It has been a little over one year since I recommended the Vanguard Small-Cap Value ETF (NYSEARCA:VBR), and it seems to have been a successful call since it outperformed the Vanguard Small-Cap Growth ETF (VBK) by 22.40% in 2021. Looking at the broader market, I remain surprised at the strength of the Large-Cap S&P 500 Index, but VBR still managed to keep pace with that benchmark last year even as mega-caps like Apple (AAPL) and Microsoft (MSFT) continued their impressive runs.
Given its success, the purpose of the article today is to assess VBR in its current state to see if the bullish thesis remains intact. After considering both secular trends for small-cap value and growth stocks, as well as VBR's current valuation, growth prospects, and volatility levels, I think it will continue outperforming small-cap growth this year. Therefore, I am maintaining my bullish rating and look forward to discussing the reasons why in more detail.
VBR tracks the CRSP US Small Cap Value Index, which includes U.S. companies in the bottom 2%-15% by market capitalization. This Index reconstitutes quarterly based on a multifactor model that assigns stocks as growth or value. CRSP classifies value stocks based on their book to price ratio, estimated and historic earnings to price ratios, dividend to price ratio, and sales to price ratio. At present, the Index includes about 1,000 securities, and VBR's expense ratio is 0.07%. I've listed some of VBR's descriptive statistics below.
As indicated, VBR is a well-established ETF with over $25 billion in assets under management and nearly 18 years of history. Its dividend growth rates are strong, and the 0.07% expense ratio is reasonable, though the median bid-ask spread of 0.06% is a bit high. You will usually find this with most small-cap ETFs, as they aren't as liquid as the mid-and large-caps. Finally, since it's a highly unconcentrated index with 993 securities and just over 5% of assets in the top ten, any meaningful analysis should focus on the sector and industry-level fundamentals and technicals. Providing examples of individual stocks would not add value because they each have inconsequential weightings.
Like the Vanguard Mid-Cap Value ETF (VOE), which I recently covered, an advantage with VBR is its diversification away from potentially overvalued Technology stocks. VBR's allocation to this sector is only 6.70%. Instead, according to CRSP, the best small-cap value stocks are found in the Financials (22.40%), Industrials (20.20%), and Consumer Discretionary (15.60%) sectors.
And, as mentioned earlier, only 5.45% of the ETF is allocated to the top ten assets. Vanguard updates the list every month, with the latest shown below. Think of these as the most likely candidates to graduate to VOE soon, so ironically, they may not have much relevance soon.
The graph below highlights VBR's long-term performance relative to VOE, VBK, and the large-cap Vanguard Value ETF (VTV). It becomes clear that diversifying away from large caps has been beneficial for total returns. However, risk, as measured by standard deviation, was higher. Downside risk-adjusted returns, which is what the Sortino Ratio measures, were also the worst for VBR. I think that, generally speaking, risk-averse investors should stick with profitable stocks more likely to be found in an ETF like VTV.
Turning to the significant performance difference between VBR and VBK, the chart below illustrates four-year trailing returns for the small-cap value and small-cap growth asset classes over the last 30 years. A key part of my thesis in December 2020 was based on the observation that growth's cumulative outperformance at the time had not been seen since at least 1975. Therefore, investors could reasonably expect a certain degree of mean reversion to occur, which has played out nicely over the last year.
At present, however, the gap is 18.61%, which is a far cry from the 78.61% at the start of last year. I've illustrated these rolling differences in the graph below.
While there's still some opportunity for small-cap value stocks to close the gap even further, it's clear that the case for investing in VBR isn't as strong as it once was. Therefore, for the remainder of the article, I will be focusing on VBR's fundamentals rather than its technicals.
Value stocks are often attractive by their relatively low price-earnings ratios, and indeed, VBR scores well on that metric with a forward ratio of just 18.39. I think you'll find this to be on the low side regarding value ETFs. For comparison purposes, I calculated VOE's to be 19.75 and VTV's to be 21.75.
I have calculated several other metrics for VBR's top 20 industries below. In addition, the net metrics for the entire fund are in the second-last row, and the net metrics for VBK are in the last row for comparison purposes. Have a look at where the exposures mainly lie, and I will provide my commentary afterward.
