Royce Investment Partners Commentary: What Will Fuel Small-Cap Returns?

Were you disappointed that the Russell 2000 Index trailed the large-cap Russell 1000 Index in 1Q24?

Chuck Royce (Trades, Portfolio): Not at all. I also think it's important to emphasize that we generally don't look at quarterly performances as being very revealing. It's rare for a single quarter or any other short-term period to signal a lasting shift in the market's direction or leadership. So, while it's still premature to call a decisive shift in favor of small-cap, we're very encouraged by how small-caps have been performing over the last several months. For example, while small-caps lagged large-caps in the first quarter, they were ahead of large-caps from the low on October 27th through the end of March. The Russell 2000 advanced 30.7% in this period, beating the Russell 1000, which was up 28.9% over the same span.

In this context, why do you think small-caps underperformed large-caps in the first quarter?

Francis Gannon: The first quarter looks to us like a fairly mild consolidation phase, in which investors digested the big gains from the end of 2023. An upswing in the 28-30% over roughly two months is quite rare, so it wasn't surprising that many investors took gains—which got 2024 off to a slow start that was tougher on small-caps than on their larger siblings. The Russell 2000 lagged the Russell 1000 from the high on December 27th through the end of 1Q24, up 3.2% versus 10.0%. However, the last two weeks of March saw small-cap move ahead of large-cap. This kind of jockeying for position is pretty common when market leadership shifts. The upshot from our perspective as small-cap specialists is that the latest phase has seen small-caps fully participate in a robust for the first time in several years—which we see as a very positive sign.

When did the Russell 2000 last reach a peak?

FG: Small-cap has still not established a new all-time high since its most recent peak on 11/8/21. So, it's been almost two-and-a-half years, which makes it the second-longest period since the index's 1979 inception that the Russell 2000 has gone without reaching or exceeding a peak—and the last one occurred during the 2008-09 Financial Crisis. As of 3/31/24, the Russell 2000 was down -9.9% from its November 2021 peak. Meanwhile, the large-cap indexes continued to reach new highs into March 2024. Of course, this is one of the reasons why we're bullish on over the long run. Even taking the strength of the last five months of performance into account, small-caps still have room to run, in our view.

Did the Russell 2000 experience a high level of concentration in its first-quarter return?

FG: Yes. There's been a lot of volatility within small-cap over the last 15 months, complete with a higher-than-usual level of concentration so far in 2024, when 12 stocks accounted for 100% of the first-quarter return for the Russell 2000. Most of this actually came from just two stocks: Super Micro Computer was up 255%, while MicroStrategy rose 170%. Together, the pair accounted for 38% of the Russell 2000's return for 1Q24. Unlike in large-cap, however, small-cap companies outgrow the benchmark when it rebalances each year in May—which more or less takes care of any concentration issues within the Russell 2000. We're much more focused on the potential for small-cap returns to broaden in the months to come.

Were you surprised that the Russell 2000 Value Index trailed the Russell 2000 Growth Index in 1Q24?

CR: Small-cap growth's relative advantage was not very surprising to us. We would expect the early stages of a strong rally to be led by growth, which is largely consistent with the history of small-cap upswings. In addition, many small-cap growth stocks were really beaten down in 2023, so there were a lot of interesting bargains in that space for investors to buy.

FG: We think the more interesting story is how competitive small-cap value has been since the October lows. From 10/27/23 through 3/31/24, the Russell 2000 Value gained 28.2%, while the Russell 2000 Growth was up 33.4%. Moreover, banks accounted for roughly 17% of the Russell 2000 Value in the first quarter—and the industry detracted significantly from the small-cap value index's results in that time period, mostly due to renewed fears of bank failures driven by New York Community Bank's recent troubles. So, while the Russell 2000 Value was up 2.9% in 1Q24, versus a 7.6% gain for small-cap growth, when we excluded banks, the first-quarter return for the small-cap value index improved to 4.9%.

What do you think needs to happen for small caps to recapture market leadership?

CR: I want to suggest—with a cautious confidence—that the phase has already begun. And I don't think it will take much for the small-cap rally to pick up more steam. The U.S. economy remains resilient—far more so than many were expecting—and a vibrant economy has historically favored small-cap stocks. We've already been through recessions in housing and manufacturing—both of which are beginning to recover. If consumers continue to spend and/or China's economy continues to rebound, the U.S. economy is likely to keep growing.

What other factors inspire your confidence in small-cap's long-term prospects?

FG: I think the comparably low degree of consolidation we mentioned earlier was a positive sign. The pace of returns slowed, but the rally rolled on. Equally important, we've begun to see corrections in the stock prices of some of the ‘Magnificent 7' group of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla. In fact, it was particularly interesting to see mega-cap companies trail in the run-up from 10/27/23 through 12/27/23. Over that roughly two-month period, the Russell Microcap rose 30.8%, the Russell 2000 gained 26.6%, while the Russell 1000 was up 17.2% and the Russell Top 50 gained 14.8%. This was a reversal of the trends in index performance we've seen over the last several years—and this same pattern repeated itself over the last two weeks in March. So, while we don't want to make too much out of short-term moves, it was certainly encouraging to see.

