Do earnings matter?

Chas Craig, BridgeTower Media Newswires

“There seems to be some perverse human characteristic that likes to make easy things difficult.”
– Warren Buffett

We try to bridge academic theory with practical relevance in this space. As such, today we pose a multiple-choice question: If offered two stock portfolios that are substantially similar except that positive income is a membership requirement for Group 1 while the average income over the preceding three years was negative for nearly 30 percent of Group 2, would you choose (A) Group 1, (B) Group 2 or (C) Doesn’t matter?

The common sense of most people who earn their living in the real economy would make them instinctively answer A, of course. However, if you earned a finance degree or spent much time listening to the street corner Efficient Market gospel preachers, you are more likely to answer C. Reason being, the Efficient Market Theory, a primary point of emphasis in most business schools, teaches that the price of a stock is always in agreement with its value. Therefore, focusing your investments in the shares of profitable businesses does not produce an investment edge because both Group 1 and Group 2 are always fairly valued.

Let’s examine the record. The S&P 600 and the Russell 2000 are the two primary indices used to track the performance of small U.S. public companies. The S&P 600 requires profitability for inclusion (Group 1), while the Russell 2000 is Group 2 from our multiple-choice question. The annualized return of the S&P 600 has consistently outperformed the Russell 2000 over the trailing 10-year (17.7 percent vs. 15.9 percent), 7-year (12.9 percent vs. 11.2 percent), 5-year (9.9 percent vs. 7.7 percent), 3-year (18.1 percent vs. 17.5 percent) and 1-year (6.6 percent vs. 4.2 percent) periods.

However, there are other things at play. Most importantly, with ever more capital flowing to index funds, figuring out which companies are most likely to get added (deleted) to (from) an index and buying (selling) ahead of the announcement can generate trading gains. Index tracking funds will be obliged to purchase or sell a substantial number of shares of an impacted company to fulfill their mandate. Because of this activity, shares of to-be-added companies are typically bid up prior to index inclusion. On the back end, when companies have grown too large to be included in a small-cap index, shares will typically sell off in anticipation of their deletion. This bid up before addition, sell off before deletion (buy high, sell low) phenomenon negatively impacts both the Russell 2000 and the S&P 600, but it is likely more potent for the Russell 2000 for two primary reasons:

• More capital is indexed to the Russell 2000 than the S&P 600.

• Companies that become too big to be included in the Russell 2000 (S&P 600) usually migrate to the Russell 1000 (S&P 400). While Ivan Cajic, director of index and ETF research at ITG, estimates that there probably is more money indexed to the S&P 600 than the S&P 400, the amount of money indexed to the Russell 2000 is clearly much larger than for the Russell 1000. So, there is a larger net sell impulse upon migration from the Russell 2000 than from the S&P 600.

While it can’t be quantified precisely, I acknowledge the apparent structural disadvantage of the Russell 2000 compared to the S&P 600 owing to trader positioning around index changes. No doubt, this explains some of the divergence in returns. However, the magnitude and persistence of the S&P 600’s outperformance leads me to reasonably conclude that, yes, earnings do matter, a lot.


Chas Craig is president of Meliora Capital in Tulsa (www.