Unexpectedly, VBR's five-year beta is currently 1.36, which is substantially different than the 1.09 the fund itself experienced over the same period. An ETF's portfolio turnover rate can cause the difference, as stocks rotate in and out of the fund at a higher-than-normal speed. Generally speaking, you won't find this issue with an ETF like VTV since large-cap stocks tend to stay large-cap for more extended periods since they don't have an Index to which they could graduate.
A key driver for the 1.36 beta can be identified by looking at VBR's top ten industries, which total 30.78% of the fund. However, I'm bullish on several of these industries, including Regional Banks, Oil & Gas Exploration & Production, and Building Products. I also want to note that since VBR is overweight in Financials, there exists an excellent opportunity for outperformance if interest rates rise. Federal Reserve Chairman Jerome Powell recently told lawmakers how committed the central bank is to tamp down inflation, which may involve increasing rates more aggressively.
The differences between VBR and VBK's historical three-year and one-year forward revenue growth rates are stark. However, analysts' EPS growth estimates are surprisingly only five points lower for VBR (13.13% vs. 18.44%). This 13.13% growth estimate is huge for a value ETF and much higher than VOE's 7.75% or VTV's 9.92%. Finally, the best part is that investors are getting this growth at an excellent valuation of just 18.39x forward earnings, which is about half of what you'd be paying for VBK. I think it's appropriate to search for low P/E stocks in this uncertain environment, so VBR is easily the better choice in this regard.
If you look at mega-cap growth stocks like Apple and Microsoft, they are the largest in the world because they are also the most profitable. Their valuations may appear high, but the market is not irrational for favoring them. To illustrate, the top 15 holdings of the Vanguard Information Technology ETF (VGT) earned an A+ Profitability Grade from Seeking Alpha (review here). High valuations are acceptable so long as growth and profits support them, but if you look at the Profitability Grade for VBK (B-), it's unclear what small-cap growth stocks offer. VBR's Profitability Grade is just as good as is its EPS Revisions Grade of C+. All these metrics I've discussed result in a much better Seeking Alpha Quant Score of 3.40 for VBR vs. 3.00 for VBK. In my view, the bull case for VBR continues, at least relative to VBK.
It seems clear to me that the Vanguard Small-Cap Value ETF is superior to the Vanguard Small-Cap Growth ETF in most areas, except for a lower revenue and earnings growth rate, which is expected. Valuation-wise, it's among the cheaper value options on the market today, and I think it provides a nice balance to most portfolios that likely have an elevated price-earnings ratio.
One potential negative with VBR is its high volatility as measured by beta, which is much higher than you will find with large-cap value ETFs. The reason appears to be an above-average allocation to inflation-friendly stocks. My view is that while inflation will get under control eventually, it probably will remain high throughout 2022, so I'm comfortable with this higher risk factor at the moment. A second potential negative is that analysts appear to be downgrading EPS estimates for small-caps at a bit faster rate than for large-caps. While VBR's low P/E ratio should help insulate it from negative earnings surprises, it's still something for risk-averse investors to consider. If this is a concern, please have a look at ETF Monkey's excellent review of VTV, which includes some additional lower-risk options to consider.
As for VBR, on balance, I see it continuing to outperform VBK this year. Therefore, I'm maintaining my bullish rating on the ETF, and I look forward to providing more updates throughout the year.
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I'm a data-driven ETF analyst who likes to do deep dives into how funds are constructed and what factors are likely to make them winners or losers. I have a database of over 700 ETFs that I follow, so I'm able to show readers the best- and worst-performing funds in each category with each one I review. My preference is for stocks to have strong cash-generating and debt management qualities. I welcome all questions, comments, and suggestions for improvement, and I enjoy my time engaging with the Seeking Alpha community.
I hold a Bachelors degree in Commerce with a major in Accounting and hold a Certificate in Advanced Investment Advice from the Canadian Securities Institute. I have also completed the Portfolio Management Techniques course, fulfilling the educational requirements for a Chartered Investment Manager (CIM) designation. I have passed CFA Level 1, and I am currently studying to become licensed to advise on options and derivatives in Canada. This past November, I became a contributor for the new Hoya Capital Income Builder Marketplace Service, and enjoy working with and sharing ideas with some of the best researchers on Seeking Alpha. Sign up for a free trial today! Hoya Capital Income Builder.
Disclosure: I/we have a beneficial long position in the shares of SPY, MSFT either through stock ownership, options, or other derivatives. 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.