Vanguard Small Cap ETF: Patience Will Eventually Pay Off (NYSEARCA:VB)

Investment Thesis

For the previous 90 years, small and mid-cap stocks have outperformed large-cap stocks. However, during shorter time frames, especially during market downturns, these two groups have repeatedly lost momentum. While I remain optimistic about the growth prospects of small caps over longer periods of time, I believe the near-term outlook remains challenging. Firstly, higher rates for longer are likely to translate into a higher floor on volatility in equity markets, which is typically an environment where small-caps underperform large-caps. Secondly, the economy is already struggling to cope with higher rates, and I believe the situation will worsen over the next couple of months, making equities in general an unattractive risk/reward proposition. This article introduces readers to the Vanguard Small Cap ETF (NYSEARCA:VB) and provides the bearish case for US small caps.

Strategy Details

The Vanguard Small Cap ETF tracks the investment results of the CRSP US Small Cap Index. The strategy invests in small-cap stocks and offers a straightforward process for measuring and tracking the performance of a diverse set of small publicly-listed businesses.

If you want to learn more about VB, you can find a detailed list of documents here, including the summary prospectus and the most recent semi-annual report.

Portfolio Composition

VB invests ~18% of total assets in Industrials, followed by Tech (~15%) and Financial Services stocks (~14%). The largest three sectors have a combined allocation of approximately 47%. In terms of geographical distribution, the fund invests over 99% of its assets in the US.

~28% of the portfolio is invested in small-cap “blend” stocks, characterized as small-sized companies where neither growth nor value characteristics predominate. Small-cap issuers are generally defined as companies with a market capitalization below $2 billion. The second-largest allocation is mid-cap “blend” stocks (~20%).

VB is currently invested in 1,515 different stocks. The top 10 holdings account for ~4% of the portfolio, with no single company weighing more than 1%. The fund is very well diversified across issuers and fulfills the criteria of a traditional ETF, which investors purchase for diversification purposes. The top 10 holdings include some of the best performers in the small/mid-cap space over the last 18 months, such as Quanta Services (PWR), Atmos Energy Corp (ATO), and Carlisle Companies Inc (CSL).

Since we are dealing with equities, one important characteristic is the portfolio’s valuation. According to data from Morningstar, VB trades at ~2x book value and ~12x earnings.

For comparison, VB is as expensive as other small-cap funds. You will find below valuation metrics for the Schwab US Small-Cap ETF (SCHA) and the iShares Core S&P Small-Cap ETF (IJR) that confirm our analysis.

Is This ETF Right for Me?

I have decided to compare VB’s price performance against SCHA and IJR over the last 5 years to assess which was a better investment. Over that period, VB slightly outperformed the other two small-cap strategies. Overall, VB, SCHA, and IJR delivered very similar returns, and for this reason, I believe that all three are suitable investment vehicles to get exposure to the small-cap universe.

To put VB’s returns into perspective, a $100 investment in this fund 5 years ago would now be worth $140.5, including dividends. This represents a compound annual growth rate of ~7%, which is a modest absolute return.

If we take a step back and look at returns over a longer time frame, VB comes last when compared with the other two strategies. Although the return spread is modest, it’s definitely something to pay attention to over the long term.

However, the next 24 months are likely to look very different when compared to the last decade. The deteriorating US economy remains the big elephant in the room and the likelihood of having a prolonged recession constitutes in my opinion an important risk factor for US small caps in the months ahead. During previous recessions, VB underperformed the market and had larger drawdowns. As a result, investors with a higher degree of risk aversion would probably be better off avoiding the small-cap space until the dust settles.

According to Wall Street, the risk of a prolonged US recession that could ultimately turn global is real. For instance, Citi predicts that the US will enter a recession in H2 2023, while Europe is probably there already. As a result, holding equities, particularly small-caps, seems to be a risky strategy given the fact that volatility is here to stay. Even if small-caps look cheap if we use traditional valuation metrics such as P/E or similar ratios, one shouldn’t lose sight of the bigger picture. The risks stemming from higher rates and an economic slowdown far outweigh the benefits of holding equities in the short term.

Key Takeaways

VB provides exposure to a basket of small publicly-listed businesses. This ETF is very well diversified both across issuers and sectors. Small-caps have historically outperformed large-cap stocks, and many are wondering if the recent correction offers an attractive buying opportunity. While I remain confident in the long-term prospects of small-cap investing, the short-term picture is complex. Since volatility will probably remain elevated over the next 18-24 months and the 2023 economic outlook is bleak, I believe that small-caps are far from being in bargain territory, despite low valuations. At the same time, I strongly suspect that the next 12 months will be filled with numerous opportunities to buy VB at lower prices.