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How is the current macro environment affecting small-cap styles?
We think the current environment is going to continue to be tailwind for small value and headwind for small growth. Let’s break it down to a couple of things. The first is around valuation, the second is around cyclicality, and the third is probably about inflation. With regard to valuation and the benefit of liquidity, as the Federal Reserve goes from quantitative easing to quantitative tightening, those stocks that benefited most from abundant liquidity, are going to continue to get hit the hardest. We think that those are largely small growth stocks. If we also go to valuation and expect that overall we’re going to see valuation compression across small caps, that again is going to hit the higher valuation, which hit small growth stocks harder. But then, let’s think about cyclicality. Again, we think that you want to have exposure to economic cyclicality. And the cyclical beneficiaries are more in small value than they are in small growth.
Russell 2000 Value vs. Russell 2000 Growth Top Three Overweights By Industry Group
As of 12/31/21
And finally, around inflation—actually, you have a number of business models in small value that are inflation beneficiaries: banks would be one, materials would be another. But there are others as well. If you contrast that with small growth, that will tend to be more populated by, often, money-losing healthcare stocks, as well as technology and software stocks. So those won’t give you the cyclical exposure, or as much. They’re going to have valuation compression, and to the extent you have lower liquidity, we think the market is going to be less hospitable there. So we think the environment continues to be one of tailwind for small value and headwind for small growth.
Russell 2000 Growth vs. Russell 2000 Value Top Three Overweights By Industry Group
As of 12/31/21
How have Royce’s value strategies been adapting to this environment?
There are two things to recall about Royce’s value strategies: first of all, that they are varied, that they execute different parts of the market. Secondly, there is some commonality. Many of them will have meaningful representations in both Information Technology as well as in Industrials.
However, there are two particular business models which we have large, now, and more recently increasing weighting in. The first of those is banks. And we may have the highest representation in banks than we’ve had, perhaps ever. We think the bank business model intersects particularly well with where we are in the economic cycle. A couple of reasons for that. One is rising interest rates are to the benefit of banks, because banks earn a spread between their deposits and their loan rates. The second is that with inflation, is often because of economic growth and you see loan growth. So if you see faster loan growth at banks and widening interest margin, that’s a really wonderful environment.
The other business model that we find very interesting are distributors—whether that’s industrial distributors or technology component distributors. And the intersection of the distribution business model and inflation is actually very beneficial. Because if prices are rising, then distributors who often work on very small margins can get a little bit of a bump across a wide range of sales volume, and that tends to increase their profitability very meaningfully.
So we would say that the areas where we’re high and have increased our focus on are banks and industrial distributors across the value strategies. And we feel very good about their opportunities ahead.
The thoughts and opinions expressed in the video are solely those of the persons speaking as of February 8, 2022 and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to 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.
