Why do you think the U.S. equity markets did so well in 2019?
Francis Gannon Sometimes the market goes up because of what doesn’t happen, so I think a lot of its success was rooted in two fears that weren’t realized: the Fed did not adopt more hawkish policies and the U.S. economy didn’t experience a recession. The absence of these two went a long way to reassuring investors and helping stocks to advance. Of course, the opposite occurred late in 2018: after raising rates in December, the Fed hinted that it would also hike multiple times in 2019. This more hawkish stance sent the market into a tailspin, and the central bank then responded with a more neutral stance of probably no rate hikes in 2019. This “Fed Pause” soon shifted again to a “Fed Pivot”—three rate cuts in 2019 that reversed all of the central bank’s 2018 increases. This more accommodative stance was solidified by the announcement of an additional $500 billion of cash injected into the money markets in December.
Chuck Royce (Trades, Portfolio) As for the absence of a recession, fears of an economic contraction have loomed over the market pretty regularly since the end of the Financial Crisis. Most recently, they’ve cropped up whenever another data point surfaces showing that the U.S. economy has lost steam. Yet even with growth decelerating, it remains positive. Currently, it’s been boosted by consumer spending, which has helped to compensate for the slowdown in manufacturing growth. I think an additional element relating to Frank’s discussion of the Fed’s shifts was also important to 2019’s advances, at least from our perspective—the increase in money supply by the Fed, which was supportive for financial assets.
What else was notable about 2019?
CR What stands out most for me was the resilience of the market. When you add up all the obstacles, both real and imagined, that faced investors in 2019—tariffs and trade wars, an inverted yield curve, sluggish global growth, uncertain prospects for China, political controversies, the specter of greater regulation for tech giants, and the possibility of a recession—the market’s performance could be seen as a sign of underlying strength. In my experience, when the market advances despite having many valid reasons to go down, it usually means that the market can go higher.
What’s the status of the market reversals that you first observed late in 3Q19?
FG All of the shifts that began on August 27th, when the market’s previous leadership patterns inverted, held through the end of 2019—small-caps outpaced large-caps, cyclicals outperformed defensives, small-cap value beat small-cap growth, and micro-caps led domestic equities. We think these patterns will hold, though the progress may not be in a straight line. We saw an example of this in the fourth quarter when small-cap growth beat small-cap value and defensives outpaced cyclicals. Of course, market shifts seldom occur all at once—what happened in late August was an exception historically. Reversals are also not always clear or obvious until a fair amount of time has passed, emerging by fits and starts until at some point the change becomes clear and/or longer lasting.
What are some of the reasons you think these reversals can persist in 2020?
CR Small-caps have historically done better than large-caps when the economy is advancing and worse when it’s contracting—the same is true for cyclicals versus defensives. So if the most recent slowdown is behind us, and the global economy is gradually improving, which appears to be the case, then that supports a continuation of these reversals. And while relative valuations are not an effective market timing signal, the historically low relative valuations for many small- and micro-cap cyclical stocks, as well as cyclicals, tilt the odds in favor of those areas leading. The global economy grew about 2% in 2019. Now, we’re not macroeconomists, but if the global economy accelerates towards its historic growth rate of around 5%, which seems like a reasonable expectation to us, that should create tailwinds for these reversals to be sustainable.
Do you still think that mega-cap stocks could be headed for a bubble?
CR I do—mostly because of their high valuations and their significant outperformance of the rest of the U.S. market. From the middle of 2018 through the end of 2019, the Russell Top 50 Index advanced 26.1% cumulatively compared with only a 3.7% gain for small-caps—and a decline of 3.9% for micro caps. And any unwinding of a mega-cap bubble—and the potential for a subsequent rotation to small-caps—is part of our constructive outlook for our asset class. Here’s a point that we think effectively illustrates the magnitude of the potential opportunity: over the last 20 years, the 50 biggest stocks in the Russell 3000 Index have averaged a combined total market cap of about four times the total market cap of the Russell 2000. At the end of 2019, that ratio was more than six times—higher than it was even at the height of the Internet bubble in 2000.
FG We’re not expecting mega-caps to collapse any time soon—that would be anomalous behavior in what we think will be an advancing market. But we do think a performance pause at their current high valuations could occur, allowing small- and micro-cap stocks to catch up.
Can you talk more about the current state of small-cap valuations, particularly in the context of the overall market making several new highs in 4Q19?
FG Small-cap valuations look pretty close to their historical averages compared with the current level of interest rates—and they look very attractive compared to large-caps. Using our preferred metric of EV/EBIT, which is enterprise value to earnings before interest and taxes, to compare small-caps with other capitalization ranges shows that both small- and micro-caps sell at their biggest discount to large-caps since 2001. Even after a strong fourth quarter, these valuation discounts are still compelling.
CR I think strong calendar years sometimes lead investors to lose sight of the longer-term context. Even after a terrific 2019, many small-caps are still carrying what I’d call a recession discount from the deep downturn at the end of 2018—which is why so many valuations look realistic or better to us, particularly in cyclical areas. So in spite of 2019 being a terrific year for small-caps, the Russell 2000 finished 2019 more than 2% shy of its August 2018 peak—which was the index’s all-time high. Small-caps have also advanced 37.3% cumulatively since their prior peak on 6/23/15, a period that saw the Russell 1000 increase more than 64%. Finally, three- and five-year annualized returns for the Russell 2000 were below their respective three- and five-year monthly rolling averages at the end of 2019. Small-cap’s more modest performance in the context of its own history, along with its modest valuations, is another aspect of our favorable outlook.
What do you think accounts for the absolute and relative strength of micro-cap stocks in 4Q19?
