What do you make of the 12-month return for the Russell 2000 Index through the end of March 2021, when the small-cap index advanced 94.8%?
Francis Gannon The Russell 2000 has had a quarter-ending 12 month return north of 90% only once before in its more than 40-year historyback in 1982-83. Using the CRSP 6-10 as our small-cap proxy, we looked further back to see if any other four-quarter periods resembled the last 12 months. We found that there hasn't been anything similar since the 1930s, which shows how rare this level of return has been.
Russell 2000 Quarterly Rolling One-Year Returns
From 12/31/79 through 3/31/21
Do the comparisons with the 1930s concern you?
Chuck Royce (Trades, Portfolio) Each period has its own context, but I don't think it's useful to glean lessons from the 1930's. My view is that investors may be reading too much into the very high trailing one-year returns. The trailing one-year period began near the bottom of the market cycle, so you'd expect strong results measuring from there. It's also important to keep in mind that market rebounds in the years since the Financial Crisis have typically been more robust, rebounding more quickly than they did earlier in my career. In the last year, we saw a short, but deep recession followed by massive fiscal spending and extraordinary monetary accommodation. Based on our experience as small-cap specialists, these developments should have led to a strong move for small capswhich is exactly what we've seen.
How has this historic small cap performance affected your outlook?
FG Our outlook remains positive. It seems to have been largely forgotten that coming into 2020, when few of us here in the U.S. were thinking about the coronavirus, the global economy looked very well positioned for expansion. So we now have considerable pent-up demand that was already growing prior to the pandemic. Along with healthy global financial conditions, the sounder underlying state of the economy is a very strong sign. A recovering economy that eventually regains its prior momentum should be a positive environment for small caps.
What are your expectations for volatility and a possible correction through the rest of this year?
CR I wouldn't be surprised at all to see a correction in the 5-15% range. But I base that on history and on our own decades of experience. It's a bit of a fool's errand, in other words, to try predicting when the market will become more volatile or by how much. We simply assume that it will be because it usually isand act accordingly. That's less important than trying to figure out what might be happening next.
Do you think small-cap investors should be concerned about inflation?
CR I don't think so, no. And it's interesting to me that everyone has been weighing in on inflation lately. The big debate has shifted from rates to inflation. In any event, small cap businesses are generally nimbler than their larger peers. They can adjust more effectively on the fly to inflation. Having said that, some business models are more negatively impacted by inflation. More specifically, many of our companies are market leaders whose managements have told us that they're confident they can pass on any price increases, at least in the short run. That's consistent with my experiences in previous inflationary periods. Moderate increases in inflation have often been good for small caps, though better for some than others.
Why do you think earnings will be so critical to small-cap performance over the next couple of years?
FG The initial stage of a bull market most commonly sees valuations growing in anticipation of a widespread earnings recovery. Seemingly every stock goes up, including those with the lowest valuations and/or lowest quality (as measured by return on invested capital and return on equity). But after around 12 months, reality starts to kick in. Not every company is going to show the same pace or sustainability of earnings growth. The forward stock price trajectory becomes flatter, and gains are driven primarily by earnings growth. I suspect that we're approaching the end of the early bull market's valuation expansion phase, which means that subsequent gains should be tied more directly to earnings growth.
Do you think small-cap stocks with higher-quality (as measured by high returns on invested capital and returns on equity) that have so far lagged in the current bull cycle will catch up?
FG We do. It has historically been common for higher quality stocks to lag in the first year of a market cycle. However, small-cap leadership frequently rotates as market cycles progress, typically shifting toward companies with high ROIC or ROE. As a bull cycle matures, there tends to be more focus on earnings stability, quality, and sustainabilityall of which would help our quality-oriented strategies.
Low Quality Has Led Early While High Quality Has Led in the Second Year of Small-Cap Rebounds
Average Russell 2000 ROE Quintile Performance for Past Four Market Recoveries
Past performance is no guarantee of future results.
Small caps have most recently been led by cyclicals and value. In each case, how long do you anticipate leadership will last?
CR I think the leadership for cyclicals and value will be with us for a while. In my view, these companies possess more potential for multiple expansion as well accelerating earnings growth because a rebounding economy has historically meant that both cyclical industries and many value stocks become market leaders. There's also the fact that cyclicals were very inexpensive compared to their defensive counterparts until the latter half of 2020and even then, the valuation gap narrowed, but didn't close. Most value stocks began to recover even later, only beginning to move up appreciably in 2020's fourth quarter. Despite value's relative outperformance for the past six months, the valuation gap between small cap value and small cap growth stocks is still meaningful.
Shifting Small-Cap Leadership
Russell 2000 Value/Growth and Cyclical/Defensive Performance Spreads Over the Last Four Quarters
Past performance is no guarantee of future results.
Do you expect micro-cap stocks to lead as well?
FG We think about the relationship between micro- and small caps in much the same way as the relationship between small- and large capbecause the dynamics are similar. On average, small-caps are more cyclical and have lower quality than large caps; similarly, micro-caps tend to be more cyclical and have lower quality than small-caps. When the market is rewarding cyclicality and is not discriminating on quality, that's typically bred a favorable environment for micro-caps, as has been the case most recently. It wasn't at all surprising that micro-caps led the cap-based asset classes in the first quarter, just as we weren't surprised that cyclical and value stocks within the asset class drove these robust results. Going forward, I expect that we'll see more divergent results from micro-cap stocks as earnings growth begins to become lumpier throughout the market.
