Why Conditions Look Favorable For Small-Cap Cyclicals—Royce
article 02-11-2020

Annual Letter: Why Conditions Look Favorable For Small-Cap Cyclicals

2019 closed on a high note for stocks—here’s why we believe the current backdrop looks promising for small-cap cyclicals.


A Big Year For Stocks

A period of pauses, pivots, and rallies, 2019 ended as a highly rewarding year for equities. The major domestic and international indexes posted healthy double-digit returns, most in the range of 20-35%. The small-cap Russell 2000 Index gained 25.5% while the Russell Top 50 Mega Cap Index advanced 32.9%, the large-cap Russell 1000 Index was up 31.4%, and the Russell Microcap Index increased 22.4%—generally, bigger was better in 2019.

Indexes Returns
As of 12/31/19


Still, the 25.5% gain for the Russell 2000 placed it in the index’s top 27% of calendar-year showings since its 1978 inception. The advance was also impressively broad, with 70% of the stocks in the small-cap index posting positive returns, 61% advancing at least 10%, and 49% posting a calendar-year gain of 20% or more. Additionally, 10 of 11 Russell 2000 sectors were positive for the year (Energy was the sole detractor).

Although many investors think that some event, or series of events, must be present to propel share prices, there are times when the absence of negative developments is more than enough to push stocks consistently upward. This was the case in 2019, when both a recession and a more hawkish Fed failed to materialize, which was all it took to kick-start the recovery that succeeded the dramatic downturn that saw out 2018.

The Fed’s course was especially interesting. Arguably out of touch with the anxieties bred by slipping oil prices and an inverted yield curve in December 2018, the Fed raised rates and announced that 2019 would likely see at least two more hikes—all of this based on the central bank’s cautiously optimistic outlook on the U.S. economy. Once the market’s plunge showed that investors did not share this view, the Fed paused, saying it would hold the line on rates. The central bank then pivoted in July 2019, reversing course by lowering rates—which it proceeded to do again in September and October. These cuts fueled a healthy fourth quarter and helped stocks to end the year on a decidedly upbeat note.

What Will Follow Mega-Cap Mania?

Performance in 2019 was mostly in line with previous snapbacks off precipitous declines—biotech, software, and other growth stocks were among those that did best, along with non-dividend payers and companies with high debt. The somewhat peculiar exception to the pattern was large-cap outperformance. In high-octane markets such as what we saw in 2019, small-cap stocks have typically contended with few, if any, competitors for leadership. This pattern was undone by the ongoing leadership of mega-cap stocks—including the now familiar “FAANG” group of Facebook, Apple, Amazon, Netflix, and Google—which have led the market by a substantial margin over the last 18 months. For example, from 6/30/18-12/31/19, the Russell Top 50 Index advanced 26.1% cumulatively compared with a paltry 3.7% gain for small-caps—and a decline of 3.9% for micro-caps.

Notable Index Performance Spreads
Russell Index Performance—6/30/18-12/31/19


Source: FactSet

If the dominance of mega-caps were to unwind, or even pause, we see the potential for a subsequent rotation to small-caps. We think one point effectively illustrates the size of the potential opportunity: over the last 20 years, the 50 biggest stocks in the Russell 3000 Index have averaged a combined total market cap of about four times the total market cap of the Russell 2000.

At the end of 2019, however, that ratio was more than six times, which is higher than it was even at the height of the Internet bubble in 2000. We’re certainly not expecting mega-caps to collapse any time soon, which would be anomalous behavior in what we think will be an advancing market. But we do think a performance pause at their current high valuations could occur, allowing small- and micro-cap stocks to catch up.

We may have seen the first seeds of such a leadership reversal in the last four months of 2019, which from our perspective provided the year’s most compelling developments. Beginning on August 27th, several reversals inverted previous market leadership patterns, each of which held through the end of 2019: small-caps outpaced large-caps, cyclicals outperformed defensives, small-cap value beat small-cap growth, and micro-caps led domestic equity performance. What was of particular interest to us about these reversals was their simultaneity. Leadership rotation is common, but the changes typically emerge over longer stretches of time before they take root.

