article 07-05-2016

Small-Cap Value Leads 2Q16 Despite Brexit Interruption

A once mildly bullish quarter turned wildly volatile in the wake of Brexit. The small-cap indexes then rebounded, recouping their losses to finish the quarter with modest gains. Despite the volatility, we saw certain longer-term trends continue to progress throughout the quarter.

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Brexit Looks Likely to Have a Minor Effect on U.S. Small-Caps

We see the Brexit vote as a political event for the European Union, not an economic event for the U.S.

Domestic small-cap companies have mostly minor ties to the EU; data from Credit Suisse shows that U.S. small-caps derive less than 10% of their revenues from Europe, the Mideast, and Africa.

Our Outlook: We see little danger of an imminent recession in the U.S. due to Brexit (or other causes). We expect the effects of this event, like previous market shocks, will dissipate and ultimately have little impact on U.S. small-cap stocks.





Small-Cap Value Continues to Lead

In our view, a critical difference so far this year in the behavior of small-cap value relative to growth has been performance in up markets. From the 2/11/16 small-cap low through 6/30/16, the Russell 2000 Value and Growth Indexes were essentially tied. In prior years (2009-2015), value led in many downdrafts but lagged in up markets. This renewed strength is a major reason for our optimism for value stocks.

In the quarter and year-to-date periods, the Russell 2000 Value Index outperformed the Russell 2000 Growth Index, and has now led in three of the last four quarters. The small-cap value index was also ahead from the Russell 2000 peak on 6/23/15 through 6/30/16 (-5.7% versus -13.5%), giving small-cap value more than a year of small-cap leadership.

Our Outlook: We think small-cap value is in the early stage of a long-term leadership cycle based on reversion to the mean and the combination of earnings and attractive valuation for many value stocks.

Russell 2000 Value vs Russell 2000 Growth Quarterly Returns (%) 





Small-Cap Still Looks Cheap Versus Large-Cap

Although the Russell 2000 Index modestly outpaced the Russell 1000 in 2Q16 (+3.8% vs. +2.5%), we still see small-caps as undervalued compared to their large-cap siblings. After more than two years of underperformance, U.S. small-caps now sell at a discount to large-caps despite what we see as more favorable growth prospects.

Through 6/30/16, the Russell 2000 was selling at a 4% discount to the Russell 1000 (based on EV/EBIT – Enterprise Value/Earnings Before Interest and Taxes) compared to a 13% premium at the end of 2013.

Our Outlook: We believe that the combination of less exposure to increasingly uncertain global markets, better growth prospects, and relatively attractive valuations makes a compelling case for small-caps.

Russell 2000 vs Russell 1000 Median Relative EV/EBIT - Enterprise Value/Earnings Before Interest and Taxes (excluding negative EBIT companies)


Source: Factset


Valuations for Cyclicals Become Even More Attractive

At the beginning of the quarter, small-cap cyclicals looked undervalued to us relative to defensive stocks. With many defensive areas such as Consumer Staples, REITs, and Utilities outperforming in the quarter, this valuation edge grew more pronounced. These same defensive areas often perform well when interest rates are falling. We expect a continued advance for defensive stocks would require further rate declines from here, a prospect we regard as unlikely.

Our Outlook: Small-cap cyclicals appear to us as the most attractive area of the small-cap universe. We expect that the intersection of attractive valuations with earnings (or high profitability) that helped give sectors such as Industrials and Materials strong year-to-date returns through 6/30/16 can drive small-cap results over the long term.

Cyclical vs Defensive Stocks Within the Russell 2000 Median Relative EV/EBIT - Enterprise Value/Earnings Before Interest and Taxes for Cyclical vs. Defensive Stocks (excluding negative EBIT companies)1


R2K-cyc-def-avg

Source: Factset
 

Active Is Beating Passive in 2016

We have uncovered an important performance relationship that we see little noted elsewhere, which is that the active/passive small-cap performance cycle often correlates with whether a market is led by value or growth stocks. So far, 2016's results support this view. As small-cap value is leading growth so far, it is not surprising to us that active managers are having greater success beating passive. According to data from Morningstar, only 31% of active managers in the Small Blend category outperformed their benchmarks from 12/31/14-6/30/15 while 48% outperformed in calendar 2015. In the first half of 2016, however, that percentage increased to 56%.

Our Outlook: We suspect that the recent leadership reversal in favor of value stocks also marked the beginning of an active management cycle that we expect will be long lasting. 





1 Cyclical and Defensive are defined as follows: Cyclical: Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Telecommunication Services, and Utilities.

Important Disclosure Information

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Investments in securities of micro-cap, small-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.)

The thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance. All indexes referenced are unmanaged and capitalization-weighted. 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 Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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