The S&P 500 Index is trading at record high valuations recently, a fact that concerns many equity investors. For those who want access to the stock market through index-based strategies, the current richness of the market may provide reason to consider an approach that focuses on company revenue. Since nearly all companies report revenue, weighting companies by their revenue, rather than their market capitalization, provides the same broad coverage of equity markets but generally creates a more value-oriented portfolio. It does so because stocks with lower valuations are overweighted relative to the traditional index.
Academic research has demonstrated that value is a key driver of equity returns, as stocks with lower valuations have historically outperformed their more expensive peers over the long term. Even with the market’s current bias toward growth stocks, we think the more value-driven, revenue-based approach could serve investors well over the long term, while also reducing their exposure to overpriced companies.
A Better Valuation Metric
When we examine equity valuations, the metric we prefer to use is the price-to-sales (P/S) ratio, which looks at a stock’s price in relation to the company’s top-line revenue. We believe that P/S is a more reliable and transparent indicator of a company’s true value than are other common valuation metrics, such as the price-to-earnings and price-to-book value ratios. Our confidence in this metric stems partly from the fact that a company’s numbers cannot be easily manipulated by accounting practices, as a company’s earnings can be.
From a historical perspective, valuations for the S&P 500 viewed through the P/S lens are unusually high today. In fact, the S&P 500 is 33% above its long-term average and is approaching levels that we haven’t seen since the Tech Bubble. See Exhibit 1.
Price-to-Sales Ratio a Good Predictor of Returns
To determine if a revenue-based valuation metric could be a reliable indicator of future stock returns, we performed a regression analysis on the quarterly average P/S ratio of the S&P 500 and its returns over the following 10 years. We found a very clear connection – a low P/S ratio led to a high future return, while higher P/S ratios were followed by lower annualized returns. The close proximity of the data point to the “best fit” line running through them illustrates the tight relationship between P/S and future returns. See Exhibit 2A.
To determine how effectively P/S predicted returns in comparison with other valuation metrics, we extended our analysis to include the price-to-earnings ratio (P/E), price-to-book value (P/B), price to cash flow (P/CF) and price to free cash flow (P/PCF) ratios over different periods. In this analysis, we used the measurement R-squared, which provides a statistical confidence level for how predictive one variable’s movements are of another’s (in this case, how predictive current valuation levels are for future returns). As R-squared approaches 1.0, the level of confidence in the relationship between two variables increases.
We can see in Exhibit 2B that, at 0.89, the R-squared relationship for P/S and 10-year future returns is quite high, both on an absolute basis and relative to the other valuation metrics. Over the long-term 10-year period, P/S has historically been a strong performance indicator. Our analysis also uncovered that none of the valuation metrics offered significant insight into future performance over shorter time periods.
Price-to-Sales Levels Are a Strong Indicator of Future Returns
Weighting by revenue tilts the portfolio away from potentially overvalued momentum stocks as the approach maintains disciplined exposure to companies based on their fundamentals. Therefore, in the short term, revenue weighting may underperform market-cap weighting during periods when growth and momentum stocks are both in favor. But in the current rich market, a more value-oriented portfolio can potentially protect investors from the risk of being overexposed to excessive valuations. In fact, given the current P/S valuation of 0.83 for the large-cap revenue-weighted index versus 2.09 for the S&P 500 Index, we believe it may be an opportune time to consider adding a revenue-weighted approach to your portfolio.
In any market, revenue weighting offers a compelling combination of benefits. Investors can use an alternative to market cap weighting that is based on an important company fundamental – revenue. Since almost all companies have sales, revenue weighting, unlike some other alternative weighting approaches, will still provide broad, diversified exposure. You will still own all the companies in the traditional index. Plus, investors can maintain this diversification while also capitalizing on the opportunity to realize excess returns, given that the P/S ratio has proven to be such a reliable predictor of long-term returns. For long-term investors who want broad market access through an index-based strategy, revenue weighting appears to be a better way to play the U.S. large-cap equity market.
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Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value. The alternate weighting approach (i.e., using revenues as a weighting measure), while designed to enhance potential returns, may not produce the desired results.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.