Unsettled Quarter Ends Bearish Year
After rising for the first two months of the fourth quarter of 2022, stock prices around the world began to fall again in December. Still, Q4 2022 ended as the only positive quarter of the year for both the small-cap Russell 2000 Index, which was up 6.2%, and the large-cap Russell 1000 Index, which was up 7.2%. Outside the US, performance improved further as the MSCI ACWI ex USA Small Cap Index increased 13.3% in Q4 2022 and the MSCI ACWI ex USA Large Cap Index increased 14.3%. These strong results left the Nasdaq Composite as an outlier. The tech-focused index fell slightly, down 0.8% for the quarter.
stocks up and down quarter
Russell 2000 and Russell 1000 Index Q4 2022 Cumulative Performance
Past performance is no guarantee of future results.
U.S. investors continued to face a dizzying, and perhaps by this point familiar, set of conflicting macro developments: rising inflation, a decidedly hawkish Fed, and the widely anticipated – Although not yet occurring – a recession to a strong labor market and surprisingly (Q3 2022 nominal GDP was revised upwards from 2.8% to 3.0% in December). GDP growth is negative, meeting one of the main criteria for a recession.
This difficult period has fueled a decidedly bearish year for equities, with widespread double-digit losses regardless of market cap or region. The Russell 2000 dropped 20.4%, the Russell 1000 dropped 19.1%, the MSCI ACWI ex USA Small Cap dropped 20.0% and the MSCI ACWI ex USA Large Cap dropped 15.3%. Similar to Q4 2022, the Nasdaq Composite is down 32.5% in 2022. The Russell 2000 also fell 26.7% from its most recent peak from 8 November 2021 to 31 December 2022 and rose 7.6%. Low until the end of the year on June 16, 2022.
However, the 2022 fall in small- and large-cap stocks did little to change the relative valuation landscape. Based on our preferred criteria of median enterprise value over the last 12 months to pre-tax earnings (LTM EV/EBIT), at the end of December, small-cap valuations were outperforming large-cap valuations over a 20-year period. remained at the lowest level.
Relative valuations of small and large caps remain at their lowest level in 20 years
Russell 2000 vs. Russell 1000 Median LTM EV/EBIT¹ (e.g. negative EBIT companies) 12/31/2002 to 12/31/2022
1Enterprise value/interest and earnings before tax.
Small Cap Value and Quality Fair Best for Q4 2022
Domestic small-cap performance patterns show that the Russell 2000 Value Index more than doubled the performance of the Russell 2000 Growth Index in the only positive quarter of the year, up 8.4% in Q4 2022. vs 4.1%. This was his eighth of the past nine quarters in which the small-cap value index has outperformed growth, including his seven-quarter streak through Q3 2022.
In addition, the best small-cap companies, i.e. those in the highest return on invested capital (“ROIC”) quintile within the Russell 2000, had the highest earnings in Q4 2022, but ROIC Companies in the lowest quintile of are the lowest. This quality advantage came in a quarter that included a short rally derailed by the correction. The third quarter of 2022 marked a similar up-and-down pattern, but during that period low-quality small-cap stocks, especially those with negative earnings before interest and taxes (“EBIT”), beat profitable companies. I beat you. Small caps with both high ROIC and earnings also led in the first half of 2022, so these stocks generally held up better overall in 2022 compared to their lower quality, less profitable siblings.
Small-cap value cuts losses and wins
Unsurprisingly, Russell 2000 Value saw a significantly smaller decline than Russell 2000 Growth in 2022, -14.5% vs. -26.4%. We believe small-cap value has regained its long-term historical advantage over small-cap growth, as we have maintained over the past few years.
Looking at the five-year annualized return of the Russell 2000 Value (as of December 31, 2021), we see one of the clearest supports for this idea. This was 9.1% against his 14.5% increase in Russell 2000 Growth (540 basis). The latter point is advantageous. The relative resilience of small-cap value to small-cap growth in 2022 has pushed this spread up considerably over his five-year period ending 12/31/22, when Russell 2000 Value rose 4.1%. reversed in quantity. Against 3.5% of Russell 2000 growth. Indeed, our confidence that Value can maintain a performance edge over growth is that Advantage has been in favor of Value over the five-year monthly rolling average period since our shared inception (12/31/78). Yes, rooted in the fact that it was 11.8. % vs. 8.8%.
From macro to micro?
To describe 2022 as a macro-centric year would be an understatement, with a radical reversal of Fed policy, sustained inflation (which has probably peaked), the ongoing Ukraine civil war, the endless impact of Covid, And while the widely predicted global recession has been imminent for over a year, it has somehow yet to materialize, at least here in the United States. These negative forces, both real and perceived, have predictably affected stock prices throughout the year. In many cases, this effect affects equities independently of their financial fundamentals or operational expertise, especially in the small-cap space we are so familiar with.
