2Q21 Small-Cap Recap—Royce
article 07-01-2021

2Q21 Small-Cap Recap

Co-CIO Francis Gannon reviews 2Q21, a ho-hum quarter in which value’s lead nonetheless continued, and details why our outlook is optimistic for active management.

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After a Year of Excitement, a Ho-Hum Quarter

Unlike some of the quarterly performances over the last 12 to 18 months, small cap returns (+4.3%) neither set nor approached new records for gains or losses in 2Q21. In that sense, it may have seemed like a somewhat boring quarter. In contrast to the sky-high results for the Russell 2000 Index over the last two quarters, each of the major domestic indexes finished the period with returns in the mid- to low single digits, with similar results for their non-U.S. cousins.

To stretch our observation a bit further to encompass a market cycle perspective, small caps roared back from their 3/18/20 trough to post a 141.0% return to the 2021 high on March 15. The Russell 2000 has made no progress since that date, declining by 1.8% from this year’s high through the end of the second quarter.

Russell 2000 Market Cycle

Large Caps Post New Highs

In contrast to the sky-high results for the Russell 2000 Index over the last two quarters, each of the major domestic indexes finished the period with returns in the mid- to high single digits, with similar results for their non-U.S. cousins.

Large Cap Wins 2Q21, But Small Cap Keeps Its Lead
Russell 2000 vs Russell 1000 Return ended 6/30/21

Russell 2000 vs Russell 1000 and 2Q21 and 1-Year

The Russell 1000, S&P 500, and Nasdaq Composite all reached new highs in 2Q21, while the Russell 2000 (as noted above) mostly treaded water—which was somewhat unsurprising in light of how far ahead small caps had advanced over the previous 12 months. Still, for small caps, 2Q21 itself was a modestly above average quarter on an absolute basis. Since its inception on 12/31/78, the average quarterly return for the Russell 2000 was 3.5% through 6/30/21.

Small-Cap Value Has More Room to Recover

There were interesting developments at both the style and sector levels during 2Q21. The Russell 2000 Value Index stayed strong and further solidified its still nascent outperformance streak over small-cap growth, up 4.6% versus 3.9% for 2Q21. To be sure, the second quarter marked the third consecutive one in which the Russell 2000 Value beat the Russell 2000 Growth Index.

This relative result gave value the advantage for the year-to-date (+26.7% vs. +9.0%) and one-year periods ended 6/30/21, where small-cap value advanced 73.3% versus 51.4% for growth. However, the Russell 2000 Value still lags its growth counterpart over longer-term periods. In fact, we find the disparity striking between the recent marked advantage for small-cap value versus small-cap growth and the still sizable performance advantage growth holds over value for the three- and five-year periods ended 6/30/21.

Small-Cap Style Disparity
Russell 2000 Value vs Russell 2000 Growth Annualized Return ended 6/30/21

Russell 2000 Value vs Russell 2000 Growth Annualized Return ended 6/30/21

These style index performance comparisons complement our bottom-up perspective, where we have observed that relative valuations for many value—as well as cyclical—stocks still look more attractive, especially over the long term, than their growth and defensive siblings. So while we understand that investors may see recent robust short-term performance for value and conclude that it’s run its course, we see the leadership shift in its favor as just getting underway.

Cyclicals Show Strength Amid Divergence

The second quarter also marked the fifth quarter in a row in which cyclicals beat defensives. Cyclical leadership during the current economic recovery is consistent with the pattern we’ve seen throughout most of the last several decades, in which economic growth benefits more economically sensitive sectors. As more and more of the world’s population is vaccinated and economies across the globe reopen, the expansion should continue to reward select cyclical companies.

Communication Services and Energy, two cyclical sectors that are among the Russell 2000’s lowest weightings, were by far its best performers in 2Q21, the former buoyed by “meme stocks,” those that saw steep and rapid price increases mostly due to social media. These sectors were followed by Real Estate (a defensive sector), Information Technology, and Consumer Discretionary. Industrials, Financials, and Materials all finished the quarter in the black, yet each lagged the small-cap index as a whole—most dramatically in the case of Industrials. We remain constructive on this broad and diverse sector, however, and see many of its companies as ‘mid-cycle’ performers that will catch up and close the gap as the global economy expands.

