Where Are Small-Caps Headed Next?

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Co-CIO Francis Gannon on the state of the current small-cap market, the prospects for value’s leadership, and why cyclical businesses with global exposure continue to look attractive.

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Where do you think we are in the small-cap market?

I've been of the belief that we have been in a consolidating market, and that the market has been at a time correction, really, since the market peaked in December of last year. From the market peak in December, about a month after the election, through really, the end of the third quarter of this year, the market has, for all intents and purposes, marked time.

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That is a form of correction, and I think that's significant, as many people have been waiting for a correction to find that right moment to be in the equity market, specifically in the small-cap equity market.

So, what does that mean now? From my perspective, the market is breaking out not because of what might or might not be happening in Washington, DC. But I go back to that original idea that this is a new small-cap cycle. The bottom of the market on February, in February of 2016 is significant, and we are in a long run rate for that.

In that environment, we're now also hitting our stride from a value perspective, because what's happening, I think, is you're seeing a synchronized global economic recovery. You're seeing a pickup in economic activity in the United States; you're seeing a weaker dollar, you're seeing many things actually benefit some of the more economically sensitive or cyclical areas of the overall market and that is very helpful, I think, within the small-cap space right now.

Will September's leadership change last?

Well, I think one of the hallmarks of the third quarter of this year is this shift back to value. It was clear, it was decisive, it took place really around the low in the 10-year, in early September.

As the 10-year began to back up, its yield backed up, we saw value reassume leadership within the small-cap space. And I do think we have a very long runway within the small-cap space towards value. Growth has been a clear winner over the past five years. It's been outperforming for a period of time.

As growth has outperformed active managers have underperformed. Now you're seeing that market rotate back to value, and in a value-led market, active managers should do better. So, we are quite pleased, not only with our performance on a year-to-date basis, but the positioning of our funds going forward.

In many respects, the headwinds that we have faced as an active manager over the past many years now are becoming tailwinds. And in that moment, it's time to take the road less traveled within small-caps.

Why do you think globally exposed small-cap cyclicals are an attractive opportunity?

One of the biggest questions we get about small-caps really goes around valuation, and where the opportunity set is today, and aren't we expecting a further correction in the overall market? I think the biggest question people should be focusing on is revenue growth, revenue, is being generated.

Many people assume, and rightfully so, that a small percentage of revenue is generated outside of the United States. It's roughly around 19.8 percent, give or take, of revenue is generated outside of the United States.

But it's significant in certain industries, and sub-industries within the Russell 2000, technology being one, industrials being another, materials being another. These are great areas to find global businesses. And people forget that small-cap businesses are global businesses, the better ones, at least the way we think about them, are global businesses. And they'll be generating revenue outside of the United States, and they think global in terms of how they operate.

There's a leg here, from an earnings perspective, that I think people are missing. Earnings from these businesses should be doing better as we see this pickup in economic activity outside of the United States, coupled with a decline in the dollar, we think is almost a double whammy for earnings growth, and many of these more economically sensitive cyclical businesses.

Article by The Royce Funds

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