Were you surprised by the depth of the declines across asset classes in 2Q22?
Frank Gannon The depth and speed were more surprising than the decline itself. I think we first need to consider the extensive list of uncertainties we’ve all been facing as investors: the prospects of recession, persistent inflation, higher energy prices, rising rates, and the ongoing war in Ukraine. Perhaps most consequentially, we’ve also had the Federal Reserve taking aggressive steps in the form of three rate increases so far in 2022—one 25 basis point hike, another of 50, and a third of 75—with the indication that there are more to come. Given these anxieties—as well as increased risk aversion and valuation compression resulting from rising rates—then the significant negative returns we saw for equities—and the fact that small-caps lagged—were not terribly surprising. However, we were a bit surprised that the Russell 2000—which fell 17.2% in 2Q22—suffered its worst ever first-half loss since its inception at the end of 1978. The small-cap index fell 23.4% for the year-to-date period ended 6/30/22. The next biggest first-half loss was 13.0% in 2020, following the initial COVID outbreak, so 2022’s first half was the biggest loss by a wide margin.
Small-Cap’s Dubious Achievement
Negative Calendar-Year First-Half Returns for the Russell 2000 Since Inception (12/31/78)
Past performance is no guarantee of future results
What parallels do you see between the current environment and other periods in your investment career?
Chuck Royce (Trades, Portfolio) One period that comes immediately to mind is the early to mid ‘70s. Not only was this the time when I assumed full portfolio management responsibilities on Royce Pennsylvania Mutual Fund, but it was also another period when investors had nowhere to hide because almost every investment option—equities, bonds, real estate, etc.—was struggling. Rates were rising, energy prices were high, and inflation was both rampant and centered around higher food and energy prices, just as it is today. The outlook for both the economy and the market was as uncertain then as it is now. Recently, some economists are even talking about the possibility of stagflation, which of course we haven’t experienced since that decade. So these elements are all familiar to me from having invested through the 1970s.
What relevant differences do you see between previous periods and the present?
CR It’s rare for the economic outlook and the direction of the capital markets to both shift as rapidly as they did over the last seven or eight months. We only have to go back to last October or November of last year to find some of the best economic minds we have who were confident that inflation wouldn’t exceed 2% and that the economy would continue growing. Along with Russia’s invasion of Ukraine, I think the recognition by both the market and the Fed that inflation was not going to be transient and so needed to be fought vigorously quickly undid this consensus. A similar recognition came more slowly in the 1970’s. Still, while these sorts of macro calls are well outside our bailiwick, I suspect that the fears about long-term rates of inflation and/or the depth of a recession may be overstated in their pessimism.
What underlies this observation?
FG The picture is not as unrelentingly negative as the headlines imply. On the one hand, there’s ample reason to be concerned about the state of the economy. The U.S. manufacturing PMI new orders component ended June at 49.2—and any number below 50 signals a contraction in activity. And vigorous Fed actions have often precipitated a recession. However, the U.S. labor market remains strong, household and bank balance sheets seem to be in decent shape—the opposite of what conditions were going into the Financial Crisis. So while a U.S. slowdown, perhaps a recession, seems probable, we also see enough positive data points to suggest that any contraction in our economy may be both short lived and shallow.
How do you integrate this mixed picture into your investment work?
CR We think it’s important to draw a hard line between what’s knowable and what’s unknowable. For example, the questions we’ve been getting most frequently from clients during this highly volatile period are: Is the economy in a recession? How deep will it be? How long will it last? Has inflation peaked? When will the Fed pause? Have we seen the bottom in small-cap prices? These are important questions that at the same time are unanswerable. Even within our own area of expertise, our decades of investment experience have taught us that trying to call a market low is a fool’s errand. It’s simply impossible to predict.
What’s your current view on small-cap's relative attractiveness versus large-cap?
FG We appreciate that in these anxious times, investors may feel more comfortable focusing on large-caps—but we’d counsel resisting that temptation, particularly now. Even with the dramatic decline in stock prices during the second quarter, there’s been no change in the extreme undervaluation of small-caps versus large-caps. Small-caps have averaged a 3% premium to large-caps over the past 20 years. At the end of June, however, small-caps were at a 20% discount, at their lowest relative valuation versus large-caps in more than 20 years.
Relative Valuations for Small-Caps vs. Large-Caps Are at Their Lowest in 20 Years
Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies)
From 6/30/02 to 6/30/22
¹ Earnings Before Interest and Taxes
Past performance is no guarantee of future results
With the Russell 2000 Value Index having largely closed the long-term performance gap with the Russell 2000 Growth Index, are you still leaning mostly toward value in your portfolios?
CR I think multiple contraction remains very real, and so I continue to lean toward value—as well as high quality—in my portfolios. In both cases, valuations are relatively more attractive than they are versus the rest of the small-cap market and even more so when compared to large-cap stocks. I also think it’s unlikely that rates go down over the next few years, and a rising rate environment creates both persistent headwinds for growth stocks of any size and tailwinds for value. Additionally, the considerable number of companies committing to reshoring—especially because of deglobalization—or increasing Capex spending are likely to help many value companies.
Where have you been finding the most interesting long-term opportunities in the Strategies you manage?
CR We’ve seen several companies that we like experience such dramatic declines that recession appears to have already been priced in. We’ve noted before that the index understates the decline in the average stock. From their respective 52-week highs, the average Russell 2000 stock was down 48% at the small-cap low on 6/16/22. For the most part, we’ve been focusing on B2B as opposed to B2C companies across several sectors and industries. However, we also hold a select number of consumer-facing businesses, all of whose stocks are down 50% or more from their recent highs, and where the industry ecosystem dynamics look promising to us over the long term: Hayward Holdings (HAYW, Financial) operates subsidiaries that design and manufacture residential pool equipment; Yeti (YETI, Financial) makes and distributes products for the outdoor and recreation markets, such as coolers, beverage holders, and bottles; and Fox Factory (FOXF, Financial), which makes high-performance suspension products used primarily on mountain bikes and other vehicles.
