Benoit Autier
Head of Product Management
[email protected]
Mike McGlone
Head of Research (US)
[email protected]
Alexander Channing
Director of Quantitative Investment Strategies
[email protected]
Alpha - Earnings Anatomy
Earnings estimates, and their revisions
The origin of earnings estimates
A stock’s intrinsic value is the sum
of its discounted cash flows
Fundamental valuation is based on the premise that a stock’s intrinsic value is the sum of its
discounted future cash flows. These cash flows are a company’s future projected earnings which are
estimated by the brokerage analysts who analyze all facets that can have an impact on the company’s
current earnings and its ability to generate earnings in the future. Therefore, the brokerage analysts’
main task is to forecast what a company Earnings per Share (EPS) will be, in other words, to provide
earnings estimates.
Buy, hold, sell …
Based on these earnings estimates, equity analysts will issue ‘Buy’, ‘Hold’, ‘Sell’ recommendations.
Historically, analysts have issued far more ‘buy’ recommendations than ‘sell’ recommendations. From
1998 to 2012, roughly 96% of the recommendations [Chart 1] have been distributed between ‘strong
buy’, ‘buy’, and ‘hold’ with the remaining 4% distributed over ‘sell’ and ‘strong sell’. This creates a
heavily skewed distribution making it difficult for investors to identify those stocks with the strongest
‘Buy’- rated convictions.
Chart 1: Equity Analysts’ Recommendations
60%
49.70%
50%
40%
31.80%
30%
20%
15.20%
10%
2.70%
0.70%
Sell
Strong Sell
0%
Strong Buy
“EPS Forecasts - Accuracy Is Not
Enough”
- Leonard Zacks, Financial Analyst Journal 1979
Buy
Hold
*Source: Zacks Investment Management: The Zacks Investment Philosophy. Data is the average distribution from
01/01/1998 to 12/31/2011
Empirical evidence has shown that equity analysts have generally been accurate at forecasting
company earnings (Gu of Carnegie Mellon and Wu of University of Rochester 2002). However,
the findings from a seminal article “EPS Forecasts – Accuracy Is Not Enough” by Leonard Zacks,
published in 1979 in the Financial Analyst Journal, explain that accurately forecasting earnings in
itself as an exclusive means of market outperformance is not sufficient. Furthermore, it has been
documented (Elton, Gruber and Gultekin of New York University 1981) that stock prices are quick to
reflect equity analysts’ consensus earnings estimates, thereby concluding it to be an unlikely approach
in generating alpha when considered in isolation.
Past performance is not indicative of future results
Alpha - Earnings Anatomy
2
Evolution Of Earnings Models
First generation approach
There have been attempts to incorporate companies’ earnings - as the principal determining factorinto investible products using an ex-post approach, i.e. where the main input into the model is the
already reported companies’ earnings: The Wisdom Tree earnings Indices provide exposure to stocks
that have generated positive earnings. These indices weight eligible stocks based on their previously
released earnings levels (ex-post). Although robust and transparent this implementation is already
“after-the-fact”. Furthermore, price performances have been highly correlated to their respective
broad benchmark indices, with not too much to offer by way of alpha generation [Table 1].
Table 1: Earnings Weighted Indices Versus Market Cap-Weighted Indices
US Large Cap
S&P 500 Index
Wisdom Tree
Correlation
Large-Cap
with S&P 500
Earnings 500 Index Index
US Small Cap
Russell 2000
Index
Wisdom Tree
Small Cap
Earnings Index
Correlation
with Russell
2000 Index
5 Year
15.6%
15.3%
99.7%
5 Year
15.6%
15.7%
99.1%
3 Year
17.5%
17.0%
99.7%
3 Year
15.3%
14.3%
98.5%
1 Year
14.3%
14.0%
99.6%
1 Year
4.4%
1.7%
98.4%
* Source: ETF Securities and Bloomberg
Data as of 01/31/2015. All returns are annualized and on a total return basis. Correlations based on daily returns. Past performance is not indicative of future returns.
