Co-CIO Francis Gannon on the promising pace of small-cap earnings and what expanding global growth could mean for certain small-cap cyclicals.

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Small-Cap Industrials
Image source: Wikimedia Commons

The pace of small-cap earnings continues to trend in a positive direction, with results in many cases exceeding expectations.

Our friends at Furey Research Partners recently reported that, with 79% of the companies in the Russell 2000 Index having reported, third-quarter earnings were up 6.3%. This compares to expectations for increases at the rate of 2.1%—meaning that small-caps earnings were increasing at almost three times their expected rate.

Furey’s report goes on to say that 60% of the companies that had reported were beating earnings expectations while 56% were beating sales expectations.

More important given our own cyclical tilt here at Royce, the strongest sectors from an earnings standpoint so far in 2017 have been Energy, Information Technology, Industrials, Materials, and Financials—all cyclical sectors.1

Small-Cap Cyclicals

Small-Cap Cyclicals

Source: Furey Research Partners

These promising developments would remain just that if they were not substantiated to a large degree by what we’ve been hearing from management teams and seeing in results for many portfolio holdings.

In industries as diverse as trucking, water systems manufacture, healthcare equipment, paper and packaging, and RV components, we’ve seen and discussed both improved sales and earnings and better-than-expected long-term prospects.

In addition, we continue to see many holdings in various technology component manufacturing and process automation areas execute at high levels that have allowed them to benefit from the global tech buildout and automation wave that both still appear to be in their early stages.

Related to this is the gathering strength of the global economy. Many observers forecast that 2017 will show higher growth than 2016, and 2018 looks likely to outpace 2017 for OECD nations.

And this includes the U.S. economy.

In fact, we agree with the emerging consensus that the global economy is fundamentally sound and growing stronger. The data showing this strength was circulating prior to last year’s elections, though many investors did not seem to take full notice of it until after all the votes were counted.

To be sure, this dovetails nicely with our contention that certain small-cap cyclicals, particularly those with more global exposure, remain very well-positioned to benefit from global growth—with or without fiscal policy implementation.

In fact, we wonder if the tonal shift to a more optimistic outlook that we began hearing from companies following 2016’s election had more to do with underlying economic strength than with the election itself—the small-cap bottom on 2/11/16 may ultimately prove to have been a more auspicious date for small-cap investors than 11/8/16.

Stay tuned…

1Cyclical and Defensive are defined as follows: Cyclical: Consumer Discretionary, Energy, Financials, Industrials, Information Technology, Materials. Defensive: Consumer Staples, Health Care, Real Estate, Telecommunication Services, Utilities

Article by The Royce Funds