Vanguard Small-Cap Value: A Year To Bet On Mean Reversion (NYSEARCA:VBR)

About six months ago, I explored why small-cap value stocks had been underperforming the broad market not only during the COVID-19 crisis but also for the past many years. Since then, the Vanguard Small-Cap Value ETF (VBR) climbed about 15%, about five percentage points short of the S&P 500 (SPY).

Back in April, I was reticent about small-cap value, choosing not to make too bullish a statement about this group of stocks in the earlier innings of a global pandemic and recession. But today, I am feeling more confident about a revival in this corner of the market.

History, at least, seems to support my optimism.

Credit: Investor Place

A quick word on VBR

First, let me recap what the Vanguard Small-Cap Value ETF is. The fund tracks a benchmark of nearly 900 stocks with average market cap of about $3.9 billion that pass the “value” criteria: high book to price, forward earnings to price, historic earnings to price, dividend-to-price ratio, and sales-to-price ratios.

Currently, VBR holds nearly one-third of its assets in the financials and almost one-fourth in the industrials sectors (see pie chart below). Among the top ten holdings, Peloton (PTON) at 80 bps and Booz Allen Hamilton (BAH) at 60 bps of the total portfolio are perhaps the two best-known stocks.

The highly-diversified, $28.5 billion ETF charges a small management fee of 0.07% per year and is very liquid, trading nearly $50 million worth of shares per day in the market.

Source: DM Martins Research, data from Vanguard

What history says

Generally speaking, both the value and small-cap factors tend to perform better during periods of economic recovery and stability. This is probably true because smaller, procyclical companies valued more cheaply (think of specialty consumer banks, regional airlines or small manufacturers) benefit the most from the systematic boost of a thriving economy.

The graph below helps to illustrate the idea. For the past 50 years or so, large-cap growth (portfolio 2, in red) did best relative to small-cap value (portfolio 1, in blue) during or just ahead of some of the less favorable economic environments: the oil crisis of the early-to-mid 1970s and the COVID-19 pandemic – it also held up better in the Great Recession of 2008-2009, but this is a bit harder to see in the chart. The opposite was true during the “roaring” 1980s-1990s and after the dot-com bubble.

Source: graph by Portfolio Visualizer

One “gut feel” thesis might be that, following the worst year in the economy since 2008 (or possibly much longer), small-cap value should finally find its way north once again as the economy eventually recovers. Of course, the idea of imminent strength in small-cap value has been tossed around for the past few years, but the theory has stubbornly failed to play out as expected.

Yet, once I look at the historical data, I can’t help but think that a reversion to the mean favoring small-cap value is very likely to happen this time. To be clear, benefiting from this possible market move requires patience and a fairly long time horizon of at least three (lower conviction), ideally five years (higher conviction).

The following scatter plot depicts the relationship between prior and forward five-year returns, in annualized terms, of a portfolio that is long small-cap value and short large-cap growth since the 1970s (rebalanced annually).

Source: DM Martins Research, data from Portfolio Visualizer

My observations and interpretation of the historical relationship are as follows:

  • being long small-cap value for a multi-year period has generally paid off (proportionally more dots above the zero mark on the x-axis), likely a result of this group of stocks being perceived as riskier and demanding higher returns.
  • five-year momentum in small-cap value has not necessarily reverted back to the mean in favor of large-cap growth (notice the balance between the upper right quadrant and the lower right quadrant). This is probably the case because cycles of economic expansion that favor small-cap value can last a decade or longer.
  • however, momentum in large-cap growth has almost always reverted back to the mean in favor of small-cap value (see upper left quadrant) – certainly the case when such momentum exceeded a mere few percentage points per year.
  • as of September 2020, outperformance of large-cap growth reached levels rarely seen before (see the red star above). The only other year in the past 50 that this group of stocks was this far ahead of small-cap value was in 1999. We all know what happened in the following several months.

Last few words

Predicting the future is pretty much impossible. But drawing conclusions based on observation of long-term historical market behavior can help investors to set expectations for what comes next. From this perspective, I find it highly likely that small-cap value, represented by an ETF like VBR, will perform better than large-cap growth over the next five years.

Sure, “this time can be different”. Maybe the dynamic between small-cap value and large-cap growth will change forever in favor of the latter, and cycles of outperformance between the two groups of stocks will cease to exist. But I am not ready to make such a bold bet. While “all or nothing” is rarely a good investment strategy, I would consider allocating part of a stock portfolio to small-cap value today.

Think differently, reap the rewards

“Thinking outside the box” is what I try to do everyday alongside my Storm-Resistant Growth (or SRG) premium community on Seeking Alpha. Since 2017, I have been working diligently to generate market-like returns with lower risk through multi-asset class diversification. To become a member of this community and further explore the investment opportunities, click here to take advantage of the 14-day free trial today.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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