Some Small-Caps Are More Global Than Others
Despite a bevy of negative headlines facing the equity market, from lagging consumer confidence surrounding the debt ceiling debate to the ongoing snafus with HealthCare.gov, new highs are coming at an almost daily pace of late. The small-cap Russell 2000 Index hit eight new all-time highs in October alone and rose for eight consecutive weeks through Halloween. In October, the Russell 2000 added 2.5%, bringing its year-to-date gain through the first 10 months of 2013 to 30.9% and 36.3% for the one-year period ended October 31, 2013.
There have always been an abundance of generalizations that circulate about the economy and the stock market. Many offer a degree of truth, but an equal number are just as often exaggerated or misunderstood. This is particularly true when it comes to the small-cap asset class. Considering the barrage of recent macro headlines, we thought it would be an opportune time to examine the effect of international revenues on recent small-cap performance.
Many observers have cited the idea that the Russell 2000 is more leveraged to domestic growth as a significant contributor to the advantage enjoyed by the index over its large-cap counterparts so far this year. (See our research article "Can Small-Cap Year-to-Date Outperformance Versus Large-Cap Continue?" for more insight.)
The argument is that this greater stateside focus particularly benefited the small-cap index earlier this year when investors were worrying about economic growth in Europe and Asia. Others, however, see this greater domestic focus as a potential disadvantage, believing that the high percentage of domestically generated revenue for small companies may keep them from enjoying the benefits of faster-growing foreign economies.
According to a recent report by Pankaj Patel of International Strategy & Investment Group LLC (ISI), U.S. small-caps (as measured by the Russell 2000) derive an average of 18.2% of their revenues from outside the U.S., though almost 43% of the companies in the small-cap index have overseas exposure. In contrast, the large-cap S&P 500 Index derives an average of 32.5% of its revenues from outside the U.S. and nearly 72% of the names in the index have foreign exposure.
Seen from the perspective of our portfolios, smaller companies are more global than many investors would seem to believe. In fact, the weighted average percentage of revenue being generated outside of the U.S. for many of our portfolios that invest primarily in U.S. smaller companies would be greater than the Russell 2000’s 18.2%.
To be sure, it is a matter of what we own versus what we do not—a clear benefit of active management in our view. For example, we are generally underweight, or do not own, Utilities, real estate investment trusts, and small banks, all of which make up a large portion of the Russell 2000 and generate most of their income domestically.
At the same time, we are more exposed to more cyclical areas of the market that are more closely tied to the global economy. The Information Technology sector, for example, derives almost “40% of its revenues from outside the U.S.; Materials are next in line with 28.3% of revenues coming from abroad; and Industrials with over 21% of its revenues coming from abroad,” according to an ISI report.
Global economies are starting to find their footing, and, as my colleague Jay Kaplan points out, defensive areas of the market are no longer defensive from a valuation standpoint.
In this context, one has to wonder if economically sensitive sectors, especially those that generate more revenue from outside the U.S., are poised to lead. Interestingly, since the end of June the Industrial and Technology sectors have outperformed.
Important Disclosure Information
Francis Gannon is a portfolio manager of Royce & Associates, LLC. Mr. Gannon’s thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements.
The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.