Value Investing

Are Small-Cap Cyclicals Signaling Good News About The Economy?

Co-CIO Francis Gannon thinks that recent performance for certain cyclical sectors means that good news may be coming for the economy.

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Small-cap returns have often been seen as something like economic mood rings, those briefly trendy baubles from the 1970s.

Broad-based bullishness is thought to reveal confidence or optimism about growth while more narrow markets (usually led by defensive stocks) generally expose feelings of caution or even pessimism about economic prospects.

Through most of 2017, investors have leaned largely in the latter direction, which helps to explain the strength of Health Care—led by biotechnology—which led all small-cap sectors YTD through 9/30/17.

However, healthcare stocks had company when it came to leadership in 3Q17, when the best-performing sectors in the Russell 2000 Index were Industrials, Health Care, and Materials.

In the context of what has so far been a narrow, growth-led market, how did two highly cyclical areas end up bookending a more defensive, duration-oriented sector?

We would argue that the results were consistent with a market that appears to be transitioning from one where investors were uncertain about economic prospects to one in which confidence is building.

A closer look at quarterly results for industry groups and subgroups within both Industrials and Materials offers some context to our contention.

Industrials—a heavily weighted sector in many Royce portfolios—is a large and diverse area, which is one of the reasons our portfolio managers are typically so widely invested in it.

Its top-contributing industry group in 3Q17 was road & rail, where stock successes came from both primarily domestic trucking and logistics companies and small-caps involved in global transportation.

The machinery group also enjoyed a strong, index-beating third quarter. Several top performers came from both the industrial machinery and construction machinery & heavy trucks subgroups—two areas that feature a mix of domestic and global businesses.

Similarly, companies with a comparable blend of U.S. and international activities drove sterling quarterly performance for the air freight & logistics group.

Two companies in the Materials sector’s forest products subgroup are primarily domestic while a third has a global reach. All had double-digit returns in 3Q17.

In addition to strong results and/or improvements at the company level, it would seem that investors are also beginning to recognize the related fact that economic growth is picking up around much of the world.

"An economy which is expanding on a global scale should mean good things for small-cap cyclicals with modest valuations and global exposure."

To be sure, we saw this in 3Q17 performance for cyclical small-cap sectors beyond the U.S. The leading sectors in the Russell Global ex-U.S. Small-Cap Index were Information Technology, Industrials, and Materials, which adds further support to our central small-cap idea—that an economy which is expanding on a global scale should mean good things for small-cap cyclicals with modest valuations and global exposure.

Time will tell, of course. But right now, we believe more strongly than ever in the value of staying active.

Stay tuned…

Article by Francis Gannon, The Royce Funds