Royce Investment Partners Commentary: 3Q22 Small-Cap Recap

By Francis Gannon

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Oct 03, 2022
  • A rally and a re-test as the bear market rolls on.
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After equity prices moved downward in volatile fashion through the first six months of 2022, the third quarter saw a spirited, but ultimately short-lived, rally that ran through July and into mid-August before down days returned, negating its midsummer gains. Unlike large-caps, however, small-caps did not reach a new low in 3Q22 as the 6/16/22 low held in spite the 17.5% decline for the Russell 2000 from 8/15/22-9/30/22.

An Up and Down Quarter for Small-Caps
Cumulative Returns for the Russell 2000, 6/30/22-9/30/22


Past performance is no guarantee of future results.

For 3Q22 as a whole, the small-cap Russell 2000 Index was down 2.2%, ahead of its large-cap sibling, the Russell 1000 Index, which was down 4.6% for the same period. Outside the U.S., the ongoing downturn was more strongly in evidence, much of it tied to the sharp surge in the U.S. dollar. So, while the MSCI ACWI ex USA Small Cap Index declined 8.4% in 3Q22, and the MSCI ACWI ex USA Large Cap Index slipped 9.9%, returns in local currencies showed smaller losses.

Negative third-quarter performance contributed to near-record losses for the small- and large-cap indexes for the first nine months of a calendar year, as the Russell 2000 was down 25.1%, while the Russell 1000 fell 24.6%. These negative results were the second worst first nine months for both the small-cap index (by just a single basis point) and the large-cap index since their 1978 inception.

Reversals in the Mini Rally

The Russell 2000 Value Index lost more than the Russell 2000 Growth Index in 3Q22, down 4.6% versus a gain of 0.2%. Small-cap value lagging reversed the previous trend—prior to 3Q22, the Russell 2000 Value had beaten the Russell 2000 Growth for seven consecutive quarters. Additionally, both the brief rally and the quarter as a whole were dominated by lower-quality small-caps: Companies with negative earnings before interest and taxes (EBIT) outpaced those with earnings, while dividend payers underperformed non-dividend payers. This pattern contrasted with higher-quality small caps leading during the first half of 2022.

Third-quarter results notwithstanding, we believe that small-cap value will recapture its long-term historical advantage over its growth counterpart. For reference, as of 12/31/21, the five-year annualized average annual return for the Russell 2000 Value was 9.1% versus a gain of 14.5% for the Russell 2000 Growth or a spread of -5.4% for value. With growth’s significant underperformance so far this year, the spread has contracted substantially for the five-year period ended 9/30/22 when the Russell 2000 Value was up 2.9% versus 3.6% for the Russell 2000 Growth. One reason that we expect value to resume its outperformance versus its growth counterpart is that over all five-year monthly rolling average periods since their inception (12/31/78), the advantage was firmly in value’s favor, 11.9% versus 8.9%

Small-Cap Value Is Recovering Its Long-Term Performance Edge
Five-Year Return Spread for the Russell 2000 Value versus the Russell 2000 Growth


1Average of monthly rolling return spreads
Past performance is no guarantee of future results.

A Hawkish Fed Sparks Recession Fears

Investors in all asset classes have been facing a host of uncertainties (many of them interrelated) through most of 2022, including inflation, lingering supply chain issues, ongoing Covid variants, a sluggish Chinese economy, and the war in Ukraine. Even more consequential was the Fed’s decidedly more hawkish stance, evidenced by three 75 basis point rate hikes and its stated intention to continue raising rates until the Fed funds level reaches 4.6% in 2023. One consequence of these Fed moves is that many investors now see a recession for the U.S. economy as a when, not an if, and have growing concerns about a contraction’s length and depth.

Stocks Searching for Direction

As ever in a declining market, anxious equity investors also want to know if the markets reached a bottom. These are not questions we (or anyone else) can answer. What we can do is offer some ultimately hopeful observations, knowing that stocks may not reverse direction in the short term. First, the average stock in the Russell 2000 was down 45% from its respective 52-week highs through the end of September. Only during the 2008-09 Financial Crisis and the depths of the Covid decline were losses for the average small-cap stock greater. This data inspires our belief that we are likely in the later stages of the current bear market even as we are unsure about when stock prices will begin a longer-lasting recovery.

We also see an advantage for small-cap compared to large-cap. Compare the decline for the average small-cap stock with the 36% slide for the average stock in the Russell 1000 from its respective 52-week highs. Moreover, the Russell 2000 fell 31.2% from its peak on 11/8/21 through its 2022 low on 6/16/22. The Russell 1000 lost far less from its peak on 1/3/22 through its 2022 low on 9/29/22, down 24.6%. In addition, the Russell 2000 entered a ‘classic’ bear market—that is, a decline of 20% or more from a previous peak—in January 2022 while the Russell 1000 reached a comparable fall from its peak only in September of 2022. In other words, it seems to us that large-cap stocks are more vulnerable to further declines than their small-cap peers. Finally, as measured by enterprise value divided by earnings before interest and taxes—EV/EBIT, one of our preferred valuation measures—the Russell 2000 finished 3Q22 much more attractively priced than the Russell 1000.

Are Large-Caps Vulnerable to Further Declines?
As of 9/30/22


2Enterprise value divided by earnings before interest and taxes.
Past performance is no guarantee of future results.

What Have Low Single-Digit Long-Term Trailing Returns Signaled?

One of our greatest sources of confidence about future returns comes from the peculiar state of long-term small-cap performance at the end of September. For the periods ended 9/30/22, the three- and five-year annualized returns for the Russell 2000 were 4.3% and 3.6%, respectively. These respective long-term returns were well below their three- and five-year monthly rolling averages since the inception of the Russell 2000, which were 10.8% and 10.5%, respectively. Trailing three- and five-year periods have not had returns at or lower than these levels since March 2020 and June 2009.

Why is this important? Small cap’s historical return pattern shows that below-average return periods have been followed by above-average return periods, with a much lower-than-average frequency of negative return periods. Specifically, 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%.

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% from 12/31/78-9/30/22


Past performance is no guarantee of future results.

As stomach-churning as investing can feel during difficult periods, we believe that investors need to think about making the commitment to some form of dollar cost averaging. It is easy to forget that, given the historically cyclical nature of markets, markets are being de-risked as they suffer negative returns. And as we have pointed out previously, market rebounds tend to happen quickly. A significant amount of an investor’s returns can be squandered if one tries to time a bottom or sit on the sidelines through a bear market. In addition, stocks have historically begun to recover before the evidence of a rebounding economy becomes clear—so there are similar risks for investors who attempt to wait out a recession before re-entering the market. Our counsel therefore remains the same as it has been for many years: Follow the old investment adage of being fearful when others are greedy, and greedy when others are fearful.

The thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce Investment Partners, and, of course, there can be no assurances with respect to future small-cap market performance. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

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I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure
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