Royce Investment Partners: Can –

How would you characterize the way small caps performed in 2021?

Francis Gannon It was certainly an inconsistent year for the asset class overall. And while a positive return is always welcome—the Russell 2000 Index advanced 14.8% in 2021—we understand why investors might be disappointed in small-cap’s relative results. Small-caps kicked off 2021 with a lot of optimism. The Russell 2000 climbed 12.7% in 1Q21—which more than doubled the Russell 1000 Index’s 5.9% gain—and hit a new high in March. Yet in spite of reaching a subsequent peak in November, small-cap results were pretty underwhelming from both an absolute and relative basis for the rest of the year. The Russell 2000 lost ground to the Russell 1000 as the year wore on. After its terrific start, the Russell 2000 gained only 1.9% from the second through the fourth quarters of 2021, so despite very strong earnings growth from small-cap companies, there wasn’t much to show for the last nine months of the year.

Bigger Was Better After 2021’s First Quarter
1Q21 Returns and 2Q21-4Q21 for the Russell 2000 and Russell 1000 Indexes


Source: Russell Investments

Why do you think large-cap did comparatively better in 2021?

Chuck Royce
(Trades, Portfolio)
I suspect a number of investors turned to mega-cap stocks as a ‘flight to safety’ as the concerns about omicron and economic growth emerged, especially with interest rates still so low. As has been the case for the last few years, large-cap performance was dominated by the biggest names. In 2021, Apple, Microsoft, Google, Nvidia, and Tesla were all very strong. I think this explanation becomes more plausible when you plug the slower pace of economic growth into the context of emergent headwinds such as inflation, the omicron variant, Fed tapering, rising rates, and economic policy dithering. Over the past several years, this cohort of mega-cap stocks has evolved to behave quite differently, and sometimes counterintuitively, from the rest of the stock market. Yet because of their gargantuan market capitalizations, this comparably small number of stocks has exercised an extraordinary effect on the performance of the large-cap or all-market indexes, thus influencing investors’ perceptions. Our view is that these stocks do best in an environment where there are concerns about economic growth, along with abundant central bank accommodation. As we see 2022 as likely to be characterized by above-average economic growth and reduced central bank accommodation, we’d be surprised to see the mega-cap cohort continue to outperform.

What effects do you think a less accommodative Fed will have on equity performance?

FG We think it will have a meaningful but differentiated impact on stocks. As Chuck mentioned, certain stocks have benefitted disproportionately up until now from the Fed’s ultra-accommodative low interest rates and abundant liquidity, and those stocks are likely to feel the greatest negative effect of the Fed’s changes. Fortunately, we think we own few stocks that fit this profile. The reduced liquidity that results from Fed tapering and any subsequent balance sheet run-off is likely to produce sharp increases in market volatility. However, those are often the moments when attractive stocks become available at temporarily depressed prices, and we’ll be ready to take advantage of those opportunities.

Perhaps the most notable development within small-cap in 2021 was the very wide performance spread between the Russell 2000 Value and Growth Indexes. What factors might help explain how this disparity contributed to small-cap’s overall underperformance in 2021?

CR I think we can learn a few important things by looking at what happened within the Russell 2000 in 2021. In contrast to the Russell 2000 Growth Index, which gained only 2.8% in 2021, the Russell 2000 Value Index had a wonderful year—beating the Russell 1000 with a gain of 28.3% versus 26.5%. In other words, all of small-cap’s relative disadvantage in 2021 came from the growth side. In a year with growing economic concerns, this is certainly unexpected. When investors grow nervous about economic growth, they’ve historically been more likely to abandon value or cyclical stocks due to their greater economic sensitivity—yet the opposite seems to have been the case in 2021.

What were the sources of the Russell 2000 Growth’s struggle to keep pace in 2021?

FG Most of the difficulty for small-cap growth came from the Health Care sector, which was also the biggest detractor and the highest average sector weighting in the Russell 2000 as a whole. Within Health Care, biotechnology—which during 2021 accounted for almost 10% of the Russell 2000, was by far the biggest industry detractor in 2021. This was good news for investors with a value orientation and/or more cyclical lean like ourselves. Financials, Industrials, and Consumer Discretionary each did very well in 2021. In spite of cyclical strength in 2021, however, we still see a sizable lack of recognition for company quality and/or earnings strength within select cyclical areas.

