Small and mid caps have outperformed large caps over the past 90 years. However, these two categories have often lost momentum over shorter periods, especially during economic downturns. Their valuation is currently close to all-time lows of 2008 and 2020, and many value investors are now wondering if now is a good time to buy or not. Personally, I suspect these stocks aren’t as cheap on a cyclically-adjusted basis, and expect profit margins to shrink over the next two months as part of the business cycle. Additionally, the outlook for a US recession has increased significantly over the past two months, putting further pressure on the performance of small and mid caps going forward.
The Vanguard Extended Market Index Fund ETF (NYSEARCA:VXF) tracks the performance of the Standard & Poor’s Completion Index. This fund offers exposure to a broadly diversified basket of US small and medium-sized company stocks not included in the S&P 500 Index.
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Composition of the portfolio
From the sector allocation table below, we can see that the index places a high weighting on the information technology sector (representing approximately 21% of the index), followed by financials (representing 15 %) and industries (representing approximately 14%). The three main sectors have a combined allocation of around 50%. In terms of geographical allocation, this ETF (exchange-traded fund) invests exclusively in the United States.
~18% of the portfolio is invested in small capitalization value issuers, characterized as small companies where value characteristics such as low P/E and P/B ratios predominate. Small cap issuers are generally defined as companies with a market capitalization of less than $2 billion. Since around 90% of the portfolio is invested in small and mid cap stocks, you should expect higher volatility than if you hold a basket of large caps or blue chips. That said, small and mid caps have the potential to grow at a faster rate and have historically outperformed large caps.
The fund is currently invested in 3,686 different stocks. The top ten holdings make up ~7% of the portfolio, with no single holding weighing more than ~1%. VXF is very well diversified in my opinion and therefore has a low level of unsystematic risk.
Since these are stocks, an important characteristic is the valuation of the portfolio. According to data from Morningstar, VXF trades at a price-to-book ratio of approximately 2 and has a price-to-earnings (“P/E”) ratio of approximately 13.5. These multiples are lower than what you would pay to buy a regular S&P 500 ETF, which currently trades at around 18 times earnings and has a price-to-book ratio of around 3.4.
Forward PER multiples have fallen significantly over the past two months, as shown below. The market is now more concerned about quantitative easing and the risk of recession, which explains the sell-off. While I really think VXF offers more value now than it did a few months ago, profit margins are still at an all-time high. If you think inflation will eventually put pressure on margins, the forward PER is likely higher on a cyclically adjusted basis, meaning there could be more downside risk from the current level. from many small and mid cap companies.
Is this ETF right for me?
I compared the value for money of VXF to that iShares Russell 2000 ETF (IWM) over the past 5 years to assess which was a better investment. During this period, VXF outperformed IWM by a margin of around 8.6 percentage points. To put VXF’s results into perspective, an investment of $100 5 years ago in this ETF would now be worth around $141.38. This represents a compound annual growth rate of around 7.2%, excluding dividends, which is an average absolute return in my opinion.
If we step back and look at 10-year price returns, the results don’t change much. VXF came out on top again, outperforming IWM since Q1 2019.
Going forward, I think investors need to pay close attention to the state of the economy. Any negative economic data is likely to increase volatility and accentuate declines over the next two months. However, I believe this ETF can provide valuable exposure to small and mid cap stocks over the long term and can be used as a diversification tool to increase returns once the economy stabilizes.
Key points to remember
VXF offers exposure to a diversified basket of small and mid-sized US stocks that are not included in the S&P 500 Index. These stocks can be extremely volatile during economic downturns and may suffer significant declines. Given that the likelihood of a recession in the United States has increased, investors should be aware that volatility is unlikely to subside over the next 12 months. On top of that, I believe a buy on every dip mentality can prove costly in this market environment unless we see a real capitulation. Over the long term, I believe VXF can be used to gain exposure to small and mid cap stocks and enhance returns, especially if we have a booming economy.