3Q21 Small-Cap Recap—Royce
article 10-01-2021

3Q21 Small-Cap Recap

Small caps trailed large caps in 3Q21, but economic reacceleration could reverse this soon.

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In 3Q21, Bigger was Better

2021’s third quarter saw the first negative return quarter for the small-cap Russell 2000 Index since 1Q20—with a return of –4.4%. It was also the second straight quarter in which large caps outperformed small caps, with the Russell 1000 Index up 0.2% for the quarter.

When it came to capitalization, bigger was better in 3Q21, as the Russell Indexes showed better performance the higher up the market cap scale one went. The Russell Midcap Index fell just 0.9% while the Russell Microcap Index was down 5.0%.

Larger Stocks Led for 3Q21
Russell Index Returns by Market Cap for 3Q21

 Index Returns

From our perspective, the large-cap advantage was driven by increased risk aversion and related anxiety about an economic slowdown—which has recently been the case as measures of economic growth have declined from their more robust pace in the first half. Investors seemed to focus more on potential sources of slowing growth—including COVID-related shutdowns, reopenings, and variants, as well as the idea that the global economy has reached ‘peak growth,’ supply chain issues, and the weakening condition of the Chinese economy. Each of these worries fueled concerns about the economy, and periods of economic anxiety are typically challenging for small caps, particularly relative to large caps.

Small Cap’s Stealth Correction

Small caps’ short-term relative performance disappointments versus large caps during the last two quarters have not crimped our optimism about the long-term absolute or relative prospects for the asset class. Looking below the surface reveals that most of the companies that comprise the Russell 2000 have been enduring more severe corrections than results for the index. While the Russell 2000 has declined only 6.1% since its peak in mid-March, the average small cap stock has experienced a decline of 24.2% from their respective 52-week highs through 9/30/21. This clandestine correction is a source of optimism for us as we anticipate that small caps may be about to resume their upward march.

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

The wide spread between R2K performance and R2K average stock

Source: Bloomberg

Cyclicals Defend, Defensives Lag

Cyclicals, which fell 2.8%, maintained their leadership over defensives (down 7.5%) within small cap in 3Q21, a position they’ve held since May of 2020. This outperformance was something of a pleasant surprise in that down or flat periods historically tend to favor defensives. The leading sectors were two reflationary areas: Energy, up 1.9%, and Financials, up 1.4%. These sectors benefited from rising oil prices and rising interest rates, respectively. In contrast, the sectors with the largest negative returns for 3Q21 made for an odd assemblage. Communications Services lost the most, falling 14.5% as the meme stock phenomenon cooled and the sector’s entertainment industry cratered. It was followed by the defensive Health Care sector (down 10.4%), and the cyclical Consumer Discretionary sector, which declined 6.8%. Our take on the relative results for the two sector categories is that cyclical stock performance did not conform to the narrative of economic pessimism, an observation that has been reinforced by our conversations with companies.

The Macro/Micro Disconnect

To be sure, our portfolio managers and analysts are hearing a distinctly different, more positive tone in their discussions with company managements than one would receive from looking at headlines—a phenomenon we define as the ‘macro-micro disconnect.’

The disconnect between micro and micro

While supply chains, inflation, and the related challenge of finding (and paying more for) qualified workers are top of mind for executives, so are growing demand and improved productivity. This divide between the more optimistic perspective we hear from companies versus underwhelming share price performance and fatalistic headlines has created several attractive long-term opportunities across our strategies in cyclical areas such as machinery, retail, media, and semiconductors.

As Rates Have Risen, Small Caps Have Outperformed

Ten-year yields bottomed on 8/3/21 before rising—slowly at first, and then with a roughly 20 basis point burst since the September Fed meeting. Rising rates often worry investors, who fear that higher yields will be accompanied by falling prices for all equities. Yet the facts don’t support these fears. To be sure, many investors have a mistaken understanding of the relationship between small-cap stock performance and rising interest rates. Small caps historically posted returns above their historic averages in one-year periods when the 10-year Treasury rose. The future direction of 10-year yields is therefore an important bellwether to watch when thinking about what’s next for small-cap results, though not in the direction many investors fear. If yields continue to rise, it’s one more reason to be optimistic about small cap’s prospective returns.

