What stands out to you about the way the small-caps performed in 2017?
Chuck Royce: It was an odd year in a lot of ways, although it was also a good one for equities as a whole. After a robust comeback in 2016, small-cap value underperformed, which was admittedly not what we were expecting. On the other hand, international small-caps rebounded in a big way, which was much more in line with our expectations because they had been trailing domestic small-caps for a number of years prior to 2017.
What also stands out for me was the strong, market-beating performance for a select number of active small-cap strategies in a year when small-cap growth led value by a sizable margin. Why was this selective performance advantage for active strategies notable?
Francis Gannon: Being narrower, growth-led markets typically create challenges for active managers—we saw this most dramatically in 2015, when near-zero interest rates and anemic economic growth were significant headwinds for active strategies. In 2016, we saw a near total reversal—earnings began to recover, and rates began to rise.
In 2017, active strategies faced headwinds in the form of investors flocking to more speculative issues while also experiencing tailwinds such as the growing global economy and earnings improvement. The last two allowed certain strategies to do very well on both an absolute and relative basis in spite of other, more inhospitable conditions for active management.
What else stood out to you about the last year in small-cap?
FG One striking—and in our view potentially very significant—reversal took place in the fourth quarter, when small-cap companies with earnings enjoyed higher returns than those without. It’s been common historically for non-earners to lead when growth outperforms, and non-earners did hold a relative edge in the Russell 2000 through the first three quarters of 2017 when loss-making companies in the small-cap index gained 16.2% compared to 9.5% for those with earnings.
This shifted, however, in the fourth quarter, when gains for loss-makers in the Russell 2000 slowed to a 2.5% advance versus an increase of 3.6% for small-cap earners. Going forward, we expect investors to increasingly focus on individual company attributes, especially earnings, as well as company-specific risks. Reuters reported in late November that individual company volatility has been on the rise, with earnings news creating the most extreme movements up or down.
We think we could see a similar performance pattern in 2018, with leadership coming from small-caps that post stronger earnings growth.
In light of this positive picture for small-cap earnings, why do you think growth stocks outperformed in 2017?
CR I can certainly offer reasons why growth did well. First, it seemed to be more a function of the industries investors preferred rather than a preference for style itself. Biotechnology and technology stocks, both of which lean toward growth, were very strong throughout most of the year, while other areas such as financials, real estate, and energy, which are more heavily weighted toward value, lagged for much of 2017. The struggles for financials, in particular banks and insurance companies, were especially important because of their large weighting in the Russell 2000 Value Index.
But none of those reasons can fully account for why growth did so well or why value trailed by such a wide spread, at least not to us. The Russell 2000 Growth Index was up 22.2% in 2017, and the Russell 2000 Value gained 7.8%. In the context of a healthy and expanding global economy in which earnings growth for U.S. small-caps has been solid to strong by and large, the absolute and relative strength of growth in 2017 just doesn’t make a lot of sense to me.
However, I’ve seen plenty of years in which various performance patterns defy explanation. Sometimes they begin to make sense later in the cycle, and sometimes they don’t.
Where do you think we are in the small-cap cycle?
FG Measuring by current valuations, a lot of stocks appear priced to perfection or higher, and the state of valuations is getting a lot of attention. However, high valuations don’t always lead to the kind of major declines, which we define as losses of 20% or more, that would kick off a new cycle.
So we think the consensus view that valuations are high seems unlikely to trigger a downdraft on its own. It’s also worth keeping in mind that for most of 2017 a lot of market observers were saying that U.S. equity valuations were unsustainably high—which did nothing to stem the pace of returns.
So you think the small-cap cycle may still have room to run?
CR We suspect it could, yes. Sentiment remains strong—the tax bill has only intensified that optimism—and the economy is growing.
We also see the current cycle in its historical context. The Russell 2000 fell 25.6% from its last peak in June 2015 through the most recent trough in February 2016. The median increase for the small-cap index following a decline of 15% or more was 98.8%. The current cycle from that February trough through the end of 2017 showed an advance of 65.4%. So while a small-cap correction in the range of 10%-15% in 2018 is certainly possible, we don’t see any red flags signaling a more significant market decline of 20% or worse.
Does the Russell 2000 still look risky to you?
FG Yes. In our view, the opportunity for small-cap investors is not the index or the asset class as whole—it’s select companies in the asset class, which is why we believe selectivity has been so critical of late.
We think it also makes sense to expect lower returns for the small-cap index going forward—we’re urging even greater caution with regard to the prospects for small-cap growth stocks. Recent one- and five-year results for both the Russell 2000 and Russell 2000 Growth ran higher than their long-term averages. For example, the small-cap index’s 14.1% five-year average annual total return for the period ended 12/31/17 ran notably higher than its 10.6% monthly rolling five-year average since inception.
The spread was even more pronounced for growth—a 15.2% five-year average annual total return for the same period versus its 8.6% monthly rolling five-year average. We believe that these higher-than-usual returns are simply not sustainable over the long run.
Think about how the metrics for the Russell 2000 stack up compared to a fundamentally strong small-cap business with positive earnings and healthy cash flows from operations. At the end of 2017, more than 34% of the companies in the small-cap index had no earnings compared to only 25% at the end of 2007.
