Is The Small-Cap Market Out Of Joint? by Royce Funds
While results for most stocks in the first half were decidedly bullish, the primary drivers of performance continue to be unsettling—especially for those with an active, risk-conscious approach who’ve lagged in an environment that has often shown favor to highly levered, non-earning, and more speculative businesses. The question is—when will the speculative bubble burst?
“The Time is Out of Joint”
Anyone reestablishing contact with the wider world at the end of June would no doubt be pleased by the numbers that guide the financial and economic parts of our lives. The economy, following a first-quarter stumble in which GDP is estimated to have grown by 0.6%, appears once again to be growing at a faster clip. One could argue that its pace could be livelier, but healthy employment numbers, improving wages, and robust housing and auto markets would seem to promise a quickening in the coming months. Inflation is, for now, not a matter of great concern. Interest rates remain low—and will remain that way on an absolute basis, even with an increase (or two) in short-term rates likely before the end of 2015. And a Fed-led increase in short rates may cause long-term rates to back up as well, which would be bad news for the bond markets, though perhaps not for stocks.
One could find positive developments in the equity markets through the first half of the year—or so it would seem. Returns for each of the major domestic indexes were in the black through the end of June, while a welcome recovery finally arrived for many non-U.S. stocks in the year’s first six months. Three- and five-year average annualized returns for the small-cap Russell 2000 Index, the Nasdaq Composite, and the large-cap Russell 1000 and S&P 500 Indexes all topped 17%, well above the rolling three- and five-year historical averages for each index. It would appear that we are living through good times for the economy and possibly great ones for equities.
Why, then, have we purloined a line from Hamlet to introduce our own take on stocks in the first half, one in which the titular protagonist warns of a troubling dislocation in the world around him? Some of the reasons are clear enough: Positive results for the first half notwithstanding, global equities were rocked by the highly publicized Greek default late in June. On the second-to-last trading day of the first half, many stocks gave away most, if not all, of their second-quarter gains. Markets in China faced arguably even more significant problems, considering how much larger and more important that nation’s economy is to the world compared to that of Greece. Chinese stocks plummeted 30% in the three weeks leading up to our Independence Day, making what seemed like a typical correction in June far more worrisome. A cut in interest rates and more relaxed rules for margin trading—both hastily put in place late in June—did little to stem the tide of selling.
Closer to home, there is the matter of how thoroughly disjointed results were for domestic equities. Large-cap returns, for example, were paltry—as can be seen from the table below—brought even lower by the Greek drama that ushered out the month of June. Performance for small-caps and the Nasdaq looked appreciably better, but in each case looks are almost assuredly deceiving. Health Care was by far the dominant sector in every market cap range, from micro to large, that Russell Investments tracks. Yet the rule in the first half seemed to be the smaller—and more growth-driven—the company, the loftier the results, especially if it was involved in biotech, the industry that has reigned supreme within the Russell 2000 over much of the last two years. This has had the effect of creating decidedly narrow market leadership within the small-cap space. Outside of biotech, strong first-half performances were mostly limited to a handful of other Health Care industries, software companies, and a few outliers such as construction materials and tobacco. The small-cap market has thus moved from the tightly correlated markets of 2011-2013 into a new phase of wide divergence and constricted leadership. From our perspective, then, the market is indeed out of joint.
“More Things in Heaven and Earth…”
We have actually been arguing that the market has been disjointed for some time now. Fed policies designed to keep the economy and capital markets above water, which included multiple rounds of QE and keeping interest rates at or near zero, had other, unintended consequences that had an outsized effect in the small-cap market. For example, it became both easy and affordable for businesses to add debt, essentially eroding the risk differential between lower- and higher-quality businesses. Lower-quality and more highly levered companies then began a historically atypical period of outperformance in which our funds mostly did not participate. The Fed’s zero-interest-rate policy (“ZIRP”) also stoked an intense hunger for yield, which drove up values for bond-proxy equities such as REITs and Utilities, regardless of their underlying quality or profitability, that have only recently begun to correct. These actions also boosted stock correlations and reduced volatility, making it harder to find the kind of mispriced opportunities that have always been our stock in trade.
Finally, there were significant runs for high-growth, nonearning, and more speculative businesses, many with negative EBIT. This continues into the present day with the recent contraction of small-cap leadership, which represents more of a bet on long-duration assets than current profitability. In each of these cases, our more qualitative, risk-conscious approaches have in general kept us away from these areas. While we are confident that this trend will fade and that speculative bubbles will burst, we also understand the frustrations that have built over the last few years as active managers such as ourselves have continued to lag our respective benchmarks.
