Buy Low, Sell High—Words to Live By in a Relative Value Rebalance

When we introduce people to WisdomTree, we emphasize time and again that we did extensive research on equity markets that led us to build our own Indexes—the first of which were launched more than 10 years ago. The concept—owning equity markets broadly while anchoring exposures to a metric of fundamental value—has delivered incredible results thus far.
What drove this success and performance in our view?
Rebalancing back to relative value.

WisdomTree U.S. Earnings Indexes: Nearly 10 Years of Live History
Over the summer of 2016, WisdomTree’s original dividend Indexes hit their 10-year anniversary. We did a great deal of analysis on the results of the dividend approach. In February 2017, WisdomTree’s earnings family will hit its 10-year anniversary, and considering today’s markets, there is no better time to review this methodology.
What Is the Main Concern Today in U.S. Equities? VALUATION
Look at the valuation multiples (price-to-earnings [P/E] ratios) of some U.S. equity Indexes generating significant attention this year:¹
•    Russell 3000 Index: 21.8x
•    S&P 500 Index: 20.3x
•    MSCI USA Minimum Volatility Index: 23.0x
•    Dow Jones U.S. Select Dividend Index: 19.9x
•    S&P MidCap 400 Index: 22.3x
•    S&P SmallCap 600 Index: 24.5x
Across the board, we see P/E multiples climb. While this does not portend an imminent or necessary collapse, it does create a hurdle for the future—specifically for the generation of future returns. It has followed throughout history that a higher valuation today means a lower total return tomorrow.
WisdomTree Earnings Indexes Had Significantly Lower P/E Ratios²
•    WisdomTree Earnings Index: 16.2x (25.8% below the Russell 3000 Index)
•    WisdomTree Earnings 500 Index: 16.1x (20.7% below the S&P 500 Index)
•    WisdomTree MidCap Earnings Index: 17.6x (21.1% below the S&P MidCap 400 Index)
•    WisdomTree SmallCap Earnings Index: 15.6x (36.3% below the S&P SmallCap 600 Index)
How WisdomTree’s Earnings Approach Was Designed with Continued Focus on Valuation in Mind
For any equity index, two things can cause the P/E ratio to rise:
1.    The price of the index climbs, indicating a willingness to pay more per dollar of earnings per share.
2.    There are companies in the index with negative earnings, lowering the overall earnings per share for the index and causing the P/E ratio to appear higher.
How Do Stocks Gain Entry into WisdomTree’s Earnings Indexes?
The answer is positive cumulative earnings over the four quarters leading up to the November 30 screening date. No profits, no inclusion. It’s that simple, and it directly attacks point No. 2 shown above.
How Do Stocks Gain Big Weights in WisdomTree’s Earnings Indexes?
They have to generate more cumulative earnings than other constituents. Small earnings, small weight. Big profits, big weight.
How Does WisdomTree’s Annual Rebalance Work?
The answer is twofold. First, companies with negative cumulative earnings are eliminated. Second, companies whose prices have increased significantly—therefore gaining greater exposure in the Index—must grow their earnings commensurately to maintain that higher weight. Great stock performance without commensurate growth in earnings leads to weight reduction. Similarly, stocks that were underperformers but whose earnings grew significantly would tend to see greater weight, as these could be the performers of tomorrow. 

WisdomTree’s Rebalance Has Reduced Trailing P/E Ratios across Size Segments for 9 Years

For definitions of terms and indexes in the chart, visit our glossary.

•    All four of the WisdomTree earnings Indexes saw P/E reductions at each of the nine live rebalances.
•    It’s interesting that the benefit was particularly strong in the small-cap and mid-cap cuts.
Does WisdomTree’s Earnings Approach Work Better in Mid- and Small Caps?
This is an appropriate question if one defines “better” as a greater reduction in P/E ratio. As mentioned above, the two things that can cause an index’s P/E ratio to rise are a rising price and a greater proportion of firms with negative earnings. The key is that the elimination of firms with negative earnings is most pronounced among small-cap stocks. Considering the Russell 2000 Index universe, approximately 20% of the market cap of this Index tends to have had negative earnings over the prior 12-month period. The greater than 83% drop in P/E ratio for the WisdomTree SmallCap Earnings Index in 2009 is a combined impact of 1) lowering weight to firms that had price performance that outpaced earnings growth and 2) eliminating exposure to firms with negative earnings. As a benchmark, the figure without the impact of eliminating negative earnings would have been closer to 44% to 45%, still a significant reduction in valuation.
If you’re looking at 2016 and, like many, are concerned with valuation, WisdomTree’s earnings strategies may be a very interesting place to turn.

Unless otherwise stated, data source is Bloomberg, as of October 10, 2016.

¹The Russell 3000, S&P 500, S&P MidCap 400 and S&P SmallCap 600 Indexes are selected as representative market capitalization-weighted benchmarks for the WisdomTree Earnings, WisdomTree Earnings 500, WisdomTree MidCap Earnings and WisdomTree SmallCap Earnings Indexes, respectively. The MSCI USA Minimum Volatility and Dow Jones U.S. Select Dividend Indexes are shown as prominent, widely followed examples of minimum-volatility and high-dividend-yield strategies. For all bullets, source is Bloomberg, as of 10/10/16.

²Source: Bloomberg, as of 10/10/16.