A new ETF offers another way to slice up the S&P; 500 for customized exposure to large-cap stocks.
The S&P 500 Capital Expenditures Portfolio (CAPX) is the first ETF launched by Elkhorn, a firm founded by former PowerShares executive Ben Fulton in 2013. Elkhorn’s first ETF offers a unique twist on exposure to large-cap U.S. stocks, replicating an index designed to include the companies with the highest “Capex efficiency” from the S&P 500.
CAPX is linked to the S&P 500 Capex Efficiency Index, a benchmark that identifies 100 large-cap stocks using a niche cash flow filter and assigns equal weight to each. The result is a subset of the popular stock index comprising stocks experiencing specific cash inflows (revenue) trends and outflows (capital expenditures).
With each dollar of free cash flow generated, companies essentially have three options:
- Payout to shareholders;
- Keep in the bank; or
- Invest in equipment and/or projects.
The third option is generally referred to as capital expenditures (or Capex) and may involve constructing a new factory, purchasing additional equipment, or other similar cash outlays. Instead of flowing through the income statement as an expense at the time of purchase, these expenditures are capitalized on the balance sheet (i.e., they become an asset) and are depreciated over time.
Companies generally incur these expenses with the expectation that the cash outlay now will generate revenue in the future. New machinery may be expected to increase output — and therefore revenue — once installed, while a new factory may allow the company to launch a new product — and new revenue stream — once complete.
Of course, the return on the initial investment will vary from company to company and even between projects. Some companies will generate high positive returns on these expenditures, while others may not recoup their investment.
The CAPX portfolio will consist of companies that have seen their capital expenditures-to-sales ratio (CE/S) decline, which may indicate increased efficiency — generating an increasing amount of revenue from each dollar invested back into the company.
The index underlying CAPX calculates a simple ratio of capital expenditures-to-sales for S&P 500 companies over the last four years. It then divides the most recent year’s ratio by the average of the previous three years to determine the current trend.
For example, Pall Corporation (PLL) had an average capital expenditures-to-sales ratio of 5.5 percent between fiscal 2011 and 2013. In 2014, that ratio dropped to just 2.7 percent, indicating a higher amount of revenue per dollar of capital expenditures:
Data Source: Google Finance
PLL’s most recent CE/S is just 49 percent of the average over the previous three years, a significant decline (2.7 / 5.5 = 0.49). The CAPX portfolio will consist of the 100 stocks from the S&P 500 with the lowest such ratio, with an equal 1.0 percent base weighting assigned to each.
At the other end of the efficiency spectrum is a company like Exxon Mobil (XOM), which is not found in CAPX. The energy giant’s capital expenditures as a percentage of sales have increased in each of the last four years, as revenue has declined, but capital investments have remained relatively stable.
The Case for Capex Efficiency
The CE/S ratio of stock may trend lower for several reasons. Companies that have recently made significant investments in new equipment and facilities, for example, may begin to see these investments pay off as revenue accelerates. Such a scenario would feature two movements — falling expenditures and rising sales — resulting in a lower CE/S ratio.
This methodology will also generally include stocks that have slashed capital expenditures recently. The table above, for example, includes Newmont Mining (NEM). As gold prices have fallen in recent years, many gold miners have drastically scaled back capital expenditures to preserve cash. Newmont’s 2014 capital expenditures were about 60 percent lower than expenditures in 2011 when gold prices were significantly higher. The decline in revenue over that period — about 30 percent — was more moderate, resulting in a significantly lower CE/S ratio.
CAPX vs. S&P 500
CAPX is a subset of the S&P 500, so it will generally maintain a similar risk profile and allocation among the various sectors of the economy. There are, however, a few slight differences in the portfolios of CAPX and the S&P 500 Equal Weight ETF (RSP):
Data Sources: Guggenheim, Elkhorn
CAPX maintains larger allocations to technology stocks and financial companies, two corners of the market that have demonstrated reasonably strong revenue growth in recent years. Conversely, CAPX is underweight in consumer stocks, perhaps reflecting softer top-line revenue growth in these sections of the domestic economy.
CAPX maintains an expense ratio of 29 basis points annually, which puts it between Vanguard’s S&P 500 ETF (VOO), which charges just 0.05 percent, and the Guggenheim S&P 500 Equal Weight ETF (RSP), which charges 0.40 percent.
CAPX in a Portfolio
Although CAPX implements a fair niche investment strategy, it also offers relatively cheap exposure to a deep and balanced portfolio of U.S. stocks. As such, investors attracted to the methodology could use it in several different ways within a portfolio. CAPX could be used to tilt exposure toward the specific subset of companies it represents or as a core holding that delivers access to large-cap U.S. stocks.
It could be viewed as a more cost-efficient alternative to RSP as well, for investors attracted to the equal weight strategy and focused on minimizing fees.
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