VUG: Fear Of Missing Out Could Drive Growth Funds Even Higher

Jan. 12, 2020 9:13 PM ETVanguard Growth ETF (VUG)24 Comments3 Likes

Summary

  • Growth stocks (and funds) have led the market over the past decade. With 2020 underway, it is reasonable to think this could continue.
  • The spread between growth and value right now is very wide, but that has been the story for the past few years.
  • Earnings growth per share in large-cap companies was negative last year. With stock prices on the rise, P/E multiples keep increasing. This suggests some level of caution is warranted.
  • The Technology sector is the largest sector by weighting in VUG, and it remains an area I am bullish on this year.

Main Thesis

The purpose of this article is to evaluate the Vanguard Growth ETF (NYSEARCA:VUG) as an investment option at its current market price. With a new decade in front of us, investors would be wise to consider some lessons from the last decade, especially when considering the right sector allocations. As the market sits near historic highs, a look back at the last decade shows us equities have done extremely well, led by those with a "growth" focus. In fact, growth investing posted the best annualized returns for the decade, and have started 2020 out with a lot of momentum. This suggests more gains could be around the corner.

Of course, there are reasons for caution too. While the growth play has been profitable, earnings multiples are rising aggressively, and investors would be paying an expensive price for new exposure. Further, as value strategies have under-performed growth over a long stretch, the relative valuation between value and growth is at a historically high level. This suggests value could be ripe for a comeback soon. However, I personally feel funds like VUG will continue to do well. The fund's underlying holdings are posting solid quarterly results, the demand for technology products and services is accelerating, and equity prices remain supported by low interest rates around the world.

Background

First, a little background on VUG. The fund is managed by Vanguard, and its objective is "to track the performance of the CRSP US Large Cap Growth Index." Currently, VUG trades at $188.20/share and yields 0.93% annually. I had recommended growth as a strategy going into 2019, but backed off it mid-way through the year, as I felt rising valuations were a headwind. In hindsight, growth stocks and funds have continued to perform well, and that story has stayed constant so far in 2020 also. Therefore, I wanted to do a review of a popular growth ETF because my general outlook for this strategy is more bullish than it was about six months ago, and I will explain why below.

Growth Has Led The Market, FOMO Could Drive More Gains

My first point on why VUG could move higher in the short term has to do with relative performance. As we have entered a new decade, investors are likely looking back at the past decade for performance trends - what worked well, what did not. An overview of sector performance from 2010 to 2019 shows us that equities and fixed-income all performed very well. This is not surprising, as markets have boomed due to quantitative easing, low interest rates, and an improving housing and labor market. While most asset classes registered impressive gains during the last decade, some sectors and strategies markedly outperformed others. Which brings us to growth. This was the top-performing asset class, on an annualized basis, over the past decade, as shown below:

Source: Lord Abbett

As you can see, while annualized gains were strong across the board, growth was the winner, and by a pretty good margin.

Looking ahead, I see this as a potential catalyst for further gains. As investors take stock of what performed well in recent years, they may be inclined to play "catch up" and pile in to sectors that have shown the most impressive returns. This concept can be known as "Fear of Missing Out (FOMO)" and, while not an investment strategy I would normally advocate, it can absolutely drive short-term returns. When we consider that many of the same macro-factors that existed over the past few years in the U.S. exist today, (low interest rates, high government spending, and low single-digit economic growth), it could stand to reason that similar investment themes will again outperform in 2020. If it happens, growth is likely to have another strong year in relative terms.

Growth/Value Spread Is Wide, But That's The New Norm

The second metric I want to look at is the diverging performance gap between growth and value. This is an area I keep a close eye on, and the widening gap was a reason for my shift to value-focused funds in mid-2019, through today. While growth and value were trading mostly in line with each other coming out of the recession, starting in early 2014, growth began to take off (in terms of relative performance). As we get further along in this historic bull market, one might expect that growth's performance gap would tighten. However, the fact is growth strategies have begun to see their relative performance accelerate against their value peers, as shown below:

Source: Invesco

As you can see, both the growth and value indexes have been performing very well, especially over the last five years. But the noticeable trend is growth has pulled away, registering even more impressive returns pretty consistently.

My overall takeaway from this graph is mixed. On the one hand, my gut tells me that it is past due for value to make a bit of a comeback, and narrow the gap between growth. On the other hand, this is a sentiment I have felt for a while, and my portfolio has under-performed growth strategies as a result. While the gap is wide, this has been the story for years, and it has continued to widen. There is no reason this trend cannot continue in the early stages of 2020, as investors are fueled by low interest rates and positive developments out of the U.S.-China trade dispute. With a major trade headwind on the back burner for now, investors could bet on economic growth picking up, both here and abroad. That should be good news for funds like VUG.

