Royce Investment Partners Commentary: 4Q22 Small-Cap Recap

A Volatile Quarter Caps a Bearish Year

Stocks rallied across much of the globe through the first two months of 2022’s fourth quarter before shares began to fall again in December. Still, 4Q22 ended as the only positive quarter of the year for both the small-cap Russell 2000 Index, which rose 6.2%, and the large-cap Russell 1000 Index, which gained 7.2%. Outside the U.S., performance was even better, as the MSCI ACWI ex USA Small Cap Index was up 13.3% in 4Q22 while the MSCI ACWI ex USA Large Cap Index advanced 14.3%. These strong results left the Nasdaq Composite as the outlier: The tech-heavy index fell slightly, down 0.8% for the quarter.

An Up and Down Quarter for Stocks
4Q22 Cumulative Performance for the Russell 2000 and Russell 1000 Indexes

Past performance is no guarantee of future results.

U.S. investors continued to face a dizzying, though perhaps by this point familiar, array of contradictory macro developments, from ongoing inflation, a decidedly hawkish Fed, and a widely anticipated—though yet to occur—recession to a strong labor market and a surprisingly (for some) resilient U.S. economy, with nominal GDP for 3Q22 adjusted upward in December from 2.8% to 3.0%. In addition, first-half U.S. GDP growth was negative, which meets one of the primary criteria for recession.

This challenging period helped spur a decidedly bearish year for stocks, with widespread double-digit losses regardless of market capitalization or geography. The Russell 2000 was down 20.4%, the Russell 1000 fell 19.1%, the MSCI ACWI ex USA Small Cap lost 20.0%, and the MSCI ACWI ex USA Large Cap declined 15.3%. As was the case in 4Q22, the Nasdaq Composite fared worst, falling 32.5% in 2022. The Russell 2000 also lost 26.7% from its most recent peak on 11/8/21 through 12/31/22—and gained 7.6% from its low on 6/16/22 through the end of the year.

2022’s losses for both small- and large-cap stocks did little, however, to shift the relative valuation picture. At the end of December, small-cap valuations remained near their lowest rate in 20 years compared to large-cap’s, based on our preferred valuation metric of the median last 12 months’ enterprise value to earnings before taxes (LTM EV/EBIT).

Relative Valuations for Small-Caps versus Large-Caps Remained Near Their Lowest in 20 Years
Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies) From 12/31/02 to 12/31/22

¹Enterprise Value/Earnings Before Interest and Taxes.

Small-Cap Value and Quality Fare Best in 4Q22

Within the domestic small-cap space, the performance pattern was what we would have expected in a down year, while in the year’s lone positive quarter the Russell 2000 Value Index more than doubled the performance of Russell 2000 Growth Index, up 8.4% in 4Q22 versus 4.1%. This marked the eighth quarter out of the last nine in which the small-cap value index has beaten its growth counterpart, including a run of seven consecutive quarters prior to 3Q22.

In addition, high-quality small-cap companies—that is, those in the highest quintile of return on invested capital (“ROIC”) within the Russell 2000—had the highest returns in 4Q22, while those in the lowest ROIC quintile had the lowest. This advantage for quality came in a quarter that encompassed a brief rally derailed by a correction. While a similar up and down pattern characterized 3Q22, that period saw lower-quality small-caps—specifically those with negative earnings before interest and taxes (“EBIT”)—beat companies with earnings. As small-caps with both higher ROIC and earnings also led in 2022’s first half, these stocks generally held up better in 2022 as a whole compared to their lower-quality, non-earning siblings.

Small-Cap Value Is Winning by Losing Less

Unsurprisingly, then, the Russell 2000 Value lost significantly less than the Russell 2000 Growth for 2022, -14.5% versus -26.4%. As we have held for the last couple of years, our view is that small-cap value has recaptured its long-term historical advantage over small-cap growth.

One revealing support for this idea can be seen by looking at the five-year annualized return for the Russell 2000 Value as of 12/31/21, which was 9.1% versus a gain of 14.5% for the Russell 2000 Growth—a 540 basis point advantage for the latter. The relative resilience of small-cap value vis-à-vis small-cap growth in 2022 caused this spread to reverse by a considerable amount for the five-year period ended 12/31/22, when the Russell 2000 Value was up 4.1% versus 3.5% for the Russell 2000 Growth. To be sure, our confidence that value can maintain performance edge over growth is rooted in the fact that over all five-year monthly rolling average periods since their shared inception (12/31/78), the advantage was squarely in value’s favor, 11.8% versus 8.8%.

From Macro to Micro?

It risks understatement to describe 2022 as a macro-centric year, with its radical reversal in Fed policy, persistent inflation (which, however, has probably peaked), the ongoing war in Ukraine, the seemingly endless effects of Covid, and a broadly predicted global recession—which has been imminent for more than a year but has somehow managed to not yet materialize, at least here in the U.S. These negative forces, both real and perceived, had a predictably dampening effect on share prices throughout the year. In many cases, this effect hit stocks independent of their financial fundamentals and/or operational expertise, particularly in the small-cap space we know so well.

