The Case for a Strong Small-Cap Run
article 03-05-2024

The Case for a Strong Small-Cap Run

Co-CIO Francis Gannon thinks current economic and investment conditions are creating potential advantages for active small-cap managers, with a particular edge developing for higher-quality small-cap companies.


We believe that current economic and investment conditions are creating potential advantages for active small-cap managers, with a particular edge developing for higher-quality small-cap companies.

“We think the potential is high for a sustained period of strong small-cap performance on both an absolute and relative basis.”
—Francis Gannon

The normalization of rates is already leading companies to make what we see as more rational capital allocation decisions—because balance sheets and financial leverage matter again. This is especially true in small-cap, with its high percentage of loss-making companies, and where debt tends to be more variable than fixed. In this context, a more historically typical interest rate era should reward successful operational performance—as opposed to financially engineered profits—and thus supports the potential for higher-quality businesses to outperform. We define high-quality businesses as those with low debt, the ability to generate free cash flow, high returns on invested capital, and management teams with proven skill at allocating capital prudently and effectively.

Within the Rusell 2000 Index—where the majority of passive small-cap index investments focus—43% of the constituents are loss-making companies, with many also having a relatively high degree of financial leverage. From a quality standpoint, actively managed small-cap portfolios look better positioned for success than the overall benchmark because active managers tend to prefer companies with attributes such as high—and consistent—returns on invested capital, low debt, free cash flow generation, and steady profitability.

All these developments may be setting the stage for above-average small-cap performance. As of 2/29/24, the Russell 2000 was down -13.0% from its last peak on 11/8/21. With rates stabilizing and the U.S. economy growing, the potential for mean reversion potential appears very high. Moreover, the 3-year average annual total return for the Russell 2000 as of 2/29/24 was 0.9%. Why is this dismal return notable? In 66 of 67 periods—or 99% of the time—when the index’s 3-year average annual total return was 3% or lower, subsequent 3-year annualized returns were positive and averaged 16.7%—a significantly higher mark than the Russell 2000’s 10.7% monthly rolling 3-year average annual return since inception (12/31/78).

Small-caps had a peak to trough decline of more than 30% in the current cycle and in many cases have already discounted a recession that has yet to materialize. We are therefore expecting a sustained catch-up phase for small-caps as returns have fallen significantly below average on a 1-, 3-, 5-, and 10-year basis through the end of February.

Given these recent returns for the Russell 2000, it will probably come as no surprise that small-cap stocks remain undervalued on both an absolute basis and relative to large-cap stocks. What is less obvious is that select small-cap businesses continue to flash considerable earnings potential. As of 12/31/23, the weighted harmonic price-to-earnings ratio (“p/e ratio”) for the Russell 2000 was well below its historical average (14.9x versus 17.9x) while large cap traded at the substantially higher P/E of 23.3x at the end of 2023.

Small-Cap P/Es are Still Below Average
Weighted Harmonic Average Price-to Earnings Ratio (Excluding Non-Earners) for the Russell 2000, 12/31/98-12/31/23

Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies)

Source: FactSet
Price-to-Earnings Ratio is calculated by dividing a company’s share price by its trailing 12-month earnings-per-share (EPS) and also excludes companies with zero or negative earnings. 42% of Index holdings were excluded as of 12/31/23). Harmonic Average is a weighted calculation that evaluates a portfolio as if it were a single stock and measures it overall by comparing the total market value of the portfolio to the portfolio’s share in the earnings or book value, as the case may be, of its underlying stocks.

In a similar vein, we have written recently that relative valuations for small-caps relative to large-caps were near their lowest in 25 years as of 12/31/23 based on our preferred index valuation metric, enterprise value to earnings before interest and taxes, or EV/EBIT. Further, earnings growth for small-caps is expected to be double that of large caps in 2024—which is consistent with the mostly positive news that our portfolio management teams heard during February 2024’s earnings season.

Finally, we see a secular opportunity for active small-cap management. Small-caps have greater exposure to U.S. economic activity. Many smaller companies will likely see powerful secular benefits from nascent trends in AI, reshoring, supply chain shifts, and deglobalization. The CHIPS Act and several infrastructure projects will also boost U.S.-centric manufacturing activity, benefiting smaller companies. All these activities will take place against the favorable backdrop of falling inflation, narrowing credit spreads, and the high probability that the Fed will cut rates later in 2024. To be sure, we think the potential is high for a sustained period of strong small-cap performance on both an absolute and relative basis.

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.

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 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. Returns for the market indexes used in this report were based on information supplied to Royce by Russell Investments. Royce has not independently verified the above-described information.

Return on Invested Capital is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock).

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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