Royce Investment Partners 2023 Annual Letter

2023: The Dog That Didn’t Bark

While every year is eventful and interesting in its own right, we think 2023 held particular interest for equity investors-specifically those of us who focus on small-cap stocks. There was no shortage of consequential geopolitical developments. Some, like the war in Ukraine, showed no evidence of ending or abating, while others, like the terrorist attack on Israel and consequent bombings in Gaza, were new events, as were the well-publicized implosions of Silicon Valley (OTC:SIVBQ), Signature (OTC:SBNY), and First Republic Banks (OTC:FRCB).

The contagion was contained, however, and the rest the of the economic news was much brighter, at least here in the U.S. The year began with inflation still stubbornly high and, as a consequence, the Fed still hiking rates and committed to doing so until the rate of rising prices slowed. This commitment bred a curious form of cognitive dissonance, with every public statement from a Fed official pledging adherence to the central bank’s target of 2% inflation almost immediately meeting with word from a financial or investment pundit insisting that they really meant 3-4%.

This was understandable to some degree. Many observers pointed to both inflation’s moderating pace (after peaking in June of 2022) and the resilience of the U.S. economy as evidence that the Fed should take a victory lap and leave rates untouched-or cut them. Many investors shared these views while no doubt hoping that the positive returns for equities through the first half of 2023 would not be put at risk by another round of rate hikes. To be sure, some investors were concerned that “higher for longer” might be all it took to snuff out a nascent recovery for stocks.

We shared some of this anxiety. After all, 2022 saw the most aggressive rate hike cycles in the Fed’s history. And it was not just a bad year for the capital markets, it was historically awful: the third-worst calendar year performance for both the small-cap Russell 2000 Index (RTY) and the large-cap Russell 1000 Index since their shared inception date at the end of 1978, with each posting their lowest respective returns since 2008. It was the seventh worst year for the S&P 500 (SP500, SPX) since its inception in 1928, and the Bloomberg Barclays US Aggregate Bond Index since its inception in 1976. As we wrote one year ago, 2022 offered nowhere to run and nowhere to hide.

In this context, the fear of a second straight down year for stocks, which periodically rattled the U.S. equity markets at various times in 2023, seemed almost logical, hitting small- and large-cap stocks at different points-and with different intensities-throughout the year. However, by the end of December these worries had mostly dissipated. With the Fed holding the line on rates, “higher for longer” ultimately did not hold back returns.

A growing economy, burgeoning optimism about a soft landing for inflation, and confidence that the rate hike cycle had ended combined to lift share prices, as did optimism for rate reductions in 2024. Despite these developments, however, the most interesting, and ultimately most significant, element to 2023 was perhaps what did not happen. The most consistently predicted and regularly anticipated recession-said to be imminent since 2021-once again failed to materialize in 2023.

Its absence reminded us of “the curious incident of the dog in the night-time” from the famous Sherlock Holmes story, “The Adventure of Silver Blaze.” The iconic detective solves the case by pointing out how odd it was that the dog guarding the pen where the titular racehorse was stabled failed to bark when Silver Blaze was stolen. The phrase has since been used as shorthand to describe situations when what doesn’t happen matters at least as much, if not more, than what does. Which is about as apt a description of 2023 as we think can be found.

The State of Small-Cap

As measured by the Russell 2000 Index, small-cap stocks did quite well in 2023, advancing 16.9%. Yet most of this gain came in a robust rally from the 2023 low on October 31st through the end of the year. So, although small-caps kicked off the year with high returns, they trended mostly downward from early February into Halloween. All told, the Russell 2000 had a positive return in just five months in 2023: January, June, July, November, and December, with the last two months combining to post an impressive gain of 22.4%.

Thanks to this exceptional close, the Russell 2000 escaped a bear market at the end of 2023, though the small-cap index remained down -14.3% from its last peak on 11/8/21, while large-caps continued to establish new highs in December and into January 2024. Moreover, as of 12/31/23, the average stock in the small-cap index was -25.1% off its 52-week high. In this context, it was not terribly surprising that small-cap’s excellent finish could not lift its calendar-year return above large-cap’s. The Russell 1000 Index gained 26.5% in 2023 while also beating small-cap for the 3-, 5-, and 10-year periods ended 12/31/23. In fact, large-caps outpaced small-caps in seven of the last 10 calendar years.

Small-Caps Lagged Large-Caps from the Russell 2000’s Last Peak

Russell 2000 and Russell 1000 Cumulative Returns, 11/8/21-12/31/23

This seemingly chronic bout of underperformance has made the current cycle a deeply frustrating one for small-cap investors. At the end of January 2024, 594 days had passed from the current cycle low for the Russell 2000, making it the second longest stretch without recovering its prior peak on record. The two other lengthy small-cap cycles each encompassed dramatic developments: the implosion of high-flying technology stocks in 2000-02, when the Russell 2000 needed 456 days from its trough to match its previous peak, and the 2008-09 Financial Crisis, when 704 days passed before small-caps recovered from the trough during that global financial catastrophe.

So, while the current small-cap cycle has taken place amid ample uncertainty along with a record pace of interest rate increases, it has lacked the existential threats that characterized the Internet Bubble and, even more so, the Financial Crisis. The latter period also saw less bifurcation between small- and large-cap returns. The key question, then, is when will this cycle end and potentially usher in a small-cap outperformance run? It’s a point we’ll touch on later in this letter.

Within small-cap, both the value and growth indexes had strong finishes to the year, with the 4Q23 advantage squarely in value’s favor: the Russell 2000 Value Index advanced 15.3% versus 12.7% for the Russell 2000 Growth Index. It’s comparatively rare for small-cap value to beat its growth sibling in a positive quarter, particularly one with double-digit gains. It’s happened in only 42 of 119 positive quarters, or 35% of the time since the Russell 2000’s inception on 12/31/78.

