Small-Cap Investing In A Bear Market—Royce
article 04-07-2020

Small-Cap Investing In A Bear Market

Portfolio Manager Chuck Royce and Co-CIO Francis Gannon look at the current bear market and discuss what a small-cap recovery might look like.


Can you give investors your overview of the current bear market?

Chuck Royce First, it was a significantly broad based, hyper-democratic decline. The Russell 2000 Index fell 30.6% in the first quarter, the largest quarterly loss for the index in its more than 40-year history. Certain areas were hurt more than others, but this was an across-the-board bear market—no sector or industry was spared, and only a tiny handful of companies escaped losses. It’s also been a deep global downturn. Its speed was unprecedented, but its depth has so far not been.

Francis Gannon Looking further into small-caps, we find that this is the sixth decline of 20% or more for the Russell 2000 Index over the last 20 years. We group these downturns into two different categories, each with three declines: First we have the small-cap bear markets of 2011, 2015-16, and late 2018. All fell within a return range of -20 to -30%. Each was a growth scare, motivated by fears of a recession that in each case did not happen. The second group encompasses the three most severe bear markets of the last 20 years, all accompanied by a recession: 2000-02, 2007-09, and the recent decline (we believe the global economy is already in a recession). From 2/20/20 through 3/18/20 (the small-cap bottom in 1Q20), the Russell 2000 Index fell 41.5%, which puts it within the range of the previous two deep bear experiences. In the Internet Bubble of 2000-02, small-caps lost 44.1%, and in the bear market of 2007-09 (which began more than a year before the Financial Crisis), small-caps were down 58.9%. We think this context is important.

Russell 2000 During Previous Bear Market Declines


Is this bear market different, given its origins in a global public health crisis?

CR Like most severe bear markets, the current bear moment was a true ‘Black Swan’ event, coming out of the blue and shocking investors. Yet because it originated in a public health crisis—not in an economic or market disruption, at least not directly—it’s unique. This makes the situation both new and yet somewhat familiar. As we’ve discussed, it’s really the speed of the current decline that’s the differentiator. I think we could also add the oil price war, which exacerbated a decline that had already demonstrated ample downward force. Energy commodity prices fell precipitously, which is really hurting areas of the U.S. that rely on energy, especially with us being a net producer. When energy prices fall, it usually acts as an economic stimulant, but with consumption now so reduced, that’s not the case.

How have these similarities and differences affected your view of the current environment?

FG We firmly believe that, as unsettling and worrisome as the pandemic is, we are not headed for a depression. We’ve already seen a significant monetary and fiscal response from the U.S. government, with more relief and infrastructure bills being discussed. Similar actions are taking place around the world. We haven’t seen any significant inflation so far, unlike the runaway rates in the stagflation era of the 1970s. And unlike 2008, balance sheet health is better for both consumers and financial institutions. So from our perspective, a steep decline with no depression suggests that we’re likely to see a deep recession, but one that could also be relatively short lived.

How valuable have your previous bear market experiences been in the current environment?

CR I think one of the most critical advantages during any period of market stress is to have your investment activities consistent with your thinking—in essence, to practice what you preach and avoid capitulating to paralysis or second guessing. That’s one of the most significant benefits of having invested through many different bear markets. We’re staying active every day, buying more on the down days without reacting emotionally. This activity allows us to systematically go after the stocks we want, knowing full well that we can’t time the bottom. Over the years, we’ve found that this dispassionate, gradual approach has served us well through numerous declines. At the end of the day, our job is to take advantage of falling prices. For the portfolios I manage, that entails finding what I think are first-rate small-cap companies capable of compounding over the long run.

How critical has the experience of the investment team been?

FG I think having a highly experienced team has been invaluable. Our most seasoned portfolio managers have several decades of experience investing in highly challenging and volatile markets. The average experience of our portfolio managers is 30-plus years in the industry. That’s very rare. Moreover, small-caps have demonstrated a lot more volatility over the last decade than large-caps, so even the younger members of our investment team have developed considerable experience investing in difficult times.

