article 10-20-2014

Five Things You Should Know About U.S. Small-Caps

Co-Chief Investment Officer Francis Gannon offers five statistics we think every investor should know about U.S. small-caps in the current volatile investment environment.

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Francis Gannon, Co-Chief Investment Officer and Managing Director of Royce & Associates, offers five statistics we think every investor should know about U.S. small-caps in the current volatile investment environment.

1 – The Russell 2000 Index is now seeing its biggest correction since 2011.

As of October 13, the Russell 2000 was down 12.9% from its 2014 high on July 3. While we have seen a number of corrections in recent times, we have not seen a double-digit correction for almost two years and we have not seen greater than 12% in more than three. The third quarter of 2014, moreover, saw the first negative quarter for the small-cap index in the last nine.

Is this worrying? No. To paraphrase Warren Buffett, we should look at market fluctuations as our friend, not our enemy.

As long-term investors looking for value and high-quality companies, we see the correction as an opportunity to find great businesses at attractive prices.

2 – Half of the companies in the Russell 2000 were down 20% or more through the end of September.

A close look inside the small-cap index reveals that 49% of its constituents are currently down at least 20% from their respective 52-week highs. More than one in 10—11%—are off more than 30% over the last 12 months. To us, this shows the correction has been rotational—in other words, it has been going on, quietly, for a long time.

This is in part attributable to fears over the global economy, with a particular focus on Europe, China, and even Japan. However, one could also call it the "Janet Yellen Correction." After first broaching the topic in May, the Fed Chair called the small-cap market "stretched" in July, thus highlighting for investors how rich many small-cap valuations were.

Since then, of course, they have come down. In early October, the Russell 2000 was trading at 17 times earnings. That is still expensive, but our deep dive into the index suggests that many high-quality small-cap stocks still look undervalued.

One metric that we think is particularly revealing of quality is ROIC—return on invested capital. Interestingly, the highest quality small-cap companies within the Russell 2000, as measured by ROIC, were trading at a discount to the highest quality large-cap companies at the end of September, while companies with the lowest ROIC accounted for virtually the entire small-cap premium (see the chart below).

The upshot is that the small-cap space currently boasts plenty of quality companies—and many look attractively priced to us.

Median LTM1 EV/EBITDA2 by ROIC Quartile as of 9/30/14

1 Last 12 Months
2 Enterprise value/earnings before interest, taxes, depreciation, and amortization Return on Invested Capital is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock). The portfolio calculation is a simple weighted average that excludes all non-equity securities, investment companies, and securities in the Financials sector with the exceptions of the asset management & custody banks and insurance brokers sub-industries. The portfolio calculation also eliminates outliers by applying the inter-quartile method of outlier removal.
Source: Russell Investment Group and Bloomberg

Interestingly, the highest quality small-cap companies within the Russell 2000, as measured by ROIC, were trading at a discount to the highest quality large-cap companies at the end of September, while companies with the lowest ROIC accounted for virtually the entire small-cap premium.

3 – A quarter of small-cap companies make no money.

Amazingly, 25% of companies in the Russell 2000 are currently non-earners3 (of those 25%, 40% are in the Health Care sector). They make no money at all.

This tells us two things. One, the index as a whole might not be as expensive as it looks because it includes such a large number of companies currently earning nothing.

Second, and much more important in our view, is the idea that small-cap investors need to really understand what they own. Active management can make an enormous difference in the small-cap space, more so we think than in other asset classes.

We see quality as paramount both to mitigating risk and achieving above-average long-term returns.

4 – The Russell 2000 has never returned between 6% and 16% in a calendar year.

This is a surprising statistic given that the average return of the index since inception was 11.8% through September 30, 2014. To have never delivered anything close to the most recent average annual total return since inception says a lot to us about the volatility of the index. We believe that after five years of mostly low volatility we are likely to see much more going forward, which has historically been good for active managers.

5 – Small-caps are rarely down when the S&P 500 has a positive year.

Since its inception in 1979, the Russell 2000 has delivered a negative calendar-year return when the S&P 500 has had a positive year only five times.

From the beginning of the small-cap correction that began in early July, the spread between large-cap and small-cap has grown wider. (Year-to-date through September 30, 2014, the Russell 2000 was down 7.4% compared to respective gains of 8.3% and 8.0% for the S&P 500 and Russell 1000.)

Small-caps may rally and end up enjoying positive results for the year. However, it is interesting to note that every time the Russell 2000 has been negative for the year and the S&P 500 positive, small-caps have outperformed the following year.

Important Disclosure Information

Francis Gannon is a Co-Chief Investment Officer and Managing Director of Royce & Associates. His thoughts in this piece concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell© is a trademark of Russell Investment Group. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 1000 index is an index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

3 Source: Furey Research Partners

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