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

Small Cap Outperformed Large Cap When 10-Year Treasury Yield Rose

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.

Small-Cap Value’s Prospects

We are often asked about the prospects for small-cap value. While small cap value’s lead over the past six months has narrowed compared to the wide performance spread it enjoyed over the prior six months, we think the probabilities continue to favor small-cap value going forward. Small-cap growth contains greater equity duration exposure than small-cap value, and the former often endures performance headwinds in periods of rising rates. Additionally, many of the concerns about lower-than-originally-projected economic growth for 2021 simply delay and in fact increase the growth projections for 2022. Small-cap value has tended to outperform small-cap growth in robust economic growth environments, and that has been the case since the economy began to recover late in 2020. Small-cap value has beaten small-cap growth in all three quarters so far in 2021. We think it’s notable that value’s relative advantage occurred in two positive quarters—1Q and 2Q—as well as in the more difficult environment in 3Q21. Outperformance in both up and down periods shows durability and suggests to us that small-cap value’s leadership is likely to endure.

Small-Cap Value’s Durability in Different Market Environments
2021 YTD Quarterly Returns for the Russell 2000 Value vs. Russell 2000 Growth

2021 YTD Quarterly Returns for the Russell 2000 Value vs. Russell 2000 Growth

Perhaps surprisingly, especially given its recent performance advantages, small-cap value remains historically cheap versus small-cap growth. However, an even greater gap in relative valuation exists between small-cap value and large-cap growth, based on our preferred valuation metric—EV/EBIT (enterprise value over earnings before interest & taxes).

As shown below, small-cap value is also significantly cheaper than large-cap growth—as inexpensive as at any time in the past 20 years. The height of the Internet Bubble was one period with a comparable valuation advantage for small-cap value. We can easily imagine a scenario in which some investors reallocate their large-cap growth allocations to small-cap value.

Relative Valuations for Small Cap Value Are Near Their Lowest in 20 Years vs. Large-Cap Growth
Russell 2000 Value vs. Russell 1000 Growth Median LTM EV/EBIT1 from 9/30/01 to 9/30/21

Russell 2000 Value vs. Russell 1000 Growth Median

1 Earnings before interest and taxes
Past performance is no guarantee of future results.
Source: FactSet

Small Caps: Breaking Down or Breaking Out?

As we look forward, we understand that small-cap investors want to know whether or not U.S. equity market leadership has shifted to large cap on a more lasting basis. While unable to tell for sure, we anticipate a reassertion of small-cap leadership and, as usual, look to data and history for our rationale. Since the 1978 inception of the Russell 2000, the performance pattern shows that small caps do not stay on a flat plain for very long. And the 9.1% difference between the small-cap high and low over the six months ended 9/30/21 represents an unusually flat period—the Russell 2000 fell 0.3% during this span. In fact, this atypical pattern of a less than 10% difference between high and low over six months has occurred only 5% of the time—that is, in only 19 six-month periods over more than 40 years.

What Follows an Atypical Six Months?
Subsequent Six-Month Russell 2000 Returns Following Six-Month Periods When the Difference Between the Index High and Low Was <10% from 12/31/78 through 9/30/21

What Follows an Atypical Six Months?

Past performance is no guarantee of future results.
Source: FactSet

Each of these periods was followed by positive returns small cap over the next six months. Equally important for our present situation is the additional fact that those 19 periods had an impressively high average return of 11.6% for the subsequent six-month period. With the supportive backdrop of a still growing global economy, we therefore believe it’s far more likely that small caps will break out—not break down. Our confidence remains strong.

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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.

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.

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 Microcap Index includes 1000 of the smallest securities in the small-cap Russell 2000 Index. The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. It includes approximately 800 of the smallest securities in the Russell 1000 Index. The Russell 1000 Growth Index consists of the respective growth stocks within the Russell 1000 as determined by Russell Investments. 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.

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