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 by Rusty Vanneman, chief investment officer of Omaha, Nebraska-based CLS Investments, LLC, and Kostya Etus, the firm’s associate portfolio manager.
At CLS Investments LLC, we have a team approach to managing our various portfolios and strategies. To help unify and guide our investment methodology, we come up with key themes on a yearly basis.
These themes represent areas of the market (both equity and fixed income) where we see potential for outperformance over a forward-looking, 12-month period. Therefore, we position our portfolios to take advantage of these themes.
With that in mind, here are the themes for 2015: high-quality focus; emerging market opportunities; technology innovation; and tactical fixed income.
Below is a description of each theme, our reason for choosing them and a brief note on ETFs that could be used to represent them.
In almost every case, high quality is superior to low quality, and we believe the same holds true for companies. High-quality companies are those with:
- Higher profitability: Measures include return on equity (ROE), return on assets (ROA) and net profit margin (NPM).
- Relatively stable earnings: Companies with higher and more stable earnings growth are able to support stronger dividend growth.
- Stronger balance sheets: A company’s balance sheet strength (i.e., lower relative debt levels) can be measured in a variety of ways including debt-to-capital (DTC).
- Higher dividend growth: Managers in stable corporations with confidence in the future are better able to consistently grow dividends.
There is a significant amount of academic support for the high-quality factor. It uses historical data to conclude that high-quality investments tend to offer consistent returns that outperform the broad market over the long term at lower risk levels.
This provides an overall smoother ride and a better investor experience. The reason for the lower risk is quality’s ability to hold up better in downmarkets. “Quality” companies with low debt, high earnings and management confidence are able to weather the storm of market turmoil, thus providing a cushion in corrections.
As you can see in the chart below, MSCI Quality has beaten the S&P 500 in bear markets over the last 30 years:
In the current environment, where economic growth is expected to be below average and interest rates are more likely to rise than fall, we believe higher-quality companies should outperform.
Likewise, let’s not forget about the strong performance of the U.S. market in recent years, leading to elevated valuations and potential for higher volatility in the years ahead. It may be reassuring to know that higher-quality companies typically soften the fall given any potential market weakness.
For high-quality allocations, CLS favors:
- iShares MSCI USA Quality Factor ETF (QUAL | A-80): Screens domestic markets for companies with high ROE, low debt to equity (financial leverage), and low earnings variability (stable, year-over-year earnings growth). We view it as one of the purest ways to gain exposure to high-quality companies.
- PowerShares S&P 500 High Quality Portfolio (SPHQ | A-77): Has a screening process that is more qualitative in nature. The S&P Committee determines which companies are the highest quality based on growth and perceived stability of earnings and dividends over the past 10 years and then weights them based on their quality rank.
- Vanguard Dividend Appreciation ETF (VIG | A-69): Includes U.S. stocks that have a history of increasing dividends for at least 10-consecutive years. It excludes stocks that might have low potential for increasing dividends in the future and also excludes REITs. This allows for pure exposure to dividend growth.
Emerging Market Opportunities
The U.S. stock market has outperformed international stock markets in recent years, and global asset allocators, including we at CLS, have felt the pain. Moving forward, though, we are more enthusiastic about the prospects of international beating the U.S. market.
The reason is the expected returns for the international markets appear more attractive, as do valuations for the overseas markets.
A back-of-the-envelope estimate used to approximate forward-expected returns is to simply add the current dividend yield to the current earnings yield (which is the inverse of the price-to-earnings (P/E) ratio).
For example, Russia currently has an earnings yield of 18.3 percent; add that to the dividend yield of 4.4 percent, and the result is an expected return of 22.7 percent. This is an extreme case, but with many of its major corporations trading at low, single-digit P/E ratios, it really isn’t that unreasonable to expect Russia would significantly outperform in the years to come.
The chart below shows the earnings yield and dividend yield for various regions and countries. Here are a few points that stand out:
- The U.S. is expected to have one of the worst valuations from both a dividend-yield and earnings-yield perspective, the combination of which leads to the lowest expected return.
- Other developed markets, such as Europe, appear to be better positioned than the U.S. and offer some potential for outperformance.
- Emerging markets (EM) appear to be the most undervalued, with some key areas showing deep value.
While valuations suggest positive returns for all stock markets, emerging markets appear to have better prospects.
Source: Ned Davis Research