Surviving Adversity to Thrive in Recovery—Royce
article 09-08-2021

Surviving Adversity to Thrive in Recovery

Co-CIO Francis Gannon on why small-cap companies that effectively managed COVID hardships look poised to lead.


August has historically been a volatile month for the equity markets, and this past period did not disappoint. It was a month of high anxiety and increased volatility as the ongoing effects of the pandemic and its more recent Delta variant continued to affect businesses across the globe while geopolitical risks re-emerged in the wake of the U.S. withdrawal from Afghanistan. At the same time—and somewhat paradoxically—the global economy continued to recover, stoking the sizable appetite for risk among investors, one that’s already led to record valuations for the U.S. large cap indexes.

Amid this more uncertain climate, we have also seen more modest returns for the small-cap market of late. Since its previous high in mid-March 2021 into mid-August, the Russell 2000 Index endured a stealth correction, down 8.2% from 3/15/21 through 8/18/21, before a rally saw out the last two weeks of the month. As of the end of August, however, the small-cap index remained 3.2% below its mid-March high. During this correction in time, corporate earnings have continued to expand while multiples have contracted. Among our numerous small-cap holdings, we have seen few disappointments in earnings or downward revisions. In this positive context for small-cap company results, we think that small caps can reassert their prior leadership—but the more relevant issue may be determining which small cap companies are best positioned to lead.

It still seems more probable than not to us that slowly rising rates should gradually pressure historically high absolute valuations that will be potentially offset by continued strong earnings and healthy prospects for ongoing growth through at least the end of next year. However, these countervailing forces will not affect all small-cap stocks in the same way, especially as the profit cycle continues to mature. Differentiation will be critical—which is why within all of our strategies, we have focused on identifying businesses that first proved capable of capitalizing on the difficulties wrought by the pandemic and ensuing recession to improve their operations, execution, and/or prospects.

“Within all of our strategies, we have focused on identifying businesses that first proved capable of capitalizing on the difficulties wrought by the pandemic and ensuing recession to improve their operations, execution, and/or prospects.” — Francis Gannon

To be sure, we are just beginning to see the fruits of their labors. For example, many of our portfolio businesses from the retail, restaurant, and even title insurance industries are just starting to see the benefits of enhanced technology investments that are leading to higher operating margins and increased profitability, which should continue well beyond the pandemic period. At the same time, we hold several industrial businesses that made effective use of the down time mandated by the COVID outbreak to push forward with production enhancements that are in turn giving them a leg up on their competitors. Moreover, we own companies in industries as diverse as trucking, semiconductors, homebuilding, and retail that are managing the ongoing interruptions in global supply chains in constructive ways. As the profit cycle matures, we expect these well-run small caps to further distinguish and distance themselves. We reserve a particular confidence for what we see as high-quality businesses—those with strong balance sheets, high returns on invested capital, and the ability to generate free cash flow—which have lagged through much of the small-cap market’s rebound from the March 2020 trough.

We anticipate that volatility will likely increase or remain elevated over the next several months as macro uncertainty lingers and earnings comparisons become more challenging in 2022. These factors should encourage investors to be more discerning, rewarding those companies that show sustainable growth in what in all likelihood will be a still expanding global economy. We have already seen that those small-cap businesses which managed adversity best have also experienced notable earnings and revenue growth. This is precisely the sort of differentiation that we expect to be key as we move forward into what looks like a very promising period for active small-cap management.



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.

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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