Small-Cap Value Stays Strong by Chuck Royce and Francis Gannon, The Royce Funds
Chairman Chuck Royce and Co-CIO Francis Gannon explain why they believe the combination of earnings and valuation will bolster value’s leadership in the current small-cap cycle, discuss the impact of Brexit, and detail what they like about companies in sectors such as Industrials, Materials, and Financials.
Both the Russell 2000 Value and Growth Indexes were enjoying solid results until the Brexit vote – what does all the wild activity in the second quarter tell you about how small-caps may perform in the second half of this year?
Chuck Royce: Before we think about where small-caps may be headed, we need to look at where they’ve been. The Russell 2000 Index reached a peak on June 23, 2015 and fell 25.7% from that high through the 2016 low on February 11. This was kind of a stealth bear market—people didn’t talk about it much outside the small-cap world, but it was a significant decline. Large-caps fell far less sharply over the same period.
This bear phase therefore gave small-caps more ground to make up versus their larger peers, which drove the rebound for the Russell 2000 until the Brexit vote interrupted the rally. And that’s very much how we see Brexit—as an interruption and not a disruption of the current cycle that we think will continue to favor small-cap value. At the end of the day, we see it as more of a political than an economic event, one that looks unlikely to have a meaningful or lasting effect on U.S. small-caps.
Prior to the vote, we’d seen a recovery for biotech as well as rebounds for internet and software companies, the industries that were hit hardest earlier in the year. We don’t see either of those areas resuming anything close to the sustained runs they made in 2014-2015 in the second half of this year, even in light of a spate of renewed strength during the last week of June. Within small-cap value, Financials led, driven in part by REITs, which also did well in 2015. But the valuations on these stocks still look high to us, so we don’t see them necessarily leading either, at least not over the long run.
Our thought is that companies in more cyclical sectors are more likely to lead primarily because of the shift in investors’ expectations that began off the small-cap peak last June. Earnings, high ROIC (returns on invested capital), and valuation have mattered a lot more over the last year than they did in the previous five or six.
Although there are some potential obstacles in the way, such as the strengthening U.S. dollar and the possibility of further contraction in credit spreads, we think the current cycle is one that value will continue to lead.
So the volatility at the end of June didn’t change your mind about the long-term advantage for small-cap value?
Francis Gannon: Not at all. We still believe strongly that we are in the early stages of a long run for small-cap value. This is due to two factors—the relatively attractive valuation and earnings picture for many cyclical stocks and the emerging advantage for small-cap value relative to growth. Perhaps the most intriguing development we’ve seen so far this year has been the strength of small-cap value through the recovery that began off the mid-February low. I think most market observers anticipated that value would do well in the decline and that growth would respond well off the bottom. But value has been more competitive than almost anyone would have imagined during this mostly bullish phase.
From 2/11/16-6/30/16, the Russell 2000 Value gained 19.5% versus 19.4% for the Russell 2000 Growth. Coupled with value holding on much better through the winter decline (as well from the 6/23/15 small-cap peak), this span of outperformance gave it a substantial edge in the first half, up 6.1% versus a loss of 1.6%. This is not surprising—when stocks come out of a bear market, leadership almost always rotates. So while we may see some brief periods when growth does better, which is what happened in the recovery following the Brexit-led decline, overall we see value maintaining small-cap leadership.
We think it’s also important to remember how critical it is to try to take advantage of volatility. We looked at the calendar-year price increases for the Russell 2000 over the last 20 years while also charting the intra-year decline—the results show just how important it is to stick to one’s discipline when the markets are falling. For example, the data shows that the Russell 2000 had double-digit positive returns in 21 out of 36 calendar years. In 16 of those 21 years, the index also endured a double-digit decline.
Russell 2000 Calendar Year Price Change with Intra-Year Declines
Source: Russell Investment Group, Royce.
Do you have comparable confidence in the prospects for small-cap cyclical stocks with earnings?
Chuck: We’re still confident that an extended period of even slow economic growth should be enough to boost the shares of many companies in sectors such as Industrials, Financials, Information Technology, Materials, and Energy—all of which are home to cyclical businesses with earnings and, in some cases, high ROIC. Those that also have reasonable to attractive valuations are the companies that we expect to lead small-cap going forward.
