Small-Cap Recap from Royce

Small-Cap Recap from Royce

In the first quarter of this year, the Russell 2000 index saw a robust 12.7% gain which represented a “record-setting one-year return of 94.8%” and gave investors an “especially vivid sign of how thoroughly the overall U.S. equity markets have been recovering from the challenge and pain wrought by the coronavirus pandemic.” This according to an article on the Royce Investment Partners website.

The performance is significant, the article notes, as the index has beat a 90% return only once before in its 40-year history. The article offers several other insights regarding the market’s first-quarter performance, as follows:

Micro caps lead: “As was the case in the record-setting 4Q20, returns in 1Q21 were highest when market capitalizations were lowest.”

Value and cyclicals are ahead:

Quality performance: The article reports that high-quality small caps stocks (identified by both ROE and return on invested capital) have lagged but noted that this is an “expected dynamic during an early rebound period.” That said, it argues that historical data shows higher-ROE companies tending to perform better as the cycle progresses, and investors paying attention “not simply to rebounding earnings but also to the quality and sustainability of earnings growth.”

Confidence and mixed signals: “The nascent global economic recovery, fueled by re-openings, fiscal and monetary stimulus, and pent-up consumer demand is in turn spurring the revitalization of value and cyclicals within small cap,” the article reports, adding that “while the recent pace of returns is clearly unsustainable, we believe there are other reasons to stick with the asset class beyond our expectation for improved performance for high-quality companies.”

It notes that three-year periods following strong years “tell a far better, more consistently positive story, with uniformly positive average annualized results” as illustrated below:

The article concludes that, “while the pace of small cap returns will slow, positive results seem likely, with history showing the possibility of low double-digit returns on an annualized basis over the next few years.”