Tag Archives: investing-strategy

The Fundamental Difference: Through A Lens Of Net Buybacks

By Jeremy Schwartz At WisdomTree, we believe that screening and weighting equity markets based on fundamentals such as dividends or earnings can potentially help produce higher total and risk-adjusted returns over a complete market cycle. One of the most important elements of a fundamental index is the annual rebalance process, where the index screens the eligible universe and then weights those securities based on their fundamentals. In essence, the process takes a detailed look at the relationship between the underlying fundamentals and price performance and tilts weight to lower-priced segments of the market. One way to illustrate the benefits of this approach for our earnings-weighted family is to compare the net buyback yield of the WisdomTree Earnings Index to a market cap-weighted peer universe. Below we look at how the net buyback yield changes when you screen and weight U.S. equity markets by firms’ profitability instead of market cap. Earnings Weighting vs. Market Cap Weighting Click to enlarge The WisdomTree Earnings Index consistently had a higher net buyback ratio than did a market cap-weighted universe consisting of the 3,000 largest securities by market cap. The WisdomTree Earnings Index averaged a net buyback yield of 2.2% over the period, compared to just 1.1% for the market cap peer universe. We believe that having an annual profitability screen for inclusion in the WisdomTree Earnings Index helps avoid speculative and unprofitable smaller-capitalization firms that have a tendency to raise capital by periodically issuing new shares. The earnings-weighted approach that tilts weight to more profitable firms can also be a reason the weighted average net buyback yield is higher. The chart below looks at the net buyback yield on a universe of the lowest price-to-earnings (P/E) ratio stocks within the 3,000 largest stocks by market cap and contrasts that with the net buyback yield on the highest P/E ratio stocks. Net Buyback Yield by P/E Ratio Click to enlarge If corporate America responds well to incentives, the higher-priced basket would issue more shares (given that their stocks are high priced and issuing more of them would be an effective way to raise growth capital) and the lower-priced basket would issue fewer shares or actually buy back shares to reduce their shares outstanding and thus power their earnings-per-share growth. What we see in the data is the higher-priced universe buys back fewer share, and instead issues more shares (having more companies with negative net buyback yields). Why Earnings Weight Going back to the WisdomTree Earnings Index in the first chart-weighting by Earnings Stream is essentially tilting weight from a market cap-weighted scheme to over-weight those companies with below average P/E ratios and to under-weight those companies with high P/E ratios. The Earnings Stream can be defined as earnings per share times shares outstanding or market cap x earnings yield (which is equivalent to 1/PE ratio). Tilting weight to the higher-earnings-yield stocks by earnings weighting thus is one effective way to tilt the net buyback yield balance in one’s favor. Companies reducing shares outstanding are essentially locking in earnings-per-share growth by reducing their share count, while companies that are issuing more shares are creating a higher hurdle to overcome to achieve earnings-per-share growth. There is a philosophical debate about the motivations for all the buybacks we are seeing today as well as fears that companies are failing to reinvest for future growth (or that they just see no growth opportunities, hence all the dividends and buybacks). One thing is clear to us from the data: the lower-priced stocks issue fewer shares, and the more expensive stocks issue more shares (and have lower net buyback yields). This can be especially true in the small-cap space, as we will discuss in a future blog post. The consistently greater-than 2% net buyback yields seen on the WisdomTree Earnings Index over the last five years, combined with 2% dividend yields on this basket today, provides critical valuation support and also helps explain why we think the earnings-weighted approach can add value over time. Jeremy Schwartz, Director of Research As WisdomTree’s Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel’s head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper “What Happened to the Original Stocks in the S&P 500?” and the Wall Street Journal article “The Great American Bond Bubble.”

