Healthy Rotation or Rally at Risk?

Small-cap stocks

Healthy Rotation or Rally at Risk?

Royce Co-CIO Francis Gannon looks at recent small-cap results and sees a consolidating asset class setting the stage for its next move up


2017's First Half Almost Reversed 2016's Reversals

The leadership shifts that arrived in 1Q17 remained in place for most of 2Q17—with large-caps, growth, healthcare, and non-U.S. equities all staying in the lead after lagging in 2016.

While this catch-up mode created a small-cap market with narrow leadership for growth through most of 2017’s first half, cyclicals and value made strong upward moves at the end of June just as several healthcare and tech names corrected, and bond yields again began to rise.

For 2Q17, the Russell 2000 Index gained 2.5%. While the Nasdaq cooled off a bit from its torrid first-quarter pace, it still comfortably led the major domestic indexes with a 3.9% gain. The large-cap Russell 1000 and S&P 500 Indexes both advanced 3.1 %. Within small-cap, the Russell 2000 Value Index was up 0.7% while the Russell 2000 Growth Index increased 4.4%.

This pattern held for the year-to-date period ended 6/30/17, with the Russell 2000 up 5.0% while the Nasdaq climbed an impressive 14.1%, and the Russell 1000 and S&P 500 each posted a YTD gain of 9.3%. The Russell 2000 Value was up 0.5% while its small-cap growth sibling gained 10.0%.

What we saw in small-cap, then, is A Tale of Two Halves, with value and growth taking different roads to similar destinations. For the one-year period ended 6/30/17, the Russell 2000 Value climbed 24.9% versus a gain of 24.4% for the Russell 2000 Growth. The former arrived there via a terrific second half of 2016 while the latter accelerated through 2017’s first half.

In our view, this first half catch-up for 2016’s laggards and flattish returns for last year’s leaders signifies a healthy market, setting the stage for its next advance.

Health Care and Tech Dominate Small-Cap Results

Small-cap results for both 2Q17 and the first half were dominated by two growth-oriented sectors, with Health Care and Information Technology making by far the largest contributions to first-half results for the Russell 2000.

Other than Energy, which declined markedly along with plunging oil prices in the first half, the remaining small-cap sectors were unremarkable. Most cyclical sectors had modest advances, while the defensive sectors of Utilities and Telecommunication Services rallied, as they often do when bond yields decline.

 

Russell 2000 Year to Date Contribution to Total Return (%)

Russell 2000 Year to Date Contribution to Total Return

Source: Factset, as of 6/30/17. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual index.

 

We suspect that many investors underappreciate the interest-rate sensitivity of growth stocks. A first half with modest economic growth and falling bond yields is one in which investors should expect non-cyclical sectors and growth stocks to lead, which is exactly what we saw.

While a lack of breadth is to be expected in a growth-led market, this degree of narrow leadership is comparatively rare, which is partly why we anticipate a resurgence for value stocks in the coming months. To be sure, the realignment at the end of June that saw Industrials and other cyclical names reviving bolstered our confidence that cyclicals could regain leadership in the second half of 2017.

If bond yields continue their recent ascent in the second half, it will create as strong a headwind for defensive sectors and growth stocks as declining yields were a favorable tailwind in the first half.

Top Heavy Rally

Further evidence of the narrow range of small-cap returns can be seen by breaking down first-half performance for the Russell 2000 into deciles.

The top-performing decile in the small-cap index contributed all of the small-cap index’s first-half return, while 50% of small-caps finished June in the red.

Both first-half sector results and these top-heavy company returns suggest to us a measure of disappointment or uncertainty from investors. Because post-election optimism was not followed by the implementation of business-friendly fiscal policies, the dissipating hopes for more robust economic growth kicked open the door for non-cyclical assets to lead. (Consumer Staples was an interesting exception to this and was likely hurt by muted consumer spending.)

Our expectation is that the ongoing earnings strength of cyclical areas will reverse this trend. While we don’t think returns will match the lofty levels of 2016’s second half, we do expect that the next market advance will be broader than what we’ve seen so far this year.

 

Russell 2000 YTD Contribution to Return (%)

Russell 2000 YTD Contribution to Return

Source: Factset, as of 6/30/17. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual index.

 

Can Value Regain Leadership in 2017?

By outpacing small-cap value in each quarter of 2017’s first half, the Russell 2000 Growth Index took steps toward reversing the reversal that small-cap value made in 2016. The latter recaptured small-cap leadership following the 6/23/15 peak for the Russell 2000.

