Unsurprisingly, Europe endured a mild recession with both the second and third quarters showing negative GDP readings. Many Eurozone economies struggled under the weight of ongoing austerity measures compounded by the structural impediments of a shared monetary policy (and currency) coupled with decentralized fiscal policies. Economic activity in the all-important BRICs economies slowed, with China and Brazil decelerating at rates that called into question the ability of these dynamic economies to maintain their vital positions as drivers of global growth.
Yet even with that backdrop, equities of all sizes climbed a wall of worry and posted solid gains for the year. A fourth-quarter surge by our favored asset class of small-cap stocks put them slightly ahead of large caps, with the Russell 2000 advancing 16.3% compared to the S&P 500, which gained an also impressive 16.0%.
All in all it was not bad for a year that understandably began with very low expectations anchored by the stiff headwinds of persistent equity outflows (and commensurate bond inflows) and no real progress on the pressing structural issues of the day—most importantly, the increasingly untenable sovereign debt burdens of the major industrialized economies. Perhaps investors are becoming increasingly numb to these macroeconomic issues or perhaps the market's muted reaction to each sequential policy deadline has made investors comfortable that these debt issues can forever be pushed out into the future.
Our sense is that the answers lie somewhere in the middle. We see substantive reasons why equities are performing well and can continue to do so in the months and years ahead even in the face of what could be a growing number of scenarios similar to the fiscal cliff that will periodically darken the skies both here and abroad.
In fact, over the next few weeks, this theory will be put to the test as Congress and the President begin to debate an increase to the debt ceiling that is required to prevent the U.S. from defaulting on its obligations. If the most recent budget debate was any indication, there will be a lot of political wrangling followed by a last minute deal that satisfies few but placates many. This should allow for a continued reorientation of investor attention to the merits of risk assets, particularly equities, which from our perspective are only becoming increasingly attractive.
Last year was also notable for the relative underperformance of active managers compared to passively managed benchmarks or ETFs—their worst showing since the dark days of the financial crisis five years ago. So while absolute returns were solid, the internal dynamics of the market were stacked against many stock pickers.
Generally speaking, Royce was no exception. Probably the most challenging part for us was the relative outperformance of more highly levered companies, which was compounded by the fact that many of these businesses are also some of the higher-yielding in the market as leverage so often goes hand in hand with high payout ratios. The Fed's zero interest rate policy and multiple bond buying programs have not only reduced borrowing costs—thus helping more highly levered companies—but also driven income-oriented investors farther out on the risk spectrum in their search for yield.
A core tenet of our risk management process has long been to avoid companies that we believe have too much debt. Over long periods of time, this discipline has served us well by mitigating the dreaded costs to a portfolio of permanent capital loss associated with businesses that fall on hard times and can no longer fund their operations. The recent period has been quite unusual in large part owing to the extraordinary measures central banks have taken to reduce borrowing costs.
This has disproportionately benefitted companies that use large amounts of debt to finance their operations, much to our relative disadvantage. Our sense is much of this benefit is now priced into the market, and the opportunity once again lies in those higher quality companies that differentiate themselves by the merits of their products and services, not their financial engineering.
The road ahead is still filled with macroeconomic uncertainty. However, our underlying confidence in the absolute and relative case for equities, and specifically smaller companies, is unwavering. They continue to be inexpensive and unloved. In fact, the fourth quarter of 2012 may be an early indicator that an important inflection in sentiment and asset allocation has finally begun to take hold. As always, only time will tell. But for our part, we like what we see.