2023-03-20 01:00:50 ET
Summary
- VIOV invests in a diversified portfolio of U.S. small-cap stocks that are trading with "value" characteristics.
- While "value" in this case is really, in my opinion, a misnomer, VIOV's focus on cheaper stocks does make the fund attractive in this environment.
- Based on a conservative forecast, I would estimate the potential for a five-year IRR of almost 13% per annum.
- I think as the U.S. heads into a potential "recession", VIOV is a good buy, as markets tend to lead the economy by up to 12 months and sometimes longer.
Vanguard S&P Small Cap 600 Value ETF ( VIOV ) is an exchange-traded fund that provides investors with exposure to so-called small-cap value stocks. The fund invests in accord with the S&P SmallCap 600 Value Index, which as of February 28, 2023 reported trailing and forward price/earnings ratios of 15.79x and 13.8x, respectively, with a price/book ratio of 1.28x. The index's methodology is focused on acquiring stocks that are cheap by price in relation to book value, earnings, and sales. Constituents are drawn from the S&P SmallCap 600.
While the methodology is simplistic, VIOV therefore has "two layers" to its stock selection criteria, making it slightly more discriminating than a simple "value" (read: cheapness) orientation. The value orientation I would describe as having a focus on "cheapness", instead, as it is not economically viable for a fund (unless it is perhaps a hedge fund) to perform actual valuations on all its constituents. This would require detailed DCF models on every stock, which would involve a significant expense for the fund, and likely result in a far more concentrated portfolio. Instead, heuristics are used in the form of multiples, and VIOV carries an expense ratio of just 0.15% in spite of having 459 different holdings.
Using VIOV's benchmark index's factsheet as a basis (as a proxy for VIOV's portfolio itself), we can build a valuation by ignoring share buybacks but assuming historical dividend distribution rates hold, and also by assuming that earnings growth rates average in the range of Morningstar 's consensus estimate of 18.49%. Actually, since that figure is very large, I am going to assume a lower rate of 5% on average. This is pretty conservative, as it basically assumes 2% nominal earnings growth (probably zero, or even negative, growth in real terms) from year four onwards (2% being used as a kind of "floor" in this way). The resulting implied IRR is still high at 12.83%.
This would suggest that even in a conservative case, the implied beta-adjusted equity risk premium is high at over 8%. In my opinion, the implied IRR of the fund should be no more than 9%, indicating the potential for upside on valuation alone of over 40%.
As corporate America has recently been exhibiting under-whelming earnings, which were expected by many off-consensus analysts (this was not a total surprise), earnings are nevertheless not as weak as many contrarian analysts were warning about. While we could be heading toward a deeper downturn (see chart below from Fidelity for U.S. business cycle positioning as of Q1 2023), this would not necessarily spell a multi-year contraction with several years of negative real earnings growth.
The price/earnings multiple of 13.80x for VIOV's benchmark, and thus by extension (as an estimate) for VIOV's portfolio, suggests a significant discount. The U.S. 10-year yield is closer to 3% than 4%, and so even with a large equity risk premium of say 6-7%, with 2% terminal earnings growth you would anticipate a forward earnings multiple of over 12.5x at a minimum. If we were to drop the 10-year to 3%, and the equity risk premium to 6%, but still give no credit to faster-than-2% earnings growth, the multiple would rise to 14.29x. This is where VIOV's earnings multiple is currently positioned, essentially within a sub-par space of zero real earnings growth.
As a result, I would take a bullish stance on VIOV. All we would need to see is earnings meeting even a fraction of expectations for the fund to generate strong returns, and over a short-term time frame (<12 months). While buying into a potential recession might seem foolhardy, markets tend to lead the economy by 12 months and sometimes longer. Provided that any recession is not prolonged significantly beyond historical average durations of recessions (e.g., 8-12 months), VIOV is likely to creep higher, and eventually surge higher, on the back of high implied equity risk premiums (depending on your chosen earnings growth trajectory, including on the other side of any recession).
VIOV also has almost 500 stocks without a particularly high beta, and the sector exposures are mostly balanced across the board (including across the broader categories of cyclical, economically sensitive, and defensive sectors).
Morningstar.com
All in all, I would take a bullish multi-year view on VIOV and would be unsurprised for the fund to generate the so-called small-cap premium (i.e., out-performance relative to a balanced portfolio of U.S. large-cap stocks) over the longer haul from present prices.
For further details see:
VIOV: Small-Cap Value Stocks Are Cheap