Next generation approach
Earnings Estimates Revisions
Equity analysts will usually have large earnings models, where the input into the models is their
earnings estimates, and the output is the intrinsic value, i.e. model driven non-market value, of that
company. If the intrinsic is below market price then the stock can be seen as undervalued. Likewise,
if above then overvalued. Raising the earnings estimates translates into raising the intrinsic value of
that company. However stocks’ market prices have a history of not immediately being impacted by
the continual earnings estimates revisions made by the covering equity analysts. This is due in part to
a conservatism bias – where there is a reluctance to incorporate positive news compared to negative
news. And also in part due to a “herding effect” – where investors may focus on the slower moving
consensus as opposed to the faster dissemination of market information based on the latest reported
earnings revision.
Research has shown (Sloan 1996) that monitoring the trends in earnings estimates revisions has been
a powerful leading indicator for identifying stocks which haven’t fully incorporated - or reacted to new market information; where those displaying positive trends in earnings estimates revisions have
empirically outperformed the market. However, the ability to digest and analyze the voluminous amount
of data with a clear view of implementation can be an arduous process even for the largest of institutions.
Past performance is not indicative of future results
Alpha - Earnings Anatomy
3
Zacks Investment Research
“Earnings estimate revisions are
the most powerful force impacting
stock prices”
– Leonard Zacks
Zacks Investment Research analyzes reports from approximately 3,000 analysts at over 150
brokerage firms. At any given point there can be up to 200,000 earnings estimates which Zacks is
monitoring, making it one of the largest independent research providers in the United States. The
founder of Zacks Investment Research, Leonard Zacks - who achieved a PhD in mathematics from
MIT – discovered that:
“Earnings estimate revisions are the most powerful force impacting stock prices”
– Leonard Zacks
Leonard Zacks published his findings in 1979 in the Financial Analysts Journal “EPS Forecasts –
Accuracy Is Not Enough”. From this article the Zacks Performance Rank was borne, which looks at
trends in earnings estimate revisions.
Zacks Performance Rank
Since 1988 the Zacks Rank #1
Strong Buy has…
Zacks Performance Rank is a proprietary model which is based on trends in earnings estimates
revisions and earnings surprise. The Zacks Performance Rank groups stocks into five categories: #1
Strong Buy, #2Buy, #3 Hold, #4 Sell, and #5 Strong Sell. The Zacks Performance Rank #1 Strong Buy
comprises all the stocks which are categorized as having a Zacks #1 Strong Buy rating. Stocks are
continually re-rated by Zacks, therefore a stock categorized as Strong Buy, and therefore a member of
the Zacks Performance Rank #1 Strong Buy may in the future be downgraded and thus move out of
this category.
Since 1988 the Zacks Performance Rank #1 Strong Buy has:
Generated average
Annual return of...
26%
…versus 9.93% for the
S&P 500 Index
Turned $10,000 into…
$3.86 Million
…compared to $109,000
for the S&P 500 Index
Beat the S&P 500
Index by…
23 of 26
…years from 1988 to
2013
* Source: Zacks.com: The Billion Dollar Secret. Past performance is not indicative of future results.
Data: 01/01/1988 – 03/31/2013. Audited and attested by Baker Tilly, an independent accounting firm.
The power of compounding…
In 1988, a hypothetical investment of $10,000 in the Zacks Rank #1 Strong Buy, would have
compounded to $3.86 million, while the same hypothetical investment in the S&P 500 would have
reached $109,000. In addition, the Zacks Rank #1 outperformed the S&P 500 index in 23 of the last 26
years (1988 to 20131) with an annual return of 26.60% per year, roughly 3 times that of the S&P 500 at
9.93%.
[1]: The Performance Rank #1 Strong Buy was negative in 1990, 2008, and 2011. And underperformed the S&P 500
Index in 1998, 2008, 2011 Results for 2013 through 03/31/2013.
Past performance is not indicative of future results
Alpha - Earnings Anatomy
4
Zacks Performance Rank: Deep Dive
In order to assess the potential impact of earnings estimate revisions, the Zacks Performance Rank
model employs a 2-step process in determining how the stocks are ranked from ‘#1 Strong Buy’ to ‘#5
Strong Sell’.
