Honey, I Shrank the Cash Flow

“In a world awash with gimmicky new exchange-traded funds -- more than 1,000 launched in the U.S. just last year -- an unflashy idea has found surprising success.

 

Companies such as Pacer ETFs and Victory Capital have attracted tens of billions of dollars to funds focused on free cash flow yield. It's a welcome development now that old-school value investing seems to have lost its magic.

 

Instead of trying to buy a dollar of assets or earnings for 60 cents, the funds focus on how much cash companies generate beyond their investment needs.

 

Some of the world's most-respected investors, including Warren Buffett, Charlie Munger, Terry Smith, Bill Nygren and Joel Greenblatt have stressed distributable cash over accounting profits.

 

Funds focusing on free cash flow yield are performing well and getting rewarded with inflows in a market otherwise obsessed with artificial intelligence. But any technique that boils security selection down to a simple screen is bound to get some things wrong.

 

One is failing to adjust for share-based compensation since it's a noncash item.

 

The stock issuance still costs shareholders, and it often soaks up extra cash they could receive too. Companies usually buy back the issued stock on the open market.

 

"If compensation isn't an expense, what is it?" asked Buffett in his 2015 letter to shareholders.

 

Several large technology companies, including some that can be found in Pacer and Victory's portfolios, have very different FCF yields before and after taking it into account.

 

Atlassian sported a seemingly decent yield of 3.4% at the beginning of this year, but one barely above zero after subtracting share awards. Uber had a 5.6% yield, but that was a full percentage point lower after share awards. Amazon and Snowflake both went from positive to negative yields after that adjustment.

 

It's "totally insane not to" include share-based compensation in FCF calculations, says Meb Faber, co-founder and chief investment officer of Cambria Investment Management. Faber wrote a book on the subject, "Shareholder Yield," and runs a suite of well-performing ETFs based on the idea.

 

But is it necessarily worth adding a layer of complexity to successful funds? Mannik Dhillon, head of ETFs at Victory Capital, says the firm's own backtests show basically no difference in performance. He says the issue is "on their radar," though.

 

Silicon Valley is where the chunkiest share awards tend to be, so it's possible the strong performance of almost anything tech-related has outweighed their ill effects so far.

 

The ETFs also hold enough other companies that their performance won't be dragged down much by a handful handing out lots of share awards.

 

It's certainly something individual investors picking stocks on the basis of free cash flow should consider. Winning formulas can be simple, but occasionally they're a little too simple.” [1]

 

1. Honey, I Shrank the Cash Flow. Jakab, Spencer.  Wall Street Journal, Eastern edition; New York, N.Y.. 01 July 2026: B12.