The Undiscovered Connection: Value-Led Periods And Active Management by Steve Lipper

We recently completed research into small-cap performance patterns that revealed a connection that we believe is significant. There seems to be a notable historical trend of active small-cap managers outperforming the Russell 2000 Index in periods when value stocks lead, while trailing the small-cap index when growth stocks lead.

Active Management

What’s Happening to Active Small-Cap Management?

Contrary to some investors’ perception, active small-cap managers actually have a strong relative performance record. Comparing Morningstar’s Small Blend category average (our proxy for active small-cap management) to the Russell 2000 Index over rolling five-year periods reveals that the Small Blend average beat the index 66% of the time.

What accounts, then, for the recent poor results of the active small cap managers? We recently completed research into small-cap performance patterns that revealed a connection that we believe is significant. There seems to be a notable historical trend of active small-cap managers outperforming the Russell 2000 Index in periods when value stocks lead, while trailing the small-cap index when growth stocks lead. If this pattern holds, it carries a number of important implications for the current market, particularly if we are beginning an extended period of outperformance for value.

Small Blend Funds Often Succeed When Value Leads

Our research first compared monthly rolling five-year returns for the “as published” Morningstar Small Blend category average to the Russell 2000, dating back to the index’s inception in 1979. We then separated each rolling five-year period into those in which the Russell 2000 Value Index led the small-cap market, and those in which the Russell 2000 Growth Index led.

The results were striking. Though the Morningstar Small Blend category average beat the Russell 2000 in 66% of all rolling five-year periods, it actually outperformed in 83% of value-led periods, but in only 21% of growth-led periods. And most periods—73%—were value-led, which contributed to greater relative success for active management.

Actively Managed Small-Cap Portfolios Outperformed in Value Led Markets 5-Year Monthly Rolling Returns from 12/31/78 through 6/30/16 (391 Periods), and & of the Periods Morningstar’s Small Blend Category1 Average Beat the Russell 2000 Active Management 1There were 559 US Small Blend Funds tracked by Morningstar with at least five years of performance history as of 6/30/16 Source: Morningstar

Scrutinizing Our Findings

These results were so compelling that we challenged them with four questions:

  1. Is the Small Blend category an appropriate proxy for active small-cap management?
    There are a number of limitations to using the Small Blend average. First, it only covers mutual funds, a subset of all active managers; second, Small Value and Small Growth managers are also active managers; and third, while Small Blend funds may be intentional about their style positioning, it may also be a residual of where their managers see current opportunities. We chose to use Small Blend as an active management proxy primarily because it is relatively style neutral and therefore a more appropriate comparison to the Russell 2000. Moreover, we feel confident that most observers would expect Small Value managers to do better versus the Russell 2000 in value-led periods. This beneficial relationship for Small Blend managers, however, was more unexpected.
  2. How could this data show such strong results when so few active small-cap funds are currently outperforming the index?
    The idea that only a few funds are outperforming the index is somewhat mistaken since 53% of Small Blend (main class only) funds (101 out of 192 funds) beat the index on a trailing five-year basis ended 6/30/16.
  3. Has this advantage been due to survivorship bias or funds moving from ‘Value’ to ‘Blend’?
    No. According to Morningstar, the Small Blend category average is in effect a frozen snapshot. We calculated trailing five-year returns from historical monthly category average return data which reflects all funds in existence that were classified as Small Blend in that month.
  4. Has this relative performance connection been consistent over time?
    The active spread of Small Blend versus the Russell 2000 for the trailing five years seems to have roughly tracked periods of value and growth leadership through history. This chart shows the active spread in green tracked along the spread between Russell 2000 Value and the Russell 2000 in gray. Periods of leadership for growth are shaded—they were relatively rare until the most recent seven-year period (2008-2015).

[drizzle]Active Spread of Small Blend vs. the Russell 2000 Five Years Ending 12/31/15 Active Management

Active Management

What explains this connection?

We wanted to know why value-led periods are far more conducive to active outperformance than growth-led periods. Our view is that two distinct factors affect this outcome: equal weighted portfolios vs. cap weighted indexes and active managers’ training.

