Micro-Cap Stock Performance—Royce
article 12-17-2019

Micro-Caps on the Move

After a long period of underperformance, the last three-plus months have seen an encouraging upward move for micro-cap stocks.

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As the year winds toward its close, large-caps continued to hold sizable performance spreads over their small- and micro-cap cap siblings, as measured by the Russell 1000, Russell 2000, and Russell Microcap Indexes. Recent moves, however, suggest that this may be changing.

Russell Indexes Average Annual Total Returns as of 11/30/19 (%)

rmicro-r2k-r1k

1Not annualized

What’s of particular interest to us about the latest run of large-cap outperformance is the effect it’s had on valuations. We first looked at the results of this in November, when our research found that small-caps were selling at their biggest discount to large-caps since 2001.

This led us to examine how this performance pattern had affected micro-cap stocks, knowing that their returns have lagged small-caps over the last few years. We found at the end of 3Q19 that the 15-month performance spread between mega-caps and micro-caps was nearly a whopping 30%. The Russell Microcap declined 15.6% over this period—the span from 6/30/18-9/30/19—while the Russell 1000 advanced 11.6% and the mega-cap Russell 50 Index did even better, rising 14.2%.

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This has created an even more substantial valuation discrepancy between micro-caps and large-caps, especially based on our preferred valuation metric, EV/EBIT (enterprise value divided by earnings before interest & taxes). The median EV/EBIT, excluding non-earners, for the Russell Microcap was 17.5x compared to 20.0x for the Russell 1000, both at the end of November. The chart below gives another look—not just how wide this valuation gap has grown but also that micro-caps were trading at their steepest discount to large-caps since 2001.

Micro-Caps Look Attractive vs. Large-Caps
Russell Microcap vs Russell 1000 Median Relative LTM EV/EBIT Ex. Negative EBIT1 chart

rus-mirco-vs-r2k

1Last Twelve Months Enterprise Value/Earnings Before Interest and Taxes
Source: FactSet 

While we think that valuations remain relatively attractive in many corners of the micro-cap world, recent returns show that the performance gap is narrowing, however gradually. A rotation began with the market’s recovery on August 27th following down months in July and August. Since then, the Russell Microcap has beaten the Russell 1000 for three consecutive months—and was ahead in December through the twelfth of that month. (This was one of a group of simultaneous reversals that upended the market leadership patterns that had previously been in place—from 8/27/19-9/30/19 small-caps outpaced large-caps, small-cap value beat small-cap growth, and cyclicals outperformed defensives.)

“While we think that valuations remain relatively attractive in many corners of the micro-cap world, recent returns show that the performance gap is narrowing, however gradually.” — Francis Gannon

Of course, our analysts and portfolio managers have noticed that valuations have looked attractive on an absolute basis in many areas of the micro-cap market for much of the last three years. In our deep value, absolute value, and core strategies, they have been very active buyers in the space in areas as diverse as healthcare devices, diagnostics, and testing; paper & packaging; semiconductors and semiconductor capital equipment; chemicals; and consumer finance.

We don’t know if the recent upward move for micro-caps will last or when they will assume market leadership. In our more than four decades of investment experience, however, we have seen similar patterns of long-term underperformance, which often ultimately ended with satisfaction for our contrarian stance.

Stay tuned…

More Small-Cap Perspectives

 

Important Disclosure Information

Mr. Gannon’s 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.

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 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 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 Microcap Index includes 1000 of the smallest securities in the small-cap Russell 2000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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. (Please see "Primary Risks for Fund Investors" in the prospectus.)

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