August’s Reversals Held
Late August Saw Key Market Shifts That Held Through The End Of 2019

august-reversals-sm-lg    august-reversals-cyc-def

Equally important, we would also argue that valuations—both relative and absolute—must be kept in mind when looking at returns. In spite of the performance boosts that came with the late August reversals, relative valuations for small-cap versus large-cap, small-cap cyclicals versus small-cap defensives, and small-cap value versus small-cap growth still looked attractive to us. At the end of 2019, each remained near the 20-year lows they hit in late August. As the chart below shows, small-cap stocks have lagged large-caps for so long that they were relatively cheaper at the end of 2019 than at any other time since 2001 based on our favorite valuation metric, EV/EBIT, (enterprise value over earnings before interest and taxes).

Small-Cap’s Relative Valuation Is Below Its Long-Term Average
Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies) from 12/31/01 to 12/31/19


1 Earnings before interest and taxes.
Source: FactSet

Beware Of The Calendar

When thinking about the prospects for small-cap performance, we think it’s important to avoid a common pitfall that we all stumble into occasionally—the tendency to put more emphasis on year-end results than on other month-end periods. From the vantage point of the calendar year, small-cap performance certainly looks good. But if we look at the two-year annualized return for the Russell 2000, we see a markedly lower gain of 5.7%. Moreover, three- and five-year annualized returns for the Russell 2000 were below their respective monthly rolling averages since inception (12/31/78) at the end of 2019.

Recent 3- and 5-Year Returns Lower Than History
Russell 2000 Average Annual Total Returns vs. Long-Term Rolling Monthly Averages as of 12/31/19

r2k-3yr    r2k-5yr

Finally, the Russell 2000 finished 2019 2.2% off its most recent peak—and all-time high—reached on 8/31/18. What do these observations of historical performance suggest? Taken together, we think they suggest that, despite 2019’s strong calendar-year return, caution or pessimism about future small-cap returns and opportunities may be misplaced.

The Case For Small-Cap Cyclicals

To be sure, we believe that small-cap stocks are more than capable of a strong run in 2020—and certainly resumed market leadership could be part of the equation. Even after a terrific 2019, many small-caps are still carrying what we would call a recession discount from the deep downturn at the end of 2018. Small-cap cyclicals continued to trade at a significant valuation discount to defensives at the end of 2019—based on EV/EBIT. In fact, the spread was wider than it was in October 2008, when a recession was exacerbated by the Great Financial Crisis.

Small-Cap Cyclicals Are Relatively Cheaper Than in 2008
Russell 2000 Relative Median EV/EBIT (Ex Negative EBIT)
From 12/31/99 to 12/31/19


These historically low relative valuations offer support for our view that late August’s performance reversals can be sustained in 2020. This confidence has led us to be active buyers in areas as diverse as energy services; healthcare devices, diagnostics, and testing; paper & packaging; semiconductors & semiconductor equipment; chemicals; and consumer finance.

“To be sure, we believe that small-cap stocks are more than capable of a strong run in 2020—and certainly resumed market leadership could be part of the equation. Even after a terrific 2019, many small-caps are still carrying what we would call a recession discount from the deep downturn at the end of 2018.”

Small-caps have also historically outpaced large-caps when the economy is growing and have lagged when it’s contracting. They have beaten large-caps, for example, in 70% of all trailing monthly rolling one-year periods—74 out of 106—when the ISM PMI rose over the last 20 years.1 This dynamic holds true for cyclicals versus defensives as well. So if the most recent slowdown is behind us, and the global economy is gradually improving (which appears to be the case), then renewed expansion supports a continuation of August’s reversals.

The Global Small-Cap Scene

Our confidence for small-cap extends beyond our borders. China had shown intermittent but promising signs of renewed growth prior to the outbreak of the coronavirus. Europe, particularly Germany, has been caught in the middle of the U.S.-China trade and tariff disputes given its more export-driven economies. It was also slowed by the protracted uncertainty over Brexit. Yet December showed marginal improvements through much of Europe, including upticks in business confidence and retail sales, which indicate that the global economy has bottomed—it grew by about 2% in 2019. If it were to begin rebounding towards the 20-year average annual nominal GDP rate of around 5%—a not unreasonable expectation, we think—then that should create tailwinds to sustain small-cap cyclicals.

