CONTRIBUTORS
Chuck Royce
Chairman, Portfolio Manager
Francis Gannon
Co-Chief Investment Officer, Managing Director
Were you disappointed that the Russell 2000 Index trailed the large-cap Russell 1000 Index in 1Q24?
Chuck Royce: Not at all. I also think it’s important to emphasize that we generally don’t look at quarterly performances as being very revealing. It’s rare for a single quarter or any other short-term period to signal a lasting shift in the market’s direction or leadership. So, while it’s still premature to call a decisive shift in favor of small-cap, we’re very encouraged by how small-caps have been performing over the last several months. For example, while small-caps lagged large-caps in the first quarter, they were ahead of large-caps from the low on October 27th through the end of March. The Russell 2000 advanced 30.7% in this period, beating the Russell 1000, which was up 28.9% over the same span.
In this context, why do you think small-caps underperformed large-caps in the first quarter?
Francis Gannon: The first quarter looks to us like a fairly mild consolidation phase, in which investors digested the big gains from the end of 2023. An upswing in the 28-30% over roughly two months is quite rare, so it wasn’t surprising that many investors took gains—which got 2024 off to a slow start that was tougher on small-caps than on their larger siblings. The Russell 2000 lagged the Russell 1000 from the high on December 27th through the end of 1Q24, up 3.2% versus 10.0%. However, the last two weeks of March saw small-cap move ahead of large-cap. This kind of jockeying for position is pretty common when market leadership shifts. The upshot from our perspective as small-cap specialists is that the latest phase has seen small-caps fully participate in a robust for the first time in several years—which we see as a very positive sign.
When did the Russell 2000 last reach a peak?
Francis Gannon: Small-cap has still not established a new all-time high since its most recent peak on 11/8/21. So, it’s been almost two-and-a-half years, which makes it the second-longest period since the index’s 1979 inception that the Russell 2000 has gone without reaching or exceeding a peak—and the last one occurred during the 2008-09 Financial Crisis. As of 3/31/24, the Russell 2000 was down -9.9% from its November 2021 peak. Meanwhile, the large-cap indexes continued to reach new highs into March 2024. Of course, this is one of the reasons why we’re bullish on over the long run. Even taking the strength of the last five months of performance into account, small-caps still have room to run, in our view.
Did the Russell 2000 experience a high level of concentration in its first-quarter return?
Francis Gannon: Yes. There’s been a lot of volatility within small-cap over the last 15 months, complete with a higher-than-usual level of concentration so far in 2024, when 12 stocks accounted for 100% of the first-quarter return for the Russell 2000. Most of this actually came from just two stocks: Super Micro Computer was up 255%, while MicroStrategy rose 170%. Together, the pair accounted for 38% of the Russell 2000’s return for 1Q24. Unlike in large-cap, however, small-cap companies outgrow the benchmark when it rebalances each year in May—which more or less takes care of any concentration issues within the Russell 2000. We’re much more focused on the potential for small-cap returns to broaden in the months to come.
Were you surprised that the Russell 2000 Value Index trailed the Russell 2000 Growth Index in 1Q24?
Chuck Royce: Small-cap growth’s relative advantage was not very surprising to us. We would expect the early stages of a strong rally to be led by growth, which is largely consistent with the history of small-cap upswings. In addition, many small-cap growth stocks were really beaten down in 2023, so there were a lot of interesting bargains in that space for investors to buy.
Francis Gannon: We think the more interesting story is how competitive small-cap value has been since the October lows. From 10/27/23 through 3/31/24, the Russell 2000 Value gained 28.2%, while the Russell 2000 Growth was up 33.4%. Moreover, banks accounted for roughly 17% of the Russell 2000 Value in the first quarter—and the industry detracted significantly from the small-cap value index’s results in that time period, mostly due to renewed fears of bank failures driven by New York Community Bank’s recent troubles. So, while the Russell 2000 Value was up 2.9% in 1Q24, versus a 7.6% gain for small-cap growth, when we excluded banks, the first-quarter return for the small-cap value index improved to 4.9%.
What do you think needs to happen for small caps to recapture market leadership?
Chuck Royce: I want to suggest—with a cautious confidence—that the phase has already begun. And I don’t think it will take much for the small-cap rally to pick up more steam. The U.S. economy remains resilient—far more so than many were expecting—and a vibrant economy has historically favored small-cap stocks. We’ve already been through recessions in housing and manufacturing—both of which are beginning to recover. If consumers continue to spend and/or China’s economy continues to rebound, the U.S. economy is likely to keep growing.
What other factors inspire your confidence in small-cap’s long-term prospects?
Francis Gannon: I think the comparably low degree of consolidation we mentioned earlier was a positive sign. The pace of returns slowed, but the rally rolled on. Equally important, we’ve begun to see corrections in the stock prices of some of the ‘Magnificent 7’ group of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla. In fact, it was particularly interesting to see mega-cap companies trail in the run-up from 10/27/23 through 12/27/23. Over that roughly two-month period, the Russell Microcap rose 30.8%, the Russell 2000 gained 26.6%, while the Russell 1000 was up 17.2% and the Russell Top 50 gained 14.8%. This was a reversal of the trends in index performance we’ve seen over the last several years—and this same pattern repeated itself over the last two weeks in March. So, while we don’t want to make too much out of short-term moves, it was certainly encouraging to see.
