Bullish for the Long Run—Royce
article 07-07-2023

Bullish for the Long Run

Portfolio Manager Chuck Royce and Co-CIO Francis Gannon look at a market tightly concentrated with big winners on top, the importance of AI, and why small-cap prospects appear so attractive to them.


What was your overall take on the market’s performance in 2Q23?

Chuck Royce: We were pleased on an absolute basis with small-cap’s results—the Russell 2000 Index was up 5.2% for the quarter. However, small cap underperformed the large-cap Russell 1000 Index, which was up 8.6% in 2Q23, while mega-caps did even better than large caps, with the Russell Top 50 Index advancing 13.2%. This pattern also held for the first half of 2023. In fact, the Russell 2000 trailed the Russell 1000 for the third consecutive quarter.

Francis Gannon: We were happy that The Royce Funds performed very well, with strong absolute and relative returns for the second quarter, year-to-date, and most longer-term periods through the end of June. And this was true for almost all of our major strategies: high quality, opportunistic value, quality value, and our more classic value approaches all performed well—which does not always happen over shorter-term periods.

Do you agree that valuations throughout the market are unsustainably high?

CR: Certainly no one is arguing that they’re low—but I also think the context is important. For all the understandable talk about how well the Nasdaq has done year-to-date—it was up 32.3% through June 30th—it also remained 13.9% off its previous peak on 11/19/21 at the end of June. And small caps are still in a bear market, down -20.8% from their last peak on 11/8/21 through June 30th. Most of the talk around elevated valuations has taken place in an inflationary climate with rising interest rates and widespread anxiety that the economy is about to slip into a recession. Market cap also needs to be taken into account. Valuations for large caps, on average, look a lot more stretched than they do for most small caps.

FG: A lot of multiple compression has occurred over the last several months among small caps, particularly small-cap value stocks. At the end of June, valuations looked highly favorable for the Russell 2000 cap on both an absolute basis and relative to the Russell 1000, where they remain close to a 20-year low based on enterprise value over earnings before interest & taxes (“EV/EBIT”). Unsurprisingly in light of how it’s recently lagged growth, the Russell 2000 Value Index finished June much more attractively valued than the Russell 2000 Growth Index, based on that same EV/EBIT metric.

Why do you think that active management, as measured by the Morningstar Small Blend category, did well in both 2Q23 and the first half of the year, particularly in a period of strength for small-cap growth stocks?

CR: First, lower return periods have historically been good for active management—and the last five years have been on average a low return period for small caps. The annualized five-year return for the Russell 2000 at the end of June was just 4.2%. Second, I think ongoing uncertainty has made small-cap investors focus more on fundamentals such as earnings and balance sheet strength. Small-cap companies with proven pricing power have also earned an edge in the inflationary environment. All of this appears to have resulted in a stock picker’s market for the asset class that’s helped disciplined, long-term active managers distinguish themselves.

Were there any other themes you saw in how returns stacked up in 2Q23 and the year’s first half?

CR: I think many investors began to look beyond the current concerns about inflation and recession toward a more stable and positive economic environment. A lot of different factors likely played a role in that mindset: returns in April and May were low for large cap and negative for small cap, which I’m sure encouraged some investors to return to equities. Employment stayed strong, and recession talk appeared to subside in terms of both coverage and volume—which was also encouraging. I suspect that the Fed skipping an interest rate hike in June—even as they all but promised increases in July and September—was an even bigger factor. However, I think the biggest catalyst by far has been the promise of artificial intelligence (“AI”), a major secular trend whose impacts have just started to register.

In what ways did you see AI’s impact on stocks prices?

FG: There was a notable demonstration of both AI’s importance and promise in the first half returns for the small handful of mega-cap companies that currently look like the biggest beneficiaries of AI adoption—Apple, Meta, Alphabet, Microsoft, Amazon, and chip designer, Nvidia. Those companies drove large-cap results. Perhaps the most vivid illustration was Nvidia’s soaring stock price. Thanks to its expertise in making the chips that are needed to power AI applications, the Taiwanese tech giant reached $1 trillion in market cap in late May, putting it in the very exclusive company of Apple, Alphabet, Amazon, and Microsoft—the only other stocks with trillion-dollar market caps. So while we’ve only just begun to see AI’s impact, it’s already having quite an effect on the market.

Why do you think large cap outperformed small cap in 2Q23 and year-to-date through the end of June?

