4Q20 Small-Cap Recap—Royce
article 01-04-2021

4Q20 Small-Cap Recap

Co-CIO Francis Gannon reviews 4Q20, small cap's best ever quarter in a tumultuous year, and details his outlook.


From Worst to First: Small Cap in 2020

Small-caps finished a most remarkable year with a 31.4% gain for 4Q20, the best quarter in the more than 40-year history of the Russell 2000 Index—and after beginning the year with the largest ever quarterly loss in the index’s history. From the depths of its 3/18/20 low through the end of December, the small-cap index rallied to a 101.3% gain. While we have witnessed many oddities in our nearly five decades of small cap investing, we have never seen a year as extreme as 2020.

Russell 2000 Quarterly Returns Since Inception

r2k lowest to highest in 1year

Past performance is no guarantee of future results.

Small-cap stocks handily outpaced large caps—and much else—in 4Q20, though the Russell 1000 Index (+13.7%) and the Nasdaq Composite (+15.4%) also posted sizable advances in the quarter. Despite the strength of small cap’s move late in the year, the Russell 2000 was not quite able to exceed the performance of its large-cap sibling for 2020. The small-cap index advanced 20.0% for the year compared to a 21.0% gain for the Russell 1000. Each trailed the tech- and biotech-laden Nasdaq’s 43.6% return for the same period.

The more recent strength for the Russell 2000 was distinct from the performances of large-cap indexes in 2020. While the Russell 1000 and Nasdaq each reached successive peaks several times in 2020, the small-cap index did not overtake its prior all-time high from August 2018 until mid-November of 2020. Small caps narrowed the gap with large caps in 2020 while also continuing to trail over the annualized three- and five-year periods. Still, the late surge in favor of the Russell 2000 is one of the reasons we think small caps are in the early stage of a leadership cycle.

The other major development in 4Q20 was the narrow edge for the Russell 2000 Value Index over its small-cap growth counterpart, up 33.4% versus 29.6%. Yet this did not prevent value from underperforming growth for the calendar year by one of the widest margins ever as the Russell 2000 Growth gained 34.6% versus 4.6% for value. Going forward, we see better leadership prospects for small-cap cyclical stocks, though their leadership should help value to continue closing the gap with growth.

Small Cap Cyclicals in High Gear

As has been the case since mid-May, small-cap cyclicals led defensives for 4Q20, though for the calendar year defensives outperformed. This relative disadvantage was mitigated in our view by the emerging strength cyclicals showed following the mid-March lows.

The six top-performing sectors for 4Q20 were cyclicals. Energy, Materials, Information Technology, Financials, Industrials, and Communication Services led the remaining five sectors in the Russell 2000, which all finished the quarter in positive territory. The rebound in the three reflationary cyclical sectors—Energy, Materials, and Financials—was spurred by a rally in commodity prices, a weakening U.S. dollar, and a steepening of the yield curve. Their improved results seemed to signal that investors are looking forward to a robust global growth spurt once vaccines are more widely available.

Russell 2000 Sectors

sectors ytd and qtd

Health Care, the small-cap index’s largest sector, was the top performer overall for the calendar year, leading by an impressive margin. It was followed by notable results for two cyclical areas—Information Technology and Consumer Discretionary. In all, seven of the Russell 2000’s 11 sectors contributed positively to 2020 performance, with cyclical sectors Industrials, Materials, and Communication Services also finishing the year in the black while Consumer Staples was the only other defensive sector, along with Health Care, to do the same.

Low Quality Rises High

As was the case in 3Q20, low-quality stocks advanced to join cyclicals as small-cap leaders in 4Q20. Companies in the lowest ROIC and ROE quintiles, along with those with no earnings and/or dividends, led the Russell 2000 while stocks with the highest ROIC and ROE trailed. Quarterly returns, however, were encouragingly high in all these factor categories—offering evidence of how strong the quarter was across the asset class.

We also want to note that lower-quality stocks typically lead in the early stages of dynamic rallies, as these stocks are often rebounding from prior steep declines. Historically, the lowest quintile ROE companies in the Russell 2000 have led in the initial stages of an upswing. However, as the market cycles matured from a frenetic pace to a more moderate advance, higher profitability stocks moved into a leadership role, with the top quintile of ROE companies outperforming.

Low Quality Has Led Early While High Quality Has Led in the Second Year of Small-Cap Rebounds
Average Russell 2000 ROE Quintile Performance for Past Four Market Recoveries

peak to trough 1year and 2year

Past performance is no guarantee of future results.

Where Are We in the Small Cap Cycle?

Long-time readers will know that we look to small-cap market cycles to provide some guidance for the road ahead. The average peak-to-peak return for the 12 previous Russell 2000 market cycles was 43.8%. Through the end of 2020, the small cap index advanced 17.3% from its prior peak in August 2018. It seems to us, then, that this small cap rally has further to go. Seeing when that next peak will arrive is well beyond anyone’s ability to forecast. Still, we can say that based on history it’s rare for small caps to see significant declines in the absence of either a recession or aggressive Fed actions, and thankfully neither appears likely in 2021.

Russell 2000 Peak-to-Peak Returns for Market Cycles Following Drawdowns of 15% or More

r2k peak to peak

Past performance is no guarantee of future results.

While our outlook is positive for small caps, it is for a more moderate advance than we have seen recently—perhaps an unsurprising observation after a record fourth quarter. 2020 was a better year for financial assets than it was for the economy, and we suspect that 2021 could be the reverse. The market’s significant advance off the March trough has undoubtedly priced in a meaningful amount of the rebound in small-cap profits anticipated in a recovery, and near-term optimism may be excessive. The expectations that are currently baked into many companies’ valuations may prove unrealistically high in 2021. A measure of disappointment is almost sure to follow, meaning increased volatility and the probability of a 10-15% correction in the months ahead—which should be good news for disciplined active managers with ample experience investing in volatile markets.

We remain confident about the prospects for select cyclical small caps for the reasons we have discussed before: economic rebounds have historically meant good things for cyclicals, which are more sensitive to economic conditions than defensives, and for small caps, which have enjoyed some of their largest outperformance spreads relative to large caps during economic recoveries.

Finally, in saying good-bye to such a difficult and—for too many—sorrowful year, we want to acknowledge our clients, our colleagues, and the many essential workers who did so much to help us all through this trying period. Better days are ahead.



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.

Return on Invested Capital is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock). Return on Average Total Equity (ROE) is the trailing twelve month net income divided by the two fiscal period average total shareholders’ equity.

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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.

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