VBR - VBR: Value Over Growth? The Bitcoin Effect

2023-07-12 01:55:08 ET

Summary

• VBR is an ETF that represents a good proxy for the Small-Cap Value Morningstar.
• Value stocks are currently trading at very attractive valuations, and usually represent "slow compounders" that create returns through EPS growth rather than meteoric increases in P/E ratios.
• The "Bitcoin effect" has led investors to seek out high-growth, high-risk assets.

Thesis

What a year so far. They said that negative EPS companies will die a quiet death, and value will once again prevail based on strong free cash flow metrics:

Boy oh boy were they wrong. The shy 4.69% return represents what the Vanguard Small Cap Value ETF has posted this year, versus the astronomical numbers posted by some of the not so profitable growth names utilized for the compare.

What seems to us more obvious by the day, is that the large investor cohort is driven by momentum and high returns expectations, rather than by quiet compounding and EPS growth. The crux of value investing these days is represented by attractive valuation levels, as reflected in low P/E multiples, expanding EPS profiles, and healthy free cash flow generation. Yet it still seems that the constant winners are companies that spin good stories, with profitability still far, far away in the future.

The thought process was that higher rates will result in lower valuations for such 'growth' enterprises, since the discount rate used for those future EPS levels will become higher. We are at 5% rates, yet there has been no capitulation:

If we look at the Morningstar box , we can notice that Small-Value is up 4.85% in the past year, whereas Small-Growth is up 16.8% even with rates increasing by more than 350 bps.

As a reminder, the Morningstar box is a widely used categorization tool for equity funds:

The Morningstar Style Box gives financial advisers, investors, and fund managers a way to understand quickly the positioning of a share fund. By providing an easy-to-understand visual representation of fund characteristics, the Morningstar Style Box allows informed comparisons and portfolio construction based on what stocks funds actually hold, rather than on assumptions based on a fund's name or other factors

The Vanguard Small-Cap Value Index Fund ETF Shares ( VBR ) is an exchange traded fund that represents a good proxy for the Small-Cap Value stocks box. The fund is one of the largest in the space, with over $25 billion in assets, and a very low fee of 0.07%.

Composition

The fund contains 848 names, with an average market cap of roughly $5.2 billion:

From a sectoral standpoint, the name is overweight financials and industrials:

This composition has held it back during the regional banks crisis, with the ETF holding some of the names present in the news.

Valuation

This is where things are looking quite attractive for VBR:

The fund has a very low P/E ratio of 10.8x versus 19x for the S&P 500 and 21x for the equivalent Small-Cap Growth fund Vanguard Small Cap Growth ETF ( VBK ). The fund components have only a marginal premium to book value, as opposed to their growth equivalents:

The discrepancy is even more pronounced when it comes to the Price/Sales ratio, where value has a ratio of 0.72x versus a 2x for Growth. Albeit this metric is a bit of a misnomer for the two categories, especially in light of names in the financials sector which do not trade on price to sales.

Small-Cap Value recorded only a -18% drawdown in 2022 versus a -33% one for small-cap growth:

The Bitcoin effect

The Bitcoin effect, in our mind, refers to the propensity of investors to try to get rich as fast as possible. Without going into much detail regarding crypto and blockchain, Bitcoin has really established itself as an asset class via its ability to have made lots of money fast for folks with little financial markets knowledge. By now we have all heard stories about investors who 'got in early' and made fortunes overnight by holding on to Bitcoin.

The human greed is insatiable. We would argue that the majority of investors would like to see as much growth in their portfolios as fast as possible, despite concepts such as macro cycle, free cash flow or balance sheet. To that end growth names will always hold a special allure in investors' minds, simply because they represent the possibility of substantial wealth creation in short periods of time.

Conclusion

VBR is an ETF that represents a good proxy for the Small-Cap Value Morningstar box. The fund had a similar drawdown to the S&P 500 in 2022, but has been left behind this year. With a return of only 4.6%, the ETF has not managed to impress when compared to its small-cap growth peer VBK, up 16% this year. VBR displays extremely attractive valuations, with a 10x P/E ratio and a Price/Book ratio of only 1.4x, but has been pulled back by its financials holdings which account for 20% of the portfolio.

Despite continued discussions around a secular rotation from growth to value, we fail to see those flows. Moreover, we think the advent of cryptocurrencies such as Bitcoin have instilled in the common consciousness the grasp for high returns in short periods of time. Small-cap value names represented by VBR are slow compounders that create returns through EPS growth rather than meteoric increases in P/E ratios. While currently attractively valued, thus making VBR a Hold , the fund will fail to match growth names return levels when the Fed starts lowering rates again.

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