VB - VB: Downside Risk Remains Despite Reasonable Valuation

2023-09-27 21:06:28 ET

Summary

• Vanguard Small-Cap ETF has a portfolio of 1500 small-cap U.S. stocks.
• VB's valuation is reasonable, but there is still high downside risk, especially in an economic recession.
• VB has a higher downside than the broader market in an economic recession.

Introduction

We have written an article on Vanguard Small-Cap Index Fund ETF Shares ( VB ) back in 2020 during the initial outbreak of the pandemic. The article is available here . At that time, we had a hold rating as there were a lot of unknowns about COVID, and that Small-Cap stocks generally do not have strong business models and balance sheets to weather the storm. However, it has been more than 3 years since we have written the article. The situation is now very different. We are now out of the pandemic and are in a high inflationary environment. Therefore, we decided it was time to analyze VB again.

ETF Overview

VB has a portfolio of about 1500 small-cap U.S. stocks. The fund’s valuation appears to be reasonable against its historical average. However, the Federal Reserve’s policy of keeping the rate elevated and for longer may eventually lead to an economic recession. In an economic recession, VB’s portfolio of small-cap stocks tends to underperform and has higher downside risk than the broader market. Therefore, investors should exercise caution and wait on the sidelines.

Fund Analysis

VB recovered some losses in 2023

Similar to many equity funds, last year was a terrible year for VB. The fund has steadily regained some ground since reaching the trough in September 2022. Unfortunately, this momentum appears to be losing steam lately. As can be seen from the chart below, VB’s fund price is on a decline since late July 2023. Overall, VB delivered a total return of about 11% from the trough reached in September 2022.

Reasonable valuation

Investors may wonder whether the sharp correction in 2022 has made VB’s valuation reasonable or perhaps even cheap. Here, we will look at Russell 2000’s historical valuation to help provide the answer. Since the Russell 2000 index tracks 2,000 small-cap stocks in the U.S., it has significant overlap with VB’s 1,500 small-cap stocks. Therefore, it is adequate to check Russell 2000’s historical valuation to gauge VB’s valuation. Below is a chart that shows the historical forward P/E ratio of Russell 2000 in the past two decades. As can be seen from the chart below, Russell 2000’s current average forward P/E ratio of 21.2x is in the middle of its historical range. Therefore, we think small-cap valuation is quite reasonable at the current price. Neither cheap nor expensive.

Downside risk could still be high

Although VB’s valuation appears to be reasonable, there is still significant downside risk, especially in an economic recession. We believe the Federal Reserve’s policy of keeping the rate elevated or higher, and for longer in order to combat persistent inflation will eventually bring the economy to a recession. While one may argue that the U.S. economy appears to be resilient in this rate hike cycle, the impact of rate hikes usually takes about 6~12 months to propagate through the economy. Therefore, we will likely start to feel this impact towards the end of the year and in the first half of 2024.

In this environment, it will be much more challenging for small-cap stocks than mid-cap or large-cap stocks. Using the analogy of a boat in a storm, passengers onboard a small boat typically feel more shaky in a storm than passengers onboard a larger boat. Likewise, small-cap stocks tend to be impacted the most in an economic recession. Their balance sheets and business models may be weaker than their mid-cap or large-cap peers. Hence, their earnings and revenues tend to be shaky during economic recessions.

Not only will small-cap stocks’ earnings get a hit, but the market also has less confidence investing in these stocks during an economic downturn. Below is a chart that compares VB and the S&P 500 index in the past 2 decades. As can be seen from the chart below, VB has suffered a decline of over 60% during the Great Recession in 2008 and 2009. In contrast, the S&P 500 index’s decline was less than 60%. Similarly, in the recession caused by the pandemic in 2020, VB also declined more than 30% from its high. In contrast, the S&P 500 index has declined by less than 25%. Therefore, VB appears to have more downside risk than the broader market.

Investor Takeaway

Although VB’s valuation appears to be reasonable, we think there is still significant downside risk. An economic recession may be inevitable and may be imminent. Therefore, investors may want to stay on the sidelines.

Additional Disclosure : This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

For further details see: