3 Reasons to Consider High-Quality Small-Cap Stocks Now—Royce
article , video 03-20-2019

3 Reasons To Consider High Quality Now

Senior Investment Strategist Steve Lipper details how higher volatility, lower returns, and the road to normalization may bode well for high-quality small-caps.


How might the road to normalization benefit high-quality small-caps?

Here at Royce, we’ve been talking about for a while this road to normalization, and there are three specific aspects that we think will typify the market environment in the upcoming years. Those three are a return to a more normalized rate structure, which is to say probably a steeper yield curve than we have today, higher volatility than we’ve experienced up until the fourth quarter, and a return environment, which is probably lower than the long-term average for small-caps. Now what’s interesting is all three of those have an effect on high-quality strategies if we look historically at which environments high quality has done best in.

“High-Quality” is the top quintile of securities in the Russell 2000, sorted by an equal combination of ROIC and the stability of ROA.


So the current environment in terms of rate normalization, you might take the view that on a short rate basis maybe we are closer to normal, but the yield curve is flat compared to history. So if
we’re correct and you do have a steepening yield curve, what does history say that effect has on high-quality strategies? Well, it’s actually pretty constructive. Over all one-year periods the high-quality strategy has outperformed an average of 480 to 490 basis points. In steepening periods, the outperformance was over 600 basis points, so even greater outperformance in those environments.

The High Quality Edge: Better When High Yield Spreads Widen
Monthly Rolling 1-Year Average Excess Returns
High Quality minus Russell 2000 from 12/31/92 through 12/31/18


Source: Factset.
High Quality: The top quintile of securities in the Russell 2000, sorted by an equal combination of ROIC and the stability of ROA.
High Yield Spread: ICE BofAML US High Yield Master II Option-Adjusted Spread measures the spread between an index of below investment grade bonds and the spot Treasury curve.

How might a high volatility environment benefit high-quality small-caps?

So in low volatility environments, what we found was that high quality outperformed on an average three-year basis about 275 basis points. In average volatility environments it was about 350 basis points, but to our perspective the real stunner was in high volatility environments—historically, high quality outperformed over 800 basis points. So if we’re headed to a medium or higher volatility environment that would be pretty attractive or could be for high quality.

The High Quality Edge: Better Relative Performance When Volatility Is High or Average
Average 3-Year Performance Spread by Volatility Ranges
3-Year Returns of High Quality minus Russell 2000 from 12/31/92 through 12/31/18


Source: Factset.
High Quality: The top quintile of securities in the Russell 2000, sorted by an equal combination of ROIC and the stability of ROA.
Volatility is measured by standard deviation within the Russell 2000. Standard deviation is a statistical measure within which the index’s total returns have varied over time. The greater the standard deviation, the greater the volatility.

How might a lower return environment impact high-quality small-caps?

So if you look at all five-year periods over the 40-year history of the Russell Index, the average return for all of them, it’s between 10 and 11%. Our perspective here is that we may see a little less than that, perhaps high single-digit returns over the next five years. What does history tell us about how high quality does in those environments? Actually, it’s the best type of environment. The outperformance of high quality strategies in a period of 5 to 10% return for the Russell, the outperformance is over 700 basis points, actually the greatest spread of any of the market return levels that we’ve seen. From rate normalization, higher volatility and high single-digit market return environment, all of those suggest this may be an attractive environment for high quality.

The High Quality Edge: Better Performance in High Single Digit Years
Monthly Rolling 5-Year Average Excess Returns: High Quality Minus Russell 2000


Source: Factset.
High Quality: The top quintile of securities in the Russell 2000, sorted by an equal combination of ROIC and the stability of ROA.

More Small-Cap Perspectives


Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the persons speaking as of January 9, 2019 and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

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.

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. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest 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.

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). The portfolio calculation is a simple weighted average that excludes cash, all non-equity securities, investment companies, and securities in the Financials sector with the exceptions of the asset management & custody banks and insurance brokers sub-industries. The portfolio calculation also eliminates outliers by applying the inter-quartile method of outlier removal.

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.)



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