Throughout 2016, the Russell 2000 Value moved up to narrow the significant performance advantage that small-cap growth had won from 2011-2015. In fact, small-cap value’s assertion of leadership looked to us like a pronounced shift.

To be sure, it has been an interesting time for the small-cap style indexes, with an advantage for growth in 2015, a big lead for value in 2016, and an edge for growth in this year’s first half.

In our view, however, with interest rates rising and QE’s unwinding expected in the U.S., the environment has made a welcome shift toward a more historically normal condition, one in which we think fundamentals such as free cash flow and balance sheet strength should support leadership for quality as well as value.

 

Russell 2000 Value - Growth Spread (%)

Russell 2000 Value - Growth Spread

Source: Bloomberg, as of 6/30/17. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual index.

 

Foreign Policy

There are indicators that global growth is heating up, especially in the developed markets, and it’s a distinct possibility that many of these economies will grow faster than the U.S., if only in the intermediate term.

Some would argue that this is bad news for small-cap stocks, considering that they derive the bulk of their revenues from domestic sources and would thus be at a disadvantage—possibly a large one—compared to large-caps.

We would agree—at least in part. In fact, the average small-cap company had only 19.8% of their sales from outside of the US. More robust growth outside the U.S. would almost definitely not be great for the Russell 2000. But it might be good for active managers.

There is great variation in the level of foreign sales by sector and industry in the Russell 2000. Based on the percentage of revenues derived from outside the U.S., Information Technology (44.1%) and Materials (33.4%) show the highest sector sensitivity to international economic growth. In addition, certain other cyclical industries such as auto components (47.2%) and machinery (35.9%) also appear well positioned to benefit from global expansion.

In addition to direct international exposure, many other small-caps participate indirectly by providing goods and/or services to U.S.-based companies that are themselves participating in global growth, such as a small electronic equipment company that sells components to Amazon or Google. And active managers can tilt their portfolios to these selectively attractive areas.

We therefore see the current environment as conducive to small-cap active management approaches as long as there is a reasonable amount of economic growth, either here or overseas.

 

% Of Foreign Revenue (last 12 months)

Small Caps % Of Foreign Revenue

Source: Factset, as of 6/30/17. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual index.

 

A Healthy Outlook for Certain Cyclicals

To be sure, our confidence in the state of small-cap earnings leads us to see a path forward for selected small-caps even in the event of an interruptive correction, which we see as more likely than not.

It’s worth recalling that for the past 20 calendar years, the Russell 2000 has had a median intra-year decline of 14.2%. So far this year, the biggest peak to trough drop was 4.7%. Thus, our thought is that after 16 months without a decline of more than 5%, a pullback in share prices seems like a good bet to us.

However, we also think that many small-caps, particularly those in several cyclical industries, are in fundamentally sound shape, and we don’t see a downturn going beyond the range of 8-12%. In any event, corrections always present us with the chance to buy opportunistically on the dips.

While a modest return outlook for the overall small-cap asset class seems appropriate to us, there is a significant difference between the earnings growth expectations for cyclical versus defensive sectors1—and active managers can take advantage of this difference.

Our daily conversations with management teams continue to confirm a solidly positive outlook for many of our holdings, particularly in the industrial cyclical areas. We also see no signs that U.S. growth is about to contract—the economy looks at least pretty good and could accelerate even in the absence of fiscal stimulus. In addition, there are also no signs of an imminent market top.

From our perspective as small-cap specialists, then, we see cyclical companies with earnings as poised to benefit from economic growth, whether here in the U.S. or abroad, over the next several years.


1The estimated 2018 EPS growth rate for small-cap cyclicals is 17.8% versus 12.8% for defensives. The Estimated EPS Growth 2018 vs. 2017 is calculated as the difference between the average estimated 2018 eps and average estimated 2017 eps provided by brokerage analysts. Both eps estimates are the average of those provided by analysts working for brokerage firms who provide research coverage on each individual security as reported by Factset.

Cyclical and Defensive are defined as follows: Cyclical: Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials; Defensive: Consumer Staples, Health Care, Real Estate, Telecommunication Services, and Utilities.

Top

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.

Outperformance does not imply positive results.

Discussions of individual securities are not intended and should not be relied upon as the basis to buy, sell or hold any security. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.

Active management does not ensure gains or protect against market declines.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

Investments in small-cap and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies.