VBR - VBR: Facing Headwinds But Potential Likely Ahead

2023-07-12 04:40:24 ET

Summary

• Small-cap stocks have experienced pressure since the start of the year despite a strong equity market rally.
• Vanguard Small-Cap Value Index Fund ETF Shares has a diverse stock composition with financials and industrials making up around 40% of the total fund weight.
• VBR's performance has been negatively affected by the uncertain macroeconomic outlook, rising interest rates, and an unexpected tech rally, suggesting short-term downside risk may be greater than upside potential.

Small-cap stocks have been under pressure since the start of year despite strong equity market rally. Given their relative underperformance to large cap stocks on a year-to-date basis, it is worth diving into Vanguard Small-Cap Value Index Fund ETF Shares (VBR) to decompose some of the performance drivers and analyse the portfolio positioning/ holdings.

The fund aims to track performance of the CRSP US Small Cap Value Index, which only invests in small cap value equities in the US. It has a very diverse pool of stocks with the fund's top 10 holdings only taking up slightly more than 5% of the total weight - which is optimal for investors seeking for value and small cap factor exposures.

With highly diverse stock compositions, it is also diversified in terms of sector exposures with several value sectors (financials and industrials) taking up ~40% of the total fund weight.

Performance Review

Year-to-date, you can clearly see two opposite sides of the coin. The broad market index favoring large cap stocks, such as SPY and URTH have massively outperformed the value indices including VBR. The IWD (large cap value) and IWN (small cap value) have their returns tracked closely to VBR, which indicate that the growth/value factor may have outsized impact as compared to small/large cap within this period - particularly driven by tech stocks rally.

Since January 2022, VBR had quite similar performance as its peer indices but all remained in the negative territory.

Risk Analytics

VBR has an annualized volatility at ~25%, which is slightly higher than its peers including SPY at around 20%. Recently, the ETF is trading at 1 sigma above the rolling mean - indicating potential overbuying for the short term.

Applying the Fama-French 3 Factor Model for VBR relative to SPY over a 5 year period, the value and size premium highly dominates its risk contribution, explaining ~94% of the active portfolio risk. demonstrating that the fund is doing what it's supposed to do (size premium favors small cap, while value premium favors high book-to-market ratio).

Using CAPM analysis, the fund's rolling Alpha relative to SPY has been terrible since the start of year, which resonates with the YTD underperformance. Meanwhile, its rolling Beta has spiked over the last quarter, which could be driven by the massive tech rally led by NVIDIA that VBR did not capture.

Deep Dives

Taking VBR's top 3 sectors, it is clear that its performance has mostly tracked the returns of its two most-exposed sectors (industrials and financials), where its return is almost the average of both. Meanwhile, consumer cyclical which is 13% of VBR, has significantly outperformed the rest with close to 20% return YTD. The deviation is likely to be led by the outperformance of automobile stocks such as TSLA, which has returned ~150% YTD.

In general, VBR has a P/E ratio of ~10x while SPY is at ~23x. Looking across its top holdings, the fund does seem to have a large range of P/E but a much more reasonable range for Forward P/E and P/B ratios. With that said, BAH and KIM may not be your typical low-cap value stocks, as BAH is a consultancy while KIM is REIT - hence being the outliers on the P/E front.

Besides, all stocks seem positive on the profitability front with pretty strong return on equity with mixed revenue growth.

Liquidity is crucial for small-cap stocks in a high interest rate environment due to potential financial stress. There are several stocks with high debt to equity ratio (BAH, BLPI, JBL) and also a few with concerning quick ratio (ATO, BG, JBL).

Summary

In short, VBR quite rightly provides investors with small-cap value factor exposures. However, the stock market has been acting against it given the uncertain macroeconomic outlook and rising interest rates environment, which often disadvantage small cap stocks. 'Unexpected' growth tech rally has also significantly derailed its performance against the large broad market indices. I am sensing an opportunity within this space but I may be worth being an observant for slightly longer before hitting the trigger - as potential downside may be more significant than its upside for now.

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