Step 1: Stocks are ranked from #1 to #5 using the four factors:
Agreement
The extent to which all brokerage analysts are revising their earnings
estimates in the same direction.
Magnitude
The size by which the consensus has changed.
Upside
The difference between the most accurate or latest estimate and the
consensus estimate.
Surprise
Takes into account the last few quarters of EPS surprise.
Step 2: Unlike other brokerage analysts’ recommendations which are highly biased towards hold/
buy/strong buy ratings [Chart 1; page 1], the Zacks Performance Rank will normally distribute the
stocks with 5% representing ‘Strong Buy’-rating, 15% ‘Buy’, 60% ‘Hold’, 15% ‘Sell’ and 5% ‘Strong Sell’.
This way, investors are truly able to identify those stocks which are positioned with the strongest rated
buy convictions.
Earnings Quality, and the Accrual Anomaly
Cash earnings are immutable
The Accruals Concept
The accrual concept is a powerful feature in financial accounting which involves the anticipation of
probable future economic benefits (e.g. cash inflows) and obligations (e.g. cash outflows). This allows
financial statements to recognize revenues and expenses at the point in time the transaction or event
occurs as opposed to when cash exchanges hands. Utilizing this concept, a company’s Reported
Earnings can be decomposed into two elements: Cash Earnings and Accrued Earnings (accruals)
[Figure 1]. Cash Earnings are immutable, however Accrued Earnings, i.e. the estimated value assigned
to the anticipated future economic benefit is subject to company management guidance within a
framework of regulation.
Figure 1: Reported Earnings - Decomposition
Reported
Earnings
=
Cash Earnings
Past performance is not indicative of future results
+
Accrued
Earnings
Alpha - Earnings Anatomy
5
There are various methods by which Accrued Earnings can be estimated by management which
are governed by accounting rules: Generally Accepted Accounting Principles (GAAP). Companies
are required to file quarterly financial statements with the Securities Exchange Commission (SEC)
accompanied with a report of non-material representation of findings by an independent auditing
firm. However, as the name infers, these are principles-based as it’s not possible for a regulator to
prescribe rules for all eventualities, leaving management with a residual amount of discretion.
As a consequence to the level of discretion and motivation employed by management, Reported
Earnings may not be sustainable and may substantially deviate from the prevailing earnings that are
eventually realized. For example: There is evidence to suggest that management may have a lagged
reaction in adjusting their accrual estimates in response to a changing market environment (Thomas
and Zhang 2002), or they may be a reluctant to take timely inventory write-downs (Allen, Larsen,
Sloan 2011). A recent report published by the CFA institute 2013, discussed reasons for management’s
propensity to window-dress Accrued Earnings, including: motivation to meet earnings expectations,
and management compensation contracts explicitly linked to accounting measures such as Return on
Equity (ROE).
The Accruals Anomaly
Accruals Anomaly
In a pioneering paper, Sloan 1996 documented the Accruals Anomaly – the negative association
between Accrued Earnings, i.e. the non-cash element of the reported earnings [Figure 1] and
subsequent stock returns. The paper brought to the fore the emerging concept of “Earnings Quality”
as a proxy for the magnitude of the accrual relative to company size; the lower the accrual the higher
the Earnings Quality, increasing the probability the Reported Earnings will in fact materialize.
Earnings Fixation Hypothesis
Despite the documented accruals anomaly, stock prices seem to behave as though investors do not
consider the full information contained within the earnings report. Contrary to the Efficient Market
Hypothesis, Sloan concluded that investors fixate on headline reported earnings figure and do not
fully incorporate the information contained within the accrual and cash flow components – at least
not until it impacts future earnings, and subsequently the stock price.
The Trading Strategy
Sloan 1996 further showed that by taking long positions in the lowest decile of accruals, the portfolio
yielded abnormal annualized positive returns of +4.90% (40,679 firms from years 1962 to 1991).
Similarly, an equal sized portfolio consisting of the highest decile of accruals yielded abnormal
annualized negative returns of -5.5%. However, as with the Zacks Performance Rank, running a
robust live model to monitor the large amounts of data with a view to implement an accruals-based
trading strategy is an arduous task and requires a solid infrastructure and fast data processing
abilities.
Past performance is not indicative of future results
Alpha - Earnings Anatomy
6
Earnings Quality
Zacks Earnings Quality …
Zacks Investment Research developed a proprietary model, Zacks Earning Quality, which analyzes a
company’s’ Reported Earnings and systematically decomposes the figures in order to determine the
Accrued Earnings relative to company size, thereby establishing the level of Earnings Quality. The
proprietary model then ranks the stocks from highest quality to lowest, as depicted in Figure 2.
Figure 2: Zacks Earning Quality
Reported Earnings:
Financial statements from
public companies
Zacks Propriety Model:
decomposes Reported
Earnings into 2 elements
Zacks Earnings Quality:
Ranks stocks from highest
Earnings Quality to lowest
rnings
Cash Ea
Reported
Earnings
Accrued
Earnings
2
1
3
Investable Product Solution
ETF Securities has collaborated with Zacks Investment Research to provide investors with a simple
and efficient method to access their proprietary models - ZACKS PERFORMANCE RANK and
ZACKS EARNINGS QUALITY, resulting in the creation of the Zacks Earnings Indices [Figure 3].
After combining the two models the indices apply a risk management overlay which minimizes sector
bias via equal weighting each sector, and subsequently equal weighting each stock within each sector.
ETF Securities has launched the first ETFs to provide simple and efficient exposure to Zacks extensive
experience with earnings analysis. Table 2 displays the funds’ recent performance statistics since
inception (01/20/2015).
Figure 3: Zacks Earnings Indices
Zacks Earnings Analysis
Proprietary models
Quantitative
model
Qualitative
model
Zacks Rank
Zacks Quality
Ticker
ZLRG
Ticker
ZSML
+
Risk
Management
Liquidity
and Sector
diversification
=
Zacks
Earnings
Indices
ETFS Zacks Earnings Large-Cap U.S. Index Fund
The Fund seeks to track the price and yield performance, before fees and
expenses, of the Zacks Earnings Large-Cap U.S. Index
ETFS Zacks Earnings Small-Cap U.S. Index Fund
The Fund seeks to track the price and yield performance, before fees and
expenses, of the Zacks Earnings Small-Cap U.S. Index
Past performance is not indicative of future results
Alpha - Earnings Anatomy
7
Performance represents past performance;
current returns may be lower or higher.
Past performance does not guarantee
future results. The investment return and
principal value will fluctuate so that an
investor’s shares, when redeemed may be
worth more or less than the original cost.
All returns reflect reinvested dividends
and capital gains distributions, but do
not reflect the deduction of taxes that
an investor would pay on distributions
or redemptions. To obtain performance
through the most recent month end,
call 844-ETFS-BUY (844-383-7289)
Table 2: Fund Statistics
01/20/2015 – 03/31/2015
ETFS Zacks Earnings Large
Cap US Fund
ETFS Zacks Earnings Small
Cap US Fund
Bloomberg Ticker
ZLRG US
ZSML US
Total Expense Ratio
0.66%
0.66%
AUM
USD 2.59 million
USD 2.82 million
Net Asset Value %
4.07
7.35
Market Value %
4.56
7.53
Underlying Index %
4.28 (ZAXERNLT)
7.42 (ZAXERNST)
Performance:
Key Terms And Definitions
Alpha
In the context of this report, the generalized
term given to a trading strategy or index which
outperforms (or at least its objective is to
outperform) a representative benchmark.
Earnings per Share (EPS)
Dividend – 12 Month Yield
The sum of the dividends which have gone exdividend over the prior 12 months, divided by
the fund price
S&P 500 Index
The reported company earnings divided by the
number of shares outstanding
A market cap-weighted index representing the
top 500 publically traded companies in the U.S.
by market capitalization
Analyst Recommendations
Russell 3000 Index
Analysts will typically issue stock
recommendations as to the positioning of those
stocks within a portfolio. Depending on the
analysts’ research they will typically recommend
5 stock positions: Strong Buy, Buy, Hold, Sell,
and Strong Sell
Net Asset Value (NAV)
Total intrinsic dollar value of the underlying
constituents to the fund
Market Value
The price of the fund
Total Expense Ratio
The amount investors pay for expenses incurred
in operating a fund (after any waivers)
Dividend – Recent Distribution
Yield
Wisdom Tree Small Cap Earnings
Index
Fundamentally weighted index that measures
the performance of earnings-generating
companies within the small-capitalization
segment of the U.S. Stock Market
Cash Earnings
The amount of cash as reported in a company’s
Reported Earnings
A market cap-weighted index representing the
top 3000 publically traded companies in the U.S.
by market capitalization
Accrued Earnings
Russell 2000 Index
Accruals
A market cap-weighted index representing the
bottom 2000 companies in the Russell 3000
Reported Earnings
The bottom line company earnings as per the
income statement
Wisdom Tree Large Cap Earnings
500 Index
Fundamentally weighted index that measures
the performance of earnings-generating
companies within the large-capitalization
segment of the U.S. Stock Market
The most recent dividend distributed by the
Fund, divided by the fund price
Past performance is not indicative of future results
Also known as Accruals, are the dollar difference
between Reported Earnings and Cash Earnings
See Accrued Earnings
Return on Equity (ROE)
Company Reported Earnings divided by total
common shareholder equity
Efficient Market Hypothesis
A investment theory based on the assumption
that stock prices fully incorporate all available
information
Alpha - Earnings Anatomy
8
Disclaimer
An investor should consider the investment objectives, risks, charges and expenses of the ETF carefully before investing. To obtain a prospectus containing this and other important information, click here, call 1-212-918-4954
or 844-ETFS-Buy (844-383-7289) or visit www.etfsecurities.com. Read the prospectus carefully before investing.
Fund Risk : There are risks associated with investing including possible loss of principal. The prices of the securities in which the Funds
invest may decline for a number of reasons, including in response to economic developments and perceptions about the creditworthiness
of individual issuers. The Fund does not attempt to outperform its index or take defensive positions in declining markets. Past performance
does not guarantee future results. There can be no assurance that the Funds’ investment objectives will be achieved. Please read the Funds’
prospectus for specific details regarding the Funds’ risk profile.
The Funds are not sponsored, endorsed, sold or promoted by Zacks Investment Research, Inc. (“Licensor”). Licensor makes no representation or warranty, express or implied, regarding the advisability of investing in securities generally or in the Fund particularly or the ability
of the Zacks Earnings Large-Cap U.S. Index (“Index”) and the Zacks Earnings Small-Cap U.S. Index to track general market performance.
Licensor’s only relationship to ETF Securities Limited (“Licensee”) is the licensing of the Index that is determined, composed and calculated
by Licensor without regard to the Licensee or the Fund. Licensor has no obligation to take the needs of the Licensee or the owners of the Fund
into consideration in determining, composing or calculating the Index. Licensor shall not be liable to any person for any error in the Index
nor shall it be under any obligation to advise any person of any error therein.
The Funds are new products with limited operating history.
Indices are unmanaged and one cannot invest directly in an index.
Investors buy and sell shares on a secondary market (i.e. not directly from Trust). Only market makers or “authorized participants” may trade
directly with the funds, typically in blocks of 50 thousand to 100 thousand shares.
ALPS is not affiliated with ETF Securities or with Zacks Investment Research, Inc.
Benoit Autier, Mike McGlone and Alexander Channing are registered representatives of ALPS Distributors, Inc.
ALPS Distributors, Inc. is the distributor for the ETFS Trust.
ETF 000812 12/31/15
ETF Securities (US) LLC
48 Wall Street
New York
NY 10005
United States
t +1 844 - ETFS - Buy (844 383 7289)
f +1 212 918 4801
e [email protected]