Chuck Royce: Is the Improving Economy a Good Sign for Active Managers? by Royce Funds
There are still enough opportunities out there to keep returns in positive territory through the end of 2014. This could make the market’s next act a very happy one for active small-cap managers.
Whatever other opinions we may all hold about the stock market’s behavior over the last six years, we think everyone can agree that it has certainly been dramatic.
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The action began in earnest in the fall of 2008, although it is important to recall that small-cap stock prices had actually been falling for more than a year prior to that—the peak for the Russell 2000 Index having been established on July 13, 2007.
Yet the full effects of the bear were unleashed by the events of the Financial Crisis, which keyed the dangerously precipitous nosedive of share prices in the fall of 2008. The tumult lasted until small-caps finally hit a bottom on March 9, 2009.
The fear and anxiety the descent created, however, reached into the next several years. The feeling of extraordinary fragility that characterized the early days of the recovery in the spring of 2009 did not magically evaporate when markets began to find their feet again.
In fact, one could argue that these emotions dominated the behavior of investors at least until the end of 2012.
The three years from 2010 through 2012 were eventful, even if the stress and excitement they generated did not equal that of the first six months of 2009.
In fact, much of the market’s most extreme moves in that entire four-year span (2009-2012) took place in the first six months of those years, driven in large part by events both actual and potential.
The recession in the U.S., debt issues in Europe, and slow growth in China were all very real, while a double-dip recession here at home, default in Europe, and implosion in China fortunately failed to materialize.
By the end of 2012, with the stock market climbing and the economy expanding, investors seemed to recognize that, in spite of high volatility and political uncertainty, equity returns had been solidly positive since the March 2009 bottom. This improved confidence helped to spur a different kind of dramatic arc.
The long, slow recovery entered a new phase in 2013—a heady, and virtually correction-free, bull run in which returns for each of the major domestic stock indexes topped 30%.
The curtain opened on 2014, then, on the heels of one of the better calendar-year performances in the history of domestic equities, which followed four consecutive years of mostly rising stock prices in an uncertain economy.
So the question now is, what is the next act for equities?
Some argue that the economy is not strong enough to really take flight. They worry about the rich valuations sported by large numbers of stocks.
Others see the relative absence of volatility as a sign of complacency and fret that stocks are about to enter a destructive bear phase.
There are those who point to increasingly unsettled international situations, such as in Ukraine, Syria, and Iraq, and argue that the market cannot continue to pretend that events in these nations take place far offstage, not in an increasingly intertwined global economy.
We, however, are in accord with the more widespread consensus that sees the U.S. economy as gradually normalizing.
As evidence we would point to the following: The deficit continues to fall, the Fed continues to wind down the rate of its monthly bond purchases, and interest rates, though they remain close to zero, look likely to rise again in the near future as they did last year between May and December.
Inflation is tame, commodity prices stable. Volatility, as measured by the VIX, finished the first half of 2014 at low levels not seen since 2007. Add an increasingly robust M&A market, and it seems to us that the recipe for ongoing growth—and bullishness, however mild, at least compared to last year—seems almost complete.
And this process of normalization looks likely to accelerate as the Fed’s role recedes further and further into the background, setting the stage for a more dynamic pace of growth.
So while there remain voices who insist that stocks are overvalued, we think the case for additional gains, which could include a correction along the way, remains persuasive.
It seems to us that the relatively lower returns of the first half of 2014 indicate not an end to a bull phase, but a chance for the market to catch its breath and assess its surroundings.
It may be that investors need a break from all the drama, a respite from the unrelenting pace of the last six years. So the desire to stand back for a moment and evaluate what is happening seems eminently reasonable.
How many investors have enjoyed more than a few moments of true calm since before the recession began back in 2007? Ultimately, we suspect that both the expanding economy and slower pace of returns will result in more fundamentally focused investors.
Indeed, the indications that the strength of companies and the businesses they manage are beginning to matter more than indexes and the macro events that move them go back to the spring of 2012, when quality stocks—those with high returns on invested capital—enjoyed a brief run of outperformance.
This nascent phenomenon re-started—again, briefly—in May 2013 when the 10-year Treasury rate reached a bottom. Quality companies, particularly those in our chosen small-cap space, have not yet emerged as leaders, but they have inched closer over the last two years. Correlation levels throughout the market are falling.
These are excellent conditions, in our view, for disciplined active management approaches, especially those with a long-term investment horizon.
No Direction Home
U.S. stocks turned in a respectable performance in the first half of 2014. If results were not as lofty as they were in the first half of 2013 (and they were not), they were achieved in a more tranquil domestic environment than in the first halves of 2010, 2011, or 2012.
One consequence of the more relaxed atmosphere of the first half was that stocks did not seem to know quite what to do with themselves. While the overvalued/not-quite-overvalued-yet argument goes on, the market has not established a clear direction so far in 2014.
