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Royce Funds Commentary: Are Healthy Earnings the Dog That Didn't Bark?

"Is there any point to which you would wish to draw my attention?"

"To the curious incident of the dog in the nighttime."

"The dog did nothing in the nighttime."

"That was the curious incident," remarked Sherlock Holmes.

Another earnings season has come and gone. For both the bulk of our holdings and the U.S. market overall, the results were solid and generally in line with expectations.


There were exceptions to this on both sides, with several companies exceeding expectations (which had admittedly been set low in many cases as the economy continues to grow at a slower pace) while others disappointed, including a number that have more exposure to China.

This mix of the expected and unexpected is fairly typical--earnings season always carries its share of surprises as well as more likely developments.

This most recent round of announcements and guidance, however, also happened to coincide with one of the more volatile periods the market has seen so far this year, as investors' concerns about slowing global growth slipped into more marked anxieties about a recession. Although the market didn't suffer anything like the damage stock prices sustained late in 2018, it has seen its share of very volatile days as investors began to run the gamut in August from bearish to bullish.

It may seem odd or counterintuitive, then, that in the recent mercurial investment climate--one very much dominated by questions and uncertainty about ongoing economic prospects--companies reported mostly positive results while also not lowering guidance for the rest of the year.

To be sure, it seems to us that this stems from the fact that the headlines and capital markets have been telling one story while companies and the economy have been weaving another, more positive narrative.

With so many warnings that recession is looming, we appear to have reached the point where the second quarter's essentially healthy earnings feel like the equivalent of the dog that didn't bark in the famous Sherlock Holmes story, "Silver Blaze."

This is, in our view, one of the potential benefits of disciplined active management approaches. We can concentrate on current opportunities in this gap between negative perceptions and more positive realities. We've been investing this way for more than 40 years.

We're therefore maintaining a cautiously constructive perspective, one rooted in company research, the analysis of industry dynamics, and discussions with company managements. What these investigations tell us is that a recession, while possible, continues to look remote.

After all, economic conditions are mixed, with tariffs, trade wars, and a declining U.S. ISM Manufacturing Index (a common proxy for economic conditions) on the one hand and strong housing, auto, and consumer activity, along with a tight labor market, on the other. Financial conditions, on the other hand, are very supportive--rates and credit spreads are low and financial market liquidity is high.

Of course, not all is well--but it seldom is. We think it's especially vital to keep in mind that the economy--both here in the U.S. and across the globe--seldom moves in lockstep, which usually occurs when growth is particularly robust or during periods when it's anemic.

In this context, it's important to keep in mind that the combination of moderate growth, low rates, cheap energy, and little inflation has historically been a favorable backdrop for equities. Also key is the fact that recessions are rare. The U.S. has endured only twelve since the end of World War II, with only three lasting more than a year.

Somewhat related is the resilience of positive small-cap stock performance. In 88% of monthly rolling three-year periods since the end of World War II, small-cap stocks, as measured by the CRSP 6-10, had positive returns, averaging a healthy 13.0%

% of Positive Rolling Three-Year Return Periods

Small-Cap (CRSP 6-10) from 12/31/45-6/30/19

crsp-post-returns

When it comes to long-term investing, in other words, the onus is on the bears--staking a claim that returns will be negative over the long run has historically been a low-probability bet.

This is one of the many reasons why we focus more on what companies are doing--and earning--than to headline hysteria.

Stay tuned...

Important Disclosure Information

Mr. Gannon's thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

The (Center for Research in Security Prices) CRSP (Center for Research in Security Pricing) equally divides the companies listed on the NYSE into 10 deciles based on market capitalization. Deciles 1-5 represent the largest domestic equity companies and Deciles 6-10 represent the smallest. CRSP then sorts all listed domestic equity companies based on these market cap ranges. By way of comparison, the CRSP 1-5 would have similar capitalization parameters to the S&P 500 and the CRSP 6-10 would have similar capitalization parameters to those of the Russell 2000.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. (Please see "Primary Risks for Fund Investors" in the prospectus.)

This article first appeared on GuruFocus.