3Q21 Small-Cap Interview: Can Small Caps Regain Leadership?—Royce
article 10-07-2021

Can Small Caps Regain Leadership?

Chuck Royce and Francis Gannon discuss what may be next for the asset class following two underwhelming quarters.

TELL US
WHAT YOU
THINK

Are you concerned that the Russell 2000 Index underperformed the large-cap Russell 1000 Index for the second consecutive quarter?

Chuck Royce We’re not overly concerned. Small caps and large caps have had remarkably similar returns, a gain of 32.5% for small caps and 32.7% for large caps, since February 20, 2020, just before the pandemic-induced down market. So I see large caps’ recent outperformance as more of a catch-up phase after they lagged small caps through the rally that began off the March 2020 lows. It’s also common for small caps to see a short-term pause or pullback within a full cycle. In fact, this last six months reminded us of very similar flat six-month period in the second and third quarter of 2010. That lackluster six months also came on the heels of a robust small cap recovery from a steep decline—in that instance the 2008-09 Financial Crisis—which was followed by a resumption of small cap’s bullish advance. At the end of the day, I’d say that small caps performed about as we expected—maybe even a little better since many intra-cycle corrections have historically fallen in the 10-12% range. I was more surprised by what looked to me like a flight to safety into mega-cap names due to investors’ increased risk aversion and fears that the more sluggish pace of economic growth we saw through the summer would persist.

An Historical Parallel?
Russell 2000 Returns

r2k-current-vs-2010

Past performance is no guarantee of future results.

Did recent small-cap performance create buying opportunities?

Francis Gannon We always look to take long-term advantage of individual stock volatility. Our investment teams added some new names where prices hit levels we found attractive while also building certain existing positions to take advantage of what we see as short-term downward price movements. For example, we built positions in companies such as infrastructure construction supplier Arcosa and CDK Global, which provides digital marketing software solutions to U.S. auto dealers. It seemed to us that investors were locked in on near-term, negative headlines or more immediate pressures on financial results. To be sure, there are serious challenges for companies right now. However, we think the best-managed, fundamentally strongest businesses will continue to fare well.

What caught your interest most during 3Q21?

FG What was most interesting to me was the way investors in both small- and large-cap stocks responded to the direction of interest rates, most notably in July and September. When rates were falling in July, the Russell 1000 was positive while the Russell 2000 fell. After the 10-year Treasury bottomed on August 3rd, rates rose slowly before moving up by roughly 20 basis points after the Fed meeting on September 22nd, in which Fed Chair Powell mentioned tapering. This news shook investors as all the major U.S. indexes declined through the last week of September, though small cap lost less. When you look further into history, you find that small-cap stocks typically fare better in rising rate environments than large caps.

Relative Asset Class Reactions to Movements in the 10-Year Treasury Yield
As Interest Rates Moved, Small- and Large-Caps Spreads Diverged

r2kv-r1k-10yryield-july-sep

Past performance is no guarantee of future results.

What effect do you think rising rates will have on small-cap performance?

CR We’re sensitive to the fact that rising rates often worry investors, who fear that higher yields will be accompanied by falling prices stocks across the market cap spectrum. However, to Frank’s point, many investors don’t know that small caps and rising interest rates have enjoyed a historically harmonious relationship—the Russell 2000 has posted returns above its historical averages in one-year periods when the 10-year Treasury rose. Based on this long history, we think that if rates continue to rise—and we suspect they will—it’s better news for small-cap stocks than many investors think.

Small Cap Outperformed Large Cap When the 10-Year Treasury Yield Rose
Russell 2000 vs Russell 1000 Trailing Monthly Rolling 1-Year Returns from 9/30/01 through 9/30/21

sc-lc-risingrates

Past performance is no guarantee of future results.
Batting average refers to the percentage of 1-year periods in which the Russell 2000 outperformed the Russell 1000 Index.

