By Chris Clark, Royce Funds CEO and co-chief investment officer
We believe we have turned the page on the 2011-2015 period in which financial markets behaved in such odd ways, and expect a strong multi-year period for thoughtful and disciplined small-cap active management.
By any measure, 2016 was a terrific year for small-cap stocks, one that featured a double-digit positive return for the Russell 2000 Index, which advanced 21.3%, and a solid advantage over their large-cap counterparts.
It was an even better year for small-cap value stocks and a highly rewarding one for cyclical sectors. These last two factors were critical in boosting results for certain active management approaches within the asset class, including a number of our own.
Arguably even more important was what these developments may be telling us about the subsequent direction of small-cap equity returns. We flesh out the details later in this letter, but these three reversals—positive results for small-caps, leadership for value over growth, and outperformance for cyclicals—should be key in setting the tone for the direction of small-caps going forward. They coalesced around the central, normalizing force of rising interest rates.
The major impact of these reversals was both highly welcome and long overdue.
We saw 2015—a year in which large-cap beat small-cap, the Russell 2000 had a negative return, and market leadership was extremely narrow—as a hinge year. It marked the transition out of the period that began in 2011, when an unprecedented amount of monetary intervention into the global economy had the unintended effect of stoking an intense appetite for yield and safety at one extreme of the U.S. equity markets and a hunger for high risk at the other.
The bottom of a commodity super cycle, with the attendant slowdowns in the world's largest developing markets, only exacerbated the challenges then faced by value stocks and active management approaches.
As has usually been the case historically, the longer market trends last, the more regularly they are mistaken for permanent realignments. In this most recent instance, the consensus lined up around the perpetuation of near-zero rates, growth stock dominance, and the futility of active management.
Whether in good times or bad for our own approaches, however, we have always stayed mindful of the fact that trends do not last forever—they persist, then, more often than not, they reverse. This investment truism should serve as a corrective for those who would take the example of a highly anomalous period for the markets and economy to validate an implacable bias against active management.
The Power of Rates and the Impact of the Paradigm Shift
Even as small-cap specialists, we recognize that few forces act as powerfully on the value of investments as interest rates. The effects can be as obvious as they are subtle. We think three conditions matter most: the level of rates, the spread between short- and long-term rates, and the disparity in borrowing rates for better-run companies worse ones.
Capitalism tends to best foster economic growth when short rates hover a bit above inflation; when long rates are high enough to encourage lenders but not so high as to discourage borrowers; and when there is a premium for fiscal prudence and a commensurate penalty for profligate debtors. During the era of zero (or near-zero) rates—roughly 2011-2015—these historically "normal" conditions were largely absent.
Yet we believe they began to manifest themselves again in 2016, marking a paradigm shift to a period of higher rates and a consequent reassessment of the relative values of financial assets.
More normalized rates have historically been better for stocks than bonds. More important for our purposes, they have also supported small-caps over large, value over growth stocks, and cyclicals over defensive areas. In many ways, 2016's results exemplified exactly this shift—and we think it is just the beginning of what could be a steady, though not linear, multi-year run.
With 2016's stellar results fresh in the mind, it may be difficult to recall just how poorly the year started and how fatalistic the expectations were for equities. Small-cap stocks plunged from the first peal of 2016's opening bell. The downdraft exacerbated a trend that had begun the previous summer following the small-cap peak on June 23, 2015.
By the time it was all over with the small-cap bottom on February 11, 2016, the Russell 2000 had fallen 25.7%. The last leg of the downdraft included many of the signs of a classic bottoming-out process—panic selling in a number of sectors (most notably within the biopharma complex), small-caps losing more than large-caps, and more resilience from value stocks—to us, the most significant development in the down phase.
As unpleasant as any bear market is, we noted that the leadership shift, because it was nearly concomitant with the rate hike, was likely to last.
Moreover, these signs also gave us some assurance that this was a historically conventional decline, making us confident that the small-cap market was undergoing its own important and familiar shift. The depths plumbed by this bear market were comparable to previous downturns—and that encouraged our belief that the worst was over just before the Russell 2000 rebounded sharply from its February low through the end of the year.
These small-cap bear and bull markets received so little comment beyond our own and that of fellow small-cap specialists that we refer to them as "stealth" markets. They also reinforced our contention that this small-cap rally has room to run.
Despite its strong showing in 2016, the Russell 2000 finished the year only 7.2% above its June 2015 peak. For additional context, it is worth noting that small-cap upswings usually extend well beyond the 47.4% advance the small-cap index made from its February bottom through the end of 2016.
There have been 12 declines of 15% or more for the Russell 2000 since its 1979 inception. The median return for the subsequent recovery period was 98.8%. So both history and the currently hospitable economic environment suggest to us that there may well be plenty of life left in the small-cap rally.
The recent extended run of small-cap growth leadership makes it worth recalling that it is actually small-cap value stocks that own the pronounced long-term historical edge in relative performance.
