Irene:
Hi, everyone. Thank you for joining WisdomTree's Office Hours on, What Makes the Quality Factor Tick, where you'll hear from Jeremy Schwartz, Global Chief Investment Officer, Matt Wagner, Associate Director of Research, and Brian Manby, Associate on our Investment Strategy Team. 

Jeremy Schwartz:
Well thanks Irene. Brian and Matt, great to be with you on the Office Hours program. We like to make these very interactive, so please if you're listening, if you didn't submit a question, we got four or five questions that came in, we'll try to address those. But let us know what's out of your mind as we talk about things. I think the topic of the call today was quality, and we have a big family of Quality Funds. It was one of our innovations that started right over a decade ago, in 2013. We started getting specifically and explicitly focused on what we call the Quality Factor. We've broadened out from just Quality Dividends to now even Quality Growth, that we've been doing for the last 15 months. We're going to talk a little bit about all these. I think it's very timely. We've got more headlines on the tape today.

There's this regional banking dynamic, New York Community Bank looks like in free fall a little bit, and looks it with these cheap stocks. But it also is one of those things where how you get exposure to small cap, small cap value, you can either get a lot of these small banks or you could get less, if you're focused on quality. So, we'll talk a little bit about some of those specific ideas. But the topic today of what makes it tick, I'm going to share one of the things and a piece that we wrote back last year. I often quote Warren Buffet a lot, and this is one of his pieces that we did following his shareholder letter, Wise Words in Warren's Recent Letter. We talked through some of his different things. One of them, he talks about a 20 slot punch card rule, which is people make too many decisions, you should make much less punches.

I had suggested one of the funds and one of the punches you should do is be focused on quality. But I actually particularly focused on what he said were two of his top ideas. When he says all of his performance can really come down to 10 to 12 ideas, but two of those were Coca-Cola and American Express, and he bought those both in 1994. He talks about, actually the piece was talking about the dividend growth from Coke. When he first bought in 94, it was 75 million. By 2022, it increased to 704 million. American Express, similar story, acquired 1.3 billion, the dividends went from 41 million to 302 million, and they seem likely to ever increase. So, Buffet always talks about basically this quality story. The main story has been, I like to buy...

When he first started being a value investor, he would talk about Ben Graham and Ben Graham's original value formula would be buying these cigar butts and these very cheap stocks. But they moved on over time, and a lot of people actually ascribe Munger, as pushing him towards what they call these high quality businesses. I think these two are my favorite quotes on that. "A great business at a fair price is far superior to a fair business at a great price." But what do they mean by a great business? Then the next line was, "We really made the money out of high quality businesses. In some cases we bought the whole business. In some cases we just bought a big block of stock. But when you analyze what happened, the big money's been made in high quality businesses and most other people made a lot of money have done so in high quality businesses." So, the high quality businesses, whenever you see Buffet and Munger talking about that, it was high returns on capital. High returns on capital, but not a lot of debt.

There's some other famous quotes where he's like, "I want to buy the high ROE, but not a lot of leverage, driving return on equity." So, from the very first day we created our Quality Dividend Growth Family in 2013, I called it the Buffet Factor. It was the idea that, interestingly when you say part of the motivation for us getting after this was seeing there's a lot of these dividend growth funds, and it's also another very timely day for this. You've got Meta paying its first dividend last week. Part of the big dividend growth funds, when we first launched in 2013, the big one was, Vanguard had the Dividend Appreciation Fund. It said you've got to grow your dividend for 10 years in a row to get included. Think about when DGRW, now an $11 billion fund 10 years later, that was the year after Apple started paying its first dividend. From the very year Apple started paying its first dividend, it was among the top five dividend payers in the world.

