Small Cap Value Should Outperform In 2016

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Includes: NFLX, VBR
by: David Sims

Summary

Between 1980 and 2010, Small Cap Value outperformed all equity classes.

Over the past five years, Small Cap Value underperformed all equity classes.

The Vanguard Small-Cap Value ETF (VBR) provides exposure to a sector that should rebound in 2016.

In the past few years, the financial media and investors have flocked to large capitalization growth stocks. These stocks soared, fueled by cheap money and high expectations. As an example, Netflix (NASDAQ:NFLX) rose from $8.00 in August 2012 to over $133 in December 2015. While the company is growing revenue, the rapid rise in the stock price outpaced growth in the underlying business.

Today, the Netflix stock price has fallen 31% off of the all-time highs, but the stock still trades at 326 times trailing earnings. Investors seem to forgetting that the streaming business, which makes up the major portion of their growth, is new technology. New technology has a habit of becoming obsolete and eventually being replaced by something else (think about those AOL dial-up CDs that used to come in the mail every week.)

This is not meant to be a critique of Netflix, but simply of the investing mindset that has taken hold. Investors have forgotten that when you buy stock on an exchange, you are buying a piece of a business. Downside risks have become an after-thought.

Sound investing strategy involves picking stocks that are undervalued. Understanding value involves knowing the business risks and in some cases, building in a margin of safety. And small cap value investing often provides the best opportunities for this type of investing, especially for individuals.

History should be the best guide. Here's a study that shows Small Cap Value stocks outperforming all other classes of equity from a period starting in 1980 and ending in 2010. Over 30 years, small cap value stocks rewarded investors with returns of 14.13% annualized. Large cap growth stocks pulled in a paltry 9.91% in comparison.

Compare that to recent trends. Small cap value has underperformed in almost any time period and category for the past 5 years. This includes the past year when small cap value stocks sold off 9.39% while large cap growth stocks are only off 1.77%.

Click to enlarge

This market has become completely disjointed and irrational (or perhaps it always is this way). For this reason, the current volatility should continue for some time as valuations reset and investors change bad habits.

The good news for value investors is that low valuation metrics tend to boost returns in the long-run. If you look at a P/E ratio as an earnings yield flipped upside down, you know that a stock with a P/E of 3 is going to yield about 33.33%. So, stable earnings over a long-period of time should help this company actually grow equity to levels that provide decent returns for an investor. Contrast this to a stock that trades with a P/E of 100 and the earnings yield is 1%. That's not much reward, especially if the underlying business hits an inevitable bump in the road.

Investors that are looking to capitalize on the disjointed market might move some money into the Vanguard Small-Cap Value ETF (NYSEARCA:VBR).

VBR Chart

VBR data by YCharts

This fund provides exposure to a beaten down area of the market, while also providing rock-bottom expenses of 0.09% and a dividend yield of 1.99%. Over the past three years, this ETF returned about 12.86%.

For investors with a long time horizon, this one may outperform. To limit downside risk, average-into a position. This is especially important during a period of market volatility.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.