After it’s Best Quarter Ever, Why Small Cap has Room to Run

Royce Investment Partners: After a record-setting fourth quarter, Chuck Royce and Francis Gannon look at what worked in small cap and talk about what might lie ahead.

    Francis Gannon

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

    Chuck Royce

    Chuck Royce Portfolio ManagerRoyce Investment Partners

    The Russell 2000 Index enjoyed the best quarter in its history (+31.4%) for 4Q20. Why do you think the fourth quarter’s rotation into small cap was so strong?

    Chuck Royce: I think the positive news on vaccines was the critical element in the small-cap surge. The reality of vaccines has allowed investors to see past the current economic uncertainty to a tangible return to something like normal. These very encouraging developments seem to have led them to take a fresh look at those companies, particularly in more cyclical areas, that had been relatively neglected for the last few years.

    As an investor, how would you characterize 2020?

    CR I would describe it as the wildest and certainly the most extreme year that I’ve seen in almost 50 years of being a small-cap investor. Think about the fact that the Russell 2000 had both its best and worst quarters ever in a single calendar year. That wasn’t the case during the recession and Financial Crisis of 2007-09. It didn’t happen in the bubble, the 1998 Asian currency crisis, or in the fall of the ‘Nifty Fifty’ back in 1973-74. The incredible speed with which the market crashed and then vigorously recovered was really extraordinary—it had never happened in such a short period of time until the pandemic.

    Why do you think small-cap’s recent strength is sustainable?

    Francis Gannon: I think three factors point to sustainable strength for the asset class: the recovery of earnings, the broadening of global economic growth, and the above-average equity risk premium. The importance of earnings is worth emphasizing. Because of all the understandable attention on the virus, vaccines, and the elections, it’s easy to forget that earnings through most of the asset class were much more resilient than expected in the latter half of 2020. We think ongoing earnings growth will be critical to equity performance in 2021, especially in small caps. And based on our analysis of small cap’s equity risk premium, valuations remain attractive at current interest rate levels, so we may see multiple expansion or some insulation for small-cap multiples if bond yields rise. We think that selectivity will be key, however, because economic activity is likely to remain uneven as growth revs up. We feel confident that whatever ‘new normal’ we find ourselves in, 2021 will be different enough from late 2019 to create potential advantages for disciplined active management.

    Russell 2000 Equity Risk Premium FCF/EV-10-Year Treasury from 12/31/00 to 12/31/20

    1 Free Cash Flow divided by Enterprise Value minus 10-Year Treasury Yield Source: FactSet. Past performance is no guarantee of future results.

    Do you expect 2021 to look very different from 2019 or early 2020?

    CR Our outlook for cyclicals for 2021 and 2022 is brighter than it was at the beginning of last year mostly due to the significant amount of monetary and fiscal stimulus, which will only add to the strength the global economy was exhibiting before the pandemic, when there was a very promising acceleration brewing. Following the vaccine roll-out, all of this aggregate stimulus seems likely to support higher growth rates than we were looking for a year ago. But, as Frank noted, that growth will be unevenly distributed—and that’s where I agree that active managers can offer an edge. The ability to recognize patterns, understand industry dynamics, and evaluate management teams should all prove crucial.

    Why else do think the current period is supportive for active management?

    CR We’ve often said that we view ourselves as risk managers first. This risk-aware focus tends to be rewarded in market declines but can also create a performance penalty during the early stages of a market recovery. In the first year of market rebounds, the lowest profitability companies often outshine those with higher profitability. However, as market cycles progress, leadership often rotates to the type of higher profitability companies that active managers like us favor.

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

    Source: FactSet. Past performance is no guarantee of future results.

    Do you think that small-cap value can re-establish small-cap leadership?

    FG To be sure, we feel more confident about the prospects for select cyclicals than we do for a broad-based shift to small-cap value leadership. As we talk to companies, we hear about growing order books, scarcity of inventory, and, in the case of many of our companies, robust balance sheets. Those indicators suggest that a robust cyclical rebound is already under way. Yet amid this impending cyclical recovery, the Russell 2000 Growth Index remained strong. Even as the Russell 2000 Value crept past it in 4Q20, up 33.4% versus 29.6%, growth still beat value for the calendar year by one of the widest margins ever—the Russell 2000 Growth gained 34.6% versus 4.6% for value.