We said, where do you think the growth is going to come from? Is it going to be Apple or everybody else? Well, I bet Apple's dividends have outgrown everybody else's dividends since it started paying. But if you had a 10-year look back, it was last year that you could first include it. The Aristocrats have a 20-year look back. We had a forward-looking model to predict dividend growth. Nobody else really has a forward-looking model. They teach it in the CFA textbooks, that the dividend growth should be sustainable... Sustainable growth should be return on equity and earnings retention. So, using that ROE as part of the factor was that I like to say we predicted Buffet would buy Apple. I forget the first year Buffet bought his first Apple shares, but we included it from the day we launched Quality Dividend Growth. He eventually bought it, now it's his largest position. But that's the background. What makes quality tick? Now, I've given a lot of monologues, so let me pause, let you guys jump in here with that.

Matt Wagner:

Yeah. I think if you were really to get factor wonky with the different factors, value, min-vol, momentum, there's always a story for why these factors work. It's either some behavioral story or some risk-based story. Quality is a trickier one to wrap your hands around, wrap your head around. Because value is very, in some ways, simple. You're investing in perhaps riskier companies or companies that are being shunned for whatever reason, so you have a risk-based story and a behavioral based story both for value, and you've got great examples where values worked historically. You have the tech bubble, you have the Japanese asset pricing bubble, there's so many great examples and stories for value. Quality, it's almost so obvious. It's so obvious that we want to invest in these companies with higher profits, and have lower leverage, and have less earnings variability. How does that happen?

To me it is a behavioral based story. You don't chase a handful of stocks that in any given year you might underperform. It's going to be the other side of momentum, and then you're not just buying the cigar butts that Jeremy referred to as well. So, you're going to try to give up... You're going to end up giving up some outperformance in years, like 2023 or 2020, but you're going to bank that outperformance when the market is selling off and these better businesses are outperforming, like in 2022. How about, Brian, you were saying about the difference in quality in large and small caps, was a question that we got ahead of this webinar that you were looking into on, what's the dispersion and the factor? Is it just a US large cap factor? Is it a small cap, international? That's one that we often get a question on.

Brian Manby:
Yeah, like Matt said, we get this question a lot, and it boils down to how does quality perform across the size spectrum? What we mean by that is small versus large. What we've really found is that the historical size premium that people have come to associate with small cap markets, is more about what you own within the small cap space rather than owning small caps outright. We think this graphic does a pretty good job of illustrating that. So, what you can see here is that within the small cap universe, if you allocate to a high profitability basket of stocks, and high profitability operating profitability is the metric that Ken French is using in his analysis here. But you can see that basically the growth of $100 invested in that factor, or the marriage of those two factors, so small caps and high profitability, would've vastly outperformed small caps with low profitability over... What are we looking at now? Over 60 years, to the tune of about nearly 5%. So, 475 BIPS.

That's pretty consistent within a 1% range, let's say, of the same effect that we see in a large cap space, where large high quality companies outperform lower profitability and lower quality large cap companies by just under 4%. So, this is something that has been illustrated over an extended period of time. Obviously there's going to be periods where sometimes low quality stocks outperform, and I'm going to get to that in a second because that relates to another question that came in. But overall, part of the reason why we believe in quality as a factor for the long-term is because of that outperformance potential, because of that resiliency, and because of that innate defensive characteristics during periods of market declines, where these businesses are robust and have efficient streamlined operations that can weather the proverbial economic storm a little bit better.

So, the second... Or at least one of the other questions that we got before starting today's Office Hour session related to, can you give us any examples of when low quality actually outperformed? I think one of the best illustrations of that is actually within the small cap space, so I'm going to pivot quickly to the Index Attribution Tool that is on our website. Sorry. I'm going to zoom out for a sec. Here we go. So, what I'm showing here is what I would call basically quality attribution, or return on equity-based attribution for our small cap Quality Dividend Growth Fund, or index in this case. So, the ticker associated with that index is DGRS. Maybe some of you are familiar with it, it's just the small cap little brother version of DGRW, and I'm relating it to the Russell 2000 Index as of the end of 2020. So, you should already be getting alarms going off in your head that that was an extremely volatile period because of COVID, so we're just looking at one year attribution here.

