1Q20 Small-Cap Investment Review & Outlook—Royce
article 04-01-2020

1Q20 Small-Cap Investment Review And Outlook

Co-CIO Francis Gannon explains how Royce PMs are investing for better days through this tumultuous market.

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1Q20: Nowhere To Run, Nowhere To Hide

The world’s equity indexes plummeted with alarming speed and depth during 2020’s opening quarter. No asset class or locale was spared as the effects of the coronavirus reverberated across the globe, causing major market dislocations.

The 30.6% first-quarter decline for the Russell 2000 Index was the largest quarterly loss for the small-cap index in its more than 40-year history.



A Typical Decline: The Relative Return Array

As might be expected in a steep bear market, small-caps bore the brunt of the decline on both a domestic and global level. To be sure, the farther down the market capitalization range one went here in the U.S., the bigger the negative result. Large-caps lost the least, followed by mid-caps, small-caps, and micro-caps.

As unprecedented as the current downturn undoubtedly feels to many investors, the array of relative returns beyond market cap size was also consistent with what an investor would typically expect when a market decline is accompanied by a recession.

So while every sector in the Russell 2000 Index experienced double-digit declines, defensives lost less than their cyclical counterparts. The three sectors that held up best in the index were defensive areas—Utilities, Health Care, and Consumer Staples—while three cyclical sectors—Energy, Consumer Discretionary, and Materials—fared worst in 1Q20.

Companies that have low leverage within the Russell 2000 did relatively better than those with higher leverage, and those in the top market cap quintile of the small-cap index lost less than those in the bottom quintile (consistent with the quarterly results of the market cap-based indexes).



History Is Rhyming, Not Repeating

The decline has so far been one of the fastest—and most unsettling—that we have experienced. Yet its depth through the end of March fell well within the range of the two previous bear markets that were accompanied by recessions. The 41.5% decline for the Russell 2000 from 2/20/20-3/18/20 (the 1Q20 bottom) was similar to the fall from 7/13/07-3/9/09—when the Russell 2000 lost 58.9%—and from 3/9/00-10/9/02, when it fell 44.1%.

The downturn greatly exacerbated by the 2008 Financial Crisis has similarities with the current market. Both declines were quite rapid and, for most investors, equally frightening. However, the balance sheet health of both households and banks is much better today than back in 2008.

During the run-up to the Internet Bubble in 2000, the market resembled the pre-coronavirus condition—with lofty valuations and multi-year leadership from large-cap and growth that led many to question the viability of value investing and active management. Yet the speed and depth of the current economic slowdown looks to be greater than what we experienced in the 2000-02 period.

The current situation is therefore different, but at the same time familiar, at least to us. From an investment perspective, we view it as another instance of history not repeating but rhyming. As our own Charlie Dreifus recently put it, we’ve seen movies with similar plots before through more than four decades of small-cap investing.



After The Correction…

A silver lining of sorts to the pandemic situation has been the speed with which a wave of monetary and fiscal actions were put in place and/or approved, in marked and welcome contrast to the slower pace each took to be implemented in 2008-09. While we anticipate that these policy actions will continue to help bring some stability to the markets, we also expect ongoing volatility in the near-term as investors attempt to find their bearings.

The critical questions now, then, are, ‘Is the worst behind us?’ and (in any event), ‘What happens once the virus has been contained and effective treatments are available?’

As is our wont, we turn to history for guidance and context. At the end of March, the five-year annualized return for the Russell 2000 was -0.2%. This is a rare occurrence. A negative average annual five-year return has only happened in 21 out of 436 month-end periods since the launch of the index more than 40 years ago—that is, it’s happened less than 5% of the time.

Results in the subsequent periods were nothing short of extraordinary, with a one-year average of 40.8%, a three-year average of 22.1%, and a five-year average of 18.3%—all well above each period’s rolling monthly averages. By staying in the market, small-cap investors more than doubled their money over the ensuing five years.

Clearly, no one knows what the market’s next sustained move will be. However, history offers compelling examples of how valuable it can be to remain invested in small-cap precisely when it feels most difficult to do so.



Investing For Better Days

For our part, we are doing exactly that—investing each day when we see attractive long-term opportunities present themselves.

We have been leaning mostly toward select, high-quality cyclical companies as we think these businesses are best positioned for a rebound. Indeed, in the years following the small-cap troughs in 2002 and 2009, small-cap cyclicals substantially outperformed defensives.

Many of our newer cyclical investments have clustered in two areas—businesses already benefiting from strong secular trends that we expect to resume and those that we think are likely to see increased demand in a recovery. In the former category are Consumer Discretionary companies offering experiences (such as RV suppliers and boating manufacturers) as opposed to goods, and professional staffing firms, as highly skilled workers will still in be short supply.

Areas we see potentially benefiting from increased demand include housing (particularly with record-low mortgage rates) and restructuring advisors, whose skills will be needed working through issues stemming from overleveraged balance sheets. In all of these areas, we are aiming to increase our holdings in companies that look well-positioned to prosper in the eventual recovery.

Finally, we wish the best to all of you, your families, and colleagues as we collectively move through these most challenging days.

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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.

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. Investments in securities of micro-cap, small-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.)

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.

Royce defines leverage as net debt to earnings before interest, taxes, depreciation, & amortization (“ND/EBITDA”).

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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an 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. The MSCI ACWI ex USA Large Cap Index is an unmanaged, capitalization-weighted index of global large-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income.

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.

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