Royce Semiannual Letter To Shareholders—Royce
article 08-04-2020

Semiannual Letter: Navigating Through the Fog of Uncertainty

While the first half of 2020 has been anything but normal, small-caps are behaving in a historically familiar way—here's why we believe they’re poised to do well going forward.


The Longest Half

Before delving into our usual analysis of the small-cap market, we first want to offer our deepest sympathies to all those affected by the coronavirus and to extend an equal measure of gratitude to the many essential workers who have done so much to help us all in various ways during this period of pandemic-induced difficulties. We are also grateful for all of the extraordinary efforts by our Royce colleagues, as they have been working diligently to keep our company operating at full strength while working from home.

The first half of 2020 was as turbulent a six-month period as we have seen in nearly 50 years of small-cap asset management. The Russell 2000 Index experienced the worst quarter in its own 40-year history in 1Q20, losing 30.6%, before rebounding to enjoy its third best in the second quarter, when it advanced 25.4%. As wide as the distance is between them, these numbers fail to fully capture the extremes. The Russell 2000 fell 41.5% from 2/20/20-3/18/20 before advancing 46.0% from March’s 2020 low through the end of June. Comparable levels of the same volatility could be seen across other capitalization ranges and geographies as the world reeled from the devastating effects of the COVID-19 pandemic, which has wreaked havoc on public health and the global economy.

From our perspective as experienced small-cap specialists, the most interesting element about the market’s V-shaped pattern since mid-February was that stocks behaved in a manner that was simultaneously anomalous and familiar. Like the public health crisis that engendered the initial decline, the speed and depth with which equities fell was indeed unprecedented. The pace and height of the subsequent rebound has been surpassed only once before, in the spring of 2009. Yet the overall pattern is one that we have seen before. Deep bear markets have historically been followed by vibrant comebacks. The range of returns along market cap parameters added to the familiar tenor. After losing more in the first quarter, small- and micro-cap stocks roared back to outpace their large-cap counterparts in the second. Moreover, factors such as cyclicality and perceived riskiness also performed in line with our expectations through most of the first half of 2020.

One notable exception, at least for a short time, was the underperformance of cyclical stocks within small-cap early in the recovery period. This temporary disadvantage may have been an unintended consequence of the Fed’s decision to put enough liquidity into the capital markets to rebuild stability and restore the financial system to something resembling normal operations as the markets were plunging. Yet these moves—which in our view were entirely appropriate and necessary—also appeared to shift higher-growth companies into pole position in small-cap, leaving cyclicals to play catch-up into the middle of May, nearly two months after the nascent upswing. Since cyclicals historically make strong moves off market bottoms (especially when accompanied by improving economic data, as was the case this year), we were somewhat surprised. Cyclicals more than made up for their slow start, however, by nearly doubling the return for defensives from mid-May through the end of June, up 18.1% versus 9.5%. Needless to say, a result in the high teens over six weeks is an impressive move under any circumstances.

Dissecting the Disconnect

The more immediate, and for many more vexing matter, however, is the disconnect between a weakened economy and a robust, albeit highly volatile, U.S. equity market. It’s always a cause for concern for some when the market appears out of sync with the economy. But in the midst of a public health crisis, one that’s led to sorrow for many and challenges for all, the contrast becomes particularly stark. We understand why many people, including a number of skilled and experienced investors, have serious misgivings about the overall upward direction of the stock market during a pandemic. However, we think these objections ultimately rest on two misconceptions.

The first is the idea that stock prices are a barometer of current corporate health. Yet stocks are almost never priced based on what’s happening today. The market’s tendency is to look forward to what is most likely to happen one, two, or even three years down the road. In other words, the market’s behavior is rooted in expectations of corporate profitability. So in spite of the currently long list of challenges we face, the market is anticipating a recovering economy over the next couple of years. Equally important, investors are confident that most companies’ profits will be higher over the next year or two, which should boost the value of their shares.

The second misconception is that equities are independent of other financial conditions. Yet stocks are, after all, financial assets. As such, conditions in the financial markets affect their prices. With interest rates at all-time lows, it makes sense that stocks would be selling at higher prices. Lower rates typically make equities appear relatively more attractive compared to other investments. The Fed’s decision to provide ample liquidity to the financial markets and maintain interest rates at close to zero should support rising stock prices because plentiful amounts of capital are available for investment, and there are relatively few attractive alternatives. The current strong and stable state of the equity markets helps to explain why “Don’t Fight the Fed” is such a reliable adage.

