Why Consider Small-Caps Now in Three Charts

Royce Investment Partners: Senior Investment Strategist Steve Lipper details two of Royce’s analytical frameworks that make the case for investing in small caps now.

    Steve Lipper

    Steve LipperSenior Investment Strategist Royce Investment Partners

    After the Russell 2000 Index completed its best quarter ever to close out 2020, investors may be wondering how much further small caps have to go. History suggests, “much further,” underpinning our optimistic view at Royce Investment Partners. We use two distinctive analytical frameworks in our historical analysis that we have found useful over the decades we have been specializing in small cap investing.

    The first concept examines market cycles as opposed to calendar time. Equity markets do not make consistent progress. They often meander for months or longer, making little progress before surging up or down in a compressed amount of time. We have found that the length of a small cap market advance is therefore highly variable. However, small cap market cycles seem, at least to us, to exhibit identifiable patterns that are helpful for developing future expectations.

    We looked at the returns from the peak of one small cap cycle to the next, and while these peak-to-peak returns show considerable variance, they historically clustered in fairly narrow return ranges. The chart below shows the peak-to-peak returns for all 12 full market cycles since the Russell 2000’s inception in 1979. The average return for all 12 peak-to-peak periods was 43.8%, and seven of those periods enjoyed returns in the 38-59% range. For comparison, the current small cap cycle’s return since the most recent index peak was only 17.3%. That indicates to us that this small cap cycle isn’t about to end.

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

    Source: FactSet. Russell 2000 Index. Past Performance is no guarantee of future results.

    Our second analysis uses the equity risk premium, an important valuation metric. We have found this tool to be much more useful than the more widely used current P/E ratio compared with its historical range mostly because the former adds critical context. Use of the latter has encouraged investors to be excessively cautious over the past five or more years. The core insight driving the use of the equity risk premium approach is that the appropriate valuation for stocks is tied to the current level of interest rates. If rates sit near all-time lows, it may be appropriate for small caps to be near all-time highs based on more traditional valuation metrics.

    There is an additional wrinkle in Royce’s equity risk premium calculation in that it is based on free cash flow yield and not P/E. It’s perhaps helpful to recall that we take a “business buyer’s” approach to valuation, asking ourselves, “What would an informed buyer pay for this entire company?” We believe a business buyer would want to know how much free cash flow (operating profits minus capital expenditures) the company generates and how much total equity and debt is on the company’s balance sheet. One subtle trend that many observers have missed is that free cash flow has been growing faster than profits over the last several years, so valuing companies based on free cash flow results in lower valuations.

    If we compare year-end equity risk premium for small caps to its average over the past 20 years, we see that at 12/31/20 the asset class’s 1.5% equity risk premium was significantly higher than its 20-year average of 0%. This is an attractive valuation level. It indicates to us that even after the impressive rally of 4Q20, small caps remain historically undervalued relative to interest rates.

    Russell 2000 Equity Risk Premium FCF/EV-10-Year Treasury 1 from 12/31/00 to 12/31/20

    Source: FactSet. Russell 2000 Index. Past Performance is no guarantee of future results.

    Some investors may respond that this relative valuation gap can be corrected either by small caps advancing or bond yields rising. This is arithmetically accurate, of course. However, the 10-year Treasury yield would need to rise 1.5% from current levels to close the gap entirely from that direction. Treasury yield forecasts are beyond our core competencies as small cap investors, but we suspect that the economy would probably need to be growing at a very robust rate to generate that sort of yield rise. And that necessary pace of growth presumably would lead to solid profit growth for small caps.

    Looking at historical return profiles starting from elevated equity risk premium levels is reassuring. If we consider prospective three-year returns when the starting point was at least a 1% equity risk premium, as shown in the chart below, we find that the average annualized three-year return was 15.4%, and that all return periods were positive.

    Average Subsequent Russell 2000 Three Year Performance in Equity Risk Premium Ranges From 12/31/00 to 12/31/20

    Source: FactSet. Russell 2000 Index. Past Performance is no guarantee of future results.

    Do these two historical comparisons using market cycles and the equity risk premium guarantee that this small cap rally will produce much higher returns before topping out? No, history cannot give us that much precision, and, as ever, past performance is no guarantee of future results. Even so, history does suggest that if this small cap cycle behaves like the typical period, there’s further to go.

    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.