Revenue-weighted ETFs are crushing their benchmarks

U.S equities are perched at a 2009 high and third-quarter earnings are coming in much better than Wall Street analysts expected, yet this has to be one of the most hated rallies (and earnings seasons) of all time.

The reason is pretty straightforward: The fundamentals and economics remain appalling. Companies are hitting or beating Street estimates because of a scorched earth policy on cost cuts. That's where the official 10.2% unemployment number came from. (It's probably closer to 20% if you count all the jobless folks who've given up looking for work.)

People without jobs, of course, spend less. (They're also spending less because they're paying off their credit cards and other personal debts at historic rates.) As DailyFinancewrote recently, companies might be beating the Street on the bottom line this earnings season, but the same doesn't hold as true for sales. When it comes to corporate revenues, there's little or no growth.

Investors can never have too many tools as they labor in the equity markets, but this no-sales growth environment makes RevenueShares' uniquely weighted (and patent pending) exchange-traded funds especially useful these days. The ETF provider, based in Paoli, Pa., has a formula that is crushing its benchmarks this year.

What's the secret sauce? Focusing on one of the most unloved ways of valuing stocks: the price/sales (P/S) ratio.

"Nobody really pays much attention to price/sales," says Sean O'Hara, president of RevenueShares Investor Services. "But it's a pretty good indicator of future equity returns."

As much as we're hooked on valuing the market by price/earnings (P/E) ratios, there's a lot to be said for measuring it by sales. Over the last 30 years the average P/S for the S&P 500 ($INX) is 1.0. That means that the sum of the 500 constituents' market capitalization equals the sum of their trailing 12-month revenues. When market cap exceeds revenue, P/S goes above one, meaning stocks are trading at a premium, and when market cap falls below sales, stocks are trading at a discount.

Now here's where it gets interesting: Over the last three decades, if you bought the S&P when its P/S was below 1.0, your average annual return was almost 17%, according to RevenueShares. That's a whopping result.

On the other hand, if you bought the S&P when its P/S was above 1.0, your annual average return was just 7%. Factor in inflation and your retirement isn't looking so comfortable with that kind of performance.

RevenueShares seeks to exploit the gaps between a company's market cap and its actual sales by re-weighting the S&P 500 by revenue. To keep the math simple, say the total revenue of the S&P 500 was $100, and Company A's revenue was $1. Company A would then get a 1% weighting in a revenue-weighted index.

"When you weight by revenue there is an economic reason to own a stock," O'Hara says. "When you weight by market cap it's a psychological reason -- people are bidding up stocks. Market cap is a beauty contest: Who do we think the prettiest stocks are? Let's bid them up."

RevenueShares licenses the S&P and then applies revenue-weighting to the six ETFs it runs. For example, the RevenueShares Large Cap Fund (RWL) owns every stock in the S&P 500; it just ranks them differently, with the biggest sales producers having more sway in the ETF. The firm lets the ETFs run for a year and then rebalances them every December to reflect the latest 12-months of revenue.

RevenueShares can't hit a grand slam that way, but it can outperform its benchmark, which is remarkably cool for an index fund. After all, it's impossible for a traditional cap-weighted index to beat its benchmark because of a couple little things called expenses and fees.

Take RWL (ETF people always call them by their tickers because the names are too long and unwieldy). It's up nearly 26% this year, beating the S&P 500 by 5 percentage points. (Active fund managers are heroes if they can achieve that kind of outperformance.) RWK (RWK), the RevenueShares Mid Cap ETF, is outpacing the S&P 400 mid-cap index by 15 points; while RWJ (RWJ), the firm's small-cap fund, is smashing the S&P 600 to the tune of 22 points.

O'Hara is the first to admit that revenue-weighting isn't a strategy that works in every market. The late 90s, for example, would have been terrible for this approach, as investors paid enormous premiums for technology stocks. Market cap soared far ahead of revenue in the dot-com days, making revenue-weighted investing a formula for underperformance.

But these days it appears to be a very canny strategy. As RevenueShares likes to say, "the top line is the bottom line." When companies to start to increase revenue again, the last two year's of traumatic cost cuts will be a big boon to earnings.

"When top-line growth comes back that will flow to bottom line, creating bigger profits," O'Hara says. "Weighting by those who have the biggest revenue streams, we think we'll get the biggest impact."

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