Equal Weighted Portfolios vs. Cap Weighted Indexes

First, most actively managed portfolios weight their holdings closer to equal weighted than based on capitalization. This means that active managers are likely to be challenged when trying to keep pace with their respective indexes in periods with narrow leadership—those dominated by a comparatively smaller number of stocks at the upper range of the index constituents.

Growth-led markets tend to demonstrate narrow leadership more often than value-led markets, which typically feature broader participation. 2015’s results offer an instructive example of this performance profile of a growth-led market with narrow leadership. The market-weighted Russell 2000 declined 4.4% in 2015, but fell 10.1% on an equal-weighted basis. During the same year, the Morningstar Small Blend category trailed the Russell 2000, falling 5.3%.

Extending back in time, the relationships among value and growth, equal-weighted and market cap-weighted, and active and passive become even clearer. For the five years ended 12/31/15, small-cap growth led value (+10.7% vs. +7.7%), the Russell 2000 led the equal-weighted index (+9.2% vs. +6.5%), and the unmanaged (that is, passive) small-cap index led active managers (+9.2% vs.+ 8.3%). Unsurprisingly, over this same period only 45% of Small Blend (main class only) funds (85 out of 189) beat the Russell 2000.

In Sync: Growth, Cap-Weighted, and Passive Led Five Years Ending 12/31/15 (%) Active Management

From these observations, we would venture that value-led markets are characterized by a larger number of stocks advancing—and that this positive breadth helps create an advantage for active management.

Active Managers’ Training

The classic training for portfolio managers and analysts contains a heavy dose of valuation work. Successful active management can be distilled to identifying situations where the intrinsic value of a company is appreciably higher than its current stock price, and this may be a second factor in Small Blend’s advantage in value-led markets. The ability to effectively use various valuation metrics is integral to this practice. As a result, active Small Blend managers will lean towards stocks with valuations selling for less than their intrinsic value and quite often less than their relevant benchmark.

Seen this way, most active Small Blend managers could be described, to some extent, as value managers. Their respective investment disciplines will make them hesitant to own, and certainly reluctant to hold at the top end of their portfolios, stocks whose valuations are meaningfully higher than their index. Yet these are precisely the companies that lead in growth-led markets. These high valuation stocks are heavily weighted in the indexes, but either not held, or underweighted, by the majority of active managers.

What are the implications for investors?

Small Blend Outperformance Jumped % of Small Blend Funds that Outperformed in 1-Year Periods Active Management

With the usual caveats about past performance being no guarantee of future performance, there appears to have been at least a frequent concurrence of active small-cap managers outperforming the Russell 2000 during periods when value had market leadership. This has timely implications as we believe a sustained period of leadership for small-cap value began with the 6/23/15 Russell 2000 peak. For example:

The Russell 2000 Value beat the Russell 2000 Growth, -2.6% versus -10.8% for the one-year period ended 6/30/16.

Small blend managers have also done better over that most recent one-year period, with 58% (142 out of 243) outperforming the Russell 2000 over that time. This compares with only 31% (73 out of 233) outperforming during the one-year period ended 6/30/15, which was a growth led period.

It seems reasonable to expect that active managers may be in the early stage of a performance rebound so long as value maintains leadership over growth. Time will tell, of course, but it may be that the apex of growth leadership in the summer of 2015 was also this cycle’s peak of passive leadership in small-cap stocks.

We think it is likely that we are heading toward a period of outperformance for both value-led strategies and active management.

What are the implications for Royce Funds investors?

This dichotomy of relative performance vis-à-vis the Russell 2000 during value-led periods and growth-led periods has had meaningful impacts on most of our portfolios’ performance. To illustrate using our five largest Funds—Royce Opportunity, Pennsylvania Mutual, Premier, Special Equity, and Total Return—we have historically seen a notable difference in outperformance frequency in value-led periods versus growth-led periods.

Royce Funds Outperformed in Value-Led Periods

% Monthly Rolling 5-Year Periods Outperformed (12/31/78-6/30/16)

Opportunity 90 66 78
Pennsylvania Mutual 74 48 67
Premier 86 53 72
Special Equity 77 59 67
Total Return 93 50 72

We believe that the same factors affecting other active managers have affected our Funds as well.

So far this year, we are also witnessing the same rebound for active small-cap management for our portfolios versus the Russell 2000 as one might expect in a value-led market, based on the historical data.

Making the Case for Small Value Leadership

Our view is that small value stocks will lead small growth stocks over the next several years based on how far recent relative performance and relative valuation has been from historical precedent. We believe that regression to the mean has historically been one of the more powerful and reliable forces with investing. Simply put, when the current behavior of an asset class is an outlier compared with its longer term history then we think that the odds favor a reversal.

The seminal academic research on small value outperformance, Fama-French’s 1992 Journal of Finance paper, noted that small value stocks had outperformed small growth stocks over the 27 year period 1962-1989. Index relative performance supports this finding. Comparing the Russell 2000 Value and Growth Index shows that, on rolling 10 year basis since the indexes inception in 1978, Value beat growth by an average of 4.26%, and a frequency of 83%. Therefore, it is striking that the most recent experience has been so much of an outlier. As of June 30, 2016, small value had lagged small growth by 1.99%. Moreover, June was the 50th month in a row where small value trailed small growth on a trailing 10 year basis. As the chart below shows, this magnitude and duration of small value underperformance is a two standard deviation event–only matched once before in the past 25+ years which was during the late 1990’s tech bubble.

Russell 2000 Value vs Growth Annualized Trailing 10-Year Relative Return as of 6/30/16 Active Management

1. The 10-year average annual total return through 6/30/16 was 5.15% for the Russell 2000 Value and 7.14% for the Russell 2000 Growth. -1.99% represents the difference.  Standard deviation is a statistical measure within which a fund’s total returns have varied over time. The greater the standard deviation, the greater a fund’s volatility.

Russell 2000 Value and Growth Shifted Median Relative LTM EV/EBIT1 Russell 2000 Value/Growth from 6/30/01 to 6/30/16 Active Management 1Last twelve months enterprise value/earnings before Interest and taxes. Source: Factset

As one might expect, this relative underperformance of small value stocks has contributed to a valuation gap emerging as well. When analyzing valuation, we prefer to use a ratio of EV (enterprise value)to EBIT (earnings before interest and taxes) as we view this as a better valuation metric than price-to-earnings ratios for understanding a company’s true worth. Based on this EV/EBIT measure, the common stocks that make up the small value index currently sell at a 22% discount to those that make up the small growth index, compared with a 15 year average of a 7% discount. While there have been periods of greater valuation discrepancy, notably the years around the tech market peak in 2000, by this measure small value stocks sell at the lowest relative valuation we have seen since 2003.

We hasten to add that as active managers we find some areas of small cap value more attractive than others. Broadly, we see many cyclically-sensitive stocks as undervalued and are concerned about the valuations of many interest-rate sensitive stocks, such as REIT’s and utilities. That said, the history of relative performance and relative valuation both signal to us the potential for a multi-year period of small value outperformance.

Performance and Expenses

As of 6/30/16

  Average Annual Total Returns(%) Annual
Opportunity 1.11 3.22 -11.38 2.45 5.80 5.43 11.30 11/19/96 1.17 1.17
Pennsylvania Mutual 1.31 7.61 -4.76 4.69 5.58 5.57 13.023 N/A 0.93 0.93
Premier 2.01 6.51 -5.61 4.05 4.28 6.61 11.08 12/31/91 1.13 1.13
Special Equity 2.53 8.31 -4.58 3.36 6.81 7.24 8.62 05/01/98 1.15 1.15
Total Return 3.28 8.62 0.07 6.32 7.68 6.16 10.46 12/15/93 1.22 1.22
Russell 2000 Index 3.79 2.22 -6.73 7.09 8.35 6.20 N/A 12/29/78 N/A N/A