The Biggest Bubble You've Never Heard Of

OK, Fools, which of these companies would you rather own?

Company A:
Trailing P/E: 19.6 times
Price-to-Book: 1.4 times
5-Year Earnings Growth Rate: -1.6% (yep, that's a negative)
Return on Equity: 7.6%

Company B:
Trailing P/E: 15.7 times
Price-to-Book: 3.1 times
5-Year Earnings Growth Rate: 6.6%
Return on Equity: 23.6%

Pretty easy call, if you ask me. If you knew nothing else, you'd pick company B because it is both cheaper and better quality. 

The only way to justify company A would be if it were less risky and had significantly better future prospects. 

But this is manifestly false.

Company A is Vanguard Small-Cap Value  (NYSE: VBR  ) (my newest bearish CAPScall), an ETF that tracks the performance of U.S. small-cap "value" stocks.

For the uninitiated, I believe small-cap "value" stocks are some of the nation's riskiest, dirtiest, most volatile stocks. They are to equity what junk bonds are to bonds. They trade at low price/book ratios and low market caps because they're -- on average -- the asset-intensive troubled "losers" of the market.

(These kinds of small-cap "value" stocks, by the way, often differ from what you see on Motley Fool Hidden Gems or Inside Value, two services that look for great companies the market has misjudged.) 

In other words, they're some of the nation's worst publicly traded companies. Because of this, these stocks are supposed to trade at a discount and offer higher returns to investors as compensation for the added risk.

And historically, they have. Small-cap "value" has beaten the stocks out of the S&P 500 over the long term. And they've done extraordinarily well over the past decade.

But this is not always the case. Small-cap "value" can go through long, long periods of underperformance, like they did during the 1990s

So when the nation's worst companies are trading at 19 times earnings -- and an all-time high with dividends reinvested -- I'd get worried about owning them.

But it gets even worse when you realize what you're giving up by owning them... 

Company B is Vanguard Dividend Appreciation  (NYSE: VIG  ) , an ETF that tracks the performance of stocks that have raised their dividend for 10 consecutive years -- in other words, some of the nation's best companies. Top holdings include IBM (NYSE: IBM  ) , Wal-Mart (NYSE: WMT  ) , and Coca-Cola (NYSE: KO  ) , all of which have increased earnings faster than small-cap "value" and are of far better quality.

And yet the nation's worst businesses are trading at a premium to them. Unbelievable. 

"Leverage will save us!"
If a Wall Street analyst were reading this, he or she would make the argument that small-cap "value" stocks currently have "cyclically depressed earnings." After all, we just went through the Great Recession. These kinds of companies have considerable operating and financial leverage, so once the economy improves, their earnings should "explode."

My response is that we should be seeing more of the fruits already. The economy and stock market have been recovering since 2009. And yet return on equity -- not assets! -- for these companies languishes at 7.6%. With all of that leverage, ROE should be better by now. 

And once the economy really improves, interest rates will likely go up, making it harder for these capital-intensive companies to refinance profitability. Couple that with the fact they lack pricing power to raise prices with inflation, and I'm not so sure their earnings will "explode."

The bottom line is, if you're betting on small-cap "value," you're speculating on future growth with trashy companies. That doesn't sound like value investing to me. 

Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by @askchrisbainesChris' stock picks and pans have outperformed 94% of players on CAPS. He owns shares of Vanguard Dividend Appreciation and (regrettably still) owns shares of Vanguard Small Cap Value. 

Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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  • Report this Comment On March 21, 2012, at 12:27 PM, DavidMerkel wrote:

    Growth and ROE both tend to mean revert. These are not static pools of stocks, but constantly change as the mean-reversion happens, and the value stocks appreciate, while the growth stocks suffer disappointments.

    Also, maybe you'd like to review the '60s & '70s where dividend stocks often disappointed. Just because a stock pays a dividend does not mean it can maintain it. Reduction or elimination of a dividend can have horrendous effects on the stock price.

    One more: yield-based investors got crushed in relative terms in the '90s. I got to know some of the leading players during that period, and all of their methods went afoul as the decade progressed -- don't get me wrong, dividends can be a sign that something good is happening, but they are far from an infallible guide to investing.

    I would take portfolio A. Book value is a better predictor of value than dividends.

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