4Q20 Small Cap Recap

Royce Investment Partners: Co-CIO Francis Gannon reviews 4Q20, small cap's best ever quarter in a tumultuous year, and details his outlook.

    Francis Gannon

    Francis GannonCo-Chief Investment Officer, Managing Director Royce Investment Partners

    From Worst to First: Small Cap in 2020

    Small-caps finished a most remarkable year with a 31.4% gain for 4Q20, the best quarter in the more than 40-year history of the Russell 2000 Index—and after beginning the year with the largest ever quarterly loss in the index’s history. From the depths of its 3/18/20 low through the end of December, the small-cap index rallied to a 101.3% gain. While we have witnessed many oddities in our nearly five decades of small cap investing, we have never seen a year as extreme as 2020.

    Russell 2000 Quarterly Returns Since Inception12/31/78-12/31/20

    Source: FactSet. Past performance is not an indicator or guarantee of future performance.

    Small-cap stocks handily outpaced large caps—and much else—in 4Q20, though the Russell 1000 Index (+13.7%) and the Nasdaq Composite (+15.4%) also posted sizable advances in the quarter. Despite the strength of small cap’s move late in the year, the Russell 2000 was not quite able to exceed the performance of its large-cap sibling for 2020. The small-cap index advanced 20.0% for the year compared to a 21.0% gain for the Russell 1000. Each trailed the tech- and biotech-laden Nasdaq’s 43.6% return for the same period.

    The more recent strength for the Russell 2000 was distinct from the performances of large-cap indexes in 2020. While the Russell 1000 and Nasdaq each reached successive peaks several times in 2020, the small-cap index did not overtake its prior all-time high from August 2018 until mid-November of 2020. Small caps narrowed the gap with large caps in 2020 while also continuing to trail over the annualized three- and five-year periods. Still, the late surge in favor of the Russell 2000 is one of the reasons we think small caps are in the early stage of a leadership cycle.

    The other major development in 4Q20 was the narrow edge for the Russell 2000 Value Index over its small-cap growth counterpart, up 33.4% versus 29.6%. Yet this did not prevent value from underperforming growth for the calendar year by one of the widest margins ever as the Russell 2000 Growth gained 34.6% versus 4.6% for value. Going forward, we see better leadership prospects for small-cap cyclical stocks, though their leadership should help value to continue closing the gap with growth.

    Small Cap Cyclicals in High Gear

    As has been the case since mid-May, small-cap cyclicals led defensives for 4Q20, though for the calendar year defensives outperformed. This relative disadvantage was mitigated, in our view, by the emerging strength cyclicals showed following the mid-March lows.

    The six top-performing sectors for 4Q20 were cyclicals. Energy, Materials, Information Technology, Financials, Industrials, and Communication Services led the remaining five sectors in the Russell 2000, which all finished the quarter in positive territory. The rebound in the three reflationary cyclical sectors—Energy, Materials, and Financials—was spurred by a rally in commodity prices, a weakening U.S. dollar, and a steepening of the yield curve. Their improved results seemed to signal that investors are looking forward to a robust global growth spurt once vaccines are more widely available.

    Russell 2000 Sectors

    Source: FactSet. Past performance is not an indicator or guarantee of future performance.

    Health Care, the small-cap index’s largest sector, was the top performer overall for the calendar year, leading by an impressive margin. It was followed by notable results for two cyclical areas—Information Technology and Consumer Discretionary. In all, seven of the Russell 2000’s 11 sectors contributed positively to 2020 performance, with cyclical sectors Industrials, Materials, and Communication Services also finishing the year in the black while Consumer Staples was the only other defensive sector, along with Health Care, to do the same.

    Low Quality Rises High

    As was the case in 3Q20, low-quality stocks advanced to join cyclicals as small-cap leaders in 4Q20. Companies in the lowest ROIC and ROE quintiles, along with those with no earnings and/or dividends, led the Russell 2000 while stocks with the highest ROIC and ROE trailed. Quarterly returns, however, were encouragingly high in all these factor categories—offering evidence of how strong the quarter was across the asset class.

    We also want to note that lower-quality stocks typically lead in the early stages of dynamic rallies, as these stocks are often rebounding from prior steep declines. Historically, the lowest quintile ROE companies in the Russell 2000 have led in the initial stages of an upswing. However, as the market cycles matured from a frenetic pace to a more moderate advance, higher profitability stocks moved into a leadership role, with the top quintile of ROE companies outperforming.

    Low Quality Has Led Early While High Quality Has Led in the Second Year of Small-Cap ReboundsAverage Russell 2000 ROE Quintile Performance for Past Four Market Recoveries

    Source: FactSet. Past performance is not an indicator or guarantee of future performance.

    Where Are We in the Small Cap Cycle?

    Long-time readers will know that we look to small-cap market cycles to provide some guidance for the road ahead. The average peak-to-peak return for the 12 previous Russell 2000 market cycles was 43.8%. Through the end of 2020, the small cap index advanced 17.3% from its prior peak in August 2018. It seems to us, then, that this small cap rally has further to go. Seeing when that next peak will arrive is well beyond anyone’s ability to forecast. Still, we can say that based on history it’s rare for small caps to see significant declines in the absence of either a recession or aggressive Fed actions such as a move up or down in interest rates of 100 basis points or more, and thankfully neither appears likely in 2021.

    Russell 2000 Peak-to-Peak Returns for Market Cycles Following Drawdowns of 15% or More 12/31/78-12/31/20

    Source: FactSet. Past performance is not an indicator or guarantee of future performance.

    While our outlook is positive for small caps, it is for a more moderate advance than we have seen recently—perhaps an unsurprising observation after a record fourth quarter. 2020 was a better year for financial assets than it was for the economy, and we suspect that 2021 could be the reverse. The market’s significant advance off the March trough has undoubtedly priced in a meaningful amount of the rebound in small-cap profits anticipated in a recovery, and near-term optimism may be excessive. The expectations that are currently baked into many companies’ valuations may prove unrealistically high in 2021. We believe a measure of disappointment is almost sure to follow, meaning increased volatility and the probability of a 10-15% correction in the months ahead—which should be good news for disciplined active managers with ample experience investing in volatile markets.

    We remain confident about the prospects for select cyclical small caps for the reasons we have discussed before: economic rebounds have historically meant good things for cyclicals, which are more sensitive to economic conditions than defensives, and for small caps, which have enjoyed some of their largest outperformance spreads relative to large caps during economic recoveries.

    Finally, in saying good-bye to such a difficult and—for too many—sorrowful year, we want to acknowledge our clients, our colleagues, and the many essential workers who did so much to help us all through this trying period. Better days are ahead.


    The term small cap describes companies with a relatively small market capitalization. A company's market capitalization is the market value of its outstanding shares. The definition for small cap varies, but generally means a company with US$300 million to US$2 billion in market capitalization.

    Return on Assets (ROA) is a calculation of how much in assets is required to generate a certain amount of after-tax profit (Net Income)?

    Return on Invested Capital (ROIC) is a calculation of how much in after-tax profits for all its investors does a company generate with all its capital?


    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. 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.

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