Also worth noting is that the cumulative two-year return for non-U.S. small-caps, as measured by the MSCI ACWI ex USA Small Cap Index, was essentially flat, up just 0.1%. Over this same period, however, earnings have been growing at healthy clip, suggesting that returns can narrow this gap. We think that the combination of attractive valuations for cyclicals, a strengthening global economy, and the flat two-year return imply that the next few years are likely to be at least as good for international small-caps as the last few—and quite possibly better.

Of course, our greatest source of confidence is not macroeconomic analysis or the examination of long-term performance patterns (though they certainly help)—it comes from our own research into companies and industries as well as the numerous conversations we have with small-cap management teams. Much to our satisfaction, most of the management teams we’ve been meeting with report that they are hiring or holding steady and seeing little if any contraction in their orders or demand.

Good-Bye To All That?

2019 closes out one of the most interesting—and challenging—decades that we have seen in more than 45 years of managing small-cap portfolios. It was a decade in which financial assets performed far better than the economy did—mostly due to frequent central bank interventions that suppressed rates and kept the capital markets flush with liquidity. We also saw developments that we would never have thought possible, such as negative interest rates. In addition, years of highly accommodative monetary policy had the unintended consequence of creating few, if any, penalties for companies that borrowed extensively.

We anticipate that each of these unusual developments should unwind to some extent over the next decade. This makes us highly confident about the prospects for select small-caps, particularly in cyclical areas, that haven’t fully participated in the decade that just passed. However, the persistence of these peculiar developments has thrown up numerous road blocks on the road back to normalization. (Indeed, one thing that has not changed over the last 10 years is the humbling nature of the prediction business.)

The question is whether or not the last decade-plus (stretching back to the 2007 market peaks and the Great Financial Crisis of 2008) of slow growth, historically low rates, and regular central bank interventions represents a “New Normal.” While our initial contention was that it did not, we now suspect that we will arrive at a blend of the old and the new. As Mark Twain is said to have quipped, “History doesn’t repeat itself, but it often rhymes.”

Perhaps, then, this will result in a series of lows—low rates, low inflation, and low (by which we mean slow) economic growth—which will translate into lower U.S. equity returns than what we have seen over the last decade, along with more frequent bouts of volatility and wider variations in stock returns. While this menu may seem unpalatable, periods with more modest performance have historically been very favorable for disciplined active management approaches.

Favorable Conditions For Small-Caps

The current backdrop looks quite promising to us for solid to strong small-cap performance overall thanks to the four favorable factors that we cited in July’s “Letter to Our Shareholders”—low inflation, modest valuations, moderate growth, and ample access to capital. Together, they suggest that small-cap returns can go higher, especially the many small-cap cyclical areas that we typically like best.

A few historical factors are also worth noting. Over the past 30 years, 76% of all monthly rolling one-year returns for the Russell 2000 have been positive—with an average return of 11.5%. So investors who are bearish on small-cap stocks are betting against the odds. To get a firmer sense of what 2020 may hold, we went back to the inception of the Russell 2000 and looked at the 11 calendar years when small-caps declined, as in 2018, and examined what happened in the second subsequent year. In nine of those 11 years the small-cap index advanced by an average of 14.5%. (2000 and 2002 were the exceptions.)

Does the Small-Cap Recovery Have Room to Run?
Russell 2000 Declines and Two Subsequent Calendar Year’s Performance from 12/31/78 through 12/31/19 (%)


Past performance is no guarantee of future results.

And two consecutive years of double-digit increases are fairly common for small-caps. Periods in which a healthy second year followed a strong one occurred in the following two-year spans: 1988-89, 1991-92, 1995-96, 2003-04, 2009-10, 2012-13, and 2016-17. With the favorable conditions we’ve outlined above in mind, we suspect that the current small-cap rally can continue, with the potential to add 2019-20 to this list.

More Small-Cap Perspectives


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.

There can be no assurance that companies that currently pay a dividend will continue to do so in the future.

The ISM Manufacturing Index (ISM) monitors employment, production, inventories, new orders and supplier deliveries.

The Purchasing Managers' Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. The purpose of the PMI is to provide information about current and future business conditions to company decision makers, analysts, and investors.

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 Microcap Index includes 1,000 of the smallest securities in the Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. 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 Russell Top 50 Mega Cap Index is an unmanaged, capitalization-weighted index of domestic mega-cap stocks that measures the performance of the 50 largest publicly traded U.S. companies in the Russell 3000 index. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The MSCI ACWI ex USA Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. 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.

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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