Do you expect small-cap value to continue outperforming small-cap growth in 2022?

FG Yes. In many ways, we think small-cap value is just starting to flex its relative performance muscles, as it were. We see three reasons to be optimistic about small cap value’s prospects. First, in spite of the strength it’s shown since the fourth quarter of 2020, the Russell 2000 Value’s annualized three- and five-year returns still trailed those for its growth sibling at the end of 2021—by a significant amount on the five-year number. Prior to starting to fall behind small-cap growth in 2011, the Russell 2000 Value had usually led over these longer-term periods. Second, small-cap value is still near the low end of its 20-year relative valuation range compared with small cap growth. And finally, the business models that disproportionately populate small-cap value are, in our view, both better suited to benefit from improving economic growth and less likely to be hurt by higher inflation.

Despite Leading for One Year, Small-Cap Value Trails by a Large Margin for Three- and Five-Year Periods
Russell 2000 Value vs Russell 2000 Growth Annualized Returns as of 12/31/21


Past performance is no guarantee of future results.
Source: Russell Investments

Do you also think small-cap can retake leadership from large-cap in 2022?

CR We think that’s likely, specifically because the global economy continues to recover and seems on course for above-average growth in 2022. Equally important, we still see much that we like in the small-cap universe in terms of valuation and fundamentals. In fact, during the second half we saw a widening gap between rising fundamental expectations for small cap’s forward profits (using Next Twelve Months Analyst Forecasted Earnings Before Interest and Taxes, NTMA EBIT, as a proxy) and declining investor sentiment, as seen by the lower valuations based on a related metric, Enterprise Value to Next Twelve Months Analyst Forecasted Earnings Before Interest and Taxes, excluding companies with negative earnings. Small-cap’s historical record of outperformance during periods of above-average economic growth, its overall lower relative valuation, and its broader market participation all support the leadership case.

Improving Small-Cap Fundamentals, Declining Valuations
NTMA EBIT versus EV/NTMA EBIT for the Russell 2000 from 6/30/21-12/31/2


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.
Source: FactSet

Where do you think we are, then, in the small-cap cycle?

FG It’s a really interesting question. Over the last two-plus decades, we’ve seen shorter small-cap upswings, which have typically lasted about two years: 1998-2000, 2009-2011, and 2016-2018, for example. But there have also been longer cycles, such as the one that spanned 2003 to 2007. So with the second anniversary of the bottom approaching in March 2022, it’s worth pondering which of these kinds of cycle we’re in. I’m going with the idea that the current cycle extends at least into 2022, if not longer. That may seem odd in light of the relatively underwhelming year the Russell 2000 had but joining our own bottom-up perspective with an examination of macro factors suggests a strong probability for small-cap outperformance.

What can you tell investors and clients who are worried about the effect inflation could have on equity returns?

CR The most important fact—and one that’s been relevant to me since I began managing portfolios in the early 1970s—is that small caps are the only major asset class that’s beaten inflation in every decade since 1930s. Large-cap stocks, bonds, and cash all have less success than small-cap during inflationary periods. These periods also create activity for small-caps in M&A, both as targets and acquirers.

Small-Caps Have Beaten Inflation in Every Decade
Average Annual Consumer Price Index (CPI) versus Average Annual CRSP 6-10 Index
12/31/1930-12/31/2020 (%)


Past performance is no guarantee of future results.
Sources: Bureau of Labor Statistics (CPI) and CRSP

Are there certain sectors, industries, and/or business models that you think are better positioned for more persistent inflation?

CR Regardless of sector or industry, we lean toward companies with pricing power, strong and longstanding customer relationships, and/or high switching costs because they’ve historically done better when inflation is more persistent. Companies that have the necessary capital available to invest in labor productivity and business effectiveness are also worth holding during inflationary periods. Additionally, I’d say companies that provide human and/or intellectual capital—those that specialize in the sourcing and provision of people, for example—are currently well positioned because wage inflation is so widespread.

