Why US small-caps can keep going strong

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.

Chuck Royce: 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?

Francis Gannon: 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?

Chuck Royce: 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.

Francis Gannon: 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?

Chuck Royce: 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.

What is your outlook?

Francis Gannon: 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 (M7) 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 M7 will continue to face the possibility of greater regulation, especially from Europe.

Chuck Royce: 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.