The Vanguard US Small Cap ETF (NYSEARCA:VB) has performed well since the beginning of the year, driven by a strong rebound in small-cap growth stocks. VB seems to have broken out upwards, At the moment, the path with the least resistance is higher. However, from a long-term perspective, real return prospects are low, with startups likely to earn only marginally above zero in real terms over the next 10 years.
VB tracks the CRSP US Small Cap Index. Market Cap Weighted Indexes include the bottom 2-15% of the investable universe. No single stock in the index has more than 0.39% weight, and the industry split is skewed toward industrial stocks with a weight of 21%, followed by financial stocks at 15% and consumer goods at 14%.The fund boasts a market capitalization of US$46 billion as assets have surged recently iShares Russell 2000 ETF (IWM). Vanguard’s website shows a tracking PE ratio of just 12.3x, which excludes loss-making firms. Including them increases this number by a factor of 21.6. The ETF has a dividend yield of 1.4% and a fee of just 0.05%. VB has consistently outperformed his IWM over the last few years and this is due to the focus on the quality of the underlying index.
Breakout due to growth recovery
In my article on IWM earlier this month, I noted that the index looked poised for a bullish breakout. For VB, this breakout is already achieved. The bearishness following the release of the CPI threatened to revive the downtrend, but the strength of the last few days seems to have confirmed the break of resistance in the downtrend line, the path of least resistance so far is upward.
After leading the decline over the past few years, it is the growth segment of the market that has driven the recovery of VBs. The Vanguard Small Cap Growth ETF (VBK) also looks to be on the upside.
Valuations aren’t cheap
VB’s near-term technical situation suggests further near-term gains, but the ETF is unlikely to generate strong long-term returns. In fact, after the recent rally, the index estimates that real returns over the next decade will be priced near zero.
The CRSP US Small Cap Index is still trading at a PE ratio of 21.6x, although valuations have eased from its high peak in 2021 due to lower prices and higher earnings. Analysts say he expects earnings growth of 22% in 2023, so this is a drop of 17.7x on a futures basis, but in this economy this is very optimistic, Analyst said. List has a track record of overestimating futures profits.
If the analysts are correct, the average return on the CRSP US Small Cap Index would rise from its long-term average of 4.5% to 7.0%. Even if record profit margins persist indefinitely, future earnings growth will be constrained by sales growth that has averaged just under 4% in real terms over the past decade. . A dividend yield of 1.6% means that forward-looking real sales growth would yield an expected annual return of about 4.5%, assuming no change in valuation or payout ratio. .
However, real sales growth is expected to slow in line with the US economy. Over the past decade, he has averaged over 2% growth, but slowing growth in the working-age population and continuing the long-term downward trend in productivity will see him fall below 1% over the next decade. There is a possibility. A 1% slowdown in future sales growth would reduce the VB’s real profitability to about 3.5%.
The main risk is declining profit margins, which fluctuate widely with the economic cycle. A 2 percentage point drop in profit margins over the next 10 years would not be above the long-term average, but would reduce annual real returns by almost 3 percentage points annually to just above zero. Given that US 10-year inflation-linked bonds offer real returns of 1.2% p.a. and have very low volatility, the investment case for venture capitalists is weak.
VB appears to be breaking upwards, led by a recovery in growth segments that are showing signs of new life from a significant weakening in 2022. Valuations remain well below his 2021 peak levels, but PE ratios remain high, even for companies. Record profit margins. Real sales growth will slow over the next few years in line with real GDP growth, so future earnings could be lower than historically, even if margins remain at record levels. there is. In my view, average returns with gradually declining margins are likely to underperform much higher volatility government bonds with real returns slightly above zero over the next decade.