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WisdomTree revisits eminent investment methodologies

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ETF provider, WisdomTree Europe, comments on the small cap theme, which has proved popular this year and how their dividend index methodology reflects the way that Warren Buffet looks at his potential acquisitions. 

WisdomTree Europe examines the methodology of both Buffett and Benjamin Graham and finds that they have both long upheld the importance of ‘quality’ within equity investing. The firm writes: “Research shows that stocks with high quality traits have indeed outperformed peers over longer holding periods. WisdomTree’s SmallCap Dividend strategies weight by cash dividends to select these quality stocks and this has helped contribute to outperformance against market-cap weighted peers.”
 
The Berkshire Hathaway Inc. Acquisition Criteria include demonstrated consistent earnings power and businesses earning good return on equity (ROE) while employing little or no debt.
 
WisdomTree writes: “The key phrase is ‘businesses earning good returns on equity while employing little or no debt.’ However, the quality discussion within equity investing has a long history, and Warren Buffett certainly isn’t the only one to mention it.”
 
One of Warren Buffett’s teachers, Benjamin Graham, who is known as one of the fathers of value investing, also had a rigorous focus on quality traits. WisdomTree writes that many focus on Graham’s criteria for finding inexpensive companies, but he was at least equally focused on attributes of quality, if not more so.
 
“Benjamin Graham’s Attributes of Quality were an ‘Adequate’ enterprise size, as insulation against the ‘vicissitudes’ of the economy;  Strong financial condition, measured by current ratios that exceed two and net current assets that exceed long-term debt; Earnings stability, measured by ten consecutive years of positive earnings; A dividend record of uninterrupted payments for at least 20 years and Earnings-per-share growth of at least one-third over the last ten years.”
 
WisdomTree also examined Fama-French Operating Profitability Factor, based on research done by Kenneth French and Eugene Fama, citing their research piece ‘A Five-Factor Asset Pricing Model’ from September 2014. Here they cited operating profitability, defined as annual revenues minus cost of goods sold, interest expense and selling, general and administrative (SG&A) expenses, all divided by book value of equity. The firm notes that this is similar to Buffett’s criteria for a company earning a good return (profits) on its equity (book value)—in other words, a high ROE.
 
WisdomTree goes on to arrange the US market into quintiles based on operating profitability and finds that further emphasises that high-quality stocks have won over longer holding periods.
 
The top two quintiles outperformed the market, the firm finds. “We saw the top two quintiles outperform the market on two fronts—average annual returns and Sharpe ratio. In other words, this outperformance was not achieved with a significant increase in risk.”
 
WisdomTree then looked at quality investor Jeremy Grantham of GMO on ‘Why Quality May Outperform over Long Periods’, quoting a paper he wrote in 2004, saying:
One of the long-standing investment practitioners of quality investing has been Jeremy Grantham’s firm, GMO. In a paper written in 2004[3], GMO wrote of quality firms:
 
“… even though many of these corporations tend to generate high profits year after year, they are systematically underpriced because they lack volatility. Instead of overpaying for these companies, as finance theory would suggest—given their low risk profile—shareholders in fact do just the opposite: they underpay. The result is that investors in high-quality companies get to forge ahead with 15+ per cent returns year after year without overpaying. Of course, in any given year, low-quality stocks can and do stage rallies and high-quality stocks can underperform. But the high-quality stocks have always won over longer holding periods. No matter what metric is used to identify quality stocks—leverage, profitability, earnings volatility or beta—high-quality stocks have beaten out low-quality stocks.”
 
 WisdomTree writes: “In other words, the desire to try to find that ‘next big thing’ tends to exert so much power over the investment psyche that focusing on quality companies has, at least historically, been one avenue through which to achieve outperformance.”
 

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