The year began on a more moderate note following a red-hot second half of 2013. The bull has so far remained in place during the current cycle; he simply slowed his run to a brisk walk in the first half.
For the year-to-date period ended June 30, 2014, the major domestic indexes remained in the black. The small-cap Russell 2000 Index gained 3.2%, taking a back seat to the more tech-oriented Nasdaq Composite, which advanced 5.5% in the first half, and the large-cap S&P 500 and Russell 1000 Indexes, which scored respective gains of 7.1% and 7.3% for the year-to-date period ended June 30, 2014.
After a challenging first quarter, many Asian equities bounced back in the second and finished closer to the European indexes, most of which had been on a tear prior to cooling off in the second quarter.
The Russell Midcap continued its notable 2014 performance, rising 5.0% in the second quarter. This gave mid-caps an impressive 8.7% advance on a year-to-date basis. In contrast, micro-caps struggled in the second quarter, suffering more in the brief downturn than their larger cousins.
Many mid-cap stocks have demonstrated strong records of growth over the last few years, and their success throughout the entire post-Financial Crisis cycle has not been a surprise to us. In fact, mid-caps have been an area of significant interest to us for years now.
The small-cap and micro-cap spaces have, by contrast, high numbers of very speculative companies and are typically more volatile—sometimes much more so in the case of micro-caps. They have also enjoyed very strong results over the last several years.
The three- and five-year annualized returns through the end of June for the Russell 2000 and Russell Microcap Indexes were terrific on an absolute basis.
With equity investors acting more cautiously, if not always consistently, so far in 2014, the relative breather for small-cap and micro-cap stocks—and we do not think it’s any more than a breather—was also not a surprise.
We are very bullish about the prospects for active small-cap management.
We have an obvious bias in favor of active approaches here at Royce, but we think that over the last 14 months—dating back to the low for the 10-year Treasury in May of last year—we have reached a point at which active management in small-cap stocks simply makes more sense, especially for long-term.
Since that May 2013 low, company fundamentals have gradually become more important as drivers of share-price success.
Rather than invest in a small-cap index vehicle in which approximately 25% of the companies are losing money (as was the case for the Russell 2000 for the 12 months ended May 31, 2014), we think it is smarter for investors to consider portfolios that look for well-run, financially strong companies with attractive long-term prospects.
So while quality has not yet seized small-cap leadership, we suspect that the reign of low-quality stocks is coming to an end. In our view, the next phase will be one in which companies with attractive characteristics such as strong balance sheets and high returns on invested capital should begin to lead.
In spite of not showing as much strength when the market was recovering in May and June, many did well enough to lead the small-cap pack from the 2014 high in March through the end of the first half.
We would expect something like this pattern to continue at least through the end of the year as the market continues to adjust to the growing normalization of the economy.
With diverse small-cap sectors such as Consumer Discretionary, Health Care, and Information Technology showing sizable declines since the end of February, we have been looking closely there (and elsewhere) for what we think are attractively priced, fundamentally strong small-cap businesses.
As always, volatility in the small-cap market is something that we seek to use to our advantage, even when it is in short supply.
We feel somewhat fortunate in that we do not need to choose a side in the “overvalued versus ongoing bull market” debate. Rather than trying to make a correct market call, our attention has been focused on those potential opportunities that can materialize even in a widespread bull market.
Corrections can arrive at any time, of course, and it has been a while since we have seen one of any significance. The last downturn of more than 10% for the Russell 2000 occurred in the fall of 2012. And share prices recovered so quickly from the 9.1% March-May decline this year that the down phase barely registered.
This might lead one to argue that the market is being set up for at least a decent-sized pullback.
Our sense, however, is that we are more likely to see smaller ones in the 5-10% range as part of the ongoing bull phase. Against the backdrop of an economy that looks poised for faster growth, a Fed tapering at a healthy clip, and an interest-rate environment in which a steady rate of increase is much more of a “when” than an “if,” less severe downturns look more likely.
Small-cap valuations on the whole are above average, though not unreasonably so given near-zero interest rates and low inflation.
A number of anomalies remain in the market, and in many cases we see a wide disparity between what look to us like expensive stocks and those that look inexpensive on an absolute basis.
The market seems to be in the process of sorting that out—certainly those areas of the market that do not interest us, and that did well in 2012 and 2013, have been more volatile so far in 2014.
In addition, we are still seeing companies that look attractively valued to us based on their fundamentals. All in all, it is looking more and more like a stock-picker’s market to us.
We could see the second half of the year being pretty similar to the first in terms of the overall returns for stocks.
More important, we think there are still enough opportunities out there to keep returns in positive territory through the end of 2014. This could make the market’s next act a very happy one for active small-cap managers.