4Q21 Small-Cap Recap—Royce
article 01-03-2022

4Q21 Small-Cap Recap

A fourth-quarter advance capped a positive year for small-cap stocks, but can they overtake large-caps in 2022?


Small-Cap in 2021: An Absolute Success Amid Relative Index Underperformance

Thanks to a spirited rally over the last two weeks of December, the small-cap Russell 2000 Index staved off a negative result for 4Q21, finishing the quarter with a gain of 2.1%. Small-caps continued to lag their large-cap siblings for the quarter, however, as the Russell 1000 Index gained 9.8% for 4Q21, much of its strength coming from mega-cap stocks.

In fact, 4Q21 resembled 3Q21 in that returns were better the higher up the capitalization scale you traveled, with the Russell Top 50 Index at the apex, advancing 12.1% while the Russell Microcap Index fell, down 2.7% for the quarter.

Calendar year performance came close to mirroring 3Q21 and 4Q21’s pattern of results—the exception being that the Russell Microcap handily outpaced the Russell 2000 in 2021, up 19.3% versus 14.8%. Otherwise, bigger was better in 2021, with the Russell 1000 gaining 26.5% and the Russell Top 50 rising even higher, up 30.1%. So while a double-digit positive return is always good news, we understand why investors might be a little disappointed in small-cap’s relative results. This is especially the case since 2021 began with considerable optimism for both absolute and relative small-cap performance. The Russell 2000 gained 12.7% in 1Q21—which more than doubled the Russell 1000 Index’s 5.9% gain—and hit a new high in March. Although the Russell 2000 then went on to establish a subsequent peak in November, much of the rest of the year was fairly underwhelming on both an absolute and relative basis.

Bigger Was Mostly Better
4Q21 and Calendar 2021 Performance for Russell Indexes

Russell Microcap, Russell 2000, Russell 2500, Russell 1000 and Russell Top 50 Returns

Past performance is no guarantee of future results

Yet small-cap’s advance was far broader than its large-cap counterpart’s in 2021. In fact, with the strong return for the Russell Microcap in 2021, we weren’t surprised to find that the 2021 equal-weighted return for the Russell 2000—an advance of 16.3%—was higher than its capitalization-weighted gain of 14.8%, which demonstrates the breadth of the small-cap index. We also weren’t surprised to find that the opposite was true for the Russell 1000, where the dominance of mega-cap stocks gave the large-cap index a lower equal-weighted return for 2021, up 22.6% versus 26.5% on a cap-weighted basis. Part of our optimism about the potential for relative outperformance for the Russell 2000 versus the Russell 1000 in 2022 stems from this observation that small-cap’s 2021 advance was much broader based than large cap’s.

Small-Cap's Strength Was Broader Than Large-Cap's in 2021
Equal Weighted versus Capitalization-Weighted Performance for the Russell 2000 and Russell 1000 Indexes in 2021

Equal Weighted versus Capitalization-Weighted Performance for the Russell 2000 and Russell 1000 Indexes in 2021

Past performance is no guarantee of future results



Small-Cap Value: A Strong Quarter Caps a Great Year

Within small-cap, 2021 was remarkable for the outperformance of small-cap value. The Russell 2000 Value Index climbed 4.4% in 4Q21, outpacing the Russell 2000 Growth Index, which was essentially flat for the same period. The fourth quarter of 2021 marked the fifth consecutive quarter in which small-cap value beat small-cap growth. The calendar year saw a similarly dramatic performance disparity between the Russell 2000 Value and the Russell 2000 Growth. The small-cap value index advanced 28.3% in 2021 versus 2.8% for small-cap growth. The disparity in results was the second-largest calendar year spread between the style indexes since their 1979 inception.

A Near-Record Advantage for Small-Cap Value in 2021
Five Largest Calendar Year Outperformance Spreads for the Russell 2000 Value versus the Russell 2000 Growth Since Inception (12/31/79)

The 2021 period is 25.4%

Past performance is no guarantee of future results

A closer look into the source of this wide performance gap between the small-cap style indexes also reveals a major factor in the Russell 2000’s relative underperformance in 2021. The Russell 2000 Growth’s underwhelming year was mostly the result of poor performance from the Health Care sector, which was also the biggest detractor and the highest sector weighting in the Russell 2000 as a whole. In fact, small-cap’s underperformance versus large-cap was driven entirely by this weakness in small-cap growth, as the Russell 2000 Value beat the Russell 1000 for the year.

Small-Cap Cyclicals Stay Strong

Despite public concerns about the delta and omicron variants of COVID, as well as their potential to derail economic growth, many investors seemed to look through these developments and instead focus on the still unfolding economic recovery. Those investors with a more cyclical lean (like ourselves) were thus rewarded as cyclicals delivered superior results in both 4Q21 and for the year as a whole. For the quarter, three of the top four Russell 2000 contributors were cyclical sectors: Industrials led, followed by Financials, Information Technology, and Real Estate (the lone top contributor among defensives). For the calendar year, Financials, Industrials, and Consumer Discretionary contributed the most by far, with the first of these sectors rebounding nicely after lagging even when the market as a whole began to recover in March of 2020. Based on our research into smaller companies and our conversations with management teams, we expect the good times to continue for cyclically sensitive small-cap businesses in 2022.