The main thing that I want to showcase first of all is that that was a really tough year for DGRS' index relative to the Russell 2000. If we decomposed the return attribution a little bit, we see one major, major story right here and it's that companies with negative return within the Russell 2000 returned over had total returns over 55%. Any residual exposure to that that was within DGRS' index didn't even return 1%. That's a massive outperformance gap obviously, and that explains a huge, huge chunk of why DGRS' index underperformed during that period. Basically just marked by speculative fervor. Low interest rates fueled, this junky, low-quality rally that we saw in markets and that was basically the opposite of what we had seen in say 2022 for example, where quality was really rewarded. So, that's a long-winded way of basically saying, factors can come and go, they can be in and out of favor. This is just an example of one where quality didn't work well. But like Matt had mentioned before, DGRW, the large cap version really outperformed the S&P [500] in 2022. So, it comes in fits and starts.

Jeremy Schwartz:

We've got a number of questions coming into the wire while we're chatting from Steven, so we appreciate those questions. Steven, we will get to all these. First question, basic one, define profitability. Are we looking at trailing 12 months, three-year average for our profitability metric? So, it's a good question. Matt, I'll let you walk through some of the details. It's very similar definition, Steven, when we look at Quality Dividend Growth and then our new Quality Growth Franchise. So, there is a few distinctions, it's very much in the weeds definitions of how you define profits, but I'll let Matt start on the Quality Dividend Growth Family and then we'll get into the Quality Growth Franchise in a second.

Matt Wagner:

Yeah. The definitions are pretty straightforward, and I think for a factor that can be very difficult to put your hands on the precise definition. We're fairly industry standard. We're using trailing three-year averages of return on equity and trailing three-year averages of return on assets. The reason for the average is, I think, kind of what the question was alluding to, just a trailing 12-month number might have some idiosyncrasies to it. There could be some business cycle reasons for why a high number in any given year, so the three-year average smooths out that cycle. Using ROE in conjunction or using ROA in conjunction with ROE is a way to weed out companies that are using excessive leverage. So, that's almost a backdoor way of having a leverage screen that some of our competitor indexes may use. It's a profitability screen that also penalizes the use of leverage. As Jeremy was mentioning, there's some nuance to how we use quality in our multifactor indexes, where we're using some trends in profitability, and then our newer Quality Growth Family that doesn't require that dividend payment also has a different definition, that is pulled up here.

Jeremy Schwartz:

Yeah. I want to show one or two things, Matt. Maybe you could pull up your intangible paper when we talk about the tangible valuations, for Steven. So, you asked a very good question about, so Amazon has low profit margins, would it get filtered out as a result? Well, in our dividend family its got to pay a dividend, so Amazon's not going to get in there. But we do actually have Quality Growth without the dividend requirement, and the Quality Growth Family, we actually just launched two brand new funds for mid and small caps. We had launched the large cap QGRW for Quality Growth the prior December.I'll get to the nuanced definition, Steven, of your question on low profit margins in just a second. But where it really can matter for this quality and growth combination, you think about small caps. The Russell family, there's been a well noted in the research that the S&P family has a quality bias compared to Russell.

S&P, to get in the S&P family, you've got to be profitable on a trailing 12-month basis to get included. Russell just includes everybody. So, they have a lot more unprofitable companies, and you can see this is on a count. So, 40% of the Russell 2000 was not profitable. You often get these big numbers, like 40% is not profitable, but it's really about 25% of the weight. They tend to be smaller companies that are not profitable. In the gross segments even more. It's 44 and 28% of the weight isn't profitable. We say, well who are they? The unprofitable universe in mid and small cap, it tends to be biotech, tech and comm services, those are your biggest ones. A little bit less in the energy, financial staples, utilities. That's one of the things. Now, some of the academic literature and what first got us going into the quality was people were talking about, where do people really use these Quality Dividend Growth Families, what makes them tick?

