2Q21 Small-Cap Interview: Can Small Caps Regain Market Leadership?—Royce
article 07-08-2021

Can Small Caps Regain Market Leadership?

Chuck Royce and Francis Gannon discuss whether small caps can retake leadership from large caps, opportunities in cyclical stocks, where we are in the value outperformance cycle, and more.


Are you concerned that small caps underperformed large caps in 2Q21?

Chuck Royce Not at all. History shows that intra-cycle leadership shifts have always been a standard element in market cycle performance patterns. It’s true that the performance spread between the Russell 2000 and the Russell 1000 (as well as the Nasdaq Composite and S&P 500) was fairly wide, with small cap up 4.3% versus 8.5% for the Russell 1000. Yet even bearing that in mind—as well as the fact that those same large cap indexes made new highs in the second quarter—the significant small-cap outperformance over the past year remained in place. We expect it to stay that way. We also expect these kinds of bumps in the road during a longer-term small-cap leadership phase.

Are there historical parallels to this most recent quarter?

CR Absolutely. After small caps experienced a very strong absolute and relative recovery in 2009, a digestion period followed in which returns were negative over the next six months before resuming their positive pace and maintaining market leadership. Equally important, I see nothing on the horizon to suggest that small cap’s leadership phase has run its course in the economy, the market itself, or—and this is always most relevant to us—in our analysis of companies and conversations with management teams. So we remain confident in the ongoing leadership for small caps.

Are there any other notable observations about 2Q21?

Francis Gannon I think it’s important to note that, for some investors, the quarter may have felt worse than it really was. Compared to the previous two quarters, in which the Russell 2000 posted double-digit and near record-setting gains, 2Q21 probably seemed fairly pedestrian, if not disappointing once underperformance versus large cap was taken into account. However, we think 2Q21 was fine on an absolute basis. If we annualize the quarter’s return, it would yield an 18.3% annual advance. In addition, the quarter’s 4.3% gain was slightly above the quarterly average of 3.5% for the Russell 2000 since its inception on 12/31/78.

CR We saw a number of headline-generating market gyrations in certain areas that I think are being overemphasized. I’m referring specifically to investments such as cryptocurrencies and meme stocks—those companies whose shares skyrocketed based on social media activity. Like SPAC’s a few quarters ago, it seems to me that investors were using the ample liquidity in the financial markets to put money to work in vehicles for which they were convinced they’d get a higher—often a significantly higher—price. Some have argued that each of these speculations indicates a stock market bubble, but I don’t see it that way. I’ve seen many different kinds of speculation during my career and, as much as these latest manifestations make for enjoyable cocktail conversation, I don’t find them useful to focus on—and never really have.

What is your take on the performance of small-cap cyclicals in 2Q21?

FG The most interesting development to us was the wide divergence in cyclical sector returns, with Energy leading and Industrials lagging. After trailing considerably over the last few years, Energy’s advance was driven by oil prices rising rapidly so far in 2021, fueled as much by anticipated demand increases as restrictions on expanding supply—which has happened for a collection of different reasons. Curiously, the same optimism that’s powered oil’s rising price did not translate into widespread outperformance for cyclicals. Beginning around the middle of May, the confidence in a cyclical recovery seemed to fade, which was also visible in declining 10-year Treasury yields. I also want to note that the high return for Communications Services was driven by one of these meme stocks—AMC Entertainment—so we suspect that 2Q21’s results don’t provide any useful signal about future cyclical sector returns.

Cyclical Returns Diverge in 2Q21
Russell 2000 Cyclical Sectors for the Quarter Ended 6/30/21

cyclical returns divergge
Source: FactSet
Past performance is no guarantee of future results.

Do you agree with this caution on the economic recovery?

FG Expertise on the economy is beyond our core competencies. Our views come from a bottom-up perspective. Having said that, our research and analysis of small cap cyclicals suggest that this cyclical caution is misplaced. The companies we’re speaking with count their biggest challenge as hiring enough skilled people to keep pace with demand. The conversations tell us that the cyclical lean of most of our portfolios still makes sense.

Industrials is the largest sector in many of the portfolios you lead. What’s your outlook for the sector?