The Case for Small-Caps in Five Charts

Our overall outlook for small-caps, then, is cautiously optimistic. In large part, this is because we expect the economy will continue to recover over the next few years, spurring profit growth as it does. We also think that small-caps continue to look relatively more attractive than most other areas of the market. Its recent robust run notwithstanding, the Russell 2000 was down 13.0% in 2020’s first half versus a loss of 2.8% for the large-cap Russell 1000 Index. Similarly, the Nasdaq made new all-time highs in this year’s rebound while the small-cap index finished June 2020 14.9% below its August 2018 peak.

Along with relatively more attractive small-cap prices, we also see the financially healthy state of many small-cap companies. We examined performance for the Russell 2000 compared to the index’s trailing 12-month cash flow per share from the peak on 8/31/18 through 6/30/20. Our analysis, seen below, showed that cash flow per share has made steady positive progress that accelerated to a more robust pace near the end of this nearly two-year period, while small-cap performance lagged this metric over the same period.

Russell 2000 Performance vs Trailing 12-month Cash Flow Per Share
Percent Change from 8/31/18 Peak as of 6/30/20


Trailing 12-Month Cash Flow Per Share is calculated as the after-tax earnings of a company plus depreciation on a per-share basis. It is often used to measure a company’s financial strength.

Taking a look at the asset class’s longer-term history paints an equally compelling picture. For example, during the subsequent two-year periods following its last major declines—the Internet Bubble and the Financial Crisis—small-caps recovered significantly more than they did during the first half of 2020.

Small-Cap’s Bear-Market Rebounds
Russell 2000 subsequent two-year periods following troughs


Also supporting the idea that small-caps have room to run is the five-year average annual total return for the Russell 2000 at the end of June—which was 4.3%. This result is well below the rolling monthly five-year average of 10.5% for the small-cap index since its inception. The subsequent five-year returns following periods of low Russell 2000 returns have on average been very attractive. Most important in our view, small-caps averaged a 13.8% subsequent five-year annualized return when trailing performance was in the 0-5% range, as it was at the end of June 2020.

Subsequent 5-Year Returns Based on Prior 5-Year Return Ranges
Russell 2000 Since Inception From 12/31/78 through 6/30/20


Coincident with small-cap’s lower return pattern over the last five years has been relative underperformance versus large-cap stocks. While leadership between small-caps and large-caps has rotated over the last several decades, the degree of current small-cap underperformance is unusual. (For longer term studies we use CRSP (Center for Research in Security Prices) indexes, whose small-cap proxy, the CRSP 6-10, has a longer history than the Russell 2000.) Since the end of 1945 through June 30th of this year, the CRSP 6-10 led the CRSP 1-5, its large-cap counterpart, with a rolling monthly average annual five-year return of 12.8% for the former compared with 11.3% or the latter. However, for the five-year period ended 6/30/20, small-cap trailed large-cap by 5.9% as the CRSP 6-10 advanced 4.8% versus a gain of 10.7% for the CRSP 1-5. This degree of small-cap underperformance is notable, as it has happened in only 13%, 107 out of 835, of all five-year periods. What happened next is equally if not more interesting: when the CRSP 6-10 lagged the CRSP 1-5 by at least 5.5%, small-cap subsequently rebounded to beat large-cap in 83% of the subsequent five-year periods—86 out of 103 times. We anticipate a rotation in leadership not simply because extreme performance spreads between asset classes and/or indexes tend to be followed by reversals but also due to small-cap’s longstanding edge over large-caps following bear markets and in particular during economic rebounds.

For the one-year period ended 6/30/20, the Russell 2000 was down 6.6% versus a gain of 7.5% for the Russell 1000. How unusual is this combination of a negative return for small-cap and a positive result for large-cap over a 12-month span? Over the last 20 years, it’s happened about 10% of the time, in only 23 out of 229 monthly rolling periods. Even more important is what typically happens next.

Small-Caps Have Rebounded Following the Rare Concurrence of a Negative 12-Month Return for Small-Cap with a Positive Return for Large-Cap
Trailing 1-Year Periods from 6/30/00 to 6/30/20


Small-cap stocks have rebounded resoundingly over the subsequent 12-month periods, beating large-cap 81% of the time and posting an average one-year return of 19.0% versus 16.8% for large-caps.