Well, they're really the opposite of the Russell value. I mean the Russell value, when you sort by price to book, you get a lot of banks, you get a lot of energy, which tends to have low profitability, low return on equity very often. Particularly if it's a Russell value, that source on price to book or DFA value, that's also sorted on price to book historically, that's where people really like combining the quality dividend growth, which has this high return equity, high profitability. Well, to the point on Amazon and tech in general, there's been some research talking about accounting rules changing, and just the new modern economy company, which partly all these companies are going to have very high price to books because they don't have a lot of assets on their balance sheet. Part of the mentality was they have IP and they've been investing in R&D over the years, that really is like an asset on their balance sheet.

If you accounted for all their R&D, this is very true for Amazon, but really all the tech companies, if you would adjust for that accounting differently, their profitability would look much higher. So, Matt, do you have your intangible asset piece on now? So, part of it in our quality growth, this is not the Quality Dividend Growth Franchise, but the Quality Growth Franchise, so QGRW and then the new Q-mid and Q-small tickers, which is QMID and QSML, those funds we have moved to a definition of profits that account for this intangible asset investment, and it capitalizes the R&D as an asset and then depreciates it over a number of years, which is much more like basically the old school companies. You get a different profit picture and you'd say the conclusion to the bottom line of Steven's question is yes, we've owned Amazon in the Quality Growth Franchise because of partly this definition of profits. But Matt, go ahead on.

Matt Wagner:

Yeah. There's been so much research on this topic that if you do want to dive in, highly recommend looking up, just really your favorite finance professor has probably written on it. There's no shortage of literature. But to Jeremy's point here, the shifting from a CapEx economy to an R&D economy is very evident, if you look at R&D as a percentage of sales and CapEx as a percentage of sales over time. So, here we're going back to 1990. If we could go back even further, we would. But you kind of get the picture. That CapEx as a percentage of sales, has declined from over 10% to closer to 7%. Meanwhile, you have R&D as a percentage of sales, increasing from almost 2% to as much as over 7%. So, R&D is very much what Meta has spent very aggressively on.

Amazon has spent very aggressively on, on AI, cloud computing, and yes, virtual reality also included in that R&D spend. So, there are these different levels of spending where accounting standards have been very, very conservative, saying R&D is not necessarily producing anything that's really tangible, in terms of you can touch it. Whereas in CapEx, you are producing a tangible asset that you can feel, and accountants feel they can assign a value to. So, if a company is using CapEx, immediately an asset is realized on the balance sheet, whereas R&D, no asset, simply an expense that makes an earnings of Amazon, of a Meta, look lower than it otherwise would if you were capitalizing the asset and depreciate it over time. So, if we were to look at the price to earnings ratio impact, this might be a bit of a messier view, but to give an idea of what we're doing on the return equity numbers.

So, there's a question on how do you measure profitability? Return on equity, this is a very straightforward, we're looking at trailing 12-month reported earnings over reported equity. Keep this number in your mind, 24, 25% for expanded tech, S&P is in the middle at 17.8 times, and this excluding expanded tech, it's about 16%. If you adjust all of these companies using a very straightforward approach that Jeremy was mentioning, you add back R&D expense and depreciate it over time, the same exact way you would for a CapEx that a company like a Caterpillar would do. You see an adjustment in the return on equity, and you see a bigger adjustment for companies that are not investing heavily today. If they're in the mature stage of their cycle, they're not going to add back as much spend. So, this is a more recent research that is being included in our current process for QGRW is the ticker of our large cap growth fund. So, very interesting new research that we've been very happy to include in the process.

Jeremy Schwartz:

Well, in terms of presenting what happens from this profits. Because that R&D expense impacts both the profit number but also the book value number, that's why these return equities go down. But the PE ratio number gives you a different story. I mean the PE ratio number shows, you go from tech being much, much more expensive than the market, to actually not being that much more expensive. So, here on the PE basis, if you do that without the intangible assets, this was a trailing number. You go from tech being 35 versus 22. So, call it, what? A 50% over 50% premium, to once you do this intangible PE, the number for the index even drops dramatically. So, for the S&P, you go down from, what was it? 22 to 18?

Matt Wagner:

Yep.

