Cyclicality Is Our Friend: Market Downturns Can Build Better Future Returns

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In a year bookended by strong performance, investors were nevertheless disappointed with overall equity returns and especially those provided by small-cap companies. After two strong years in which the small-cap Russell 2000 Index was up 27.2% (2009) and 26.9% (2010), a pause was not unexpected. A review of the index's calendar-year returns reveals that over the 33 years of its existence, 23 have ended with a positive return while 10 have wound up in the red. Therefore, on average, about every third to fourth calendar year return has been negative.

Interestingly, calendar-year performances following a negative return year were positive in each instance but one (2008) and generally were very robust (1985, 1988, 1991, 1995, 1999, 2003, 2009), again with one exception (2001).

The Russell 2000's historical returns reflect both the long-term upward bias of the equity market and its cyclical downturns. While bear markets never feel good, they generally set the stage for higher returns. As contrarians, downturns serve a very important function in our investment process, allowing for the accumulation of well-run companies at attractive prices. Total return is a function of entry price. With a downturn having occurred on average every third or fourth year, the opportunity to earn higher future returns has often been created during these periods.

Beyond The Headlines

Two thousand eleven will be remembered as the Year of the Headline. Difficulties both in the U.S. and abroad were well-chronicled—a slow-growth economy, financial meltdown in Europe, high unemployment, poor housing statistics, etc.— and affected not only equity performance, but the willingness of investors to commit to equities in general. (Equity mutual funds experienced significant outflows in 2011.)

While investors were aware of the calendar-year downturn in 2011 for small-cap equities, many may have overlooked its potential significance in building better future returns. Those fixated on 2011's headlines may have missed that the Russell 2000's 29.1% decline from its April 29, 2011 peak through its October 3, 2011 low presented ample purchase opportunities—history would suggest that underperformance of such magnitude has often provided the impetus for subsequent outperformance.

We think it's important to remember that downdrafts are neither unusual nor unprecedented. Using the Russell 2000 as an example, the small-cap index has experienced 18 downturns of 10% or more since its 1979 inception, including the most recent one in 2011. While calendar-year declines have occurred about every third or fourth year, downturns of 10% or more have happened about every other year.

While the 7/13/07-3/9/09 peak-to-trough period was the worst on record, with a decline of 58.9%, there have been nine peak-to-trough declines of at least 20% in the index's history. In the eight periods prior to 2011, performance following these downturns was considerable. As the table above indicates, the average return following declines of at least 10% was 29.6% during the first six months and 46.8% for the twelve months following the decline.

One-year returns following declines of 20% or more ranged from 33.8% to 99.1%, while three-year average annual total returns ranged from 6.7% to 36.2%. Following declines of 10% or more, the three-year average annual total return was 17.9%. Higher ensuing returns tended to follow the most severe downturns. What may be most interesting about 2011's peak-to-trough decline is that it ranks as the sixth worst on record in the history of the Russell 2000. The five worst declines prior to the current period were followed by dynamic returns out as far as ten years. Here's hoping that history will repeat itself as we distance ourselves from the 2011 downturn.

Bell Curve Opportunities

One final observation regarding the 2011 decline gives us additional encouragement: the 29.1% downturn was an average for the entire small-cap index. While some of the index's constituents fared better, many also fared worse, thus creating even greater potential return opportunities. As the chart below indicates, half of the companies that comprise the small-cap index were off 30% or more during the peak-to-trough period. In fact, 30.7% (592 companies) were down more than 40%, and 16.3% (314 companies) of index constituents were off 50% or more during the downdraft.

A decline of 30% means that a company's stock price must appreciate 43% to get back to where it was at the start of the decline; a 40% decline must appreciate 67%; and a 50% decline must rebound 100% in order get back to even. From our perspective, not every security in the Russell 2000 Index that depreciated by these significant amounts is worthy of purchase consideration, but many are, which fuels our excitement about the potential of small-cap returns.

Again, downturns are never fun, but they remain important components in the creation of higher long-term returns.