CR I think it’s important not to generalize too much about a sector as broad and diverse as Industrials, or to extrapolate too much from one quarter’s results. On an individual stock basis, we’re still optimistic about our industrial holdings. We’re confident that many of them will narrow the performance gap as the economy continues to gather steam.

Where are most of your holdings focused in the sector?

CR We like areas such as engineering & construction that have exposure to infrastructure and the still-strong housing market. We’re also leaning into asset light industrial businesses, especially with the current dearth of skilled labor accelerating the need for innovation and automation. A lot of our machinery stocks, where my portfolios have considerable exposure, fall into that category. In addition, we remain constructive on companies in transportation, logistics, and supply chain management as the growing economy is still facing interesting changes and challenges in inventory management, shipping, and distribution. Finally, we see important opportunities in companies that help to increase agricultural yields.

Five 2Q21 Lagging Industrial Areas Where We See Opportunities
Returns for the Quarter Ended 6/30/21

5 lagging industries in 2q21
Source: FactSet
Past performance is no guarantee of future results.

While interest rates dropped during the quarter, many small-cap investors are still concerned about the effect rising interest rate could have on small caps. Do you share these concerns?

FG When I speak to investors, I find that many don’t know that periods of rising rates have historically created a favorable environment for small caps—the exceptions being periods in which rates climb very quickly, which seems unlikely to us. More important, we see measured rate increases as a positive for cyclicals and value—where we focus the vast majority of our investments. Most small-cap defensive and/or growth stocks still have appreciably higher valuations than cyclicals and/or value stocks, based on EV/EBIT (which is the last twelve months enterprise value divided by earnings before interest and taxes), which would make defensive and/or growth stocks more vulnerable to rising interest rates. So we’re not overly concerned with the effect of rising rates on our portfolios.

Many investors are also concerned about inflation. Has increased inflation altered your investment approach at all?

CR No—we already hold companies that we think can benefit from inflation, and I’ve have been adding to several of these existing positions in my portfolios. One area that Miles Lewis and I like, for example, are industrial distributors, which are not only positioned for a vibrant recovery via the improving economy but also tend to see operating margins expand and earnings improve during inflationary periods. Most of these companies have a relatively small and fragmented customer base, which makes it easier for them to seamlessly pass along higher prices from their suppliers. And inflation is like any other economic phenomenon—it creates long-term buying opportunities if you know where and how to look.

What are your thoughts on the strong results for non-U.S. small caps in 2Q21?

FG In April, we noted that non-U.S. small caps were lagging their U.S. cousins meaningfully for the trailing one-year through March 31st, so we weren’t surprised to see the MSCI ACWI ex-USA Small Cap Index beat U.S. small caps by advancing 6.4% in 2Q21. In fact, the index outpaced the Russell 2000 for the first time since 2020’s first quarter. This was coincident, of course, with many European and some Asian economies beginning to catch up to the U.S. in vaccination rates and economic reopenings. Yet non-U.S. small caps still have a ways to go to match or exceed the longer-term results for their stateside cousins. For the five-year period ended 6/30/21, the MSCI ACWI ex USA Small Cap Index advanced 12.0% on an average annualized basis compared to 16.5% for the Russell 2000. We see this as an excellent opportunity. From our perspective as small-cap specialists, many non-U.S. small caps still sport a very attractive combination of quality and value—what we regard as the ideal combination for patient investors. We remain very excited about the long-term prospects for small caps on a global scale.

What’s your view about where we are in the value outperformance cycle?

CR Small-cap value continued to lead small-cap growth in 2Q21—it’s now beaten growth for three consecutive quarters. However, I think many investors are looking at this cycle differently than I am. Although value led for the past year, up 73.3% versus 51.4% for growth, the Russell 2000 Value still lags its growth counterpart by more than 500 basis points for the five-year period ended 6/30/21. Given the depth of value’s underperformance over much of the past five years, the idea that value’s run is over just makes no sense to me. Eventually, time will tell, but I can say that I am increasing the weighting of value stocks in the core strategies that I lead.

Russell 2000 Value Still Lags Growth Over the Last 5 Years
Value of $10,000 from 6/30/16 to 6/30/21

Russell 2000 Value Still Lags Growth Over the Last 5 Years
Past performance is no guarantee of future results.

