Why Small-Caps Can Keep Going Strong—Royce
article 01-08-2024

Why Small-Caps Can Keep Going Strong

Portfolio Manager Chuck Royce and Co-CIO Francis Gannon look at a terrific quarter for small-caps, why the rally may have legs, and three high-confidence holdings.

TELL US
WHAT YOU
THINK

Were you surprised by how well the Russell 2000 Index rebounded in 4Q23?

Chuck Royce: We were surprised to some degree, yes. On the one hand, we had been waiting for a meaningful small-cap rebound for some time and really felt as though it was long overdue by the time the fourth quarter rolled around. We’ve also been showing data over the last few years which highlights how undervalued the Russell 2000 Index is relative to the large-cap Russell 1000 Index—even at the end of 2023, small-caps were still trading close to their 20 year lows based on a valuation metric that we often use, the last 12 months of enterprise value to earnings before interest and taxes (EV/EBIT). In addition, we thought that the Fed’s decision to pause rate hikes would spur an increase in stock prices. Based on all of that, the 14.0% 4Q23 advance for the Russell 2000 was not a surprise. But in light of how dominant large- and mega-cap stocks have been over the last several years—and how stubbornly they’ve clung to leadership—it was very satisfying to see the Russell 2000 beat both the Russell 1000 and Russell Top 50 in 4Q23.

What other factors were notable about the performance of small-caps in 4Q23?

Francis Gannon: First, we were pleased to see small-cap value beat small-cap growth in the fourth quarter: the Russell 2000 Value Index was up 15.3% versus a 12.7% gain for the Russell 2000 Growth Index. A similar dynamic to the one that Chuck mentioned regarding valuations between small- and large-cap can also be seen in the relative valuations of small-cap value and small-cap growth. Based on that same EV/EBIT metric, the Russell 2000 Value was trading at much lower valuations at the end of 2023 compared to the Russell 2000 Growth.

What do you see as the implications for these cheaper relative valuations for small-cap and small-cap value going forward?

FG: I think the critical factor is how much running room small-cap stocks have on both an absolute and relative basis. Consider that, even after its very bullish fourth quarter, the Russell 2000 underperformed the Russell 1000 in 2023 by a wide margin, up 16.9% versus 26.5%. Similarly, the Russell 2000 Value gained 14.6% versus 18.7% for the Russell 2000 Growth in 2023. Moreover, the Russell 2000 finished the year -14.3% shy of its prior peak on 11/8/21 while large-caps continued to make new highs into the end of December 2023.

Small-Caps Lagged Large-Caps from the Russell 2000’s Last Peak
Russell 2000 and Russell 1000 Cumulative Returns
11/8/21-12/31/23

 

Past performance is no guarantee of future results

In addition, 45% of the companies in the Rusell 2000 remained down -20.0% or more as of 12/31/23. This tells us that terrific long-term opportunities can still be found—in particular for attractively undervalued and/or high-quality companies with strong fundamentals and promising long-term growth prospects, which are exactly the kinds of businesses we look for in our major domestic Strategies.

CR: I think it’s also worth noting that the Russell Microcap looks, if anything, even cheaper based on EV/EBIT—which really reinforces Frank’s point about the long-term opportunities' patient investors can source within the small- and micro-cap asset classes. Both are much broader and more diverse than large-cap—and receive far less analyst coverage. This lack of institutional attention creates challenges—but these same obstacles have often given us—and our investors—rewards over the long run.

Do you see small-cap overtaking large-cap at some point?

FG: Yes—though we obviously don’t know when. When we look at long-term performance patterns, small-cap had a longstanding advantage—just as small-cap value did versus small-cap growth. Each of these dynamics began to shift in the aftermath of the Financial Crisis, starting in earnest in 2011. In nine of the last 13 years, the Russell 1000 and Russell 2000 Growth beat both the Russell 2000 and Russell 2000 Value. Yet prior to that, the long-term edge was with the Russell 2000 and Russell 2000 Value. What we think many investors may have forgotten is how anomalous the backdrop to the last 13 years has been—with mostly anemic economic growth and record low interest rates. Now that these elements are returning to more historically typical levels, we expect to see some meaningful long-term mean reversion going forward.

Do you think a more historically normal level of rates can help high-quality small-caps going forward?

CR: First, I think a more historically normal level of rates ultimately helps a lot of stocks, if only from the standpoint of stability. Companies fear uncertainty and instability more than almost any other factors, so I think the end of the Fed rate hike cycle should be viewed as a positive for most equities other than the most highly levered businesses. Of course, this has as much if not more to do with the end of the fastest rate of increase in history as it does with where rates are currently sitting. But in any event, I think that companies with low leverage, the ability to generate free cash flow, and proven capital allocation skills are poised to benefit most. And it’s true that we find those attributes most frequently in the small-cap quality zone—that is, companies that also have high and consistent returns on invested capital, discernible competitive advantages, and a sustainable franchise.

FG: The price of carrying leverage on the balance sheet began to climb when the Fed first started raising rates in March of 2022. I don’t think we can stress how important low leverage is—especially now that we’re in a more historically normal interest rate environment. Of course, we’ve always focused on small-cap companies with low or no leverage, though we accept that the era of zero or ultra-low rates made the issue of leverage less important for many companies and investors. But we are no longer in that environment—and we anticipate that investors will begin to reward well-managed companies with low-debt balance sheets more regularly.

What investment themes or industries within small-cap look most promising to you as a long-term investor?

