3Q18 Small-Cap Investment Update
article 10-01-2018

3Q18 Small-Cap Investment Update

Small-cap stocks saw record highs, even lower volatility, and a market cap performance reversal. See why we’re focusing on the curious but promising juxtaposition between strong fundamentals and stretched valuations.

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Ongoing Trends Lift Small-Caps To New Highs

In many ways, 3Q18 resembled 2Q18—domestic equity returns were solidly positive across all asset classes as the economy continued to show robust growth.

Both the small-cap Russell 2000 and large-cap Russell 1000 Indexes saw record highs in the quarter, with the most recent for the small-cap index on 8/31/18 and on 9/20/18 for large-cap stocks.

Investors once again shook off the by-now routine headlines about the potential dangers of tariffs, trade wars, inflation, and rising rates to keep equity performance climbing. This was in line with our expectations as we thought much of the pessimism around the market was exaggerated.

Investors seemed more influenced by the current tide of positive news, such as ongoing growth, strong earnings, and high employment, than by the risks mentioned above (which have not yet been fully realized—or realized at all).

Most non-U.S. indexes saw more of the same performance pattern as they slid a little further back in 3Q18 after posting negative results in each of the year’s first two quarters. Results were hampered by slower growth in developed economies and trouble in certain emerging markets.

Recent domestic small-cap performance has been quite impressive. The three-year cumulative return for the Russell 2000 was 60.7% for the period ended 9/30/18 compared to its rolling monthly three-year cumulative average since inception (12/29/78) of 39.2%.

Year-to-date through 9/30/18, the Russell 2000 gained 11.5%. If results for the small-cap index remain in this range, it will mark the third consecutive year of double digit small-cap performance, something that has happened only twice before—and not for more than 20 years—since the inception of the index on 12/29/78.



Market Cap Reversals for Small-Caps And Large-Caps

In 2Q18, smaller was better. Returns were highest for micro-caps, followed by small- and large-caps. This trend reversed with perfect symmetry in 3Q18. As measured by the Russell indexes, large-cap led, followed by SMid-cap, small-cap, and micro-cap.

As large-caps have historically led when investors become wary of continued growth, does their outperformance in 3Q18 signal that economic growth is nearing its last stage in this cycle? We suspect it does not.

While it’s possible that the pace of growth could slacken, we see enough signs of ongoing growth—including what the companies we hold are telling us—to maintain our confidence that growth will remain healthy. We see recent large-cap outperformance, which was possibly driven by diminishing fear of negative tariff effects, as more of a catch-up after those stocks lagged significantly in the first half.

More important, we believe that cyclical companies will continue to emerge as leaders, which will allow small-cap stocks to stay ahead of their large-cap siblings.



Pull Backs For The Russell 2000 Value Index and Small-Cap Breadth

The seesaw of quarterly performance continued within small-cap in 3Q18. The Russell 2000 Value Index trailed the Russell 2000 Growth Index in 1Q18 (-2.6% versus +2.3%), outperformed in 2Q18 (+8.3% versus +7.2%), and then fell behind in 3Q18 (+1.6% versus +5.5%).

Unsurprisingly, since leadership for growth typically signals narrow market leadership, small-cap breadth also reversed course by contracting in the quarter. The cap-weighted Russell 2000 rose 3.6% in 3Q18 versus an advance of only 2.3% for the equal-weighted small-cap index. This is partly attributable not just to the strength of growth stocks but also to the lagging results for Financials.

The stubborn and puzzling issue that we’ve examined before therefore remains in place. An environment featuring robust economic growth and rising interest rates is, at least historically, tailor made for small-cap value to assert its long-term historical advantage over growth. Yet these conditions have been present since at least the beginning of 2017, and during this otherwise wonderful period growth has beaten value in six out of seven quarters.