The Russell 2000 Value also led from the previous 2023 small-cap high on July 31st, up 4.0% versus -0.2% through the end of December. For 2023 as a whole, however, growth led, gaining 18.7% versus 14.6%. It’s worth noting that 2023’s results contributed to something of a sawtooth pattern of relative performance. The Russell 2000 Value led for the 3-year (in which the Russell 2000 Growth lost -3.5%) and 5-year periods while small-cap growth, in addition to its 1-year advantage, also outperformed for the 10-year period ended 12/31/23.

The Valuation Situation

Reviewing long-term performance patterns, we find that small-cap enjoyed a longstanding advantage over large-cap-just as small-cap value did versus small-cap growth. Each of these dynamics began to shift in the aftermath of the Financial Crisis, starting in earnest in 2011. In eight of the last 13 years, the Russell 1000 and Russell 2000 Growth each had higher returns than both the Russell 2000 and Russell 2000 Value. Yet prior to that, the long-term edge was with the Russell 2000 and Russell 2000 Value. In light of this dominance from large-caps-and more recently mega-cap stocks-it appears that many investors may have forgotten how anomalous the backdrop to the last 13 years has been until just recently, with anemic economic growth and record low interest rates.

Now that both GDP and rates are returning to more historically typical levels, we expect to see some meaningful long-term mean reversion going forward. To that end, large-cap outperformance cycles have historically peaked when a relatively small number of the largest stocks were winning the lion’s share of performance-which was the case with the S&P 500 and the Nasdaq Composite Indexes in 1973 and March 2000.

Large-Cap Cycles Peak at Market Tops Crowded with Mega-Caps

Weight of Top 5 S&P 500 Stocks vs. Small-Cap Relative Performance, 9/29/72-12/31/23

We therefore see something of a silver lining to the recent relative performance woes for small-cap stocks versus their larger peers. The Russell 2000 sported a far more attractive valuation than its large-cap counterpart at the end of last year. Using our preferred index valuation metric of enterprise value to earnings before interest and taxes, or EV/EBIT, the Russell 2000 finished 2023 not far from its 25-year low relative to the Russell 1000.

Relative Valuations for Small Caps vs. Large Caps Are Near Their Lowest in 25 Years

Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (ex. Negative EBIT Companies), 12/31/98 through 12/31/23

Similarly, small-cap value continued to sell at a below average valuation compared to small-cap growth at the end of the year, as measured by EV/EBIT. Micro-cap stocks also remain very attractively valued relative to large-cap based on EV/EBIT. As small-cap specialists, we see the combination of more attractive valuations and reversals in long-term performance patterns as showing the significant performance potential that exists for small-cap, small-cap value, and micro-cap stocks-especially when stacked against their large- and mega-cap counterparts.

Small-Cap Opportunities

To be sure, with the Fed’s decision on 1/31/24 to leave interest rates unchanged for a third consecutive time, the backdrop of normalized interest rates, tamer inflation, and a growing, nicely resilient U.S. economy appears amenable to strong equity performance. It also looks to us that small-cap’s lengthy stretch in the relative performance wilderness has run its course. Our reasoning is rooted in the notion that, as the economy continues to stabilize, valuations are likely to rise for those businesses that have largely sat out the mega-cap performance regime. Such a move looks more likely to benefit small-cap companies than larger ones. Moreover, the early tracking estimates for real GDP in 1Q24 are highly favorable, and ongoing positive GDP growth brings the U.S. economy that much closer to the Fed’s desired “soft landing.”

Of course, we are bottom-up stock pickers and portfolio managers, not economists-and we eschew predictions. But we also understand that long-term mean reversion to small-cap leadership requires a catalyst. For all of the encouraging developments, the U.S. economy is at this writing in something of a schizoid condition, with high levels of consumer spending on one hand and a manufacturing and industrial slowdown on the other. Yet in 2024, the U.S. economy will see more tangible benefits from reshoring, the CHIPS Act, and several infrastructure projects. Closer to our zone of expertise, earnings growth for small-cap companies is currently expected to be higher than for larger-cap businesses in 2024.

Small-Cap’s Estimated Earnings Growth Is Expected to Be Higher in 2024 than Large-Cap’s

One Year EPS Growth as of 12/31/23

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One critical consequence of interest rates normalizing is that access to capital now has real costs-which should benefit conservatively capitalized, fiscally prudent small-cap companies and the asset managers who hold them. The price of carrying leverage on the balance sheet began to climb when the Fed first started raising rates in March of 2022-and its increased cost means that advantages should accrue to those businesses with low debt, the ability to generate free cash flow, and proven skill allocating capital prudently and effectively.

Returns are thus likely to be spread more widely over the next few years, with the reign of the Magnificent 7-the mega-cap cohort of Alphabet (GOOG,GOOGL) , Amazon (AMZN), Apple (AAPL), META, Microsoft (MSFT), Nvidia (NVDA), and Tesla (TSLA)-likely coming to an end and with it, small-cap’s long stretch of underperformance. To be sure, attractively priced, high-quality and/or growing small-cap businesses that have largely sat out the mega-cap performance regime could be clear beneficiaries.

To us, this represents a great opportunity for active managers seeking to identify those small-cap businesses best positioned for long-term success. Our outlook is therefore constructive. Of course, we always put the most stock in what we’re hearing from management teams-most of whom remain cautiously optimistic about 2024. We are therefore looking forward to what we think should be a favorable cycle for small-cap stocks and active management. We are more optimistic about the long-term prospects for select small-caps than we have been in several years.

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