Portfolio Manager Chuck Royce (Trades, Portfolio) and Co-CIO Francis Gannon recap 2Q18 and look at why the current state of small-cap looks so curious to us.
What was your take on 2018’s second quarter?
Chuck Royce (Trades, Portfolio) It was a really curious quarter in many ways. Although it finished on a wild and bearish note, it was both a lot more bullish and a lot less volatile than the first quarter. We also saw a late shift in style leadership within small-cap that we’ll be watching very closely. And while the end result was good news for small-cap stocks—the Russell 2000 made a new historical high and more than doubled the return for large-caps, up 7.8% versus 3.6% for the Russell 1000—we’re wary.
Our concern is the disconnect between the confidence of the management teams we’ve met with and the relatively underwhelming performance for many cyclical industries. We anticipated that stocks in these industries would do better owing to their earnings and prospects as well as to the strength of the U.S. economy. In a similar way, the faster pace of economic growth seems at odds with the ongoing weakness of 10-year Treasury yields. So domestic small-cap returns look wonderful, but when we check under the hood, as it were, there are a few issues that have us concerned in terms of sustainability and style leadership.
How did 2Q18’s domestic small-cap results compare with those outside the U.S.?
Francis Gannon It was a much better quarter for U.S. stocks than it was for international companies, mostly due to currency issues. Domestic stocks were solidly positive in spite of several challenging developments, including tariff and trade war talk, a strengthening dollar, market and economic softness in China, slower growth in Europe, and negative news out of Brazil and Argentina. To varying degrees, all of these developments made the last weeks of June by far the most volatile of the entire second quarter.
The international indexes slipped deeper into correction mode during the second quarter. Indeed, the combination of a modest slowdown in international growth, rising emerging market instability, heightened trade war concerns, and especially a stronger dollar led investors to prefer all things domestic.
Have you been surprised by the recent performance for small-cap value stocks?
CR We were pleased to see value stocks outperform this past quarter, but I’d say we’ve been more surprised by how well growth has performed over the last 18 months, especially in relation to small-cap value. The stage has been almost perfectly set for small-cap value to outperform—strong growth in the U.S., related increases in corporate profits, and rising interest rates—all of which have historically been tailwinds for value.
2Q18 Shift to Value Leadership
Quarterly spread between the Russell 2000 Value and Russell 2000 Growth from 3/31/17–6/30/18
These factors strongly suggest a more sustained period of leadership for value. But each of these factors has been present for the last year-and-a-half—and growth has beaten value in five out of the last six quarters. So while it was encouraging to see value’s relative advantage in the second quarter, it’s been frustrating that a performance edge has been mostly absent while the economy has been expanding.
Where do you think we are in the current small-cap cycle?
FG When we look at previous small-cap cycles, we find that the median recovery following a bear market—which we had with the 25.7% decline for the Russell 2000 from 6/23/15 through 2/11/16—was 98.8%. From the February 2016 bottom through the end of the second quarter, the Russell 2000 has so far gained 78.1%. So it’s certainly possible for small-caps to keep running, especially considering the strength of the economy.
Small-Cap Up Market Performance
After a Decline of 15% or Greater
Median includes only full recovery periods
CR I agree with Frank—I think the cycle may have room to run. However, it’s also helpful to keep in mind that the Russell 2000’s two-year cumulative return at the end of June was 46.5%—that’s not a sustainable pace. So we’re really of two minds about the current cycle. On the one hand, we’re optimistic about small-cap earnings growth and like the fundamentals of many holdings in terms of balance sheets, cash flows, and earnings strength. But we also think that we could see some consolidation or a correction—the latter certainly seems more probable now than it did a year ago. And the kind of leadership change that we expect—from growth to value and from defensives to cyclical—seldom occurs without a fair bit of turbulence.
So your expectations for small-cap earnings growth remain positive?
FG Our expectations for small-cap earnings growth are still pretty positive. Earnings for small-caps have grown so far in 2018, in many cases showing robust, better-than-expected increases. And our own analyses show that many companies in cyclical industries continue to show strength and growth on an absolute level and relative to defensives and large-cap as a group. Needless to say, the earnings profile for many portfolio holdings across all of our strategies supports this data.
CR It also seems to me that the strength of small-cap earnings has been largely lost in the headlines. Whether the attention has been fixed on macro events such as trade wars or the ongoing strength of mega-cap names, such as the ‘FAANG’ (Facebook, Amazon, Apple, Netflix, and Google) group, the fact that small-cap earnings have been very good over the last 18-24 months hasn’t received a lot of play. The conundrum is that cyclical stock performance has steadily lagged cyclical company performance—and it’s not clear to us exactly why that’s happened.
Based on that, what is your analysis of the state of small-cap valuations?
FG If you look at the P/E ratio for the Russell 2000, valuations don’t look especially rich. However, when you look at the last twelve months enterprise value to earnings before interest and taxes (EV/EBIT), as we prefer to do, then you find higher-than-average historical valuations. And this corresponds to the higher-than-average returns for the one-, five-, and 10-year periods ended 6/30/18 for the Russell 2000. So we could see a longish period of multiple compression, which is another reason why we’re so focused on select small-caps with strong earnings prospects and/or modest valuations. If we see increased volatility over the balance of the year, these types of stocks look better positioned to cope more effectively with the turbulence.
