3Q23 Small-Cap Recap—Royce
article 10-02-2023

3Q23 Small-Cap Recap

The Small-Cap Bear Rolls On…

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Equities Struggle as Yields Climb in 3Q23

The major U.S. stock market indexes were down across the board in 3Q23, thanks to a combination of revived recession warnings, rising yields, and a looming government shutdown. The 10-Year Treasury yield rose to 4.6% in September, climbing by more than 20.0% in 3Q23 to its highest rate since October 2007. And even with Google and Amazon facing anti-trust suits, small- and micro-cap stocks bore the brunt of the quarterly downturn. The Russell 2000 Index fell -5.1 % in 3Q23 while the Russell Microcap Index lost -7.9% compared to respective losses of -3.1% and -2.8% for the Russell 1000 Index and mega-cap Russell Top 50 Index. In fact, the Russell 2000 fell -10.6 % in August and September alone.

Larger Lost Less in 3Q23’s Downturn
3Q23 Returns for the Russell Top 50, Russell 1000, Russell 2000, and Russell Microcap Indexes

An Up and Down Quarter for Stocks

Past performance is no guarantee of future results.

This reinforced a stubborn pattern of small-cap underperformance that has been in place for several years and has been consistent so far in 2023. For the year-to-date period ended 9/30/23, the Russell 2000 was up 2.5%, and the Russell Microcap was in the red at -5.8%, while the Russell 1000 was up 13.0%—and the mega-cap index nearly doubled that return with a year-to-date gain of 24.3%.

The Russell 2000 thus finished September 1,047 basis points behind its large-cap sibling. The end of September also marked the biggest 1-year spread between the Russell 2000 (+8.9%) and the Russell Microcap (-1.3%) since the latter’s inception in June 2000. Equally important, the Russell 2000 slipped back into bear territory in 3Q23, down -24.8% from its last peak on 11/8/21, putting the asset class into a nearly 2-year bear cycle while large caps experienced only a minor loss through this lengthy small-cap correction.

A Bear Market for Small Cap, a Small Loss for Large Cap
Cumulative Returns for the Russell 2000 and Russell 1000 Indexes from 11/8/21-9/30/23

An Up and Down Quarter for Stocks

Past performance is no guarantee of future results.

Non-U.S. indexes did not fare much better, for understandable reasons—China and Europe remain in various stages of recession or markedly slower economic growth. However, the MSCI ACWI ex-US Small Cap Index lost only -1.7% in 3Q23 while the MSCI ACWI ex-US Large Cap Index fell -4.1%. For the year-to-date period ended 9/30/23, the two indexes were nearly even, with the non-U.S. small-cap index gaining 5.0% and its large-cap counterpart up 5.3%.

The Small-Cap Seesaw

As might be expected in a down quarter, the Russell 2000 Value Index lost significantly less than the Russell 2000 Growth Index, down -3.0% in 3Q23 versus -7.3%. The small-cap value index still trailed on a year-to-date basis, down -0.5% versus a gain of 5.2%.

Over longer-term periods the relative advantage switched around a bit, with the small-cap value index winning for the 3- and 5-year periods while the growth index won for the 1- and 10-year periods ended 9/30/23. One element that has not changed, however, is the absolute and relative valuation of small-cap value. Using our preferred index valuation metric of enterprise value over earnings before interest & taxes (EV/EBIT), we can see that the Russell 2000 Value remained attractively valued at the end of 3Q23, particularly relative to the Russell 2000 Growth.

Relative Valuations for Small-Cap Value vs. Small-Cap Growth Remain Near Their Lowest in 20 Years
Russell 2000 Value vs. Russell 2000 Growth Median LTM EV/EBIT¹ (ex. Negative EBIT Companies)
From 9/30/03 through 9/30/23

An Up and Down Quarter for Stocks

1Last twelve months Enterprise Value/Earnings Before Interest and Taxes.
Past performance is no guarantee of future results.

As might be expected, the Russell 2000 was far more attractively valued at the end of September than the Russell 1000, based on the same EV/EBIT metric.

