Nowhere to Run

Royce Investment Partners: A tumultuous first quarter may pave the way for better days in the small-cap market.

    Francis Gannon

    Francis GannonCo-Chief Investment Officer, Managing DirectorRoyce Investment Partners

    The world’s equity indexes plummeted with alarming speed and depth during 2020’s opening quarter. No asset class or locale was spared as the effects of the coronavirus reverberated across the globe, causing major market dislocations.

    The 30.6% first-quarter decline for the Russell 2000 Index was the largest quarterly loss for the small-cap index in its more than 40-year history.

    Source: Bloomberg, as of 3/31/20. US Large represented by the Russell 1000 Index (R1K). International Large represented by the MSCI ACWI Ex USA Large Cap Index. International Small represented by the MSCI ACWI Ex USA Small Cap Index. US Small represented by the Russell 2000 Index (R2K). Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    A Typical Decline: The Relative Return Array

    As might be expected in a steep bear market, small-caps bore the brunt of the decline on both a domestic and global level. To be sure, the farther down the market capitalization range one went here in the U.S., the bigger the negative result. Large-caps lost the least, followed by mid-caps, small-caps, and micro-caps.

    As unprecedented as the current downturn undoubtedly feels to many investors, the array of relative returns beyond market cap size was also consistent with what an investor would typically expect when a market decline is accompanied by a recession.

    So while every sector in the Russell 2000 Index experienced double-digit declines, defensives lost less than their cyclical counterparts. The three sectors that held up best in the index were defensive areas—Utilities, Health Care, and Consumer Staples—while three cyclical sectors—Energy, Consumer Discretionary, and Materials—fared worst in 1Q20.

    Companies that have low leverage within the Russell 2000 did relatively better than those with higher leverage, and those in the top market cap quintile of the small-cap index lost less than those in the bottom quintile (consistent with the quarterly results of the market cap-based indexes).

    Source: Bloomberg. CYC = Cyclical. DEF = Defensive. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment

    History Is Rhyming, Not Repeating

    The decline has so far been one of the fastest—and most unsettling—that we have experienced. Yet its depth through the end of March fell well within the range of the two previous bear markets that were accompanied by recessions. The 41.5% decline for the Russell 2000 from 2/20/20-3/18/20 (the 1Q20 bottom) was similar to the fall from 7/13/07-3/9/09—when the Russell 2000 lost 58.9%—and from 3/9/00-10/9/02, when it fell 44.1%.

    Source: Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    The downturn greatly exacerbated by the 2008 Financial Crisis has similarities with the current market. Both declines were quite rapid and, for most investors, equally frightening. However, the balance sheet health of both households and banks is much better today than back in 2008.

    During the run-up to the Internet Bubble in 2000, the market resembled the pre-coronavirus condition—with lofty valuations and multi-year leadership from large-cap and growth that led many to question the viability of value investing and active management. Yet the speed and depth of the current economic slowdown looks to be greater than what we experienced in the 2000-02 period.

    The current situation is therefore different, but at the same time familiar, at least to us. From an investment perspective, we view it as another instance of history not repeating but rhyming. As our own Charlie Dreifus recently put it, we’ve seen movies with similar plots before through more than four decades of small-cap investing.

    After The Correction…

    A silver lining of sorts to the pandemic situation has been the speed with which a wave of monetary and fiscal actions were put in place and/or approved, in marked and welcome contrast to the slower pace each took to be implemented in 2008-09. While we anticipate that these policy actions will continue to help bring some stability to the markets, we also expect ongoing volatility in the near-term as investors attempt to find their bearings.

    The critical questions now, then, are, ‘Is the worst behind us?’ and (in any event), ‘What happens once the virus has been contained and effective treatments are available?’

    As is our wont, we turn to history for guidance and context. At the end of March, the five-year annualized return for the Russell 2000 was -0.2%. This is a rare occurrence. A negative average annual five-year return has only happened in 21 out of 436 month-end periods since the launch of the index more than 40 years ago—that is, it’s happened less than 5% of the time.

    Results in the subsequent periods were nothing short of extraordinary, with a one-year average of 40.8%, a three-year average of 22.1%, and a five-year average of 18.3%—all well above each period’s rolling monthly averages. By staying in the market, small-cap investors more than doubled their money over the ensuing five years.

    Clearly, no one knows what the market’s next sustained move will be. However, history offers compelling examples of how valuable it can be to remain invested in small-cap precisely when it feels most difficult to do so.

    Source: Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    Investing For Better Days

    For our part, we are doing exactly that—investing each day when we see attractive long-term opportunities present themselves.

    We have been leaning mostly toward select, high-quality cyclical companies as we think these businesses are best positioned for a rebound. Indeed, in the years following the small-cap troughs in 2002 and 2009, small-cap cyclicals substantially outperformed defensives.

    Source: Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    Many of our newer cyclical investments have clustered in two areas—businesses already benefiting from strong secular trends that we expect to resume and those that we think are likely to see increased demand in a recovery. In the former category are Consumer Discretionary companies offering experiences (such as RV suppliers and boating manufacturers) as opposed to goods, and professional staffing firms, as highly skilled workers will still in be short supply.

    Areas we see potentially benefiting from increased demand include housing (particularly with record-low mortgage rates) and restructuring advisors, whose skills will be needed working through issues stemming from overleveraged balance sheets. 

    Finally, we wish the best to all of you, your families, and colleagues as we collectively move through these most challenging days.


    DEFINITIONS

    The 2008 Financial Crisis, also known as the Great Recession, the financial crisis of 2007–08, the Great Financial Crisis (GFC) and the global financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.

    A Bear Market is a 20%+ drop in stocks prices.

    A cyclical stock refers to an equity security whose price is affected by macroeconomic, systematic changes in the overall economy. Cyclical stocks are known for following the cycles of an economy through expansion, peak, recession, and recovery

    A defensive stock is a stock that provides a constant dividend and stable earnings regardless of the state of the overall stock market. Defensive stocks tend to perform better than the broader market during recessions. However, during an expansion phase, they tend to perform below the market.

    The Internet bubble (also known as the tech bubble and the dot-com bubble) was a stock market bubble caused by excessive speculation in Internet-related companies in the late 1990s.

    Market capitalization (market cap) is the total dollar market value of all of a company's (indexes) outstanding shares; it is calculated by multiplying a company's (indexes) shares outstanding by the current market price of one share.

    Microcap stocks make up less than 3% of the U.S. equity market (by market cap) and consist of the smallest 1,000 securities in the small-cap Russell 2000® Index, plus the next smallest eligible securities by market cap

    The MSCI ACWI ex USA Large Cap Index is an unmanaged, capitalization-weighted index of global large-cap stocks, excluding the United States.

    The MSCI ACWI ex USA Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States.

    The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

    The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.

    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.