3Market Overview

44Q22 Small-Cap Overview

5Year-to-Date Small-Cap Overview as of 12/31/22

64Q22 Sector and Industry Review

7Year-to-Date Sector and Industry Review

8Small-Cap Value Looks Cheap, Particularly versus Large-Cap Growth

9Historical Perspective

10Historically Small-Cap Cycles Have Averaged More Than a Decade

11Small Cap’s Weight in the Russell 3000 near 20-Year Low

12Large-Cap Cycles Peak at Market Tops Crowded with Mega-Caps

13Relative Valuations for Small Caps vs. Large Caps Are at Their Lowest in 20 Years

14Waiting for Recession’s End to Invest Has Been Costly for Small-Cap Investors

15Small-Cap Market Outlook

16Most Down Years Have Historically Been Followed by Up Years for Small Caps

17100% of the Time, Positive 5-Year Returns Have Followed Low Return Markets

18Are Large Caps Vulnerable to Further Declines?

19Historically Small Caps Have Outperformed When Inflation Decreases

20Small Caps Have Beaten Inflation in Every Decade Since the 1930’s

21Key Takeaways for 4Q22

22Notes, Performance and Risk Disclosure

 

4Q22 Small-Cap Overview

The Russell 2000 Value Index gained more than the Russell 2000 Growth Index in 4Q22, marking the eighth quarter out of the last nine in which small-cap value has beaten its growth counterpart. Additionally, unlike the third quarter, both the brief rally and the quarter as a whole were dominated by higher-quality small-caps: Companies with earnings outpaced those with negative earnings before interest and taxes (EBIT) while dividend payers outperformed non-dividend payers.

 

Year-to-Date Small-Cap Overview as of 12/31/22

The fourth quarter ended as the only positive quarter of the year for the Russell 2000. For the full year 2022, while declines were broad based, three areas stood out: value held up much better than growth; highest ROIC declined less than lowest ROIC, and dividend payers dropped much less than non-payers.

 

4Q22 Sector and Industry Review

All but one sector in the Russell 2000 was positive for the quarter. Energy continued to benefit from ongoing geopolitical stress while Pharmaceuticals Biotechnology & Life Sciences helped propel Heath Care into negative territory for the quarter while Energy benefited from continued geopolitical stress.

 

Year-to-Date Sector and Industry Review

Energy was the only sector to advance for the year-to-date period, benefiting from ongoing geopolitical tensions and higher oil prices. The Communcation Services, Information Technology, and Consumer Discretionary sectors declined the most for the year, reflecting the market de-risking into a potential recession. 

 

Small-Cap Value Looks Cheap, Particularly versus Large-Cap Growth

Four observations leap out when comparing various segments of the U.S. equity market: 1) Small-Cap Value, Small-Cap Core, and Small-Cap Growth are the cheapest segments of U.S. equities, 2) these segments are the only ones that are below their 25-year average valuation, 3) while all three value segments (Small-Cap, Mid-Cap, and Large-Cap) have nearly identical 25-year average valuations, their current valuations are vastly different, and 4) Mid-Cap Growth and overall Large-Cap valuations still have a long way to fall to reach their 25-year average valuations.

 

 

Historically Small-Cap Cycles Have Averaged More Than a Decade

Secular changes in economic trends, interest rates, and monetary and fiscal policies are altering the long-term investment landscape. The winners under the past decade’s zero interest rate, low inflation, and low nominal growth regime will no longer lead. The unfolding macroenvironment points to the small-cap asset class being able to sustain, not just tactically outperform, large-cap.

 

Small Cap’s Weight in the Russell 3000 near 20-Year Low

Small caps’ underperformance versus large-caps has reached an extreme point. Other than the COVID-related market trough in March 2020, small caps are at their lowest weighting in the Russell 3000 in more than 20 years, another indicator suggesting that a small-cap rebound may be coming.

 

 

Relative Valuations for Small Caps vs. Large Caps Are at Their Lowest in 20 Years

Following small cap’s underperformance of large cap over the past year, the Russell 2000 is extremely undervalued compared to its relative valuation range over the past 20 years.