CR On that point, we've been focusing mostly on what we call quality micro-caps in my portfolios. These are typically larger and more mature businesses, those with market caps of at least $500 million. We also think that there's ample dispersion of returns and diversity of businesses in the micro-cap space, more than enough to provide active managers with attractive opportunities to identify mispriced companies. Many of these companies receive little to no analyst coverage, and we try to benefit from this inattention by doing in-depth research and knowing the companies very well.
What do you see in the dynamics of small-cap results that would differentiate what's happening in today's market from 2016, when small caps, value and cyclicals had a relatively brief period of outperformance?
FG There are several important differences. In December 2016, the Fed began a series of eight increases in the Fed Funds Rate that acted as a headwind to economic growth, cyclical businesses, and small cap stocks. Today, the Fed has committed to remaining ultra-accommodative, seeking higher inflation that's a big difference. I'd also add the very healthy state of consumer balance sheets, the ongoing housing boom, and significant fiscal spending as important differentiators.
CR I think the most notable element is the Darwinian crucible wrought by the virus, which gave a lot of companies a jolt. Even the best businesses become subject to inertia at times. But the very challenging task of dealing with the virus forced a lot of companies to become more efficient and effective in their execution, which has helped in many ways.
What have you heard recently from company management teams that has most caught your attention?
CR Management teams are still dealing with the legacies of COVID-driven challenges, most notably in terms of supply chain and inventory management. While the supply chains in many industries are still being revamped or rethought, the inventory situation has been reversing over the last monthscompanies are now hustling to keep items in stock. Inventory in boating, for example, is low because the demand has been so high. Another issue that's come up are technology companies which are rethinking their operations and/or opportunities in China. Technology and related industrial automation looked like an enormous growth opportunity in China as recently as 18 months ago, but there are other considerations that have come into play throughout the pandemic period that are leading to different paths.
What has happened historically after such a strong 12-month run as small caps have enjoyed? Are they ever followed by another 12-month period of positive returns?
FG The record is definitely mixed over the following year, though it's not nearly as bad as some might guess. After all, the conventional wisdom is that higher-return periods are followed by lower return periods. But the 12 months following the 10 strongest four-quarter periods for the Russell 2000 is about evenly split between positive and negative 12-month periods. The returns have ranged from double-digit advances to declines in the mid- to high teens, with many returns in between. The historical record, in other words, defeats any effort to guess at where small-cap returns may fall over the next 12 months. The Russell 2000 could tread water, experience a correction or two, or keep moving up, though at a slower pace.
CR To me, how we get to wherever we wind up next year is the really interesting element. The current period has been, purely from an investor's perspective I hasten to add, wonderful, but almost unprecedented. As Frank suggests, that makes any short-term predictions almost useless. I'm actually looking forward to more of the volatility the market displayed in March. My long-term outlook is positive, so I'd welcome more short-term uncertainty since it would offer us the chance to buy more of what we like.
What have small-cap returns been over longer-term periods following very strong years?
FG Following the kind of very strong one-year periods we had through the end of March, the three-year annualized returns for the Russell 2000 were all positive. Even better, the average annualized three-year return following the 10 strongest four-quarter periods was 11.9%versus the 10.3% average for all quarterly-rolling three-year returns since inception of the Russell 2000.
Small Caps Stay Positive for the Annualized Three-Year Periods Following Strong Years
Russell 2000's 10 Strongest Four-Quarter Periods
CR These impressive longer-term results might seem to fly in the face of conventional wisdom. Many investors might expect a long-lasting correction or cooling off period after such strong runs. However, we also keep in mind that the long-term direction of equity returns trends overwhelmingly to the positive. We like to remind investors that since 1945, 88% of all rolling three-year rolling return periods for small caps have been positiveagain, using the CRSP 6-10 as our small-cap proxy. When you combine that historical pattern with low interest rates, ample access to capital, and a rebounding global economy, you can see why we're optimistic even after an almost record-setting 12-month performance for the Russell 2000.
So you're not very concerned about the elevated state of small-cap valuations?
CR We're always conscious of the valuation picture, though we're more focused on the valuations of individual companies as opposed to the asset class as a whole. Second, valuations always need to be examined in the context of other factors. It can be dangerous to apply a single valuation metric or standard without looking at other important factors, such as earnings growth potential, cash flows, industry dynamics, etc.
FG On the one hand, valuations are elevated through most of the U.S. stock market, regardless of market cap. And I think it's fair to say that multiple expansion is getting harder to come by. However, current valuations are also based on trough earnings, and the prospects for earnings growth remain favorable as the economy continues heating up. Interest rates are rising but are still very low on an absolute basiswhich as we know has been an important element in keeping investors in equities. All of this suggests to me that valuations are not as dangerously high as other market observers seem to think, though they're by no means inexpensive on average.
You've discussed the encouraging long-term historical performance pattern and the economic recovery. What other developments do you see that underpin your confidence in small-cap stocks going forward?
CR I want to be a bit more precise about what underlies my optimism. Small caps rise most of the time, and the real danger signs for poor small-cap returns are impending recessions or restrictive Fed actions. Neither seems likely for a while. My highest level of optimism is for the investment opportunities that have arisen from the increased differentiation among companies as they've responded with varying degrees of effectiveness to the multiple changes in our economy. As an investor, I continue to focus on high-demand small-cap nichesespecially companies that enhance or improve existing technology or that help companies to innovate or automate. With unemployment falling, the need for automation in manufacturing and other areas should only increase. Along with the breadth of earnings growth, these factors are positive signs for disciplined active managers. The tailwinds for positive performance look sustainable to methough I expect a more moderate paceand the headwinds for quality should abate. So I feel very good about the prospects for small cap investing.
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.
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.