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Canadian Value
Canadian Value
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Small Cap Guru Chuck Royce on Current Valuations of Small Caps

January 14, 2014 | About:

Do you think that small-cap stocks have peaked?

That’s the question that everyone has been asking. However, no one has a perfect answer because no one can say for sure where the market is headed next. In thinking about the current dynamic pace of returns, I also thought about a few things that are key to how we see the small-cap world here at Royce: We believe in reversion to the mean; the cyclical nature of markets is very real to us. We don’t pretend to know how to time market cycles, but we never get too excited during bullish phases like the current period, and we don’t get too upset during corrections. Markets are always changing, and we work hard to be prepared for those changes. Related to this is the idea of rotation. I can’t say for sure what part of the equity world will lead next—we’re obviously hoping it’s high quality—but it’s clear that there will be a shift. So while small-caps, as measured by the Russell 2000 Index, may have hit, or may be near, a peak, we see plenty of opportunity out there.

Do small-caps look overvalued to you?

The index as a whole looks overvalued right now, at least to me. But our selection universe is much wider than the Russell 2000. We’re working in an asset class that includes more than 4,000 companies with market caps up to $2.5 billion, and we’re also active in mid-cap stocks with market caps between $2.5 billion and $5 billion. So I take issue with the idea that the Russell 2000—or any other small-cap index—is the singular measure of what small-cap valuations look like. In these days of ETFs and strong relative results for index-based investing, I think the enormous breadth of the small-cap space has been forgotten to some degree. We hold some stocks that have reached our estimate of their value, but when we look for potential buys each day, we’re still finding names. Their number has diminished, but they’re still out there.

Are you still anticipating market leadership for high-quality companies?

I do, but I think it’s important to point out that quality small-cap companies—defined as those with high returns on invested capital—have generally done very well on an absolute basis. They trailed the rest of the small-cap field in 2013 but still posted strong returns. As for when quality small-cap stocks might assume market leadership, I don’t know if the shift will occur after a decline or after a period of large-cap leadership, but I am confident that investors will begin to focus more on fundamentals, particularly those that reveal high quality such as strong balance sheets, returns on invested capital, and dividends, in the not-too-distant future. In fact, we first began to see signs of a quiet resurgence for quality stocks when taper talk was first announced in early May.

Were you surprised by the Russell 2000 Index’s five-year average annual total returns through the end of December?

Seen from the perspective of long-term market history, I think the results look improbable, even absurd, and certainly counterintuitive. We have always been fond of the idea that a healthy target for absolute long-term equity average annual returns should be low double digits. So what does it mean when these results are in the range of the high-teens to the mid-twenties? Did we and others do something different or unusually smart to achieve these results?

I think the answer is a lot simpler and less flattering to our stock-picking acumen. The high five-year equity index average annual returns are in part a consequence of the market’s recent strength and, more important, the result of dropping some unusually bad numbers from the fourth quarter of 2008. The five-year average annual total return for the Russell 2000 Index as of December 31, 2012 was 3.6%. Yet when we fast-forward to the end of December 2013, we see the five-year return for the Russell 2000 jump to 20.1%. Most of the time, a five-year period would capture a variety of experiences, perhaps a whole market cycle or two. But occasionally it does not, and the result is a distortion springing from an uncommonly steady, mostly bullish period. So while we do not expect five-year returns to remain this robust, we’re still enthusiastic about the potential for small-cap returns.

Equally important, we have always thought that any evaluation of returns must be both long-term and multi-dimensional in order to measure more accurately what is being accomplished. For example, rolling returns are an excellent tool to examine mutual fund performance. It allows us to look at returns over multiple time periods and to gauge the experience of investors who enter the market at different points of time. We always try to keep in mind the following—if the number looks too high, it probably is.


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