Investors have no shortage of metrics to evaluate equities, but not all measures capture the same economic reality. In an environment defined by elevated capital spending and market concentration, earnings-based measures may not fully reflect how efficiently companies convert investment into cash.
Free cash flow (FCF) is a metric that offers an additional lens. This provides investors with insight into what remains after operating and capital needs are met. This can provide information on financial flexibility that traditional metrics may overlook. VictoryShares and Solutions portfolio manager Michael Mack joined TMX VettaFi in a recent panel discussion to unpack FCF investing considerations.
While the current market landscape offers investors opportunities to position their portfolios to capture potential market upside, it also brings a heavy dose of uncertainty. Mack specifically called out three risk factors that could derail the market: overconcentration in Magnificent Seven stocks (Amazon, Alphabet, Apple, Meta, Microsoft, Nvidia, and Tesla), valuation risk that could spark volatility, and earnings sustainability risk. As Mack noted, the Magnificent Seven’s heavy capital expenditures (CapEx) have widened the gap between earnings and FCF, given their build-out of artificial intelligence (AI) infrastructure. Because CapEx is capitalized on the balance sheet and depreciated over time rather than expensed immediately, reported earnings can overstate the business’s true cash-generative capacity during periods of heavy investment. In this context, the impact on FCF is immediate and would be reflected in the same reporting period.
“The way that CapEx can show up in earnings is over time via depreciation,” Mack explained, resulting in possible value miscalculations. “So currently, we believe earnings are painting a rosier picture than free cash flow.”
To help solve this conundrum, investors may want to consider strategies centered on FCF, which offers another lens for assessing a company’s underlying value. FCF is the cash a company generates after accounting for operating and capital expenses. Companies with excess FCF can reinvest the cash into their operations, reduce debt, offer dividends, or invest in other activities to build shareholder value.
ETFs like the VictoryShares Free Cash Flow ETF (VFLO) and VictoryShares Free Cash Flow Growth ETF (GFLW) track indexes that select companies with strong FCF and favorable growth prospects. These FCF-driven methodologies may help uncover opportunities in sectors outside traditional value allocations, potentially enabling greater diversification.
“VFLO’s Index will look at the companies with the highest FCF yield based on forward-looking metrics and screen out the slow growers,” said Mack, adding that on the growth side of the equation, “GFLW tracks an index that targets companies with high profitability based on FCF.”
VFLO and GFLW may offer complementary style exposures on both the value and growth sides of the style box, respectively.
International FCF Flexibility
During the webinar, attendees were asked which investment styles in the equities space they were most likely to allocate in the next six months. An overwhelming majority (over 50% of the respondents) identified international equities—a response that surprised the webinar panel. However, with a declining dollar and questionable valuations in the U.S. equities market, it’s a sign that investors are increasingly looking for opportunities overseas.
Mack noted that FCF can also apply to opportunities outside of U.S. borders. VictoryShares currently offers two FCF ETFs providing exposure to international equities: the VictoryShares International Free Cash Flow ETF (IFLO) and VictoryShares International Free Cash Flow Growth ETF (GRIN). The focus is on companies with high FCF yields and high FCF profitability, and strong growth prospects.
“What’s interesting to note is that over the past ten years, the Russell 1000 Value Index has lagged the Russell 1000 Growth Index in the U.S., but internationally, the MSCI World Ex USA Growth Index has lagged the MSCI World Ex USA Value Index,” Mack said. “We think there’s a mean reversion opportunity in international growth, but there’s certainly applications for value and growth in this space.”
For additional information on these FCF ETFs or to view the entire suite of VictoryShares ETFs, click here.
For more news, information, and analysis, visit the Free Cash Flow Content Hub.
Disclosure Information
Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. To obtain a prospectus or summary prospectus containing this and other important information, visit http://www.vcm.com/prospectus. Read it carefully before investing.
