Talk Your Book: Turning Capex Into Cashflow

0:00Today's Animal Spirits Talk Your Book is brought to you by Pacer ETFs. Go to Pacer ETFs.com to learn more about the Pacer NASDAQ 100 Top 50 Cash Cows Growth Leaders ETF, QQQG. Again, that's PacerETFs.com to learn more. 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. All 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.

0:36Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:44Welcome to Animal Spirits with Michael and Ben. On today's show, we are joined by Sean O 'Hara. Sean is the director of Pacer Financial and the president at Pacer ETFs. Free cash flow. What a bear that was on the CFA test, right? I remember I had a whiteboard. I hate whiteboards. Big anti-whiteboard guy. But I did have a whiteboard in my bedroom with all of the different formulas. Remember free cash flow to the firm? Free cash flow to operations? You remember that stuff? I definitely had a couple of sheets that were laminated on both sides. Do you start with net operating profit after tax or do you start with EBIT?

1:22Ooh, horrible. And even to this day, free cash flow is not really readily available at most casual websites, right? I thought you could find it. It's probably much easier to find these days than it used to be. Well, you know what? I'm sure ChatGPT can help. But at a generic stock website, you see sales, you see maybe margins, obviously market cap, all those sort of metrics. But we spoke today about, I think that the ETF wrapper at this point is something that we take for granted just because it's so ubiquitous. It's been part of the building blocks for financial advisors for so long. But it really is kind of an amazing product when you think about it.

2:01Can you imagine trying to make some of these strategies yourself with 50, 100, and 150 names? Calculating them, rebalancing, figuring that out. Yes, the fact that it is just so easy and automated is in a tax-efficient wrapper. It's wonderful. It's a wonderful step forward for individual investors. We're a pro ETF podcast. Absolutely. All right. So I feel like that's enough of an intro. What do you think? No, but the free cash flow thing, the reason that it's important is because sometimes you can see a company with low or negative earnings. And this was the whole Amazon thing forever. Remember, people thought Amazon was overvalued for years and years and years.

2:39Wasn't that why you shorted it? Fundamentals? Well, also like things like stock-based compensation. Not that it's not an expense, but it's not cash flow. So you're looking at how much money these companies are actually producing. And it's a different metric. And sometimes these fundamentals can be at odds with one another. And understanding, especially I think for tech stocks, it makes a lot of sense to look at it this way. So again, we spoke to Sean O 'Hara today from Pacer about their Cash Calls Growth Leaders ETF, QQQG. Here's our conversation with Sean.

3:14Sean, welcome to the show. Thanks for having me. I appreciate it. I saw a note from Gina Martin-Adams this morning posted on LinkedIn where she shared a chart that shows the operating margin since the year 2000 of the S &P 500 alongside information technology as well as X information technology. And you probably know where I'm going with this. The S &P 500 and X Infotech follow each other for the most part, but operating margins for information technology stocks have gone from, what was this, like a 14%, whatever it is, up to 35 % all-time high, no cap there. It just keeps going up and to the right.

3:57And this to me is one of the defining stories of the stock market in the United States over the last 15 years, despite all of the claims of trees don't grow to the sky, the law of large numbers incorrectly used. Nobody, I think, could have predicted that the inherent leverage in these businesses would continue to expand and expand. So that's a nice segue into the conversation that we're going to have. The ticker for the ETF that we're talking about today is QQQG. So it is a spin on some of these information technology names. What are you trying to accomplish with this product? Well, I mean, Michael, as you said, we use free cash flow margin.

4:42And so for those who don't know what free cash flow margin is, it's the free cash flow company generates divided by sales. So it's a measurement of how successful a company is in converting their sales and revenues into excess free cash flow. And we like free cash flow as the metric because it's something that you really can't mess with. If you will, earnings and things like that can be sort of manipulated. Free cash flow is the money that's left over after a company's paid all of its bills. It's very, very hard to manipulate. And so what we do is we use that as a screening mechanism. And what you were on to, like the reason NVIDIA is such a great stock is their free cash flow margin is like 47%.

