article 07-08-2014

Examining recent small-cap returns during positive and negative performance periods reveals an interesting historical pattern...

Gleanings from the second quarter—a decent market, with quality small-caps doing very well in the small correction from 3/4/14-5/15/14.

For the eighth consecutive quarter the small-cap Russell 2000 Index advanced, gaining 2.1% in the second quarter of 2014. The index rose 3.2% for the year-to-date period ended June 30, 2014 and climbed 23.6% for the one-year period through the end of June. This is its longest quarterly winning streak since 1995-1996. 

Yet we all know equity markets never move in a straight line. In fact, during the just-completed first half, the Russell 2000 declined 9.1% from its March 4 interim peak through May 15. Ironically, the market's transition to quality companies—those with attractive characteristics such as strong balance sheets and high returns on invested capital—is ongoing, but has been equally bumpy.

As Jim Furey of Furey Research Partners recently pointed out, the small-cap advance in June was led by low quality—loss-making, low-priced, negative growth, etc.—companies.

"This trend has been in place for a long time now—in the 16 months since March 2013 (including MTD), there have been 10 months of positive small-cap returns and 6 months of negative returns. In the 10 positive months, loss-makers outperformed profitable companies on 8 occasions (80%). Conversely, in the 6 negative months, profitable companies outperformed loss-makers on 5 occasions (83%)."

We are quite pleased with the performance of our portfolios since that early March interim peak, as our focus remains squarely on risk management, absolute valuations, and quality-enhanced returns, especially in corrective market phases.

At the same time, we look forward to the day when high-quality companies meaningfully lead in both down and up phases of the cycle.

To be sure, it has been awhile since we've seen a correction of any significance. In fact, the last downturn of more than 10% for the Russell 2000 occurred in the fall of 2012.

Valuations in general are high for the small-cap index, stretched further by the fact that 25% of the Russell 2000's companies did not make money in the last 12 months.

Corrections can arrive at any time, yet we remain optimistic going forward because of our greater exposure to high-quality companies with cyclical orientations.

For The Royce Funds' one-, five-, 10-year, and/or since inception returns as of the most recent quarter-end period, please see our Prices and Performance page.

Important Disclosure Information

Francis Gannon is Co-Chief Investment Officer and Managing Director of Royce & Associates, LLC, investment adviser for The Royce Funds. Mr. Gannon's thoughts and opinions expressed in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to 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 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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