Q&A: State of the Market for Small Cap Equities
By Francis Gannon, Co-Chief Investment Officer and Steve Lipper, Senior Investment Strategist, Royce Investment Partners
Q: How are you positioning your portfolios for small cap equity market opportunities?
A: Across all our portfolios, we are pivoting towards companies with long-term growing demand that people may have sort of forgotten about, with valuations that are pressed or situations where we anticipate even greater demand coming out of the recession. Depending on the advisor's orientation and the client's risk tolerance, the three smart choices are a chicken wing metaphor: mild, medium and spicy. Mild would be our Royce Total Return and Royce Special Equity Funds; medium our Royce Pennsylvania Mutual Fund and Royce Premier Fund; and spicy would obviously be our Royce Opportunity Fund.
Q: How have the small cap markets fared amidst the recent downturn?
A: The first quarter of 2020 was the worst quarter in the history of the Russell 2000 Index, declining over 30 percent. March was one of the worst months, down 21.7 percent, since October 2008, when the Russell fell 22.4 percent and October 1987 – 29 percent. What has been most interesting has been the speed of the decline. From February 20 through the end of March, the market declined about 41 percent to the bottom, on March 18.
The good thing about this decline is that it is within the range seen in similar-type downturns. The bursting of the tech bubble brought a 4.1 percent correction in the Russell 2000. The Global Financial Crisis brought an almost 59 percent correction. Small caps have actually had a bunch of market corrections since the Financial Crisis. The current decline is the third bear market in the past five years.
The speed of the decline has been alarming, but the depth is actually quite familiar. The speed of the response, fiscally and monetarily, has also been quite supportive. So, in many respects, we have seen this before. History is not necessarily repeating, but it is definitely rhyming.
Q: Does that means we have seen the bottom of the market?
A: That’s the question everybody is trying to answer: is this the bottom, or will it be in 30 days, or three months? We do not know if we've seen the bottom with all the unknowns around the coronavirus, the economy, earnings, etc. What is knowable is asking clients their target amounts for small-caps and getting there in steps, whether over three months or six.
We cannot answer whether small caps are going to be higher or lower in three years. But we can look at history and see the possibility that returns could be positive in three years.
Q: How have you been investing?
A: With so much focus on the bear market it's hard to say this, but internally our people are smiling. They put cash to work, buying great businesses on sale over the past several weeks. We continue to invest daily. Dollar cost averaging is really appropriate given the long-term opportunities. We are investing in many businesses we owned previously and/or currently own.
One of the areas we focus on – given growth scares and now recessionary scares – are cyclical investments. More economically sensitive areas historically do quite well coming out of market troughs and we expect the same to happen this time. We would not expect utilities, consumer staples and even REITs to do well coming out of this moment.
Many of the great companies we own have under-levered balance sheets and are well positioned in this uncertain environment. Better businesses are going to be able to take advantage of the balance sheet mistakes other companies have made over the past five years and continue to grow their businesses. We think there is extraordinary opportunity and we are well positioned for it.
Q: What kind of companies are considered to be attractive opportunities in this environment?
A: One such opportunity is an aircraft leasing company, Air Lease*. In a panic, the market loses some of its discriminating ability. Our research shows more leveraged small cap companies decline much faster than the less leveraged. That’s as expected. However, the leverage matters: what's the collateral?
What was the company's experience in 2008? If they had to repossess planes, how often did it take to repivot them to another airline? That worked out very well. When airline balance sheets get worse, they need Air Lease more. Airlines cannot afford to hold airplanes on their balance sheet. Those are some of the inefficiencies we look to take advantage of.
Q: Can you provide another example of a company well-positioned in this market?
A: If you have ever been in commercial building, late, you will see workers buffing up the floors with commercial cleaners. The machines that do that are sold by Tennant**. We expect there to be increased secular demand coming out of the pandemic for cleaner buildings. As the quality of cleanliness goes up, we think demand for Tennant’s machines and services will go way up.
Q: What other trends are you seeing as you position portfolios?
A: For greater growth coming out of this, we look at everything around housing. As people come back to work, we will still have low mortgage rates. The trends were good coming in, demand exceeding supply. We are optimistic about builders, building supply and residential housing.
Second, there promises to be a fair amount of commercial bankruptcies and restructurings. Some boutique M&A advisers have large restructuring practices but only a small group has the very elite expertise to execute these restructurings. Those look attractive too.
Francis Gannon is Co-Chief Investment Officer and Steve Lipper is Senior Investment Strategist at Royce Investment Partners, a subsidiary of Legg Mason. Their opinions are not meant to be viewed as investment advice or a solicitation for investment.
* Air Lease, Percentage of Holdings as of 3/31/20
- Penn Mutual 0.5%
- Premier 2.3%
- Opportunity 0.9%
** Tennant Company, Percentage of Holdings as of 3/31/20
- Penn Mutual 1.1%
- Premier 1.7%
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Royce Pennsylvania Mutual Fund: The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 25% of its net assets in foreign securities that may involve political, economic, currency, and other risks not encountered in U.S. investments.
Royce Premier Portfolios: All investments involve risk, including loss of principal and there is no guarantee that investment objectives will be met. Investments may be made in small-cap companies, which involve a higher degree of risk and volatility than investments in large-cap companies. The Portfolio generally invest a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any one of these stocks would cause the Portfolio's overall value to decline to a greater degree. Investments may be concentrated in a limited number of industries and issuers. Equity securities are subject to price fluctuation and possible loss of principal. Certain securities are subject to illiquidity risk, which is the risk that securities may be difficult to sell at certain prices when no market participants are willing to purchase the securities at such prices. The managers’ investment style may become out of favor and/or the manager’s selection process may prove incorrect, which may have a negative impact on strategy performance.
Royce Opportunity Fund: The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss.
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Francis Gannon, Co-Chief Investment Officer, Royce Investment Partners
Steve Lipper, Senior Investment Strategist, Royce Investment Partners
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