3Q20 Small-Cap Interview: Long-Term Optimism/Short-Term Uncertainty—Royce
article 10-07-2020

Long-Term Optimism/Short-Term Uncertainty

Although the next few months may be volatile, Chuck Royce and Francis Gannon are optimistic for small-caps over the next few years.


Do you think the market’s strength is sustainable?

Chuck Royce Over at least the next few years, yes. Based on what I see in small cap’s fundamentals, current valuations, and market behavior, I’m cautiously optimistic. September was a volatile month, as well as the first month with negative returns for most of the indexes around the globe since the recovery began in March. The losses, however, weren’t significant. This sort of more benign correction is common over the course of recoveries and gives me more confidence in the market’s underlying strength. Yet, with a vaccine still to come, a contentious election in November, ample economic uncertainty, and the recent positive diagnoses for the president and certain members of his staff, I don’t have a firm conviction about the short run. Although I also don’t see the likelihood of a major correction, I do think stocks could experience more of the corrective volatility we saw in September over the next few months.

What positive signs do you see that support your long-term conviction?

CR I’m encouraged by the number of welcome developments. The market’s strength coming off the mid-March lows has been a pleasant surprise, and the economy is growing stronger, even if by fits and starts. Equally if not more important, the world is making progress toward a coronavirus vaccine that’s likely to be available by the early to middle part of next year. I’m also pleased with the way that so many companies are moving forward and effectively managing their way through an extraordinary period—one that’s been unprecedented for most of them. The markets are behaving mostly as we’d anticipate in a typical recovery from a recession. In fact, with so much of the world feeling upside down, it’s interesting how “normal” the investment environment has been.

With the economy showing mixed signals, what’s your sense of its condition?

CR I think the economy is in pretty good shape—and getting better. The road ahead looks promising to me, with no recession or financial crisis on the horizon. Because the coronavirus is an exogenous event, I think it makes the prospect of a sustained recovery more likely. The global economy was in solid shape going back to the early part of 2020. Indeed, some of our holdings, such as those with exposure to housing and certain niche consumer areas, are doing quite well. In addition, many of the management teams we’ve spoken to in industries such as chemicals, electrical equipment, and machinery are preparing for continued economic recovery.

How is your view of the recovery affecting how you’re looking at companies?

Francis Gannon What stands out most is the sizable gap between perception and fundamentals. Even as the market rises, much of the world seems apprehensive about the overall state of corporate health, especially in small-caps, where the companies are often seen as being less financially sound. Yet we see a large number of small-cap businesses that have solid free cash flows, strong balance sheets, and capable, innovative management teams that have been executing at a high level throughout 2020. Those are the kinds of characteristics that we think will help companies to emerge stronger.

Is there anything happening in the market that you think investors may be missing?

FG I think a lot of investors aren’t aware of how much risk there is in passive equity products where mega-cap names predominate. Apple, Microsoft, and Amazon—along with Google and Facebook, part of the “FAAMG” group—each made up more than 10% of the Nasdaq 100 Index at the end of September—more than 30% of the index’s total market cap. This high degree of concentration creates considerable risk. Given that investors often turn to passive vehicles in an effort to reduce risk, we think they may be particularly disappointed when risk shows up where it’s least expected—and there’s more concentration risk in large-cap passive investments right now than I can ever recall seeing.

What else have you observed that other investors may not be aware of?

CR I think one of the more interesting stories in the third quarter was the strength of non-U.S. small-caps. Along with their non-U.S. large-cap counterparts, they outpaced domestic small-cap stocks in the third quarter, beating the Russell 2000 in all three months. It’s equally notable that non-U.S. small-caps (as measured by the MSCI ACWI ex-USA Small Cap Index) have outperformed their U.S. small-cap peers in three of the past four quarters and are now ahead on a one-year basis after trailing for several years.

The Surprising Strength of Non-U.S. Small-Caps
Recent performance of non-U.S. small-caps versus U.S. small-caps as of 9/30/20


Not annualized. Past performance is no guarantee of future results.

This could be the beginning of an extended period of attractive returns for non-U.S. small caps. Yet many other investors aren’t allocating or even looking at what we see as very fertile ground that can provide terrific opportunities for active managers.

What are the implications for small-cap investors of the Fed’s decision to keep very low rates longer, allow higher inflation, and welcome strong labor markets?

FG We can’t be certain yet about the full extent of the effects. However, the Fed’s decision to keep rates lower for longer certainly suggests tailwinds that can help equity prices to continue drifting higher. The Fed has also become what I’d call a fiscal policy advocate. By essentially saying that the deficit is not something we currently need to worry about, the central bank is encouraging additional fiscal stimulus to revitalize the economy.

Are there any themes emerging in areas you find attractive?

FG There are two related factors we look for, regardless of industry or sector. The first is companies that are profitably using their technology and/or intellectual property to help other businesses innovate or execute more effectively. The second would be companies that are effectively absorbing technology and other innovations for their own uses. I don’t know if other investors are scrutinizing the advantages that these attributes can create, but we see them as absolutely critical to a company’s long-term success. We also like companies that help businesses make smarter decisions about technology—which is a specialty of Forrester Research.

Which sectors and industries do you think look most likely to emerge stronger?

CR We own two machinery companies, Valmont Industries and Lindsay Corporation, that are good examples of what Frank just referred to. They’re involved in precision engineering for agriculture, which is another area that we like. These companies are leveraging intellectual property and technological skill to enhance crop yields, which benefits their customers, most of whom are farmers. Another area would be companies that have an edge in supply chain logistics and inventory management, such as Manhattan Associates, a holding we’ve discussed before. The company has the number one share in warehouse management systems software. COVID-19’s global reach made this industry especially important, but we think the companies that were most successful in helping other businesses manage their supply chains and logistics through the pandemic have a long runway for growth in a post-COVID-19 environment.

