V - MGK: Buy On Any Pullbacks

2023-11-10 11:17:27 ET

Summary

• Vanguard Mega Cap Growth ETF has a portfolio of large-cap growth stocks in the U.S.
• The fund has outperformed the S&P 500 index thanks to its strong growth characteristics.
• Given its strong growth profile, investors should be buyers of MGK in any pullbacks.

Introduction

We wrote an article on Vanguard Mega Cap Growth ETF ( MGK ) back in July 2020. At that time, we indicated to readers that MGK is a good ETF to own in the long run, especially in the midst of the pandemic. It has been more than 3 years since we wrote that article . Hence, we think it is time to analyze MGK again and provide our insights and recommendations again.

ETF Overview

MGK invests in a portfolio of large-cap growth stocks in the United States. The fund basically tracks the CRSP US Mega Cap Growth Index. This index aims to include stocks that belong to the top 70% of investable equity market capitalization that has strong growth characteristics. The fund's expense ratio of 0.07% is low among its peers. Other funds such as iShares S&P 500 Growth ETF ( IVW ) have a much higher expense ratio of 0.18%. MGK has outperformed the S&P 500 in the long run due to its better growth profile, especially its exposure to technology stocks. However, its valuation is still quite rich and may be vulnerable in an economic recession. Given its strong growth characteristics, we think investors should treat any pullback as a good buying opportunity to accumulate shares of MGK.

Fund Analysis

Solid rebound in the first half of 2023

Investors of MGK had a rollercoaster ride in the past 2 years. The fund has declined significantly by nearly 35% in 2022. This decline was primarily the result of its lofty valuation and the Federal Reserve's tightening monetary policy to combat inflation. Despite the decline, MGK has also rebounded strongly in the first half of 2023. It has gained over 40% from the beginning of the year to mid-July 2023. Even with a slight pullback in the past two months, the fund still delivered a positive return of 38% year-to-date.

MGK has outperformed the S&P 500 index

MGK has delivered a total return of 470.5% since its inception in 2007. This was much better than the S&P 500 index's 311.6% in the same period.

MGK's better performance is not at all surprising as it includes large-cap growth stocks. In contrast, the S&P 500 index includes a combination of both growth and value stocks. Let us now look at MGK's historical earnings growth rate. As can be seen from the table below, the fund has an average annual earnings growth rate of 23.2% in the past 5 years. This growth rate is much superior than the S&P 500's 18.3%. No wonder MGK delivered a much better performance in the long run.

Source: Vanguard

MGK's exposure to the technology sector is beneficial

Below is a table that shows the top 10 holdings of MGK. These holdings represent about 61.5% of MGK's total portfolio. Therefore, MGK is quite concentrated. While some may argue that there is concentration risk, we think this risk is not huge as many of these stocks do generate excessive cash flow in the long run and are aggressively repurchasing their shares. For example, 6 of its top 10 stocks such as Apple ( AAPL ), Microsoft ( MSFT ), Google ( GOOGL ), Nvidia ( NVDA ), Facebook ( META ), and Visa ( V ) have already spent billions of dollars on stock repurchases in 2023 and are expected to continue to repurchase stocks in the future. This should in turn support MGK's valuation.

Technology stocks represent a large chunk of MGK's portfolio. In fact, as can be seen from the table below, the technology sector represents nearly 56% of MGK's total portfolio. Many of these stocks will continue to benefit from important secular growth trends such as artificial intelligence, Internet of Things (IoTs), industrial automation, cloud and edge computing, autonomous electric vehicles, etc.

MGK still has an elevated valuation

Let us now look at MGK's valuation to see if it is currently attractive or not. Below is a chart that shows the forward P/E ratio of growth stocks and value stocks in the S&P 500 index since 1995. While S&P 500 growth stocks are not entirely the same as the stocks in MGK's portfolio, there is considerable overlap. In fact, most of the stocks in MGK's portfolio also belong to the S&P 500 growth stocks. Therefore, we can still gauge the valuation of MGK by examining the average valuation of the S&P 500 growth stocks.

As can be seen from the chart below, growth stocks in the S&P 500 index currently have an average forward P/E ratio of 20.3x. This ratio is now significantly lower from the high of 30x reached during the pandemic in 2020 and 2021. Although the average forward P/E ratio of growth stocks is now much lowered, it is still quite elevated relative to the periods between 2005 and 2013. Therefore, we think MGK is still not cheap.

Should investors be buyers of MGK?

We like MGK's growth characteristics and think investors should own this fund in the long term as the fund offers an attractive return on equity of 33.6% according to Vanguard. This return on equity is much higher than the S&P 500's 24.6%. However, investors should be prepared for higher volatility to show up.

Our base case is that there is likely going be a recession arriving in the first half of 2024. The reason it has not yet happened is that it typically takes a year or more for the monetary policy to fully transmit through the economy. Therefore, the rate hike cycle that began last year should eventually result in an economic recession in H1 2024. In the upcoming recession, we think there will be significant volatility and high downside risk especially given MGK's elevated valuation. However, investors should treat any pullback as a good buying opportunity given the fund's strong growth characteristic.

Investor Takeaway

As we have analyzed in our article, MGK has a better growth profile than the S&P 500 in the long run. However, its valuation is quite rich and downside risk remains. Given MGK's strong growth characteristic, we think investors should own this fund in the long run and should be buyers of the fund when there is any pullback.

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