First Trust Capital Strength ETF (NASDAQ:FTCS) is a solid quality-centered fund I attempt to cover at least on a quarterly basis since July 2022 to keep pace with the reconstitution/rebalancing of the Capital Strength Index which this ETF is supposed to replicate the performance of.

Since my December 2022 article, the fund has declined by about 5.6%, partly proving that my assessment of the valuation risks was correct.

Today, I would like to reexamine this investment vehicle, addressing portfolio composition changes, to check whether its factor exposure has become attractive enough for the current environment to create a bullish thesis.

The strategy: the major points

To recap, the index takes a maximalist quality-focused approach by selecting only 50 players (REITs are welcome) from the NASDAQ US Benchmark Index and weighing them equally, capping industry weights.

As described on the FTCS website, the essential prerequisite is the amount of cash or short-term investments on the balance sheet being no less than $1 billion. The index has zero tolerance for overleveraged companies, showing the red light to those with a Long-term debt/Market cap ratio north of 30%. It should be noted that this rule is one of the indirect factors that make the index permanently underweight growthier picks as borrowings are in most cases (there are exceptions) a necessary ingredient of robust growth stories, especially those leveraging inorganic means (i.e., acquisitions) instead of organic ones. Below in the note, I will illustrate that FTCS’ growth characteristics are unsurprisingly soft, mostly as a consequence of the low debt criteria.

Next, Return on Equity must exceed 15%. Obviously, names who struggle to cover all the expenses, interest, and taxes, have zero chances to qualify and as of March 23, none of the stocks in the FTCS portfolio have a net loss, with the weighted-average ROE standing at 47%, as of my calculations. After all, to polish the equity mix, the realized volatility screen is used when only 50 constituents are selected.

Importantly, here I provided just a quick summary; for more details on the process, I recommend reading the prospectus.

Portfolio overview: what has changed

Since my December note, FTCS has removed 13 companies (25.6% weight) from its portfolio and added precisely the same number; the fund is still long 50 names. The removals were as follows:

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Created by the author using data from the fund

A few reasons could have driven the removal. For instance, I believe Walmart (WMT), a retail industry heavyweight, was deleted from the index most likely since its ROE was only 10.7% as of writing the previous note. It has since then advanced past 15%, so it might make a comeback during the April reconstitution, especially considering it has an immense cash position.

At the same time, Public Storage (PSA) has seen its cash & equivalents declining for two quarters in a row, so its removal was most likely the consequence of its cash being around $884 million as of the September quarter.

The additions are presented in the table below:

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Created by the author using data from Seeking Alpha and the fund

I should comment on CL’s enormous ROE of 221%. Here, one of the vulnerabilities of FTCS’ strategy comes to light. I acknowledge this company had an enormous cash pile and Total debt/Market cap of ~15.2%, but its Debt/Equity ratio of over 1150% makes ROE of 221% unreliable. However, the silver lining here is that CL has a Return on Total Capital of close to 24% and Return on Assets of 11.4%, so there is no doubt that this consumer staples heavyweight is highly efficient.

On a side note, CL’s cash shrunk to $950 billion in the Q4 2022, so I believe it is likely that it will lose its place in the index upon the April reconstitution.

Next, as a result of the January reconstitution, the fund’s industry mix has also changed. For instance, one energy stock has qualified, namely Chevron. Consumer staples saw a solid boost, now having a 16.6% weight. Financials, contrarily, lost about 4.8%.

Click to enlarge

Created by the author using data from the fund

Finally, it would be pertinent to compare the key weighted-average metrics to uncover whether they have improved in the wake of the portfolio changes and the price decline.

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Computed by the author using data from Seeking Alpha and the fund

Let me summarize the major changes:

• First, we see a marginal improvement in the earnings yield together with an expectable decline in market cap, which is a positive. Another noticeable improvement is the P/S ratio going sharply lower. Yet in my view, this is still hardly supportive of a bullish thesis. As I said in my first note on FTCS published in July 2022, valuation is the major blind spot of its strategy; and this remains an issue, especially considering relatively overvalued companies (with a D+ Valuation grade and lower) account for 72.5%.
• Second, growth characteristics have even become bleaker, with both forward revenue and earnings growth rates going down a few %, which is, in my view, consistent with the P/E and P/S ratios also declining.
• Quality remains solid, though the decline in the WA ROA is a small disappointment.

Investor takeaway

Does FTCS ETF deserve a rating upgrade today? There are a few nuances to consider.

There is no denying that the fund can select top-quality behemoths as I illustrated a few times in my notes. Its exposure to the profitability factor is simply excellent (none of the stocks currently have a Quant Profitability rating lower than B), even though there are minor blind spots of this strategy including a possibility of high-D/E companies qualifying for inclusion in the index as described above in the case of CL.

However, I strongly believe the value ingredient is not to ignore, even assuming some investors may have an opinion that after the recent 25 bps hike, the Fed will soon stop tightening as the conditions are already supportive of inflation retreating to the tolerable level consistently, and going too hawkish might simply result in a recession. No more interest rate increases should be favorable for the growth stock echelon (contributing to the growth premia that were decimated in 2022), as well as those equities that tend to trade with multiples I would call disconnected from reality. At the same time, amid this anti-value rotation, the cheaper stocks should languish.

And I can agree here. But the problem here is “should be” together with an overall uncertainty surrounding the equity market these days. To navigate it, both quality and value are essential. In this regard, the Hold rating is maintained.