VFVA: Combination Of Value And Quality Instills Confidence (BATS:VFVA)

Vanguard U.S. Value Factor ETF (BATS:VFVA) is an actively managed fund designed to provide relatively low-cost exposure to a large basket of U.S. equities trading at a discount to peers.

The bear party on Wall Street that has been reinvigorated by a few unpleasant earnings surprises and somewhat mixed guidance from tech heavyweights which I have discussed in the recent article has resulted in the iShares S&P 500 ETF (IVV) declining by almost 16% since the beginning of the year. More growth-centered funds have seen much steeper losses, with the Invesco S&P 500 Pure Growth ETF (RPG) declining by close to 26%. Not to mention quality-light, growth-heavy funds like the ARK Innovation ETF (ARKK) which is now close to the early-pandemic levels after sliding by almost 57% since the beginning of the hawkish 2022.

And even though funds enamored of value stocks have not been totally immune to the bearishness currently prevailing in the market, most have fared far better than embattled tech, growth, and speculative tech vehicles. Perhaps, the best example is the Invesco S&P 500 Pure Value ETF (RPV) which has remained mostly flat defying the Wall Street turmoil.

And though not the best example, VFVA is one of those ETFs that also did suffer from the broad decline in equities but still clearly not cratered, delivering ~(7.6)% returns this year so far.

A few months ago, I wrote a bullish note on the fund touting its large exposure to stocks with at least B- Quant Valuation grades, as well as solid quality. Even though it has been in the red, it nevertheless has fared slightly better compared to the U.S. bellwether index.

And also, I still believe the combination of reasonable valuation and robust margins/returns on capital should be a winning one in the current rather hysteric market environment.

Today, I would like to reassess VFVA for two reasons. First, I suppose it is worth discussing what investment decisions the fund has made since February, trying to figure out the likely rationale behind them. Second, it is also necessary to verify whether VFVA’s exposure to the value and quality factors has changed materially, either because of capital appreciation/depreciation of its holdings, deteriorating/improving fundamentals, or for any other reasons. This should allow us to make a conclusion whether the ETF has a favorable factor mix at the moment and thus remains a Buy or not.

Portfolio changes since February 2022 and likely rationale behind the moves

VFVA is an actively managed fund, with the purpose to pick relatively cheaper U.S. stocks of various sizes to deliver returns superior to the Russell 3000 index. Its strategy is not fully transparent, with only a few details available on what value indicators it uses in its stock-picking process. Namely, as we know from the prospectus, the value factor is based on BV/P, earnings yield, as well as cash flow yield; the latter is used exclusively for non-financial companies. Hence, the likely reason for a stock addition/deletion from its portfolio is its capital appreciation or decline in fundamentals that trigger an increase in the respective multiples (that is to say, contraction of the yields).

As of my estimates, the fund has disposed of 140 stocks (~9% weight) since February 12, while 46 were added (~5.3% weight). At the moment, its equity basket encompasses 721 holdings vs. 816 previously.

First, let us discuss the most notable deletions,

1. Becton, Dickinson and Company (BDX), a stock with the largest weight amongst those deleted, ~0.3%. It is complicated to say what exactly triggered its removal since BDX has already been rather expensive in February, with a TTM P/E of ~47.2x, P/B of ~3.2x, and a Quant Valuation grade of D-; since then its multiples have even become a bit less inflated.
2. Northrop Grumman (NOC), which has delivered a solid ~16.5% return YTD amid the broad rally in aerospace & defense names, has been ousted likely because capital appreciation sent its multiples to a level uncomfortable for the fund.
3. Humana (HUM), a healthcare company, was rather expensive in February, with a D Valuation grade, which has marginally improved since then; anyway, it is no longer in the portfolio.
4. TEGNA (TGNA) is being acquired by Standard General.
5. Johnson & Johnson (JNJ), a healthcare heavyweight, was also sold; JNJ has already been rather overappreciated in February, with a D+ grade.

The most remarkable additions are as follows,

1. Moderna (MRNA), a vaccine play that saw its share price inflating rapidly in 2021. However, after a steep correction, most of the multiples have dropped to a value level, so I believe its presence in the VFVA is justified.
2. Meta Platforms (FB); after a few totally lackluster months and an incessant decline initially triggered by the soft 4Q21 earnings and weak guidance, FB is not trading with ~14.9x TTM P/E, down from the mid-20s seen in January. Anyway, other metrics remain elevated.
3. Novavax (NVAX) has seen a catastrophic, over 62% price decline this year which pushed the name into the value territory.

Little has changed in terms of sector exposure. The chart below compares the fund’s sector mix with the iShares Russell 3000 ETF (IWV). In short, VFVA is still substantially underweight IT and healthcare, while overweight in financials, energy, etc.

Now, I would like to pay attention to the two Quant factors, namely value and profitability.

First, allocation to stocks with value characteristics (B- grade or better) has improved, going up to almost 62% from ~58%. Just around 11% are comparatively overvalued (D+ grade and lower).

For better context, the chart below summarized the Forward P/E and P/B ratios for ~89% of the holdings (since those with missing earnings estimates or negative net worth of both were excluded).

It should be noted that the fund sold Coeur Mining (CDE), an outlier that traded with almost 140x Forward P/E you can see on the chart I shared in my previous article. Now, Consolidated Communications Holdings (CNSL) has the highest Forward P/E in the set, over 50x; its weight in the fund is just ~2 bps.

Second, though the quality is not perfect, a close to 73% allocation vs. 72% in February remains completely fine (I would like to see it higher if VFVA was a dividend-oriented fund).

Investor takeaway

1. In sum, the major advantage of VFVA’s active strategy is that when prices inflate, VFVA can rotate out of stocks that have run a bit too high replacing them with beaten-down names, thus always maintaining optimal exposure to the value style. Meanwhile, passive funds have to carry these stocks between reconstitutions even if they consider exposure to them to be a drag on potential returns.
2. The essential conclusion is that as of May 9, VFVA remained grossly overweight stocks trading at a substantial discount to their respective sector medians and five-year averages, with an ~62% allocation. Meanwhile, a worrisome deterioration in quality is simply not observable. That is to say, I am content with its factor mix and expect it to weather the hawkish 2022 better compared to quality-light funds burdened by overvalued stocks. I maintain my Buy rating.