CEO Chuck Royce and Co-CIO Francis Gannon explain why they saw familiar signs of a small-cap bottom in mid-February, what the first quarter’s dramatic and earnings-driven reversal for both small-cap value and cyclicals may mean, and why the recent turn toward higher-quality fundamentals is likely to last.
Do you think the market hit a likely bottom on 2/11/16?
Chuck Royce (Trades, Portfolio): I do. We’ve seen all the signs one typically finds in a bottoming out process—panic-selling in a number of sectors (most notably within the bio-pharma complex), small-caps losing more than large-caps, greater resilience from value stocks, the continued implosion of oil prices, other commodities struggling, anxiety over possible bank defaults, and the devaluation of currency in China—all of these led to a few sessions in which hysteria ruled the equity markets.
I think what's most important is that the recent downturn, which stretches back to the small-cap peak on 6/23/15, was a classic bear market. The Russell 2000 lost 25.7% from that peak through the 2016 small-cap low on 2/11/16.
That means the bear was awake. It also meant a leadership shift to small-cap value, one that we think can last. The Russell 2000 Value Index outperformed the Russell 2000 Growth from last June’s peak through the end of March as well as in 2016’s first quarter.
After several years of trailing its small-cap growth counterpart, value looks poised for what could be a lengthy stint of small-cap leadership.
What led to the recent rebound for many of your more cyclical holdings?
Francis Gannon: I think it's been fundamentally driven by the earnings outlook. We saw it first in October of last year and again in February of this one. Many companies, including several of our holdings, reported decent earnings while also not revising guidance downward.
This was a positive in that expectations were so low, particularly for companies in more economically sensitive sectors, that "pretty good" or "not that bad" was in several instances much better news than people were expecting. And the general lack of downward earnings revisions both last fall and this year allowed for some recovery for these companies' shares.
To be sure, the rebound for these companies last fall was very brief, and so far this year it has been as well. But we think the current strength is more likely to last—we're encouraged by the fact that in 2016's first quarter, many of our cyclical holdings held up better when the markets were falling and remained strong when shares recovered.
We didn’t see much of that dual strength during 2015. And most of the surprises in our industrial and consumer holdings this year have been on the upside.
What level of growth do you think is needed for companies in more economically sensitive areas to continue rebounding?
Chuck: I suspect growth has to be only modestly positive for these areas to do well—something in the 1-2% range. We've seen many companies that we hold manage themselves very effectively over the last several years when growth ranged anywhere from -1% to close to 2% on average.
So we're confident that even a low, positive growth rate can be enough, especially when you factor in how low expectations and a preference for faster-growing stocks have depressed the share prices of so many small-caps that we see as terrific businesses.
Francis: I think it's important to emphasize just how well many businesses have adapted to the "New Normal" of slower growth. So while we'd all love to see a more robust pace here at home and abroad, we're very pleased with the way that management teams continue to find ways to cut costs while remaining both profitable, productive, and innovative—innovation is not the sole province of growth companies.
We're also seeing what looks like an improved M&A climate so far this year, and we hold companies that are being acquired as well as those that are buying. To us, this is a strong sign that better businesses are continuing to find creative ways to meet the challenges of the slow-growth state we're in.
What do you make of the disparity between the alarmist headlines earlier in the quarter, recent, more positive developments, and what you've been hearing from companies?
Francis: First of all, the pessimism is noticeably less pronounced than it was a few months ago, when poor holiday sales and the concerns Chuck mentioned resulted in a lot of nervous chatter about the state of the economy and capital markets.
Lately, we've seen more stability in both the stock market and oil prices, which have run in parallel over the last several months, so the more melodramatic tone of the news has subsided.
However, all it would take is another jolt—a significant slide in oil prices, bad news out of China, a geopolitical event—for pessimism to return to the headlines. But based on what we see in our analyses and hear from companies, we think the U.S. economy is basically sound.
Chuck: It's very interesting to us that the kind of extreme negativity we saw in the headlines seemed disconnected to both the company fundamentals we were evaluating and the tone of our meetings with managements, both of which painted a relatively more positive picture, suggesting that things were not nearly as awful as the market's movements were indicating.
Of course, active management is designed to sort truth from fiction, and the truth we were seeing and hearing every day gave us a much more sanguine impression.
In what range do you expect small-cap returns to fall over the next few years?
Chuck: If you look at small-cap returns following bear markets, they've historically been very strong. But we also have to consider the strength of small-cap performance from 2012 through the first half of 2015, results were often well above their historical averages.
In addition, small-cap P/E levels look higher than they typically do during bear markets. So we think returns are almost definitely going to be lower than they were through June 2015 but we also think they'll be positive—anywhere from high single digits to low double digits annualized over the next three years dating from the February 2016 low.
In any event, we're confident going forward because many of the risk-conscious, company-specific approaches we use here at Royce have generally been successful whether returns were negative, flat, or low.
Are you still more concerned about credit spreads than interest rates?
Chuck: We are definitely more concerned with widening credit spreads than we are with interest rates and the actions of the Fed.
It's also important to remember that QE and zero interest rates made credit more widely available than it should be in what I would call a normally functioning economy. For businesses that are carrying a lot of leverage and/or aren't profitable, credit shouldn't be so easy to obtain.
Of course, there are legitimate concerns about the expanding spreads: When credit contracts, smaller, more fragile businesses tend to feel the negative effects most acutely. For example, I think widening spreads absolutely had an influence on the more severe downturn for small-caps than large-caps through the first month-and-a-half of the year.
As difficult as that period was, however, we saw it as another step, however painful, on the road to normalization, while our own cautiously optimistic take on the economy has helped to mitigate our fears of a significant credit event.
Of course, we're also aware that tightening credit can be like a time-released capsule, with a slowly building, cumulative effect. We continue to watch spreads very closely, though right now we don’t see any evidence of a financial crisis or any signs of a looming recession.
Why do you think fundamentals such as earnings and free cash flow generation should matter more to investors in the current cycle?
Chuck: It has to do with the historical realities of equity investing. In spite of what we all experienced over the last five years, the best measures of a company's financial health remain attributes such as a strong balance sheet and the ability to generate free cash flow, while profitability remains the foundation for the ongoing stability and sustainability of any business.
Periodically, investors lose sight of these basic realities and get caught up in trends. We saw this in the "Nifty Fifty" market in 1973-4, in the tech bubble, and over the last few years. In this last case, these arguably ill-advised investor preferences were unintentionally aided and abetted by the easy money policies of the Fed.
But that's all changing, which should be good news for disciplined active managers like us.
Do you anticipate more market volatility over the next few months?
Francis: Yes, we do. Of course, short-term moves are usually the hardest to anticipate, but we think things are likely to remain somewhat volatile going forward.
We could see the market pulling back, recovering, then pulling back in a sort of two-steps-forward, one-step-back type of movement, perhaps bumping along the bottom as it does.
However, we think the worst is likely behind us. In any event we feel very good about the prospects for active small-cap management in the coming months.
Important Disclosure Information
Mr. Royce's and Mr. Gannon's thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
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