Royce Annual Letter To Shareholders—Royce
article 02-02-2022

Annual Letter: The Market’s Unexpected Guest

Why we’re confident in small-cap value amid the bear market, the Fed pivot, and inflation.


The Bear Is Back—Now What?

2021 was a year of decelerating optimism for many small-cap investors as performance momentum slowed as the weeks passed by between April and December. With the benefit of a late January vantagepoint, we can now see that decreasing market momentum, increasing concerns about inflation throughout the last nine months of 2021, and a significant Fed pivot all foreshadowed a sharp small-cap decline to start 2022. So while the Russell 2000 Index enjoyed a strong year on an absolute basis, rising 14.8%, nearly all of the year’s gain came in the first quarter, when the Russell 2000 climbed 12.7%. Following this strong and promising start, the small-cap index gained only 1.9% from the second through the fourth quarter of 2021. Having so little to show for the last nine months was even more frustrating in light of the generally strong earnings growth from small-cap companies, many of which also raised guidance or offered optimistic outlooks in the second half of 2021.

Bigger Was Better After 2021’s First Quarter
1Q21 Returns and 2Q21-4Q21 for the Russell 2000 and Russell 1000 Indexes

Russell 2000 and Russell 1000 Returns

Past performance is no guarantee of future results

In addition to the disappointment felt by making little progress after a strong start, small-cap investors also saw the asset class progressively cede its wide first-quarter lead over large-caps, with the Russell 2000 finishing the year substantially behind the large-cap Russell 1000 Index’s 26.5% advance in 2021. We suspect that many investors turned to mega-cap stocks during the year in a ‘flight to safety’ as concerns about the Omicron variant and the pace of economic growth emerged, especially when interest rates were still so low. As the early results in 2022 have indicated, we expect these same mega-cap stocks to struggle going forward because their valuations are particularly vulnerable to higher inflation, rising interest rates, and constrained liquidity.

Regardless of the more recent struggles for equities of all capitalization sizes, we recognize that it may seem odd to characterize small-cap investors as feeling let down after a year that provided a healthy 14.8% return—while also marking a third consecutive year of double-digit positive performance for the Russell 2000. Yet we are cognizant that 2021 might feel like a year of unfulfilled promise for many of these investors. After all, 2021 did begin with an ample dose of confidence in both the absolute and relative returns for the Russell 2000—which was rewarded in the first quarter. However, a closer look at small-cap returns in 2021 suggests that one’s perspective on the year probably differs considerably depending on how heavily an investor leaned towards small-cap value or small-cap growth.

Value: Small-Cap’s Happy Exception

The best news for small-cap investors in 2021 arguably came from value stocks. The Russell 2000 Value Index had a wonderful year—advancing 28.3% (thus beating the Russell 1000). The small-cap value index also walloped the Russell 2000 Growth Index, which was up a paltry 2.8% for the year. 2021 marked the first calendar-year outperformance for the Russell 2000 Value over its small-cap growth sibling since 2016. We think small-cap value is just starting to flex its relative performance muscles, as it were, and we see three reasons to be optimistic about small-cap value’s prospects. First, in spite of the strength it’s shown since the fourth quarter of 2020, the Russell 2000 Value’s annualized three- and five-year returns still trailed those for its growth sibling at the end of 2021—by a significant amount on the five-year number. Equally important, this result stands in stark contrast to the average return spread for all five-year periods, which is about 300 basis points in favor of small-cap value. Based on history, then, it appears that the Russell 2000 Value has further to go before fully reverting to its historical outperformance of the Russell 2000 Growth over multi-year periods. This also suggests that the difficult times for small-cap growth investors may persist longer than its adherents would like.

Small-Cap Growth’s Recent 5-Year Outperformance Contrasts with Historical Pattern
As of 12/31/21

5-years ended 12/31/21 and and average of all five-year periods since 12/31/78

Past performance is no guarantee of future results

Advantage Value?

A second reason underscoring our confidence in the ongoing leadership for small-cap value is that significant differences exist in economic exposures among value and growth portfolios, which are mirrored by the meaningful divergences in composition between the two small-cap styles indexes. Looking into each index’s composition reveals certain factors that help explain why returns often have varied so much between the two style indexes over the last 40-plus years. The two industry groups where the Russell 2000 Value is most overweight compared with the Russell 2000 Growth are banks and real estate, both traditional beneficiaries of inflation and cyclical activity. These industry groups, banks in particular, often have high exposures in active small-cap value portfolios. Conversely, the three industry groups where the Russell 2000 Value is most underweight—software & services; pharmaceuticals, biotechnology & life sciences; and health care equipment & services—are areas that have historically struggled in inflationary environments and tend not to participate in cyclical expansions. Notably, these three areas also have a large percentage of non-earning companies, and we expect that the forthcoming market environment of reduced liquidity will be much less supportive of non-earners than most of the past 10 years have been. We’ve also observed that these three areas are often lower weighted in active small-cap value portfolios. This compositional analysis corroborates our expectation that an economic environment of above-average growth and higher-than-average inflation is likely to favor the overweighted areas within small-cap value and create headwinds for those groups with greater exposure within small-cap growth.

