Avoid This Ticker ... for Now

Over long periods of time -- eight decades -- the best place you could have put your money has been in small-cap value stocks.

You have to like those odds
From 1927 to 2005, small-cap value shredded the returns of small-cap growth, large caps of both value and growth persuasions, as well as the total stock market. Given the substantial margin of victory and the exhaustive length of the study (80 years!), you must seriously consider small-cap value stocks for part of your portfolio.

That was my tune a year and a half ago, when I named the Vanguard Small Cap Value (VBR) exchange-traded fund the "best ETF for 2007."

To go along with a massive historical sample of dominating other asset classes, Vanguard Small Cap Value had a few other things going for it. Specifically, it is very cheap. You can buy shares for the cost of a stock commission ($10 or so) and an expense ratio of 0.11% -- a full 14 basis points cheaper than a notable competitor.

This just makes too much sense
Not surprisingly, most investors have their savings tied up in large-cap stocks. The nation's largest mutual funds (by total assets) will illustrate just how heavy this exposure is:

Fund

Total Assets

Average Market Cap in Portfolio

Largest Holdings

American Funds Growth Fund of America (AGTHX)

$182 billion

$47.7 billion

Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT), Oracle (NASDAQ:ORCL)

American Funds Capital Builder (CAIBX)

$106 billion

$44.9 billion

E.ON, AT&T (NYSE:T), Verizon

Vanguard 500 Index (VFINX)

$110 billion

$56.0 billion

ExxonMobil (NYSE:XOM), General Electric (NYSE:GE), Microsoft

Fidelity Contrafund (FCNTX)

$72 billion

$42.1 billion

Google, Berkshire Hathaway, ExxonMobil

Source: Morningstar.

Now, the Vanguard Small Cap Value offers broad but smart diversification. Check out its makeup:

Fund/ETF

Total Assets

Average Market Cap in Portfolio

Largest Holdings

Vanguard Small Cap Value (VBR)

$4.5 billion

$1.5 billion

Energen, URS, Service Corp.

Source: Morningstar.

The ETF holds nearly 1,000 small names, so while you get concentrated exposure to the small-cap segment of the market, it comes with muted volatility.

The older I get, the dumber I look
So what happened in 2007? VBR got smoked. It lost about 7% of its value; the large-cap-dominant S&P 500 gained about 6%. It's already dropped another 7% year to date, although that's less than the S&P has sunk.

What happened is a familiar story by now: Subprime mortgages blew up, credit markets dried up, and banks were pummeled. See, VBR's single-largest sector concentration is "financial services," which accounts for 30% of the fund. (For comparison, financial services account for just 17% of the Vanguard 500 Index.)

Anyone who has followed megacap banks like Citigroup (NYSE: C  ) knows that financials have been rocked in the past year. If a highly diversified multinational bank like Citigroup can shed half its value in a year, think about what would happen to small regional banks facing similar problems without similar resources.

That's one reason why my friend and colleague Tim Hanson went so far as to suggest that small-cap banks -- though they currently sport attractive multiples -- are stocks you don't want to buy today.

Where to from here?
Why? Because with all of the troubles in the credit market, and with a recession either under way or on its way, with small banks, it's all about the balance sheet. And while you may be able to trust the balance sheets of specific small banks you know cold, as a group, they're in for an uncertain near-term future.

That's why VBR is a ticker to avoid ... for now. Let me be clear, though: It's not a "sell," either. I still believe it's a winning ETF for patient long-term owners. But for new money, that much indiscriminate exposure to a collection of small banks may not be the smartest move.

Besides, I see too many individual small-cap value stocks trading at bargain prices. Our team at Motley Fool Hidden Gems, in fact, just reviewed more than 25 small-cap stocks and ranked each one by letter grade. You can see all those rankings and read about our favorite small-cap ideas for new money with a no-obligation 30-day free trial.

Brian Richards was surprised to learn that "subprime" was not in Merriam-Webster's Collegiate Dictionary but "misremember" was. Brian owns shares of Microsoft and the Vanguard 500 Index fund. The Motley Fool owns shares of Berkshire Hathaway. Berkshire and Microsoft are Inside Value recommendations. Berkshire is also a Stock Advisor selection. The Motley Fool has a disclosure policy, disclosed here.


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  • Report this Comment On April 04, 2008, at 12:50 PM, rhammer99 wrote:

    I agree. An important advantage in investing in small cap stocks (value or growth) is to avoid the price premiums invariably created where institutional investors are investing.

    The "big boys" aren't interested in small caps. Any significant investment by them just sends the price of any thinly traded stock soaring beyond economic reason. And multiple, smaller purchases are mainly too time and effort consuming for them to bother.

    Individual investors, on the other hand, stand to be well rewarded for their research and selection efforts. And in a thin market, after you've researched and selected the stock you want, a low-ball bid just might pay off.

  • Report this Comment On April 04, 2008, at 4:49 PM, PhillyGator wrote:

    The idea that small regional banks will get rocked makes sense.

    But, one component that is back in their favor is loan originations which is a windfall left in the wake of the CMBS companies. Commercial real estate owners, REITs among them need capital and are not offered the big $ from sales, they need to re-finance and interest rates are still "low". That said, interesting read and on point.

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