ETFs To Steer Clear Of Suspect Earnings

October 08, 2014

Finding companies with truly promising earnings is as simple as picking the right ETF.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is co-authored by Mike Venuto, co-founder and chief investment officer, and David Dziekanski, portfolio manager, at New York-based Toroso Investments.

Equity markets are at or near all-time highs, as are corporate earnings. It may all be too good to be true.

That’s because we’ve identified what we consider to be a quality problem with earnings. That said, we believe by maximizing quality of earnings in a portfolio, we can help investors minimize risks related to what we think are inflated earnings in equity markets.

So, how did we get here, and what is to be done? The common response is that our economy is selling more goods, and therefore earning more profit.

But the deeper story is this: While there has been positive sales growth the last few years, it has been relatively small compared with earnings growth since March 2009. Ignoring the dramatic downturn of 2008 and the snapback rebound of 2009, earnings have grown more than 80 percent since Dec. 31, 2009, while sales growth is just about 24 percent.

We think the way to focus on the real action with U.S. corporations is by owning equity ETFs designed to favor companies with real and even powerful revenue growth. We’re talking about funds such as the RevenueShares Mid Cap ETF (RWK | C-72).

Before pushing on, notice that we’re not talking about large-caps. We’ll get to why that’s the case, but first, a bit more on what’s wrong with corporate America’s current earnings picture.

Expanding Margins: More Is Less

The bull market over the past few years has coincided with a massive margins expansion, unlike any we’ve seen in recent history. But that increase has not been driven by a significant increase in sales. Companies are, in some cases, earning twice as much per dollar of revenue than they have historically.

So how did we get here? It’s important to view this in the context of the current market. Here are a few possibilities:

  • Interest rates are at or near historical lows, creating cheaper debt financing
  • Increased productivity
  • Increase in part-time employment, which has reduced employer costs
  • Lack of significant wage growth or inflation

 

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