CR I think it’s also important that we’ve always held a central conviction: active managers are risk managers first and foremost. In my view, that’s one of the reasons so many of our strategies have been successful not only in downturns but also over full market cycle periods. And we still believe that full cycles are the best way to measure the success of an investment approach.

How much longer—and deeper—do you expect the correction could go?

CR It’s an understandable question, but I’m not sure it’s a useful one because no one knows. We’re expecting more volatility for sure, but other than that we’re facing a large number of unknowns. We don’t know when the virus will be contained. We don’t know the full extent of what the knock-on effects to the economy will be. So while our long-term outlook is decidedly optimistic, trying to gauge the depth or the timeline is impossible right now.

FG It seems clear that each day’s headlines will dictate the behavior of the majority of investors for the duration of the outbreak. It’s going to take time for the market to settle down. For now, perception and short-term thinking are dominating. So we’re investing across our strategies in a contrarian way in that we’re thinking in terms of years as opposed to making decisions based on the latest news.

What shape do you think an economic and market recovery is likely to take?

CR I don’t think the economy will look dramatically different when we reach the recovery. It seems to me that the current crisis will act as more of an accelerant than an agent of major economic change. So there’ll be a speeding up of trends already in place, mostly centered on innovation, especially in telecommunications, and automation. This is already happening in the first of these two zones, with so much of the world working remotely. We’re also already seeing a reexamination of supply chain and logistics management—particularly in ‘just in time’ industries—and we’ve been investing in these asset-light areas for many years.

FG The GDP numbers over the next two quarters are going to be ugly—but we’re looking past the valley to the recovery. It can be challenging to maintain this long-term outlook, but we stay focused on the fact that the global economy looks fully capable of rebounding, even within the context of a new normal. We also see a robust fiscal response as being potentially helpful, whether in infrastructure improvements, filling revenue gaps at the state and municipal levels, or giving additional help to now-vulnerable small businesses.

What are some of the factors that inspire your longer-term confidence, for both the market as a whole and small-cap stocks in particular?

CR First, this is ultimately a finite situation. And as challenging as it is, it’s important to recall that, prior to the correction, we had one of the strongest employment trends in history. The consumer was generally in good shape. We all know that we’re entering a period of higher unemployment and, as Frank said, some unattractive GDP numbers. That’s a harsh reality, but we’re also starting from a much different—and much better—baseline than we did in 2008. So the short-term is undoubtedly going to be hard—but we think the aftermath can be highly positive.

FG We always turn to history for guidance and context. At the end of the first quarter, the five-year annualized return for the Russell 2000 was -0.2%. This is a really rare occurrence. Small-caps have had a negative average annual five-year return in only 21 out of 436 month-end periods since the inception of the Russell 2000 more than 40 years ago. That’s less than 5% of the time. Equally important, results in the subsequent periods were really impressive, with a one-year average return of 40.8%, a three-year average of 22.1%, and a five-year average of 18.3%—all well above each period’s respective rolling monthly averages. By staying in the market, small-cap investors more than doubled their money over the ensuing five years. So while none of us one knows what the market’s next sustained move will be, history offers compelling examples of how valuable it is to stay invested in small-caps precisely when it feels most difficult to do so.

Average Returns Following Negative Russell 2000 5-Year Return Periods vs. Long-Term Averages


Why is understanding leverage so important right now?

CR First, because balance sheets are always important. Having low—or no—debt and ample cash are critical to helping companies survive the inevitable difficulties every company faces at some point. What’s most interesting to me about small-caps and balance sheet strength at a time like this is how easy it is for investors to forget about the many dimensions of leverage. For example, we’ve recently seen small-cap stocks with higher leverage decline more than those that are conservatively capitalized. The market has suddenly taken on a strong aversion to leverage. It’s done so, however, without first determining the nature of that leverage—what’s the collateral, the business model, the level of risk, etc. We look at all of these elements and, equally important, place them in context. We pay attention to debt on the balance sheet relative to EBITDA (earnings before interest, taxes, depreciation, & amortization). We look at a company’s profit relative to its interest expense (that is, interest coverage), which can create major issues if profits drop. And, of course, it’s not just the level of debt or coverage or rates—it’s also covenants. And covenants, while sort of behind the scenes, are where companies get into trouble or avoid trouble it.

