2023-09-27 12:01:30 ET
Summary
- EPS weights 500 large-cap US stocks on the basis of cumulative earnings.
- We note how there isn't any great incentive to this strategy.
- We close with some thoughts on the technicals, valuations, and the dominant sector holdings.
ETF Profile
The WisdomTree U.S. LargeCap Fund ( EPS ) with over 15 years of trading history, and $660m in AUM, focuses on an earnings-weighted large-cap index. Essentially, EPS takes the 500 largest stocks (by market cap) from the WisdomTree US Total Market Index (stocks that are chosen here are screened based on certain proprietary quantitative risk screens), and then assigns weights based on aggregate earnings generated over the prior 4 quarters (as of Dec every year). The individual percentage weight of each stock will be a function of its own cumulative trailing earnings, relative to the cumulative trailing earnings of all the other members of the index.
When one thinks about EPS’s underlying rationale, there are both good and bad facets to note. Firstly, we think a product of this sort could have plenty of takers in an environment where the market-cap-weighted benchmark is held up by the performance of just a few large-cap names. During a scenario like this, when the discount rate becomes more steeper, and investors get more discerning about the earnings they get at a certain price, EPS’s dominant holdings could help paint a more palatable picture from a valuation angle, thus making it less susceptible to brutal sell-offs.
On the other hand, we are not necessarily convinced that a cumulative earnings screener is an ample barometer of quality. Firstly, since this is a function of earnings over 4 quarters, a company with 3 quarters of profits and 1 quarter of losses could still make the cut. Secondly, the earnings of a company are often skewed by one-off items or non-cash items and don't necessarily give you a wholesome picture of the innate cash-generating capability of a business model.
Has There Been Ample Merit In Pursuing Earnings-Weighted Large-Caps?
Prima facie, we are ambivalent about EPS’s qualities, but let’s see how it has performed relative to the market. As you can see from the image below, purely from a total return perspective (since EPS’s listing date in 2007), there’s not an awful lot to choose from between EPS and SPY, with the former slightly edging the latter by a few percentage points. Nonetheless, there’s some merit in slightly outperforming the benchmark, when you can be accessed at a lower expense ratio (EPS’s expense ratio is 0.08%, whereas for SPY it comes in at 0.09%)
However, just sticking to total returns won’t necessarily give you a comprehensive picture of EPS’s qualities. It’s also important to consider the degree of excess returns that this portfolio generates (relative to the risk-free rate), considering the degree of risk it takes (as measured by the standard deviation). This is captured by the Sharpe ratio, and here we can see that over the last 15 years, the S&P500 has done a better job of juggling its risk and returns.
Also taken into consideration, the Sortino ratio which gives you a sense of the ability of these products to generate excess returns when faced with downside deviation. On this front, the variance between the two products is a lot wider, with the benchmark coming out on top once again.
All things considered, it appears that so far there hasn’t been any great incentive in pursuing EPS over the benchmark, and we don’t see any major reasons why this narrative should drastically shift.
Closing Thoughts- Notable Considerations For Those Pursuing EPS
Nonetheless, if you are still keen to pursue this product, here are a few important talking points.
Given this is an earnings-themed product, it's no surprise to discover that the valuation picture looks a lot more attractive than what it looks for the benchmark (as constituents with higher cumulative earnings receive larger weights dampening the overall portfolio P/E). According to Morningstar, EPS is currently priced at 16x P/E, a 20% discount to the corresponding multiple of the S&P500. At that lower multiple, you’re also poised to receive better long-term earnings growth of 13% (vs 11.7% for SPY).
Meanwhile, the relative strength chart of EPS as a function of SPY suggests that it could benefit from some mean-reversion as it is currently trading quite some way off the mid-point of the long-term range.
Then, if one reviews EPS’s weekly price imprints over the past year or so we can see that it has been trending up in the shape of an ascending channel. If one were to use the boundaries of the channel as pivot points and contemplate a long position at this juncture, the reward-to-risk equation looks rather favorable at over 4.5x.
All this is very well, but investors should also consider that EPS’s top sector exposure- the technology sector, currently looks like one of the most overbought counters in the market, with its relative strength versus the S&P500 trading well above the mid-point of its long-term range. This could make it vulnerable to a correction.
Yes, we recognize that there's an outside chance that these sector weights move around when the index gets reconstituted in around 3 months, but it is difficult to envisage the tech sector not taking up a lion’s share, given that large-cap tech stock earnings have largely been coming in well above what the street has been budgeting.
Even in the medium term, there’s a good chance that dominance of the tech sector (alongside communication services) in EPS’s portfolio may well continue as it is likely to generate one of the highest earnings growth rates next year as well.
For further details see:
EPS ETF: Yes And No