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It happens like clockwork. Every January, April, July, and October, publicly-traded companies issue quarterly financial reports. The numbers are dissected instantly, and can move stock prices way up … or way down.
Quarterly reports are chock-full of numbers, but the bottom line is earnings. Today I’ll explain why earnings are important. Then I’ll show you how ETFs can help grow your earnings, too.
What Are Earnings?
Let’s start by defining our terms. For a corporation, “earnings” is what’s left after all the adjustments, and it can be positive or negative. “Net Income” is a more precise term. Whatever it’s called, profits are what you want to see. That means the company was able to cover all its expenses and make money for the shareholders.
Earnings are usually reported on a “per share” basis. When you hear analysts talk about “EPS,” they’re referring to “earnings per share.”
Earnings matter because investors buy stocks in the hope of making a profit. Maybe they’ll wait if the company has a good story, but they won’t wait forever.
Just this week, for instance, toy-maker Mattel (MAT) reported first-quarter total net income of $7.8 million, or $0.02 per share.
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| Mattel needs them to spend more. |
Is two cents per share good or bad? That depends on the price. Before the announcement, Mattel shares were trading near $34.
Would you pay $34 to buy a share that earned you only two cents over the last three months? Probably not. Mattel shares fell 10 percent on the disappointing news.
Earnings-Weighted ETFs
So how does this relate to ETFs? I don’t mean to sound flippant here, but stock ETFs are composed of stocks. All those companies either make money or lose money. Your earnings depend on their earnings.
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This being the case, you probably want to be in an ETF whose stocks are, on average, delivering decent earnings, relative to their share prices.
Remember our Mattel example above? That two-cent EPS number would have been much less startling if the shares were only, say, $10 instead of $34. Earnings and price are closely related.
A few years ago, a company called WisdomTree began offering ETFs with a unique fundamental-based strategy. Traditionally, stock portfolios had been weighted by a company’s size, or capitalization. That approach has its advantages but isn’t always best.
WisdomTree is probably best known for its dividend ETFs, another form of fundamental weighting, but also offers ETFs based on the size of each company’s earnings stream. Why? Because earnings ultimately give any stock its value.
Investors tend to be hopeful about their stocks, however, so it’s common to see “popular” names grow far bigger than their earnings stream can justify.
Suppose, for instance, you have two companies. Both had net income of $10 billion last year. Both have the same number of shares outstanding. But one company trades at $25 while the other is at $75.
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| Same profits, different size. |
In a cap-weighted ETF, the portfolio will have three times as much allocated to the more expensive stock — even though it isn’t generating any additional profits.
Under an earnings weighted approach, both stocks would have the same allocation because both are equally profitable.
WisdomTree implements this methodology in six domestic stock ETFs. It seems to work well. WisdomTree Earnings 500 (EPS), for example, holds the same 500 stocks as SPDR S&P 500 (SPY), and over the past 12 months, EPS has outperformed SPY by about 2 percent.
As I mentioned, earnings and dividends are just two factors that can be used to create fundamentally weighted ETFs. Check out Get Creative With Alternative Weightings ETFs in the Money and Markets archive to learn more.
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| Places to look for earnings-related ETFs |
Other sponsors also include earnings as part of their ETF weighting schemes. You may also want to check out the menu at Russell Investments. Their “Investment Discipline” ETFs use earnings as one of the stock-selection criteria for ETFs like Russell Growth at a Reasonable Price ETF (GRPC).
PowerShares has many ETFs in their lineup based on RAFI indexes, such as PowerShares FTSE RAFI US 1000 (PRF). The RAFI methodology doesn’t target earnings directly, but their impact is taken into account via other factors.
If you want more earnings, then take a closer look at these earnings ETFs. One word of caution, though: Many investors have not yet discovered these gems. As a result, their liquidity can be quite low. Be sure to use a limit order if you decide to venture in, and monitor your investment closely.
Best wishes,
Ron