Of course, our strategies each focus selectively, concentrating on more than just the overall small-cap market. Their differences notwithstanding, each has an overall tilt toward economically sensitive cyclical sectors, with most weighted heavily in Industrials and Information Technology while others, such as our dividend-value portfolios, typically have much more exposure to Financials than technology companies. Regardless of each strategy’s areas of focus, we think these three sectors offer a broad and diverse selection of companies with attractive attributes.

As has been the case with small-cap value and growth, cyclicals have been lagging their defensive counterparts over the last several years. However, the U.S. economy appears to have bottomed in April. The monthly ISM (Institute for Supply Management) manufacturing index began to climb again in May and rose by a highly encouraging 9.5 points between May and June, from 43.1 to 52.6. This was also significant in that a number more than 50 indicates expanding growth in manufacturing orders and production. The U.S. housing market also continues to grow, showing remarkable resilience in the face of the pandemic. The all-important U.S. consumer remains something of a wild card considering the still uncertain state of public health. However, if consumer spending continues to trend positively, as it did during May, then the economy should grow more quickly. In addition to a global economic recovery, cyclicals would benefit from a weaker dollar, a dose of inflation, and earnings growth—as would value stocks.

Within this optimistic scenario, the valuation picture is also critical as it forms an integral part of the case for small-cap cyclicals. As a whole, small-cap valuations appear far more reasonable than those of large-caps. Within small-cap, cyclicals look much cheaper than defensive stocks. To be sure, at the end of June they were at their cheapest in more than 20 years compared to defensives, based on our preferred valuation metric, the Russell 2000’s relative median EV/EBIT (Enterprise Value divided by Earnings Before Interest & Taxes, excluding companies with negative EBIT).

Russell 2000 Relative Median EV/EBIT (Ex Negative EBIT)
From 6/30/00 to 6/30/20


EV/EBIT: Enterprise Value/Earnings Before Interest and Taxes. Cyclical is defined as follows: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities. Source: FactSet

Why is all of this data important? While past performance patterns are never sure to repeat themselves, the economic growth periods that have followed recessions have disproportionately rewarded small-cap cyclical stocks throughout history.

It’s the Vista, Not the View

As we look forward, we have kept our scope squarely on the long run. However optimistic we are about the years ahead, the view of the next weeks and months remains foggy. Our confidence in an economic recovery and the likely rewards that would flow to small-cap cyclicals and select value stocks is therefore rooted in our perennial long-term perspective. Some market observers argue that equities could tread water through the end of this year before resuming an upward move in an improving economy. As plausible as this case is, we are not entirely convinced that evidence of a recovered economy is the only catalyst that can keep share prices afloat. The second half of 2009 provides what may be an instructive example. After their recovery off the trough in March of that year, equities continued to advance through the end of December. Throughout the entire year of 2009, pessimism reigned, buoyed by anxieties about the seeming contradiction among rising stock prices, the underwhelming state of the global economy, and the fragility of the world’s financial system. Yet the market scaled that wall of worry with relative ease. Our own experience, both then and now, has taught us two lessons that are of particular relevance to the present moment: First, shocks are what have hurt stocks the most historically—known worries are often priced in fully or at least close to it; second, stocks often advance on economic news that is less grim, meaning that even slight improvements in economic data could be more than enough impetus to keep investors buying.

In fact, we think those more fatalistic investors may be surprised by how quickly earnings recover. Our current situation is unique in many ways. This is especially true for the markets and the economy where the struggles have been bred by a public health crisis as opposed to financial excess or economic distress. The resulting short-term uncertainty and attendant market turbulence are allowing us to try taking advantage of two market dynamics that we believe play to the strengths of active management: high volatility and short-term thinking. And our own habit of looking beyond the near term has opened up a brighter vista where we can see both the economy and corporate profits rebounding beyond the next several quarters.

Finally, we want to share the news about three recent additions to our investment staff: Portfolio Manager Miles Lewis, CFA®; Senior Analyst and Director of International Research Mark Fischer; and Senior Analyst and Director of Strategic Research Jag Sriram, CFA®. All joined Royce during the second quarter of 2020, and their respective arrivals highlight the fact that, even in these challenging times, we are committed to adding skilled professionals to our firm. Miles, Mark, and Jag are important additions to our highly experienced investment team. We look forward to them contributing investment insights to our portfolios that benefit our investors.

Prices & Performance


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 (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.

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 NASDAQ Composite Index measures all NASDAQ domestic and international based common type stocks listed on The Nasdaq Stock Market. It is a broad based Index and is calculated under a market capitalization weighted methodology index. 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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