FG Interestingly, I think the fragility of small-caps, especially with regard to leverage, has been exaggerated to some degree through the correction. Of course, this attention to small-cap debt underscores the rationale behind most of our own active strategies, which prioritize the understanding and analysis of balance sheets. To be sure, one of the reasons the financial media has offered for not buying small-caps—because their higher leverage makes them riskier investments—are reasons we see as pointing up the importance of selective, disciplined, and risk-conscious active management within the asset class.

What other metrics or qualities matter most to you when you’re looking at companies in this kind of market?

CR It’s really no different now in terms of the attributes we examine. We have all-weather investment principles and haven’t changed anything about the metrics that matter most to us when we’re evaluating companies. That would include return on invested capital, return on equity, gross margin, and free cash flow characteristics, to name just a few. As such, we’re avoiding enterprises that are eroding in value and looking for those that look capable of adapting to the current stresses, which should also create an advantage in a recovery. We view adaptability, differentiation, and financial strength as among the hallmarks of high quality.

How have you been investing in your portfolios?

CR We have been leaning mostly toward select, high-quality cyclical companies as we think these businesses are best positioned for a rebound. After the small-cap troughs in 2002 and 2009, small-cap cyclicals substantially outperformed defensives. So in addition to the areas we mentioned above, we’re looking in a general way at businesses that appear well-positioned to benefit from long-term secular trends, those that, while currently interrupted, seem likely to reemerge with strength. This has led us to several companies involved in automation, many of which we’ve been holding for years. We really like what we think are high-quality businesses that either help other companies to automate and innovate or that are taking advantage of automation. It’s an increasingly important part of how all facets of manufacturing are being done, and we think that trend is only going to expand in the years to come.

Other areas we’ve been looking at would include component suppliers for electrical batteries because we think the use of electric vehicles will continue to grow.

We also like consumer companies that specialize in experiences over goods, as we expect consumers to maintain or even build on that trend during a recovery. Specifically, we like recreational vehicle component manufacturers. The downturn has also led several mid-cap companies to fall into the larger small-cap zone, say $2-$5 billion in market cap, including some that we’ve owned before or otherwise know well.

1-Year Returns From Recent Market Troughs


FG A few other areas are also worth mentioning. Very low mortgage rates, along with a robust housing market prior to the economic shutdown, have made housing an area of interest. Medical device companies, particularly those involved in blood analysis, look attractive, and we also own shares of a company that cleans buildings. The management has been telling us that the demand for increasingly high cleanliness standards in commercial buildings is growing. So there are several business models where we’re anticipating increased demand even as their share prices have been cut dramatically.

What is your long-term outlook on non-U.S. small-cap companies?

CR The potential for small-cap as a global asset class remains extraordinary in our view, obviously even more so in light of the decline. Like the Russell 2000, the trailing five-year annualized return for the MSCI ACWI ex USA Small Cap was negative through the end of March, at -0.8%. The subsequent one-, three-, and five-year average returns following these negative five-year returns periods for the international small-cap index were 18.5%, 19.0%, and 18.8%, respectively. As active managers, we’re also really excited that there are so many international small-caps with no research coverage, which significantly increases the chance for us to find mispriced stocks. One area of particular focus is on companies that are classified as cyclical businesses that actually have steady revenues. As is the case with our domestic investments, we’re prepared to be patient as we wait for better days.

What would you tell investors who are still skittish about going into the market?

FG I think we’d emphasize the critical importance of investing incrementally over time during uncertain, volatile periods like this. Not even the best or most seasoned investment professional can time bottoms. It’s equally important to remember that bottoms for sectors, industries, and companies seldom occur simultaneously with the overall market and/or a broad index. More often than not, they have bottoms of their own.



Important Disclosure Information

Mr. Royce’s and Mr. Gannon’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

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.

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