It was the sort of year that, when you first look at the final equity market returns, might seem unexceptional, almost quiet. It is only when plugged into the context of the long, mostly bullish market since March 2009 that 2015s more muted results begin to make more sense one could even be forgiven for wondering why the losses for the major domestic stock indexes were not steeper than they were at the end of December, considering the heights to which most indexes ascended following the end of the financial crisis. Yet the mostly single-digit losses that marked 2015 were the first negative calendar-year returns for small-caps since 2011 (as measured by the Russell 2000 Index). For their part, large-caps, as measured by the Russell 1000 and Standard & Poor's 500 Indexes, had low single-digit positive returns.
An equally important contextual piece is the larger macro situation and few stock market cycles have been shaped as deeply as the current period has been by forces beyond the companies themselves. So while factors such as interest rates, commodity prices, technological innovation, consumer confidence and the like always influence the movement of share prices to some extent, the fragility of the global economy in the years following the crisis has resulted in levels of central bank and other government interventions not seen since The Great Depression. These actions were almost assuredly necessary to keep the economy afloat. At the same time, however, these policies particularly zero interest rates and quantitative easing had significant unintended consequences. And only now, a full seven years after the tumult, is the situation in the U.S. slouching toward something resembling the Old Normal that is, in a business cycle in which access to credit is more constrained, borrowing has a cost (however low), and both financial health and profitable execution are likely to matter to investors. To be sure, the road back has proved both longer and more winding than any of us could have foreseen at almost any point over the last seven years. At this writing in January 2016, we know the path in front of us will have its own share of formidable challenges as we embark on the latest leg of the journey.
As equity investors, we find ourselves in a curious, ambiguous place. The number of risks affecting share prices (among other things) is long and somewhat chilling: Weak commodity prices, flagging currency in China, elevated credit concerns and geopolitical instability. By year-end, the spread between the U.S. 10-Year note and the Two-Year notewhich, when it inverts, often signals recessionhad narrowed to a point near the bottom of its six-year range at about 122 basis points. Still far from inverted, it is worth keeping an eye on. We also saw widening credit spreads, a growing number of defaults and additional signs of a potential credit crunch, especially in the energy industry. Our concerns over credit only intensified in light of the markets mild reaction to the Feds hike on Dec. 16. The situation is of particular interest and concern to us as small-cap specialists. As has been the case historically, a significant deterioration in access to capital would likely have a larger negative impact on small-caps, especially those carrying excess leverage. Of course, this development could also produce an advantage for more conservatively capitalized small-cap businesses and we own plenty across our value, core and growth strategies.
This is one facet of what we believe is a strong case for disciplined, contrarian, bottom-up small-cap approaches that put a premium on managing risk. More widespread success for these kinds of approaches would be a welcome departure from 2015, to which we are happy to say, Goodbye and good riddance.
'A wild ride to nowhere'
Our own Charlie Dreifus described 2015 as a wild ride to nowhere. We can think of no more fitting way to characterize the year, which was distinguished by high volatility and broadly divergent sector and industry results. The markets indecision and frustration displayed itself with 19 crossings back and forth over the flat line for the S&P 500. There were single-digit gains in 2015 for a few global and domestic indexes and single-digit losses for several more. The important exceptions to the downward trend were the Nasdaq Composite, U.S. large-caps and European issues small-caps in particular. The Nasdaq Composite was the clear domestic leader in 2015, while the large-cap Russell 1000 and S&P 500 just barely escaped a volatile and bearish December to finish with modestly positive results.
Within our chosen specialty of small-cap stocks, there were strong returns for Health Care and discreet, more growth-oriented pockets of Information Technology that were accompanied by losses for each of the indexs eight remaining equity sectors, including Energy, Materials, Industrials and Consumer Discretionary. Along with Information Technology, those four sectors have been among our largest portfolio weightings and/or substantial overweights versus our Funds respective benchmarks over the last few years. One can get a sense of how confounding 2015 was by noting the confluence of losses for Energy and Consumer Discretionary, which defied the historical trend of low energy prices creating widespread demand for discretionary purchases. Indeed, traditional retail stocks were a particular source of red ink for the sector, in spite of consumer confidence remaining high and select, mostly large online companies scoring significant successes. In fact, the 4.4% decline for the Russell 2000 in 2015 masks just how challenging it was to find strong small-cap performers, especially outside the bio-pharma complex. The difficulty becomes clearer in the context of the small-cap indexs decline of 10.1% on an equal-weighted basis in 2015. (Similarly, the S&P 500 was also down on an equal-weighted basis, falling 2.2% for the calendar year.)
