It has been a long road to recognition for small caps. In 1978, there were just 13 open-end small-cap funds in the United States. That number grew to 121 in 1992 and sat at 501 as of September 30, 2022, in addition to 113 exchange-traded funds also devoted to small caps. Over the course of about fifty years, small caps have gone from being an obscure and misunderstood portion of global equity markets to an established and institutionally recognized asset class. The companies making up the small-cap universe have changed quite a bit over that time as well. On June 30, 1985, a little over a year after the introduction of the Russell 2000 Index, the weighted average market capitalization of the Russell 2000 was $140 million. As of November 30, 2022, that number stood at $2,927 million – an increase of 1,990%.
Our team at Royce always saw small caps as exciting but misunderstood, which is why we went against the current in making them our focus in 1972. And while many things have changed since the 1970s, the principles of small cap investing remain the same and relevant as ever. Three of those principles are: 1) stay invested over the long term; 2) understand that preserving capital is just as important as growing it; and 3) invest with risk-conscious approaches that are effective with small caps.
Investors are currently facing a macroeconomic environment that is reminiscent of the 1970s, with inflation challenges, a looming recession and rising energy prices. In the early 1970s, however, market volatility initially led investors toward large, high-profile stocks known as the “Nifty Fifty,” using the theory that large caps were the safest and surest route to growth. To the degree that small caps were recognized, investors saw them as the place to find one – or maybe a few – highly risky growth stocks. But by the end of 1974, the Nifty Fifty had collapsed, and investors experienced a widespread bear market.
Whether or not investors will face a similar outcome is yet to be determined. But the first principle of investing in small caps is a simple one: stay invested over the long term, even in the midst of a bear market. Many investors – past and present – try to time the market, but even professional investors rarely see seismic events on the horizon. There is no shortage of examples to illustrate this point: the Stagflation of the 1970s, the “Death of Equities” and Black Monday of the 1980s, the currency crises of the 1990s, the .com Bubble, the Great Financial Crisis, and, most recently, Covid. When tumultuous market events occur, they typically frighten and discourage investors. But for each of the examples listed above, markets ultimately recovered and prospered, which rewarded those who had the stomach – and patience – to stay invested.
Deep periods of market decline can actually be good periods of entry for the patient small-cap investor. In analyzing small-cap returns since 1946 using the Center for Research in Security Prices (CRSP) 6-10 Index, a proxy for small caps –we identified 24 years over that period with negative calendar-year returns. In 19 of 24 of the years following a negative return year for the CRSP 6-10, or 79% of the time, the small cap index posted a positive return in the subsequent calendar year. On the other side, the CRSP 6-10 index posted a positive return in 65% of calendar years following a positive return year. Arguably, the most notable finding of our research showed that the average return for the CSRP 6-10 index since 1946 in the calendar year following a negative return year was 25.9%, which is significantly higher than the average 10% return for the index in calendar years following a positive return year. With small caps, it is important to remember that the dark times may give way to brighter days ahead.
The second principle of investing in small caps is that preserving capital is just as important as growing it. In other words, finding success in investing is not just about being strong in a bull market, it is also about being resilient in a bear market. Few things will lead an investor to reevaluate their investment discipline more than deep losses. And rather than being discouraged by losses, investors should use these moments to evolve their investment approach. Through fifty years of investing in small caps, we have learned that strategies that lost less during downturns, and were at least competitive in bullish periods, could provide strong absolute returns while also being likely to beat their benchmarks.
Our third principle is that risk-conscious investment approaches are very effective with small caps, possibly even more than established, larger asset classes. Despite the growth in institutional recognition, small caps remain an inefficient and labor-intensive sector of equity markets and do not garner the same attention as large caps. These companies typically do not have their own dedicated research analysts, and there are fewer resources dedicated to studying this space.
But investors should remember that investing in companies that are unknown – or barely researched – can uncover numerous potentially profitable opportunities. Small caps still exhibit their own distinctive investment attributes and performance patterns as a discrete asset class. Like any other asset class, investors must consider their risk tolerance and invest accordingly. As small-cap specialists, we continue to look toward conservatively capitalized, financially strong businesses with steady earnings and positive free cash flows.
Looking ahead to 2023, we are more confident in the prospects for small caps than large caps, and we believe that the winners of the previous decade’s environment of zero interest rates, low inflation and low nominal growth, will no longer lead. It is possible that, once investors have more fully acclimated to the recent larger-than-usual amount of uncertainty, they will look closely at fundamentals and recognize that valuations for many companies, especially within small cap, are reasonable to inexpensive at present.
As Royce Investment Partners celebrates its 50th anniversary of actively managing small cap investments, we remain excited about the opportunities within the asset class, and we look forward to the next 50 years of investing in them.
Chuck Royce is known as one of the pioneers of small-cap investing. He has been a portfolio manager since founding his own firm in 1972. Chris Clark joined Royce Investment Partners in 2007 and is Chief Executive Officer, Co-Chief Investment Officer, and President of Royce Fund Services, LLC. Royce Investment Partners became a subsidiary of Franklin Templeton in 2020.
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TN23-4
1 The Center for Research in Security Prices (CRSP) equally divides the companies listed on the NYSE into 10 deciles based on market capitalization. Deciles 1-5 represent the largest domestic equity companies and Deciles 6-10 represent the smallest. CRSP then sorts all listed domestic equity companies based on these market cap ranges. By way of comparison, the CRSP 1-5 would have similar capitalization parameters to the S&P 500 and the CRSP 6-10 would have similar capitalization parameters to those of the Russell 2000.
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