Small-Cap Value Leads 2Q16 Despite Brexit Interruption by Francis Gannon, The Royce Funds
A once mildly bullish quarter turned wildly volatile in the wake of Brexit. The small-cap indexes then rebounded, recouping their losses to finish the quarter with modest gains. Despite the volatility, we saw certain longer-term trends continue to progress throughout the quarter.
Brexit Looks Likely to Have a Minor Effect on U.S. Small-Caps
Recently, Bruce Greenwald carried out a virtual Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital. Greenwald and Lu covered multiple topics during the discussion, addressing everything from the value investor's approach to appraising businesses and what he had learned from his great friend Charlie Munger. The duo also discussed China's economy Read More
We see the Brexit vote as a political event for the European Union, not an economic event for the U.S.
Domestic small-cap companies have mostly minor ties to the EU; data from Credit Suisse shows that U.S. small-caps derive less than 10% of their revenues from Europe, the Mideast, and Africa.
Our Outlook: We see little danger of an imminent recession in the U.S. due to Brexit (or other causes). We expect the effects of this event, like previous market shocks, will dissipate and ultimately have little impact on U.S. small-cap stocks.
Small-Cap Value Continues to Lead
In our view, a critical difference so far this year in the behavior of small-cap value relative to growth has been performance in up markets. From the 2/11/16 small-cap low through 6/30/16, the Russell 2000 Value and Growth Indexes were essentially tied. In prior years (2009-2015), value led in many downdrafts but lagged in up markets. This renewed strength is a major reason for our optimism for value stocks.
In the quarter and year-to-date periods, the Russell 2000 Value Index outperformed the Russell 2000 Growth Index, and has now led in three of the last four quarters. The small-cap value index was also ahead from the Russell 2000 peak on 6/23/15 through 6/30/16 (-5.7% versus -13.5%), giving small-cap value more than a year of small-cap leadership.
Our Outlook: We think small-cap value is in the early stage of a long-term leadership cycle based on reversion to the mean and the combination of earnings and attractive valuation for many value stocks.
Russell 2000 Value vs Russell 2000 Growth Quarterly Returns (%)
Small-Cap Still Looks Cheap Versus Large-Cap
Although the Russell 2000 Index modestly outpaced the Russell 1000 in 2Q16 (+3.8% vs. +2.5%), we still see small-caps as undervalued compared to their large-cap siblings. After more than two years of underperformance, U.S. small-caps now sell at a discount to large-caps despite what we see as more favorable growth prospects.
Through 6/30/16, the Russell 2000 was selling at a 4% discount to the Russell 1000 (based on EV/EBIT – Enterprise Value/Earnings Before Interest and Taxes) compared to a 13% premium at the end of 2013.
Our Outlook: We believe that the combination of less exposure to increasingly uncertain global markets, better growth prospects, and relatively attractive valuations makes a compelling case for small-caps.
Russell 2000 vs Russell 1000 Median Relative EV/EBIT – Enterprise Value/Earnings Before Interest and Taxes (excluding negative EBIT companies)
Valuations for Cyclicals Become Even More Attractive
At the beginning of the quarter, small-cap cyclicals looked undervalued to us relative to defensive stocks. With many defensive areas such as Consumer Staples, REITs, and Utilities outperforming in the quarter, this valuation edge grew more pronounced. These same defensive areas often perform well when interest rates are falling. We expect a continued advance for defensive stocks would require further rate declines from here, a prospect we regard as unlikely.
Our Outlook: Small-cap cyclicals appear to us as the most attractive area of the small-cap universe. We expect that the intersection of attractive valuations with earnings (or high profitability) that helped give sectors such as Industrials and Materials strong year-to-date returns through 6/30/16 can drive small-cap results over the long term.
Russell 2000 Median Relative EV/EBIT – Enterprise Value/Earnings Before Interest and Taxes for Cyclical vs. Defensive Stocks (excluding negative EBIT companies)1
Active Is Beating Passive in 2016
We have uncovered an important performance relationship that we see little noted elsewhere, which is that the active/passive small-cap performance cycle often correlates with whether a market is led by value or growth stocks. So far, 2016’s results support this view. As small-cap value is leading growth so far, it is not surprising to us that active managers are having greater success beating passive. According to data from Morningstar, only 31% of active managers in the Small Blend category outperformed their benchmarks from 12/31/14-6/30/15 while 48% outperformed in calendar 2015. In the first half of 2016, however, that percentage increased to 56%.
Our Outlook: We suspect that the recent leadership reversal in favor of value stocks also marked the beginning of an active management cycle that we expect will be long lasting.