Small Cap Pioneers Share Their Investing Principles

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.