What You Don't Know About Small Caps

Small-cap stocks have taken a pounding in recent months, but Francis Gannon of Royce Funds recently offered some intriguing data indicating that fundamental-focused investors would be wise not to quit on smaller stocks.

In commentary on Royce’s website, Gannon noted that currently, 25% of all companies in the Russell 2000 index of small stocks are not making any money. “This tells us two things,” he said. “One, the index as a whole might not be as expensive as it looks because it includes such a large number of companies currently earning nothing. Second, and much more important in our view, is the idea that small cap investors need to really understand what they own. Active management can make an enormous difference in the small-cap space, more so we think than in other asset classes.” 

Gannon also notes that, while lower quality small caps are selling at a major premium to large caps, high-quality small caps don’t look nearly as expensive. Royce broke the small-cap space down into quartiles based on return on invested capital. The quartile of small stocks with the lowest ROIC were trading at a 52% premium to large caps at the end of the 3rd quarter; the next-to-last quartile was trading at a 13% premium to large caps. But the second-highest quartile and highest quartile based on return on invested capital were actually trading at a discount to large caps (6% for the second-highest quartile and 9% for the highest quartile).

Finally, Gannon notes that since its inception in 1979, the Russell 2000 has been in the red in only five calendar years when the S&P has been in the black. Each of those times, the Russell 2000 has outperformed the following year.