Will the optimistic case prevail, and how might it impact market leadership? We offer three potential scenarios for how the economy and markets could perform in the wake of the tax bill’s passage and, in each case, examine the potential benefits and considerations of a revenue-weighted investment approach.
Revenue Weighting Offers Exposure to Value and Growth Stocks
As the name implies, our revenue-weighted strategies weight securities by company revenues, as opposed to market capitalizations, the approach used by traditional indices. In doing so, the strategies systematically seek to deliver long-term results by rebalancing quarterly toward a top-line fundamental that anchors portfolios toward attractively valued companies. While they are value-oriented, however, the strategies do not ignore growth stocks because they own all of the securities that the traditional index would, but in different weights. Ultimately, by having exposure to both value and growth stocks, investors do not need to attempt to time changes in value or growth leadership, because weighting by revenues historically has resulted in attractive performance in both types of markets.
At the portfolio level, revenue weighting historically has delivered more consistent sector and industry exposure relative to a market-cap-weighted method. Within each industry, this approach targets companies with higher sales and, therefore, tends to exhibit higher market share. Companies with higher market share are generally better able to capture economies of scale and also benefit from a higher barrier to entry than their lower-revenue-producing competitors.
Performance Leading Up to Tax Reform
We observed a shift in market leadership in the last two months of 2017 as tax reform became a reality. The year-end run-up in equities reflected a mix of cyclical sectors and those that stand to benefit most from changes to the corporate tax code, including the telecom, financial, and consumer discretionary sectors. Conversely, Technology stocks sat out much of the tax-reform exuberance, as these firms stand to benefit the least from the tax bill. The reason: A territorial tax system will dampen the appeal of the accounting practices that have benefitted the earnings of many multi-national technology companies of late.
During this time, our revenue-weighted strategies outperformed significantly, helping to erase earlier underperformance. Contributions to returns were driven by overweights to out-of-favor firms in the consumer sectors and underweights to information technology sectors.
Three Possible Outcomes for 2018
Given this context, we believe that there are three distinct outlooks for 2018, with varying outcomes for revenue-weighted strategies relative to market-cap-weighted indices.
1. More of the Same for the Economy and Markets
The U.S. economy continues to grow at a modest rate as the passage of the tax bill does not produce higher sustained growth. The U.S. equity market would likely continue to be led by a narrow subset of true high-growth companies. Our revenue-weighted strategies may underperform market-cap-weighted strategies in the short term, but will likely perform better than other strategies that are tilted more toward value relative to growth. In other words, the revenue-weighted strategies will likely participate in market rallies, but continually reweight each quarter away from market momentum and toward company fundamentals.
2. Value Thrives as Economic Growth Improves
Passage of the tax bill leads to improved economic growth and sector leadership as value-oriented sectors start to win consistently for the first time in years. In short, the trend that began during the last week of November continues. A revenue-weighted strategy would likely be well positioned to outperform as the tax bill can serve as the catalyst for higher sustained economic output and helps sectors that have been out of favor, such as those that are consumer driven, perform well.
3. The Cycle Ends
A longer-term outlook could see investors continuing to bid up the highest market capitalization stocks with the best momentum while the economic cycle matures. Ultimately the cycle, like every one before it, ends and market multiples come down. The revenue-weighted strategy, which does not have as much exposure to the highest market capitalization names and typically trades at a lower valuation, will likely be well positioned to experience improved drawdowns when multiples contract.
In the cases of scenarios 2 and 3, investors will likely receive little forewarning, and shifts in market conditions and/or leadership may escalate quickly as flows have already been moving toward value. Importantly, this fundamental approach applies over the long-term regardless of the macroeconomic backdrop because our revenue-weighted strategies have delivered robust capital appreciation by grounding security weights by fundamentals as opposed to letting the market determine the weights of holdings. In the meantime, our revenue-weighted strategies have the potential to capture most of the upside of this market, as we do not need to rely on only value or growth to drive performance.
OppenheimerFunds is not undertaking to provide impartial investment advice or to provide advice in a fiduciary capacity.
Alternative weighting approaches (i.e., using factor weighting as a measure), while designed to enhance potential returns, may not produce the desired results.