5:17Is that good? That's huge. So for every$100 in sales, they're generating$47 worth of free cash flow. And they're able to plow that back into their business and continue to grow, number one. And number two, it's an indication that they're not really an asset-heavy company, which can tend to weigh down companies over time. So we started focusing on free cash flow a decade ago on the value side. We've now transitioned on the growth side using free cash flow margin. And with QQQG, what we do is we take the NASDAQ 100 and sort of take it apart. The way people maybe traditionally know is it's cap weighted.

5:52I think the flaw in that is that you've got seven companies that basically take up like 45 or 50 % of the weight. So there's fantastic companies in the NASDAQ 100 that get underappreciated with regard to the allocation. We screen for the 50 companies with the highest free cash flow margin. And so what we're trying to do is identify that key metric that you talked about at the beginning, which is companies who are great at converting their sales into free cash flow. So I want to get into the investment process in a little bit, but I thought this would be a good jumping off point to talk about Palantir, which is a company a lot of people have been talking about lately.

6:24And some people just can't, are pulling their hair out saying, this company has, this has to be the most overvalued company in the index. It's trading at like 70 times sales or something. If you look at a chart. Michael did a chart last week that shows the, well, I guess it depends. This is as I'm sure what they had at a 70. So anyway, Mike got a chart showing Coca-Cola of market cap over time and Palantir's caught it in like the last two years, essentially. It's crazy. And so you guys have it as, I'm looking at Y charts for your top holdings as the second largest holding. So maybe you could explain how Palantir looks on a cash flow basis?

7:02Because it is funny, depending on what kind of valuation metric you use, how different these things can look to certain people. Well, they have a similar free cash flow margin to a name like Nvidia, for example. So they generate gobs and gobs of excess free cash flow. I agree that you make an argument the stock is probably overvalued, but we rebalance this portfolio on a quarterly basis. And we only use that one metric, which is essentially that free cash flow margin. The second thing though that we do is we momentum weight the portfolio. So I'm not necessarily going to have the highest free cash flow margin name at the top of my list.

7:35I'm going to use relative strength and momentum weight, which is why Palantir gets pulled up into that weight in the portfolio, which by the way, is one of the things that distinguishes us from a return perspective to the NASDAQ 100. Yeah. So when you say we momentum weight, are you talking about price or accelerating free cash flow margins? Price, purely price. So momentum's powerful when it's there, you want to make sure you take advantage of it. And the whole story about QQQG and all of this whole series that we have using free cash flow margin is to sort of move away from traditional cap weighting, which is the big elephant in the room is whether you look at the Russell 1000 growth or the NASDAQ or the S &P growth, they all have the same similar characteristic.

8:13They all have a big overweight to seven names and a vast majority of the portfolio is amongst those seven names. And so what we're trying to do is give people an opportunity to not own the companies maybe that have grown the most over the last 10 years, but maybe more weight in the portfolio to those companies, like you mentioned, Palantir or Palo Alto or AppLove and or Fortinet that are underrepresented in the broad index just because they're cap weighted. So how do you do when you do your quarterly balances? How do you weight the portfolio? Is it evenly weighted? No, we momentum weight the portfolio.

8:46So we pick the 50 stocks with the highest free cash flow margin, and we run that momentum screen on top of that. So there's 50 names always in the portfolio. They all come out of the NASDAQ 100. And then each company is given a weight in the portfolio based on their momentum or their relative strength score. But everything's capped at 5%. So I don't want to have 20 % in the name. I don't want to have 15 % in the name. So if I got a company that would normally, just because of its momentum score, go into a 12 % weight, I'm going to take that 7 % excess weight and sort of trickle it down the rest of the portfolio.

9:18So you mentioned that cap weighting has been the elephant in the room. I think the top seven stocks are 35 % of the S &P, an even larger percentage of the NASDAQ 100. So why did you choose free cash flow as the thing to benchmark against? Why not? I don't know. Anything else? What's so special about free cash flow? that you think is going to filter its way to the bottom line of the share price? Well, because when you think about growth, if you look at a broad index like the Russell Growth, for example, one of the things they'll factor into what goes into that index is sales growth. And sales growth, everybody thinks is a great thing.

