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A Smart ETF Strategy to Find Value in U.S. Stocks

This article was originally published on ETFTrends.com.

ETF investors who still believe in the U.S. equity story should look to value plays through a revenue-weighted indexing strategy as a way to enhance a portfolio and capture U.S. market opportunities.

On the recent webcast (available On Demand for CE Credit), Finding Value in U.S. Large Cap Equities, Talley Leger, Equity Strategist at OppenheimerFunds, pointed out that tightening monetary policy, rising short-term rates, flatter yield curve, below-average economic growth, earnings growth and positive momentum have provided strong tailwinds for growth stocks. However, Leger believes that a brighter economic outlook is a missing link in the chain of events leading to a durable value regime ahead.

As investors continue to favor U.S. equities, Leger argued that large-caps may continue to outperform small-caps for at least another year. Some believe that valuations in large-caps look pricey, but larger companies have traditionally traded at larger price-to-sales ratios than their small-cap peers due to the higher risk and lower liquidity in smaller companies. The last time small-caps outperformed was when their discount rose to 62% against large-caps, and we are still not there yet.

The Trump administration has been great for large-caps. Larger companies typically benefit more from lower corporate tax rates than small-caps. While the reduction in the tax rate for small companies is generally larger than it is for big companies, the current tax law continues to give large corporations a distinct advantage over their smaller competitors.

Large-caps typically do better during the initial stages of Federal Reserve monetary tightening. When the U.S. Treasury yield curve flattens as the Fed hikes short-term rates, larger company stocks have enjoyed an average 1.6% excess return to small-caps, going as far back as the 1980s.

"A flattening curve now points to more challenging economic conditions down the road, and bad news for economy-sensitive segments of the stock market. When the Fed starts normalizing monetary policy, raising interest rates, flattening the curve and discouraging risk taking, which is exactly what it’s doing, the mature, established companies in the U.S. equity universe tend to benefit," Leger said.

U.S. large-caps have also shown average excess returns of 3.5% over small-caps during periods of falling U.S. manufacturing activity based on the ISM Manufacturing PMI since the 1980s. Leger argued that stable companies are relatively insulated from a softer macro backdrop compared to their volatile brethren, which would occur during peaking economic growth or the later stages of the business cycle.

Despite the potential head winds or short-term risks, like tariffs and the trade wars, large-caps may continue to experience faster growth, compared to their small-cap peers. The S&P 500's expected 12-month forward earnings per share increased by 20.4% year-over-year, compared to the Russell 2000's equivalent rising by 20.0% year-over-year.

Investors also continue to vote with their money, and many are funneling billions into large-caps over small-caps. U.S. equity large-cap funds have attracted $405 billion through early 2018, whereas U.S. equity small-cap and mid-cap funds saw $19 billion in inflows and -$5 billion in outflows, respectively.

"Simply put, investors are expressing a clear preference for large-cap stocks over small- and mid-cap equities," Leger said.

U.S. large-caps may continue to enjoy greater tailwinds behind future growth when compared to small-caps.

"We see 11 forces supporting the continued outperformance of U.S. large-cap stocks: 1) investor regime switching away from U.S. small-cap stocks; 2) easy credit conditions in the form of loose bank lending standards; 3) heightened volatility; 4) lower corporate tax rates; 5) a flattening Treasury yield curve; 6) below-average U.S. economic growth; 7) higher exposure to faster international growth; 8) U.S. dollar weakness; 9) better earnings growth; 10) strong investor inflows; and 11) positive price momentum," Leger added.

As a way to gain exposure to U.S. large-cap stocks with a focus on those with strong financials to help improve investment outcomes, Mo Haghbin, Head of Product, Beta Solutions at OppenheimerFunds, pointed to the smart-beta, revenue-weighted indexing methodology, which acts as the underlying strategy for the Oppenheimer Large Cap Revenue ETF (RWL) . This alternative index-based strategy would reweight portfolios based on different factors results in different weightings across sectors, industries, and individual stocks.

"Revenue offers a unique way to weight a portfolio because it is a metric that cannot be easily manipulated by accounting practices, like earnings, and it is not based on a management decision, as dividends are. Furthermore, when incorporated into a portfolio, revenue weighting provides investors a combination of benefits," Haghbin said.

For example, revenue weighting can provide broad coverage of the market since revenue provides the same complete, diversified coverage of the equity market that market-cap weighting does. However, the exposures in a revenue-based portfolio will not be based on companies’ unpredictable stock prices.

Revenue is also seen as a pure indicator of value where a portfolio tilts away from potentially overvalued momentum stocks and toward low valuation companies, which historically have been able to generate excess returns over time.

Additionally, Ryan O'Carroll, ETF Specialist for OppenheimerFunds argued that the revenue focus may exhibit greater stable exposure in many different markets. Historical evidence suggests that revenue-weighted portfolios maintain more stable sector and country exposures than market-cap weighting because the portfolios are grounded in fundamentals, not stock prices, and they are rebalanced quarterly by companies’ latest revenue results.

Financial advisors who are interested in learning more about how to find value in U.S. large cap equities can watch the webcast here on demand.