It's Not the Index

Small-cap stocks

It's Not the Index

The companies best-positioned to benefit from burgeoning economic strength around the globe aren't necessarily the companies in the Russell 2000.

With the global economy experiencing synchronized expansion; our own economy appearing to have broken through the 2% GDP growth ceiling; and earnings improving, the stage certainly seems set for small-cap to excel. Add the effects of a tax cut and some deregulation, and the small-cap scenario looks even more promising.

Some believe there's equally compelling support for a more pessimistic outlook. I was recently quoted in an article in a top financial newspaper which asserted that small-caps as a group are expensive, have debt issues and highly exposed the threat of rising interest rates. 

We do currently face a somewhat contradictory mix of historically high valuations, which means that multiples could remain level or contract, along with an accelerating global economy, which suggests that earnings are heading higher.

Which of the two forces will win out? We see the answer lying in which part of the market you’re invested in.

Is growth's recent run really sustainable?

Both growth and defensive stocks within the small-cap Russell 2000 Index have outpaced their value and cyclical counterparts over the last few years, resulting in returns for small-cap growth stocks that are running well above their long-term rolling monthly averages.

This, in our estimation, cannot be sustained.

The combination of high valuations, ample leverage—much of it in floating-rate debt—and unprofitability is very likely to spell trouble for a sizable number of small-cap companies, as well as for investments in small-cap indexes, where the weight of these businesses is likely to impact returns for the asset class as a whole.

Perhaps counterintuitively, this is good news in our view for disciplined and selective active managers.

After all, effective active management is not about investing in an overall asset class—and certainly not in indexes. It’s about investing in businesses that we think are capable of having long-term success trading at prices that don’t fully reflect their favorable prospects.

Dispersion means opportunity

Every day, we put our experience and expertise to work in the effort to find these kinds of businesses across the large and diverse small-cap asset class that, it should be emphasized, contains thousands of companies outside the Russell 2000.

We think investors need to be especially mindful of this breadth and diversity. For example, the top two deciles of the Russell 2000 were up 121% and 51% in 2017, while the bottom two fell 55% and 28%. Given such wide dispersion, we believe that we can always find long-term opportunities.

Small Cap Stocks

Source: Royce Funds, Bloomberg

And as we look at what we hold today, we see plenty in economically sensitive industries that blend the attributes of profitability, relatively attractive valuations, and global exposure (both direct and indirect).

These are the kinds of companies that appear best-positioned to benefit from burgeoning economic strength across the globe.

Remember—the opportunity in small-caps is not with the index, it’s with select companies in the entire asset class.

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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.