What was your view of the market’s movements in 1Q23?
Chuck Royce (Trades, Portfolio): It was one of the more interesting quarters I’ve seen in a long time. The year began with a strong upward move that was succeeded by what looked like a mild corrective phase in February, before the failures of Silicon Valley and Signature Banks, combined with the fragile condition of First Republic Bank and Credit Suisse, drove share prices further down. The Russell 2000 Index gained 13.7% through 2/2/23 but wound up gaining only 2.7% for 1Q23 as a whole.
Were you surprised by the depth of the correction in February and March?
CR: Not at all. This steeper correction seemed consistent with the growing conviction—which materialized very quickly—that the economy was inching closer to a recession. And the possibility of a banking crisis always frightens investors—and this fear has only grown more intense in the 15 years since the Great Financial Crisis. Most banks—and that includes all regional and smaller institutions—exist largely on the confidence of their depositors and the communities they serve, so anything that disrupts or threatens that confidence is taken very seriously and often has a ripple effect into other areas of the economy. As of now, we’re cautiously optimistic that this recent threat is behind us, with the potential crisis having been averted.
Francis Gannon: I think it’s also important to point out that the fear of bank failures spreading made a disproportionate impact on small-cap performance in the first quarter because both the Russell 2000 and Russell 2000 Value have sizable weightings in regional banks. In the small-cap value index, for example, the weighting was roughly 16% at the end of March.
Why do you think that large cap and growth outperformed in 1Q23?
FG: I think we saw what I’d call a flight to the familiar in the quarter, as opposed to a flight to safety, during a highly uncertain time. Treasury yields have been behaving with the sort of high volatility we’re used to seeing in more speculative equities, so in that sense it was not surprising to see investors flock back to what we think is merely the perceived safety of mega-cap stocks. However, these behemoths, such as Meta Platforms, Apple, Microsoft, and Alphabet—which all rallied through the end of March—are also selling for multiples that look unsustainably high to us. Small caps, on the other hand, were behind their larger and more growth-oriented peers for the quarter, with the Russell 1000 Index up 7.5%, the Russell Top 50 Mega Cap Index up 12.9%, and the Nasdaq Composite up 17.0%.
Do you anticipate that the rally for mega-cap stocks will be short lived?
CR: I think that’s the most likely case in light of the high multiples that Frank mentioned. Of course, the near-term picture is very cloudy right now, so I’m hesitant about any prediction—my own or anyone else’s—that doesn’t take a long-term view. To take just one example, the advances in artificial intelligence, such as Chat GPT, could conceivably create a meaningful rally for larger technology companies, if not an eventual secular bubble. But we don’t know when that technology will be ready for more reliable and widespread use. We also don’t know which companies will be best positioned to benefit, or what the impact on profitability will be.
How much of a role do you think those more volatile Treasury yields played in higher returns for the biggest stocks?
FG: A pretty sizable role, I think, along with the mistaken belief that the Fed was about to ease or even reduce rates. We’re experiencing one of the fastest and steepest rates of increase for interest rates in years, which, coupled with the uncertain outlook for the economy, is causing considerable volatility in yields. The 2-year Treasury, for example, began 2023 at 4.4%. It fell to 4.1% in mid-January, rose to 5.1% in early March, and then fell once more to finish the quarter at 3.8%. So, while rates have been rising, some investors appear to be leery of getting into debt securities.
Do you think that small-cap valuations have become more attractive in the wake of recent market developments?
CR: Yes, the Russell 2000 was still in a bear market at the end of March. It fell -24.7% from its peak on 11/8/21 through 3/31/23, and the average stock in the Russell 2000 was down -35.2% from their respective 52-week highs through the end of March. This has created opportunities for us to add to our highest conviction names as well as the chance to investigate new names in several areas. The troubles for regional banks rippled to hit many value and cyclical stocks hard. But our long-term investment perspective and emphasis on quality allow us to tune out the short-term noise, which is especially important at times like this. Within Financials, for example, we like insurance companies, business development companies, and alternative asset managers. These are long-term investments in companies that are not reliant on the banking system. And we’re also looking closely at select regional banks to see which companies look best positioned to survive the currently difficult conditions for the industry.
What is your outlook for small-cap value and small-cap quality in light of ongoing market and economic uncertainty?
FG: Small-cap value fell behind growth in first quarter after a mostly steady run of outperforming over the last eight quarters. The Russell 2000 Value Index fell -0.7% in the first quarter compared to a gain of 6.1% for the Russell 2000 Growth Index. We’re confident that this disadvantage for value will prove temporary. The pivot in Fed policy from the epoch of zero (or near zero) interest rates and easy money to one of rate hikes and quantitative tightening, both against the backdrop of persistent inflation, means that the investment landscape has also shifted. The stocks that performed best under the previous decade’s regime of zero interest rates, low inflation, and low nominal growth—which were mega-caps and small-cap growth—are unlikely to lead going forward, regardless of what direction the U.S. economy ultimately takes. Conversely, those areas of the equity market that lagged during this long period are likely, in our view, to capture long-term leadership.