CR: There were two factors at work, one that helped large cap, and another that hurt small cap. The first would be AI helping large cap. Information Technology—which is heavily weighted in the mega-cap stocks that were AI winners and had a more than 25% weighting in the Russell 1000 at the end of June—made by far the biggest contribution to returns for both 2Q23 and the year-to-date period within the large-cap index. The second factor had to do with the lingering impact of the banking crisis, which had some of its most adverse effects on the share prices of smaller regional players. And while banks are not nearly as heavily weighted in the Russell 2000 as tech stocks are in the Russell 1000, they were the largest industry weight in the Russell 2000 at the end of June.

Do you expect AI to eventually have a measurable effect on small caps as well?

FG: It seems likely. Just as the advent of the Internet has had profound effects on the speed and availability of information, we think AI will have an analogous effect on the processing of information. It’s hard to overstate how important that will be. The number of beneficiaries will almost definitely extend beyond the limited number of players that are already reaping rewards. At the same time, it’s doubtful that we’ll see the equivalent of what we saw in the Internet Bubble, where hundreds of dot.com companies proliferated in short order. However, most major technological innovations—everything from websites and cell phones to the cloud—require components and services that small-cap companies provide—and we anticipate the growth of AI will be no different.

Can you recall a comparable period when such a small number of companies had such an oversized effect on market performance?

CR: The Nifty Fifty market of the ‘70s and the 2000-2001 Internet Bubble are the only roughly comparable periods—though I think the current period is the most concentrated of any that I’ve invested through. For example, the bulk of large cap returns so far this year have come from seven stocks: the six tech companies we mentioned earlier along with Tesla. Considering that there are more than 4,000 publicly traded companies in the U.S., this is an almost absurd level of concentration. It certainly looks unsustainable to me. Going back 25 years, we haven’t really seen anything like the level we’re seeing currently.

No Room at the Top?
Top Five Stocks in the Russell 1000 / Russell 2000 by Market Value, 6/30/03-6/30/23


What signs at the macroeconomic level might signal a turnaround for small-cap performance?

FG: Certainly we’re hoping for a robust rebound for the U.S. economy for many reasons, not the least of which is that small caps tend to do especially well in a thriving economy. We’ve seen signs that we are getting closer. To be sure, a soft landing looks more and more likely, while the kind of deep and potentially lengthy recession many have been anticipating since late 2021 looks less and less likely. As Neil Dutta at Renaissance Macro recently put it, “The statute of limitations has now kicked in” regarding a recession in the U.S. Here’s a great example: In May, the U.S. Commerce Department reported a 0.9% seasonally adjusted increase in construction spending. Yet what was most interesting to us was how much of that spending went on new manufacturing facilities. There was a 76.3% increase from a year earlier, as well as a 1% advance in May over April. In addition, the Commerce Department showed that spending on manufacturing construction accounted for almost 0.5% of 1Q23’s GDP, which was its largest share since 1991. Its second-quarter share of GDP will probably be even higher.

CR: We’ve seen other promising developments as well: durable goods orders rose for the fourth consecutive month in June, hitting a record high for nondefense capital goods (excluding aircraft or core capital goods, a proxy for business equipment investment). Homebuilding rose by 21.7% in May, a record monthly surge that also defied expectations of a slowdown. Let’s also keep in mind that over the next year or so rate hikes and inflation will likely be sunsetting. Additionally, we’ll be starting to measure the positive impacts of reshoring, the infrastructure bill, and the CHIPs Act over a similar timeframe.

Are there other signs you can point to that suggest an improving climate for small caps?

FG: As always, we put a lot of trust into what we’re hearing from company management teams. In our conversations, there continues to be a sense of cautious optimism—which was reflected in generally solid earnings for many holdings for the second quarter. All of this is consistent with our contention that small caps are due—perhaps overdue—for a breakout.

Then you’re not concerned about comparatively lackluster results for the Russell 2000 so far in 2023?

FG: It’s true that January and June were the only months so far in 2023 when the Russel 2000 had positive returns. There were four straight down months in between. This is a rare occurrence that’s happened only nine times since the inception of the index on 12/31/78. We wanted to see what shape performance took over the subsequent one-, three-, and five-year spans. What we found was very encouraging, with each period coming in comfortably above the one-, three-, and five-year monthly rolling averages for the Russell 2000 since inception. For the eight periods for which we have data, subsequent one-year returns averaged 24.7%; subsequent three-year returns averaged 21.0%; and subsequent five-year returns averaged 16.8%.