Do you think more volatility is likely in the coming months?

FG I think so, but with the caveat that we’re perennially pro volatility because of the long-term buying opportunities it offers. It would also be unusual to close out 2021 without a correction somewhere in the 7-12% zone. Small-cap stocks have had a fair amount of volatility day to day or week to week but have also still advanced for nine straight months—and this kind of smooth run rarely lasts for long. I can’t say what might cause a correction—it could be any number of things—but we always stay prepared for volatility by immediately trying to take advantage of temporarily depressed prices on behalf of our investors.

Do you still expect high-ROIC, quality small caps to perform better in the current cycle?

CR The second quarter was relatively disappointing for our Premier Quality Strategy, but our confidence remains high. I think investors need to be aware that simply buying the market worked very well for most of the last decade. The conditions were close to ideal for this kind of approach. The economy grew but did so very slowly—which helped growth stocks—while rates were zero or near zero, enhancing the general appeal of equities and boosting duration-sensitive stocks. I’d describe this decade or so period as “the era of beta” because overall market returns were so high, making it difficult for active strategies to stand out. But I think the “age of alpha” is in front of us—alpha being the term that describes an investment approach’s ability to beat the market. As earnings comparisons become harder to beat over the next year or so, it gives disciplined active managers, especially those with a quality bias, an excellent opportunity to excel in a market where there will be considerable differentiation in the fundamentals that we focus on most.

beta to alpha

What is your outlook for active management in small cap going forward?

CR I’m always excited about the opportunities in small caps—there are so many diverse and interesting companies and evolving industries. And I’m just as excited to work with my Royce colleagues to identify stocks we think can sell for much higher prices in a few years. What interests me most now is identifying those businesses that were able to use the difficulties wrought by the pandemic and ensuing recession to get stronger. We’re finding those businesses today at what we think are attractive valuations, largely in Industrials, Information Technology, and Financials. This leg of the cycle is typically when company results, rather than valuation expansion, begins to drive most of the stock price movement—and we believe that suits our skill sets well.

FG We’re also not worried about the prospect of lower returns than we’ve seen over the past five years. With all of the ups and downs the market’s experienced since June 30, 2016, many investors may not realize that small caps have more than doubled over that five-year span. A multi-year period of moderately lower returns is to be expected after that high level of performance. However, the good news is that active small-cap managers have actually added their greatest share of excess return when the Russell 2000 had single-digit results over five-year periods.

Monthly Rolling 5-Year U.S. Small Blend 1 Average Excess Returns During Russell 2000 Return Ranges
From 12/31/78 through 6/30/21

Monthly Rolling 5-Year U.S. Small Blend

1 There were 514 US Fund Small Blend Funds tracked by Morningstar with at least five years of performance history as of 6/30/21.
Past performance is no guarantee of future results. The excess return for a Morningstar category would be the category’s return for the period minus the Index return.
Source: Morningstar

There are certain challenges, of course. The expanding global economy and consequent optimism continue to stoke a bigger appetite for risk among investors, one that’s already led to higher share prices and valuations for the indexes. This situation translates to more modest prospects, certainly in our view, for the small-cap market. The asset class has to contend with two countervailing forces: slowly rising rates should push down on valuations just as many companies are likely to report healthily growing earnings through at least the end of next year. These forces, however, will not affect all small cap stocks equally. What we believe we offer our investors is the experience, discipline, and expertise to select those companies best positioned to benefit from the more challenging environment we see ahead. We highly doubt that we’ll see many more “boring” quarters as we go forward into what looks like a promising period for active small-cap management.



Important Disclosure Information

Mr. Royce’s and 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.

Cyclical and Defensive are defined as follows: Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

Beta is a measure of the volatility or risk of an investment compared to the market as a whole. Alpha describes an investment strategy's ability to beat the market.

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 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell 1000 Index is an unmanaged, capitalization-weighted 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. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The MSCI ACWI ex USA Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. 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 NASDAQ Composite Index measures all NASDAQ domestic and international based common type stocks listed on The Nasdaq Stock Market. It is a broad-based index and is calculated under a market capitalization weighted methodology index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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