At the same time, there has been a significant revaluation of growth stocks, not surprising given that more than a decade of zero interest rates and easy access to capital is coming to an end. On the impact of much higher inflation. This was most clearly seen at his two ends of the stock market in 2022. The aforementioned big correction in small-cap growth stocks and the sharp drop in many mega-cap companies. The latter group used to be a safe haven for many investors who saw little, if any, choice in an environment with little to offer in the form of yield.
But those days are gone. Higher interest rates combined with inflation brought about a major regime change. Multiple periods of compression are likely to divert investor attention, at least to some extent, to company fundamentals from his macro scene, which has been acknowledged to be crowded and uncertain. . A sign of this is a series of commentary in the financial media, accompanied by fears over the potential for lower fourth-quarter earnings and the number of companies that may revise their guidance downwards for the remainder of 2023. can be seen in
Will today’s fog bring clear skies?
Short-term forecasts for stocks are as uncertain as I can remember, but we see better weather in the long run, especially for small caps. For these reasons, we welcome some increased scrutiny of corporate fundamentals.
In fact, throughout 2022, we are often surprised by the contrast between the more confident (albeit cautious) outlook from many of the executives we meet with the fatal headlines we see almost daily. Of course, these companies have attractive valuations (according to our analysis), strong long-term prospects, low debt, positive free cash flow, high ROIC, and/or proven management expertise. Overall, they appear to be well positioned for the market from a market focused on fundamentals and/or a reacceleration of the economy.
A recession remains possible, but no one knows when, how long, or how deep it will be. What we do know is that, like bear markets, recessions are ultimately finite. Recessions are followed by recovery. It’s also worth remembering that, as history shows, small-cap stocks are likely to start rallying before many of us know for sure that the economy is recovering in earnest.
Take a long-term view of small-cap stocks
Equally important is the fact that the downturn in most small-cap stocks has been followed by positive performance since the end of World War II. Prior to 2022, there were 24 other years with negative small-cap calendar year results (using Center for Securities Prices (“CRSP”) 6-10 as a long-term small-cap proxy). Over the next 19 years, or 79% of the time, small caps enjoyed positive returns the following year. Perhaps even more notably, the average positive year return following a negative year was 25.9%, significantly higher than the average calendar year return of 10% following a positive small cap return.
Small-cap stocks have historically lost years followed by years of gains
For CRSP 6 to 10, 12/31/45 to 12/31/19, calendar years revert to negative return years for subsequent years
Past performance is no guarantee of future results.
In addition, historical performance patterns for small-cap stocks have shown that periods of below-average long-term returns are followed by periods of above-average long-term returns, followed by periods of mostly positive returns. I’m here. Subsequent 3-year annualized returns from a 3-year entry point of less than 5% were positive 99% of the time. /78 launched. The Russell 2000 five-year annualized return was positive 100% of the time (that is, for all 81 five-year periods), and the average five-year return was less than 5%. Why is this especially important now? As of December 31, 2022, the Russell 2000’s three- and five-year annualized returns were 3.1% and 4.1%, respectively.
Are small-cap stocks likely to perform positively?
The average annualized performance of the Russell 2000 over the subsequent 5 years is 12/31/83-12/31/22
Past performance is no guarantee of future results.
In our view, these historical patterns not only suggest that small-cap stocks are unlikely to suffer losses over the long term of at least three years, but also present an opportunity to wait or try to bottom out. suggesting that it is costly. Market or economy—high potential. So while no one can predict future market or economic outcomes, we carefully examine small-cap stocks’ historical performance patterns in ways that can help us understand the present as we prepare for the uncertain days ahead. You can.
The Russell 2000 has fallen 31.9% from November 8, 2021 to its current low on June 16, 2022. In the last 44 years, only three bear markets have dropped at least another 10% and gone significantly deeper than this. Each of these recessions was exacerbated by monumental negative events. The Great Financial Crisis caused small cap losses of 58.9% between July 13, 2007 and March 9, 2009. The bursting Internet bubble caused the Russell 2000 to drop 44.1% from 3/9/00 to 10/9/02. In the Covid pandemic, the Small Cap Index fell 41.8% from 8/31/18-3/18/20. Both have presented investors with a daunting challenge to continue investing, let alone increase allocations to small caps. In both cases, the subsequent market recovery led to very compelling long-term returns. Regardless of what happens next, we believe the current period of uncertainty presents an excellent opportunity to invest aggressively in select small-cap stocks for the long term.
Important disclosure information
Recent market movements and thoughts regarding the future prospects of small-cap stocks are those of Royce Investment Partners alone and, of course, no guarantees can be made regarding future small-cap market performance. Past performance is no guarantee of future results. Past market trends are not necessarily indicative of future market trends.