Which areas have been most attractive in the firm’s other major strategies?
FG It’s been more on a stock-by-stock basis, though certain themes have stood out. In our Small-Cap Opportunistic Value Strategy, for example, the team has been focusing on companies that they think can benefit from inflation. Their portfolios also remain overweight in semiconductors & semiconductor equipment as they continue to see high demand even as supply chain constraints linger, bringing share prices lower. Additionally, they’re seeing certain secular themes in industries that look better positioned to survive the slowing economy, which includes select communications services companies, as well as those involved in the shift to sustainable energy and reshoring.
Can you discuss a high-conviction holding?
CR I think Air Lease (AL, Financial) is a good candidate. It’s a leading lessor of commercial aircraft that we think of as an effective asset manager of planes. In fact, the company’s founder was a pioneer in aviation leasing. Air Lease focuses on more fuel-efficient narrow body planes. We also like its exposure to the higher rates of air travel by the growing global middle class. With many airlines’ balance sheets even more challenged in the post-Covid world, leasing is becoming an increasingly attractive option. The rising cost of capital limits the ability of smaller players to be aggressive on price, so better pricing equates to better spreads for Air Lease.
Air Lease (NYSE: AL) 12/31/21-6/30/22
Past performance is no guarantee of future results
We also expect Air Lease to benefit from rising interest rates because its funding costs are largely fixed and have longer maturities. From a valuation standpoint, its stock trades at a significant discount to its liquidation (or tangible book) value. Finally, a smaller, lower-quality competitor was recently acquired for roughly 1.1x its tangible book value, which is a meaningful premium to Air Lease’s valuation, which suggests to us how undervalued the company is.
Even without trying to predict a bottom for small-caps, where do you think we are in the small-cap cycle?
FG Knowing how easy it is for investors to be discouraged by markets like this, we think it’s important for them to know that the current depth of the small-cap market’s swoon is comparable to the median drawdown for the 12 declines of 20% or more since the Russell 2000’s inception. So while we don’t know for sure when the bottom will occur, history suggests that the bulk of the small-cap decline is behind us.
Russell 2000’s Median Decline Suggests the Worst is Over
Median Decline of 20% or More for the Russell 2000 versus Most Recent Peak-to-Low Return (11/8/21-6/16/22)
Past performance is no guarantee of future results
CR I’d add how striking it is that the current small-cap bear market has coincided—very counterintuitively—with a period of solid company fundamentals and growing profits. As measured by the trailing 12-month EBIT for the Russell 2000, small-cap profits grew by 53.5% over the last 12 months. Yet during this same period, the small-cap index fell 25.2%. This wide divergence has in many cases dramatically reduced small-cap valuations. Using our preferred metric of EV/EBIT (enterprise value over earnings before interest & taxes), the Russell 2000 now has a weighted median valuation of 14.2x, down from its 18.2x valuation a year ago, and below its 20-year average of 15.9x.
What is your outlook for small-caps over the next few years?
CR We are currently in what I’d call a “sum of all fears” environment. War, inflation, slower growth, and rising rates are all understandably frightening investors. Both consumer and investor sentiment are near historic lows. As noted, the VIX is currently flashing a fear signal, ending June in the top 20% of its highest average monthly readings since its inception. I would challenge investors to think about whether our present moment is markedly worse than previous periods—including the Internet Bubble era, the months following the attacks on 9-11, and the Great Financial Crisis. I would argue against the current sentiment, in other words.
FG We have found that the most opportune times to invest are when fear is high and trailing returns are low. Subsequent returns from these levels have been attractive—if investors possess the necessary fortitude. Moreover, the annualized three-year return for the Russell 2000 at the end of June was 4.2% compared to its three-year monthly rolling average since inception of 10.9%. Subsequent annualized three-year returns for small-cap from comparable trailing low-return entry points have been positive 97% of the time since the Russell 2000’s inception, averaging 11.9%. Coming off a record negative first half during what may well be a late stage of the bear market, the current period looks like a pretty good entry point for long-term small-cap returns going forward. We think all of this makes a very convincing argument for ongoing small-cap investment.
97% of the Time, Positive 3-Year Returns Have Followed Low Return Markets
Subsequent Average Annualized 3-Year Performance for the Russell 2000 Following 3-Year Annualized Return Ranges of 0-5%
12/31/78-6/30/22
Past performance is no guarantee of future results
What would you say to investors who are still hesitant to invest in small-cap?
CR One consistent historical pattern in small-cap is that the recoveries have happened very quickly, so investors who miss out on just a few months would have forfeited a large portion of their return. We looked at the one-year results coming off market bottoms and then tracked the average returns for an investor who missed the first one, two, or three months of each one-year recovery. The results were striking. On average, if an investor missed only the first month of the recovery, their one-year return was on average about one third lower than if they had been investing at the trough (+63.8% vs. +41.8%). For an investor who missed the first three months of the recovery, their subsequent one-year return was less than half of what investors experienced by investing at the bottom (+63.8% vs. +31.2%). I suppose my final word, then, is that we think it’s wise to follow the investment maxim, “Be fearful when others are greedy and greedy when others are fearful.”
Why Stay Invested? Missing the Rally’s Earliest Stage Has Been Historically Costly
Average and Median Returns for the Russell 2000 During the First 12 Months of a Recovery Depending on Entry Point
12/31/78-6/30/22
Past performance is no guarantee of future results
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.
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