After two underwhelming quarters, what is your take on the state of small-cap valuations?

FG One of the perennial misunderstandings about small-cap stocks is the degree to which the performance of individual stocks diverges from the index. A deeper dive is often very revealing. For example, from its 2021 high on March 15th through the end of September, the small-cap index was down only 6.1%. At the same time, most small-cap stocks have undergone much deeper corrections. Measuring from the respective 52-week highs of each company in the index through the end of 3Q21, the average stock in the Russell 2000 was down 24.2%. We see this depth of decline as a sort of stealth correction within small cap. As a result, our investment teams are not lacking interesting long-term ideas at reasonable to attractive valuations.

A Correction in Hiding?
A Wide Spread Exists between the Russell 2000’s Performance and the Average R2K Stock

r2k-vs-avgstock-high-to-current

Source: Bloomberg

What kinds of opportunities has this created?

CR Overall, we’re maintaining our longstanding cyclical tilt and are still primarily leaning into value. Most of our opportunities have come on a stock-by-stock basis rather than sector or industry plays. One particularly interesting name is Avid Technology, a multi-media technology company that sells software and integrated solutions for video and content creation, management, and distribution. Avid also works with major film studios. Roughly 90% of the original content from leading streaming services such as Netflix, Amazon Prime, and Apple TV is produced with Avid solutions—and Avid is agnostic as to whether content growth comes from traditional media enterprises or streaming services. A second act of durable growth is emerging, following the arrival of new management that took over in 2018. This team reinvigorated product investment, as Avid has enacted a value-accretive cloud-based software transition while doubling its total addressable market.

Are you still confident in the long-term performance prospects for high-quality U.S. small caps?

FG We are, especially as we look out to the next three to five years. However, it’s important for investors to keep in mind that three- and five-year average annualized returns for the Russell 2000 were above their historical rolling averages at the end of 3Q21—and long-term above-average returns tend to be followed by below average performance. Additionally, small caps have tended to have more muted performance starting from the low levels of high yield spreads that we have today. There is good news, however—high-quality small caps have tended to deliver their best levels of outperformance when the overall small cap market experienced single-digit returns.

Monthly Rolling 5-Year Average Excess Returns: High Quality 1 Minus Russell 2000
From 6/30/97 through 9/30/21

quality-5-year-return-range

1 High Quality: The top decile of securities in the Russell 2000 sorted by a combination of ROIC and stability of ROA.
Past performance is no guarantee of future results.

Can you give us an example of a company that exemplifies these high-quality attributes?

CR A great example is Kadant, a global leader in the manufacture of highly engineered systems and components used in multiple processing industries. Its solutions address critical needs in their customers’ production processes where quality, reliability, and service are paramount. Most recently, Kadant has been benefiting from increased demand for core packaging processing equipment thanks to the global rise of online retailing, as e-commerce uses three to six times more containerboard per shipment than a retail store. More importantly, Kadant’s management has been transitioning the business to be more growth oriented by serving multiple industries. The company has a large and sticky customer base that’s given it a dominant market position. In addition, a full two thirds of sales are parts and consumables, resulting in a highly resilient, asset-light business model with strong cash flow generation. Management has exhibited a focused, prudent track record of capital redeployment into new products and industries, utilizing a ROIC (Return on Invested Capital) investment hurdle. We’re confident that management’s new operating model, combined with its quality attributes, will result in continued favorable compounding returns.

Are you positioning your portfolios for increased inflation?

CR Along with supply chains, inflation has been one of the first topics we’ve discussed with management teams over the last several months. However, our overall positioning hasn’t shifted much. Part of the reason is that many of the fundamental attributes we like are those that help companies deal effectively with inflation when it does arise. For example, we like companies with a dominant market share in their niche, which gives them pricing power that’s critical in an inflationary environment. Similarly, we like companies with a history of long-lasting customer relationships and/or whose services involve high switching costs—both of which also help when there’s inflation.