CR: We think small cap is ready to roll and expect the next three to five years to be strong on both an absolute and relative basis. The rising rate environment is creating advantages for companies that can self-finance due to their balance sheet strength and capital allocation practices. Equally important, the Russell 2000’s valuation remained near its lowest rate in 20 years compared to the Russell 1000’s, based on our preferred valuation metric of the median last 12 months’ enterprise value to earnings before taxes (LTM EV/EBIT). Using the same metric within small cap, we found that value finished the first quarter at a substantially more attractive valuation than small-cap growth.
Relative Valuations for Small-Caps versus Large-Caps Remained Near Their Lowest in 20 Years
Russell 2000 vs. Russell 1000 Median LTM EV/EBITÂą (ex. Negative EBIT Companies) From 3/31/02 to 3/31/23
Did you observe any noteworthy performance differences between small and large cap at the sector level in 1Q23?
FG: The disparity in sector returns was the most notable element. Within the Russell 2000, for example, Financials unsurprisingly had a large loss and detracted most from first-quarter performance. The sector also declines in the Russell 1000 but did so far less impactfully. Similarly, Information Technology was the top contributor in both indexes, but both the sector returns and their respective contributions to overall performance were much greater in the large-cap index.
Sector Advantage: Large Cap
Russell 2000 vs. Russell 1000 1Q23 Sector Returns
Can you discuss a lagging holding in which you have high confidence?
CR: Rogers Corporation is one of our high-quality holdings. Rogers designs and manufactures highly specialized, high reliability engineered materials for a diverse set of industries. It’s also the oldest publicly traded NYSE company, having been founded in 1832. Rogers was also the first to develop the high-frequency circuit that went into the Mercury spacecraft, the first U.S. human space flight in the 1960s. It’s often mistaken for a tech business, but Rogers is a specialty chemicals company that focuses on high-growth, niche applications, including 5G wireless base stations, advanced driver assistance systems, and electric and hybrid electric vehicles. We like its B2B status—its sales are made engineer to engineer—its specialized base and its low cost of materials. We also think that management has allocated capital in a highly effective way as they’ve reinvested 100% of the company’s profits over the last 10 years while generating strong cash flows.
Rogers Corporation (ROG, Financial)
(3/31/22-3/31/23)
Can you talk about a stock that’s done well so far in 2023 that also has your long-term confidence?
CR: First Citizens BancShares is a company that we’ve owned for many years, owing mostly to its strong liquidity position and stellar deposit franchise, both of which make it unlikely to see deposit outflows and/or a run on the bank. We also thought that its valuation in late 2022 into 2023 was attractive, as the stock was trading at roughly 5x earnings per share, so we took advantage of what looked like a terrific opportunity to add shares of a bank we liked a lot. Most recently, First Citizens was chosen by the FDIC to acquire Silicon Valley Bank—there were 17 potential acquirers—probably in light of their long and mostly successful history of buying failed banks. First Citizens has bought 20 since 2009 and 50 in their more than 100-year history. We had anticipated that the FDIC would likely want to sell to an experienced acquirer of failed banks. Its price bottomed on March 17 and then rose sharply on news of the acquisition.
First Citizens BancShares Cl. A (FCNCA, Financial)
(3/31/22-3/31/23)
What is your outlook for actively managed small caps?
FG: Our view hasn’t really changed from the end of 2022. Since the end of World War 2, most down years for small caps have been followed by positive performance. Prior to 2022, there were 24 years in which small caps had a negative calendar year return—we use the Center for Research in Securities Prices (“CRSP”) 6-10 as our longer-term small-cap proxy. In 19 of the subsequent years—that is, 79% of the time—small caps enjoyed a positive return the following year. Perhaps even more notable was that the average return for those positive years following a negative one was 25.9%, a substantially better result than the 10% average return for calendar years that followed a positive small-cap return.
CR: The near term is as cloudy as any we can recall. A recession is a strong possibility, but we don’t know how long or deep it will be. What we do know is that a recession, like a bear market, is ultimately finite. And in most cases, each has been followed by a recovery. We know that bear markets are always a challenge. It’s hard to stay invested when prices are falling. But another important historical lesson is that the market’s recoveries from bear markets are enjoyed most by investors who have the patience and discipline to stick it out. Periods like the last 12-18 months have sorely tested every investor’s forbearance. But more than 50 years of portfolio management have taught us that these are often the most rewarding times to be invested in select small-cap stocks for the long run.
Mr. Royce’s and Mr. Gannon’s 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.