Many Small-Caps Sell at a Significant Discount
Bottom Three Deciles in Russell 2000 Median LTM EV/EBIT1 ex negative EBIT as of 6/30/18
1 Last Twelve Months Enterprise Value/Earnings Before Interest and Taxes
CR There’s another related point that we think is equally important when considering valuations: The sheer size and diversity of the small-cap asset class means that there are almost always opportunities to find what we think are promising or quality businesses trading at attractive discounts. Looking again at EV/EBIT, you find that the bottom three deciles of the Russell 2000 were trading at healthy discounts compared to the average for the index as a whole.
Do you still believe the economy and markets are on the road to normalization?
CR I’d say the economy has been on that road for a while now. Through the end of June, the U.S. economy had grown for 109 consecutive months, current GDP growth has converged with its long-term average, unemployment recently reached an 18-year low, personal consumption expenditure inflation hit the Fed’s 2% target in May, and short rates are rising, which is another important sign. The economy looks both strong and historically normal to me. Markets, however, are another matter.
FG As Chuck mentioned, the very noticeable—and stubborn—exception on the road to normal has been the 10-year Treasury yield and the asset values dependent on it. In fact, the most frustrating detours on the road to normalization have occurred when the 10-year has fallen back. It seems to me that each time this has happened over the last 18 months, the market has seen a flight to high yield or growth stocks while value and economically sensitive issues lag. It’s as if investors become temporarily convinced that we’ve fallen back into the quantitative easing and zero interest rate era.
But the current environment, with higher inflation, accelerating growth, and rising rates, couldn’t be more different. We’re cautiously optimistic that this will lead some investors to rethink their preferences and focus more on earnings, though it’s also possible that the shift in small-cap leadership won’t run a smooth course.
Road to Normalization: Economy vs Markets
Source: Bloomberg
As risk managers using bottom-up approaches, how do you think about inflation?
CR We think about it a lot for the simple reason that what companies pay to do business has an impact on margins. So we look not only at the usual data such as the CPI (Consumer Price Index), but also wage growth, input costs, and anything else that raises the price of doing business.
A company’s cost structure is also very important. That’s the main reason why our strategies typically have such low exposure to commodity-based businesses. Commodity prices are notoriously volatile and unpredictable, and it’s not always possible or advisable to pass on those increased costs to customers. So it’s something that we’re always aware of, and in the current environment, we’ve been looking most closely at wage growth—because companies have been more challenged to fill positions—and rising input costs, whose effects have not shown up as much as we think they will as the year rolls on.
Are you concerned about trade wars and tariffs?
CR Even with all the admittedly concerning trade war and tariff talk, I have to think that policies will ultimately settle in a place that’s advantageous for global growth—in particular because that’s what’s in our own best interest here in the U.S. We also suspect that many investors are not aware of how many small-cap companies have operations overseas as well as in the U.S. and are therefore far less vulnerable to tariffs than may be thought.
Do you still generally prefer small-caps in more cyclical industries?
CR Yes, and historically that’s been the case because cyclicals are where we’ve typically found the best combination of value, quality, and/or growth prospects—it’s a function of our bottom-up process rather than a top down view of the economy. This has given many of our portfolios perennially higher weightings in Industrials, Information Technology and, to a lesser extent, Materials.
Additionally, our investors can expect us to lean into those areas where we see excess pessimism. Most recently, we’re seeing superior fundamentals based on earnings and cash flow quality, as well as confident management teams, in selected cyclical areas that other investors are avoiding more than we believe is warranted. For example, the supply/demand dynamics in a number of industries, such as semiconductors and semiconductor equipment, transportation, and chemicals, seem favorable to us and are not fully reflected in their current valuations.
FG Many of these cyclical companies look much better positioned to us for intermediate-term growth than defensive and/or growth stocks. So while they’ve mostly lagged over the last 18 months, they’re also much more reasonably priced than defensives based on EV to EBIT. We remain convinced that fundamentally strong small-cap companies, especially those with attractive-to-reasonable valuations, will become more appealing to investors as confidence in the U.S. economy continues to build.
Cyclicals Cheaper than Defensives
Median LTM EV/EBIT¹ Ex. Negative EBIT for Russell 2000 as of 6/30/18
¹ Last Twelve Months Enterprise Value/Earnings Before Interest and Taxes
What is the current case for active management?
FG We think it’s worth noting that the three changes in the market environment that we expect—lower returns, higher volatility, and value/cyclical leadership—have all historically been coincident with leadership for active management.
We saw some enticing signs of progress in the second quarter that we’re squarely on the long road to normalization. This was mostly evident in the modest increases in bond yields and the reemergence of value’s leadership. We expect to see more signs of normalizing markets to emerge as the year goes on.
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.
This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. Please read the prospectus carefully before investing or sending money. Investments in securities of small-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see “Primary Risks for Fund Investors” in the prospectus.)
