If you were to ask investors what's been leading the broader market higher over the last couple of years, you'd probably get a variety of answers, including growth stocks and companies that are monetizing artificial intelligence (AI).
While those themes have certainly contributed to the rally, the more complete answer is large-cap stocks.
Even amid last week's growth stock sell-off, there were plenty of pockets of the market that performed well. And it may surprise you to learn that sectors like industrials and energy, led by income and value stocks, are hovering around all-time highs.
Companies that generate positive cash flow and don't rely on debt have generally been more protected from high interest rates and inflation than smaller companies. So it makes sense that small-cap stocks have been underperforming the S&P 500 by a wide margin recently. The S&P 500 is up over 19% during that period, while the Russell 2000 (INDEXRUSSELL: RUT) is down over 12%.
Here's why the Vanguard Small-Cap ETF(NYSEMKT: VB) and its 1,413 holdings are the perfect way to play a rebound in small-cap stocks.
Image source: Getty Images.
Small but mighty
What immediately stands out about the Vanguard Small-Cap ETF is the sheer number of holdings and the fund's mere 0.05% expense ratio -- or a $5 annual fee for every $10,000 invested. Today's low-cost exchange-traded funds (ETFs) have made it inexpensive for investors to achieve diversification and exposure to something new.
The median market cap of the ETF is just $7.3 billion, which is far lower than, say, the Vanguard S&P 500 ETF (NYSEMKT: VOO), which has a median market cap of $224.7 billion.
The 10 largest holdings in the Vanguard Small-Cap ETF make up less than 4% of the fund, so it's not nearly as top-heavy as the S&P 500 or the Nasdaq Composite, where big tech stocks carry much of the weight.
In this vein, one of the biggest advantages of the Vanguard Small-Cap ETF is that it provides exposure to many different companies that would be almost impossible to replicate without the help of an ETF.
Sector breakdown
Some of the ETF's top holdings include companies you may have heard of, like AI software company MicroStrategy, DraftKings, and Williams-Sonoma. But the bulk of the fund is in value-orientated parts of the market. Interestingly enough, industrials are by far the largest sector in the ETF. If you browse through the fund's holding, it's easy to see why.
Sector | Weight |
|---|---|
Industrials | 22.5% |
Consumer Discretionary | 16.4% |
Financials | 13.5% |
Technology | 12.9% |
Health Care | 10.6% |
Real Estate | 6.9% |
Energy | 5.6% |
Basic Materials | 4.1% |
Utilities | 3.2% |
Consumer Staples | 3.1% |
Telecommunications | 1.2% |
Data source: Vanguard.
A good example of a stock you'll find in the ETF is Watsco, which distributes air conditioning, heating, and refrigeration equipment, among other products. Another example would be Booz Allen Hamilton, a consulting firm. There's also Casey's General Stores, which are mainly concentrated in the Midwest U.S. Another holding is homebuilder Toll Brothers.
These are relatively small companies that are leaders in niche parts of different sectors. Watsco is a far smaller company than industrial behemoths like United Parcel Service or Caterpillar. But it plays a big role in its specific market. Casey's General Stores is far smaller than Walmart or Costco Wholesale, so it wouldn't normally show up on the radar of an investor looking to invest in big retail. In this vein, small caps are just small relative to the rest of the market, but they are still multi-billion dollar established businesses.
There tends to be a lot of these types of companies in the industrial sector, which is why the Vanguard Small Cap ETF is a great fit for investors that like the value and income that the sector has to offer, while also getting exposure to the cyclicalitiy and potential gain of the broader economy.
Poised for a turnaround
One of the simplest reasons why small-cap stocks are good buys now is because many of them are inexpensive. The average price-to-earnings (P/E) ratio of a holding in the Vanguard Small Cap ETF is just 18.2, and the average price-to-book (P/B) ratio is 2.4. By comparison, the average P/E ratio of a holding in the Vanguard S&P 500 ETF is 26.1, and the average P/B is 4.5.
Small-cap stocks arguably deserve to trade at a discount to the S&P 500 because they lack the advantages of larger companies. Still, a 30% difference between the P/E ratio of the Vanguard Small Cap ETF and the Vanguard S&P 500 ETF is sizable.
If the market continues to sell off, investors could gravitate toward quality companies that are better values, like small caps, which have been largely left out of the broader market rally.
A role in a diversified portfolio
One of the reasons why an ETF could be a better fit than an individual stock is that it can serve a specific purpose in a portfolio. For example, an investor looking for more exposure to AI may choose an AI-focused ETF. Or an investor looking for large, safe, dividend-paying value stocks may go with the Vanguard Value ETF.
The Vanguard Small Cap ETF is a good fit if you're looking for hidden gem companies but don't know where to start. Or if you're looking for beaten-down value stocks. Either way, the Vanguard Small Cap ETF makes opening starter positions in 1,413 small-cap stocks easy and inexpensive.
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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Costco Wholesale, Vanguard Index Funds-Vanguard Small-Cap ETF, Vanguard Index Funds-Vanguard Value ETF, Vanguard S&P 500 ETF, Walmart, Watsco, and Williams-Sonoma. The Motley Fool recommends Booz Allen Hamilton, Casey's General Stores, and United Parcel Service. The Motley Fool has a disclosure policy.