Even with the peak last June shifting investor preferences—eventually sparking the turnaround for many of our holdings—expectations for many of these businesses remain low. In many cases, stocks were oversold back in the winter to the point that, even after experiencing some recovery, their valuations still look attractive to us. Several looked even cheaper in late June.
Francis: Some recent data from Furey Research Associates reinforces Chuck’s point. It showed that at the end of March small-caps were the cheapest they’ve been versus large-caps in the last 13 years, that value is cheap relative to growth, and that cyclicals are cheap compared with non-cyclicals. So we feel like we have a lot of reasons to feel good about the long-term potential for both profitable smaller companies and small-cap value.
Where have you and your team been looking most frequently?
Chuck: We’re always looking for that sweet spot—that intersection of an attractive valuation with a terrific, well-managed, and profitable business that’s conservatively capitalized. Nothing makes us happier than finding a good business with an attractively low stock price. This excludes a number of defensive areas, such as utilities and REITS, because the company quality and valuations don’t fit our criteria.
The same is true for a lot of biopharma stocks. So we’ve remained most active in those cyclical sectors that have been our focus for the last few years—Industrials look promising to us, particularly machinery and services companies, as do select areas of Financials such as asset managers, the less speculative, more earnings-driven industries in Information Technology like semiconductors and other components makers, and Materials, where chemicals have been our main area of interest. Certain energy services companies also fit this profile.
Are you concerned that, with additional Brexit-bred uncertainty and interest rates still so low, small-cap investors will move to safety and/or high yield at one extreme and speculative growth at the other?
Chuck: It’s definitely a risk—we saw some of that in the first half with the recoveries for biotechnology, banks, and REITS following the February low and the Brexit vote. There are three factors, however, that we believe work against this:
First, we also saw strength in the second quarter from Industrials, Materials, and Energy—all of which were laggards in 2015—as well as from less speculative industries within Health Care and Information Technology. These and other areas are all giving small-cap value its post-bottom lift.
Second, credit spreads remain wider than they were a year ago at this time, even with the 10-year Treasury rate falling again, so the cost of capital remains higher, which should help profitable, lower leverage businesses.
Finally, there is reversion to the mean— the middle of 2015 marked a two standard deviation event in terms of a performance edge for the Russell 2000 Growth.
The headlines are once again focusing on uncertainty and the possibility of recession, yet equity returns have been climbing since the mid-February lows. What are you hearing from the companies you’re meeting with? Is the outlook as fatalistic as the news would suggest?
Francis: I would say that while the headlines have been fatalistic, even panicky at times, the management teams we’re talking to are more cautious and uncertain than pessimistic. To be sure, they’re well aware of how fragile things are—economic growth is slow, the global situation remains anxiously unsettled, and our upcoming election looks like another polarizing one. However, we’re also hearing some measured optimism in terms of growth picking up, however gradually or in fits and starts.
One important insight we’ve gained is how supply and demand seem to be coming closer to balancing in industries as diverse as steel, in-land barges, onshore oil services, and irrigation equipment. Moreover, global commodity prices have been stabilizing, led by oil. M&A (merger & acquisition) activity has been picking up, which we’re seeing from both the acquirer and acquiree side as small- and mid-cap investors. And it’s a positive sign that, when many deals have been announced, both companies are seeing an increase in their share prices.
If the dollar weakens again, that should help many industrial and manufacturing companies while more infrastructure spending would also provide a big boost. In addition, there was evidence into mid-June, admittedly anecdotal, of Capex ticking up, which is long overdue. So it’s not a rosy picture by any stretch, but it’s far from the more excitable tone of recent headlines.
Even with the limited remaining monetary policy options remaining to them, the developed world’s central banks were making accommodative comments in the wake of Brexit. Do you see this as a problem for stocks and the economy?
Chuck: In the long run, I’d say, ‘no’ because we are on the road toward a more historically typical environment in which interest rates are more a function of free trading—set by markets rather than by central bank fiats. However, with the added uncertainty that Brexit created—and we were already facing considerable uncertainty in terms of global growth—there is the risk that central bankers will forestall the inevitable and put off subsequent rate increases, which I think would be a mistake.
The worst part of the Fed’s decision not to raise rates earlier in June was its interruption of a gradual and long-delayed normalization process for rates, which in turn is helping the equity markets and economy to also normalize. At this stage, fiscal stimulus in the form infrastructure spending strikes me as the sounder path, at least for the U.S. and maybe for the U.K. as well.