CR: As always, we look carefully at almost every sector and industry in our efforts to find high quality and/or attractively undervalued small-cap companies. Some areas yield more ideas than others, of course, and we continue to lean toward more cyclical sectors. I think the most prominent themes in the portfolios I work on remain high quality and companies involved in automation or other innovations that provide other businesses with the tools and services that improve efficiency and productivity. In fact, many of these companies were utilizing AI for years before we all began talking about ChatGPT.

Can you talk about a key holding that didn’t fare well in 2023 that still has your long-term confidence?

CR: A value stock we like is Advance Auto Parts, which we think has a terrific, recession-resistant business in replacement auto parts that could grow in a weaker macroeconomic environment as consumers make needs-based purchases. The stock slumped about 58% in 2023. A lot went wrong for the company, including a decision to cut its dividend and needing to slash its financial forecasts twice. We think the stock can rebound, however, as margins improve because its underlying core business remains strong.

Advance Auto Parts (NYSE: AAP)
12/31/22-12/31/23

 

Past performance is no guarantee of future results

Can you also discuss a company that did well in 2023 that you think still has room to run?

CR: One would be Assured Guaranty, which provides financial guaranty insurance and reinsurance coverage for municipal, structured, and infrastructure bonds. It’s a fairly prosaic business that we like a lot because it’s mostly steady owing to Assured’s strong record and long-running financial strength. Its underwriting strategies are sound and innovative, which gives it a competitive advantage. We also like its risk management and loss mitigation practices as well as its generally consistent earnings history and dividend.

Assured Guaranty (NYSE: AGO)
12/31/22-12/31/23

 

Past performance is no guarantee of future results

Haemonetics would be another. Its performance in 2023 wasn’t as strong as Assured Guaranty, and its shares were pretty volatile, but we think it’s well positioned to grow in the years ahead. The company specializes in plasma collection, a business that continued to outperform expectations despite losing its biggest customer—who nonetheless continues to use Haemonetics’s collection platform. The newer Hospital segment of its business has become a larger-than-expected contributor. Vascade, its vascular closure franchise, has grown more than 30% per year since its acquisition in 2021—and Haemonetics is now expanding sales of Vascade into Europe and Japan. The company also recently closed its acquisition of a Canadian company, OpSens, that provides proprietary fiberoptic sensor technology, which will contribute to the hospital segment and is expected to be immediately accretive.

Haemonetics (NYSE: HAE)
12/31/22-12/31/23

 

Past performance is no guarantee of future results

FG: Our outlook is constructive. First, we suspect that returns are likely to skew more widely over the next few years and that the reign of the Magnificent 7—the mega-cap cohort of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla—may be coming to an end, especially if 2023’s fourth quarter and early January 2024 are any indication. The backdrop of moderating inflation, normalized interest rates, and a still growing U.S. economy, also bolsters our belief that small-cap’s lengthy stretch in the relative performance wilderness has run its course. Moderate economic growth and the more normalized rate environment should support a broadening of equity market returns where small-caps could be clear beneficiaries, especially those businesses that have largely sat out the mega-cap performance regime. In addition, large-cap cycles have historically peaked when a relatively small number of the largest stocks were winning the lion’s share of performance. We saw this with the S&P 500 in 1973 and in March 2000. Furthermore, a few of the Magnificent 7 will continue to face the possibility of greater regulation, especially from Europe.

CR: Of course, we always put the most stock in what we’re hearing from management teams—most of whom remain cautiously optimistic about 2024. It appears increasingly likely, for example, that the U.S. economy will achieve the much-desired soft landing—which is encouraging for many reasons. The next few years will see even more tangible benefits of reshoring, the CHIPS Act, and numerous infrastructure projects, and many of our holdings are poised to benefit from these developments. So, we’re looking forward to what we think should be a favorable cycle for small-cap stocks.

Important Disclosure Information

Mr. Royce’s and Mr. Gannon’s thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce Investment Partners, and, of course, there can be no assurances with respect to future small-cap market performance. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Percentage of Fund Holdings as of 12/31/23(%)

  Pennsylvania Mutual Dividend Value Global Financial Services International Premier Micro-Cap Small-Cap Opportunity Premier Small-Cap Special Equity Small-Cap Total Return Small-Cap Value Smaller-Companies Growth

Advance Auto Parts

0.3

0.0

0.0

0.0

0.0

0.0

0.0

0.0

2.4

0.0

0.0

Assured Guaranty Ltd.

1.1

2.1

2.1

0.0

0.0

0.0

0.0

0.0

1.8

0.0

0.0

Haemonetics Corporation

1.4

0.0

0.0

0.0

0.0

0.0

2.3

0.0

0.0

0.0

0.0

Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. All indexes referenced are unmanaged and capitalization weighted. 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 unmanaged, capitalization-weighted 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 Russell Top 50 Index measures the performance of the largest companies in the Russell 3000 Index. It includes approximately 50 of the largest securities based on a combination of their market cap and current index membership and represents approximately 40% of the total market capitalization of the Russell 3000 Index. The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. The (Center for Research in Security Prices) CRSP (Center for Research in Security Pricing) equally divides the companies listed on the NYSE into 10 deciles based on market capitalization. Deciles 1-5 represent the largest domestic equity companies and Deciles 6-10 represent the smallest. CRSP then sorts all listed domestic equity companies based on these market cap ranges. By way of comparison, the CRSP 1-5 would have similar capitalization parameters to the S&P 500 and the CRSP 6-10 would have similar capitalization parameters to those of the Russell 2000. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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. The performance data and trends outlined in this article are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements. 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.)

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