Looking within small-cap from a style perspective reveals another year in which the Russell 2000 Growth Index, which was down 1.4%, outpaced the Russell 2000 Value Index, which lost 7.5%. Yet small-cap value actually fared better than its growth sibling during the third-quarter correction, losing 10.7% versus 13.1%. Perhaps more interestingly to us, at least small-cap value led from the July 17, 2015 high for small-cap nonearners through year-end, falling 8.0% compared to an 11.3% decline for small-cap growth. Down and flat markets have historically favored value, as well as other valuation-focused approaches, so it was reassuring to see that pattern recur, however briefly, in 2015. The last decade, after all, has belonged to small-cap growth. The Russell 2000 Growth beat the Russell 2000 Value for the third consecutive year as of the end of 2015 and finished ahead in seven of the last 10 calendar years, resulting in a historically wide margin of outperformance on a trailing 10-year basis through the end of 2015. As long-time believers in mean reversion, we suspect that leadership from value will be the more likely relative performance pattern going forward. (Certainly that has been the case through January the Russell 2000 Value Index has thus far held up better than its growth counterpart.)
Where are we now?
The question is: Where are we now? We first want to stress that, while the equity and other capital markets are under pressure, not all the news is grim. Several notable bright spots are present that militate against the rising wave of recessionary anxieties: Job growth in the U.S. remains steady while real incomes, as well as expectations, have risen. Perhaps more important is the fact that household formations picked up in 2015, and many expect them to rise again in 2016. The economy also received a probable boost late in December when the government passed a budget deal that increased spending and put business tax credits in place. These moves, which could add as much as 0.7% to U.S. GDP in 2016, could also help areas as diverse as technology, defense, consumer and nonresidential construction. With so much of the global spotlight on China, its also worth mentioning that the U.S. economy remains by far the worlds largest and has little dependence on that of China.
That being said, many investors are understandably anxious over the 4 Cs of commodities, currency, credit and China worries that were intense even before the massive sell-off that opened 2016. As mentioned, we peg the troubled state of the credit markets as the greatest concern for small-cap investors, especially in the near term. Yet we also believe that these uncertain conditions offer fertile ground for disciplined stock pickers (though Januarys ground probably felt more like quicksand for many). The driving force behind each of our distinct investment strategies value, growth and core is a bottom-up approach, the result of our firm conviction that deep knowledge of companies and their industry dynamics ultimately matter more than the larger macro picture. While the last five years have not been kind to these approaches, we think the seismic shifts in the markets of late are another sign that the next five years will be different.
In addition to the tightening credit climate, we think that the world is moving out of an intensely macro-focused phase into a more historically typical period that will feature lower equity returns. Long-term returns for the Russell 2000 have shifted from spectacular highs to levels more in line with their historical averages. We think returns for the next three to five years will be positive but lower than, or close to, their long-term average. In this environment, we expect leadership to come from companies with low leverage, high returns on invested capital and other financial and/or operational strengths, which should bode well for many of our holdings in more cyclical areas. So while there may be additional pain for many small-caps in the initial phase of a significant credit or other market-rocking event, we think financially self-supporting companies should emerge in far better condition than their more highly leveraged and/or less profitable peers. Earnings will matter. Their increasing importance should cause a shift in small-cap leadership away from unprofitable or money-losing businesses toward profitable ones. We see earnings growth, as opposed to P/E expansion, driving market returns as stocks seek to regain their balance later in 2016.
To be sure, we saw evidence of positive change during January 2016. As equity prices were falling at an alarming rate, most of our portfolios held up very well. In fact, 13 of the 14 funds in this Annual Review and Report outpaced their respective benchmarks in January. In addition, four portfolios Royce Dividend Value, Heritage, Small-Cap Value and Total Return Funds also outperformed the Russell 2000 for the one-year period ended Jan. 31. While not wanting to make too much of a short-term period, we were especially pleased by the strength shown by two funds Dividend Value and Total Return that have long histories of strong down market showings. We were also happy that outperformance, for both the bearish month and one-year period, came from two of our three bottom-up strategies, with value and core approaches faring well. These developments bolster our optimism for better times ahead.