FG We also view inflation as a force that affects different businesses differently. We’ve already seen some holdings take advantage of pricing power, for example, which is providing them with greater operating leverage and wider margins. It’s also important that investors know how well small caps have done historically when prices are rising—they’ve outpaced inflation in every decade going back to the 1930s—and are the only major asset class to do so. From our perspective, then, inflation is a force we adapt to, and not something we worry over. What we do think about are the varying effects on companies of more transitory inflation, such as we’ve seen recently with certain commodities like lumber, versus what appears to be more lasting inflation—such as wages.

Are you concerned about recent changes announced in China?

CR I would say that the policy and regulatory changes in China could reverberate across the capital markets over many years. So I’m going to offer an atypical perspective that departs from my usual bottom-up view. China is both our chief economic competitor and a critical trading partner. It’s also the world’s biggest manufacturer, with roughly 28% of global output. The country’s leadership has decided to embrace slower growth in order to pursue what its political leaders view as their sociocultural priorities. We’re humble enough to understand that we don’t know what the consequences of these changes will be. Still, they seem likely to be consequential and to create a drag on Chinese and, by extension, global growth. Based on these changes, we’ve shifted our view when analyzing individual companies. Where we once saw a business’s meaningful exposure to China as an advantage, we now view it as a negative. That’s a very significant shift.

Based on these concerns, are you still optimistic about U.S. small caps relative to the other investments?

CR It’s admittedly a bit of a mixed picture. We’re in an odd position where, for many people in the world, the last 18 months have been an extremely difficult period because of the pandemic. However, for investors, particularly those in the U.S., the trailing returns are very, very good. Going forward, I expect U.S. investors will need to temper their expectations. A lasting return to normal will be very welcome news, even if the prospective results for stocks are not as high as they’ve been for many investors. Within the U.S. capital markets, however, I’m confident that small caps are positioned to outperform U.S. large caps, as well as domestic fixed income and cash. I think investors should feel very comfortable with their U.S. small cap allocations. I’d also add that it’s historically during less robust performance periods that active management has added the greatest value—and we look forward to doing so for our investors.

Active Small Cap Historically Has Done Better in Single Digit Return Periods
Monthly Rolling 5-Year U.S. Small Blend 1 Average Excess Returns During Russell 2000 Return Ranges from 12/31/78 through 9/30/21

R2K-5-year-return-range

1 There were 520 US Fund Small Blend Funds tracked by Morningstar with at least five years of performance history as of 9/30/21.
Past performance is no guarantee of future results. The excess return for a Morningstar category would be the category’s return for the period minus the Index return.
Source: Morningstar

VIEW FUND PERFORMANCE

 

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.

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.

Percentage of Fund Holdings As of 9/30/2021 (%)

 
  Arcosa CDK Global Avid Technology Kadant
Royce Dividend Value Fund 0.0 0.0 0.0 0.0
Royce Global Financial Services Fund 0.0 0.0 0.0 0.0
Royce Global Value Trust 0.0 0.0 0.0 0.8
Royce International Premier Fund 0.0 0.0 0.0 0.0
Royce Micro-Cap Fund 0.0 0.0 0.0 0.0
Royce Opportunity Fund 0.6 0.0 0.5 0.0
Royce Pennsylvania Mutual Fund 0.9 0.2 0.5 0.9
Royce Premier Fund 1.7 0.0 0.6 2.2
Royce Small—Cap Value Fund 0.0 0.0 0.0 0.0
Royce Smaller-Companies Growth Fund 0.0 0.0 0.0 0.0
Royce Special Equity Fund 0.0 0.0 0.0 0.0
Royce Micro-Cap Trust 0.0 0.0 0.3 0.0
Royce Total Return Fund 0.0 1.5 0.0 0.0
Royce Value Trust 0.4 0.0 0.8 1.2

Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio 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.

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.

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).

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.

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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