The index in aggregate also had higher leverage than it did 10 years ago: at the end of 2017, the debt to capital ratio for the Russell 2000 was 35% versus 29% at the end of 2007. Add to all this the fact that small-caps have not seen a pullback greater than 6.4% for nearly two years (dating back to the last small-cap trough on 2/11/16), and the Russell 2000 looks pretty risky to us.
So while we’re confident in the prospects for select small-cap companies, we’re also firm believers in reversion to the mean.
CR I would add one other point. As excited as we are about the expanding global economy, it’s important to remember that Main Street and Wall Street do not always walk hand in hand. Market cycles and economic cycles are different animals.
It’s counterintuitive, but as economic news continues to improve, there’s no guarantee that the market will match its pace. In fact, it’s possible that the U.S. economy (and its workers) may do a little better than equity investors over the next few years. Ultimately, we see global growth as a positive for stocks, small-caps in particular. But the market may well deviate from what the economy is doing in the months ahead, which is pretty standard.
Are Royce’s different strategies still leaning more toward cyclical areas, as they’ve generally done historically?
FG They are, yes. As different as our active small-cap strategies are, they all search for companies along a continuum that encompasses low valuation and high company quality. They vary mostly by emphasizing one to various degrees over the other.
However, that combination typically leads our portfolio managers to more economically sensitive, cyclical industries. Cyclicals underperformed defensives in 2017 and over the last five years. As with small-cap earners versus non-earners, however, small-cap cyclicals beat defensives in the fourth quarter.
We also think it’s important that, like growth stocks, small-cap defensives exceeded their long-term monthly rolling averages. (Cyclicals also did, though defensives advanced by a much wider margin.) The strength of defensives against the backdrop of an accelerating economy in 2017 was also anomalous.
In light of all this, what is your outlook for small-cap cyclicals?
FG We see some key potential advantages for cyclicals going forward: First, as confidence in the economy solidifies, the mounting importance of earnings growth or recovery should benefit cyclicals—small-caps in particular—as it has in the past.
Cyclicals have historically done best in exactly the kind of economic environment in which we now find ourselves. This is what we think investors should be focusing on. Second, valuations for small-cap cyclicals, based on enterprise value to EBIT, look more attractive relative to defensives. Third, the extended, 30-year bull market for bonds is over. Being far less yield sensitive, cyclicals should benefit.
For many years, you’ve been investing in companies that increase productivity. Where have you been finding opportunities in these kinds of companies?
CR Companies that help others do business faster, cheaper, and more effectively has been a sort of picks and shovels approach that has frequently led me to industrial and technology companies with very interesting—and in many cases ultimately profitable—businesses. That much hasn’t changed.
Over the last few years, there’s been a lot of innovation in areas such as process automation, robotics, lasers, cloud storage, etc.—all of which need equipment, components, and related technology, which has led to a lot of investments in companies that have successfully helped other businesses to innovate and/or increase productivity.
In fact, companies involved in process automation, robotics, and other areas look very promising to us over the long term as the recent global technology build-out rolls on.
CR Financial companies have always been a fertile investment area for me. Over the last few years, though, I’ve shifted my attention a bit from the areas on which I’ve historically concentrated—traditional asset managers and insurance—to include alternative asset managers and banks.
The latter group has looked more and more promising to me as rates have risen and regulations have relaxed. Their performance was pretty underwhelming in 2017 as other investors seemed more concerned with what was going wrong, such as slow loan growth and the flattening yield curve, rather than on what might go right. Historically, when Main Street does well, small banks usually benefit.
How large an effect do you think the recently passed tax bill will have on small-cap performance?
FG We think the reduced corporate rate is a real positive for small-cap stocks. Having said that, we think investors need to understand a few key points: First, the positive effect of the lower rate becomes more lasting only to the degree that it encourages productive capital investment and allocation—in our view, that’s the key to creating additional growth beyond the reduced rate.
We also think that the excitement over tax reform has kept many investors from seeing what looks to us like the more significant development—the acceleration of the global economy. Its effects can already be seen when you look more closely at 2017’s returns. Companies in the Russell 2000 with no foreign sales were up 12% while those with foreign sales of 30% or greater advanced 19%.
CR Investors looking for another way to potentially take advantage of accelerating global growth might want to consider international small-caps, which not only enjoyed a stellar 2017, but also have a history of rewarding selectivity. For example, within the Russell Global ex-U.S. Small Cap Index, companies with positive earnings have beaten the index as a whole, gaining 8.7% versus 6.8% on an average annual total return basis from 7/31/96-12/31/17.
What do you expect will drive small-cap returns going forward?
FG We think small-cap performance will be driven by three factors: a preference for profitability, relatively lower valuations for both cyclicals and value stocks, and burgeoning economic strength at home and abroad.
Together, these support the leadership case for small-cap companies with global exposure in cyclical industries that also possess quality in the form of high returns on invested capital. Russell 2000 companies with the highest ROIC did quite well in 2017, in fact. These kinds of businesses look best positioned to benefit from increasing economic growth—even in the event of a correction.
With selectivity and discipline being the keys, we see the opportunity for active small-cap strategies to shine in 2018.
Article by The Royce Funds