Is the Small-Cap Earnings Recovery Just Beginning?—Royce
article 03-16-2021

Is the Small-Cap Earnings Recovery Just Beginning?

Co-CIO Francis Gannon on why he thinks earnings will drive the market as the economy heats up.


It has been quite a year since the Russell 2000 Index bottomed on 3/18/20. The reality of the pandemic plunged global economies into recession while almost simultaneously spurring unprecedented amounts of monetary and fiscal stimulus. In spite of the high and sorrowful human cost, one year later we are beginning to see stronger economic growth fueled by the related developments of multiple coronavirus vaccines and economies reopening. In fact, the latest estimate by the Atlanta Fed on first quarter Gross Domestic Product (GDP) is currently north of 8%—and subsequent quarters could rise even higher. Small-cap stocks, as measured by the Russell 2000, have rebounded 138.8% from the March 2020 low through 3/11/21.

The transition over the past twelve months from recession to recovery and into expansion is seemingly priced into many small-cap companies. Yet, as the shift to a sustained economic expansion continues, the tug of war between expectations and underlying fundamentals is likely to be the critical factor in determining further multiple expansion. As we move into the second year of the bull market, earnings will be key. And for many sectors within the small cap universe, the earnings recovery is just beginning.

“As we move into the second year of the bull market, earnings will be key. And for many sectors within the small cap universe, the earnings recovery is just beginning.” — Francis Gannon

To be sure, the market appears to be rediscovering the importance of earnings. After a period of subpar economic growth, earnings are just now beginning a robust recovery, with many industries still well shy of pre-COVID levels. In fact, the trough in small cap looks to have occurred during the final quarter of 2020, when 49% of the Russell 2000 Index was comprised of non-earners, a number we expect to drop dramatically over the next few quarters. In that same fourth quarter, 60% of the companies in the Russell 2000 beat earnings estimates, and 50% beat on both earnings and sales.

In the meantime, Wall Street estimates for 2021 small-cap earnings growth have moved steadily upward so far this year, with expectations of 50% growth year over year—an estimate in line with the average earnings growth coming out of the two previous recessions. As we’re just now transitioning to a period of sustained expansion, the story of small-cap earnings improvement is likely still in its early chapters. If, as seems likely to us, we continue to see broader economic participation and earnings strength, the combination will likely reward smaller companies in general—and in particular high-quality and other fundamentally strong small-cap cyclicals—even amid escalating inflation and rising interest rates.

Finally, it should be noted that economic growth will be unevenly distributed. There will also likely be market pullbacks along the way as investors digest inflationary pressures and higher long-term yields, which is precisely why we think active managers can offer an edge. As we have been saying of late, the skill set of pattern recognition, understanding industry dynamics, and evaluating management teams should prove crucial in the months ahead.

Stay tuned…

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Important Disclosure Information

Mr. Gannon’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

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.

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.

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