 

Waiting for Recession’s End to Invest Has Been Costly for Small-Cap Investors

History shows that small caps tend to trough before recessions end, with the average return from the market trough to the end of a recession being 33%.

 

 

Most Down Years Have Historically Been Followed by Up Years for Small Caps

Since the end of World War 2, most down years for small caps have been followed by positive performance. Prior to 2022, there were 24 previous years in which small caps had a negative calendar year result (using the Center for Research in Securities Prices (“CRSP”) 6-10 as our longer-term small-cap proxy). In 19 of the subsequent years, or 79% of the time, small caps went on to enjoy positive returns in the following year. Perhaps even more notable was that the average return for those positive years that followed a negative one was 25.9%, a significantly higher result than the 10% average return for calendar years that followed a positive small-cap return.

 

100% of the Time, Positive 5-Year Returns Have Followed Low Return Markets

Small cap’s historical return pattern shows that below-average return periods have been followed by those with above-average returns, with a much lower-than-average frequency of negative return periods. Specifically, the Russell 2000 had positive annualized five-year returns 100% of the time—that is, in all 81 periods—averaging an impressive 14.9% following five-year periods of less than 5% annualized returns.

 

Are Large Caps Vulnerable to Further Declines?

The 38% decline for the average small-cap stock is notable compared to the 27% slide for the average stock in the Russell 1000 from the respective 52-week highs for the average stock in each index. Moreover, the Russell 2000 fell 32% from its peak on 11/8/21 through its most recent low on 6/16/22. The Russell 1000 lost far less from its peak on 1/3/22 through its most recent low on 9/30/22, down 25%. Finally, the Russell 2000 finished 4Q22 much more attractively priced than the Russell 1000.

 

 

 

Market Overview

After equity prices moved downward in a volatile fashion through the first nine months of 2022, the Fourth quarter ended as the only positive quarter of the year. For 2022, value stocks held up better than growth stocks, and those with certain quality attributes also performed in line with expectations by generally losing less. Small caps and small-cap value ended the quarter with the lowest valuations of any of the major U.S. stock style/size segments.

Historical Perspective

Perhaps counterintuitively, we believe that the Russell 2000’s miserable 2022 may be setting the stage for a robust small-cap rebound, particularly compared with large-caps. Small caps continue to be at their lowest relative valuation versus large caps in more than 20 years, and small cap’s weighting in the Russell 3000 is also near a 20-year low. Finally, for those waiting to invest until after a recession, it’s helpful to know how strongly small caps have historically rebounded before a recession ends.

Small-Cap Market Outlook

One of our greatest sources of confidence about future returns comes from the peculiar state of long-term small-cap performance at the end of December 2022. Small cap’s historical return pattern shows that below-average return periods have been followed by above-average return periods, with a much lower-than-average frequency of negative return periods.

We note four observations that support our expectation of small-caps leading large-caps: 1) most down years have historically been followed by up years for small-caps 2) when small caps have lagged on a 5-year basis by the current spread, they have usually led in the following 5-year period, 3) large caps appear more vulnerable to further declines based on higher valuations and shallower declines so far, 4) from small caps’ current level of average decline, they have often recovered more robustly to lead large caps.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. All performance information is presented on a total return basis and reflects the reinvestment of distributions. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. 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 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. The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. It includes approximately 800 of the smallest securities in the Russell 1000 Index. The Bloomberg Barclays US Aggregate Bond Index is an unmanaged, capitalization-weighted index of investment grade, US dollar-denominated, fixed-rate taxable bonds. 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. The CBOE S&P 500 Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days and is quoted as an annualized standard deviation. 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. Return on Average Total Equity (ROE) is the trailing twelve month net income divided by the two fiscal period average total shareholders’ equity. Royce & Associates, LP, the investment advisor of The Royce Fund and Royce Capital Fund, is a limited partnership organized under the laws of Delaware. Royce & Associates, LP primarily conducts its business under the name Royce Investment Partners.

Sector and industry 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.