Beyond the Magnificent 7: The Rise of Free Cash Flow Investing
For decades, value investing has been associated with finding stocks that appear cheap based on fundamental ratios like price-to-book (P/B) and price-to-earnings (P/E). Warren Buffett and his mentor Benjamin Graham popularized this method, emphasizing the importance of buying undervalued companies and holding them long-term. However, as markets evolve, so too must investment strategies.
Today, we are witnessing a transformation in how investors define value. The traditional approach, which focused on tangible assets like real estate, factories, and equipment, is becoming less relevant in an era dominated by technology and intellectual property. The stock market has shifted toward businesses that rely on software, patents, brand value, and data rather than physical assets. As a result, value investing has had to adapt, and one metric has risen to the forefront: free cash flow yield (FCF yield).
Why Traditional Value Investing is Struggling
Fifty years ago, less than 20% of the assets in the S&P 500 were intangible. Today, intangible assets account for more than 80% of the index. The implications are significant: balance sheets no longer reflect the true worth of a company. Traditional value investors who rely on book value alone may be systematically undervaluing—or completely ignoring—some of the most valuable companies in the market.
Economists Eugene Fama and Kenneth French demonstrated in 1992 that stocks with low price-to-book ratios significantly outperformed their more expensive counterparts over the long run. However, this finding was based on data from an era when a company’s value was more tied to physical assets. Companies today derive their worth from innovation, intellectual capital, and network effects—none of which are adequately captured in book value calculations. As a result, the conventional definition of value is missing a crucial component of modern business.
Free Cash Flow Yield: A Better Approach
Free cash flow (FCF) is the money left over after a company has covered its operating expenses and capital expenditures. It represents the actual cash a company has available to return to shareholders through dividends, share buybacks, or reinvestment in the business. FCF yield is calculated as free cash flow divided by enterprise value (EV)—a measure that includes both a company’s market capitalization and its debt. This metric offers a more accurate picture of a company's ability to generate real cash.
Why FCF Yield is Superior to Book Value
Captures Intangible Assets – Unlike price-to-book, FCF yield considers companies that generate cash through brand recognition, data, or proprietary technology.
Reflects Actual Profitability – Earnings can be manipulated through accounting methods, but cash flow is harder to distort.
Prioritizes Shareholder Returns – High FCF yield companies are often generous with dividends and share buybacks, making them attractive to income-focused investors.
Resilient in Economic Downturns – Companies with strong cash flow generation tend to withstand recessions better than those relying on financial engineering.
How Cash Cows Are Beating the Market
Investment strategies that prioritize free cash flow are significantly outperforming traditional value investing. Analysts at fund manager Lord Abbett found that between 2002 and mid-2024, portfolios based on FCF yield returned more than twice as much as those based on book value.
One of the best examples of this shift is the Pacer U.S. Cash Cows 100 ETF (COWZ).
Pacer U.S. Cash Cows 100 ETF (COWZ)
This case study was originally highlighted in The Wall Street Journal and illustrates how focusing on free cash flow can lead to superior returns.
COWZ is an ETF that selects the top 100 companies within the Russell 1000 Index based on their free cash flow yield. Unlike many traditional value ETFs, which are weighted by market cap, COWZ is weighted by actual free cash flow, ensuring that cash-rich businesses receive more representation.
Key Facts About COWZ:
Five-Year Annualized Return: 15.7%
Beats the Russell 1000 Value Index by: 7 percentage points per year
Outperforms the broader Russell 1000 Index by: 1.4 percentage points per year
Dividend Yield (End of 2024): 7.32%
Assets Under Management: ~$25 billion
Given its strong performance, other ETFs have started replicating this strategy. Funds like Global X’s FLOW, Invesco’s QOWZ, and VictoryShares’ VFLO have emerged, all trying to capture the benefits of free cash flow investing.
Will FCF Yield Strategies Work in All Market Conditions?
One of the biggest criticisms of growth investing typified by the Magnificent 7 stocks (Apple, Microsoft, Nvidia, Amazon, Meta, Tesla, and Alphabet) is that they are over-reliant on future earnings growth. If interest rates rise, these companies could struggle as borrowing costs increase.
FCF-based strategies, however, have historically performed best in periods of slowing economic growth and rising inflation. S&P Dow Jones Indices created a version of the S&P 500 based on free cash flow yield, and its historical backtesting shows that this strategy beats the broad market in tough times. This makes sense: companies generating strong free cash flow are better positioned to weather downturns because they have more flexibility to pay dividends, reinvest in growth, or reduce debt.
The Cash Flow Titans of 2025
With nervousness growing around high-growth tech stocks, free-cash-flow-rich companies are emerging as potential new market leaders. The top seven highest free-cash-flow yielders in COWZ at the start of 2025 were:
Qualcomm (QCOM)
Gilead Sciences (GILD)
Cencora (CORC)
Tenet Healthcare (THC)
Valero Energy (VLO)
Archer-Daniels-Midland (ADM)
Bristol-Myers Squibb (BMY)
These companies are leaders in their respective industries and are significantly outperforming the broader market.
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Disclaimer: This article is for informational purposes only and should not be considered financial advice. Investments carry risks, and individuals should conduct their own research or consult with a licensed financial professional before making any investment decisions.