9:57It's a good thing until there's not any profits. The poster child for that would be Peloton, right? And I love Peloton. I own two of their bikes. I'm a cyclist. It's a great product. But during the pandemic, when we're all locked in our houses wearing masks amongst our families, you know that stock went crazy because everybody sort of extrapolated that sales number into the future and thought eventually they'll be profitable well we don't think that that's a very good long term measure of success as a matter of fact if you just focus on sales growth you actually destroy alpha when you look at free cash flow margin and you look at the top decile or quintile names in any index that have the highest free cash flow margin they add three to five percent per year in excess return versus their broad benchmark.

10:36And so we stumbled on free cash flow a decade ago, and we applied it to value using free cash flow yield. That would be the original cash cow series that we had. We've now sort of went back to the well, if you will. We use the same research folks. We outsourced that to a company called Empirical. I think they're one of the smartest people I've known in 40 years in this business. And we asked them the same simple question. If we're going to do growth, but we're not going to use traditional growth metrics, what should we use? They said, reduced free cash flow margin. So that's how we got here. So people might say, might look at some of the same as this portfolio and say, oh my goodness, how could you possibly buy a stock trading at 100 times trend, like 70 times forward, whatever the case may be.

11:15And you would say, well, markets aren't dumb, dummy. There's a reason why these companies are richly valued. It's because they are gushing cash and investors value that over everything else. Yeah. I mean, you could have made the argument, the same argument against NVIDIA four or five years ago, you would have missed out on an enormous amount of excess return. And NVIDIA will eventually slow down, as we think Palantir will. But by rebalancing the portfolio, we're always looking for those next names. Some of the names that are not in this portfolio, Amazon, Tesla, and Costco, which are big holdings, are all top 10 holdings in the NASDAQ 100.

11:45I mean, Amazon's free cash flow margin is single digits. And so I'm not looking for a name like Amazon is generating single digits excess free cash flow, because I want companies with 30 % or more excess free cash flow because I think they'll be able to convert that free cash flow into continued sales. We also get the excess return by overweighting names and underweighting names, right? So we own NVIDIA, we own Google, we own Apple, and we own Meta. But those five stocks are not 25 % of the portfolio, but probably collectively less than about 11 % of the portfolio. The names on the overweight side are Palantir, Palo Alto, Apple Oven, which is a phenomenal stock, and Fortinet.

12:25But the way these broad indexes work is that because they're market cap weighted, those giant trillion dollar companies squeeze out investors from allocating to these other companies. You get way underrepresented in these other great growing companies like Apple Oven, for example, I think is up more than Nvidia. And so you're missing out on opportunities by focusing on cap weighting and what free cash flow margin does and using it as a screen and and only picking 50 stocks gives you that exposure to these names that are way, way, way underweighted in the broad index. So I guess if I had to really simplify your strategy in one sentence, it would just be that you're buying these tech stocks that produce a lot of free cash flow, but they're also going up.

13:08So how important is that momentum screen in all of this? And does that, I assume that just has to increase the turnover because I can't imagine the free cash flow margins change all that much over time. And Sean, just to jump into a follow-up or an additional question on that point. It's like, what would happen when the stocks are going down? How would you factor in momentum when there's negative momentum? I mean, the momentum score is really, really important, right? So growth is different than value investing. Value investing is like, what's the stock worth today? And can I make a case that it's way undervalued, right?

13:36No. Okay. Growth investing is looking forward, right? But there's two different distinct growth regimes that I think we've seen, right? One is when everything's great and everybody's making a lot of money, the economy is humming and you can make a good case for growth. The other is when you have multiple expansion, which is what we've had for the last couple of years up until the beginning of this year, right? And if you don't pay attention to that multiple expansion, which is the momentum play, you miss out a great deal. And so that's why we do what we do, is that we want to be momentum weighted, but we want this fundamental that we believe in so much, which is free cash flow margin.

