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. Some of 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)

$197 billion

$42.3 billion

Oracle, Target (NYSE: TGT  ) , Yahoo! (Nasdaq: YHOO  )

American Funds Capital Builder (CAIBX)

$112 billion

$38.2 billion

E.ON, AT&T, Bank of America (NYSE: BAC  )

Vanguard 500 Index (VFINX)

$117 billion

$49.5 billion

ExxonMobil, ConocoPhillips (NYSE: COP  ) , Merck (NYSE: MRK  )

Fidelity Contrafund (FCNTX)

$78 billion

$45.5 billion

Google, Research In Motion (Nasdaq: RIMM  ) , 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)

$5.0 billion

$1.4 billion

Reliance Steel, FMC, Ryder System

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 5%. It's down about 5% so far this year, although that's better than the S&P has fared.

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 32% of the fund. (For comparison, financial services account for just 17% of the Vanguard 500 Index.)

Anyone who has followed mega-cap banks like Wells Fargo (NYSE: WFC  ) knows that financials have been rocked in the past year. If a highly diversified bank like Wells Fargo can lose more than 12% of its value last year, and then another 14% year to date, 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, small banks live or die by their balance sheets. 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 ranked their five favorite small-cap stocks. You can see those rankings and read about our favorite small-cap ideas for new money with a no-obligation 30-day free trial.

This article was first published April 4, 2008. It has been updated.

Brian Richards was surprised to learn that "subprime" was not in Merriam-Webster's Collegiate Dictionary, but "misremember" was. Brian owns shares of the Vanguard 500 Index fund. Bank of America is a Motley Fool Income Investor selection. Google is a Rule Breakers pick. The Motley Fool has a disclosure policy, disclosed here.


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