Is this consistent with what you're hearing from companies?

CR: We look out roughly three years when we analyze companies. When we talk to management teams, we always ask what the long-term plans are, specifically around revenue and earnings growth, innovation, and efficiency. One of our mantras has always been that psychology drives the market in the short run, but earnings drive it in the long run. Much of what we've been hearing has been positive—though always with an expected dose of caution. This squares with the research we've seen and published—which shows more earnings acceleration for small-cap companies than for large-cap businesses through the end of 2024.

How would you gauge small-cap valuations on both an absolute basis and relative to large-cap stocks?

FG: At the end of March, the Russell 2000 had a much more attractive valuation than the Russell 1000, based on our preferred index valuation metric of enterprise value to earnings before interest and taxes, or EV/EBIT. Small-cap value also sold at a lower average valuation than small-cap growth at the end of the first quarter, as measured by EV/EBIT. In addition, micro-cap stocks with positive EBIT—roughly half the companies in the Russell Microcap at the end of 1Q24—were also attractively valued relative to large-cap based on EV/EBIT. (By comparison, 67% of the companies in the Russell 2000 had positive EBIT and more than 90% in the Russell 1000 had positive EBIT as of 3/31/24.)

Can you discuss two high-confidence holdings?

CR: The first would be Haemonetics, which is a long-time position that had a strong first quarter. Haemonetics is the world's number one provider of plasma collection devices and consumables. Its stock rebounded recently after management provided additional specificity on the timing and contingency plans for the long-expected run-off of business with its largest customer over the next 18 months. Although this customer's decision was disclosed more than two years ago, the pace of the ramp down in purchases was outlined only recently. Haemonetics expects to offset the sales and earnings impact from market share gains with other key clients with whom it's been underpenetrated, above-market volume growth as global plasma inventories are replenished, an improved business mix, and the continued growth of its Hospital Segment. Over the past five years, Haemonetics has systematically built this segment primarily via acquisitions of interventional technologies that improve the outcomes and safety of surgical procedures, particularly in cardiology and electrophysiology. This included leading positions in hemostasis management, vascular closure, and next generation structural guidewires that are used in minimally invasive aortic valve replacement procedures. The segment is on pace to eventually surpass Plasma as Haemonetics's largest segment, while also generating sizable margin improvement as the Hospital Segment salesforce sells more of its portfolio of products. All of this has given management confidence that it can still achieve its fiscal 2026 goal of more than $1.4 billion in revenue and margin improvement of at least 5% over the next two years.

What's the second company?

CR: This company has struggled over the last few years, but we like its long-term prospects. Ziff Davis acquires and operates digital media and internet brands in high-value areas, generating relevant content that's designed to attract consumers with high “intent to purchase.” Roughly 60% of its revenues come from advertising on its sites, which include Everyday Health, What to Expect When You're Expecting, PCMag.com, IGN.com, and RetailMeNot. The remaining 40% comes from subscription-based revenue via its broadband connectivity data services and its marketing technology and cybersecurity offerings. The digital ad spending recession appears to finally be ending, and Ziff Davis is projecting a return to organic revenue growth in 2024. However, the pace of recovery has been slower than its 7.5% growth target, which reflects some conservatism since its advertising revenues are more weighted to the holiday selling season in the second half of the year. There's also been uncertainty around the rise of subscription-based “answer engines,” such as ChatGPT—their potential impact on Google search traffic remains an overhang because the technology is still fairly new. No one can really gauge that impact right now. Despite the company's strong and consistent free cash flows and an acquisition track record that delivered returns on investments of at least 20%, investors have been impatient that Ziff Davis has gone more than two years without making a sizeable acquisition in the digital media space. Our view is that the stock price looks like it's already discounted most of these concerns as it trades at an attractive valuation of roughly 6.2x EV/EBITDA. We think investors will ultimately be rewarded by management's discipline and patience on the capital allocation front.

What is your outlook for active small-cap management?

CR: We're optimistic as we look out over the next few years. We think that as the U.S. economy receives ever more of the tangible benefits accrued from reshoring, the CHIPS Act, and several infrastructure projects, advantages will flow to many small-cap companies—which should play a big role in the earnings acceleration that we talked about. We see that as a distinct advantage for active small-cap managers who focus on profitable companies and other fundamental measures of financial and operational strength.

FG: There's a historical phenomenon that also gives us confidence. At the end of March, the Russell 2000's 3-year average annual total return was -0.1%. When the small-cap index had low or negative returns over previous annualized 3-year periods, the subsequent 3-year annualized returns were positive 99% of the time, in 66 of 67 periods. They averaged 16.7%, beating the Russell 2000's long-term average annualized 3-year return of 10.7%. So, with valuations, earnings, and fundamentals /all favoring select small-caps, we are confident in the long-term prospects for active and risk-conscious small-cap management.

Mr. Royce's and Mr. Gannon's 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.

The performance data and trends outlined in this presentation 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.