Russell 2000 Value vs Russell 2000 Growth Top Three Underweights and Overweights by Industry Group
As of 12/31/21

Value underweights and overweights

Finally, as we have noted elsewhere, despite its significant outperformance, small-cap value is still priced near the bottom of its 20-year valuation range compared with small-cap growth, as measured by one of our preferred valuation metrics, the median last 12 months’ enterprise value over earnings before interest & taxes (LTM EV/EBIT), excluding companies with negative EBIT. For all these reasons, we think small-cap value may have many years left in its current outperformance trend.

In the Shadow of the Bear

As of this writing, of course, most investors are wondering—and worrying—about the correction that pushed small-caps into bear territory (a decline of 20% or more). The Russell 2000 fell 20.7% from its most recent peak on 11/8/21 through 1/27/22, as share price weakness broadened and deepened considerably in January. The speed of this descent—just 49 days between the 52-week high in early November and its initial 52-week low in January—was the fourth fastest such move in the Russell 2000’s history. A genuinely startling fall, though steep, sharp declines have been more common than not since the Financial Crisis.

As we seek to understand the market’s latest movements, we think it’s important to note that bond market signals have yet to move in the direction they often took in prior equity declines—bond yields commonly fall, and high-yield spreads widen when there are heightened concerns about future economic growth. We have seen neither so far in 2022. The contrast between the dramatic volatility of stocks and the nonplussed reaction of the bond market leads us to view this decline as a resetting of equity valuations rather than an increased concern about, or signal of, recession. Even more important, this latter view is corroborated by our recent conversations with company managements, where their largest challenges remain supply channel issues and the shortage of skilled workers to keep pace with the demand these companies are seeing.

Still, in our view, it’s significant that the Federal Reserve is making such a consequential pivot—from extraordinary monetary accommodation to mitigate the effects of COVID to more aggressive, and opposite, actions in an attempt to tame inflation. Liquidity and inflation are therefore now center stage. They have pushed Omicron and the pace of GDP growth toward the wings, though it is fair to say that all these developments (along with lingering supply chain issues) are interrelated. Indeed, periods like the present offer a reminder, however sobering, that, while equity markets are connected to the economy, the Fed functions in large part as the connective tissue between the two because it's the gatekeeper of liquidity. The consequence of this interrelationship is that any major move from the Fed will spur volatility. The central bank’s newest policies constitute two significant reversals—the shift from keeping a lid on rates to raising them and the move away from keeping the capital markets awash in liquidity to limiting it. After being in place for most of the last decade, these related Fed policy reversals happened in comparably short order, and thus it’s not surprising that the market has been reacting in an extreme fashion. From our perspective as experienced small-cap investors, this downturn is not about company fundamentals—it’s about valuations and liquidity. The days of generous monetary policy driving multiple expansion are over. It made sense to us, then, that more speculative assets—cryptocurrencies and growth stocks, for instance—experienced some of the most negative reactions to the Fed’s policy shift.

Importantly, if we are correct in suggesting that we are experiencing a valuation reset due to concerns about higher inflation, it’s worth recalling that, based on the CRSP (Center for Research in Securities Prices) data, small-caps are the only major asset class to have outpaced inflation in every decade since the 1970’s.

Small-Caps Have Beaten Inflation in Every Decade
Average Annual Consumer Price Index (CPI) versus Average Annual CRSP 6-10 Index 
12/31/1930- 12/31/2020 (%)

 Average Annual Consumer Price Index (CPI) versus Average Annual CRSP 6-10 Index, 12/31/1930- 12/31/2020 (%)

Past performance is no guarantee of future results.
Sources: Bureau of Labor Statistics (CPI) and CRSP

Additionally, since 2003, small-caps have on average delivered attractive returns when inflation expectations were rising. Finally, if all equity assets are undergoing a valuation reset, then it may be comforting to know that small-caps are at the low end of their relative valuation range over the past 20 years versus large-caps, which may limit their downside exposure relative to their larger siblings.

We hasten to add that we live in a complex world where it’s critical for us to practice humility about attributing causes and effects. As of this writing, there is also heightened geopolitical tension, and the possibility of an armed conflict on a scale not seen in decades. It’s difficult to imagine that these events are not exerting downward pressure of their own on equity valuations.

The Value in Small-Cap

What, then, are small-cap investors to do? We have already outlined why we think small-cap value stocks look poised to endure the current spate of higher volatility and lower returns in better shape than their growth counterparts. Even amid a challenging and uncertain climate for equities, much about the small-cap earnings picture remains constructive—particularly in the more cyclical precincts where we are most active currently. As we noted above, the probability of a U.S. recession looks low for at least this year and perhaps longer. U.S. and global GDP growth continue to trend in a positive, if bumpy, fashion. While our portfolio teams pursue distinct investment strategies and tend to focus on different types of small-cap stocks, they have found some common ground in identifying opportunities in the Industrial and Financial sectors, as well as in the lower valuation areas of Information Technology. Four areas that appear attractive are the semiconductor and housing ecosystems, select capital goods companies, and regional banks.

