European markets are garnering attention again in 2017. Most of the flows have targeted broad beta benchmarks in simple execution of a regional allocation. For longer-term and strategic allocators who will hold positions in Europe for many years, WisdomTree believes focusing on a factor approach for European markets can add significant value and address some of the concerns investors might still have regarding the current set of stocks with high exposures in traditional market cap-weighted indexes.

Long-Term Returns to a Quality Approach

A growing line of academic research has focused on the “quality factor.” The Fama and French three-factor model, which started off looking at just beta, size and value as three principal drivers of returns, added quality as a key additional factor that can influence returns. But what do we and Fama and French mean by “quality”? If we look to their formal definition, profitability is described as “annual revenues minus cost of goods sold, interest expense and selling, general and administrative expenses, all divided by book. We call this variable operating profitability, OP, but it is operating profitability minus interest expense.”¹

The simpler variable and term people will be familiar with: return on equity (ROE) or profits over equity. 

That is the same variable Warren Buffett often focuses on when he describes companies he is most interested in acquiring that deliver high ROE with little debt.

When we look at the returns to the European markets over the last 30 years, in the large-cap space, the difference between large-cap high-quality stocks and large-cap low-quality stocks is substantial: on the order of almost 7 percentage points per year. This leads to a dramatic long-term chart for European high-quality firms compared to European low-quality firms. 

Long-Term Returns to European Quality (ROE)