1Q21 Small-Cap Recap—Royce
article 04-01-2021

1Q21 Small-Cap Recap

Co-CIO Francis Gannon reviews 1Q21, small cap’s stellar 12-month return, and details his optimistic outlook.

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Small-Cap 1Q21: Another Strong Quarter, Nearly Another Record

2021’s opening quarter was the second consecutive strong one for the Russell 2000 Index, which advanced 12.7%. This robust result also led the small-cap index to a nearly record-setting one-year return of 94.8% through 3/31/21, which gave investors an especially vivid sign of how thoroughly the overall U.S. equity markets have been recovering from the challenge and pain wrought by the coronavirus pandemic.

How momentous is this 12-month quarter-end return? The Russell 2000 has exceeded a 90% result only once before in its more than 40-year history, with a 97.5% gain over a year-long span in 1982-83 (based on the index’s historical 12-month quarter-end results). To find another comparable performance, we had to go back nearly a century to the 1930s (using the CRSP 6-10 as the small-cap proxy), where there were only seven instances when small-cap returns approached or exceeded 100% for a trailing 12-month period. We have, however, seen similarly lofty small cap returns in the past as recently as 2009-2010.

The extraordinary one-year performance was capped by a very volatile March, which after an advance on its last day just missed being only the second month in the last 12 with a negative return for small caps—September 2020 being the only month in the last year to post a loss. After a very robust run over the last two quarters, this increased volatility looks to us like a healthy sign for stocks in general. To be sure, we would not be at all surprised if the next few months showed similarly high levels of volatility as investors try to make sense of the current dynamic bull phase just as the global economic recovery is getting underway.

Micro Caps Lead as Small Caps Stay Hot

As was the case in the record-setting 4Q20, returns in 1Q21 were highest when market capitalizations were lowest. The Russell Microcap Index did best, followed by the small-cap, mid-cap, and large-cap indexes.

Smaller Was Better in 1Q21
1Q21 Returns

quarter to date index array

As the chart shows, the lowest return by far among the major U.S. indexes was 2020’s big winner, the Nasdaq Composite, which posted a 2.8% gain for the first quarter. Much of this was due to relatively underwhelming results for certain of the Composite’s mega-cap constituents, including a few of the ‘FAAMG’ group of Facebook, Amazon, Apple, Microsoft, and Google.

From our perspective as small-cap specialists, the recent leadership rotation from large to small appears sustainable. Although it’s inarguable that small-cap valuations finished March near historical highs, this must be balanced against the fact that these rich valuations are based on what are likely to be trough earnings during what remains a very low interest rate environment. In addition, small caps remain far less expensive than their domestic large cap peers, as measured by EV/EBIT (enterprise value/earnings before interest and taxes).

Value Beats Growth—Cyclicals Stay Strong

The Russell 2000 Value Index enjoyed a very strong quarter on both an absolute and relative basis in 1Q21, gaining 21.2% and significantly outpacing the Russell 2000 Growth Index, which was up 4.9%. The small-cap value index also pulled ahead of small-cap growth for the one-year period ended 3/31/21, up 97.1% versus 90.2%.

Cyclicals finished the quarter significantly ahead of defensives, with the biggest contributions to small cap returns coming from cyclical stalwarts Consumer Discretionary, Financials, and Industrials. The rebound for Financials, which, along with Materials and Energy, is often referred to as a “reflationary” sector, was driven in large part by rising interest rates while the latter two sectors benefited from commodity price strength and optimism for the global economic recovery.

Value and Cyclicals Leading
1Q21 Russell 2000 Returns

quarter to date value and cyclical lead

The proximity of first quarter returns for value and cyclicals makes sense given the significant overlap between the two. Within the Russell 2000 Value, for example, 75% of the companies come from cyclical sectors compared to 56% in the Russell 2000 Growth.

Lending additional support to the theme of rebounds and rotations were the most significant impacts at the industry level, which came from areas that struggled through both 2020’s bear market and the early months of the recovery: banks (from Financials), specialty retail, and hotels, restaurants & leisure—both in Consumer Discretionary.

Cyclical Strength in 1Q21
1Q21 Russell 2000 Sector Returns

sectors quarter to date

The Case for Quality

Another area within small cap—and an important strategy of ours—has so far lagged through the rally: high quality (which we measure with both return on equity and return on invested capital). Indeed, as welcome as the rally has been, it has so far favored companies with lower ROE and higher leverage (as well as no dividends)—an expected dynamic during an early rebound period, especially one that’s also seen contracting credit spreads.

Yet the history of small-cap bull markets shows that higher-ROE companies tend to do better as the cycle matures, and investors begin to pay attention not simply to rebounding earnings but also to the quality and sustainability of earnings growth. This intra-cycle rotation is particularly relevant because profits and earnings are beginning to show considerable variation and dispersion—creating an environment that should benefit active management approaches rooted in fundamentals and a long-term investment horizon.

Measured Confidence Amid Mixed Signals

The nascent global economic recovery, fueled by re-openings, fiscal and monetary stimulus, and pent-up consumer demand is in turn spurring the revitalization of value and cyclicals within small cap. So, while the recent pace of returns is clearly unsustainable, we believe there are other reasons to stick with the asset class beyond our expectation for improved performance for high-quality companies. The lofty heights of the current period are somewhat new, but the experience of high small-cap returns is not.

This is the case even in a market where valuations are elevated throughout the stock market. To get a better sense of what may be coming next, we looked at one-year small-cap results that followed the previous 10 highest 12-month returns for quarter end periods. The record over the subsequent 12 months is decidedly mixed, ranging from double-digit advances to declines in the mid- to high teens. Based on history, then, the Russell 2000 could tread water, experience a correction or two, or keep moving up, albeit at a markedly slower pace, over the next year.

Subsequent three-year periods, however, tell a far better, more consistently positive story, with uniformly positive average annualized results. The average three-year return for the Russell 2000 following its 10 strongest four-quarter periods is 11.9% versus 10.3% for all quarterly-rolling three-year returns since inception.

Small Caps Stay Positive for the Annualized Three-Year Periods Following Strong Years
Russell 2000’s 10 Strongest Four-Quarter Periods

subsequent three year after high 12 months

We think this historical pattern should hold. Despite rich valuations, there are several contrasting positive factors, each of which is likely to have staying power. The housing market remains strong, consumer balance sheets are in excellent shape, the scale of fiscal stimulus is likely to expand (possibly with significant infrastructure spending), and the Fed has signaled that it is no longer as concerned about inflation overheating the economy, reversing the view it held over the last several years. So, while the pace of small cap returns will slow, positive results seem likely, with history showing the possibility of low double-digit returns on an annualized basis over the next few years. We also believe that we are reaching the point where company results will diverge, offering disciplined active managers the opportunity to add value—and we look forward to taking advantage of these opportunities for 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.

Return on Average Total Equity (ROE) is the trailing twelve-month net income divided by the two fiscal period average total shareholders’ equity.

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). Return on Average Total Equity (ROE) is the trailing twelve-month net income divided by the two fiscal period average total shareholders’ equity.

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.

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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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.

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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