Cyclical Returns Diverge
Russell 2000 Cyclical Sectors ended 6/30/21

Russell 2000 Cyclical Sectors ended 6/30/21

We also saw curious developments at the factor level, where the first signs of high-quality small caps making a move were evident in results for the top quintile of companies based on profitability within the Russell 2000, which outperformed the index as a whole. At the same time, however, highly leveraged companies also outpaced the index, so companies with lower quality balance sheets were also in favor during the quarter. At the sector and factor levels, in other words, it appears that investors are trying to get a bead on what is likely to work best in a recovering economy.

Watch This Space: Are Non-U.S. Small Caps Ready to Run?

For the first time since 2020’s first, wildly bearish, quarter, small caps outside the U.S. beat their Russell 2000 cousins, with the MSCI ACWI ex-USA Small Cap Index up 6.4%. As many European and some Asian economies are lagging in vaccination rates and economic recovery, this quarter might have marked the beginning of a relative performance shift to equities located beyond our shores. Non-U.S. small caps have a wide gap to close with their stateside counterparts as the MSCI ACWI ex USA Small Cap Index advanced 12.0% on an average annual basis over the past five years compared to a 16.5% rise for the Russell 2000.

A Stabilizing Global Economy and Potential Rate Increases Likely Lower Prospective Returns...

As fundamentally based bottom-up stock pickers, we claim no expertise on the economy. However, we agree with the consensus view that the world’s economies, at least the major ones, are in fundamentally sound shape, with formidable prospects for above-average growth over the intermediate term. Fiscal support and monetary accommodation have been generous throughout most developed economies, and these actions have reduced near-term risks for investors.

This is inarguably positive news. Yet this increased comfort is already reflected in less risk aversion among investors, which has led to higher share prices and valuations. This process results, perhaps counterintuitively, in more modest prospects for the overall small-cap market. We anticipate that the small-cap market as a whole will see moderate prospective returns as the asset class wrestles with two countervailing forces: slowly rising rates should push down on valuations just as many companies are likely to report robustly growing earnings through at least the end of next year. These forces, however, will not affect all small caps equally.

… Yet Also Create Opportunities for Active Management

Still, we hasten to remind our investors that active small-cap managers have added the greatest amount of excess return when the Russell 2000 delivered single-digit results over multi-year periods, as shown in the chart below.

Monthly Rolling 5-Year U.S. Small Blend 1 Average Excess Returns During Russell 2000 Return Ranges
From 12/31/78 through 6/30/21

Monthly Rolling 5-Year U.S. Small Blend 1 Average Excess Returns During Russell 2000 Return Ranges

1 There were 514 US Fund Small Blend Funds tracked by Morningstar with at least five years of performance history as of 6/30/21.
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

This current divergent environment will in all likelihood lead to differentiated company results, which sets up a constructive context for active managers. Compressing multiples should disproportionately hinder returns for more highly valued stocks while above-average economic growth should better support the earnings for cyclically sensitive business models. We therefore continue to lean even more toward economically sensitive cyclical areas and lower valuation stocks in most of our portfolios.

Further supporting the case for active management’s potential advantage in the coming months is that it would be unusual to finish the calendar year without at least a 10% correction. While the market has experienced some intra-month volatility, small caps have advanced for nine consecutive months—and this kind of positive placidity rarely lasts for long in the market. Rather than try to predict the triggering event, we will instead be prepared for the market’s inevitable volatility by trying to take advantage of temporarily depressed prices on behalf of our investors.

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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. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

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.)

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.

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 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. 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. 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. Index returns include net reinvested dividends and/or interest income. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor’s based on market size, liquidity, and industry grouping, among other factors, and includes reinvested dividends. 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.

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.

For the Morningstar Small Blend Category: © 2021 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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