Annual Letter: When Will the Bear Give Way to the Bull?
article 02-07-2023

Annual Letter: When Will the Bear Give Way to the Bull?

When it comes to small caps, should the bear be feeling high anxiety?


2022: The Market’s Annus Horribilis

Most investors were happy to see a miserable 2022 end. In a down year for U.S. equities, both small-and large-cap stocks suffered, with the Russell 2000 Index falling -20.4% while its large-cap sibling, the Russell 1000 Index, declined -19.1%. It was the third-worst calendar year performance for both indexes since their shared inception date of 12/31/78; each posted their lowest respective returns since 2008. The only two years that had lower returns were the same pair for both indexes: 2008 during the Financial Crisis and 2002 through the worst year of the Internet Bubble—which certainly puts the difficulties investors faced last year in context. The tech-heavy Nasdaq Composite fared even worse in 2022, losing -32.5%. Beyond the U.S., results were not much better: the MSCI ACWI ex USA Small Cap Index lost -20.0% for the calendar year, and the MSCI ACWI ex USA Large Cap Index fell -15.3%. Moreover, the double-digit losses were not limited to equities, as the Bloomberg Barclays U.S. Aggregate Bond Index was down -13.0% while its global counterpart, the Bloomberg Barclays Global Aggregate Bond Index, was off -16.2%.

Negative return years for both stocks and bonds are rare occurrences—it’s happened roughly a dozen times since the Great Depression. The combined double-digit losses for large-caps and bonds made 2022 even more exceptional for another, related reason: it was one of the worst years on record for that longstanding staple of diversified portfolios, the 60/40 mix of stocks and bonds. Since the 1930s, the 60/40 split has had double-digit calendar year losses only six times. So, while 2022’s final quarter saw positive results for many equity indexes, the entire year gave most investors “nowhere to run to, nowhere to hide,” beyond certain commodities and the U.S. dollar.

The steep declines for so many different investment vehicles made sense not simply due to the many challenges facing the world, but also because of the now familiar but still dizzying array of contradictory macro developments. On the negative side, we endured ongoing inflation, a decidedly hawkish Fed, the war in Ukraine, and a widely anticipated—though yet to occur—recession. On the positive end, we had strong labor markets and a surprisingly resilient U.S. economy, with real U.S. GDP (Gross Domestic Product) for the third quarter adjusted upward in December from 2.8% to 3.2%— and initial fourth quarter estimates being pegged at 2.8%. Although these figures do not equate to vibrant economic growth, they are far from indicating recession. The question is what comes next for stocks? If the bear market’s days are numbered, when will its number be up? While we make no claim to having a definitive answer, we have done our usual rounds of digging into history and current valuations to help us make sense of the present and to see what factors might be signaling a brighter course for small caps as well as for our own investment strategies. In our estimation, it makes sense for the bear to be feeling some high anxiety.

Small Cap’s Bright(er) Future

The -38% decline for the average stock in the Russell 2000 is notable compared to the -27% slide for the average stock in the Russell 1000 from each index’s respective 52-week highs. Moreover, the Russell 2000 fell -31.9% from its peak on 11/8/21 through its most recent low on 6/16/22, while the Russell 1000 lost less from its peak on 1/3/22 through its most recent low on 9/30/22, down -25.0%. In addition, several years of small-cap underperformance have led to the Russell 2000 hitting an extreme point versus the Russell 1000 at year-end: apart from the Covid-related market trough in March of 2020, small caps fell to their lowest weighting in the Russell 3000 Index in more than 20 years on 12/31/22. Finally, and arguably most importantly, the Russell 2000’s valuation remained near its lowest rate in 20 years compared to the Russell 1000’s, based on our preferred valuation metric of the median last 12 months’ enterprise value to earnings before taxes (LTM EV/EBIT)—even in the immediate aftermath of 2022’s correction.