The Small-Cap Sector Story

In light of the widespread attention on AI, as well as the coming impact of the CHIPS and Science Act, it was somewhat surprising to see Information Technology stocks hit hard within the Russell 2000 in 3Q23. Along with Health Care—another locus of innovation—the tech sector had the sharpest losses and the biggest negative impact on small-cap results in 3Q23. All told, only Energy and previously beleaguered Financials finished the third quarter in the black, though double-digit losses on a sector basis were limited to Health Care and Information Technology. Along with the U.S. dollar, energy and financial stocks offered one of the few attractive investments for 3Q23. These widespread sector declines created a number of interesting long-term buying opportunities.

Small-Cap Sector Results Mostly Negative in 3Q23
Russell 2000 Performance by Sector

An Up and Down Quarter for Stocks

Past performance is no guarantee of future results.

The Active Opportunity

Of course, we view performance over much longer time periods than the just concluded quarter—and much of what we see skews positive over the long run. First, in the 18 months that followed the first Fed rate hike in March of 2022, the Russell 2000 was down -10.0% while the Russell 1000 was marginally positive at 0.3%. Yet history shows that 1- and 3-year returns for both indexes were mostly positive following the nine previous initial tightenings by the Fed. This recent departure from the historical pattern suggests to us that the market may have already priced in a potential recession—and that higher small-cap returns may be on the horizon.

Is a Recession Already Priced in?
1- and 3-Year Performance from Initial Fed Tightening (%) as of 9/30/23

Is a Recession Already Priced in?

Past performance is no guarantee of future results.

Another historical pattern that has so far not materialized is the relationship between small-cap performance and high-yield credit spreads. When the latter contract, as they have been doing since peaking in July of 2022, small-cap stock prices typically rise. High-yield spread have fallen 2000 basis points over the last 14 months. From 7/31/22-9/30/23, however, the Russell 2000 fell -3.5%. The last time high-yield spreads experienced a fall from a similar level with a comparable decline was from 7/31/20-12/31/20—and the Russell 20000 climbed 34.1% over that brief five-month span.

While these historical patterns are of great interest to us, we are more encouraged by the combination of valuations and long-term opportunities. The Russell 2000 finished September 2023 with a 2.4% 5-year annualized return—a performance nearly identical to its year-to-date result through the end of 3Q23 and evidence of just how underwhelming recent returns have been for the small-cap index. (To be sure, we are very pleased that performance of our own disciplined and active domestic Strategies has been far better.) Yet the average price to earnings ratio for the Russell 2000 five years ago on 9/30/18 was 18.4x—close to its long-term average of 18.1x—versus 12.5x at 9/30/23. While returns have stalled, multiples have compressed, creating a considerable number of buying opportunities.

Small Cap P/Es Have Come Down Amid Lackluster Returns
Weighted Harmonic Average Price-to Earnings Ratio (Excluding Non-Earners) for the Russell 2000 from 9/30/98-9/30/23

An Up and Down Quarter for Stocks

Past performance is no guarantee of future results.

Combine the attractive valuations for small caps as a whole with the fact—which we have discussed before—that small caps enjoyed strong and lasting recoveries following prior periods with low 5-year annualized returns. Indeed, the Russell 2000 had positive annualized 5-year returns 100% of the time—in all 81 five-year periods—averaging an impressive 14.9%, which was well above its monthly rolling five-year return since inception of 10.4%.

This history takes on more relevance for us in light of the exciting long-term opportunities that our portfolio management teams are seeing in areas as diverse as semiconductors, electric vehicles, electrification, aerospace & defense, medical devices, electronics manufacturing services, banking, and retail. They are also seeing considerable potential in those small-cap businesses that look poised to benefit from the growth of AI applications, much of it in areas beyond tech such as industrial uses. Current challenges notwithstanding, we think it’s a wonderful time to be invested in select small caps for the long run—and for active management to potentially shine.

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.

Average Annual Total Returns as of 9/30/2023 (%)