Small Caps Shine Following Four Consecutive Months with Negative Returns
Russell 2000 Average Returns Following Four Consecutive Months with Negative Returns Since Inception (12/31/78)


Past performance is no guarantee of future results

What else informs you optimism for small-cap stocks?

FG: We’ve also compiled the data which shows how strong and lasting a rebound that small caps have historically enjoyed after low annualized five-year periods such as we had at the end of June. The Russell 2000 had positive annualized five-year returns 100% of the time—in all 81 five-year periods—averaging an impressive 14.9%, which was well above its monthly rolling five-year return since inception of 10.4%.

Is Improved Small-Cap Performance Ahead?
Subsequent Average Annualized 5-Year Performance for the Russell 2000 Following 5-Year Annualized Return Ranges of Less Than 5% from 12/31/83 through 6/30/23


Past performance is no guarantee of future results

Can you talk about a high confidence holding that has performed well so far this year?

CR: We have a lot of long-term confidence in Fox Factory. It’s a leading manufacturer of highly engineered suspension systems for mountain bikes, trucks, ATVs, and other sporting vehicles. Senior Analyst Zach Weiss recently did an excellent deep dive into the company. Suffice it to say, we really like its position in a few different niches, each of which looks attractive in the long run. In our view, Fox has the potential to compound earnings growth thanks to secular themes such as electrification, digitization, and connectivity. Its bike business—which is what the company started with—can grow with the adoption of e-bikes and increasingly connected suspension systems, while its specialized suspension and shock absorbers can potentially capture market share gains with automotive original equipment manufacturers of trucks and SUVs thank to Fox’s reputation for quality and innovation.

Fox Factory (Nasdaq: FOXF)


Past performance is no guarantee of future results

Can you tell us about a key holding that has not done as well in the first half of 2023?

CR: The aircraft leasing company, Air Lease, purchases, sells, and leases commercial aircraft for a global client base. We’ve owned it for a number of years and really like its status as a pioneer in its niche, especially given the growth in the aircraft leasing business over the last several decades. The company buys aircraft in bulk, so it gets reasonable to attractive prices and also often holds inventory that other sellers or lessors don’t have. It also enjoys lower costs of capital than the airlines. Airline traffic demand is growing as part of the wider post-Covid bump in travel. Leasing stalled during the pandemic, which lowered rates, but this is beginning to normalize, especially as travel volumes rise. Based on this, we think it has room to run.

Air Lease (NYSE: AL)


Past performance is no guarantee of future results



Important Disclosure Information

Mr. Royce’s and Mr. Gannon’s 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. 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 6/30/23 (%)

  Dividend Value Global Financial Services International Premier Micro-Cap Pennsylvania Mutual Premier Small-Cap Opportunity Small-Cap Special Equity Small-Cap Total Return Small-Cap Value Smaller-Companies Growth

Air Lease Cl. A












Fox Factory Holding Corporation












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.

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.

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 Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell Top 50 Index measures the performance of the largest companies in the Russell 3000 Index. It includes approximately 50 of the largest securities based on a combination of their market cap and current index membership and represents approximately 40% of the total market capitalization of the Russell 3000 Index. The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. 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 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. The performance data and trends outlined in this article 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. 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.)

The Morningstar Small Blend Category had a performance advantage over the Russell 2000 for the one- (+12.5% versus +12.3%), three- (+14.1% versus +10.8%), and five-year periods (+5.2% versus +4.2%) ended 6/30/23, while finishing essentially even for the 10-year period (+8.3% versus + 8.3%) ended 6/30/23. When we excluded index funds and included only the oldest share class of a fund within a category, 107 out of 173 funds outperformed the Russell 2000 for the one-year period; 145 out of 166 funds outpaced the small-cap index for the three-year period; 120 out of 156 funds did so for the five-year period; and 76 out of 130 funds beat the Russell 2000 for the 10-year period—all ended 6/30/23. There were 616 U.S. Fund Small Blend Funds tracked by Morningstar with at least one year of performance history, 595 with at least three years, 551 with at least five years, and 380 with at least 10 years as of 6/30/23. Morningstar category averages are equal-weighted category returns. The calculation is simply the average of the returns for all the funds in a given category. The standard category average calculation is based on constituents of the category at the end of the period. Our calculation excluded index funds and included only the oldest share class of a fund in the category.

For the Morningstar Small Blend Category: © 2023 Morningstar. All Rights Reserved. The information regarding the category in this piece is: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.



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