Relative Valuations for Small-Caps versus Large-Caps Remained Near Their Lowest in 20 Years
Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies) from 12/31/02 to 12/31/22

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

¹Enterprise Value/Earnings Before Interest and Taxes
Past performance is no guarantee of future results. Source: FactSet

Both the “Nifty Fifty” market of the early 1970s and the current period were marked by uncertainty and prominent worries of high inflation and recession. The Nifty Fifty was a group of mostly multinational large-cap companies that many believed offered a steady, sure, and safe road to growth—until they were badly bruised in the bear market of 1973-74. In the current period, a perception of safety was reserved until recently for an even smaller number of mega-cap stocks: the “FAAMG” group of Facebook, Apple, Amazon, Microsoft, and Google. Prior to each period’s bear market, the large-cap peak was crowded with these mega-cap stocks—which most recently reached their high in August of 2020. At 2020’s large-cap peak, these five stocks accounted for nearly 25% of the U.S. market’s total capitalization, much as AT&T, Eastman Kodak, Exxon, GM, and IBM did before the sharp correction of the 1970s. The earlier decline was followed by a long run of success for small-cap stocks on both an absolute and relative basis. Combined with small cap’s more favorable valuation and long, historically uncharacteristic period of underperformance, we think the stage is set for the asset class to retake market leadership from large cap.

Another important reversal suggests the likelihood of improved relative results for small caps in coming years: the pivot in Fed policy from the era of zero (or near zero) interest rates and easy money and the knock-on effect of persistent inflation rate hikes and quantitative tightening. For equity investors, this shift means a radically altered investment landscape. We believe those stocks that were the biggest winners under the past decade’s zero interest rate, low inflation, and low nominal growth regime will no longer lead, and that the unfolding macro environment points to small caps being able to sustainably, and not just tactically, outpace large caps.

Further supporting our relative case for small caps is the asset class’s superior record in two varying inflationary climates. A comparison of the average annual U.S. consumer price index (CPI) to returns for the Center for Research in Security Prices (CRSP) 6-10 Index (the small-cap proxy we use when reaching farther back in history than the Russell 2000’s 1979 inception) shows that the CRSP 6-10 beat the CPI in every decade since the 1930s—a claim that cannot be made for large caps. In addition to their long-term historical edge during inflationary periods, small caps tend to be nimbler than large caps, which allows them to potentially act more quickly in a climate of contracting liquidity and Fed tightening. Of course, much of the data is indicating that inflation has peaked, outside of wage inflation, which is proving much stickier (and will remain so for as long as the job market stays strong). 2022 saw sharp deflation in several areas. The Baltic Dry Index, which measures the cost of shipping goods worldwide, fell more than 70% from its high in May through the end of December, while lumber, steel, and copper prices also slipped precipitously. We expect this dynamic of persistent wage inflation accompanied by decreased goods inflation to continue. And historically, periods of falling inflations have also given small caps a relative advantage.

Historically Small-Cap Have Outperformed When Inflation Decreases
From 12/31/45 to 12/31/22

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

Past performance is no guarantee of future results.

Is It Time for Small-Cap Success?

The performance advantage for large caps over small caps from 2011-2022 was somewhat paralleled by an edge for the Russell 2000 Growth Index over the Russell 2000 Value Index through most of that period. Over the last few years, the market has seen a deep and far-reaching re-rating of growth stocks, an unsurprising development following the Fed’s reversal. To be sure, we saw this most clearly at two ends of the equity market in 2022: in the deeper correction for small-cap growth stocks and in the steep declines for many mega-cap companies we discussed above. To be sure, rising rates and inflation have led to a period of multiple compression that we expect will reorient investors’ attention, to some degree, at least, away from the crowded and uncertain macro environment and onto corporate fundamentals, which we view as an advantage for the kind of conservatively capitalized, free cash flow generating companies that most of our major strategies hold. We saw this in 2022, when quality small caps—defined as those with higher returns on invested capital (ROIC) and earnings—held up better than their lower-quality, non-earning siblings in three of 2022’s four quarters, including the fourth quarter’s upswing.

Unsurprisingly, then, the Russell 2000 Value lost significantly less than the Russell 2000 Growth in 2022, -14.5% versus -26.4%. We have been asserting for the last few years that small-cap value would recapture its long-term historical advantage over small-cap growth. One especially revealing support for this idea comes from looking at the five-year annualized return for the Russell 2000 Value as of 12/31/21, which was 9.1% versus a gain of 14.5% for the Russell 2000 Growth—a 540 basis point advantage for the latter. The relative resilience of small-cap value vis-à-vis small-cap growth in 2022 caused this spread to reverse by a considerable amount for the five-year period ended 12/31/22, when the Russell 2000 Value outpaced the growth index, up 4.1% versus 3.5%. Our confidence that value can maintain its performance edge over growth is further rooted in the fact that over all five-year monthly rolling average periods since their shared inception (12/31/78), the advantage was squarely in value’s favor, 11.8% versus 8.8%. Yet at the end of 2022, the Russell 2000 Value was at a lower valuation than its growth counterpart, based on the LTM EV/EBIT metric.

