Can Small Cap Cyclicals Keep Running?—Royce
article 06-09-2021

Can Small Cap Cyclicals Keep Running?

Has the bulk of improved corporate profitability already been reflected in stock prices, or can select small caps continue to perform well?

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Over the past 14 months, we have been struck by the extraordinary rate of change with which the markets, the economy, and corporate earnings first priced in the effects of the pandemic before embarking on a synchronized global economic recovery. We experienced the largest ever quarterly loss for the Russell 2000 Index its more than 40-year history—a decline of 30.6%—only to see the index rebound for its best-ever showing in 4Q20 with a gain of 31.4%. Similarly, U.S. GDP contracted -31.4% in the second quarter of 2020, only to be followed by a rebound of +33.4% in 3Q20.

Given these recent extremes, it’s interesting that the Russell 2000 has been mostly treading water since hitting its most recent peak on 3/15/21 even as stellar first quarter earnings, generally positive corporate outlook statements, and economic data have all been reported. One can only wonder if, much like the market of late, overall growth is stalling. With the significant amount of monetary and fiscal stimulus that have already flowed into the U.S. economy, have we passed the peak in rate of change for the economy? Has the bulk of improved corporate profitability already been reflected in stock prices?

While we understand these concerns, especially in our still uncertain, not-quite-post-pandemic world, we take a more sanguine, cautiously optimistic view. From our perspective, the economy is normalizing and broadening out, which is both a healthy and welcome development. While index returns have been flat of late, we have seen considerable rotation beneath the surface. Excess liquidity is finding its way to previously forgotten parts of the market—consistent with we have seen in prior economic expansions.

Unsurprisingly, first-quarter earnings generally saw sharp revenue and earnings growth across a broad range of sectors, amplified by strong year-over-year comparisons against 2020’s lockdown-induced lows. However, a closer look at earnings estimate revision trends into 2022 following the first quarter shows plenty of strength coming from most cyclical sectors—including Industrials, Materials, Energy, and Consumer Discretionary—while Health Care, the more growth-oriented areas of Information Technology, and Real Estate weaken.

Many of our pro-cyclical investments in areas such as housing, housing materials, trucking, logistics, retail, banking, and title insurance exceeded expectations—and many raised guidance. Interestingly, as the economy reopens, we have also seen explosive margin expansion in many of the industries hardest hit by the pandemic, including some that would normally be negatively affected by rising input costs. Retailers offer a great example, benefiting from increasing demand with limited to no pricing discounts. Other examples would include building materials, home builders, and furniture manufacturers, which would all typically be subject to dramatic margin erosion as input prices move up. Yet many—especially those with established reputations for high quality—have seen their margins remain stable or expand as they have passed along pricing at a pace and rate that we have not seen in many, many years.

“As the economy reopens, we have seen explosive margin expansion in many of the industries hardest hit by the pandemic, including some that would normally be negatively affected by rising inputs costs.” — Francis Gannon

Further margin expansion will be key for many of these industries as we head into next year. COVID forced greater corporate efficiency which should show up in stronger margins as the economy fully recovers, especially for those high-quality business that were able to bolster their competitive standing even in the depths of the pandemic. Offsetting this, however, is the prospect for higher corporate tax rates.

Still, as earnings comparisons undoubtedly become increasingly difficult, and the market grows more selective, we think active management should continue to benefit from the ongoing cyclical rebound as the economy continues to normalize. A more traditional economic cycle should show growth and profitability coming from a broader swath of the overall economy—as has been the case since roughly last fall (triggered by the approval of vaccines).

To be sure, forward market returns are likely to decline from current levels as we approach and pass the respective peaks in the rate of change for the economy and company profitability. Yet history shows that active small-cap strategies have done better in single-digit return periods. Employing active approaches that are both disciplined and more differentiated through this transition will be paramount to achieving strong absolute and relative returns going forward.

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.

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.

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 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 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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