Of course, it makes sense that many investors were not conscious of this history at the beginning of the year. Prior to resuming leadership, the Russell 2000 Value Index trailed the Russell 2000 Growth Index in six out of seven years between 2009 and 2015. Based on their long-term performance and leadership history, this was an inordinately lengthy span.
Is it now value's turn, then? We think so. Prolonged periods of leadership for small-cap growth have historically been followed by long tenures at the helm for value.
Multi-year trends typically do not have brief reversals before reappearing. Based on this pattern, we think the current leadership status of small-cap value is likely to last. Further, value stocks have historically outpaced growth issues when the economy is expanding—growth companies generally being most highly valued when growth is scarce in the economy.
Rising interest rates have also historically provided a relative headwind for growth stocks because their valuations typically have a long-duration bond aspect to them that is highly sensitive to changes in rates.
We saw the postelection rally and the sudden shift in investor perspective that came with it as more symptom than cause of an overall improved environment for both the economy and stocks.
After all, some had forecast the pickup in GDP growth prior to any votes being cast just as many investors realized that the era of "lower forever" interest rates had reached its conclusion before the Fed officially announced the hike in December. There were also encouraging pickups in employment and incremental growth in wages.
Along with the added certainty that comes after nearly every election, especially a contentious one, all of this stoked bullishness. So while the election was undoubtedly an accelerant, it seemed to us that many investors—and management teams— simply needed the experience of a tangible event before they felt comfortable enough to embrace the good news that had been accumulating prior to November.
The aftermath of the election has set the stage for changes that could benefit small-cap companies, beginning with a lower corporate tax rate. With the bulk of their money coming from domestic sources, many small-cap businesses would receive a disproportionate benefit from any rate reduction.
Also encouraging are the prospects for repatriation. It was not surprising, then, that the postelection period also witnessed a dramatic rotation away from safety—bonds and defensive stocks most notably. Investors are bullish on the potential for accelerated economic growth and the policy shift from monetary to fiscal—chiefly in the form of tax cuts and projected spending increases on infrastructure and defense. The critical question going forward is, how much of this has already been priced in?
Turn the Page
All of this has convinced us that we have turned the page on that 2011-2015 period in which financial markets behaved in such odd and unprecedented ways.
We firmly believe that we are back on the road to a more historically normal market environment. We expect a multi-year run for the current environment of increased return dispersion, declining correlation, and a steepening yield curve, such as we saw in 2016, and think this will also lead to more historically normal relative return patterns for equity asset classes.
Only time will tell, of course. However, we do not think a significant correction—that is, a decline of 15% or more—is in the offing. We see no signs of a recession or financial crisis. Still, a downdraft of anywhere from 8-10% would not be at all unexpected, and arguably healthy, given the strength of small-cap’s 2016 run.
When one does occur, we are prepared to act opportunistically by trying to turn any volatility to our investors' long-term advantage. In any event, we see ongoing leadership not only for small-cap value but for many cyclical sectors as well.
Cyclicals lagged for so long that, as with value stocks (with which there is substantial overlap), we were anticipating a shift, which is precisely what we are seeing in the current cycle. Financials are benefiting from the steepening yield curve, which should help to lift bank profits, while the potential for accelerated economic growth is boosting Industrials and many Materials stocks. The latter are also benefiting from rebounding commodity prices that ignited energy stocks as well. In addition, the U.S. consumer continues to spend. We see all of these as potentially ongoing trends.
And although the global outlook is admittedly less certain, any rebound in worldwide industrial activity would be an additional, and significant, positive.
A New Day for Active Managers?
Ongoing leadership for value and the related strength of cyclicals could produce distinct advantages for small-cap active management. As rates continue to rise and access to capital begins to contract more consistently, the number of bankruptcies should escalate, restoring the healthy, Darwinian force that generally ensures survival for the best-run, most prudently managed enterprises while putting others at potentially greater risk.
It creates challenges for more debt-dependent, long-duration growth while offering potential benefits for companies that are conservatively capitalized. If we are correct in our argument that a multi-year period of value leadership is just beginning, then we also expect it to be a strong period for thoughtful and disciplined small-cap active management.
To be sure, this was the case in 2016. Twelve of our 13 domestic small-cap portfolios advanced 16% or more in the calendar year; seven increased at least 23% (and bested their benchmark in the process). These performances were largely rooted in our dogged commitment to disciplined approaches to small-cap stock investing.
They support the confidence we have going forward, which is also bolstered by the fact that our analysis of the dynamics in our asset class was sound. We felt validated not only by the high returns for several portfolios but also that performance took place against the backdrop of a gradually growing economy.
Historically, value-led periods have been good for many Royce Funds, and we remain committed to the effort of delivering strong results for our investors in the years to come.
You have our great thanks and deep appreciation for the commitment you have shown to us and our approaches over the years.
For The Royce Funds' one-, five-, 10-year, and/or since inception returns as of the most recent quarter-end period, please see our Prices and Performance page.
Important Disclosure Information
The thoughts expressed in this letter concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at December 31, 2016, and, of course, historical market trends are not necessarily indicative of future market movements.