Royce Investment Partners Semiannual Letter: Now Showing: 'The Sum of All Fears'

The First Half of 2022: A Season of Worsts for the Capital Markets

The first half of 2022—in particular its more tumultuous second quarter—offered few if any safe havens for investors, regardless of the investment focus. To be sure, the list of negative superlatives is long. As measured by the Russell Indexes, for example, it was the worst calendar first half since the shared 12/31/78 inception dates for the large-cap Russell 1000 Index (-20.9%), the Russell Midcap Index (-21.65%), the small-cap Russell 2000 Index (-23.4%), and the Russell Microcap Index (-25.1% and whose start goes back to 6/30/00). For the large-cap S&P 500 Index, its 20.0% decline marked its worst first half return since 1970 and its most volatile first six months since 2009. Using Center for Research in Securities Prices (CRSP) data that dates back to 1926 shows that the small-cap proxy, the CRSP 6-10 Index, had its fourth-worst first half in nearly 100 years. The three others occurred in 1932 (during the depth of the Great Depression), 1970, and 1973. For the CRSP 1-5—the large-cap cohort—it was the third-worst first half, with only 1932 and 1962 (during the “Kennedy Slide” that followed a decade of rising share prices) faring worse.

Outside the U.S., the results were equally grim. The MSCI ACWI Small Cap (-22.3%) and MSCI ACWI ex-US Small Cap (-22.9%) Indexes each suffered their worst first half since their 1994 inception while the MSCI Emerging Market Index (-17.9%) turned in its second worst. And the damage was not limited to equities. Bonds also posted negative returns in the first half, declining in both the first and second quarters. This is especially notable because stocks and bonds seldom decline in tandem. They have both had negative returns in just 20 quarters since 1976 (a period that encompasses 186 quarters) and have experienced negative returns for two consecutive quarters only five times—as was the case in 2022—since that same year. In addition, cryptocurrencies are estimated to have lost roughly $2 trillion in value during 2022’s first half, while it is estimated that the amount of wealth in the U.S. has shrunk by as much as $5 trillion so far in 2022. The first half of 2022 saw a significant resetting of asset values on a global scale in a series of deep and broad-based declines that offered, in the words of the Motown classic, “nowhere to run to, nowhere to hide.”

The reasons for this extensive simultaneous swoon have been well rehearsed: Inflation, rising interest rates, an aggressively tightening Fed (with central banks through much of the developed world following suit), lingering supply chain issues, ongoing Covid variants, a sluggish Chinese economy, and the war in Ukraine. Many of these developments are interrelated, with continued Covid outbreaks hampering both a resolution to supply chain delays and growth in China while the war and supply chains delays are exacerbating inflation. The headwinds can be seen in recent economic data, with behemoths such as Walmart, a bellwether for moderate- and low-income U.S. consumers, reporting lower-than-anticipated quarterly earnings and underwhelming near-term prospects while the J.P. Morgan Global Manufacturing PMI^TM hit a 22-month low at the end of June. The U.S. manufacturing PMI new orders component ended June at 49.2—and any number below 50 signals a contraction in activity. However, U.S. home and durable good sales rose in June, while of this writing the U.S. labor market remains strong—and surprisingly resilient in the face of so much dire news. An added positive came from recent bank results, which included reassuring news about the health of consumer credit, as well as the banks’ own balance sheets. The shared health of banks and household balance sheets is important from our perspective as it bolsters the view that any U.S. slowdown seems likely to be both shallow and short-lived. Other dynamics create a different picture outside of the U.S., where a global slowdown looks more worrisome in Europe than in Asia, with the U.S. in between. Regardless of the near-term economic forecast, however, we have examined several small-cap data points that point to potentially better times ahead for investors with the fortitude to remain invested. Much of our case rests on an admittedly counterintuitive and somewhat ironic reason: Improved results for small-cap stocks are rooted in the fact that the environment has been so difficult.