Jeremy Schwartz:

For tech it goes from 35 down to 22. So, it shows you that there's a lot more profits if you account for some of their investments that are currently all being expensed. If you capitalize it and then depreciate it, it would say their profitability is much higher. So, that's one of the reasons why you would get an Amazon. But that also, it's not a straight line that this is always going to be better, right, Matt? The trend in R&D matters.

Matt Wagner:

Yes.

Jeremy Schwartz:

That if you're slowing your R&D down, it actually will make you look more expensive than-

Matt Wagner:

Exactly.

Jeremy Schwartz:

... if you're ramping R&D, it makes you look cheaper. So, a lot of these companies have been ramping R&D, which is why their current profits are understated versus a steady state. So, it's all quite interesting. But we are using this, the bottom line is we're using what we think is the best measure, and best measure for our quality factor definition in the Quality Growth Franchise. We probably will reflect that type of thinking in other products over time. But we launched this new Quality Growth Franchise in the last 15 months. We say it's working quite well, and we'll look to see if we include that definition in other places.

Matt Wagner:

One question, what was the last ticker that we were just referring to? That is QGRW is the US Quality Growth Fund. I think that was the question.

Jeremy Schwartz:

Yeah, do you want to show QGRW versus the S&P 500, and even DGRW? You could show the top holdings. So, yeah. Kevin, that last ticker is QGRW, like the DGRW, but with a Q. So, you can think of it as, in some ways it's a different version of the NASDAQ, or our version of growth. It was definitely... I mean, it is not going to always be in the Magnificent Seven, but it was in the Magnificent Seven. This is the latest rebalance and it added Broadcom to that.

Matt Wagner:

Yeah. So, exactly the key point is, you see the Magnificent Seven, top seven holdings in the S&P 500 today, and we do hold them in QGRW. But exactly right that we are not going to always own these names. This process is a semi-annual rebalance. So, we rebalance this fully rules-based quantitative in December, we'll do so again in June. If you see any of these names roll over in terms of their... An element is looking at trailing sales growth and future looking sales growth and earnings growth. So, if any of these companies are starting to tumble on these metrics, perhaps our rules would exclude them. But for today they are overweight in those names. We think what's interesting is if you pair DGRW, which is going to be underweight, even Apple, which is a second or third largest holding in DGRW is underweight, the S&P weight of 7%. You pair these two in a hypothetical 50/50 and you get an 8.3% in an Apple. So, you actually would be overweight each of the Magnificent Seven other than Alphabet and Amazon, which is an interesting combination if you're using these two quality exposures together.

Jeremy Schwartz:

Chuck asked the very good question, and just to reiterate something I said, but just to say it again. Chuck asked the question of, you're doing this quality factor, the intangible adjustments in this QGRW, why not do it in DGRW as well? Good question, Chuck. Often when we include some new piece of research, you don't do it... You try it out first, make sure you think it's working exactly as you expected. When we launched our Multifactor Family back... I don't remember the first year we launched that.

Matt Wagner:

2017.

Jeremy Schwartz:

2017, time goes by quickly. So, call it six, seven years ago, you had some of your latest research and you put some new things in that family that you didn't bring out to all of your funds, that had a whole history. You try things out, you see how it works, you learn from it and then you start applying disciplines. Part of our risk factor screening came from our Multifactor approach that we launched in 2017. I think part of our definition here on quality, we launched with this Quality Growth Family. You run through a few rebalances, you get a sense of what's happening. It's definitely working in real time. You see it demonstrate the track record on QGRW and now we launched it in the minimum small caps. So, you see we're gaining conviction, doing it in more places. But for an $11 billion fund, you're going to take that very conservatively and make sure it's continuing to progress as you expect.

So, we'll definitely be studying that, Chuck, to see if some of those updated definitions come in somewhere else. Steven comes back to, are you considering a quality ETF for developed international markets? Steven, we have some. So, we have a few of those. For the developed international markets, we have... Let me just go to... I'm going to just show the website to walk you through where you can find some of these. So, let's open up, let me go back to my screen. That's the wrong... Okay. So, under ETFs you go to International Equities and there's two here. So, there's international... 

