Through much of this long recovery for equity prices following the market bottom on March 9, 2009, specifically the period from 2011-2014, many active small-cap approaches, our own included, struggled to beat their benchmarks. The initial years of the cycle (2009-2010) were strong on both an absolute and relative basis for the majority of our Featured Funds. However, the last four calendar years saw many of our portfolios coming up short on a relative basis.
We can accept relative underperformance for a oneyear period with equanimity. A three-year period is more difficult to swallow because it represents to us the threshold between the short and long terms. However, we could ultimately accept that too, provided we saw strong signs of market or economic changes that looked likely to benefit our disciplined approach. A five-year underperformance period, on the other hand, is another matter entirely. (It bears mentioning that the respective five-year average annual total returns for both our flagship, Royce Pennsylvania Mutual Fund (“PMF”) (+12.8%), and the Russell 2000 (+15.5%) were well in excess of their respective historical rolling monthly five-year averages of 9.8% and 7.6% since the small-cap index’s inception on 12/31/78.)
This most recent underperformance period led us to attempt to answer two critical questions that are important to us and that we know have been on the minds of our investors: First, what forces have helped to shape the current cycle and contributed to the relative advantage for the small-cap index? Second, what signs, if any, reveal that some of these forces may be ebbing or reversing?
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy Read More
Three specific market conditions have resulted in relative performance challenges: when smallcap stocks are generating returns well above their long-term averages, when there is lower-than-usual volatility for small-cap stocks, and/or when credit spreads—or the cost of capital—is declining. When only one of these conditions was present, our relative performance often suffered, if only in the short run. Yet for much of the past five years, each of these three conditions converged.
Before looking more closely at these developments, we want to emphasize that our belief in the cyclical nature of financial markets is fundamental and unshakeable. We were not surprised to find, then, that all three were showing signs of abating at the end of 2014. And while we cannot predict future performance patterns, we are nonetheless encouraged by many of our Featured Funds’ long-term histories, especially following similar underperformance periods.
Credit Spreads* and Royce Funds Returns
The availability of capital for businesses expands and contracts over time. In 2008, capital was understandably both quite scarce and very expensive. Contrast this with 2013 when capital was widely available. One metric used to assess the price, or cost, of capital is the difference in yield between U.S. Treasury bonds and high-yield bonds. When this yield differential, or yield spread, is high, the cost of capital is also, which often causes problems for highly leveraged businesses.
When the cost of capital declines and the yield spread drops, it creates a potential advantage for the kind of highly leveraged stocks that we typically avoid. Yet many high-leverage stocks find homes in the Russell 2000. When the cost of capital was declining (and the yield spread was narrow), these stocks contributed to the index’s stellar performance. The reverse held true when the cost of capital rose, expanding the yield spread. As a result, our relative performance has often correlated with movements in high-yield credit spreads. As shown in the following table, from 1996-2014 PMF slightly underperformed when the credit spread range contracted, typically had a slight excess return when this range was narrow (and more stable), and had a more decisive advantage when the range widened—that is, when the cost of capital rose.
We are therefore encouraged by the recent increase in the cost of capital. From a peak of 21.8% at the end of 2008, yield spreads contracted all the way down to 3.4% in the early summer of 2014 and have already begun to widen. They stood at 5.0% at the end of 2014.
Volatility Is an Ally
Low volatility environments have historically been challenging for most active managers, including ourselves. The reason is that differentiation lies at the core of active management. We evaluate multiple aspects of a company and then judge 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 occur more frequently when stock prices are volatile. The following table shows that over the past 36 years, our investment approach with PMF on average generated excess returns versus the Russell 2000 in most market environments—except those with the lowest volatility. But for most of the last five years, volatility has been falling and has remained low, which has created a more difficult environment for active managers to outpace their benchmarks.
It’s worth pointing out that since the second quarter of 2014 U.S. small-caps have seen increased volatility. If the trend continues, it should create more opportunities for us to buy at attractive prices.
How Long Can High Returns Last?
From the inception of the Russell 2000 (12/31/78) through the end of 2014, there were 373 monthly trailing five-year return periods. In 27% of those periods, five-year average annual total returns were greater than 15%. The five-year period ended 12/31/14 was one of these periods, with the small-cap index returning 15.5%. While such high return periods are not the norm, they have historically been challenging for active mangers such as ourselves. In fact, when trailing five-year returns for the Russell 2000 were 15% or greater, PMF underperformed 51% of the time. Our expectation going forward is for something closer to small-cap’s five-year average annual total rolling return of 7.6%. Such periods, as can be seen in the table below, were favorable to our approach.
…So What Happens Next?
In our experience, markets are cyclical. Most trends reverse, though they can linger for longer than initially anticipated (or desired). The three trends we have examined — narrow credit spreads, lower-than-average volatility, and higher-than-usual small-cap returns — all showed signs of reversing in the latter part of 2014.
We view these shifts as part of the eventual normalization of the financial markets, by which we mean lower average annual returns with higher volatility. We see these developments as being accompanied by an eventual increase in the cost of capital, driven both by higher interest rates and wider credit spreads, which is a natural result of an ongoing economic expansion. A higher cost of capital usually has a significant and negative effect on highly leveraged businesses.
We thought it might be instructive to look at relative performance following historical underperformance periods. We identified 36 five-year spans from the Russell 2000 inception when PMF underperformed the Russell 2000 by 3.0% or more on an average annual basis. We then looked at the relative performance, as measured by excess returns, in the subsequent five-year periods. In 92% of them (33 of the 36), the Fund outpaced its benchmark. Moreover, the average excess return for all 36 subsequent average annual five-year periods was a healthy 6.4% per year.
Past performance is no guarantee of future results. That being said, and looking closely at history, particularly within the context of the highly anomalous period we have just endured, we suspect that investors may be able to appreciate why we are so optimistic about the prospects for both the relative and absolute performance of our disciplined, value-oriented approaches.
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