Are better days ahead for small caps?

What did you find most notable or surprising about the market’s performance in 3Q23?

Francis Gannon: The most striking thing was that equity returns were negative across the board. Both here in the U.S. and elsewhere, the major indexes all trended downward in 3Q23. For small cap, this was especially disappointing because returns for the Russell 2000 Index were positive in June and July. What looked like the beginning of a promising turnaround, with small caps reaching their 2023 high on July 31 and beating large caps in that month, ended with a -10.0% loss for August and September. The upshot was that the Russell 2000 finished the third quarter with a gain of 2.5% year-to-date, 1,047 basis points behind its large-cap sibling, the Russell 1000 Index, which was up 13.0% for the same period.

What insights can you offer about why small caps have had only three (possibly four) months of positive performance so far in 2023?

Francis Gannon: There have been several different developments throughout the year that have hurt small-cap returns. The bank failures have played a large role, particularly for the Russell 2000 Value Index, where they account for close to 20% of the index. Banks were also the biggest detractor on an industry level year-to-date in the Russell 2000 through the end of September. And the banking industry has struggled from an investment standpoint regardless of whether or not smaller banks are operating effectively—as some of them are, especially in areas of the country with strong population growth. More recently, we’ve seen corrections in small-cap healthcare, consumer, and tech stocks. In fact, Energy and Financials were the only sectors in the Russell 2000 that were in the black for 3Q23 and the latter sector made only a marginal positive contribution. Rising yields have probably been the biggest culprit. Their negative effect has been evident through most of the year.

What is your take on the state of the U.S. economy in light of the many contradictory signals we’ve seen over the last two years?

Chuck Royce: We’re awash in contradictory data. Regardless of whether you’re optimistic or pessimistic, there’s enough data to justify your point of view on the economy. Beyond employment—which remains quite strong—the leading economic indicators look mixed. For example, housing prices are climbing but sales have been uneven, and mortgage rates reached a 23-year high at the end of September; consumers continue to spend, but confidence has been trending lower; auto sales have been strong but are threatened by the United Auto Workers (UAW) strikes. So, I don’t have a strong view one way or the other about where we are right now.

Do you have a view on whether or not we’ll see a recession?

Francis Gannon: I agree with Chuck that it’s impossible to say as long as the data remain as inconsistent as it’s been. What was particularly interesting to see in September, however, was how quickly the consensus shifted from a soft landing to the increased likelihood of a recession without any pronounced shift in the numbers. The only significant moves were in stock prices, which fell, and yields, which keep rising. The 10-year Treasury hit 4.8% in early October while the 30-year reached 5.0%. But the bond market has been signaling recession for at least two years now, and we haven’t experienced one yet. That doesn't mean it won’t happen. It’s certainly possible, but the increased fatalism we’ve seen recently doesn’t appear to have any more support than the more measured optimism we saw during the summer.

How has economic uncertainty affected the way you invest?

Chuck Royce: The market seems more fatalistic than the data can support, especially among small caps—which is a positive over the long run because this pessimism is creating plenty of interesting long-term opportunities. Small caps finished September in a bear market. The Russell 2000 was down -24.8% from its last peak on 11/8/21 through the end of the third quarter. Many companies we’ve looked at—and bought—appear to have already priced in a recession. Both in terms of P/E (price-to-earnings) and EV/EBIT (enterprise value over earnings before interest and taxes), many small caps look undervalued. They look even cheaper compared to large caps. Based on EV/EBIT, small caps remained close to 20-year lows relative to large caps at the end of September. So as difficult as 2023 has been for small cap performance, the opportunity set has looked compelling from a valuation standpoint.

How does the current bear market compare with previous downturns?

Francis Gannon: We define bear markets as those with a decline of -20.0% or more from a previous peak. Since the inception of the Russell 2000 at the end of 1978, the average duration of a bear market, measuring from a previous peak to the point when that peak was reached again, was 701 days. And while the current trough for the Russell 2000 occurred in June 2022, small caps remain in bear territory and are well shy of matching that November 2021 peak. So regardless of when the recovery phase begins in earnest, the current bear period will almost certainly go down as one of the longest in the history of the small-cap index.

What is notable about the five-year return for the Russell 2000 at the end of 3Q23?

Francis Gannon: The Russell 2000 also had an annualized return of just 2.4% for the five-year period ended 9/30/23, which was almost identical to its 2023 year-to-date return. This was among the lowest five-year returns since the inception of the Russell 2000 and shows that many small caps have essentially been treading water for the last five years. And while the last five years have been a very trying period for small-cap investors, especially when weighed against the markedly higher returns for large cap over the same five-year span, our long-term confidence is high. We’ve talked before about how these lower-than average annualized five-year returns for the Russell 2000 have historically led to higher-than-average returns over the next five years. The Russell 2000 had positive annualized 5-year returns 100% of the time—in all 81 five-year periods—averaging 14.9%, which was well above its monthly rolling five-year return since inception of 10.4%.

Circling back to Chuck’s point about valuations, the weighted harmonic average P/E for the Russell 2000 five years ago was 18.4x, which is very close to the index’s 25-year average of 18.1x. At the end of 3Q23, however, its weighted harmonic average was 12.5x. We think that taken together these numbers paint a very promising picture of the long-term prospects for small-cap stocks.

What other factors underlie your long-term optimism?

Chuck Royce: We’re either near or at the end of the rate hike cycle. One more increase is possible, but I don’t see the Fed raising rates beyond that. In addition, inflation continues to trend down—which is a positive on its own as well as a sign that more hawkish monetary policy has done what it was supposed to do. In addition to the strong labor market and consumer spending remaining steady, we can add the strength of Capex, the reshoring phenomenon, the effects of the CHIPS and Science Act, and AI applications all as highly promising elements whose benefits haven’t yet registered fully, if at all. Of course, the most significant factor for us is that the majority of the management teams we’ve been speaking to remain cautiously optimistic over the long run. So, while the near-term view remains as cloudy as any I’ve seen, there are enough positives for me to have a very constructive view for long-term small-cap returns going forward.

How has active management been doing within small cap through this uncertain period?

Francis Gannon: The strength and success of active small-cap management has really stood out over the last several years. As we usually do, we use Morningstar’s Small Blend1 Category as our proxy for active management. This category beat the Russell 2000 for the 1-, 3-, 5-, and 10-year periods ended 9/30/23. When we excluded index funds and included only the oldest share class of a fund within the category for periods ended 9/30/23, 146 out of 174 funds outperformed the Russell 2000 for the 1-year period; 150 out of 167 funds beat the small-cap index for three-year period; 131 out of 158 did so for the five-year period; and 88 out of 131 funds beat it for the 10-year period. Equally, if not more important, performance has been strong across our domestic strategies on both an absolute and relative basis. I’d say that, as confident as we are for small-cap’s prospects as a whole, we feel even stronger about the prospects for active small-cap management, especially when the economy begins to grow at a more robust pace, in all likelihood against the backdrop of a more normalized interest rate environment.