Investor Education: Dilution
Dilution refers to the decrease in ownership that an individual or entity holds in a company when additional shares are issued to the market by a company.
Read our overview of Dilution!
Small Stocks Big Value
“I have a friend who says, ‘The first rule of fishing is to fish where the fish are. And the second rule of fishing is to never forget the first rule.’ And we’ve gotten good at fishing where the fish are.” —Charlie Munger
Stock markets were mixed last week. The S&P 500 continued its upward climb as it rose 0.69%. The Dow was the big winner, with a rise of more than 2%. And the Nasdaq was down on the week, falling 0.57%.
While the main indices continue to trade at high valuations—and the S&P 500 is now just 5.43% below the all-time high it reached on January 3, 2022—there are pockets of the market that seem to be trading at good absolute value. In a recent interview, author, historian, and neurologist turned investment advisor William Bernstein discussed where he sees value today:
Small, value stocks around the world are cheap. They’re selling single-digit PEs abroad, both in emerging markets as well as in developed markets.
U.S. small-value stocks are selling at, not quite single-digit PEs, but close.
To give a quick sample of value outside of the big technology companies, and small-cap value’s relative attractiveness versus the S&P 500, here are a few ETFs in comparison to the S&P 500 (SPY) as of June 30, 2023:
SPY: SPDR S&P 500 ETF
P/E Ratio: 22.83
P/S Ratio: 2.55
RPV: Invesco S&P 500 Pure Value ETF
P/E Ratio: 9.67
P/S Ratio: 0.47
VBR: Vanguard Small-Cap Value Index Fund ETF
P/E Ratio: 10.69
P/S Ratio: 0.88
VTWV: Vanguard Russell 2000 Value Index Fund ETF
P/E Ratio: 8.49
P/S Ratio: 0.82
A case can certainly be made that the S&P 500 deserves a higher multiple. But, if that’s so, how much higher? And what happens if profit margins don’t stay abnormally high?
Given its current valuation, many people expect the S&P 500 to return little or nothing—or maybe even less-than-nothing—during the next 5-10 years. For people retiring that have significant exposure to the highly-valued indices, earning nothing for a decade can ruin many retirement plans. And at current prices, a good return from here in the most widely-owned index requires sustaining a historically high valuation:
But with interest rates on fixed income being reasonable these days, especially at the shorter end of the Treasury market, and reasonable-to-cheap valuations in value stocks, there is hope. As Bernstein continued:
I am reasonably optimistic, as optimistic as I’ve actually been in 15 or 20 years, about securities returns and about people’s ability to spend. What we told people until relatively recently was: If you’re a typical 65-year-old retiree, a 2% burn rate is bulletproof, 3% is probably safe, 4%, you’re probably taking some risk, and at a 5% burn rate, you’re taking a real risk. And I think that, given the increase in real bond rates and the general decrease in valuations almost everywhere in the world except in the U.S.—and especially with U.S. large-cap stocks—I think that expected returns have increased to the point that you can increase those burn rates by about a percent.
And that may not sound like very much. But going from 2% to 3% gives you 50% more spending power each and every year. So, I’m reasonably optimistic about future security returns, both for people who are going to be putting money away, and people who are going to be spending as well—assuming they didn’t get too badly clobbered in 2022.
For those that look at individual stocks, the value world seems like, once again, a significantly better area to fish—especially the small and micro-cap value world. For those that diversify more widely and have significant equity exposure, especially if nearing retirement, it may be a good time to check your asset allocation and make sure all of your exposure isn’t in the more richly-valued areas of the market.
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