14:12But you have to sort of play both sides of the street as a growth investor. Getting back to the question about how would you think about momentum? price momentum when stocks are falling? Would it be like the ones that are falling the least would have, I guess, relatively the highest momentum? Yeah, it's just a relative screen versus the other 50 names. Okay. So looking at the free cash flow margin comparison, your companies or the companies in this portfolio weighted by, I guess, the weighting is 28 % versus 22 % for the Nasdaq 100, give or take. Is there empirical evidence, I guess, looking backwards because we don't have, a back test, a front test.

14:49Do high free cash flow in companies correlate with higher performance? The answer is in the research that we've seen, and we get it from empirical research, which is funny that you said empirical because there's two different ways to use that word. One is the way you used it, and the other is the name of the research firm, is that there is ample evidence that really going back for decades, if you will, that this free cash flow is a super metric, and it can be applied a number of different ways to identify companies that have potentially better long-term growth prospects. We launched a similar product almost three years ago, COWG, which uses the Russell 1000, and it pulls out the 100 stocks with the highest free cash flow margin.

15:31And it's beating the NASDAQ, and it's beating the Russell growth pretty handily, like double the last 12 months. And it's for the very same reason that QQQG works, and that is that we're underweighting those mega cap names and we're overweighting those next companies who potentially have the opportunity to be the real superstars. So you've done a lot of historical work on this. JP Morgan's Michael Semblis did this chart a few months ago where he looked at the free cash flow margins of the 10 biggest firms in the S &P by decade. And in the 70s and 80s, it was relatively low, call it under 10%. And it's gone up about 5 % per decade since then.

16:08where now it's approaching 30%. And it seems to me like this is just something that we've never seen before. Do you find that the companies from today are just that much better at producing cashflow than even your historical backtest show? Well, I mean, I think, Ben, the market's really different today. If I went back to the 70s and I said, how do we value stocks? Like 90 % of the value of a stock in the 70s was based on their price to book. And only 10 % on intangible assets, right? Those are things you can't see touch field, pick up, or put a price tag on. Today, it's the other way around. It's 90 % intangible assets and only 10 % tangible.

16:45So, the world changed, right? So, it wouldn't surprise me if you went back and look at the 70s, 80s, and 90s that the constituents would change a great deal. Tech and this current movement that we're going through with AI, I think, is a transformational period. And I think there's going to be massive winners in this space, but it's not going to be limited to just seven stocks. There's a lot of really great names in the NASDAQ 100, for example, or the Russell Growth that just get underrepresented. And so it's not a surprise to me that we have much higher free cash flow margins, for example, today than we did, say, 20 years ago.

17:21How do you or how are people thinking about when you talk to advisors and users or empirical, how might AI impact free cash flow margins. I think a lot of people are looking forward to higher productivity gains, ostensibly higher free cash flow margins. But what if it's the case that some of the AI companies that are coming to market, some of the incumbents just destroy these companies? I don't know that they're going to destroy these companies. I think what they're going to do is enhance their capabilities. I mean, there's two different distinct ways to think about AI, right? One is the folks that are embedded in the large language models and AI learning.

17:59But then it's the application case for companies that you wouldn't think are necessarily AI companies, which will help to increase their productivity. So I don't think it's going to destroy companies. I think it's going to make them far more productive over time. So how about this? And maybe we're getting too far in the weeds, but looking at the site, free cash flow, the definition, and more, this has given me PTSD flashbacks to the CFA material. A company's cash flow from operations minus capital expenditures, expenses, interest, taxes and long-term investments. Okay. On the CapEx side, I was reading in Barron's over the weekend, Oracle is spending like, I don't know, 40 % of its revenue on CapEx or some crazy number.

18:38So I guess your answer would just be, well, okay, well then higher CapEx, lower free cash margins, lower rating in the portfolio. Yeah. And we'll wait to see whether that excess CapEx is going to turn into real money, right? The best example over the last five years would be the energy companies i mean they slashed their capex massively oil prices spiked and so they are generating gobs and gobs of excess free cash flow and so we've got a few energy names in our growth product using the russell 1000 but that cycle will change as well i think the big energy companies are going to sort of you know pull in their horns a little bit in terms of being really really aggressive and they're going to shift i think that the energy stocks are going to be, they're the only people I think that can solve this quote unquote green energy problem.

