Small Cap: The Original Alternative Asset Class
article 02-14-2023

Small Cap: The Original Alternative Asset Class

Co-CIO Francis Gannon on why we remain as excited about the opportunities within the asset class as we have been in more than a decade as the economy—as well as monetary and fiscal policy—are changing dramatically.

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The abnormally high fears of recession and heightened market volatility of 2022 have given way to surprisingly steady economic data—much of it positive—and rising equity prices for the first several weeks of 2023. The Russell 2000 Index advanced 9.8% in January to open the year and rose 18.1% from its most recent low on 6/16/22 through the end of January 2023. At the same time, however, the small-cap index remained down -19.6% from its most recent high on 11/8/21. So far, then, small cap’s comeback is very much in the early stages.

“From our perspective, the outperformance of small over large cap over the past year is significant: it reflects the idea that small caps offer many of the characteristics of an alternative asset class, in particular when put in the context of where the market as a whole has been over the past decade. Always close students of history, we have seen this before.” — Francis Gannon

For these and other, more company or industry-specific reasons, we remain as excited about the opportunities within the asset class as we have been in more than a decade. The economy—as well as monetary and fiscal policy—are changing dramatically at a time when small-cap stocks look inexpensive on both an absolute and relative basis—despite the run-up since June of 2022. Perhaps most interestingly, amid all the market turmoil, the ongoing predictions of recession, stubbornly high inflation, and aggressive tightening by the Federal Reserve, the Russell 2000 outperformed the large-cap Russell 1000 Index by more than 500 basis points for the 12 months ending January 2023, down -3.4% versus a loss of -8.6%. Following more than a decade of relative underperformance, we are equally convinced that small cap’s relative performance advantage over large cap is also in its initial stages.

From our perspective, the outperformance of small over large cap over the past year is significant: it reflects the idea that small cap offers many of the characteristics of an alternative asset class, in particular when put in the context of where the market as a whole has been over the past decade. Always close students of history, we have seen this before. In a scenario that may sound familiar, the “Nifty Fifty” market of the early 1970s was marked by uncertainty and conspicuous worries about high inflation and recession. The Nifty Fifty was a group of mostly multinational large-cap companies that many believed offered a steady, sure, and safe road to growth—until they were badly bruised in the bear market of 1973-74. In the current period, a perception of safety was reserved until recently for an even smaller cohort of mega-cap stocks: the “FAAMG” group of Facebook, Apple, Amazon, Microsoft, and Google. Prior to each period’s bear market, the large-cap peak was crowded with these mega-cap stocks—which most recently reached their high in August of 2020. At that large-cap peak, these five stocks accounted for nearly 25% of the U.S. market’s total capitalization, much as AT&T, Eastman Kodak, Exxon, GM, and IBM did before the sharp correction of the 1970s. The earlier decline was followed by a long run of success for small-cap stocks on both an absolute and relative basis. Combined with small cap’s more favorable valuation and long, historically uncharacteristic period of underperformance, we think the stage is set for the asset class to retake market leadership from large cap.

Weight of Top 5 S&P 500 Stocks vs. Small-Cap Relative Performance
From 9/29/72 through 12/31/22

Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies)

Source: Furey Research Partners
Past performance is no guarantee of future results.

Small cap stocks are admittedly pricing in less recession risk than they did in June of 2022. They are also ripe for consolidation following such a strong advance so far this year. However, we continue to believe that secular changes in economic trends, fiscal policy, and rising interest rates along with other monetary policy shifts are all altering the long-term investment landscape. The unfolding macro environment points to a shift in market leadership where small cap stocks will be able to sustainably, not just tactically, outperform.

Stay tuned…

Important Disclosure Information

Mr. Gannon’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. All indexes referenced are unmanaged and capitalization weighted. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 1000 Index is an index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 Index. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor’s based on market size, liquidity, and industry grouping, among other factors, and includes reinvested dividends. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. Returns for the market indexes used in this report were based on information supplied to Royce by Russell Investments. Royce has not independently verified the above described information.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

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