Equity Indexes as of June 30, 2015 (%)
- Greek Drama Creates Underwhelming Results—The Greek default late in June eroded gains—giving equities second-quarter results that more closely hugged the flat line. The tech-oriented Nasdaq Composite was the leader, up 1.8%, followed by the small-cap Russell 2000 Index, which finished the quarter with a gain of 0.4%. The large-cap S&P 500 and Russell 1000 Indexes rose 0.3% and 0.1%, respectively.
- Long-Term Returns in Excess—Both large-cap and small-cap indexes’ three- and five-year average annual total returns for the periods ended 6/30/15 were above 17%, well in excess of each index’s historical average.
- Healthy and Informed—Health Care and Information Technology were the best performing sectors in the Russell 2000 year-to-date through 6/30/15—the former led by a wide margin—while Utilities and Materials were the worst performers in the year’s first half.
|YTD1||1 YR||3 YR||5 YR||10 YR|
|Russell Global ex-U.S. Small Cap||7.74||-3.46||11.35||8.99||7.07|
|Russell Global ex-U.S. Large Cap||4.23||-5.02||9.96||8.13||5.80|
1 Not Annualized
So do these challenges mean that something is rotten in the state of small-cap, if only in some of its actively managed precincts? That is the question, more or less, that we have been wrestling with of late. To be sure, we ran the gamut in the first half from disappointment to optimism to frustration as investor preferences moved around. They first showed favor to long-duration assets, then looked, if only briefly, toward consistently profitable and/or conservatively capitalized companies before shifting back again. However, we have seen enough signs, both economically and in the market, which suggest that stocks are slowly moving back to what we would call their historical norm—lower overall returns, higher volatility, and long-term advantages for companies with consistent profits and high returns on invested capital.
Most notably, there was a positive directional trend dating from the first-half low for the 10-year Treasury on January 30 through the end of the first half. During this period, which included the bearish month of April, we were pleased with the way many of our portfolios either outperformed their benchmarks or began to narrow the gap. This was very clear during the growth scare engendered by (at the time) negative first-quarter GDP numbers, which led many companies to begin revising their earnings expectations downward. Of course, when it became clear that much of what put a drag on first-quarter numbers was temporary, including such factors as the awful winter weather, the West Coast port strike, and the plunge in oil prices, things began to pick up again fairly quickly, at least for the more speculative areas within Health Care and a few other narrow equity locales.
“The Readiness is All”
Yet this period also offered a potential preview of how the landscape for stocks will look when short-term interest rates begin to rise—which is likely to be later this year. We see higher rates breeding more uncertainty, be it about inflation, the cost of capital, or a number of other issues. This in turn typically leads to more mispricing in the short run, which creates precisely the opportunities that we crave as risk-conscious bargain hunters. To us, high rates are synonymous with higher risk. A higher-risk environment also tends to benefit quality companies (by which we mean conservatively capitalized, profitable businesses with high returns on invested capital and effective, shareholder-friendly management). So we have no worries about rising rates or greater volatility in the markets. In fact, we welcome both.
We see quality differentiating itself when risk premiums rise because quality businesses are better businesses—as profitable, financially sound enterprises, they are purpose-built and run to survive periods of higher risk and/or greater uncertainty, which helps to explain why the market of the last several years has seen many of these companies disadvantaged in the easy-money, ZIRP environment. In a phase in which few if any of the traditional penalties were paid for larding leverage onto corporate balance sheets, there were also scant advantages that have historically accrued to higher-quality, more conservatively capitalized companies.
We feel confident that this era is over. Our expectation is for lower returns for stocks as a whole, but relatively better returns for both high-quality companies and more cyclical, less defensive sectors. We suspect that in a few years market observers will look back at 2015—and perhaps the longer span covering 2013-2015—as a hinge period in which the gradual sun-setting of interventionist Fed policies, coupled with the steady growth of the economy, restored the capital markets to something closer to more familiar historical patterns of performance and volatility. This is why we have been patiently holding so many companies in cyclical sectors, such as Industrials, Materials, and, more recently, Energy—they boast many attractive characteristics that the market has not yet fully recognized, a phenomenon we expect will change as the economy heats up. In our estimation their profitability, growth prospects, and reasonable to attractive valuations make them coiled springs. Until then, we wait.
To be sure, it has been a cycle of, at times, seemingly endless challenges for our active and risk-conscious approaches. Our collective patience has been sorely tested as we have waited (and waited) for many of our highest-confidence holdings to turn around. Of course, transitions are never easy, and the turn we have been anticipating has taken longer, after a few false starts, than any of us initially anticipated. Change, however, can take time—and we are often aware that a dramatic turn has occurred only in retrospect. We are content, then, to continue investing in the same way that we have for more than four decades—with a close eye on risk as we look for the intersection of attractive valuation and organic growth potential.
For The Royce Funds’ one-, five-, 10-year, and/or since inception returns as of the most recent quarter-end period, please see our Prices and Performance page.