Small-Cap is a Different World

Throughout our five decades of investing, we have found that there are two critical features about the overall small-cap market that many investors miss or forget: First, small-cap operates in its own way—frequently diverging from large-cap. This is borne out not only by the differences—often significant—in long-term performance, but also in the varying market cycles, responses to various economic and monetary regimes and sector and industry concentrations. Second, small-cap is a highly heterogeneous asset class. Its roughly 3,000 publicly traded companies can be found in ample supply in every sector and industry and are involved in almost every imaginable kind of business. Equally important, the depth and breadth of the universe means that there are nearly always potential opportunities for disciplined and discerning investors with the requisite patience for long-term investing.

So, while we can appreciate that investors may feel more comfortable focusing on large-caps in these anxious times, we would counsel resisting that temptation, particularly in the current environment. For example, one of the primary differences between small- and large-cap stocks at the end of June was the radically different valuation picture for each asset class. Despite the dramatic decline in stock prices so far during 2022—which might lead some to believe that valuations throughout the U.S. equity market have been falling to attractively inexpensive levels—large-cap stocks on average remain expensive. And this is true not only in light of their own history, but also versus small-caps. In fact, there has been little change in the extreme valuation gap between the Russell 2000 and Russell 1000 since late 2020. On 6/30/22 the Russell 2000 was at a 20% discount—which marked its lowest relative valuation versus the large-cap index in more than two decades. This stands in stark contrast to the past 20 years, a period in which small-caps have averaged a 3% premium to their larger siblings.

Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies)
From 6/30/02 to 6/30/22

¹Earnings before interest and taxes.

When Valuation Is a Matter of Style

Within small-cap, valuations continue to favor value, even as the Russell 2000 Value Index continued to outpace the Russell 2000 Growth Index in small-cap’s miserable first half—in this case by losing less, down 17.3% versus 29.5% for the year-to-date period ended 6/30/22. There were four additional observations that we found equally relevant when comparing valuations for the various segments of the U.S. equity market:

1. Small-Cap Value and Small-Cap Core were the cheapest segments of U.S. equities as of 6/30/22.
2. These segments were the only ones that were below their 25-year average valuation.
3. While all three value segments (Small-Cap, Mid-Cap, and Large-Cap) had nearly identical 25-year average valuations, their valuations at the end of June were vastly different.
4. Large-Cap and Mid-Cap Growth valuations remained well above their 25-year average valuations at the end of 2022’s first half.

Median EV/EBIT¹ (ex-Negative EBIT) Levels for Russell Indexes
As of 6/30/22

Enterprise value divided by earnings before interest and taxes.

These valuation disparities are particularly pertinent now because it seems likely that U.S. equity valuations, at least for some asset classes or styles, may take years to surpass their earlier respective peaks. Our view is that an environment featuring somewhat higher interest rates and inflation, along with a less accommodative Federal Reserve and increased geopolitical rivalries, will combine for a greater risk environment. (It will also be nearly the reverse of the period from 2009-2021, which saw unprecedented levels of liquidity and near-zero interest rates.) This new climate will therefore probably see somewhat lower equity valuations than we have seen over much of the last 10 years. We think that one important consequence of this shifting and uncertain environment is that investors should consider allocating away from higher valuation assets, which may have stiff headwinds to appreciation, into lower valuation assets, which may receive help from at least a neutral environment or perhaps modest tailwinds. Small-caps, in general, and small-cap value specifically, look relatively attractive in this context.

So Bad It’s Good? Reasons for Long-Term Small-Cap Optimism

Even with a more attractive valuation than large-caps—and a further valuation advantage for small-cap value—we can appreciate that investors may be reticent to put fresh capital to work in the asset class or its value style subset, having just endured the worst first half in the more than 40-year history of the Russell 2000 Index. We also understand their weariness and anxiety as they survey the litany of challenges we have reviewed above. No one, it would seem, needs a reason not to invest these days. Yet that negative perception—substantiated by record lows in both investor and consumer sentiment—is exactly why we are so emphatic that this looks like a genuinely attractive time to invest in small-caps. We think the case is even stronger, particularly if an investor uses large-cap stocks—with their relatively much higher valuations—as a source of funds.

