Vanguard Small-Cap Growth ETF: Passively Invest With Peter Lynch’s Principles (NYSEARCA:VBK)

The Vanguard Small-Cap Growth ETF (VBK) is a Vanguard ETF that passively tracks the CRSP U.S. Small Cap Growth Index for a low expense ratio of 0.07%. The index constructs its holdings by first selecting stocks with market caps between roughly $1B and $12B which CRSP considers to be small cap. The median market cap of the index is $6B. Then, the small cap stocks are screened and assigned as a “growth” stock based on the following factors: future long-term growth in earnings per share (NYSEARCA:EPS), future short-term growth in EPS, 3-year historical growth in EPS, 3-year historical growth in sales per share, current investment-to-assets ratio, and return on assets.

Holdings

VBK is fairly well diversified across its ~600 holdings. No single stock is more than 1% of its total assets. VBK is more heavily weighted in growth sectors like technology and healthcare, which is unsurprising given its focus on EPS growth. However, it’s also exposed to some more traditionally defensive and stable industries such as industrials and real estate.

Source: SeekingAlpha

Performance

VBK, despite being somewhat correlated with the S&P 500, has outperformed the S&P 500 since the ETF was created. For myself, I own several ETFs in various sectors and market-caps and VBK has handily outperformed them all since 2016.

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This falls in line with research that shows that small cap stocks tend to outperform large cap stocks on average over the long run. This effect is typically explained by the increased risk the investor takes when investing in small cap growth stocks. An excellent video from Ben Felix summarizes the research on this quite well.

For VBK, investors should not expect safety from dividends as the average dividend yield of the ETF is far below that of an S&P 500 ETF such as SPY. This is because small cap growth stocks need to reinvest their earnings to grow their business instead of paying cash to shareholders.

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Additionally, investors in VBK will be exposed to more volatility as measured by 3Y Beta than investors in SPY.

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Promotes Peter’s Principles Passively

Peter Lynch famously ran Fidelity’s Magellan Fund and averaged nearly a 30% annual return in his 13 year tenure, crushing the broader market. He shared many of his stock picking principles in various books over the years including One Up On Wall Street. Some of his main principles include investing in small cap stocks which have more room to grow, stocks that have low coverage and low interest from institutions and the public, and focusing on sustainable earnings growth (10-25% annually).

VBK focuses on small cap stocks which can conceivably double or triple their market cap in a few years. Its much easier to double or triple from a $6B market cap in a few years than for a company that’s already mature such as the popular FAANG stocks. You want to invest in companies like Netflix (NFLX) when it was a small cap stock and its market cap was around $6B as late as 2013 instead of over $200B now in 2020.

VBK also invests with a set formula rather than on momentum or hype which leads to holding lesser known tickers. Just looking at the top ten holdings, Etsy (ETSY) is probably the only company a layperson would recognize. Lynch believes that investing in “boring” stocks and industries gives an investor a better chance to find undervalued growth options and helps avoid buying overvalued momentum stocks at the top. Investors investing in VBK would be avoiding the momentum investing currently happening with popular large cap tech tickers and recent IPOs such as Tesla (TSLA), Palantir (PLTR) and Snowflake (SNOW) with very high valuations.

Some may argue that VBK’s heavier weight towards “hot” industries such as technology and healthcare would contradict Lynch’s principles. I’d argue that technology and healthcare may have seemed like the “hot” industries back when Lynch wrote his books but in today’s time, technology and healthcare have matured significantly and is ubiquitous, making it similar to oil and retail back in Lynch’s prime in the 80’s and 90’s. This means companies within those sectors are very diverse from a popularity perspective. There are certainly “boring” companies within those sectors that don’t necessary have the same cult following as some of the hotter tech and healthcare stocks. A passive ETF like VBK will include those “boring” options.

Finally, VBK’s holdings have an average 5-year earnings growth rate of 18% which is well within Lynch’s target for sustainable growth.

Passive?

In all likelihood, Lynch would not support investing in a passive option as he often encourages his readers to perform their own rigorous on-the-ground research into their favorite companies. He believes that any regular investor can also outperform the market like he did if they put in enough work.

However, active investing is not for everyone, especially for investors who do not have the time and energy to dedicate to research as Lynch did. Even if they did, stock picking a non-diversified portfolio comes with significant risk as just a few bad earnings reports can wipe out the investor.

Additionally, picking the right stocks is very difficult as over a very long period of time, just a small percentage of stocks account for total market gains. If investors instead invest in a broader index, they are more likely to include the big winners. This is why index investors often outperform active investors because active investors are unable to pick the few big winners.

Conclusion

I believe VBK is a great compromise of passive index investing and Lynch’s principles. VBK is best for investors with a marginally higher risk appetite looking to beat the general market. I am continuing to hold and add to my position in VBK.

If you enjoyed reading this article, please consider reading my other articles on passive Vanguard ETFs, Total Bond Market (BND) and Health Care (VHT).

Disclosure: I am/we are long VBK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am not a financial advisor. All recommendations here are purely my own opinion and is intended for a general audience. Please perform your own due diligence and research for your specific financial circumstances before making an investment decision.

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