Quality Growth Shines

How quickly narratives shift. 

A sharp rise in interest rates, which pummeled growth stocks, was the dominant storyline last year.

The theory was that a rise in interest rates disproportionately impacts the valuations of high-growth companies, which earn a greater percentage of their value from uncertain, distant cash flows.

Short-term interest rates (1–12 months) have climbed this year as the Federal Reserve continues to hike interest rates, but longer dated (5–30-year) yields are roughly unchanged.

In short, the interest rate backdrop has hardly budged from last year, as measured by the intermediate to long-term rates that tend to have a bigger impact on equity valuations.

Without the tailwind of a significant drop in interest rates, what explains the 22% year-to-date outperformance of growth relative to value?

Growth vs. Value Relative Performance

Enter two new dominant narratives:

• Artificial intelligence (AI) and the profit tailwinds for companies that are likely to capitalize on new technological innovations, primarily in the Information Technology and Communication Services sectors

• Expectations for an economic slowdown—that has not yet materialized—has contributed to a slump in cyclical sectors, particularly for companies in the Energy and Materials sectors

The below chart shows the change in forward 12-month profit expectations for select growth (Communication Services and Information Technology) and value (Energy and Materials) sectors. Profits have declined across most sectors since the middle of last year, but the decline has been most pronounced in cyclical/value sectors.

Changes in Profit Expectations from Mid-2022

The WisdomTree U.S. Quality Growth Index, which was launched at the end of November 2022, has been over-weight in the companies that market participants anticipate are well-positioned to benefit from the AI revolution and have earnings that are expected to be less adversely impacted by a potential recession.

Three companies—Apple, Microsoft and NVIDIA—have been the clear winners this year, adding hundreds of billions to their already significant market capitalizations.

Largest Increases in Market Cap YTD ($Billion)

Index Construction

The WisdomTree U.S. Quality Growth Index is a market capitalization-weighted Index of companies with quality and growth characteristics. The top 500 U.S. companies by market cap are ranked on a composite score of two fundamental factors: growth and quality, which are equally weighted.

The Index is comprised of the 100 U.S. companies (1st quintile) with the highest composite scores.

Growth factor: The growth factor is determined by a company’s ranking based on a 50% weight in its median analyst earnings growth forecast, a 25% weight in its trailing five-year EBITDA (earnings before interest, taxes, depreciation and amortization) growth and a 25% weight in its trailing five-year sales growth.

Quality factor: The quality factor is determined by a company’s ranking based on a 50% weight in its trailing three-year average return on equity and 50% weight on its trailing three-year average return on assets.

Investment Process

The Index is intended to be a high-conviction, relatively concentrated growth portfolio aimed to be over-weight in the largest quality growth companies. As a result, the Index has a high percentage of its weight (58%) in the top 10 holdings.

The top seven holdings in the Index also happen to be the same companies that we saw with the greatest gains in market cap this year, or a group more often being referred to as the “Magnificent Seven.”

Index Top Holdings

Performance Attribution

The WisdomTree U.S. Quality Growth Index has outperformed the Russell 1000 Growth Index by over 11% year-to-date, through 6/30/23.

Over half of the outperformance (57%) can be explained by positive attribution from the outperforming Information Technology and Communication Services sectors.

The Index has also benefited from what it didn’t hold—under-weight allocations to the lagging Consumer Staples, Industrials, Health Care, Energy and Real Estate sectors combined to contribute 5% of positive attribution.

The Index’s outperformance has been spread broadly across sectors with positive attribution coming from 10 of 11 sectors (only the Financials sector detracted 0.5%).

Year-to-Date Attribution

Conclusion: When Will the Narrative Shift?

The question on every investor’s mind is whether the narratives driving the narrow leadership of the Magnificent Seven will continue to resonate for the remainder of this year, and into next.

Timing that is anyone’s guess.

The WisdomTree U.S. Quality Growth Index has a rules-based methodology that reconstitutes on a semi-annual basis each June and December. The design of the Index is to not bet on individual names, or a basket of several names, over the long run, but to represent a relatively high-conviction allocation to 100 companies with high profitability and growth characteristics.