Exhibit 1: The Start of Something Small?
Russell Index Returns 10/27/23-12/27/23
Source: Russell Investments. Past performance is no guarantee of future results.
Is this consistent with what you’re hearing from companies?
Chuck Royce: We look out roughly three years when we analyze companies. When we talk to management teams, we always ask what the long-term plans are, specifically around revenue and earnings growth, innovation, and efficiency. One of our mantras has always been that psychology drives the market in the short run, but earnings drive it in the long run. Much of what we’ve been hearing has been positive—though always with an expected dose of caution. This squares with the research we’ve seen and published—which shows more earnings acceleration for small-cap companies than for large-cap businesses through the end of 2024.
Exhibit 2: Small-Cap’s Estimated Earnings Growth Is Expected to Be Higher in 2024 than Large-Cap’s
1-Year EPS Growth as of 3/31/24
Source: FactSet. Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The EPS Growth Estimates are the pre-calculated mean long-term EPS growth rate estimates by brokerage analysts. Long Term Growth (LTG) is the annual EPS growth that the company can sustain over the next 3 or 5 years. Both estimates are the average of those provided by analysts working for brokerage firms who provide research coverage on each individual security as reported by FactSet. All non-equity securities, investment companies, companies without brokerage analyst coverage are excluded. Past performance is no guarantee of future results.
How would you gauge small-cap valuations on both an absolute basis and relative to large-cap stocks?
Francis Gannon: At the end of March, the Russell 2000 had a much more attractive valuation than the Russell 1000, based on our preferred index valuation metric of enterprise value to earnings before interest and taxes, or EV/EBIT. Small-cap value also sold at a lower average valuation than small-cap growth at the end of the first quarter, as measured by EV/EBIT. In addition, micro-cap stocks with positive EBIT—roughly half the companies in the Russell Microcap at the end of 1Q24—were also attractively valued relative to large-cap based on EV/EBIT. (By comparison, 67% of the companies in the Russell 2000 had positive EBIT and more than 90% in the Russell 1000 had positive EBIT as of 3/31/24.)
Exhibit 3: Relative Valuations for Small- and Micro-Caps vs. Large-Caps Are Near Their Lowest in 20 Years
Russell 2000 and Russell Microcap vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies), 3/31/04 through 3/31/24
Source: Russell Investments. Past performance is no guarantee of future results.
What is your outlook for active small-cap management?
Chuck Royce: We’re optimistic as we look out over the next few years. We think that as the U.S. economy receives ever more of the tangible benefits accrued from reshoring, the CHIPS Act, and several infrastructure projects, advantages will flow to many small-cap companies—which should play a big role in the earnings acceleration that we talked about. We see that as a distinct advantage for active small-cap managers who focus on profitable companies and other fundamental measures of financial and operational strength.
Francis Gannon: There’s a historical phenomenon that also gives us confidence. At the end of March, the Russell 2000’s 3-year average annual total return was -0.1%. When the small-cap index had low or negative returns over previous annualized 3-year periods, the subsequent 3-year annualized returns were positive 99% of the time, in 66 of 67 periods. They averaged 16.7%, beating the Russell 2000’s long-term average annualized 3-year return of 10.7%. So, with valuations, earnings, and fundamentals /all favoring select small-caps, we are confident in the long-term prospects for active and risk-conscious small-cap management.
Exhibit 4: 99% of the Time, Positive 3-Year Returns Have Followed Low Return Markets
Subsequent Average Annualized 3-Year Performance for the Russell 2000 Following 3-Year Annualized Return Ranges of Less Than 3%, 12/31/81-3/31/24
Source: Russell Investments. Past performance is no guarantee of future results. As of 3/31/24, the average of subsequent 3-year return ranges <3% had 67 periods, the average 3-year return since inception had 508 periods.
Definitions
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 US companies in the Russell 3000 Index.
The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded US 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.
Enterprise value (EV) refers to the entire value of a company after taking into account both holders of debt and equity.
The EV/EBIT multiple is the ratio between enterprise value (EV) and earnings before interest and taxes (EBIT).
Magnificent 7 data refers to the following set of stocks: Microsoft (MSFT), Amazon (AMZN), Meta (META), Apple (AAPL), Google parent Alphabet (GOOGL), Nvidia (NVDA), and Tesla (TSLA). There is no assurance that any estimate, forecast or projection will be realized.
The CHIPS and Science Act (CHIPS Act) is a US federal statute enacted by the 117th United States Congress and signed into law by US President Joe Biden on August 9, 2022. The act provides roughly $280 billion in new funding to boost domestic research and manufacturing of semiconductors in the United States.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal.
Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. Past performance does not guarantee future results.
Data and figures quoted in this article sourced from Russell Investments, Bloomberg and Reuters.