Emerging Sector Strength Was Encouraging For Small-Cap Cyclicals

We also saw some decidedly positive developments in 3Q18. Three of the most notable—and related—in our view were: the stronger showing for small-cap earners versus non-earners, which finished 3Q18 virtually even; the outperformance of some cyclical sectors over defensives, and the renewed strength for small-cap industrial companies—the majority of which lagged through the first half of the year.

In fact, along with Information Technology and Health Care (which have both enjoyed strong years so far), the Industrials sector made one of the three largest contributions to return within the Russell 2000 in 3Q18.

We were even more pleased to see that the sector boasted strong, index-beating quarterly results for industries in which our portfolios have significant exposure, such as machinery, electrical equipment, and aerospace & defense.



Strong Fundamentals, Stretched Valuations For Small-Cap Stocks

This juxtaposition goes to the heart of why prospective results for the overall market are unusually difficult to gauge while at the same time it bolsters our confidence that select small-cap cyclicals can lead.

The current risks are very real: valuations for many stocks appear stretched while investors seem far too comfortable, lulled into complacency by low volatility as they stick with the stocks, styles, and/or strategies that have worked through much of the post-Financial Crisis period—the bio-pharma complex and software, growth stocks, and passive investments.

Markets have also been unusually and eerily calm, reaching cruising altitude with very little turbulence. The historical average of trading days over the last 20 years with moves of 1% or more for the Russell 2000 is 40%. But since the beginning of 2017 only about 20% of its trading sessions have met or exceeded that threshold. However pleasant, these conditions are unsustainable.

Additionally, we are wary that contracting financial liquidity created by a decline in money supply growth in an accelerating economy could trigger a correction.

At the same time, much of the domestic backdrop is highly positive for select equities: the U.S. economy continues to grow at a steady clip while interest rates are slowly climbing toward more historically typical levels. Current earnings, future EBIT growth expectations, and many macroeconomic measures—particularly Leading Economic Indicators and Institute for Supply Management new orders—also remain encouraging.

And while rates, wages, and inflation are all rising, each is moving at a more-than-manageable pace. Recession risk appears very low.

Perhaps most important, valuations are not uniformly high—or unreasonable—within the small-cap universe. Many profitable cyclical businesses, for example, are valued quite reasonably in our estimation.



The Selectively Bullish Case For Small-Caps

To be sure, the outlook and earnings picture that we are seeing from the companies we meet with continues to skew toward cautious optimism. Most of management’s concerns focus on tariffs, trade, and inflationary pressures.

In the cyclical industries where the vast majority of our companies are found, earnings remain strong and much of the guidance remains positive. Small-cap earnings prospects also look more promising for cyclical companies than for defensive areas. For example, many industrial companies have been posting strong earnings that seem to be ahead of their respective stock prices, meaning that even in a high-priced market they may have room to run.

In fact, there has been a growing valuation gap so far this year between small-cap industrials and the rest of the market. As returns keep climbing while industrials labor to keep up, the latter’s solid earnings profiles give many of them increasingly attractive valuations.

At the same time, many growth stocks and defensive industries carry both higher valuations and less attractive earnings profiles, putting them is an especially precarious condition during a rising interest rate environment.

Buying opportunities are admittedly somewhat scarce—a reality reflected in many portfolios’ higher-than-usual cash positions—but we are happy to be holding what we think is a roster of great small-cap businesses. In general, we have been trimming high valuation holdings and tilting portfolios toward select cyclicals.

This is a diverse group that includes alternative asset managers and M&A boutiques, productivity boosting software companies (especially timely when labor is scarce), financial intermediaries that look poised to benefit from (eventually) higher volatility, and contrarian positions in the media and recreational vehicles industries where excess pessimism about future prospects has depressed valuations to what think are attractive levels.

From our perspective as small-cap specialists, the kinds of cyclicals that we hold, those with strong earnings and/or profitability, look best positioned for the promising but uncertain road ahead.

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Important Disclosure Information

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.

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.)

Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

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 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell Microcap Index includes 1,000 of the smallest securities in the small-cap Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. The Russell 2500 is index of the 2,500 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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.

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