In a recovery, sales trump size in weighted indexes

Indexing based on a fundamental factor such as actual sales — as opposed to a company’s size — may be just the right strategy for an economic cycle entering a recovery mode. The upside of a revenue-weighted model right now is that it offers more-direct exposure to better-capitalized companies and stronger earnings than a traditional capitalization-weighted index.

“Most companies are in really good shape right now because they’ve gone through and chopped expenses as much as possible, and they’re sitting on a ton of cash,” said Tom Lydon, president of Global Trends Investments. “As we get into a situation where the economy improves, it will bode well for those companies with better sales.”

While most of the longer-term data on revenue-weighted indexes come from back-tested simulations, they suggest a legitimate means of getting more out of an index than just market performance. Not only does deviating from the 100-year-old cap-weighted model change the makeup of an index, it can also radically alter some critical valuations, which is where investors can gain an edge.

For example, in comparing a traditional cap-weighted index such as the S&P 500 with an index that is weighted based on reported revenue, the respective price-to-sales ratios really pop out.

The price-sales ratio of the S&P 500, which adjusts continually by giving the largest index weight to the largest company by market cap, is 1.13. That means investors are paying $1.13 worth of market cap for $1 worth of revenue.

By contrast, RevenueShares Large Cap (RWL), a revenue-weighted index exchange-traded fund, has a price-sales ratio of 0.49, which means investors pay only 49 cents for each dollar worth of revenue — a better value.

POWER OF REVENUE

RevenueShares Investor Services, which launched a suite of three revenue-weighted index ETFs in early 2008, is emphasizing the power of reported revenue. But the ultimate objective is to maintain an index with a lower price-to-sales ratio, which shows measurable benefits.

According to research by Thomas Bulkowski, a well-known technical analyst and best-selling author, the relationship between price-sales ratios and performance works for both individual stocks and broad market indexes. In a study of the performance of the market-cap-weighted S&P 500 over the 30-year period through 2007, Mr. Bulkowski found that during the 17 years when the index’s price-sales ratio was below 1, its average return was 16.7%.

But over the remaining 13 years, when the price-sales ratio was above 1, the index had a 7% average return.

“Most indexes are just ways to measure the market, and most ETFs are just cap-weighted versions of the indexes for people looking to buy the market,” said Sean O’Hara, RevenueShares’ president. “I would rather increase my weight in a company that has doubled its sales than a company that has doubled its stock price,” he said. “We like revenue because it beats everything else.”

MIXED RESULTS

Grabbing more sales per investment dollar isn’t always the best way to outperform the market. During the tech market bubble of the late 1990s, for example, a revenue-weighted index wouldn’t have been able to keep pace with the hyperinflated price-sales ratios as the Nasdaq Composite Index gained more than 400% between July 1995 and March 2000.

However, had a revenue-weighted index existed at the time, it would have had just a 10% weighting in tech stocks, which compares with a 30% weighting in technology by the cap-weighted S&P 500 at the time.

Thus, as the tech sector saw its stock market value cut in half in less than a year, the impact on the revenue-weighted index would have been much less severe.

Ultimately, a market-cap-weighted index will always be more heavily weighted in companies with the best recent performance, and underweight those companies with the worst recent performance, said Christian Magoon, chief executive of Magoon Capital LLC, a consulting and business development firm.

“Market-cap-weighted indexes will let winners run until they prove they’re not winners,” he said. “Or you can buy the exact same companies that are in the S&P 500 but based on an investment factor like revenue.”

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].