2Q23 Small-Cap Recap—Royce
article 07-03-2023

2Q23 Small-Cap Recap

A Positive Quarter Within a Small-Cap Bear Market

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Small Cap Stays in the Black

The Russell 2000 Index rose 5.2% in 2Q23. After posting negative results in April and May, small caps rebounded in June. Most of the action, however, took place in the upper echelons of market capitalization. The Russell 1000 Index gained 8.6%, and the mega-cap Russell Top 50 was up 13.2%. Moreover, the tech-laden Nasdaq Composite, home to market cap behemoths such as Apple, Alphabet, Amazon, and Nvidia, advanced 13.2%. So while 2Q23 results were somewhat saw-toothed—the Russell Midcap Index was up 4.8%—returns were tightly concentrated at the very top of the market.

Bigger Worked Best in 2Q23
2Q23 Returns for the Russell Top 50, Russell 1000, and Russell 2000 Indexes

An Up and Down Quarter for Stocks

Past performance is no guarantee of future results.

This pattern mostly held for the year-to-date period ended 6/30/23 as well. For 2023’s first half, the Russell 2000 was up 8.1%, while the Russell 1000 increased 16.7%, the Russell Top 50 rose 27.8%, and the Nasdaq advanced 32.3%. Interestingly, the year began with an advantage for small cap, which unfortunately only lasted until Groundhog Day, this year’s high for the small-cap index. At the end of January, the Russell 2000 was 300 basis points ahead of its large-cap counterpart; it finished June 859 basis points behind it year to date.

Although returns were lower, large-cap outperformance could also be seen among non-U.S. stocks, with the important difference that the spread for both 2Q23 and the year-to-date period was much narrower. For 2Q23, the MSCI ACWI Small Cap ex USA Index rose 2.0% while the MSCI ACWI ex USA Large Cap Index was up 2.7%; for the year-to-date period ended 6/30/23, the international small cap index advanced 6.8% and the international large cap index increased 9.8%.

Notable Sector Spreads

Two factors drove the reversal in leadership between U.S. small and large cap stocks. Small caps bore the brunt of the damage from the banking crisis, which had some of its most adverse effects on the share prices of smaller regional players. Unsurprisingly, then, banks were the top-detracting industry in the Russell 2000 for both 2Q23 and the year’s first half.

2Q23 Highest Contribution by Sector for the Russell 2000 and Russell 1000 Indexes
As of 6/30/23

An Up and Down Quarter for Stocks

Past performance is no guarantee of future results.

Information Technology—which accounts for more than 25% of the large-cap index—dominated performance within the Russell 1000, followed by notable contributions from Consumer Discretionary and Communication Services. Health Care led within small cap, followed by Industrials and Information Technology. However, none of these three small-cap sectors carries anything close to the weight of Tech in the Russell 1000, nor did their respective contributions approach the dominance technology stocks demonstrated within large cap.

The Small-Cap Story

We think it’s important to remember that the Russell 2000 remained in a bear market at the end of June, despite positive returns for 2Q23 and the first half of 2023. The small-cap index was down -20.8% from its high on 11/8/21 through 6/30/23. When it comes to small cap, many investors would appear to agree with the bond market about the uncertain state of the U.S. economy.

This lack of attention to small caps can be seen in other ways. Inflation is falling, and the Fed paused, yet neither development did anything to improve small-cap performance on an absolute or relative basis. Both rising and falling inflation have historically been accompanied by strong absolute and relative performance for small cap—a record that goes back almost a century to the 1930s—but the Russell 2000 underperformed during the rise and subsequent drop in inflation from its 9.1% high in June 2022 to 4.0% at the end of May 2023.

Consistent with the notion that economic apprehensiveness is keeping investors away from many small-cap stocks were the relatively underwhelming results for more economically sensitive cyclical stocks within the Russell 2000, which significantly trailed their defensive siblings in 2Q23. Moreover, the Russell 2000 Value Index trailed the Russell 2000 Growth Index for both 2Q23 (+3.2% versus +7.1%) and 2023’s first half (+2.5% versus +13.6%), eroding much of its long-term relative performance edge.

Where Are We Now?

Yet we are resolutely confident about the long-term prospects for our chosen asset class. Thanks to a significant amount of multiple compression over the last several months, valuations still look highly favorable for small cap on both an absolute basis and relative to large cap, where they remain close to a 20-year low based on enterprise value over earnings before interest & taxes (“EV/EBIT”).

Relative Valuations for Small Caps vs. Large Caps Remain Near Their Lowest in 20 Years
Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies)
From 6/30/03 through 6/30/23

An Up and Down Quarter for Stocks

1Last twelve months Enterprise Value/Earnings Before Interest and Taxes.
Past performance is no guarantee of future results. Source: FactSet

Similarly, the Russell 2000 Value finished June much more attractively valued than the Russell 2000 Growth, based on the same EV/EBIT metric.

Finally, small-cap active management is having a moment. Using the Morningstar Small Blend1 Category as our proxy, we found that actively managed funds 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.

1There 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.

We are particularly pleased that The Royce Funds have participated in this trend, with strong absolute and relative performance for the second quarter and year-to-date periods.

Our Outlook

January and June were the only months with positive small-cap returns so far in 2023. Sandwiched in between were four straight down months for the Russell 2000. Ever alert to historical patterns, we looked at previous four-month negative return periods 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 well above the one-, three-, and five-year monthly rolling averages for the Russell 2000 since inception.

Since the inception of the index on 12/31/78, small cap has experienced four consecutive months of negative performance nine times. 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)

An Up and Down Quarter for Stocks

Past performance is no guarantee of future results.

