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Royce Funds: Third-Quarter 2019 Small-Cap Investment Review And Outlook

3Q19--Two Markets in One Quarter





Results for the major U.S. indexes were flat to negative and aligned along the size spectrum in 3Q19. The large-cap Russell 1000 Index was up 1.4%, the Russell 2000 Index finished the third quarter down 2.4%, and the Russell Microcap Index fell 5.5%.


Beneath this seemingly calm surface, however, there was a lot of action. In essence, everything that had been leading the market for the last two-plus years staggered through the market's September recovery while previous laggards took on leadership.



Reversals and Rotations



The rotation began with the market's recovery on August 27th following down months in July and August. This rebound included a number of simultaneous reversals that inverted the market leadership patterns we've seen during recent upward moves for equities.

The upshot was that from 8/27/19-9/30/19 small-caps outpaced large-caps, small-cap value beat small-cap growth, and cyclicals outperformed defensives, in each case by solid margins. All of these areas were lagging for the quarter, year-to-date or one-year periods prior to the market's recovery.

3Q19-reversals

At the sector level, the most sizable contributions came from Industrials and Financials, followed by Consumer Discretionary and Real Estate. So while most of the sectors in the Russell 2000 were positive (Health Care detracted slightly) during this short rebound, cyclicals markedly outperformed defensives.

And while leadership rotation is common, what makes 3Q19 unusual was that the rotation happened more or less simultaneously on 8/27/19. Additionally, the rotations remained solidly in place amid considerable geopolitical developments and domestic political issues.

It was even more interesting to us that small-cap value handily beat its growth counterpart on an upward move--which has been an infrequent occurrence of late, in particular because the pattern of growth winning on the upside has mostly been the market's norm for much of the last few years.



In fact, 3Q19 returns were consistent with valuations as the cheapest 20% of small-caps (as measured by free cash flow to enterprise value) posted a modest gain while the most expensive quintile within the Russell 2000 declined by double digits.

More important, the relative valuations for small-cap versus large-cap, small-cap value versus small-cap growth, and small-cap cyclicals versus small-cap defensives were at or near 20-year lows on 8/27/19. So while no one knows if these reversals will be lasting, it seems reasonable to suggest that reversions to the mean were overdue in all three cases.


What Bellwether Industries May Be Signaling



In trying to get a sense of the sustainability of these reversals, we looked at the relative strength of industries within the index so far this year. What we saw were notable performances from three economically sensitive industries that are also economic bellwethers--construction materials, semiconductors & semiconductor equipment, and building products.



From our perspective, it appears that investors are responding to the absence of bad news about the U.S. economy. They appear to have recognized that there is an important difference between slower growth--which we have--and a recession, for which the prospect still looks remote.

And with rates and inflation equally low, a slow- to moderate growth environment is a healthy one for equities.


Bulls vs. Bears



Let's consider the following pros and cons for ongoing positive equity performance--contrasting the more bullish perspective with a bearish point of view.



The latter look at the slowing pace of U.S. growth, the even more sluggish state of growth outside the U.S., and the ongoing negative impact of tariffs and trade wars. They worry that the declining U.S. ISM Manufacturing Index (a common proxy for economic conditions) is flashing a recession warning. They point to the fact that there is now more than $17 trillion in negative yielding debt worldwide, with 30% of all investment grade securities bearing sub-zero yields.

This is all genuinely worrisome. But before ceding the argument to market fatalists, we would counter with the following: the U.S. consumer continues to spend and enjoy confidence--in large part thanks to a robust labor market and wage growth.

Moreover, credit markets are healthy--as are financial conditions overall, which are providing increasing amounts of liquidity to the capital markets. And in our area of expertise, we continue to see reasonable to attractive valuations for many small-cap holdings--which also look much less expensive than most of the their large-cap counterparts. In addition, the corporate management teams that we speak with remain cautiously constructive--few if any are worrying about recession.



Where Do Small-Caps Go From Here?



Over the last four quarters, small-caps have gone straight down (4Q18) and straight up (1Q19), before treading water over the most recent two.

The market, in other words, is still searching for direction. Stocks do not move sideways indefinitely. At some point, they either break down or break out.

In this murky context, we think there are two key questions: Can small-cap earnings growth improve from here? If yes, then we see a breakout; if not, a breakdown. What might drive small-cap earnings growth? Three areas are currently weak--and may soon be bottoming: year over year small-cap EPS growth, the ISM Manufacturing Index, and Western European and Chinese economies.

To be sure, when thinking about the prospects for small-cap stocks, it's also important to remember that we are still in the historically anomalous situation of positive trailing one-year returns for the Russell 1000 (3.9%) with negative results for the Russell 2000 over the same period (-8.9%). Over the past 20 years, this divergence has occurred only 8% of the monthly trailing one-year periods.

In our view, investors might want to keep in mind not only how rare this particular performance disparity has been, but also that the historical frequency for a favorable small-cap reversal has been very high.

Rare Return Divergence

Trailing 1-Year Periods from 9/30/99 through 9/30/19

lc-rose-sc-fell

The current economy remains a fascinating mix of paradoxical data, which creates foggy conditions when trying to look forward. When taken together, however, we see attractive valuations and enough fundamental progress to suggest the probability of a shift to small-cap leadership.

Important Disclosure Information

The 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.

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. Investments in securities of micro-cap, small-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.)

Cyclical and Defensive are defined as follows: Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

The ISM Manufacturing Index (ISM) monitors employment, production, inventories, new orders and supplier deliveries.

This article first appeared on GuruFocus.