    Still, small-cap value has often outperformed small-cap growth when nominal gross domestic product (GDP) has exceeded 5%—and most economists are projecting even higher nominal growth for the coming year. So, it’s certainly possible that value’s 4Q20 leadership continues. There are two additional points worth mentioning: Since the Russell 2000 Value is so heavily weighted with regional banks, we’ll likely need to see continued steepening of the yield curve for it to outperform, and that sort of macro projection lies beyond our core competencies. Perhaps more important, the small-cap value index is not the best proxy for how our own value-oriented strategies invest, so we believe our investors in these portfolios may be able to do well regardless of what the value index does.

    How has weaking the U.S. dollar affected your investments?

    FG It’s definitely been helping because we hold many companies that are more export oriented, have global reach, or sell to larger firms that are global players. What we hold as a firm, even limiting it to our domestic positions, is far more global than the Russell 2000. The weakening U.S. dollar also helped to drive the fourth quarter rebound for the three reflationary cyclical sectors—Energy, Materials, and Financials—along with the rally in commodity prices and the steepening yield curve.

    Do you expect more volatility in 2021?

    CR It’s relatively easy to say that we expect less volatility in 2021 than we saw in 2020, but markets do not necessarily make immediate transitions from high volatility to low volatility. After the surge in volatility in 2008, for example, the next three years all saw volatility spikes. Even though we left a lot of headline risk behind in 2020—COVID, the elections, Brexit, etc.—2021 is sure to have some surprises of its own. Volatility nearly always comes from shocks, from the events no one is anticipating. The events in Washington in early January are a good example of a shocking event that most of us didn't see coming. Over the last 23 years, the average calendar year has seen 40% of the trading days for the Russell 2000 move up or down 1% or more. In 2020, however, 55% of the days moved in that range. I expect periodic surges in volatility in 2021, though with fewer overall extreme moves than we had last year.

    Percentage of Trading Days with Moves of 1% or More in the Russell 2000 Through 12/31/20

    Source: FactSet. The average percentage does not include 2020 YTD data.

    FG To pick up on Chuck’s point about the likelihood of more volatility, the Russell 2000 was up 101.3% from its mid-March bottom through the end of the year. This very impressive move implies that the market has priced in a lot of the anticipated rebound in small-cap profits. The expectations that are currently reflected in many companies’ valuations may prove unrealistically high in 2021. In those instances, disappointed investors are almost sure to sell, creating increased volatility and the probability of at least some minor corrections. Of course, that would be a positive for disciplined active managers with a lot of experience investing in volatile markets.

    What’s a theme that you think represents promising long-term opportunity in small cap?

    CR We see potential long-term opportunities in three areas that look poised to benefit from sustained changes in consumer behaviors that have been precipitated or accelerated by the pandemic. The accelerated transition to e-commerce is not likely to reverse, so the first example would be underappreciated opportunities in companies that help to manage the increased complexity of logistics for other businesses, such as companies that provide machine vision systems that are used to automate warehouse operations, those that provide supply chain management software, and an asset-light truckload carrier. We’ve also seen a dramatic increase in demand for outdoor leisure activities, specifically recreational vehicles and boating. Both boat and Recreational Vehicle buyers are making a multi-year commitment, and we hold manufacturers that should benefit from a sustained level of higher demand for their products and aftermarket services. Finally, the housing market remains vibrant. Many employees now see that it’s viable for them to live further from their employers, particularly if they’re not commuting to work every day. However, they need space for a home office, and that trend is creating demand for new homes and home remodeling.

    What do you think is most important for small-cap investors to know as we move into 2021?

    FG I think one of the most important is a perennial practice here at Royce: Take the long view and try to use volatility to your advantage. While we’re expecting a solid market—though not as high flying as the last several months of 2020—history suggests that a 10-15% correction is more likely than not. Reversion to the mean is real—but it almost never comes in a straight line. We may also see the potential for a battle between earnings growth and multiple expansion if the yield curve continues to steepen as the 10-year Treasury rises.

    I’d also note that the average peak-to-peak return for the last 12 small-cap cycles was 43.8%. At the end of December, the Russell 2000 was up only 17.3% from its prior peak in August 2018. So, it seems clear to us that small cap has room to run. It’s not possible to call the next peak, though it’s fair to say that, based on history, it’s rare for small caps to see major declines unless there’s a recession or aggressive Fed actions. Neither looks likely in 2021.

    Russell 2000 Peak-to-Peak Returns for Market Cycles Following Drawdowns of 15% or More12/31/78-12/31/20

    Source: FactSet. Past performance is no guarantee of future results.

    CR I think that captures our guarded optimism well. The next few months look uncertain to me, but the wide distribution of vaccines should put us squarely on the road back to strong economic growth by spring or summer—and strong growth has historically meant good times for the kind of select small-cap cyclicals that we seek to own.


    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.


    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.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. 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 U.S. government. Even when the U.S. 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.