All investing involves risk, including the potential loss of principal. The market prices of securities may go up or down, sometimes rapidly or unpredictably, due to general market conditions, such as real or perceived adverse economic, political, or regulatory conditions, recessions, inflation, or changes in interest or currency rates. The Funds have the same risks as the underlying securities traded on the exchange throughout the day. ETFs may trade at a premium or discount to their net asset value. GFLW, IFLO and GRIN are new Funds with limited operating histories. As a result, they do not have a record of performance or other dealings for prospective investors to evaluate when making investment decisions. Investing in companies with high free cash flows could lead to underperformance when such investments are unpopular or during periods of industry disruptions. The funds could also be affected by company-specific factors that could jeopardize the generation of free cash flow. Index Funds invest in securities included in, or representative of securities included in, the Index, regardless of their investment merits. The performance of the Funds may diverge from that of their respective Indexes. International investments can be more volatile than the U.S. market due to increased risks of adverse issuer, political, regulatory, market, or economic developments and can perform differently from U.S. investments. Large shareholders, including other funds advised by the Adviser, may own a substantial amount of the Funds shares. The actions of large shareholders, including large inflows or outflows of cash, may adversely affect other shareholders, including potentially increasing capital gains. Investments concentrated in an industry or group of industries may face more risks and exhibit higher volatility than investments that are more broadly diversified over industries or sectors. Investments in companies in the energy sector may be subject to substantial government regulation, as well as risks involving changes in energy prices, international political instability, and liability for environmental damage and accidents resulting in loss of life or property. The profitability of companies in the healthcare sector may be affected by government regulations and healthcare programs, fluctuations in the cost of, and demand for, medical products and services and product liability claims. Investments in companies in the industrials sector, including producers of durable goods and companies that process raw materials, may be adversely affected by changes in supply and demand for products and services, governmental regulation and changes in spending policies, world events and economic conditions. Derivatives may not work as intended and may result in losses. The Funds may frequently change their holdings, resulting in higher fees, lower returns, and more capital gains. The value of your investment is also subject to geopolitical risks such as wars, terrorism, trade disputes, environmental disasters, and public health crises; the risk of technology malfunctions or disruptions; and the responses to such events by governments and/or individual companies. Diversification does not assure a profit or protect against loss.
The Victory Free Cash Flow Growth Index focuses on high quality profitable companies that display a positive free cash flow trend. It selects larger cap companies with the highest free cash flow relative to invested capital that also exhibit higher growth.
The Victory U.S. Large Cap Free Cash Flow Index aims to select high quality companies from its starting universe by applying profitability screens. It then selects companies with the strongest free cash flow yield that exhibit higher growth. The Index is rebalanced and reconstituted quarterly. This Index calculates free cash flow yield by dividing expected free cash flow by enterprise value. Expected free cash flow is the average of trailing 12-month FCF and next 12-month forward free cash flow. Enterprise value (EV) measures a company’s total value, often used as a more comprehensive alternative to equity market capitalization.
The Victory International Free Cash Flow Growth Index measures the performance of profitable companies in the developed world, excluding the United States, that generate high free cash flow yield and higher growth characteristics. The indices are subject to sector country and individual security weight constraints. Constituents are weighted by free cash flow modified absolute momentum.
The Victory International Free Cash Flow Index measures the performance of profitable companies in the developed world, excluding the United States, that generate high free cash flow from invested capital and display higher growth characteristics. The indices are subject to sector country and security weight constraints. The constituents are weighted by modified free cash flow yield.
The Russell 1000® Growth Index is a market-capitalization-weighted index that measures the performance of Russell 1000®Index companies with higher price-to-book ratios and higher forecasted growth values.
The Russell 1000® Index Value Index is a market-capitalization-weighted index that measures the performance of Russell 1000® Index companies with lower price-to-book ratios and lower forecasted growth rates.
The MSCI World ex USA Growth Index captures large and mid cap securities exhibiting overall growth style characteristics across Developed Markets (DM) countries–excluding the United States. The growth investment style characteristics for index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend.
The MSCI World ex USA Value Index captures large and mid cap securities exhibiting overall value style characteristics across Developed Markets countries. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.
VictoryShares ETFs distributed by Victory Capital Services, Inc. (VCS). VCS is not affiliated with VettaFi.
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VettaFi LLC (“VettaFi”) is the index provider for GFLW, VFLO, IFLO, GRIN, for which it receives an index licensing fee. However, GFLW, VFLO, IFLO, GRIN are not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of GFLW, VFLO, IFLO, GRIN.
