2020 Small-Cap Earnings—Royce
article 02-24-2020

Will 2020 See Widespread Earnings Recovery For Small-Caps?

Co-CIO Francis Gannon details research that shows why he believes small-cap earnings may have a multi-quarter turnaround.

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In an environment where the largest five stocks in the Russell 1000 Index have a combined valuation that is 2.3 times bigger than the total market cap of the Russell 2000 Index, many smaller companies find themselves in an unsought but familiar position two months into 2020—once again trailing the broader market. With the Russell 1000 reaching fresh highs in the new year, the Russell 2000 has continued to lag even in the face of improving economic data. The ISM Manufacturing Index, for example, positively inflected in January. This was not enough, however, to push small-caps ahead of their large-cap siblings, as one would typically expect when economic growth signals are flashing green.

We believe that investors have doubts as to whether or not that positive inflection can be sustained in the months ahead, especially as the full economic impact of the coronavirus remains unclear. At the same time, fourth-quarter 2019 earnings for small-caps are coming out, with a large number looking lackluster vis-à-vis their large-cap counterparts. However, we believe that is beginning to change.

From our perspective, with more than a third of the companies in the Russell 2000 having reported as of this writing, small-cap earnings appear to be kicking off what we believe could be a multi-quarter turnaround—barring any significant economic hiccups, of course.

“From our perspective, with more than a third of the companies in the Russell 2000 having reported as of this writing, small-cap earnings appear to be kicking off what we believe could be a multi-quarter turnaround—barring any significant economic hiccups, of course.” — Francis Gannon

Earnings growth for the Russell 2000 came in at 22.4% in 2018 before decelerating sharply in 2019. While we await the final figure for 2019, estimated growth is currently slated at just 4.4%. But fourth-quarter 2019 year-over-year earnings growth is currently up 5%—versus flat expectations, no less—with 64% of Russell 2000 companies reporting that they beat estimates. Not surprising, the Energy sector has seen the largest percentage of misses while Information Technology and Utilities are so far showing the largest earnings beats. Equally important, current estimates for the Russell 2000 in 2020 show earnings growth accelerating quarter by quarter through the remainder of the year to more than 15% in the fourth quarter of 2020.

Obviously, those numbers are subject to change, but in an environment where the trajectory of global economic growth is constantly being questioned, we suspect that certain small-cap stocks may prove resilient. Moderate growth, low inflation, low rates, and an accommodative Federal Reserve continue to provide a solid backdrop for smaller companies.

While uncertainties linger over the long-term economic impact of the coronavirus—and its effects on earnings growth—we remain focused on the opportunities at hand. Liquidity is increasingly becoming an issue for small-cap stocks as more and more market capital flows to mega-cap companies. As a result, we’ve observed an increase in individual stock volatility in many pockets of our asset class, which has understandably tended to increase around quarterly earnings reports. As disciplined, long-term active managers in the small-cap space, we are often liquidity providers who need to be prepared to take advantage of dislocations when they occur.

We believe that the small-cap earnings story should continue to improve as the year progresses, especially versus forgiving comparisons to 2019. Additionally, we would not be at all surprised if further stimulus from China acts helps to accelerate earnings improvement—and stock performance—for small-cap companies in the not-too-distant future.

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.

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.

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.

The ISM Manufacturing Index (ISM) monitors employment, production, inventories, new orders and supplier deliveries.

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 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. 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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