Co-CIO Francis Gannon on why a vibrant global economy can be a good thing—for certain types of small-caps.
There is a common assumption in small-cap circles right now that the current rally for the Russell 2000 Index, which has cooled off quite a bit since 12/9/16, needs fiscal policy initiatives to keep rolling.
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The Russell 2000 advanced 47.4% from the 2/11/16 small-cap trough to 12/9/16. From that December high through 7/17/17, however, the small-cap index rose only 4.0%.
According to this line of thinking, without the shot in the arm of a cocktail combining corporate tax cuts, deregulation, and infrastructure spending, the good times are likely to wind down.
This assumption is rooted in a historical observation, which has grown into something of an established truism about U.S. small-cap performance, that smaller stocks do best in an expanding U.S. economy.
This is based on the fact that revenues for most small-caps come from domestic sources. In the Russell 2000, for example, the average company had only 19.8% of its sales from outside of the U.S. as of 6/30/17.
So the lack of progress from Washington may be alarming to small-cap investors, and this anxiety about the U.S. economy may be exacerbated when combined with the quickening pace of global growth.
Recent data shows that 2Q17 was the eurozone’s best quarter in more than six years, buoyed by strong manufacturing numbers, job growth, and elevated business confidence.
Meanwhile, the news out of China in mid-July showed surprisingly strong GDP growth of 6.9% in 2Q17. This was consistent with the country’s solid first quarter and was driven by increased retail sales, investment, and industry output—all of which trumped estimates.
So with the U.S. economy growing at what seems like an endlessly slow pace, it’s fair to ask if the party might be drawing to a close for U.S. small-caps.
We would humbly suggest that this depends on the kind of small-caps that one owns.
To be sure, many that derive the bulk of their revenues from domestic sources would potentially be at a disadvantage—possibly a sizable one—compared to large-caps.
However, the level of foreign sales varies considerably by sector and industry in the Russell 2000, with Information Technology (44.1%) and Materials (33.4%) showing the highest percentages of revenue derived from non-U.S. sources by sector.
Source: Factset
There are also certain other cyclical industries, including auto components (47.2%) and machinery (35.9%), that boast significant international exposure and therefore appear well positioned to benefit from global expansion.
In addition, small-caps can benefit indirectly from international growth by providing goods and/or services to U.S.-based companies that are themselves participating in global growth, such as a small electronic equipment company that sells components to Amazon or Google.
As experienced small-cap specialists, we see a rebounding global economy as being a potential advantage for active managers who, like us, have more of a cyclical tilt in their portfolios.
So we view the current environment as potentially challenging for the asset class a whole while also looking favorable for disciplined small-cap active management approaches that are geared more globally. Vive la difference!
Stay tuned…
Article by Francis Gannon, The Royce Funds