Given all that you’ve both discussed, what is your overall outlook for small-cap and small-cap value in 2022?

FG Our outlook is very positive for small-cap value but is more nuanced for small-cap as a whole. The Russell 2000 enjoyed a third consecutive year of double-digit positive returns in 2021, which is pretty rare for any equity index. It’s happened only twice before since the inception of the Russell 2000 in 1979—from 1991-1993 and 1995-1997. In each instance, a fourth year of double-digit positive performance failed to materialize. We always put a lot of weight on history, and this pattern, along with the likelihood of a less accommodative Fed, makes us think that performance for the Russell 2000 will be more muted in 2022. We also expect high-quality small-caps—which we define as those in the top decile of returns on invested capital and stability of return on assets—to continue outpacing the asset class as a whole, as they did in 2021’s second half. These last two expectations are related. We’ve often seen high-quality small-caps have their best outperformance in periods when the index is posting more modest returns. A not widely discussed aspect of 2021 is that active management, as measured by our proxy, the Morningstar Small Blend category, beat the Russell 2000 in 2021, gaining 24.2%. Based on the currently strong fundamentals for many small-cap companies, we think the same is likely for 2022.

CR History also tells us, however, that small-cap value and cyclicals do well, particularly on a relative basis, during periods of improving economic growth. This is consistent with the encouraging signs we’ve been seeing on a company-by-company basis. The current valuation picture for small-cap value also looks compelling. We often use the equity risk premium, based on the difference between free cash flow and the 10-year Treasury yield, to gauge valuation. Based on this metric, small-cap value sells at a current valuation from which subsequent three-year returns have been in the low teens. Even if small-cap value delivers somewhat less than these high historical rates of return, we see it as perhaps the most attractive investment segment among U.S. equities.

Average Subsequent Russell 2000 Value Three-Year Performance in Equity Risk Premium Ranges¹
From 12/31/01 to 12/31/21


¹ Equity Risk Premium = Latest Twelve Months Free Cash Flow divided by Enterprise Value minus 10-Year Treasury Yield. Past performance is no guarantee of future results.
Source: Russell Investments

Can you detail the investment thesis for a high-quality holding that enjoyed a strong 2021?

CR One company would be Inter Parfums, which is a global developer and designer of prestige fragrances, primarily under licenses of high-end brands such as Mont Blanc, Coach, Jimmy Choo, and Guess. We first bought shares more than 20 years ago, though Lauren Romeo has handled the bulk of our analysis over the last several years. With most of its sales coming from traditional brick-and-mortar department or specialty stores or travel retail such as duty-free shops, its revenue fell by 24.5% in 2020. Its operating margins, however, fell by only 170 basis points to a still healthy 13% for 2020. We thought these results reflected the company’s high variable expense and capital light business model. The stock was up more than 60% in 2021, boosted by better-than-expected growth from improved store traffic and higher gross margins due in part to improved sales from newly launched higher-margin products. In September, the company reported that, excluding one-time gains, 2021 would be its best year ever for sales and earnings per share.

Inter Parfums (IPAR, Financial)


Source: Bloomberg

What about a company that’s earned your confidence but whose stock hasn’t yet taken off?

CR I would say GCM Grosvenor, which is an alternative asset manager that Andrew Palen and I have done a lot of work on over the last few years. They manage assets for a global client base in hedge fund strategies, private equity, real estate, infrastructure, and multi-asset class investments. I’ve been actively investing in the alternative asset management space for several years. Their business models are complex, and many investors tend to avoid them until the shares begin to take off—so when we get it right, these are close to ideal investments. As for GCM Grosvenor itself, Andrew and I like that it’s trading for roughly 15x earnings—compared to twice that multiple for most of its competitors. Its stock was down in 2021, but we think several developments are aligning, especially its improving fundamentals, that can reverse the downward trend. Grosvenor has made some major investments and is moving from high-single to double-digit top-line growth as earnings improve from the mid-teens to more than 20%. It’s also a highly profitable business with more than 40% EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margins. Taking all of this into consideration, along with its attractive valuation, we think it’s a strong candidate for a significant rebound.

GCM Grosvenor (GCMG, Financial)


Important Disclosure Information

Mr. Royce’s and 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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