It's basically the same underlying stock strategy IQDG, IHDG. They both have about 10 years history. So, just one has the currency hedge, one does not.Okay. So, Steve's asked one that doesn't require dividends instead of about these two that do have the dividends. Internationally in the developed world, basically everybody pays a dividend in EAFE. There's very few non-payers. So, in the US you have that Magnificent Seven cohort, the Amazons, Netflix, Google, you would've said Meta until last week. You had all these companies that don't pay dividends. There's not a lot of very large international companies that you don't get.

So, IQDG, IHDG are right in... If you go to the Morningstar style box, they're already in the large cap growth bucket. We were missing a true large cap growth option in the US, which is what QGRW did. We sort of have the large cap growth bucket in international and emerging markets. We've had our ex state owned approach, which gives you a lot of the China tech companies or the core with a growth tilt. So, I'm not quite as sure it's as valuable internationally, but it's something we'll study all the time if we find a good use case for it. We're definitely doing more with this quality growth as you see the mid and small cap. So, we'll study it, but for now it is not on the short list.

Matt Wagner:

Yeah. What is interesting, just we've talked a lot about Meta initiating their dividend. I don't know if it got as much attention, Alibaba, another company that started paying a dividend. There was this feeling that over the past 10 years, Jeremy, if a company is a tech company that wants to consider themselves as being in the growth category, they cannot pay a dividend. Does it almost feel like a shift there a little bit?

Jeremy Schwartz:

Well, you had Microsoft start paying in 2003, so its got 20 year history. Maybe it's going to get added to the Aristocrats. Maybe it did get added to the Aristocrats with a 20-year history. I think it just hit 20 years last year.

Matt Wagner:

I think if they do it requires 25, so maybe not.

Jeremy Schwartz:

Oh, yeah. Some of them at 25. They started at 25, then went down to 20 for some of the Aristocrats. So, Microsoft was the first, it canceled a stock option policy the day it paid its first dividend. So, they started doing restricted stock. Then you had Apple in 2012/2013 timeframe, maybe it was 2012. Google is probably the next big high cash generating business that could. Amazon keeps reinvesting and reinvesting and reinvesting, and applying it back in R&D. It'll be interesting. But I do think Meta started. It is helpful. They're doing all these buybacks, and the buybacks you could say are meant to offset stock option issuance and that's been the reputation. But a lot of these companies, Meta for sure was a cheap value stock, and it's multiple. So, buying back stock was very, very smart. I do think this is partly one way Zuckerberg can take...

He was in the headlines for selling a lot of shares. I think he probably doesn't want to do that. It's a way he get a consistent cash return without having to sell shares. So, maybe some of these other tech executives look at it like that over time. But the reaction to Meta I think, will be helpful. Now, it's always hard to disaggregate, how much was the dividend, how much was other... Just the year of efficiency leading to lower... 25% reduction in people, 25% growth in sales. We didn't need all these people. I do think you're going to get more of that year of efficiency in some of these other tech companies. I'm expecting at Alphabet as your next big year of efficiency story coming soon. Then the question is, will they then pay their first dividend? We can hope.

Matt Wagner:

Yeah. No. I mean, what better example of the discipline for sure? I think that's the point there, so there's definitely a handful of tech companies that come to mind.

Jeremy Schwartz:

I think we've answered the live questions. Any further questions from the crowd or anything that came in before pre-questions?

Matt Wagner:

Did we miss any of the... I think we hit most of the pre-submitted questions. We touched on a lot of different strategies, the DGRW, QGRW, differences. Brian mentioned we did launch QGRW in the mid and small format, so we do have US mid and small quality growth. Then the international versions and emerging market versions. So, if there's interest in quality, we have it in all size, cuts and regions.

Jeremy Schwartz:

Well, we appreciate everybody spending their afternoon with us. If you have any further follow-ups, get in touch, let us know how we can help and we appreciate you coming onto the call.

Irene:

Thank you.