Tech Has Growth Now, And It Is Expected To Accelerate

With these first two points in mind, investors are likely having difficulty deciding if growth really does have a good chance of further outperformance. While my view is cautious as well, I continue to be bullish on the Information Technology sector, which makes up a large percentage of VUG, shown below:

Source: Vanguard

Clearly, this is a sector whose fortunes will drive VUG's performance, as well as the premium (if any) investors are willing to pay to own the underlying shares.

Fortunately, the Tech sector is one that has been growing quite handsomely, and in areas that are relatively new to the market. For example, some areas that saw growth in 2019 included wearable tech, connected cars (through wireless/broadband), and smart homes. In fact, growth was between 3-4% for each of those categories, on a year-over-year basis, as shown below:

Source: S&P Global

Clearly, these are areas posting some healthy growth figures. And what really gets me excited is how diverse the opportunities are. Wearable tech encompasses a lot of different products (think Apple Watch, AirPods headphones), while connecting homes and cars has more to do with service providers and wireless tech services. This tells me the growth in each sub-sector may not cannibalize the other, and is really a play on a substantial shift in consumer demand and behavior.

While I view the recent growth figures positively, what really makes me bullish on this sector is the future growth outlook. Looking ahead, the percentage of U.S. households expected to embrace wearable tech, smart homes, and connected cars sits over 30% by 2023, as shown in the graph below:

Source: S&P Global

Clearly, this target date is not very far off, and suggests the strong growth figures we saw last year may even accelerate over the next few years.

My overall takeaway is, despite the high stock prices for large tech firms, there can easily be an argument that those shares will move higher. The Tech sector is benefiting from growing consumer demand for the products and services it offers, and expectations are this demand will continue in the years ahead.

Keep An Eye On Earnings Growth This Year

While I have painted a mostly positive picture on the growth sector, and VUG by extension, I do need to point out that investors should approach this strategy with some caution. We are in the very late stages of the bull market, and investors buying in now will be paying a very hefty premium for exposure to this area. While I do feel there are very valid reasons growth stocks will do well in 2020, I still see this as a risk-on strategy, and certainly is not appropriate for every investor. Furthermore, given how wide the spread between growth and value is right now, if the trend corrects, the downside potential for growth is quite large.

Aside from that general outlook, investors should have some caution for the market as a whole right now. While stock prices continue to rise higher and higher, nearing the 29k mark, we have to understand that actual earnings growth is not what is driving this market. While positive future expectations can drive markets for a long time, eventually, investors want to see real dollars, not just speculation. Unfortunately, 2019 actually saw a decline in earnings per share growth, on average, within the S&P 500, as shown below:

Source: Bloomberg

Clearly, this is not a positive trend, although we have to consider that, on an absolute level, large-cap earnings are still quite high. However, when we consider the gain the S&P 500 saw in 2019, the fact that earnings growth was actually negative may suggest that such a strong a move was not justifiable.

With this in mind, investors may be asking, why would I want to buy growth funds like VUG? It is a fair question, and forces me again to reiterate this is for the more risk-seeking investor. However, there is another reason why I like VUG specifically, at the expense of other types of growth options.

The reason is actual earnings for the companies in VUG's portfolio, which offer a more attractive picture than the broader S&P 500 graph showed above. To see the story, let us look at some of the top holdings within VUG, which includes Microsoft Corp. (MSFT), Apple Inc. (AAPL), and Alphabet Inc. (GOOG) (GOOGL). While only three companies, they collectively make up almost 23% of total fund assets, so the fortunes of these companies will disproportionately impact VUG. For a quick look at the most recent quarterly results for each company, see the chart below, which should leave investors feeling confident:

Stock YOY Revenue Gain YOY Net Income Gain Recent Dividend Increase
MSFT 13.6% 21.0% 10.9%
AAPL 1.8% (3.1%) 5.5%
GOOG 20.0% 30.1% N/A

Source: Seeking Alpha

As you can see, these results are pretty strong across the board. Further, seeing some dividend growth is especially comforting. Even though this is not a strategy I would use for yield, seeing dividend growth illustrates that management is confident in the future outlook of the company.

My overall takeaway here is VUG is being led by some of the top companies in the world, who are actually seeing revenue and dividend growth, at a time when the broader S&P 500 saw earnings decline slightly. While I would suggest investors keep a keen eye on earnings growth, both for the stocks within VUG and across the market as a whole, the story right now is positive enough for me to suggest VUG will move higher from here.

Bottom line

Growth has had a tremendous run, and investors may be thinking it is time to rotate out of the sector after a very strong decade. While I would not fault anyone for taking a more cautious stance now, I believe growth could still lead the market in 2020, and VUG is a good way to play this potential. Specifically, I would recommend investors who have both a long-term view and the ability to take on some risk and withstand some volatility, to take a serious look at the fund at this time.

This article was written by

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