Slow Global Growth Hitting Small-Cap Cyclical Stocks by Royce Funds

As of October 13, the small-cap Russell 2000 Index was down 12.9% from its 2014 high on July 3—a double-digit correction not seen in more than three years. With the U.S. economy slowly improving and Fed tapering winding down as scheduled, what is driving this pullback? Co-Chief Investment Officer Francis Gannon talks about economic growth beyond our borders and how it has been playing a role in shifting investor sentiment.

Slow Global Growth Hitting Small-Cap Cyclical Stocks

Investors can be forgiven if they felt like Halloween arrived a little early this year.

Volatility has returned to the equity markets with a vengeance of late. Investors fear that the pronounced economic malaise that currently holds Europe and Asia in its grasp may spread to the U.S. As of October 13, the small-cap Russell 2000 Index was down 12.9% from its 2014 high on July 3.

While there have been a number of mild pullbacks in recent years, the small-cap market had not seen a double-digit correction for more than three years prior to this most recent decline. Interestingly, the third quarter of 2014 also saw the first negative quarter for the small-cap index in the last nine.

A closer look at the correction-to-date and the just-completed third quarter reveals some compelling developments that began with a down month in July in which the Russell 2000 lost 6.1%. Federal Reserve Chair Janet Yellen’s comments about “stretched” valuations within small-cap, specifically biotech and the social media end of technology, made an already anxious small-cap market even more uneasy.

Most of our Featured Funds were also down during the month, though most outperformed their respective benchmarks. In August, the Russell 2000 rebounded with a 5.0% gain, and in this strong positive month most of these same portfolios trailed their benchmarks—again, as we would typically expect.

September, however, was an unusual month that dispensed with history’s more familiar script. The pace of global economic growth was questioned while here in the U.S. Fed tapering continued to wind down.

What, then, made September, and ultimately the third quarter, so unusual and far more of a trick than a treat for most equity investors?

It was not the 6.1% decline for the Russell 2000 in September. September was unusual because it did not matter where you were on the quality spectrum, which often provides down market protection. What mattered in this unpredictable period was one’s sector exposure.

Our sector exposure varies, but for the most part our Featured Fund portfolios have been overweight most recently in economically sensitive sectors, including Consumer Discretionary, Energy, Industrials, Information Technology, and Materials, and underweight in more defensive areas such as Health Care and Utilities.

During September, mounting concerns about the slowing pace of global growth disproportionally hit economically sensitive areas of the market, resulting in steep net losses within the Russell 2000 for Consumer Discretionary (-5.3%), Energy (-15.4%), Industrials (-7.4%), and Materials (-8.6%).

Two unwanted tricks were handed out with these declines: First, the sell-offs have tended to be highly indiscriminate, taking little account of small-cap companies with the kind of strong fundamentals that we seek, such as strong balance sheets, positive cash flows, and high returns on invested capital.

Second, the violent swings of high volatility have lasted well into October. As of October 23, the Halloween month was positive for small-caps but negative for most large-cap indexes as well as most non-U.S. indexes, regardless of cap size.

Corrections are of course a normal part of the equity landscape. From our perspective, the market dislocations of September and October seem to be driven, at least for the moment, by a clear sentiment shift in global growth expectations.

We have always thought that having a long-term investment horizon is of paramount importance. This is especially true in a transitional phase from Fed-driven liquidity to a more exclusively growth-driven market.

Uncertainty might abound right now to the point where many investors may feel like they’re lost in a haunted house, but our approach remains consistent and we have stayed calm.

The indiscriminate selling has allowed us to re-enter some of our favorite names at absolute valuations with which we are very comfortable. And finding what we think are excellent businesses at attractively discounted prices is our favorite kind of treat—at Halloween or any other time of year.

Royce Featured Funds Average Annual Total Returns as of Quarter-End 9/30/14 (%)

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Average Annual Total Returns Annual Expenses
Fund QTR1 YTD1 One-
Year
Three-
Year
Five-
Year
10-
Year
15-
Year
Since
Inception
Date Gross
Operating
Expenses
Net
Operating
Expenses
Pennsylvania Mutual -7.58 -5.70 3.29 18.32 12.56 8.45 10.78 16.002 1/1/1900 0.93 0.93
Premier -8.55 -1.85 5.86 16.13 12.55 10.05 11.88 12.13 12/31/1991 1.09 1.09
Micro-Cap -10.03 -9.11 -2.78 9.31 7.71 7.30 10.63 11.76 12/31/1991 1.56 1.56
Low-Priced Stock -9.83 -1.69 2.21 7.75 6.70 6.31 10.22 11.12 12/15/1993 1.51 1.49
Total Return -6.47 -3.91 4.44 17.93 13.08 7.99 9.98 11.06 12/15/1993 1.18 1.18
Heritage -7.38 -4.69 1.23 15.47 10.99 8.98 10.50 13.12 12/27/1995 1.49 1.49
Opportunity -8.99 -6.24 3.79 24.81 14.61 9.00 12.21 12.82 11/19/1996 1.17 1.17
Special Equity -7.06 -6.91 -1.04 16.50 11.60 8.15 11.11 9.38 5/1/1998 1.13 1.13
Value -5.60 -2.37 5.87 15.16 10.44 9.18 N/A 10.86 6/14/2001 1.48 1.48
Value Plus -6.53 -2.72 5.12 18.30 10.55 7.72 N/A 11.87 6/14/2001 1.49 1.49
100 -9.00 -6.47 0.12 16.58 10.54 9.62 N/A 10.49 6/30/2003 1.51 1.51
Dividend Value -7.41 -4.31 3.91 18.32 13.54 9.34 N/A 9.17 5/3/2004 1.52 1.52
Global Value -9.81 0.15 4.34 5.87 7.29 N/A N/A 4.90 12/29/2006 1.84 1.70
International Smaller-Cos -7.04 -0.92 4.30 10.04 7.56 N/A N/A 6.00 6/30/2008 2.08 1.70
Special Equity Multi-Cap -0.44 4.88 12.03 20.80 N/A N/A N/A 15.39 12/31/2010 1.46 1.24