  QTD1 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE ANNUAL
OPERATING EXPENSES
NET               GROSS
Pennsylvania Mutual -2.73 23.72 13.04 6.01 7.69 N/A N/A  0.96  0.96
Dividend Value -3.38 24.00 10.48 4.59 6.09 7.85 05/03/04  1.34  1.62
Global Financial Services -0.82 9.73 6.05 3.57 6.25 7.17 12/31/03  1.57  1.98
International Premier -7.57 9.33 -5.56 0.21 4.51 4.75 12/31/10  1.44  1.59
Micro-Cap -3.24 18.23 13.73 5.44 5.17 10.13 12/31/91  1.24  1.24
Small-Cap Opportunity -4.95 20.85 17.48 7.53 8.61 11.58 11/19/96  1.23  1.23
Premier -4.78 19.71 10.30 5.80 7.73 10.93 12/31/91  1.18  1.18
Small-Cap Special Equity -3.96 15.47 11.43 5.34 5.70 8.34 05/01/98  1.21  1.21
Small-Cap Total Return 0.42 22.22 14.35 5.31 6.95 9.89 12/15/93  1.26  1.26
Small-Cap Value 0.31 22.76 16.76 3.59 4.64 8.25 06/14/01  1.49  1.59
Smaller-Companies Growth -10.92 6.56 -0.03 1.31 5.83 9.42 06/14/01  1.49  1.55
Russell 2000
-5.13 8.93 7.16 2.40 6.65 N/A N/A  N/A  N/A
Russell 2500
-4.78 11.28 8.39 4.55 7.90 N/A N/A  N/A  N/A
MSCI ACWI SC
-3.41 15.24 6.81 3.53 6.16 N/A N/A  N/A  N/A
MSCI ACWI x USA SC
-1.70 19.01 4.01 2.58 4.35 N/A N/A  N/A  N/A
Russell Microcap
-7.93 -1.35 4.85 0.23 5.25 N/A N/A  N/A  N/A
Russell 2000 Value
-2.96 7.84 13.32 2.59 6.19 N/A N/A  N/A  N/A
Russell 2000 Growth
-7.32 9.59 1.09 1.55 6.72 N/A N/A  N/A  N/A
1 Not annualized.

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes a shareholder would pay on Fund distributions or the redemption of Fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Investment and Service Class shares redeemed within 30 days of purchase may be subject to a 1% redemption fee payable to the Fund (2% for Royce International Premier Fund). Redemption fees are not reflected in the performance shown above; if they were, performance would be lower. Current performance may be higher or lower than performance quoted. Current month-end performance may be obtained at www.royceinvest.com. All performance and expense information reflects results of the Funds’ oldest share Class (Investment Class or Service Class, as the case may be). Price and total return information is based on net asset values calculated for shareholder transactions. Annual gross operating expenses reflect the Fund’s gross total annual operating expenses and include management fees, any 12b-1 distribution and service fees, other expenses, and any applicable acquired fund fees and expenses. Annual net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses, excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business, to the extent necessary to maintain net operating expenses at or below: 1.34% for Royce Dividend Value Fund; 1.44% for Royce International Premier Fund; and 1.49% for each the Royce Global Financial Services, Small-Cap Value, and Smaller-Companies Growth Funds through April 30, 2024. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds and other investment companies.

Service Class shares bear an annual distribution expense that is not borne by the Funds’ Investment Class. If such distribution expenses had been reflected for Funds showing Investment Class performance, returns would have been lower. 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.) Certain Funds invest a significant portion of their respective assets in foreign companies that 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 Foreign Securities” in the prospectus.) Therefore, the prices of securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of securities of U.S. companies. (Please see “Primary Risk of Fund Investors” in the prospectus.) Certain Funds generally invest a significant portion of their assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause their overall value to decline to a greater degree. A broadly diversified portfolio, however, does not ensure a profit or guarantee against loss. (See "Primary Risks for Fund Investors" in the respective prospectus.) Please read the prospectus carefully before investing or sending money.

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.)

The Price-Earnings, or P/E, ratio is calculated by dividing a company's share price by its trailing 12-month earnings-per-share (EPS). Harmonic Average is a weighted calculation that evaluates an index as if it were a single stock and measures it overall. It compares the total market value of the index to the index’s share in the earnings of its underlying stocks. The P/E ratio calculation excludes companies with zero or negative earnings (42% of Index holdings as of 9/30/23). If the negative P/E is over 30% we are unable to display the P/E Ratio due to not enough positive earnings.

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 Top 50 Index measures the performance of the largest companies in the Russell 3000 Index. It includes approximately 50 of the largest securities based on a combination of their market cap and current index membership and represents approximately 40% of the total market capitalization of the Russell 3000 Index. The Russell Midcap® Index measures the performance of the mid-cap segment of the U.S. equity universe and is a subset of the Russell 1000® Index that includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. 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 material 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. The MSCI ACWI ex USA Large Cap Index is an unmanaged, capitalization weighted index of global large-cap stocks, excluding the United States. The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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