The next two weeks hosts the bulk of earnings season. Big cap technology is always an important feature as it has been leading earnings growth for many years. According to the Bloomberg bottom up Q1 consensus, the Technology sector is a significant driver of total EPS for the market. It’s the largest sector by a factor of more than 2x at over 27% of the S&P 500. The next 2 largest sectors together (healthcare 13% and consumer discretionary 12.5%) do not equal technology. As the table below highlights, the market cap weighted EPS is far greater than the equal weight EPS speaking to the importance of a handful of very large companies. The top 10/75 stocks in the sector represent close to 70% of the market cap of the sector.

Looking at the market cap large cap tech ETF (XLK) and the equal weight ETF (RYT) since 2006, you can see long periods where market cap beats equal weight and the opposite. We are in a period over the past few quarters where the equal weight has done better. RYT might be the better way to play it over the next year.

Factor based investing should be on your radar. The above example is the size factor. Overweighting smaller cap companies at times delivers better total returns. The momentum and quality (price and earnings) factors have defined overall market excess returns in recent years. You can find a good report from MSCI on the momentum factor here.

The momentum factor refers to the tendency of winning stocks to continue performing well in the near term. Momentum is categorized as a “persistence” factor i.e., it tends to benefit from continued trends in markets (see “Performance and Implementation”). The MSCI Momentum Index measures:

• Risk-adjusted excess return – that which exceeds the benchmark – for 6-month periods
• Risk-adjusted excess return – that which exceeds the benchmark – for 12-month periods

The biggest weight in the momentum and quality factors have been the technology sector.

MTUM is a momentum factor ETF for US large caps overall. 41% of the ETF is in the technology sector. This speaks to where persistent earnings momentum has come from.

For an important background on momentum factor investing, this is a key research report by Jegadeesh and Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 1993.

The quality factor refers to the tendency of high-quality stocks with typically more stable earnings, stronger balance sheets and higher margins to outperform low-quality stocks, over a long time horizon.

The outperformance of high-quality stocks over low-quality stocks is well-documented in financial literature although the actual measure of “quality” is disputed. Metrics such as a company’s earnings, dividend payments and debt levels have all been shown to have as much explanatory power in relation to a stock’s performance as the value factor.

Quality-based strategies try to capture the premium associated with high-quality stocks versus low-quality stocks. However, of all the risk factors, this is perhaps the hardest to define as investors are divided on the best way to measure quality.

Depending on the investment manager, quality can mean gross profitability, return on invested capital, growth, stability of earnings, high payout rates, or low volatility and fundamental risk. Regardless of the metric, strategies that attempt to target quality typically outperform the market, as they are better equipped to weather adverse economic conditions.

The quality factor remains something of an enigma for factor investors and academics alike, since higher-quality stocks intuitively should come with higher prices. The fact that quality is not fully priced into the stock, perhaps due to inadequate risk models or behavioural biases, may go some way to explaining the existence of the premia.

MSCI defines quality as stocks exhibiting positive fundamentals (high return on equity, stable year-over-year earnings growth and low financial leverage)

This week in our weekly Thursday Spring 2021 Berman’s Call virtual roadshow we will focus on technology earnings and the momentum and quality factor and how to incorporate factor investing in your portfolios. Register at www.etfcm.com or at www.investorsguidetothriving.com  The format this series will be a 30-40 minute weekly presentation that changes each week to current market developments and a 30-40 minute Q&A.

Subscribe to my new YouTube channel LarryBermanOfficial which is the new site for all our educational content and my new weekly market recap and ETF bull and bear picks of the week.

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