3Q20 Small-Cap Recap—Royce
article 10-01-2020

3Q20 Small-Cap Recap

Co-CIO Francis Gannon reviews 3Q20 and details his outlook for a quarter that saw a volatile September slow momentum.


September’s Losses Slow the Momentum

A highly volatile September made for a weaker market as five consecutive months of positive returns came to a close not only for small-cap stocks but also for most of the globe’s major indexes, nearly all of which finished the month in the red. For September, the Russell 2000 Index fell 3.3%, giving it a modest 4.9% gain for 3Q20.

At the end of 3Q20, the Russell 2000 was 10.7% shy of its 8/31/18 peak, down 8.7% year-to-date, and up 53.3% from its 3/18/20 low through 9/30/20.

Small-Cap Still Shy of Its All-Time Peak
Russell 2000 Returns from the 8/31/18 all-time peak through 9/30/20


1 Not Annualized
Past performance is no guarantee of future results.

Volatility also returned in September after a relatively calm August, as small-caps moved 1% up or down on 10 days—or 48% of the time—compared with only 5 days, or 24% of the time, in August. We see its resurgence as a telling example of the volatility of volatility. One consequence of September’s volatile downturn was that the disconnect between a sputtering economy and a robust market—which has persisted since the March market low—was eroded somewhat.

Bigger Was Better in 3Q20

Although September’s losses ran in a relatively narrow band for the domestic indexes (roughly losses of 3.3%-5.2%), July and August were much stronger for large-cap stocks. This advantage through the first two months of the quarter meant that bigger was better in 3Q20, with the mega-caps in the “FAAMG” (Facebook, Apple, Amazon, Microsoft, & Google) group continuing to lead, and micro-caps faring worst.

Bigger Was Better in 3Q20
3Q20 Returns for Russell Indexes (%)


Past performance is no guarantee of future results.

As you can see from the chart above, mega-cap companies have had a disproportionate impact on performance, with a small number of companies driving the bulk of large-cap returns. This can be seen even more clearly by looking at the one-year cap-weighted versus equal-weighted returns for the Russell 1000 and Russell 2000 Indexes, which show the striking contrasts in large-cap performance even more starkly.

The Distorting Effect of Mega-Caps
1-Year Equal- and Cap-Weighted Returns for the Russell 1000 and 2000 Indexes as of 9/30/20


Past performance is no guarantee of future results.

Equally important, the lower equal-weighted return for large-caps shows that the disconnect between the stock market and the economy is not as pronounced as is often presumed. There is another disconnect, however, between mega-cap companies and the rest of the U.S. stock market, which can be seen in how close the equal-weighted returns are for small-cap and large-cap over the last 12 months.

Small-Cap Cyclicals Led Again

Small-cap cyclicals began to show relative strength in May, and this continued through 3Q20. While this may seem somewhat counterintuitive, it is consistent with a U.S. economic rebound that has been stronger than many expected in the spring. Though employment and overall economic activity are below what they were last year at this date, stocks often react positively to results that are better than feared and/or positive rates of change. Small-cap earnings in many cyclical areas were better than anticipated, and many management teams in cyclical businesses are positioning their firms for a continued rebound.

An odd combination of strong and weak results within both cyclicals and defensives reflected the mixed nature of the current recovery and made for an uneven quarter. Consumer Discretionary and Consumer Staples were the leaders of their respective groups, perhaps foreshadowing the dramatic increase recently reported in consumer confidence. Each consumer-related sector led the second-best cyclical sector—Industrials—and next-best defensive sector—Health Care—by appreciable margins.

Small-Cap Cyclicals Led Through Uncertain Times
3Q20 Russell 2000 Returns by Sector as of 9/30/20 (%)


Past performance is no guarantee of future results.

Risk Was Rewarded

The Russell 2000 Growth Index remained well ahead of Russell 2000 Value in 3Q20, up 7.2% versus 2.6%. This extended a period of sustained outperformance for small-cap growth, which also led value decisively for the year-to-date and longer-term periods ended 9/30/20.

