VBK - VBK: Small-Cap Growth Stocks Are Undervalued But Remain Volatile

2023-05-03 04:24:18 ET

Summary

• VBK invests in small-cap U.S. growth stocks.
• The fund is most likely undervalued and should continue to perform reasonably well.
• However, the fund is large, diversified, and likely subject to "noisy" rebalancings which affect the investment proposition longer term.
• I think VBK should do well, but recognize that it is a better source of beta than alpha.
• VBK might be undervalued, but in volatility-adjusted terms, it is unlikely to generate especially impressive returns.

Vanguard Small-Cap Growth Index Fund ETF ( VBK ) is an exchange-traded fund that provides investors with exposure to small-cap growth stocks. The fund's benchmark is the CRSP US Small Cap Growth Index. The expense ratio is cheap, at 0.07% (as of the end of April 2023), and the fund had net assets of $28.6 billion at the end of March 2023.

Based on data from Vanguard themselves, the fund had a trailing price/earnings ratio of 22.9x as of March 31, 2023. Meanwhile, on a forward basis, Morningstar report price/earnings ratio of 21.08x with a price/book ratio of 2.91x as of the same date. Based on this information, the underlying return on equity is some 13.8% on a forward, weighted basis. Morningstar also estimate that three- to five-year earnings growth will reach some 17.95% on average. This is the kind of fund where one may have to consider the potential for the portfolio to expand its underlying return on equity, rather than mature into lower rates of return.

I last covered VBK in September 2022, at which point I thought the fund was not overvalued per se, but poorly positioned cyclically. Since then, the fund has fallen by -6.20% (excluding dividends) vs. the S&P 500's move of +0.87%, according to Seeking Alpha data. Bear in mind the fund's beta is about 1.07x as at the time of writing on a five-year historical basis. So, the fund has not been performing well, yet it is worth revisiting, as markets have been performing better more recently in 2023. VBK has also benefited from inflows of circa $559 million over the past year or so (see below).

VBK is exposed to the United States only, so what we have here is a portfolio of higher-risk, potentially higher-growth small-cap stocks, and an opportunity to potentially capture a "small-cap premium" in a diversified manner. The fund's beta, as noted, is closer to 1x, which is driven by a wide portfolio of 671 separate holdings as of March 2023 month-end.

I do, however, have some trouble in reconciling the large earnings growth assumptions embedded in Morningstar's consensus estimate thereof, with the forward earnings growth implied by the differences in Morningstar's and Vanguard's trailing and forward price/earnings ratios, respectively (of +8.63%). I feel like the index is liable to drive churn, where once faster-growers have achieved their fast growth, they are then dropped from the index, so that while the fund's price/earnings multiple might continue to hold up and look rich, the actual holdings that VBK owns at any given time might not hold long enough in the portfolio on a weighted basis to achieve higher returns on equity.

In theory, that should not be an issue, as forward earnings multiples and growth expectations should be tailored to today's holdings. In any event, we can start with a "conservative case", assuming earnings growth picks up initially, but drops back such that the return on equity matures toward 11%. The result is a headline IRR of 11.08% over five years.

It is also interesting to note from my previous article that Morningstar previously had an earnings growth average of less than 15%. So, estimates have been revised upward. Admittedly, I am taking a very conservative approach this time, but the IRR still holds up fairly well. If I instead have the return on equity mature more slowly to 12%, the IRR improves a little more. Interestingly, since my last article, the forward price/earnings multiple is very similar; I won't assume any changes on a forward basis in five years' time for now. The IRR moves higher to over 13%.

I want to make one final case. Let's give Morningstar the benefit of the doubt, and keep earnings growth high, with returns on equity roaring higher. However, we will temper this by dropping the forward price/earnings multiple to a lower level of circa 18x. The IRR moves higher to 15.59%.

In each case, VBK offers a high underlying equity risk premium in line with its risk, and appears undervalued on a straightforward beta-adjusted basis. However, on a volatility-adjusted basis, I would expect a sub-1x Sharpe return in each case; that is, net of the risk-free rate (presently 3.43% at the time of writing, as the U.S. 10-year), the underlying return compares not so well to a historically high 20-30% standard deviation. In the "growth case", where we give credit to consensus analyst estimates, VBK is likely to perform very well, even adjusted for volatility. However, in my more conservative cases (the first two cases above), volatility-adjusted returns are unlikely to be impressive.

Since I am generally optimistic on the economy long term, and since VBK seems genuinely undervalued, I am taking a bullish stance. However, I am taking this stance while also understanding that VBK is more "beta" than "alpha", and that firmer, less "noisy" ETF portfolios are available.

For further details see: