Factors Favoring Small-Cap Stocks in 2021

Royce Investment Partners sees opportunities across small-cap strategies.

    In looking toward 2021, we think one of the most significant factors, which has been affecting equity valuations over the last several years, is the precipitous decline in interest rates. In fact, recent years have seen lower rates than most financial professionals have seen over their entire careers. However, many equity investors have still not adapted their valuation tools to account for this. As experienced small-cap specialists, we think this omission has fostered misleading conclusions.

    We take the classic ‘Finance 101’ view that a company is worth its future free cash flows discounted at some rate back to the present. As we are now experiencing some of the lowest rates on record, it would support among the highest valuations well. To evaluate current small cap valuations by taking ultra-low interest rates into account, we use the equity risk premium, subtracting the free cash flow yield (free cash flow divided by enterprise value) from the U.S. 10-year Treasury Yield. A higher number is preferable because it indicates the potential extra return “risk premium” that the market is offering for small caps compared with Treasuries. The small cap equity risk premium at the end of September was greater than 1%. That number may sound small, but the historic returns from periods when the equity risk premium was 1% or more have been anything but. When the equity risk premium was 1% or greater over the past 20 years, the subsequent average one-year return was 25.5%.

    Do past patterns of market cycles, recent subpar small-cap returns, and higher than average equity risk premiums assure us that better days are ahead? Not necessarily, of course, as past performance cannot guarantee future results. What we can offer as experienced small-cap investors is the close examination of past patterns to identify when we think the probabilities are indicating it’s a good time to invest in small caps. We think now is one of those times.

    Historically High Equity Risk Premium Has Led to High ReturnsAverage Subsequent Russell 2000 1-Year Performance in Equity Risk Premium Ranges from 9/30/00 to 9/30/20

    Equity Risk Premium = Latest Twelve Months Free Cash Flow divided by Enterprise Value minus 10-Year Treasury Yield.

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

    Have the U.S. elections impacted our viewpoints on the above?

    Small caps have done well (and poorly) regardless of which party was occupying the White House. As a result, we think investors tend to overweight the impact of government actions on stocks. In our experience, industry supply and demand dynamics play a much bigger role than regulatory changes or tax policies. In today’s highly partisan environment, the likelihood for consequential investment legislation is low unless one party has majorities in both houses of Congress in addition to the White House—and even in that case, the long-term effects are likely to be less meaningful compared to where we are in the economic cycle. If Republicans retain control of the Senate, the recovery is likely to proceed at a moderate pace. If the Democrats win a majority, we may get a more significant fiscal response, probably driven by spending increases and higher taxes. In any event, a significant increase in fiscal stimulus would likely improve what we think is already a favorable climate for small-cap stocks.

    What challenges or headwinds do we believe could affect small cap performance?

    In our view, the timing, efficacy, and adoption of vaccines remains the wild card, as it were. Progress has been highly encouraging, yet the longer the world waits, the longer it will likely take for a robust economic rebound to get fully underway. If incremental news about a vaccine roll-out turns negative, either for logistical or public adoption reasons, that will likely cause a downgrade in the cyclical outlook, which would be negative for small caps.

    While a fiscal package would likely accelerate the current risk-on factor rotation into cyclical names, a more modest stimulus (or none at all) may not prove sufficient to counteract the near-term negative effects of increasing cases and resulting restrictions on activity and therefore could also create challenges for small caps.

    What are the investment opportunities Royce sees across its small-cap strategies?

    As a general observation, we see the pandemic’s effects on various industries not as a change in course but as an acceleration of existing trends. The first opportunity we see surrounds the accelerated adoption of digitalization and related technologies that enhance productivity and efficiency, especially inside the factory walls of many industrial companies. Ongoing reshoring would amplify this already vibrant trend.

    The second theme is related. We like the prospects for companies that allow other businesses to innovate or improve efficiency. For example, there are firms that provide robust apps for local community banks, allowing them to better compete with bigger industry players. Another example would be companies that are helping to enable e-commerce from both digital natives, such as Amazon and Wayfair, as well as branded apparel companies like Levi Strauss and Ralph Lauren. Other small-cap opportunities we have identified include companies providing supply chain management software, transport, and logistics. Finally, there are recreational areas that are benefiting from changes in consumer leisure time behavior in which demand is exceeding capacity—most notably in RVs and boating. We mostly own businesses that provide parts and services, which are less dramatically cyclical.

    Based on what we see in small cap’s fundamentals, current valuations, and market behavior, we’re optimistic for appealing returns over at least the next several years. We’re in accord with the consensus that expects the economic recovery to continue broadening and deepening, which should be highly supportive for small-cap stocks.


    WHAT ARE THE RISKS?

    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.

    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.