Inflated Concerns for Small-Cap Investors?

Along with the omicron variant, the biggest source of worry for investors in the second half of the year has arguably been inflation. However, we think that concerns about inflation on the part of small-cap investors are misplaced. During the year, small-cap performance seemed to move positively on market-based inflation projections in 2021, even more so than by actual increases in the Consumer Price Index. To be sure, the most important fact—and one that’s been relevant to us since Chuck began managing portfolios in the early 1970s—is that small caps, as measured by the CRSP 6-10 Index, are the only major asset class that’s beaten inflation in every decade since the 1930s. Large-cap stocks, bonds, and cash all have had less success than small-caps during inflationary periods. From our perspective, this is largely due to their size, which allows smaller companies to adapt more quickly. We think this is especially the case with high-quality small-caps, where companies with high returns on invested capital, prudent capital allocation practices, and strong balance sheets are often better equipped to handle sudden changes, such as inflation.

Will Earnings and Equity Returns Diverge in 2022?

We have a nuanced, though positive view of the prospects for small-cap returns going forward. We continue to see much that we like in the small-cap universe in terms of valuation and fundamentals. In fact, we saw a widening gap in the second half between increasing fundamental expectations for small cap’s forward profits (using Next Twelve Months Analyst Forecasted Earnings Before Interest and Taxes, (NTMA EBIT, as a proxy) and declining investor sentiment, as evidenced by lower valuations based on the metric, Enterprise Value to Next Twelve Months Analyst Forecasted Earnings Before Interest and Taxes, excluding companies with negative earnings.

Improving Small-Cap Fundamentals, Declining Valuations
NTMA EBIT versus EV/NTMA EBIT for the Russell 2000 from 6/30/21-12/31/21

Increasing expectations vs. lower valuations

NTMA EBIT: Next 12-Month Analyst Forecasted Earnings Before Interest and Taxes
EV/NTMA EBIT: Enterprise Value Over Next 12 Months Analyst Forecasted Earnings Before Interest and Taxes.
Source: FactSet

As active investors, we get excited when we see solid fundamentals that other investors appear to be overlooking, which is what we see in many cases today. We also expect that small-cap can reassert leadership over large-cap, as much if not more due to large-cap weakness than small-cap strength, particularly based on the latter’s historical record of outperformance during periods of above-average economic growth, its lower relative valuation, and its broader market participation. The Russell 2000 is also still roughly 8% below its November peak, while the Russell 1000 sits near its all-time high, another point in favor of small cap’s likely path toward catching up.

In addition, we expect that small-cap value will maintain its lead over small-cap growth, that cyclicals will stay ahead of defensives, and that high-quality small-caps—in particular those with high returns on invested capital and stable returns on assets—can continue to outpace the asset class as a whole. Small-cap value and cyclicals have tended to do well, particularly on a relative basis, during periods of improving economic growth. And we agree with the consensus that 2022 should see a pace of growth that’s above the historical average for the still recovering global economy.

At the same time, the Russell 2000 posted its third consecutive year of double-digit positive returns in 2021. This is a comparably rare feat for any equity index and has happened only twice before since the inception of the Russell 2000 in 1979 (from 1991-1993 and 1995-1997). In each of the prior instances, a fourth year of double-digit positive returns did not follow. This historical pattern, along with the expectation of a less accommodative Federal Reserve in the coming year, leads us to expect more muted performance for the Russell 2000 in 2022, despite the positives of a growing economy, strong fundamental trends for many small-cap companies, and still reasonable valuations.

Tailwinds for Small Cap Performance and Possible Obstacles

All of this context suggests to us that, even in a lower positive return environment, the long-term prospects for small-cap stocks look attractive, especially relative to large-caps. We also hasten to remind investors that some of the best environments for active small-cap managers have historically been those when the small-cap index delivered more modest returns.

Important Disclosure Information

The thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce Investment Partners, and, of course, there can be no assurances with respect to future small-cap market performance. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

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. The performance data and trends outlined in this article 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. Investments in securities of micro-cap, small-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.)

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.

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 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. 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 Microcap Index includes 1000 of the smallest securities in the small-cap Russell 2000 Index. The Russell 2500 is an index of the 2,500 smallest publicly traded U.S. companies in the Russell 3000 index. The Russell Top 50 Mega Cap Index is an unmanaged, capitalization-weighted index of domestic mega-cap stocks that measures the performance of the 50 largest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

The (Center for Research in Security Prices) CRSP (Center for Research in Security Pricing) equally divides the companies listed on the NYSE into 10 deciles based on market capitalization. Deciles 1-5 represent the largest domestic equity companies and Deciles 6-10 represent the smallest. CRSP then sorts all listed domestic equity companies based on these market cap ranges. By way of comparison, the CRSP 1-5 would have similar capitalization parameters to the S&P 500 and the CRSP 6-10 would have similar capitalization parameters to those of the Russell 2000.

The Enterprise Value to Next Twelve Months Earnings Before Interest and Taxes (EV/NTMA EBIT) is the sum of index constituent current Enterprise Value divided by the sum of index constituent analyst forecasted EBIT over the next twelve months. Companies considered by FactSet to be in banking, insurance, or other financial industries are excluded from the calculation. Real Estate Investment Trusts (REITs), however, are included.

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. 



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