Smaller companies in the US could double in value from last year’s low point, with the rally seen since February 2016 potentially just the beginning of a major shift upwards, according to Legg Mason affiliate Royce & Associates.
Valuations of US smaller companies were hit hard early last year, racking up a decline of 26% in total from peak to trough and leaving them in bear market territory.
The broad-based retreat for US small caps, caused by a flight to safety by investors, has left valuations poised for a sharp recovery, according to Francis Gannon, Co-CIO of Royce.
“While many investors are focusing on the S&P in general, and the fact that we haven’t seen a major decline within the S&P 500 for a period of time, the Russell 2000 has actually had two distinct cycles since the bottom of the market in March of 2009,” he said.
“The most recent one just completed in February 2016, where we had a bear market decline of over 26%. For us, that means the prognosis for the market going forward is actually one that is quite positive, and we believe the small-cap cycle still has room to run.”
Gannon noted that the Russell 2000 index has seen 12 declines of more than 15% in value from peak to trough since 1979. In the corresponding recovery phase, the average return for the index was 98.8%.
The Russell 2000 has recovered some 42% since last February’s low, with the Legg Mason Royce US Small Cap Opportunity fund returning 74.6%2 over the period.
In terms of where the winners have emerged in this latest cycle, Gannon said value companies have come to the fore, and he expects this to continue, along with the recent shift to cyclical names by investors.
“For a period of time we had talked about how defensives and safety in general, was overpriced in the market, especially within the small-cap space. Investors were looking for dividend and equity bond-like proxies within the equity space, but that reversed last year quite dramatically and you saw cyclicals outperform.”
Gannon said the recent steepening of the overall yield curve post-election had been a key factor behind this trade, while he expected the handover of influence from the central bank to the government, coupled with any further acceleration of GDP growth from here, to enable such stocks to keep winning.
“Along with potential tax cuts and the baton being passed from monetary to fiscal policy, that acceleration would be a clear benefit for many small-cap companies that derive the majority of the revenue in the United States,” he said.