VB - VB: Better Than Large Cap

2023-07-17 13:14:00 ET

Summary

• Small-cap stocks are under pressure due to rising borrowing costs and a weak macroeconomic outlook, but are still beating expectations with 11% YTD returns.
• The Vanguard Small Cap ETF is a well-diversified index across value and growth stocks, tracking the performance of the CRSP US Small Cap Index.
• Despite lagging behind the large-cap index, VB has seen $1.5bn in net inflows over the past year, indicating a healthy investor appetite.
• Bullish for lower concentration risk over large cap with decent risk-adjusted performance, strong underlying fundamentals, and the potential to outperform during rate cut.

Amid the high interest rate environment, small cap stocks are under increasing pressure to cope with rising borrowing costs and weak macroeconomic outlook. Even though small cap equities have underperformed the large cap broad market index, they are still beating expectations with 11% YTD returns, without the significant concentration risk posed by large cap index.

The Vanguard Small Cap ETF ( VB ) is a well-diversified index across value and growth stocks, aiming to track the performance of the CRSP US Small Cap Index. Due to small cap weighting, its top 10 holdings only represent roughly 3.5% of the total portfolio weight, as compared to nearly 35% by S&P 500 ( SPY ). With such differentiation, it is worth diving deeper into VB to understand more about its performance and risk characteristics, alongside underlying fundamentals. Over the 1Y period, VB has seen $1.5bn in net inflows, which indicates decent investor appetite.

Performance Review

As mentioned earlier, VB has lagged the large cap index ((SPY)) but not by a huge margin on a year-to-date basis, given that SPY returns can be largely attributed to several big tech names with the AI boom and growth rally. Besides, VB also tracks very closely to its small cap peer index ( IWM ) and mid-cap peer index ( IJH ).

However, taking a view from a longer time frame since January 2021, the size factor becomes much more significant with large cap outperforming mid cap, followed by mid cap outperforming small cap. Over this period, small cap stocks were still negatively impacted from the impacts of Covid as they are more disadvantaged to cope with such stress scenarios which impact both top line and bottom line. However, it does outperform its small cap peer ((IWM)) over that time period, which is still generating returns in the negative territory.

Risk Analytics

While small cap stocks are known to be more volatile, VB is about 3% higher than SPY, but similar to IJH and IWM. Given that small cap stocks have been underperforming large cap stocks over recent periods, small cap equities may have worse risk-adjusted returns.

Looking at the Bollinger Bands below, VB is currently trading above one sigma - indicating recent momentum trending upwards.

By decomposing its active risk according to Fama-French 3-Factor Model against SPY, size premium (small cap factor) contributes to most of the active risk - which indicates that the index is doing what it’s supposed to do. Meanwhile, value premium (high book to price ratio) is also playing a sizable role in active risk contribution.

Relative to SPY, VB’s rolling-alpha is bouncing back but remained in the negative territory throughout this year.

Its rolling-beta, however, has been trading above 1 throughout this year - signifying higher volatility/ sensitivity to broad market movements.

Sector Deep Dive

VB has very well-diversified sector distribution, led by industrials, technology, healthcare, consumer cyclicals, and financial services.

While VB’s performance has lagged the wider technology and consumer cyclicals sectors which returns have been largely driven by large cap companies such as Meta, Nvidia, and Tesla, it has performed better than the other more defensive sectors including healthcare, industrials and financial services

Fundamentals Deep Dive

In terms of fundamentals, VB has a P/E ratio of 12.5x and P/B ratio of 2x, which is much lower than 23x of SPY. Looking at the underlying valuations per top holdings, it paints a varied picture, with companies having a range of trading multiples. More mature companies such as BLDR and BG are priced more conservatively with 9x and 9.8x P/E respectively, while a young molecular diagnostics company, EXAS , does not actually have earnings.

However, profitability looks much more positive with return on equity and assets widely positive with healthy margins, with the exception of ((EXAS)).

Liquidity is perhaps one of the most important risk considerations when it comes to small cap stock investing. Debt ratios are generally healthy (<1) with the exceptions of ENTG and TRGP . However, there are several companies with concerning quick ratio (<1) which may potentially lead to insolvency. ((TRGP)), which has very high debt to equity ratio with low quick ratio is in fact a midstream energy infrastructure corporation, where the industry accepts a high leverage ratio as a norm.

Price targets of VB top holdings are strongly positive with mean target upside ranging from 2.8% to 27.1%, with the exception of ((BLDR)) due to its underwhelming revenue growth shown previously.

Summary

With that, I am bullish on VB over the medium to long-term with 3 main rationales. Firstly, I like the fact that it is still performing well without high concentration risk presented by large cap index - which indicates a purer factor performance as compared to idiosyncratic gains. Secondly, I believe that if small cap equities can perform in a resilient manner during a high interest rate environment which disadvantages their financial positions, they will be able to outperform when rate cuts take place in the future. Thirdly (in conjunction with my second point), the underlying fundamentals of small cap stocks still look decent, with much lower P/E than large cap peers and strong profitability. There also does not seem to be concerns over liquidity widely across the fund. As the index is very well diversified, stock-specific liquidity events may have very limited impact on its overall returns.

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