Were you encouraged by the relative strength of small-cap cyclicals in 3Q20?

FG Within small-caps, the third quarter was good for both cyclical stocks and risk in general. Because cyclical stocks are viewed as riskier than defensives, that makes sense. From a risk perspective, small-caps with no earnings or dividends, as well as those with higher debt, all performed relatively better. Those factors made the quarter more challenging for our quality-focused strategies. Within the Russell 2000 Growth, we saw a shift away from those areas that have led most often over the last several years—the bio-pharma complex and software—with some of the best results coming from the more prosaic precincts of retailing in Consumer Discretionary and, to a lesser extent, insurance in Financials and capital goods in Industrials.

What conditions need to be present for small-caps to outperform large-caps?

FG I think the case is pretty straightforward: We agree with the consensus that’s expecting the economic recovery to continue broadening and deepening. A consistently strengthening economy should be highly supportive for small-cap stocks, as it has been historically, especially the economically sensitive cyclical sectors that our portfolios lean toward. There are other developments that should also help small-cap cyclicals. We’ve been hearing a lot about increased CapEx spending, inventory restocking, and expanded connectivity in several industries. Increased growth in these areas would boost many cyclical companies.

Are there any specific advantages you believe 2020 has provided for active managers?

CR The surges in volatility have been the key. We’ve always sought to take advantage of tumultuous markets—and I think we’ve managed it well so far in 2020 across the firm. In the portfolios I lead, we’re always looking for attributes such as strong balance sheets, industry leadership, and innovation. These are the qualities that have historically helped companies to make it through difficult markets and recover successfully. When the market is hit with volatility, those attributes go on sale, as it were, because so many investors begin to sell without taking fundamentals or long-term success into account. That short-term mindset is something that any effective active manager tries to use to their advantage. So far this year, we’ve seen extreme volatility during February and March and less dramatic instances in July and September—and we were actively buying through each period.

Are you optimistic about the long-term prospects for small-cap stocks?

FG I think the prospects for small-caps look especially positive. At the end of September, the Russell 2000 Index finished 10.7% off its all-time peak from August of 2018, and its three- and five-year annualized returns were below their three- and five-year rolling monthly averages—dramatically lower in the case of the three-year return at the end of 3Q20. So a sustainable period of strong small-cap returns is definitely possible. I think it’s even more plausible in the context of record-low rates and a large-cap market that looks a lot more overvalued than small-cap, though admittedly much of large-cap’s richer valuations are attributable to mega-cap names.

Recent Small-Cap Returns Lower Than Historical Averages
3- and 5-Year Monthly Rolling Averages vs. Average Annualized Returns for the Russell 2000 as of 9/30/20


1 From Russell inception on 12/31/78-9/30/20.
Past performance is no guarantee of future results.

What also bolsters our optimism is the absence of two negative indicators that often precede difficulties or present challenges for small-cap stocks. The first is an aggressive Federal Reserve raising interest rates. The Fed’s recent announcements suggest quite the opposite scenario, in which the central bank seems content to leave rates at their current near-zero levels for at least the next few years. The second would be an impending recession such as what we’re coming out of now. Yet at this stage the economy appears to be firmly (if unevenly) in recovery mode, having put the recession in its rearview mirror.

What is your view of current valuations for small-caps?

FG Based on how we look at valuations, we think they’re attractive. In fact, small-cap valuations relative to interest rates finished September at levels that historically precede higher returns. The Equity Risk Premium—which compares the free cash flow yield of the Russell 2000 to current interest rates—was more than 1% at the end of 3Q20. The average one-year return for the small-cap index following periods where the risk premium was 1% or more was more than 25%. That’s really impressive—though past performance doesn’t guarantee future results.

Better Days Ahead for Small-Cap? Historically, High Equity Risk Premium Has Led to High Returns
Average Subsequent Russell 2000 1-Year Performance in Equity Risk Premium Ranges1 from 9/30/00 to 9/30/20


1 Equity Risk Premium = Latest Twelve Months Free Cash Flow divided by Enterprise Value minus 10-Year Treasury Yield.
Source: FactSet

Do these views bolster your confidence in small-cap cyclicals?

CR Very much so. From our perspective, small-cap cyclicals represent the most attractive opportunities in the asset class. At the end of September, they were selling near 20-year lows on a relative valuation basis compared to small-cap defensives. In addition to the areas we mentioned, several other select cyclical industries, such as road & rail, air freight, and building products, have been doing well over the last few months. And of course, the case for select small-cap cyclicals becomes even stronger if the dollar continues to weaken, giving a boost to export opportunities.

FG We’re also mindful that the world hasn’t seen anything like this pandemic in at least a century, so we’re balancing our long-term confidence with the acknowledgment that our collective near-term situation is uncertain. With all of this in mind, we remain confident in the prospects for a solid to strong global economic recovery that should reward select small-cap cyclicals.



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.

Percentage of Fund Holdings As of 9/30/2020 (%)

  Forrester Research, Inc. Valmont Industries  Lindsay Corporation  Manhattan Associates, Inc.

Royce Dividend Value





Royce Global Financial Services





Royce Pennsylvania Mutual





Royce Premier





Royce Total Return





Royce Global Value Trust





Royce Micro-Cap Trust





Royce Value Trust





Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.

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.

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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an 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 Nasdaq100 is an unmanaged, capitalization-weighted index. It measures the performance of the 100 largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.

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.)



Sign Up