Risk was rewarded in the quarter as small-caps with no earnings or dividends, as well as high debt, all performed relatively better. Within the Russell 2000 Growth, we saw a shift away from those areas that have led most often over the last several years (the bio-pharma complex and software) with some of the best results coming from the more prosaic precincts of retailing in Consumer Discretionary and, to a lesser extent, insurance in Financials and capital goods in Industrials. For the Russell 2000 as a whole, banks—which are also by far the largest industry within the Russell 2000 Value—detracted from 3Q20’s results. Hindered by record-low interest rates and concerns about defaults on real estate loans, the group has been a drag on small-cap value’s results over much of the last several years.

While many investors and market observers (ourselves included) have been expecting the relationship between small-cap value and growth to mean revert, and with it value’s traditional role of long-term leadership within small-cap, growth’s leadership has persisted for far longer than most had been anticipating—even in an era of record-low interest rates (which often present headwinds for value and tailwinds for growth). So while we still think that select small-cap value stocks offer compelling long-term opportunities, we are no longer as sure as we once were that value will soon resume a sustainable stint of small-cap leadership.

Five Reasons to Be Optimistic about Small-Cap

We see the presence of three factors and the absence of two others that add up to five reasons to be optimistic about the current state of small-caps. First, small-cap valuations relative to interest rates are at levels that have usually preceded attractive returns. The Equity Risk Premium—which compares the free cash flow yield of the Russell 2000 to current interest rates—is more than 1%. The average subsequent one-year return for periods starting with a risk premium 1% or more were in excess of 25%.

Better Days Ahead for Small-Cap?
Historically High Equity Risk Premium Has Led to High Returns
Average Subsequent Russell 2000 1-Year Performance in Equity Risk Premium Ranges1 from 9/30/00 to 9/30/20


1 Equity Risk Premium = Latest Twelve Months Free Cash Flow divided by Enterprise Value minus 10-Year Treasury Yield
Source: FactSet

Small-caps also remain 10.7% below their all-time peak on 8/31/18. Historically, they have advanced well beyond their prior peaks after a recession. Third, at the end of September, trailing three- and five-year returns for small-caps were below their monthly rolling three- and five-year averages, which suggests to us that a period of above-average three- and five-year returns may lie ahead.

Recent Small-Cap Returns Lower Than Averages
3- and 5-Year Monthly Rolling Averages vs. Average Annualized Returns for the Russell 2000 as of 9/30/20


1 From Russell inception on 12/31/78-9/30/20.
Past performance is no guarantee of future results.

Our last two reasons are the absence of important warning signs for small-cap investors. First, a Federal Reserve aggressively raising interest rates typically creates challenges for most stocks. However, the Fed’s recent announcements suggest that the central bank is likely to leave rates at current near-zero levels for years to come.

Second, impending recessions have often triggered sharp small-cap declines (as we saw in the first quarter), yet the economy appears to be firmly (if unevenly) in recovery mode with the recession now in the rearview mirror. The absence of each bolsters our optimism about small-caps.

To be sure, we see the most attractive opportunities among small-cap cyclical stocks, which finished September selling at 20-year lows on a relative valuation basis compared to their defensive siblings. Select cyclical industries, such as road & rail, air freight, and building products, have all been demonstrating positive momentum over the last few months. The case for select small-cap cyclicals becomes even more convincing if the dollar continues to weaken, giving a boost to export opportunities.

Still, we are mindful that the world has not seen anything like the current pandemic and its significant effects in at least a century, so we balance our long-term confidence with the acknowledgment that the near-term outlook remains cloudy and uncertain. We are still working toward a vaccine and/or effective treatment for the coronavirus, economic signals remain quite mixed, and a contentious election is coming up. Bearing all of this in mind, we are nonetheless confident in the longer-term prospects for a solid to strong global economic recovery—one that should reward select small-cap cyclicals.



Important Disclosure Information

The thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce Investment Partner, 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.

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