First Trust Capital Strength ETF (NASDAQ: FTCS) seeks cash-rich, low-leverage large-cap US companies capable of generating returns on equity of at least 15%. It is a quality oriented and risk aware ETF due to the volatility screen. Selection of the 50 fittest names from the 500-strong universe, the fund weights them equally.
I fully understand the logic behind creating a wallet like this.
Equity strategies focused on financial flexibility are now more relevant than ever. This is a particularly attractive proposition in a context of impending capital shortages, as the rising cost of capital due to higher interest rates will inevitably stifle investment, which is a painful side effect of control of inflation, and only players who have succeeded in amassing large sums of cash would have the luxury of carrying out their expansion plans without turning to the capital markets to finance their growth, but already at rates higher. It is an environment where self-sufficiency is back in fashion. But is the FTCS strategy capable of generating significant alpha? Historical returns and factor analysis will tell.
The Capital Strength Index is the cornerstone of the FTCS strategy. Its selection universe includes the 500 largest liquid stocks in the NASDAQ US benchmark index. The candidate must hold at least $1 billion in cash and short-term investments on the balance sheet, have long-term debt representing less than 30% of the market capitalization and display an ROE greater than 15%. The volatility factor based on 3-month and 12-month data is then considered to exclude the riskiest players from the list.
The result of this strategy is that the FTCS portfolio is clearly overweight in healthcare (around 30.8% as of July 28), with an equally large share allocated to industrials (28.8%), followed by financials (around 14 %). The weightings on the fund’s website differ because it uses ICB sectors instead of GICS sectors.
Quite a surprising top three, at least for me, as I expected to find IT among the key allocations, a sector with traditionally higher margins (for mature companies with lower R&D spend as a % of turnover), as well as low capex favorable to stronger balance sheets. Yet FTCS has only invested in five IT players, including Amphenol (APH), Texas Instruments (TXN), Cisco Systems (CSCO), Paychex (PAYX) and Automatic Data Processing (ADP), together accounting for around 10.6% .
It should be noted that industrials are known to be capital-intensive, typically with heavy net debt given the need for large sustaining/growth investments. However, the median cash and cash equivalents of FTCS holdings in the sector are $2.8 billion, with most having a current ratio of at least 1.2, indicating the resilience of their balance sheets, as well as such a high return on total capital. like 22% in the case of United Parcel Service (UPS), with a median of 11.7%, a decent result compared to the industry median of just 6.9%.
Meanwhile, the fund sees little value in the real estate, materials and consumer discretionary sectors, with around 2% allocated to each while ignoring energy altogether. Low-margin, heavily indebted utilities also fell short, as did communication.
However, one point worth making is that in the past the fund was less skeptical of the ICB oil and gas industry. For example, page 35 of the 2019 annual report shows it was long Phillips 66 (PSX), a refining and marketing company. It remains an open question whether oil players would be eligible to be included in the upcoming quarterly rebalancing, given how lucrative this year has been for them as the price of crude oil hovered around a $100 milestone. per barrel, and the most efficient companies benefited from billions in FCF. . For example, Chevron (CVX) has steadily reduced its total debt since peaking at $45.4 billion in March 2021, to just $26.2 billion as of June 31, 2022, while its cash and cash equivalents cash plus marketable securities more than doubled this year to $12.3. billion compared to $5.67 billion in December 2021.
Performance: the capital strength factor did not guarantee a constant alpha
For better context, I would like to compare FTCS with the Distillate Fundamental Stability & Value ETF (DSTL), an equally unemotional fund to find quality in the equity market, keeping in mind the valuation factor, one that the First Trust ETF ignores. The iShares Core S&P 500 (IVV) ETF is selected to represent market performance. I also added a low-cost, quality-focused Invesco S&P 500 Quality (SPHQ) ETF to add a little more color.
Let’s take a look at their returns over a few time periods. Since the FTCS adopted the Capital Strength Index in June 2013, its returns prior to that date are essentially irrelevant, and including them in the analysis would skew the results. I would ignore them.
The first target period is July 2013 – July 2022.
Clearly, FTCS underperformed both IVV and SPHQ, with risk-adjusted returns tied, and exhibited lower volatility.
Then, the period from November 2018 to July 2022 (DSTL was launched in October 2018).
With a CAGR of 16.6% and a Sortino ratio of 1.4, the Distillate ETF is unmatched here.
Finally, let’s look at the YTD results.
Once again, DSTL is ahead thanks to its value tilt, while the others’ total returns are tied.
Strategy blind spots
Its underlying index’s stock-selection process has blind spots, jeopardizing its future returns if inflation data surprises on the upside and the market reverts to lower growth premiums after the recent boosted euphoria. by the profits of the tech giants.
The main blind spot is valuation. This is evident from the table below which covers his 25 key investments.
Overall, more than 70% of holdings have a quantitative rating of D+ or worse, while only three stocks (5.9% weighting) are comparatively undervalued (B- rating or better).
The silver lining is that low-profit businesses are simply missing from his portfolio. All holdings have at least a B-Quant profitability rating. A solid achievement, but I don’t think that alone is enough to give the fund a buy rating. I would like to see a more balanced quality/price ratio.
Data since the index change shows that FTCS has been delivering positive returns over time, but its strategy is not performing as well as investors might expect. Again, the reasoning that more complicated smart beta strategies consistently yield better returns is misleading.
It should be noted that FTCS has worked almost exactly like IVV in the past, but still with marginal alpha, which is worth appreciating. A significant discrepancy only appeared during the vaccine-induced capital turnover at the end of 2020, which seems somewhat odd given that both fundamentally ignore the value factor.
But times have changed. In an environment where capital scarcity is a real threat, lean balance sheets with ample liquidity immediately gained importance. The more dry powder a company has, the easier it will be to outsmart and outperform competitors who would struggle to deploy their capital efficiently, as higher rates make their old models unprofitable and irrelevant.
Does this warrant a bullish rating for this ETF? Barely. I see no reason to own a fund with a 55 bps expense ratio and even lower dividend yield than the IVV and almost identical returns (sometimes slightly lower in risk-adjusted terms) to the ETF bellwether index. Slightly lower volatility is something to appreciate though. Nevertheless, despite a seemingly solid strategy, it has no advantage over simplistic blue-chip ETFs, at least in my opinion, while DSTL and SPHQ obviously performed better over the periods analysed.