Summary
- VOT invests in U.S. mid-cap growth stocks.
- VOT has the potential to deliver long-term capital gains, but its valuation is still not attractive enough relative to its value peer.
- Given economic uncertainties in 2023, investors may want to wait on the sidelines.
ETF Overview
Vanguard Mid Cap Growth ETF ( VOT ) owns a portfolio of U.S. mid-cap growth stocks. The fund has delivered a total return over 300% since its inception in mid-2006. However, it has underperformed its value peer in this bear market thus far. Given macroeconomic uncertainties in 2023, we think investors may want to wait for a better entry point.
YCharts
Fund Analysis
Last year was a brutal year for VOT
Like many other ETFs that owns growth stocks, VOT had an abysmal year in 2022. The fund delivered a total loss of 28.86% last year. This was much worse than the S&P 500's negative 18.11%. The result was not surprising as sky-rocketed inflation we have not seen in a few decades forced the Federal Reserve to raise rates aggressively. Equities such as growth stocks that already have high valuations experienced severe multiple compressions. VOT's portfolio of growth stocks also got hit hard in the rate rise cycle last year.
VOT underperformed its mid-cap peer
VOT also underperformed its peers Vanguard Mid-Cap Value ETF ( VOE ) and the blended ETF Vanguard Mid Cap ETF ( VO ) in this bear market. Since reaching the peak in mid to late 2021, VOT has suffered a total loss of 24.77%. On the other hand, VOE and VO delivered negative returns of 4.23% and 13.9%, respectively.
YCharts
Is VOT's valuation attractive?
In a bear market, VOT has historically performed pretty much in line with VOE or VO. As can be seen from the chart below, during the Great Recession in 2008/2009, all three funds have experienced similar magnitude of declines. The same was also true during the beginning of the outbreak of pandemic in 2020.
YCharts
Given that VOT and VOE has historically seen similar declines in the past bear markets, one may wonder with a 24.77% decline since reaching the peak in late-2021 versus VOE's 5.97% decline, is VOT's valuation now much more reasonable or even attractive? The quick answer we have is that the valuation is more reasonable but still not attractive enough. Here, we will explain why.
As the chart below shows, mid-cap growth stocks have historically always traded at a premium valuation to mid-cap value stocks. The average premium was around 40% in the past 20 years. However, the Federal Reserve's quantitative easing policy during the pandemic has pushed this premium to a record high. During the pandemic, mid-cap growth stocks premium to value stocks was twice over 90%. Although last year's sharp decline of mid-cap growth stocks relative to value stocks has pushed this premium down, it may still not be enough to reach the average premium of 40% or below. Despite the fact that the chart below shows only data till the end of Q1 2022, we can still have an estimate of the projection given that VOT only dropped about 11% since Q1 2022 till now. Therefore, it is unlikely to see the premium going from about 65% in the end of Q1 2022 to 40% or below. Therefore, we think the valuation of growth stock is only reasonable and not attractive enough.
Should you invest in VOT now?
Given macroeconomic uncertainties and that the Federal Reserve still has a long path to bring inflation down to 3% and below, Fed fund rate will likely stay elevated for a lengthy period. We will likely continue to see rate hikes several times this year although at a slower pace than last year. This will continue to suppress VOT's valuation. In addition, a possible economic recession will also send stock prices lower as earnings got revised downward. Therefore, we may see mid-cap growth stocks' premium valuation to value stocks get compressed even further. Our base case is that there will be a mild recession at some point in 2023. Since stock market usually bottom not before the recession, but in the middle of an economic recession, we do not think this is the right time to invest in VOT now as we are not even in a recession yet.
Investor Takeaway
VOT has a portfolio of mid-cap growth stocks. Based on our analysis, we see that its valuation is likely fair but not attractive enough. Given that an economic recession is likely in the horizon, we do not think this is the best time to invest in VOT. Investors should exercise patience and wait on the sidelines.
For further details see:
VOT: Valuation Fair, But Still Not Attractive Enough