VB - VB: A Few Reasons I'm Still Bullish On Small Caps

2024-01-08 04:21:57 ET

Summary

• The Vanguard Small-Cap Index Fund ETF has outperformed the S&P 500 in a short period of time.
• Small-cap U.S. equities, including VB, have a lot of momentum and positive tailwinds.
• Small-caps are priced attractively compared to the rest of the domestic market.

Main Thesis & Background

The purpose of this article is to evaluate the Vanguard Small-Cap Index Fund ETF (VB) as an investment at the current market price. This fund's objective is "to track the performance of the CRSP US Small Cap Index, which measures the investment return of small-capitalization stocks".

This is a fund (and broader theme) I was bullish on heading into Q4. Suffice it to say, I was right on this call, as VB has outperformed the S&P 500 in this short window of time. While both did well, VB is the clear winner:

This actually leads me to one of my first reasons why I am reiterating a bullish case. It is that VB - and small-cap U.S. equities by extension - have a lot of momentum right now. The market has clearly turned in their favor and I see a few positive tailwinds that could keep this up as we move deeper into Q1. So while momentum alone is not always a precise indicator of further gains, I do view this positively and see it as support for buying/owning this fund. But I will also discuss the other attributes that warrant a positive lens as well in this review.

Valuation Gap Is A Point Of Focus

Perhaps one of the most fundamental reasons for wanting small-cap exposure going forward is the valuation. Specifically, the relative valuation of small-caps against their mid and large-cap peers. Of note, even with VB's strong gain in Q4, this fund tracks a sector that looks under-valued from a historical perspective against the rest of the market (domestically):

I believe this is a critical element because as the major market indices begin 2024 nearing all-time highs, investors are likely to step back and look for "value". While value can mean a lot of different things to different people, I personally focus on the relative value aspect. Small-caps look cheap compared to their larger peers, and that is a central reason why I feel confident using this thematic idea (through VB) as a way to diversify my portfolio.

This Is Definitely A Play On US Growth

Looking into VB more specifically, I don't want to understate the inherent risk in this type of fund. While I see value in small-caps, and I do stand by that assessment, that is not to suggest this is a "sure thing" by any means. VB, and small-caps more generally, have unique risks and are generally not as stable as their large-cap competitors.

Also of note, VB is definitely a fund that requires economic growth to sustain real gains. While it is a good way to diversify from the large-cap names (i.e. Mag 7) that dominate large-cap ETFs and other funds, it is still a cyclical equity play. If we look at the sector breakdown, we see Consumer Discretionary and Industrials combine to make up over 1/3 of the fund in total:

What this suggests is that VB is only going to perform well if the US sees strong (or at least not weak) economic growth and activity and the US consumer feels confident enough to spend. Neither of these factors is a given in 2024, despite a rallying stock market in 2023.

But I do see some reasons for optimism that could support these underlying sectors. One is that the US consumer continues to feel confident. A rising stock market and strong labor market are no doubt helping. Spending going forward could also be supported if the Fed does push interest rates down a bit this year. That would encourage consumption domestically. And US consumers, at least for now, appear to be on the side of the bulls. While inflation continues to take a bit out of paychecks, US households are overwhelmingly under the impression their personal situation will be better in the future, rather than worse:

The conclusion I draw from this is that American households feel confident going into the new year. Whether or not that is completely justified from my point of view is almost irrelevant. If people feel confident in their current and future prospects, that bodes well for consumer spending, home improvement projects, and travel, among other things. That broadly is bullish for consumer-oriented sectors and plays right into the hands of funds like VB.

Business Activity Improves, But We Are Not Out Of The Woods Yet

While the consumer story looks rosy, the economic growth/activity attribute is more mixed. This is relevant especially for the "Industrials" exposure within VB, as well as other sectors such as Materials and Energy. I think most investors were a bit surprised by how resilient the American economy has been throughout 2023. This has shown us manageable growth, kept a recession at bay, and restored global confidence.

However, certain business activity metrics should be taken with a grain of salt. For example, new orders and inventory readings are a mixed bag. While they both show improvement in the short-term, they also sit in territory that would indicate economic contraction (below a score of 50), not expansion:

I bring this up to both manage expectations and showcase the opportunity. We don't necessarily want to buy into any stock/sector/theme when the coast is all clear. Part of finding "alpha" is being willing to buy when others are hesitant. So I see a not-so-clear economic picture as a chance to get small-cap exposure at a reasonable price. This is certainly why funds like VB trade at a discount right now.

But there are risks to this too. I never suggest any investment is a sure-fire play or risk-free. My followers know I won't pump any investment - even the ones I own. With that said, economic activity in the US is not exactly firing on all cylinders. If we see a contraction in 2024 or even just weak growth, the opportunity in small caps could be limited. After a 9% pop already in the last few months, this is a fund that remains at risk of a correction if economic growth disappoints. Keep that in mind when evaluating whether or not this belongs in your portfolio, as well as the sizing of any position.

Dividend Growth Continued In Q4

My next point is a quick one - but important to me as a "Dividend Seeker". I discussed how VB had seen reasonable dividend growth in my last review, and I am happy to report this theme continued in Q4 last year as well:

Source: Vanguard

I won't spend a lot of time on this because VB is not exactly a "yield play" and 7% growth in the distribution isn't anything to get wildly excited about either. But at the same time, this shows responsible, relatively attractive growth that was consistent throughout 2023. To me, this means the underlying companies in VB's portfolio are starting off 2024 on the right foot and there are other conditions in place that support my bullish outlook. Combining these factors together keeps me comfortable that a "buy" rating is still appropriate.

Just Buying Bonds Not Enough

My last topic has to do with why I ventured into small caps to begin with. It was primarily for the simple reason of diversification. My large-cap holdings, while numerous, have gotten very correlated with each other because of the dominance of the "Mag 7". Whether I own a Tech fund, a S&P 500 fund, or a Nasdaq fund, all of them are continuously being dominated by the same set of stocks. This even extends to many dividend funds as well (via Apple ( AAPL ) and Microsoft ( MSFT )). The fact is that the performance of the Mag 7, while very profitable for me, has left me with a lot of concentration risk.

To combat this, I have used a variety of options, including non-US equities, commodities, and bonds. But I have ventured into small caps because many non-US holdings are moving in tandem with US markets anyway. Further, stocks and bonds have also seen their correlation shoot up. While not in uncharted territory by any means, it is still a sharp uptick from years past:

What I take away from this is that bonds as a hedge or diversification tool are less helpful at the moment. This means investors have to get a bit more creative if they want to find ways to hedge a large-cap-dominated portfolio (such as the one I have). This has steered me in the direction of small-caps, not as a catch-all, but as just another tool in my disposal to keep my portfolio from getting too concentrated on assets that move together.

Bottom line

VB has seen a nice bump since my last buy article and I see an environment where more gains could be forthcoming. While I wouldn't go "all-in" at these levels, given the big move already and the headwinds on the horizon, I like the idea of riding this momentum. Small-caps offer a way to diversify, to capitalize on domestic growth, and they will benefit from a more optimistic consumer.

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