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Royce Investment Partners Commentary: Will 2020 See Widespread Earnings Recovery for Small-Caps?

In an environment where the largest five stocks in the Russell 1000 Index have a combined valuation that is 2.3 times bigger than the total market cap of the Russell 2000 Index, many smaller companies find themselves in an unsought but familiar position two months into 2020--once again trailing the broader market. With the Russell 1000 reaching fresh highs in the new year, the Russell 2000 has continued to lag even in the face of improving economic data. The ISM Manufacturing Index, for example, positively inflected in January. This was not enough, however, to push small-caps ahead of their large-cap siblings, as one would typically expect when economic growth signals are flashing green.

We believe that investors have doubts as to whether or not that positive inflection can be sustained in the months ahead, especially as the full economic impact of the coronavirus remains unclear. At the same time, fourth-quarter 2019 earnings for small-caps are coming out, with a large number looking lackluster vis-a-vis their large-cap counterparts. However, we believe that is beginning to change.

From our perspective, with more than a third of the companies in the Russell 2000 having reported as of this writing, small-cap earnings appear to be kicking off what we believe could be a multi-quarter turnaround--barring any significant economic hiccups, of course.

Earnings growth for the Russell 2000 came in at 22.4% in 2018 before decelerating sharply in 2019. While we await the final figure for 2019, estimated growth is currently slated at just 4.4%. But fourth-quarter 2019 year-over-year earnings growth is currently up 5%--versus flat expectations, no less--with 64% of Russell 2000 companies reporting that they beat estimates. Not surprising, the Energy sector has seen the largest percentage of misses while Information Technology and Utilities are so far showing the largest earnings beats. Equally important, current estimates for the Russell 2000 in 2020 show earnings growth accelerating quarter by quarter through the remainder of the year to more than 15% in the fourth quarter of 2020.

Obviously, those numbers are subject to change, but in an environment where the trajectory of global economic growth is constantly being questioned, we suspect that certain small-cap stocks may prove resilient. Moderate growth, low inflation, low rates, and an accommodative Federal Reserve continue to provide a solid backdrop for smaller companies.

While uncertainties linger over the long-term economic impact of the coronavirus--and its effects on earnings growth--we remain focused on the opportunities at hand. Liquidity is increasingly becoming an issue for small-cap stocks as more and more market capital flows to mega-cap companies. As a result, we've observed an increase in individual stock volatility in many pockets of our asset class, which has understandably tended to increase around quarterly earnings reports. As disciplined, long-term active managers in the small-cap space, we are often liquidity providers who need to be prepared to take advantage of dislocations when they occur.

We believe that the small-cap earnings story should continue to improve as the year progresses, especially versus forgiving comparisons to 2019. Additionally, we would not be at all surprised if further stimulus from China acts helps to accelerate earnings improvement--and stock performance--for small-cap companies in the not-too-distant future.

Stay tuned...

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

This article first appeared on GuruFocus.