This transcript has been edited for clarity.

John Davis: Hello everyone and welcome to this Royce Investment Partners podcast. My name is John Davis, I'm the director of communications and marketing here at Royce and I'm joined today by our Co Chief Investment Officer, Francis Gannon. Frank, how are you?

Francis Gannon: Well, John. Thanks for having me.

JD: Excellent. We're going to talk today about the state of current small-cap valuations. Year-to-date through October the 25th, the Russell 2000 index was down -5.1% with a 1-year return of -6.6%, 3-year of 1.5%, and a 5-year of 3.3%. So, these have been very negative to low return periods for the Russell 2000, Frank. And in this context, where we see negative or lower turns over both short and long term periods? What can you tell us about the state of small-cap valuations? Specifically, where are valuations for the Russell 2000 relative to the large-cap Russell 1000 Index?

FG: I guess adding to the terrible performance of the Russell relative to large-cap: small-cap stocks have been in a bear market for coming up now on two years and have been out of favor for over a decade. But especially over the past several years, you've seen a big dispersion in performance between small-caps and large-caps.

I think one of the ways that we have always looked at valuation in terms of the companies we put into our portfolios has always been through enterprise value to EBIT [earnings before interest & taxes]. One of the studies that we've been looking at over the past several years has been looking at the EV to EBIT of all the different equity asset classes. And what you find is that there's an enormous gap right now between the Russell 2000 and the Russell 1000 today. In fact, the relative valuations for small-caps at the end of September were near their lowest levels that we've seen in close to 25 years. I think that's just shows you the opportunity set that we're seeing within small-caps.

Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies)
From 9/30/98 through 9/30/23

¹Enterprise value over earnings before interest and taxes.

I would also say that obviously small-caps have a different performance profile over time. While we seem to be out of favor with the broader market, the valuation opportunity that we're seeing today within small-caps is quite large, and that is a very positive thing for us as active managers within the small-cap space. I would also say that as the world is worried about a recession—which is hard to believe when we just had a print recently of 4.9% in terms of GDP for the third quarter—small-caps have, I think, effectively priced in a recession and have been in a significant bear market now for coming up on two years. So it's important to keep in mind that when people talk about the market and they talk about valuations and they talk about the Russell 1000 or the S&P 500 and the Nasdaq, which are heavily weighted to these mega-cap stocks, which have done so well, that we are seeing great opportunities in the small-cap space both in the Russell 2000, and I would say even the Russell 2000 Value Index, are showing some great valuation opportunities.

JD: I think it's particularly interesting because we keep reading so much about how the market is overvalued and yet, usually, as you point out, when people are referring to the market, whether it's in the media, certainly within a lot of financial commentary, they are often talking about the S&P 500 or the Nasdaq, which is obviously very heavily weighted with mega-cap stocks. Small-cap, we've always maintained here at Royce, is different. It has its own performance patterns. In many years we see it outperforming large-cap. Obviously, more recently we've seen it underperforming large-cap. But the important thing to remember, I suppose, is that small-cap definitely has different patterns, and if you overlay long-term performances, you would see during different periods of time very significant disparities in performance.

You mentioned that we had been looking at other equity asset classes within the U.S. market. What have we found in terms of small-cap versus mid-cap or large-cap value, large-cap growth etc.? In other words, is small-cap consistently undervalued versus other asset classes or even other styles?

FG: We've done many studies on that just to see where the valuation opportunity is in the broader equity market here in the United States and what we found is that if you use EV to EBIT, which is a great way to level the playing field between the different the equity asset classes—small-cap, mid-cap, large-cap. As you know, the Russell 2000 at the end of the third quarter of this year had about 42% of its constituents that actually were loss-making entities.

Small-Cap Value and Small-Cap are the Only Indexes Cheaper than Their Historical Average
Current and 25-Year Average Median EV/EBIT1 (ex-Negative EBIT) Levels for Russell Indexes as of 9/30/23

¹Enterprise value over earnings before interest and taxes.

What you find is really four things: The first observation is that small-cap value and small-cap core are the cheapest segments within the U.S. stock market. The second observation is that they are trading well below their 25-year valuation as measured by EV to EBIT. One of the more interesting things that I find is that all three of the value segments—in terms of small-cap, mid-cap and large-cap—if you look at their 25-year EV to EBIT multiples, what you find is they all have nearly identical 25-year average valuations trading around 14.8x or 15.0x.