FG I think it was a constellation of factors. Part of it was reversion to the mean as micro-caps have trailed the rest of the market over the last few years, as Chuck noted—and have trailed large-cap by significant margins—so a rebound seemed inevitable at some point. More specifically, several micro-cap biotech companies were acquisition targets in the fourth quarter. Additionally, we’ve seen the ISM Manufacturing Index tick upward (though it fell back a bit in December) and credit conditions are very healthy. Along with a slowly recovering global economy, all of these factors played a role in micro-cap companies leading the market in the fourth quarter.
Can you discuss a micro-cap holding that’s new to your high-quality strategy in 2019?
CR Mesa Laboratories (MLAB, Financial), which is a company we’ve held in other portfolios for more than a decade, is a good example. It’s an innovative business with a global presence. Mesa designs and manufactures quality control and calibration solutions primarily to the biopharma and healthcare industries, with a strong presence in niche applications in sterilization and disinfection and medical device quality assurance/quality control. Its customers have regulatory requirements that many of the firm’s offerings must meet. These requirements are often specified into their manufacturing and workflows, creating customer “stickiness” and/or high switching costs. Additionally, a new CEO from Danaher (DHR, Financial) joined Mesa a little more than two years ago. He’s been implementing continuous operational improvements that will scale the company via acquisitions as Mesa looks to consolidate its highly fragmented industry.
Are you still focusing on companies that innovate, automate, or otherwise boost productivity?
CR Yes—and there seems to be an enduring bias that innovation is mostly the province of large-cap companies, which gives us the opportunity to find wonderful, innovative niche companies at attractive valuations. One example is Faro Technologies (FARO, Financial), a Florida-based company that provides measurement and imaging solutions for 3D manufacturing, construction, and other applications. The company offers a broad-based array of products and solutions that help make its clients’ employees and processes more productive. With the ongoing shortage of skilled labor, we see a long runway for their offerings. Faro’s experienced some earnings disappointments, which gave it an attractive entry price in the second half of 2019. We think it’s a promising long-term opportunity, especially with a new CEO who’s committed to revamp the firm’s operations and add new talent to bolster leadership.
In which sectors and industries have you been most active recently?
FG Throughout the firm, we’ve found the best values in the larger end of the micro-cap space and the smaller areas of small-cap across a variety of industries, including healthcare devices, diagnostics, and testing; paper & packaging; semiconductors and semiconductor capital equipment; chemicals; and consumer finance.
CR It seems to me that the market is starting to pivot from rewarding those areas that have succeeded to those that have lagged. So for the portfolios where I’m involved, we’ve been looking most closely at those areas that either didn’t participate in 2019’s upswing or trailed significantly. In addition to some of the areas Frank mentioned, we’ve looked at energy companies—mostly on the service side.
Is your outlook for small-caps positive?
CR It is, yes. The backdrop looks quite favorable to us for solid to strong small-cap performance overall. We’ve talked before about four favorable factors in the current market environment—low inflation, modest valuations, moderate growth, and increased access to capital. Each of these remains present and suggests that small-cap returns can go higher, in particular for the many small-cap cyclical areas that we typically like best.
FG I think a few historical factors are also worth noting. Over the past 30 years, 76% of all monthly rolling 1-year returns for small-caps have been positive—they’ve had an average return of 11.5%. So investors who may be bearish on small-cap are betting against the odds. Second, to get a sense of what 2020 might have in store, we went back to the inception of the Russell 2000 and looked at the 11 calendar years when there was a decline, as in 2018, and what happened in the second subsequent year. In nine of those 11 years the Russell 2000 advanced by an average of 14.5%. (2000 and 2002 were the exceptions.)
And two consecutive years of double-digit increases are fairly common for small-caps. Periods in which a healthy second year followed a strong one came in 1988-9, 1991-2, 1995-6, 2003-4, 2009-10, 2012-13, and 2016-17. With the favorable conditions we’ve outlined above in mind, we suspect that the current small-cap rally can continue, with the potential to add 2019-20 to this list.
As you look back over the last decade, what are your thoughts for investors?
CR It certainly developed much differently than we expected. To somewhat echo our take on 2019, if at the beginning the decade we’d known about all of the challenges and troubles we would have to endure, I think we would have been very happy with the 11.8% annualized 10-year return for small-caps, which is higher than the 10-year monthly rolling average for the Russell 2000 of 9.8%. It was also one of the most interesting decades of my career, one in which financial assets did much, much better than the overall economy—which was mostly due to central bank interventions. We also saw developments such as negative interest rates—something that we never thought was possible. In addition, there was little or no penalty for companies that borrowed extensively. Finally, we saw the rapid emergence of a handful of companies that are growing at a pace which I can’t recall seeing ever before for very large companies. I generally expect each of these unusual developments to unwind to some extent over the next decade. This makes me very excited about the prospects for select small-caps, particularly in cyclical areas, that haven’t fully participated in the decade that’s just passed.
What led the firm to introduce its new brand name, Royce Investment Partners?
CR It was really a matter of our brand identity catching up to the reality of our business. We’ve been running institutional products for more than three decades and have had sub-advisory relationships for several years—yet we knew that most people who knew us thought that we were mostly, if not exclusively, mutual fund managers. Over the last several years, we’ve also streamlined the number of our investment strategies and launched collective investment trusts, separately managed accounts, and new international distribution agreements. So as the firm, our offerings and vehicles, and client base have all evolved, it became increasingly important for our brand identity to represent to all of our constituents who we are now as a firm. We also wanted a name that reflects the importance we place on the spirit of partnership—with one another, our clients, and our companies.
Mr. Royce’s and Mr. Gannon’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.
