Chuck Royce: Great Expectations for Small-Cap Active Management by Royce Funds
Widening credit spreads, increasing volatility, and decreasing stock correlation should allow stock pickers the chance to emerge as performance leaders. We continue to see good times ahead for active managers who focus on business fundamentals.
A Tale of Two Markets
It wasn’t the best of times; it wasn’t the worst of times. As 2014 began, it all seemed just right, with small-caps easing into the year on a more mutedly bullish note following their extraordinary run in 2013. So relaxed was the pace of returns, and in such stark contrast to the eventful years of 2008- 2013, that in our June 30 Semiannual Review we remarked on how agreeably peaceful and undramatic it all was. During the year’s first six months, inflation was nearly non-existent, most commodity prices were stable, and volatility, as measured by the VIX, reached the end of June at its lowest level since 2007. These factors, along with a sprightly M&A market, looked to us like clear signs of ongoing growth. The case appeared even stronger as the Federal Reserve moved further and further into the background of the U.S. economy. We were not alone in thinking that the anticipated end of QE (“quantitative easing”) and what looked like an inevitable rise in interest rates would set the stage for a more dynamic pace of economic expansion. We also thought an extension of the bull market that began off the March 9, 2009 bottom seemed likely, though we were expecting both lower returns and increased volatility.
As it happens, this call was somewhat accurate: the economy did pick up speed in the second half while the bull market rolled on for large-cap stocks. More turbulent, small-caps (along with most Energy stocks) could not keep up. Of course, equity markets simply do not stay undisturbed for long, so the increased volatility in the second half of 2014 was not a surprise. Yet its highly selective reach was puzzling, even allowing for the historically higher volatility exhibited by smaller companies. Shortly after the Russell 2000 Index established a year-to-date high on July 3 (a high that would last into late December), small-cap prices began to fall. They slid most precipitously in July and September and rallied to varying degrees in August, October, November, and December. The downdrafts were sharper than the upswings, however—it took a furious rally in the final two weeks of the year’s closing month to shore up a modest positive return for the Russell 2000 in the second half. Meanwhile, the S&P 500 and Russell 1000 Indexes lost comparatively little in those two bearish months and posted solid gains during the other four. The upshot was such a strong year for large-cap companies that 2014 was the ninth-largest calendar-year spread between the Russell 2000 and the S&P 500 in the 36-year history of the small-cap index.
What, then, to make of a year in which the Russell 2000 posted a relatively undistinguished single-digit gain of 4.9%, ceded leadership to its larger siblings, and still bested most actively managed small-cap portfolios? A few developments in particular stood out. First, the rotation in leadership from small-cap to large in 2014 looked very much like a classic case of reversion to the mean to us. The former led the market decisively from the bottom in March of 2009 through the end of 2013, a prolonged period of small-cap leadership that made a shift all but inevitable. The second trend was more worrisome. Within small-cap, more economically cyclical sectors continued to lag in spite of the growing economy. The same held true for what we define as quality companies—those with strong balance sheets and high returns on invested capital. Even with the economy accelerating, investors tended to ignore profitable companies with solid fundamentals while they continued to be drawn more to defensive and/or high-growth areas. This included utilities and REITs among the highly successful defensive areas of 2014, and social media, biotech, and pharmaceuticals among the speedy growth industries. In most instances, companies in these sectors and industries do not satisfy our purchase criteria because they lack the combination of balance-sheet strength and a long-term history of profitability that we find most attractive.
We were hopeful that the end of QE (along with rising rates) would help to reverse this trend. But the strengthening U.S. dollar and monetary stimulus efforts in Japan and Europe conspired to make the October conclusion of QE something of a non-event, while interest rates fell through most of the year. On the whole, then, 2014 was an often confounding period for us, especially its second half. Indeed, if there is a theme that best captures the year, it might be “A Tale of Two Markets.” And we should point out that Dickens’s rubric covers not just the very different halves of the year for small-cap stocks but also the disparity in results and volatility between small-caps and their bigger siblings. (More index returns can be found below.)
Equity Indexes as of December 31, 2014 (%)
- The third quarter was the worst for the Russell 2000 since 9/30/11 and, relative to the S&P 500, was the index’s worst quarterly performance since 3/31/99. It also ended a streak of eight consecutive quarters of positive performance.
- Small-caps rallied in October and December to outpace their large-cap counterparts in the fourth quarter.
- 2014 marked just the fifth time since its inception in 1979 that the Russell 2000 had a gain in the single digits (+4.9%). Small-caps trailed large-caps by the widest margin since 1998.