We see an array of potential triggers that would jumpstart small-cap performance in the coming months. First, a soft landing looks more and more likely, and a recession—specifically the kind of deep and potentially lengthy contraction many have been anticipating since late 2021—looks less and less likely.

We have already seen promising developments that suggest a nascently robust economy: durable goods orders rose for the fourth consecutive month in June—and hit a record high for nondefense capital goods (excluding aircraft or core capital goods, a proxy for business equipment investment)—while homebuilding rose by 21.7% in May, a record monthly surge that also defied expectations for a slowdown.

Even more important in our view is the ongoing sense of cautious optimism we have been hearing from many management teams—which was reflected by 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. We have shown the data which examines how strong and lasting a rebound small caps have historically enjoyed after low annualized three- and five-year periods.

Amid the difficulties of bear markets and periods of economic uncertainty, we think it’s crucial to remind investors of the opportunity to build their small-cap allocation at attractively low prices. History shows the rewards that have accrued to investors who had the necessary patience and discipline to stay invested during periods of sluggish or negative performance. We continue to see the currently unsettled period as an opportune time to invest in select small caps for the long run.

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.

Average Annual Total Returns as of 6/30/2023 (%)

  QTD1 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE ANNUAL
OPERATING EXPENSES
NET               GROSS
Pennsylvania Mutual 6.68 21.50 15.51 7.58 9.09 N/A N/A  0.96  0.96
Dividend Value 5.02 22.44 12.85 6.12 7.34 8.15 05/03/04  1.34  1.62
Global Financial Services 4.96 6.04 7.11 3.67 7.18 7.31 12/31/03  1.57  1.98
International Premier -2.60 4.16 0.18 2.38 6.17 5.51 12/31/10  1.44  1.59
Micro-Cap 6.71 17.63 16.07 6.71 6.53 10.33 12/31/91  1.24  1.24
Small-Cap Opportunity 6.78 20.42 23.76 8.91 10.14 11.91 11/19/96  1.23  1.23
Premier 4.45 19.60 13.07 7.99 9.27 11.19 12/31/91  1.18  1.18
Small-Cap Special Equity 4.31 15.89 13.89 6.25 6.98 8.60 05/01/98  1.21  1.21
Small-Cap Total Return 6.50 9.42 14.29 5.81 7.76 9.97 12/15/93  1.26  1.26
Smaller-Companies Growth 5.33 22.28 7.10 4.76 8.00 10.11 06/14/01  1.49  1.55
Small-Cap Value 5.29 20.91 17.60 3.68 5.48 8.33 06/14/01  1.49  1.59
Russell 2000
5.21 12.31 10.82 4.21 8.26 N/A N/A  N/A  N/A
Russell 2500
5.22 13.58 12.29 6.55 9.38 N/A N/A  N/A  N/A
MSCI ACWI SC
3.62 13.02 10.83 4.53 7.62 N/A N/A  N/A  N/A
MSCI ACWI x USA SC
2.05 10.93 8.15 2.62 5.75 N/A N/A  N/A  N/A
Russell Microcap
5.29 6.63 9.09 2.07 7.29 N/A N/A  N/A  N/A
Russell 2000 Value
3.18 6.01 15.43 3.54 7.29 N/A N/A  N/A  N/A
Russell 2000 Growth
7.05 18.53 6.10 4.22 8.83 N/A N/A  N/A  N/A
1 Not annualized.

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes a shareholder would pay on Fund distributions or the redemption of Fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Investment and Service Class shares redeemed within 30 days of purchase may be subject to a 1% redemption fee payable to the Fund (2% for Royce International Premier Fund). Redemption fees are not reflected in the performance shown above; if they were, performance would be lower. Current performance may be higher or lower than performance quoted. Current month-end performance may be obtained at www.royceinvest.com. All performance and expense information reflects results of the Funds’ oldest share Class (Investment Class or Service Class, as the case may be). Price and total return information is based on net asset values calculated for shareholder transactions. Annual gross operating expenses reflect the Fund’s gross total annual operating expenses and include management fees, any 12b-1 distribution and service fees, other expenses, and any applicable acquired fund fees and expenses. Annual net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses, excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business, to the extent necessary to maintain net operating expenses at or below: 1.34% for Royce Dividend Value Fund; 1.44% for Royce International Premier Fund; and 1.49% for each the Royce Global Financial Services, Small-Cap Value, and Smaller-Companies Growth Funds through April 30, 2024. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds and other investment companies.

Service Class shares bear an annual distribution expense that is not borne by the Funds’ Investment Class. If such distribution expenses had been reflected for Funds showing Investment Class performance, returns would have been lower. 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.) Certain Funds invest a significant portion of their respective assets in foreign companies that 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 Foreign Securities” in the prospectus.) Therefore, the prices of securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of securities of U.S. companies. (Please see “Primary Risk of Fund Investors” in the prospectus.) Certain Funds generally invest a significant portion of their assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause their overall value to decline to a greater degree. A broadly diversified portfolio, however, does not ensure a profit or guarantee against loss. (See "Primary Risks for Fund Investors" in the respective prospectus.) Please read the prospectus carefully before investing or sending money.

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.)

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).

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 Russell Midcap® Index measures the performance of the mid-cap segment of the U.S. equity universe and is a subset of the Russell 1000® Index that includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. 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 material 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. The MSCI ACWI ex USA Large Cap Index is an unmanaged, capitalization weighted index of global large-cap stocks, excluding the United States. 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.

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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