Why do you think large-cap stocks did so much better than small-caps in 2014?
I think much of large-cap's outperformance was related to reversion to the mean.
Although most stocks have been doing well since the bottom in March 2009, small-caps have been out in front—often by a sizable margin—throughout most of that period. That began to change in 2014, particularly in the second quarter when both the S&P 500 and Russell 1000 outpaced the Russell 2000 by a decent-sized spread. This didn't surprise us.
Small-caps had been ahead for so long and had held such a substantial edge from that trough coming into 2014 that a shift in leadership for equities seemed imminent. What's interesting to me is that small-caps gave up leadership mostly during downdrafts, which were barely noticeable for larger stocks in 2014.
Small-caps experienced losses between March and May and, more seriously, between July 5 and October 13, and these declines really set the stage for the leadership rotation we saw for the year as a whole.
Considering the lower returns for small-caps in 2014, were you expecting better relative results for many Royce Funds?
Absolutely. We were expecting quality stocks—those with strong balance sheets, solid cash flow characteristics, and high returns on invested capital—to emerge as leaders within the small-cap asset class.
We still see, especially among cyclicals, a number of profitable, conservatively capitalized businesses that have either been ignored or have lagged. We expect this to change.
Related to this was our thought that many stocks in economically sensitive cyclical sectors would also do well considering what we see as their financial and operational strengths and relatively lower valuations. After a solid first half for many small-caps that fit these descriptions, things went south in a hurry.
During most of the second half of 2014, almost nothing we did as a firm worked. It wasn't simply that quality small-caps didn't do well—our more opportunistic and GARP-oriented portfolios were also out of sync, as were our dividend-paying portfolios. Some portfolios were overweight in Energy stocks, but we have a number with very low exposure to Energy that didn't fare much better.
continue reading: http://www.roycefunds.com/insights/2015/01/chuck-q4-interview-positioning-for-normalizing-economy
