Talk Your Book: Turning Capex Into Cashflow
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Today's Animal Spirits Talk Your Book is brought to you by Pacer ETFs. Go to PacerETFs.com to learn more about the Pacer NASDAQ 100 Top 50 Cash Cow's 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. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

Welcome to Analyst 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? Ooh, 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. 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.

Can 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. Wasn'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 cows growth leaders ETF, QQQG. Here's our conversation with Sean. Sean, 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. And 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. And 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 cashflow. And we like free cashflow as the metric

because it's something that you really can't mess with, if you will. Earnings and things like that can be 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, the reason Nvidia is such a great stock is their free cash flow margin is like 47%. Is that

Is 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. I 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. And 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 it. Yeah.

Michael did a chart last week that shows the, well, I guess it depends. This is as of Sherwood, they had a 70. So anyway, Mike got a chart showing Coca-Cola's 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. Yeah.

So maybe you could explain how Palantir looks on a cashflow basis, because 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 cashflow margin to a name like NVIDIA, for example. So they generate gobs and gobs of excess free cashflow. 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. I'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, 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

They all have the same similar characteristic. They 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 rebalances, how do you weight the portfolio? Is it evenly weighted or? No, we momentum weight the portfolio. So we pick the 50 stocks with the highest free cashflow 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, garner a 12% weight, I'm going to take that 7% excess weight and sort of trickle it down the rest of the portfolio.

You mentioned that cap weighting has been the elephant in the room. I think the top seven stocks are 35% of the S&P and 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. It'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 were all locked in our houses wearing masks amongst our families, 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 3% to 5% per year in excess return versus their broad benchmark. And 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 outsource 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 use free cash flow margins. So that's how we got here.

So people might say, might look at some of the Zimz's 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? And you would say, well, markets aren't dumb, don't.

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 access 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. I 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

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.

But 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, and 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 then 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. So how much...

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 cashflow margins change all that much over time. And Sean, just to jump in, a follow-up or an additional question on that point is 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? No. No.

Growth investing is looking forward. But there's two different distinct growth regimes that I think we've seen. 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. 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. But 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... What's the opposite of a back test? A front test? Do 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 others, 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.

And 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 Sembliss did this chart a few months ago where he looked at the free cash flow margins of like 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, where 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 cash flow than even your historical backtest show? Well, I mean, I think, you know, 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 pickup or put a price tag on. Today, it's the other way around. It's 90% intangible assets and only 10%

tangible. So 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. How 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.

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. But 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, there are, 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. So I guess your answer would just be, well, okay, well then higher CapEx, lower free cash flow 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 now.

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 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.

And 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. Yeah.

But then industrials are an 11% weighting as of 3-31-2025. 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 health care names, it would be probably sort of the drug makers that would fit into that category. If they hit big on a drug, they're going to generate huge amounts of excess free cash flow as a specific example. I'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.

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. And 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, right? If you don't have free cash flow, you're dead. That's number one. Number two is before we bring anything to market, right? We have the liberty of going back and running a whole bunch of scenarios, right? So I can run, you know, cap weightings. I can run different weighting schemes. I can run rebalances and I can put additional rules. And what we found is

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, you know, short track record, almost three years on the Russell side and a shorter track record here. But, you know, 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 is

It's pretty incredible. I think we take it for granted often. Yeah, I mean, we can rebalance the portfolio without having to worry about-- on the value side, for example, I remember we owned Meta 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. We'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 tax 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

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. From a portfolio management perspective, do you view this as more of a satellite type approach where you have the building block of the S&P 500 or the total US stock market or the NASDAQ 100 and this is sort of an offshoot of that?

The way we try to position this is that beta is free, essentially. You can give beta exposures to all kinds of indexes for nothing. And that makes sense. But what we think is this is a complementary position to traditional beta, where you can put something in the portfolio that works differently.

and it's constructed differently that we hope over time we'll add to the excess returns. It's no fun just getting the market's return, right? You want to beat it over time. So this gives you a tool if you're a financial advisor to add something that

will create true diversification in your growth sleeve, for example, without looking like what everybody else does. Because if you look at growth managers today, if they're not overweight than mag seven, they're in big trouble. So they look very much like traditional closet indexers, if you want to know the truth. This is not closet indexing. This is decidedly different.

