Introducing our newest quarterly resource for Financial Professionals-Royce’s Small-Cap Market Review
Insights on all things small-cap, featuring:
- An interview with Chuck Royce and Francis Gannon
- Charts that offer a comprehensive overview of the small-cap market
- Fund performance and commentary for our featured U.S. value and core strategies
Small-Cap Market – 1Q17 Interview
Portfolio Manager Chuck Royce and Co-CIO Francis Gannon look at the performance reversals and cross-currents in 1Q17, the likelihood of higher volatility, and why lower returns for small-caps might be the pause that refreshes.
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What was your take on 1Q17?
Chuck Royce I think what was most interesting in 1Q17 were the short-term reversals of what worked in 2016, especially in the fourth quarter. In the first quarter, we saw reversals in leadership based on market capitalization, style, and sector. Large-caps beat small-caps, growth beat value, and healthcare stocks overcame a weak 2016 while Energy— one of the stronger areas for smallcap in 2016—fell farthest. So a lot of what worked best in 2016, especially late in 2016, did not work in 1Q17—and vice versa.
Francis Gannon The higher returns for growth seemed to us in many ways like a validation of the high returns small-cap value stocks posted in 2016, even allowing for the fact that overall valuations were somewhat high as we entered April based on more realistic expectations. In other words, if those returns didn’t feel in some sense well-earned to investors, we probably would have seen a bigger pullback for value in addition to the catch-up for growth. That it played out the way it did, with a strong return for growth with value down just slightly, suggests to us that equities remain in basically good shape.
After the Russell 2000 Index hit a new high on 3/1/17, what leads you to believe that small-caps still have room to run?
CR I think context is critical when thinking about the longevity of the current small-cap cycle. First, the bull market in large-cap stocks is aged. It just hit its eight-year anniversary, dating back to 3/9/09, which was the market trough following the Financial Crisis. Small-caps bottomed on that same day, too, but the Russell 2000 Index has since had two subsequent bear markets–the first ended on 10/3/11 and the second on 2/11/16. So the current small-cap cycle, which is a little more than a year old, is quite young, especially compared to large-cap’s.
FG It’s also important to keep in mind just how resilient the current rally has been, which we find very encouraging. In less than a year, the markets have been rocked by Brexit, the highly contentious election, and the false start on healthcare reform. Yet none of these events have done more than temporarily slow the overall upward move for small-caps.
Closely related to this is the median return for the Russell 2000 following declines of 15% or more. There have been 11 since the Russell 2000’s inception in 1979. The median return in the subsequent recovery was 98.8%. The last small-cap bear market, which Chuck mentioned, was a 25.7% drop from 6/23/15-2/11/16, and from that February 2016 bottom through the end of 1Q17, the Russell 2000 was up 47.8%. So history suggests we are less than halfway through, which means the cycle is young not just in terms of time— and in our view has room to run.
Do you think small-caps could still experience a modest correction?
CR Yes. We don’t expect a significant decline or bear market for small-caps. Our estimate is somewhere in the 5-12% range. Many investors seem concerned that the timeline for new stimulative fiscal policies may extend into 2018, tempering the postelection optimism that animated 4Q16’s market. In fact, at the end of 1Q17, much of the market looked high priced enough to us and many others that the next downdraft will be one of the most highly anticipated in many years. All of this sounds more to us like a pause in a longer bull phase than a scenario for a bear market. Instead of a broad-based pullback, we think additional rolling sector- and industry-based corrections are more likely in the months ahead, similar to what we saw for industrial stocks in 2015, healthcare in 2016, and energy so far in 2017.
FG As bottom-up small-cap specialists, we’re not as concerned as some investors are with developments in Washington, whether at the Fed or on Capitol Hill. Our focus is on our analysis of, and communication with, individual companies, so we see the rally as having a more substantial foundation.
This is why we think upcoming earnings announcements—and guidance—will play a big role in the market’s moves, which is what we would want and expect in the current climate. Psychology runs the market in the short run, but earnings run it in the long run. And this smallcap market seems to be going through a correction in time, where future earnings need to catch up to current prices.
Were you surprised that both high-quality and low-quality small-caps did well in 1Q17?
CR Not entirely, although it was such a strong quarter for growth that it may seem a little counterintuitive that quality did so well. However, quality companies, which we measure by high returns on invested capital (ROIC), were substantially disadvantaged, and therefore deeply discounted, by expansive monetary policy and zero interest rates from 2011-2015. So even after last year’s strong run, other investors are continuing to show interest in a number of high-quality small-caps.
FG It’s also helped that, as monetary policy moves off center stage, more attention is being paid to fundamentals such as earnings, profitability, and the ability to self-finance. This clearly helped many high-quality small-caps in 2016 and in 1Q17.
As for lower quality, I think it had to do with the ongoing success of many tech companies, which received little attention, as well as the catch-up dynamic we mentioned earlier. There’s also the possibility for additional economic acceleration.
Can you expand on the performance patterns you saw in 1Q17?
CR In our small-cap market, we noticed how narrow returns for the asset class were in 1Q17, which is often the case when growth leads. The cap-weighted Russell 2000 was up 2.5% while the equal-weighted index was up only 0.1% in 1Q17. This suggests that the market was weaker than it appeared, which is borne out by the fact that healthcare’s leadership was itself confined primarily to the sector’s biotechnology, pharmaceutical, and healthcare technology areas. We certainly did not see a broad-based move for growth as a whole in 1Q17.
So it looked a lot to us like 3Q16 in that much of what worked best in 2016 as a whole—dividends and low leverage, for example—trailed in both periods. In fact, 1Q17 looked to us like a consolidating market, with laggards such as the Nasdaq, large-caps, and growth all catching up, which was the opposite of what happened in 2016. Still, we see the cycle as a very healthy one, even with its ‘two steps forward, one step back’ pattern.
Article by The Royce Funds
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