Given our confidence in the prospects for ongoing small-cap value leadership, we think it’s also useful for investors to know that a robust historical trend exists connecting value-led markets to success for active small-cap management. In 81% of value-led markets, active small-cap management outperformed the Russell 2000, a far more frequent record of success than in growth-led markets, when active management outperformed the small-cap index in only 14% of the five-year periods ended 12/31/21.

Active Small Blend Management: Better in Value-Led Markets
% of Outperformance Periods for Morningstar Small Blend Category Average1 vs. the Russell 2000
12/31/78- 12/31/21

In value-led periods: 81%; in growth-led periods: 14%

Small Blend outperformed in 68% of 10-year periods (270/397) with an average of 10.8% vs Russell 2000 average 10.0%
¹There were 523 US Fund Small Blend Funds tracked by Morningstar with at least five years of performance history as of 12/31/21.
25-Year Monthly Rolling Returns From 12/31/78 to 12/31/21 (457 Periods)
Past performance is no guarantee of future results.
Source: Morningstar

We are actively buying, as we always do during corrections. We try to use volatility to lock in what we think are attractive long-term opportunities as the market reacts—and on certain company-by-company bases overreacts—to short-term movements. Historically, some of our most profitable experiences have begun in bear markets. All markets—bull, bear, and all of those in between—are finite. Entry points matter.

Facing the Great Unknown

How these various macroeconomic uncertainties play out is beyond our circle of competence. Our own expertise and focus lie in identifying attractive valued stocks. If pressed to offer a market outlook beyond our long-term confidence in small-cap value, we would be hard pressed to offer an expectation, starting from late January’s low levels, of other than an intermediate term-return similar to the Russell 2000’s historical average of about 10%. The favorable and unfavorable factors seem roughly in balance. For the latter, economic growth, though likely above average this year, will also likely slow next year; high-yield spreads, whose decline is often an accelerant for small-cap returns, remain at low levels; valuations, while not concerning, are also not so low that they offer much potential for expanding multiples, and a Federal Reserve that is removing monetary accommodation is rarely coincident with above-average equity returns. Still, on the positive side, we begin (as we often do) with the long term: Since 1945, based on data from CRSP, small-cap stocks have posted positive annualized three-year returns 88% of the time on a rolling monthly basis, with an average return in the low double digits. Moreover, there is the impressive record of small-cap rebounds from declines of 20% or more from a previous peak. The recent January 2022 low marked the twelfth such decline since the 1979 launch of the Russell 2000. The average subsequent one-year return from the first day of the eleven previous declines was 19.6%. In addition, the small-cap index produced positive returns over the subsequent year in all eleven periods, save one—which occurred in the Great Financial Crisis.

Subsequent 1-Year Performance of Russell 2000 after a 20% Decline
As of 1/31/22

Subsequent 1-Year Performance of Russell 2000 after a 20% Decline

Past performance is no guarantee of future results.

Even with the myriad challenges currently facing the world, we think it’s fair to say that current conditions do not resemble those of the Great Financial Crisis. However, another historical instance may be worth noting. The last time the Fed aggressively removed monetary accommodation with the move not triggering a recession occurred in 1994, when the Russell 2000 was down 1.8% for the year. But that reset year was followed by a glorious period for small-caps, with the annualized return for 1995-97 totaling 22.3% for the Russell 2000.

We also remain convinced that earnings ultimately drive individual company stock returns, and (as we mentioned above) the earnings prospects for many small-cap companies remain promising, specifically those with sound fundamentals, including low-debt balance sheets, positive cash flows, and the ability to pass on higher costs in this inflationary period. We have always believed that focusing on what we know and not worrying about what we cannot control are paramount to effective and successful active management. Our commitment to a disciplined process across each of our small-cap strategies is the best way to give our shareholders the greatest opportunities to build wealth over the long run. This remains true even in the most challenging times.



Important Disclosure Information

The thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce Investment Partners, and, of course, there can be no assurances with respect to future small-cap market performance.

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.

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.

The (Center for Research in Security Prices) CRSP (Center for Research in Security Pricing) equally divides the companies listed on the NYSE into 10 deciles based on market capitalization. Deciles 1-5 represent the largest domestic equity companies and Deciles 6-10 represent the smallest. CRSP then sorts all listed domestic equity companies based on these market cap ranges. By way of comparison, the CRSP 1-5 would have similar capitalization parameters to the S&P 500 and the CRSP 6-10 would have similar capitalization parameters to those of the Russell 2000.

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Indexes are available for the U.S. and various geographic areas. Average price data for select utility, automotive fuel, and food items are also available.

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 unmanaged, capitalization-weighted 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 Russell 2000 Value and Growth indices consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

For the Morningstar Small Blend Category: © 2022 Morningstar. All Rights Reserved. The information regarding the category in this piece is: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

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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