A little-known dynamic exists between large- and small-cap stock performance as investors’ fears wax and wane. We have found it useful to watch the CBOE S&P 500 Volatility Index (VIX) as a barometer for risk tolerance. (The VIX measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices.) Risk tolerance tends to ebb and flow with events. However, regardless of the specific event (e.g., Long-Term Capital Management’s 1998 meltdown, 9/11, the Great Financial Crisis of 2008-09, the Greek Debt Crisis in 2011, 2020’s Covid shutdown), risk tolerance initially plummets before investors show their resilience and acclimatize to the new development, leading to a normalizing of risk tolerance.

This pattern forms the history of markets. Yet there is another revealing and consistent pattern within U.S. equities: In general, small-cap stocks have absorbed a greater proportion of heightened fear than large-caps as overall stock prices fall—which paradoxically creates an opportunity, as the chart below shows. Using above-average VIX levels as a proxy for markets in the grip of high anxiety shows that these periods have historically supplied two attractive elements for small-cap investors: strong absolute subsequent returns and, equally compelling, often excellent entry points for small-cap outperformance over large-caps. When the VIX has had an average monthly reading of 25 or more, as it did in June 2022, the subsequent three-year annualized returns for the Russell 2000 have been 14.1%, compared with 9.4% for the Russell 1000. Even more striking than the spread of outperformance has been the 83% frequency with which small-caps have beaten large-caps over the subsequent three years from similar starting points of higher-than-average volatility. We think of small-caps as being like a coiled spring in these periods of high investor anxiety, contracting more as fear builds and bouncing robustly back as fear recedes.

Subsequent Average Annualized Three-Year Return for the Russell 2000 Starting in Monthly Rolling VIX Return Ranges
From 12/31/89 to 6/30/22

Past performance is no guarantee of future results. Batting Average refers to the percentage of monthly three-year periods in which the Russell 2000 Index outperformed the Russell 1000 Index. The monthly average VIX from 12/31/89-6/30/22 was 19.6. Higher VIX readings occur when market volatility is higher.

The Value of Staying Invested

We are certainly in what we would call a “sum of all fears” environment, with war, inflation, slower growth, and rising rates all understandably frightening investors. The anxious realities of our current conditions notwithstanding, we 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. We would argue against the current sentiment, in other words.

More importantly, 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 for those investors with the discipline to stay invested. For instance, 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—that is, in 30 out of 31 three-year annualized periods—since the Russell 2000’s inception, averaging 11.9%. Coming off a record negative first half and enduring what may well be a late stage of the bear market, the current period looks, to us, 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.

Subsequent Average Annualized 3-Year Performance for the Russell 2000 Following 3-Year Annualized Return Ranges of 0-5%
From 12/31/78-6/30/22

Past performance is no guarantee of future results.

We have one final observation—which is that small-cap recoveries have historically happened very quickly, so investors who miss even a few months would have forfeited a sizeable share of their return. We looked at the one-year results coming off market bottoms—declines of at least 15% from the previous peak—and then tracked the average returns for investors who missed the first one, two, or three months of each one-year recovery. The results were striking. On average, if an investor were to miss only the first month of the recovery, their one-year return was on average about one third lower than if they had been investing throughout 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%).

Average and Median Returns for the Russell 2000 During the First 12 Months of a Recovery Depending on Entry Point
From 12/31/78-6/30/22

Past performance is no guarantee of future results. Royce defines the starting date of a recovery as the market cycle trough of a decline of 15% or more from the index’s prior historical high.

Our final counsel then, is to follow the wisdom of the investment maxim, “Be fearful when others are greedy and greedy when others are fearful.”

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