And so it gives that financial advisor and their client a tool that they can add to sort of move away from what I think is the elephant in the room, which is I think these seven stocks control everything. And they're not necessarily going to be the whole story over time. There are many, many, many high quality companies that have far, we think, far greater growth potential than the mag seven do.

I think sometimes portfolio managers have the tendency to overdo things because complexity sells, as we mentioned earlier. Are there things that you look at outside of price momentum and free cash flow that

Not on this particular product, no. And on the value side, we look at free cash flow yield and we weight by free cash flow dollars. So we sort of are the anti-market cap weighting story, which we also think makes sense over time. It's not traditional equal weight, but by not being tied to that quote unquote market cap scheme, you leave lots and lots of room in your portfolio for other names that are going to get squeezed out or won't get enough weight in the portfolio to mean anything.

You mentioned, that's also a good one, anti-market cap. I'm looking at this real quick. Do we have a, oh, here we go. Weighted average market cap. All right. Holy cow. This is wild. Am I reading this right? The weighted average market. Okay. So the weighted average market cap

In millions. Oh God, don't make me do math. I'm not going to do it. I'm not going to do it. Just say the first three numbers. I can't. There's seven numbers. It threw me off. Let's just say this. This is- Wait, I got it. I got it. I got it. Hold on. I've never seen millions and millions. Is this 10 billion? I won't even try. Don't fact check me. But the point is this. The weighted average market cap is about a quarter of the size of the NASDAQ 100. So-

You're right. This is significantly different. Now, listen, I'm guessing it's a higher beta. Smaller companies tend to have higher betas, but it is different than the NASDAQ 100 for sure. Yes.

And it's driven by two things. The one is, you know, we have a much bigger weight, for example, to Apple of and then the Nasdaq 100 does. And we have a much lower weight to, let's say, NVIDIA. We own NVIDIA, but it's a lower weight. Right. And when you think about, you know, average weighted market cap, you know, it gets skewed in a traditional index because, you know, the five companies that are all over seven companies over a trillion dollars in.

market cap. When you do what we do and you don't use market cap as your screen, you use something else, then you're automatically going to tamp it down. The example I would give people is that I think the weighted market cap of the S&P 500 is north of $500 billion today, but the equal weighted version of it is like $110 billion. So they're the same 500 stocks, there's just a different weighting scheme. So we're not the same stock, but that'll give you an idea how to think about that, if you will.

So people have been worried about valuations in tech stocks, it seems like for, I don't know, seven to 10 years or so.

Do you have any concerns about these stocks, the fact that they've gone up so much? Or do you just kind of say, listen, we're playing by the rules here and following the fundamentals and stocks that are going up and whatever stocks do from there, it's up to them? We think that's the way to do it. If you have companies that are generating lots and lots of sales or generating lots and lots of access-free cash flow, we think that's a good thing.

What the market will put on it as a multiple, that's up to the market. That's just sort of the way things work. But over time, by rebalancing, we always have a fresh look at the 50 stocks in QQQG as an example that has free cash flow margins. So as somebody gets big enough, let's say, and their free cash flow margin starts to shrink a little bit, then I want to replace them with somebody who's got a higher free cash flow margin down the road.

Okay, Sean, for anyone who's listening and wants to learn more about, I got the name, Michael. Pays for NASDAQ 100 Top 50 Cash Cows Growth Leaders ETF. That's QQQG. That's the SEC's fault. If anyone wants to learn more, where do we? That's the SEC's fault because the naming conventions today are so ridiculous that we have to fight about names. It would be easier to call it something shorter. So you have to be very explicit? Is that the thing? They're talking about truth in labeling.

Okay, so if anyone wants to learn more about this product, where do we send them? PacerETFs.com. Order your financial advisor. All right. Thanks very much, Sean. Okay, thanks to Sean. Remember to check out PacerETFs.com. To learn more, email us, animalspirits at thecompoundnews.com.