At the same time, there has been a deep and far-reaching re-rating of growth stocks, an unsurprising development in light of more than a decade’s worth of zero interest rates and easy access to capital coming to a close—with the knock-on effect of much higher inflation. We saw this most clearly in 2022 at two ends of the equity market: in the deeper correction for small-cap growth stocks that we discussed above and in the steep declines for many mega-cap companies. The latter group had formerly been something of a safe haven for many investors who saw few, if any, alternatives in an environment that offered so little in the form of yields.

But those days are gone. Rising rates and inflation have combined to usher in a major regime change, a period of multiple compression that we suspect will begin to move investors’ attention—to some extent, at least—away from the admittedly crowded and uncertain macro scene and onto corporate fundamentals. Signs of this can already be seen in the rounds of commentary in the financial media about the likelihood of lower fourth-quarter earnings accompanied by anxiety over the number of companies that may revise guidance lower for the remainder of 2023.

Will Today’s Fog Bring Sunnier Skies?

While the near-term forecast for equities is as unclear as any we can recall, we also see better weather over the long-term horizon, especially for small-cap stocks. For this and other reasons, we welcome any degree of increased scrutiny of company fundamentals.

Indeed, throughout 2022 we have often been struck by the contrast between the more confident—albeit cautious—outlooks from the many management teams we’ve met with and the fatalistic headlines we see almost every day. Of course, these companies boast some combination of attractive valuation (per our analyses), strong long-term prospects, low debt, positive free cash flows, high ROIC, and/or proven management expertise. Overall they appear well positioned for a market that is more focused on fundamentals and/or from a reaccelerating economy.

And while recession remains a possibility, none of us knows when it will hit, how long it will last, or how deep it will go. What we do know is that any recession—like any bear market—is ultimately finite. Any recession will be followed by a recovery. It’s worth keeping in mind that history also shows that small caps will likely begin an upward move before many of us know for sure that the economy is rebounding in earnest.

Taking the Long View of Small-Cap

Equally important is the fact that, since the end of World War 2, most down years for small caps have been followed by positive performance. Prior to 2022, there were 24 other years in which small-caps had a negative calendar year result (using the Center for Research in Securities Prices (“CRSP”) 6-10 as our longer-term small-cap proxy). In 19 of the subsequent years, or 79% of the time, small caps went on to enjoy positive returns in the following year. Perhaps even more notable was that the average return for those positive years that followed a negative one was 25.9%, a significantly higher result than the 10% average return for calendar years that followed a positive small-cap return.

Most Down Years Have Historically Been Followed by Up Years for Small-Caps
Calendar year returns for subsequent years to negative return years for the CRSP 6-10, 12/31/45-12/31/19

Past performance is no guarantee of future results.

Small-cap’s historical performance patterns also show that periods with below-average longer-term returns have been followed by those with above-average longer-term returns—and the subsequent periods have enjoyed positive returns most of the time. Subsequent annualized three-year returns from three-year entry points of less than 5% have been positive 99% of the time—that is, in 75 out of 76 three-year annualized periods—averaging 16.1% since the Russell 2000’s 12/31/78 inception. The Russell 2000 also had positive annualized five-year returns 100% of the time—that is, in all 81 five-year periods—and averaged an impressive 14.9% following five-year periods with annualized returns of 5% or lower. Why is this especially relevant now? The respective three- and five-year annualized returns for the Russell 2000 as of 12/31/22 were 3.1% and 4.1%.

A High Probability of Positive Small-Cap Performance Ahead?
Average Subsequent Five-Year Annualized Performance for the Russell 2000 in Trailing Five-Year Return Ranges 12/31/83-12/31/22

Past performance is no guarantee of future results.

In our view, these historical patterns not only suggest a low probability of loss for small-caps over longer-term periods of at least three years, but they also imply that the opportunity cost of waiting or trying to time a bottom—whether for the market or the economy—may be high. So while no one can predict future outcomes for the markets or the economy, we can carefully examine small-caps’ past performance patterns in a way that helps us make sense of the present as we prepare for the uncertain days ahead.

The Russell 2000 fell 31.9% from 11/8/21 through the current bottom on 6/16/22, which places it precisely at the average of Russell 2000 downturns of 15% or more since the inception of the small-cap index. Over that 44-year span, only three bear markets went markedly deeper than this one by falling at least another 10%. Each of these downturns was exacerbated by a monumental negative event: the Great Financial Crisis led to small-cap losses of 58.9% from 7/13/07-3/9/09; the bursting Internet Bubble saw the Russell 2000 down 44.1% from 3/9/00-10/9/02; and in the Covid pandemic the small-cap index declined 41.8% from 8/31/18-3/18/20. Each presented investors with a formidable test to stay invested, much less increasing their small-cap allocation—and in each case the market’s subsequent recovery led to very compelling long-term returns. Regardless of what happens next, then, we see the current period of uncertainty as a highly opportune time to actively invest in select small caps for the long run.

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