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Small Value's Best Bargain

This ETF offers the cheapest way to take advantage of the small-value premium. 

Alex Bryan, 04/12/2013

Small-cap value historically has been the best-performing segment of the United States equity market, and Vanguard Small Cap Value ETF VBR offers investors a low-cost way to take advantage of this value premium. It invests in the cheaper and potentially higher-returning half of the U.S. small-cap market. However, VBR is not for the faint of heart. Most small-cap stocks lack sustainable competitive advantages and are typically more volatile than the broad market. Within this segment, value stocks tend to carry slightly greater risk than their growth counterparts. Consequently, VBR is a suitable small core holding for long-term investors with a relatively high tolerance for risk.

Value stocks tend to carry relatively high business risk, poor prospects for growth, and may remain out of favor for years. Yet, investors tend to penalize these companies too much by extrapolating recent performance too far into the future. This myopic focus can push prices below their fair values. Consequently, value stocks have generated better risk-adjusted returns than the market over the long run. Their depressed valuations can provide a margin of safety and offer attractive upside if they exceed expectations, which are low to begin with.

Because Vanguard Small Cap Value ETF covers approximately half of the small-cap market, small-blend stocks dilute its value tilt. However, this fund has less overlap with its growth counterpart, Vanguard Small Cap Growth ETF VBK, than rival value and growth funds based on the Russell 2000 and S&P SmallCap 600 indexes. Even still, VBR and VBK were 0.96 correlated over the past five years. VBR's correlation with the broad Vanguard Small Cap ETF VB over that same span was even higher (0.99). Therefore, VBR does not offer significant diversification benefits to investors who already have broad exposure to U.S. small-cap stocks. It does, however, provide better diversification for investors who already have heavy exposure to large-cap stocks or funds.

Vanguard announced that it is switching Vanguard Small Cap Value ETF's index from the MSCI US Small Cap Value to the CRSP US Small Cap Value, citing potential cost savings. However, the fund will continue to offer very similar exposure. In order to prevent arbitragers from taking advantage of this switch, Vanguard has not released the date when this change will go into effect.

Fundamental View
In the U.S., small-cap value stocks (low price/book) have outpaced their growth counterparts by a whopping 6% annualized from 1927 through 2012. While it would be unreasonable to expect small value to outpace small growth by that wide of a margin going forward, there is reason to believe the value premium will persist. Many efficient market advocates attribute value's superior performance to additional risk. This risk story is plausible. Relative to their growth counterparts, value stocks tend to have lower profit margins, dimmer growth prospects, and higher debt burdens. Additionally, these stocks tend to slightly underperform during market downturns (the post-tech bubble correction is a notable exception). However, value stocks still offer better risk-adjusted returns. There is a growing pool of evidence that suggests investors tend to extrapolate past growth too far into the future and discount the impact of competition. This creates systematic mispricing that may partially explain the value premium. Although small-blend stocks dilute the fund's exposure to the value premium, its style tilt should modestly boost returns over the long run.

Some researchers and practitioners argue that small-cap stocks offer a smaller yet distinct premium from value. While small-cap stocks have historically outperformed their large-cap counterparts, this effect is largely isolated to value stocks. In fact, small-cap growth stocks historically have underperformed their large-cap counterparts. Therefore, the value effect largely subsumes the small-cap premium. Small-cap value companies are frequent buyout and acquisition targets. The premiums from these deals can help boost returns and may contribute to small-cap value stocks' superior long-term performance.      

In the near term, the U.S. economic recovery should continue to benefit the fund's holdings, particularly if acquisition activity picks up. The U.S. economy has been surprisingly resilient over the past few years. Households and companies have reduced their leverage in recent years, consumer spending is reasonably healthy, inflation is low, manufacturing activity and oil production have picked up, and the unemployment rate has continued its gradual decline. Renewed strength in the housing market could continue to drive the recovery forward and further bolster consumer spending.

While valuations have run up a bit during the past few months, small-cap value stocks still look reasonably priced. As of the end of March, the MSCI US Small Cap Value Index was trading at 15.1 times trailing earnings, which, while not a bargain, looks cheap compared with the MSCI US Small Cap Growth Index (trading at 21.5 times earnings). Value stocks warrant a greater margin of safety than their growth counterparts because they tend to carry greater business risk. However, this large valuation gap should give small-cap value stocks an edge over the long run.  

Alex Bryan is an ETF analyst with Morningstar.

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