Earnings Are Fueling Small Cap’s Recent Rebound—Royce
article 11-22-2021

Earnings Are Fueling Small Cap’s Recent Rebound

Co-CIO Francis Gannon on how earnings growth is driving recent small-cap performance.


Small caps recently broke out of an eight-month sideways consolidation, making a broad and powerful move even as inflationary numbers surge. The Russell 2000 Index has advanced more than 5% so far in November while reaching new all-time highs. The breakout was powered by taper language from the Fed that was more dovish than expected and, we think even most importantly, strong third-quarter earnings. With most companies in the small-cap index, having reported better than expected third quarter earnings, total small-cap earnings are expected to rise over 50% on strong sales growth even with rising labor cost and supply chain issues. Pricing power has been key during the most recent quarter, a trend that we believe will continue well into next year.

The Russell 2000's November High

Despite lingering global supply chain disruptions and elevated inflation, smaller companies have mostly been successful navigating most of these margin headwinds by relying on pricing power. The Energy, Materials, and Industrials sectors led the way in the quarter, each delivering generally strong earnings growth and margin upside while Utilities and Consumer Staples lagged. In our own portfolios, industrial distributors, select retailers, and machinery companies were among the industries that showed the strongest earnings growth while highlighting their respective abilities to pass on costs. Perhaps the reporting season’s most interesting development was the divergence between beats and misses, as even low valuation, low expectation stocks, which would usually have some shelter if they missed, were dramatically punished.

Pricing Power

As we look to 2022, earnings expectations should reflect continued economic growth. Given the strong global growth backdrop and related positive results from companies in the first three quarters of 2021, expectations are moving higher in most sectors even as uncertainty around labor costs, supply chains, and future corporate tax policy lingers. The clear risk as we move forward is how companies weigh robust demand and the inability to fulfill orders—which could lead to eventual demand destruction. At the same time, it is important to highlight that the improvement in corporate earnings outside the U.S. is still unfolding as most other countries have lagged in the recovery and so could represent further upside into 2022.

So while inflation has assumed center stage, it has not derailed the equity markets or blunted earnings growth. More than a year after Pfizer announced its first positive vaccine results in fall 2020, the Russell 2000 has advanced more than 40% through mid-November 2021. Price pressures may continue for the next several months, but supply bottlenecks are showing signs of easing. Against this cautiously optimistic backdrop, earnings have been key to returns, and will continue to be. To be sure, our expectation is that pro-cyclical groups will continue leading the way. Upward earnings revisions reflect confidence in economic expansion even among those sectors hardest hit by the pandemic. And economic expansion has historically left small-cap earnings poised to exceed those of their large-cap siblings, which should in turn drive relative outperformance. Adding to this optimistic view, small-cap’s relative valuation versus large cap remains near 20-year lows even with November’s strong results so far.

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. Yet earnings comparisons will also become more difficult next year, which will likely make the market more selective, resulting in lower overall returns. However, history shows that active small-cap strategies have done better in high single-digit return periods. In our view, employing disciplined and differentiated active approaches through this transitional period will be paramount to achieving strong absolute and relative returns going forward.

Stay tuned…



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.)



Sign Up