19:23And we need everything, right? We need oil and gas. We need coal, but we need other stuff. And so they're going to take their CapEx probably at some point start investing more heavily into non-traditional energy production. You should market this as a wait and see approach to AI investing. Well, it's sort of like the proof is in the pudding at the end of the day, right? I don't own any companies that generate less than the 50 best free cash flow margin generators. So there you go. All right. So we've spent the majority of this conversation so far talking about technology companies because they are the natural winner in terms of operating leverage, higher margins, higher free cash flow.

20:05But then industrials are an 11 % weighting as of 331, 2025. Healthcare, almost 10%. How are some of the other companies, and it's funny because we've spoken about this a lot in the NASDAQ 100, like you mentioned, Costco. I believe Pepsi is in there. I think there's an airline in there. It is not only technology stocks or communication services. So how are industrials able, or whatever sector you want to talk about, able to generate so much free cash flow? Well, if you take the healthcare names, it would be probably sort of the drug makers that would fit into that category, right? If they hit big on a drug, they're going to generate huge amounts of excess free cash flow as a specific example.

20:48I'm just trying to get my list of names up here so I can see if I can pick an industrial for you guys to take a look at. But at the end of the day, we're very simplistic and very straightforward. It's 100 % rules-based. I don't care what sector they're in. I don't even care what their name is. What I care about is do they generate enough excess free cash flow margin compared to everybody else, and I want to give them excess weight in my portfolio. Yeah. I am a big proponent of the simplicity and less is more. And it seems like the rules for this strategy are very simple and straightforward. And it's funny because a lot of times, a lot of these quantitative strategies will be more in the weeds and more detail-oriented.

21:25And sometimes it seems like the end investor wants that complexity. It makes them feel it's easier sales pitch. I'm just curious how the advisors you're talking to, or the retail investors, institutional investors, how comfortable they are with this process, being that it is relatively straightforward and simple and easy to understand? Well, I think most of them deal with business owners to a great degree. And if you're a business owner, you understand free cash flow implicitly, if you don't have free cash flow, you're dead. That's number one. Number two is before we bring anything to market, we have the liberty of going back and running a whole bunch of scenarios.

21:57So I can run cap weightings, I can run different weighting schemes, I can run rebalances, and I I can put additional rules in. What we found, to be honest, Ben, is that the fewer inputs that you import into something like an index methodology like what we put together here, the fewer, the better. The more complex you make it, you just water it down. And so either you believe having a high free cash flow margin is a good thing, and you believe that over time that might lead to higher excess returns, or you don't. But the data that we have, and so far, short track record, almost three years on the Russell side and a shorter track record here.

22:36But I think we believe implicitly that we're in the right place here. One of the great things about the ETF wrapper is that it allows you for systematic investing. And particularly on the free cash flow side, this is not generally a metric that you could just find on the internet at Yahoo. Maybe it's there, maybe it's not, I don't know. But this is something that is a pain in the A to calculate. And the fact that you are able to have a quantitative, rules-based approach inside of a tax-efficient vehicle, just doing this on your behalf, it's pretty incredible. I think we take it for granted often.

23:09Yeah. I mean, we can rebalance the portfolio without having to worry about, you know, like on the value side, for example, I remember we owned Meadow one time for like a quarter. It was up 90%. Now we sold it because the stock price went up, which meant its free cash flow yield went down. But I don't have that normal decision-making process that a traditional 40-act mutual fund manager would have, which is, If I sell this stock, I'm going to distribute big capital gains and my shareholders won't like that. ETFs allow you to rebalance on a quarterly basis, for example, like we do with most of our stuff, and not have to worry about that capital gain distribution at the end of the year because of what's called custom in-kind creation redemption.

23:45We're able to rebalance using that tactic. The other thing that you mentioned, free cash flow and those kinds of things. If you have a fact-set subscription, you can find it. But the average person on the street trying to do the research on something like this themselves, it's fairly difficult. And so this is just a different way to get into a story that we believe makes sense and that we think other people agree with us that it makes sense over time, where you don't have to be like you have your head in your computer all day long trying to run stocks, free cash flow margins. Obviously, this is a more concentrated strategy with 50 names.