The Dead Model

Click to enlarge How Lucky Do You Feel? Nine years ago, I wrote about the so-called “Fed Model.” The insights there are still true, though the model has yielded no useful signals over that time. It would have told you to remain in stocks, which given the way many panic, would not have been a bad decision. I’m here to write about a related issue this evening. To a first approximation, most investment judgments are a comparison between two figures, whether most people want to admit it or not. Take the “Fed Model” as an example . You decide to invest in stocks or not based on the difference between Treasury yields and the earnings yield of stocks as a whole. Now with interest rates so low, belief in the Fed Model is tantamount to saying “there is no alternative to stocks.” [TINA] That should make everyone take a step back and say, “Wait. You mean that stocks can’t do badly when Treasury yields are low, even if it is due to deflationary conditions?” Well, if there were only two assets to choose from, a S&P 500 index fund and 10-year Treasuries, and that might be the case, especially if the government were borrowing on behalf of the corporations. Here’s why: in my prior piece on the Fed Model, I showed how the Fed Model was basically an implication of the Dividend Discount Model. With a few simplifying assumptions, the model collapses to the differences between the earnings yield of the corporation/index and its cost of capital. Now that’s a basic idea that makes sense, particularly when consider how corporations work. If a corporation can issue cheap debt capital to retire stock with a higher yield on earnings, in the short-run it is a plus for the stock. After all, if the markets have priced the debt so richly, the trade of expensive debt for cheap equity makes sense in foresight, even if a bad scenario comes along afterwards. If true for corporations, it should be true for the market as a whole. The means the “Fed Model” is a good concept, but not as commonly practiced, using Treasuries – rather, the firm’s cost of capital is the tradeoff. My proxy for the cost of capital for the market as a whole is the long-term Moody’s Baa bond index, for which we have about 100 years of yield data. It’s not perfect, but here are some reasons why it is a reasonable proxy: Like equity, which is a long duration asset, these bonds in the index are noncallable with 25-30 years of maturity. The Baa bonds are on the cusp of investment grade. The equity of the S&P 500 is not investment grade in the same sense as a bond, but its cash flows are very reliable on average. You could tranche off a pseudo-debt interest in a way akin to the old Americus Trusts , and the cash flows would price out much like corporate debt or a preferred stock interest. The debt ratings of most of the S&P 500 would be strong investment grade. Mixing in equity and extending to a bond of 25-30 years throws on enough yield that it is going to be comparable to the cost of capital, with perhaps a spread to compensate for the difference. As such, I think a better comparison is the earnings yield on the S&P 500 vs the yield on the Moody’s BAA index if you’re going to do something like the Fed Model. That’s a better pair to compare against one another. Click to enlarge A new take on the Equity Premium! That brings up another bad binary comparison that is common – the equity premium. What do stock returns have to with the returns on T-bills? Directly, they have nothing to do with one another. Indirectly, as in the above slide from a recent presentation that I gave, the spread between the two of them can be broken into the sum of three spreads that are more commonly analyzed – those of maturity risk, credit risk and business risk. (And the last of those should be split into an economic earnings factor and a valuation change factor.) This is why I’m not a fan of the concept of the equity premium . The concept relies on the idea that equities and T-bills are a binary choice within the beta calculation, as if only the risky returns trade against one another. The returns of equities can be explained in a simpler non-binary way, one that a businessman or bond manager could appreciate. At certain points lending long is attractive, or taking credit risk, or raising capital to start a business. Together these form an explanation for equity returns more robust than the non-informative academic view of the equity premium, which mysteriously appears out of nowhere. Summary When looking at investment analyses, ask “What’s the comparison here?” By doing that, you will make more intelligent investment decisions. Even a simple purchase or sale of stock makes a statement about the relative desirability of cash versus the stock. ( That’s why I prefer swap transactions .) People aren’t always good at knowing what they are comparing, so pay attention, and you may find that the comparison doesn’t make much sense, leading you to ask different questions as a result. Disclosure: None

The Sweet Spot Of Zero Leverage Equity?

Global economic momentum is modest at best, equities and bonds are overvalued, and while allocating your funds entirely to gold, cash and shorts is enticing, it isn’t possible for the majority of money managers. What are investors to do then? The ranking of creditors and equity in the capital structure suggest that high-grade corporate bonds – and sovereigns – is the optimal allocation. When the going gets tough, the equity is wiped out, but as creditor, you are at least assured a recovery on your investment – even if it may be a slim one. This time could be different, however. As an alternative, I propose equities with zero leverage. There aren’t many around, and those that do remain unlevered are looked upon with suspicion by the market. After all, if the CFO hasn’t jumped on the bandwagon and issued debt to finance dividends and buybacks, she must be an idiot. But if you believe – as I do – that corporate bonds is the new bubble, being overweight equities with no leverage isn’t a bad idea. These securities won’t be immune to a crisis, but they offer two key advantages. Firstly, they likely will decline less than their overlevered brethren, and the risk of a bankruptcy is smaller. If a repeat of 2008 really beckons, capital preservation may turn out to be the key metric of survival, no matter the drawdown. Secondly, buying equities with zero, or very low, leverage is also a free option. If we are wrong, and the debt finance buyback and dividend party goes on, a portfolio of equities with zero leverage eventually will join the party too. In all likelihood, that means excess returns for your stocks. Once leverage has increased, you can sell and go looking for another batch of firms with no leverage, primed to lever their balance sheet to hand out money to shareholders. We concede that this latter rationale partly is a contradiction. But we would rather buy firms with a clean balance sheet than the alternative of buying equities that have already maxed out their potential for debt-financed shareholder gifts. Confusing charts; no directional clarity Meanwhile, looking at the macro, strategy and technical charts has left me confused – a bit like Macro Man , I suppose. Macroeconomic leading indicators have stabilised based on the most recent data. The year-over-year rate in the U.S. and EZ headline indices have climbed marginally, and have risen strongly in China. In Japan, however, the message from the headline index is grim. Global money supply growth has turned up further, helped by the U.S. and China. It is particularly encouraging to see that M1 growth has accelerated slightly in the U.S. On the contrary, my short-term charts of the market are sending a very unclear message. In the U.S. put-call ratios point to further upside despite the recent rally, while the advance-decline ratio continues to roll over. My equity valuation scores point to a slow grind higher in coming months, before a sell-off takes over towards the end of the summer. On sovereign bonds I remain bearish.