Wall Street Is Ignoring This Part of the Market. That's Why I'm Interested.
Key Points
The Vanguard Small-Cap ETF (VB) trades at a P/E ratio of 21.6, well below the 27.4 multiple of the Vanguard S&P 500 ETF (VOO).
In 2027, year-over-year earnings growth for small caps is forecast to accelerate to 18.3%, compared to 17.3% for large caps.
Small caps look like a buy, with earnings growing faster and stocks trading at lower prices.
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Everyone on Wall Street is watching Nvidia, Apple, and the artificial intelligence (AI) trade. It's understandable, given that the "Magnificent Seven" stocks have generated huge returns over the past three years.
The part that few people are paying attention to right now, though, is the other end of the market cap spectrum. Small caps and the Vanguard Small-Cap ETF (NYSEMKT: VB) have become legitimately attractive investment options right now. This fund is up 25.5% over the past year, beating the 22.7% return of the Vanguard S&P 500 ETF over the same period, even as large-cap tech is roaring.
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The improving earnings outlook for this segment, along with comparatively attractive valuations, makes this a strong buy candidate over the next several months.
Image source: Getty Images.
How the Vanguard Small-Cap ETF is constructed
This fund tracks the CRSP U.S. Small Cap Index, which covers roughly the 85th to 98th percentile of U.S. market cap.
That methodology accomplishes two things: It has a median market cap of over $10 billion, well above the $4 billion median market caps of the Vanguard Russell 2000 ETF and the Vanguard S&P Small Cap 600 ETF. That gives this fund much more of a large-cap tilt.
The S&P 600 index also uses a profitability screen for inclusion, whereas the Vanguard Small-Cap ETF methodology does not. If you feel small caps are going to rally, I personally would not want the quality criteria in place. Unprofitable companies are generally more growth-oriented and have greater upside potential in a bull-market rally.
VB: Performance and key metrics
| Metric | Vanguard Small-Cap ETF (VB) |
|---|---|
| Expense ratio | 0.03% |
| Assets under management | $77.2 billion |
| One-year return | 26% |
| Three-year return (annualized) | 15.7% |
| Five-year return (annualized) | 6.4% |
| Number of holdings | 1,309 |
| Top sectors | Industrials (23%), tech (14%), financials (13%), consumer discretionary (13%) |
Data source: Vanguard.
Why small caps are a buy now
The potential of small caps is keyed on earnings and valuations. Small-company stocks are seeing earnings growth rates accelerate. That trend is likely to continue. In 2027, the group is forecast to grow earnings by 18.3%, compared with a 17.3% growth rate for large caps.
On top of that, the Vanguard Small-Cap ETF trades at a price/earnings (P/E) multiple of 21.6. That's a discount of more than 20% compared to the 27.4 multiple for the Vanguard S&P 500 ETF.
Whenever you can get a high double-digit earnings growth rate that's higher than that of the S&P 500 and trades for roughly 20% cheaper, you have to pay attention.
Small-caps haven't necessarily been an investor's best friend over the past several years. But if you look at the underlying fundamentals, that reputation is about to change.
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David Dierking has positions in Apple. The Motley Fool has positions in and recommends Apple, Nvidia, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
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