This shows that markets are efficient over long periods of time, and that there are opportunities for us to take advantage of. I think small-caps trading well below their 25-year average really just shows you the opportunity set we're seeing today. Finally, what you would see is that mid-cap growth and large-cap growth are trading well above their 25-year averages and have a long way to fall before hitting their 25-year average. I think that is just reflective of what we've seen in the performance numbers that we've talked about, where larger-cap and mid-cap have done well over the past several years and small, as measured by the Russell 2000 or the Russell 2000 Value Index, have been out of favor. But it also represents that great opportunity we're thinking about today.

JD: Small-cap looks terrific based on everything you've said relative both to big happened, the large-cap currently and so we've looked so far relative valuations. If we look at price to earnings ratios, how do small-caps stack up versus its own long-term averages? I should point out that at Royce we calculate the price to earnings ratio by dividing a company share price by its trailing 12-month earnings per share, and we exclude companies with zero or negative earnings, which, as Frank pointed out currently is about 42% of the Russell 2000 Index. We then use a harmonic average price to earnings, which is a weighted calculation that evaluates a portfolio as if it were a single stock and measures it overall, compares the total market value of the portfolio to the portfolio share in the earnings or book value, as the case may be, of its underlying stocks. The question, I guess, Frank is, what is the current P/E for the Russell 2000 and how does it compare to its long-term historical average?

FG: One of the things, John, we focused on of late has been the compression in multiples, the P/E multiple of the Russell 2000, especially over the past five years. We've noted the dramatic underperformance on a 5-year basis in the Russell relative to the large-cap space and the Russell has only returned, you know, 2.4% through the end of September on a 5-year annualized basis, which is one of the lower numbers we've seen in quite a long period of time.

That being said, what you've seen is a dramatic compression of valuations. The average price to earnings ratio for the Russell 2000 stood at 12.5x times at the end of September. That is below its long term average of 18.1x, and below where it was five years ago at 18.4x. Returns have stalled, as we've noted, but multiples have compressed and that's created a significant number of buying opportunities. It's something we're finding across all of our strategies here is a lot of opportunities in the market with the average stock down some -33.0% within the Russell 2000 from its 52-week high at the end of September. What you'll see from our perspective—our analysts and portfolio managers are finding very compelling long-term opportunities and a lot of diverse areas including semiconductors, electric vehicles, electrification, aerospace & defense, medical devices, electronics manufacturing services, banking, and retail.

Weighted Harmonic Average Price-to Earnings Ratio (Excluding Non-Earners) for the Russell 2000
From 9/30/98 through 9/30/23

Source: FactSet
The Price-to-Earnings Ratio is calculated by dividing a company’s share price by its trailing 12-month earnings-per-share (EPS) and also excludes companies with zero or negative earnings. 42% of Index holdings were excluded as of 9/30/23). Harmonic Average. This weighted calculation evaluates a portfolio as if it were a single stock and measures it overall. It compares the total market value of the portfolio to the portfolio’s share in the earnings or book value, as the case may be, of its underlying stocks.

They are also seeing ample potential in the small-cap businesses that look to poised to benefit from the growth of AI applications, much of it in areas beyond tech, such as industrials, and I think that's that something to important to focus on, especially in the world where everybody seems to be so focused on AI and the growth of AI that we have a lot of wonderful innovative businesses that are on sale effectively in our in our part of the market that will benefit from that going forward.

In addition, these lower returns, as we've mentioned, kind of suggest the idea that long-term returns for small-caps as a whole should be better going forward. This may sound very obvious—that low-return periods, especially over long periods of time, have been followed by higher returns. Our research shows that the annualized 3- and 5-year returns of 5% or lower have been followed typically by higher-than-average returns over the subsequent 3- and 5-year periods.

I think that's really important when trying to understand the opportunity set within small-caps today. Equally, if not more important, these lower turns have typically been coupled with attractive valuations and are a potentially rewarding combination for patient and disciplined active small-cap managers. A great opportunity exists for both alpha and beta in the small-cap world today, and I think that is a key point. We have this moment for all of us from an active standpoint within small-caps to generate alpha going forward. But we also have the market opportunity, given the valuations within the small-cap space, from a beta perspective as well. You have this historic opportunity within the small-cap market today that we hope investors will take advantage of.

JD: That sounds like a great opportunity for small-cap, Frank and I want to thank you again for joining us today. And that'll conclude today’s Royce podcast.

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