Royce Investment Partners Commentary: Mind the Gap

This time is understandably far from joyous for small-cap investors. Fear is running hot. Recent headlines are abysmal, rising rates are colliding with elevated inflationary pressures, the war in Ukraine goes on, and supply chain disruptions continue due to ongoing lockdowns in China. All of which have made for a miserable start to the year that has put the bears out in full force throughout the equity markets. Following the worst April in the history of the small-cap Russell 2000 Index—and its second worst start to the year—May has provided little in the form of relief as markets have fallen even further. The Russell 2000 declined 26.2% from its high on 11/8/21 through 5/13/22, while the average small-cap stock was off more than 44% from their respective 52-week highs through that same day in May.

From our perspective, today’s uncertainty is creating attractive opportunities for long-term investors, especially further down the capitalization spectrum. The forward returns for small-cap investors should be quite strong. Using history as our guide, we have gleaned some interesting insights from studying the VIX (that is, the CBOE S&P 500 Volatility Index), which tracks the market’s expectations for near-term volatility. Higher-than-average volatility indicates that risk aversion is running hotter than usual. Investor sentiment has historically been a contrary indicator—which suggests that the market will soon move in a different direction. Since its inception in 1990, the VIX monthly average was roughly 19%. In March 2022, however, it averaged 27%. During May, it has so far averaged more than 31% (through 5/13/22). We think this is relevant because subsequent three-year average annualized returns following months when the VIX averaged more than 25% were 14.1% for the Russell 2000 and 9.4% for the Russell 1000. Moreover, small-cap beat large-cap in 83% of these three-year periods—which is a very impressive batting average. This trend underpins our long-term optimism for both absolute and relative small-cap returns.

As cited above, many small-cap stock prices have dropped nearly in half even as many companies are posting rising profits. Since the Russell 2000’s peak on 11/8/21, forward profit expectations have continued to rise as valuations have continued to fall. At the end of September, the next 12 months’ forward EV/EBIT (enterprise value/earnings before interest and taxes) multiple for the Russell 2000 stood at 22.7x, while at the end of April this same metric had fallen to 16.8x, below its 15-year average of 17.6x.

The Widening Gap between Small-Cap Fundamentals and Valuations
Next 12-Month EBIT ($mil) Estimates versus NTM EV/EBIT for the Russell 2000 from 9/30/21-4/30/22


NTMA EBIT: Next 12-Month Analyst Forecasted Earnings Before Interest and Taxes
EV/NTMA EBIT: Enterprise Value Over Next 12 Months Analyst Forecasted Earnings Before Interest and Taxes.
The Enterprise Value to Next Twelve Months Earnings Before Interest and Taxes (EV/NTMA EBIT) is the sum of index constituents’ current Enterprise Value divided by the sum of index constituent analysts’ forecasted EBIT over the next twelve months. Companies considered by FactSet to be in banking, insurance, or other financial industries are excluded from the calculation. Real Estate Investment Trusts (REITs), however, are included.
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.
Source: FactSet

While these ongoing declines in market sentiment and valuations are understandable in light of current uncertainties, they have also opened up a large gap between sentiment and small-cap fundamentals as we see them. In contrast to recently pervasive market anxiety, for example, the bulk of our companies reported strong ongoing demand and offered solid to optimistic guidance during early May’s earnings season.

Our various investment teams are finding opportunities in numerous areas. For example, our more contrarian, opportunistic value team likes what they see in the consumer and energy spaces. The first of these areas admittedly carries risk as U.S. consumers are facing higher energy prices as well as inflation in other key areas, such as food. However, they see their holdings in various consumer companies as possessing certain competitive and / or other advantages that they believe should help these businesses survive and succeed in the current uncertain climate. Most of the portfolio’s energy investments are in natural gas exploration & production companies, with a smaller number involved in liquid natural gas transport and distillates. These are long-term investments as the globe resets its energy sources in light of the invasion of Ukraine. They also continue to see high demand in select tech-related industries that are continuing to generate decent to strong revenue and /or earnings growth.

Our quality value team is excited about the valuations they’re seeing in Consumer Discretionary, where the market appears to have already priced in a recession and attendant weakness in U.S. consumer spending—yet with some evidence of inflation potentially peaking and a large buffer of savings and spending power, we believe the US consumer will prove more resilient than seems widely feared. Within select technology businesses, “the baby being thrown out with the bathwater” has led to opportunities to add to companies with attractive business models and growth profiles at deeply discounted prices. Housing is another area of interest, as rising interest rates hit anything tied to the housing supply chain. While the team agrees that the housing market is likely to cool, they also believe its structural demand dynamics remain intact and should therefore ultimately lead to a more sustainable housing cycle in the years ahead. They are currently focusing on opportunities in building materials companies and title insurance.

Finally, our premier quality team has identified what they believe are overlooked opportunities among beneficiaries of increased capital spending. The long-term signs are positive in several industries that are budgeting for increased capital expenditures into 2023. Companies that appear poised to benefit from the large number of new factories and distribution facilities that are being built or on schedule for construction during the next year or two are additional areas of recent investment interest.

Each bear market is different of course, but history has shown us time and time again that at market extremes opportunities abound. In effect, forward returns are on sale today. Many of our portfolio managers, while unhappy about the year-to-date losses in the portfolios we manage for clients, are very pleased by the breadth of attractive stock price opportunities they see. Their excitement has been bolstered by interactions with company management teams, where news of solid results and robust expectations have been common.

Stay tuned…

Important Disclosure Information

Mr. Gannon’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

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.

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