- Within the Russell 2000, Health Care, Utilities, and REITs were the best-performing areas in 2014 while Energy was by far the largest detractor.
|Russell Global ex-U.S. Small Cap
|Russell Global ex-U.S. Large Cap
1 Not Annualized
Volatility—Our Mutual Friend
Yet the level of conviction in our value-oriented approaches remains high. (And as disappointing as recent relative results have been, three- and five-year results through the end of 2014 for many of our Featured Funds were closer to or above their historical averages.) Although it may seem counterintuitive (or worse), the current extended period of relative underperformance for many Royce-managed portfolios actually helps to fuel our confidence in the years to come. Let us explain why. First, we have always viewed volatility as an ally, agreeing with Warren Buffett’s statement: “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” So while many investors think of volatility as being synonymous (or nearly so) with risk or even loss, we have never seen it that way. Instead, we try to take advantage of market movements—an essential skill for any successful active manager. Those times when the market cannot seem to make up its mind are exactly when securities tend to be most mispriced. And therein lies one of the keys to outperformance for active managers—the identification and purchase of mispriced securities.
We recently conducted research that looked at some of the market forces that have helped to shape the current cycle, in particular the years from 2011-2014 when many active approaches struggled on a relative basis. (The full results of this research are available here.) As we have previously argued, the Fed’s easy-money policies of QE and ZIRP (“zero-interest rates”) have had the unintentional effect of stoking appetites for high yield and creating too few (if any) consequences for companies carrying a lot of debt. This led many investors to relatively neglect businesses with more pristine balance sheets and/or those with steady but smaller dividends. It also meant that from the beginning of 2011 through the end of 2014, the small-cap market was in a peculiar state, one characterized by a pile-up of anomalies—the combination of declining volatility with higher-than-average returns converging with contracting credit spreads.
Needless to say, our risk-conscious, balance-sheet-centric approaches have been challenged in this setting, at least on a relative basis. Low volatility has arguably created the highest hurdle. We have always felt most comfortable in markets with higher levels of volatility, which usually create the differentiation that lies at the core of our active management styles. We analyze, assess, and evaluate multiple aspects of a company before determining whether or not the current stock price reflects the long-term prospects we see. Opportunities to purchase what we deem to be attractively undervalued companies tend to proliferate when stock prices are volatile rather than when markets are calm. Yet for most of the last four years, volatility has been falling, at least until the second half of 2014. This has made it far more difficult for our funds to outpace their respective benchmarks.
The questions are: How much longer is this going to last? More specifically, are interest rates going to remain at or near zero? Is the pace of economic growth likely to slacken? Are financial markets going to continue to behave atypically even as the economy continues to normalize? Will small-cap companies indefinitely gain an advantage by carrying more debt? Are three- and five-year average annual total returns for the Russell 2000 going to remain at levels higher than the index’s historical monthly rolling averages of 8.2% and 7.6%, respectively? For those who believe that most, or even some, of these things are likely to happen, then our approach would seem a bit at odds.
We confess that we have been anticipating some of these shifts for nearly two years. This has meant re-learning the hard lesson that change seldom occurs when we most want it to. Yet we are convinced that markets remain cyclical (recent events notwithstanding). In our view, reversion to the mean is as close to an iron law as the capital markets allow. Most trends reverse, though they may linger for longer than initially anticipated (or desired). Widening credit spreads, increasing volatility, and decreasing stock correlation should all help active management and allow stock pickers the chance to emerge as performance leaders.
We also expect equity returns to remain attractive, though we see a decrease from the high levels we have seen over the last three to five years. Cyclical companies appear due for a round of revenue acceleration, particularly those in the Consumer Discretionary and Industrials sectors, as do some industries in the Information Technology sector. The best-managed companies within these areas could also see solid margin expansion. Among other cyclical sectors, we also see a number of profitable, conservatively capitalized businesses that have either been ignored or whose returns have lagged. We expect this to change.
On the valuation front, the picture looked admittedly tricky at the end of 2014. For example, an examination of trailing 12-month earnings for many companies suggests that small-cap share prices may be on the high side. But if you believe, as we do, that the economy is going to keep growing, that credit spreads will continue to expand, and that a more robust CAPEX cycle is in the offing, then valuations seem pretty reasonable, if not attractive in certain areas, Energy in particular. Many stocks look fairly valued though not fully valued to us. So while we do not shrink from the sobering truth of relative underperformance through much of this now-long bullish cycle, we continue to see good times ahead for our risk-conscious, fundamentally based approach.
The argument that we have been making for more than four decades remains the same. Small-cap is an inefficient area of the market in which we search for qualitative advantages and valuation discrepancies. Our belief that fundamentally strong companies trading at discounts to their private worth can outperform over the long term, often with lower volatility, will not change. It is our core investment principle, and it has served us very, very well over most of the last 40+ years.