Despite Recent Outperformance, Small-Cap Value Sells at a Below Average Valuation to Small-Cap Growth
Russell 2000 Value/Growth Shifted Median Relative LTM EV/EBIT1 (ex-Negative EBIT) from 3/31/00 through 12/31/22

Median EV/EBIT¹ (ex-Negative EBIT) Levels for Russell Indexes

1Last twelve months Enterprise Value/Warnings Before Interest and Taxes.
Past performance is no guarantee of future results. Source: FactSet

Is Time on Small-Cap’s Side?

Throughout 2022, we saw many small-cap stock prices hit hard regardless of their financial fundamentals and/or operating efficiency. While we were often struck by the contrast between the more confident—albeit cautious—outlooks from the many management teams our investment teams met with and the fatalistic headlines we were seeing almost every day, we are also accustomed to seeing valuations decouple from company attributes—often by what we deem to be highly disproportionate amounts. Our more than five decades of experience have taught us the value of patience—which is often hardest for investors to practice when it’s needed most.

Related to this is the fact that small-cap’s historical performance patterns show that below-average longer-term return periods have typically been followed by positive returns—most often by periods of above-average longer- term returns. For example, subsequent annualized three-year returns from three-year entry points of less than 5% have been positive 99% of the time—that is, in 75 out of 76 three- year annualized periods—averaging 16.0% since the Russell 2000’s 12/31/78 inception. The small-cap index also enjoyed positive annualized five-year returns 100% of the time—that is, in all 81 five-year periods—and averaged an impressive 14.9% following five-year periods with annualized returns of 5% or less. This appears especially relevant now because the respective three- and five-year annualized returns for the Russell 2000 as of 12/31/22 were 3.1% and 4.1%.

A High Probability of Positive Small-Cap Performance Ahead?
Average Subsequent Five-Year Annualized Performance for the Russell 2000 in Trailing Five-Year Return Ranges of less than 5% from 12/31/83 through 12/31/22

Subsequent Average Annualized Three-Year Return for the Russell 2000 Starting in Monthly Rolling VIX Return Ranges

Past performance is no guarantee of future results. Source: FactSet.

The Waiting Is the Hardest Part

It is of course possible that stock prices will get worse before they get better. As of this writing, inflation and earnings multiples are higher while interest rates, credit spreads, the VIX (Volatility Index), and the unemployment rate are lower. Many market observers are convinced that sales and earnings growth are much more likely to decline—or at least flatline—in 2023 than they are to climb, at least no until late in the year. At the same time, however, margins for many companies are expected to expand in 2023, thus helping earnings. In other words, the signals continue to flash conflicting messages—which goes some distance to explain why the outlooks for our portfolio managers range from fear that stocks have yet to touch bottom to full-throated bullishness. The ongoing presence of these mixed signals did nothing to keep stocks from enjoying a highly robust January of 2023. Notably, the Russell 2000 was well ahead of the Russell 1000 for the one-year period ended 1/31/23, down -3.4% versus -8.6%.

So, while recession is still a possibility, none of us knows how long it will last or how deep it will go. What we do firmly believe is that any recession—like any bear market—is ultimately finite. We believe any recession will be followed by a recovery. It’s worth keeping in mind that history also shows that small caps will likely begin an upward move before many of us know for sure that the economy is rebounding in earnest. As difficult as bear markets are, they also present investors with the opportunity to build their small-cap allocation at attractively low prices. The aftermath of the three worst bear markets of the past 25 years—the Internet Bubble, the Great Financial Crisis, and the Covid period—were highly rewarding for investors who showed the fortitude to stay in the market. Regardless of what the near term brings, then, we see the currently uncertain period as a highly opportune time to actively invest in select small caps for the long run.

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.

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 2000 Value and Growth Indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. Securities are weighted based on their style score. 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 Russell Midcap Index consists of the 800 smallest publicly traded U.S. companies in the Russell 1000 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. 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 material 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 Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks. The MSCI ACWI ex USA Small Cap Index is an unmanaged, capitalization weighted index of global small-cap stocks, excluding the United States. The MSCI Emerging Markets Index is an unmanaged, capitalization-weighted index of stocks in emerging markets countries. The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. 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. 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. 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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