and some of those in the past where the price goes up a lot, then it sells off, goes out of favor for a long time, then it becomes really cheap and growth does recover. There's a belief that if you're priced down, your growth can't recover, but that's not the case. So Zoom is a case of that where they're actually, their fundamentals are strong. It's just the momentum's been negative on the stock from a price momentum standpoint, which is what you're looking for.

16:21A lot of free cash flow relative to enterprise value. I'm curious what kind of quant you are because some quants say, I don't care what stocks are in our portfolio. I follow the rules and they are what they are. And some people don't even really pay attention. They care more about the risk factors or the characteristics of the portfolio. Do you actually follow the individual companies that are in your portfolio or are you just kind of saying I'm going to let the model do what the model is going to do? We do let the model do. It is unconstrained. I think it's like the way we think about it, this is the second free cashflow fund I've had the chance to develop.

16:51So you do get opportunities to improve things, you know, when the, over maybe a 10 year period, but in general, I do think it's important to look at it like an active investor. I think the advantage of a strategy like this is, is it's coming from the lens of kind of, I mean, our team does a lot of active quantitative strategies. So I think if you look at a lot of the index providers, I think one of the challenges, they're quants and engineers. So like, if you look at all the traditional value, I think any active person, if you polled all your guests, I bet they would all say cash flow is a consideration.

17:22But I think what people are surprised to know is almost every traditional value index does not include free cash flow. Everyone includes price to book. None of them include free cash flow. And I think that's because the data, if you look at where the data is, you got 150 years academic research on price to book. You got nothing on free cash flow yield, but an active manager who knows the fundamentals would know to look for that. So I think it's important to understand these companies and how they work. Even if you are, it's just stripping out that emotional element in terms of the day-to-day decision-making that you want the passive element to this.

17:56So free cashflow on top, enterprise value on the bottom. Why enterprise value? It comes down to debt, right? I mean, and I'll get an extreme example, by the way, is NVIDIA. We have an example on our deck where NVIDIA was, in 2013, their free cash flow was 15%. And what was interesting about that example is at that time, they had a$7 billion,$8 billion market cap. Half of their market cap was cash. They had no debt, or at least they had a net cash position of$3.5 billion on an enterprise value of$7 billion. So hopefully I've made you all sick knowing that NVIDIA was a$7 billion company. It makes me sick talking about it, right?

18:39Well, I'm sure Apple probably too. Apple probably 2013 is the same exact thing. Yes. You had a lot of mag seven that screened well in the early part of the decade. But yeah, in that case, they had a ton of cash where then if you looked at energy companies, right, they're loaded with debt. So enterprise value looks at their whole balance sheet, tilts you towards stronger balance sheets, and it keeps you from buying those leveraged names that appear cheap. Let me play devil's advocate. So enterprise value makes a lot of sense if you're thinking about, all right, what is a business worth if you acquire the whole thing, right?

19:09Like if a private equity comes in there, takes the whole thing or there's M &A and somebody, you know, competitor buys it, they, you know, debt is certainly a part of the equation for sure. But what about, what about like if a company has no chance of being taken out and the debt is, I don't know, like normal where it's, it's, it's healthy debt. It's not an overly levered company. In that case, would it make sense to really include the debt? But I think it still makes sense to use it. One of the cool things about free cash flow versus other value strategies is you have a built-in catalyst. So if your stock's cheap, you can take advantage of that and buy back stock.

19:46And so having a big cash pile is going to allow you to buy back more stock. If you have debt, you may not be able to buy as much stock back. But if you think about a free cash flow yield, it tells you how much you could buy back. So in a case of a stock like Zoom, they don't need a catalyst. As long as their free cash flow generation remains intact, they don't need someone to buy them. They don't need something to happen. They can just organically grow the business by buying shares, kind of the Apple way, if you will. You talked about NVIDIA being cheap back in the day. Your team sent us some really cool stats that said in 2010, I guess when this bull market kind of took off, the Russell 1000 growth and the Russell 1000 value were trading at like equal P ratios, basically.

20:27and the idea being that one of the reasons that maybe growth has had such a good run is that it was actually pretty cheap on a relative basis, right? You would expect a value index to be much cheaper than a growth index. And I think a lot of people are trying to figure out, is this just a really long cycle or is something completely changed, right? And this time is totally different and tech stocks are going to eat the world and growth is going to work forever. And I'm just curious how you think about that push and pull between valuation and maybe thinking about how this cycle plays out and where we stand now versus 2010.

21:00No, that's a great point. That's exactly how we think about it. I mean, if you're trying to figure out, I mean, let's separate value investing from do valuations matter. They certainly do, right? And so to your point, right? If gross trade in the same multiples value, you buy growth all day. So we think the first part of this move was just growth valuations normalizing, right? Where there's a healthy premium in terms of the price to earnings. And then, of course, we think it has gotten excessive, right? But I think if you understand that the first 10 years were rational, and it's probably post-COVID where things have became a little frothy, I think it does give you more patience.

21:35And if you didn't understand the beginning, you might wonder, is this ever going to happen? But we think valuations remain intact. In fact, we think it helped support growth for a long time. Do you guys have any opinion on buybacks or dividends? Does that enter into your equations at all? No, we prefer to go to the source. So regardless of how you grow your dividend, pay a buyback or do a buyback, either works, right? It's really who can have the most. Because the other thing with buybacks is not all buybacks are great. The buybacks that are best for shareholders are when the company's cheap. So we know if we solve for free cash flow yield, we know the companies, if they do buybacks, we know it's going to be beneficial to shareholders because again, we think of free cashflow yield as the amount of company could buy back every year.

22:20So you could have a company where the earnings are flat in dollar amount, but if they have a 10 % free cashflow yield, they can buy back 10 % of their shares sustainably every year and basically manufacture their own growth. It's a part that people often miss on the value side is you can get growth through that company returning capital to shareholders. What about margins? I would assume that just flows through to what you're already looking at. It does. It's that there's a link between free cashflow and earnings and its returns on capital, the quality metrics you will, which is tied to margins, but we're not specific.

22:52This isn't going to be specifically tied to margins. You can have like a healthcare stock where the, or they have really low margins, like the health insurers. We own some of those, right? Cigna, they, they have a very low margin, but they do a lot of volume. So it's a profitable business. All right. Well, here's one more. What What if the company has a high free cash flow yield, but the free cash flow has declined for four consecutive quarters? Is that something that you look at? That's interesting. So the way we do our growth filter is it's designed to look at not like the short-term growth.

23:22It's designed, we call it the growth trajectory. It's a seven-year number, five years historical, two years forward. And we're basically trying to rank companies one, two, and three and eliminate the threes. And if you think about it, I joke that this is like the IBM filter. For years, I used to run a free cash flow strategy before this. And for years, IBM sat in the portfolio at like$120, right? And I know it's rallied, but once you hate a stock, you hate it. And so what's interesting about IBM is that they have a high free cash flow yield. But if you think about why they have a high free cash flow yield, it's not always because the company's cheap.