Chuck Royce and Francis Gannon discuss the recent regime shift in the market and what types of small-cap industrials look attractive to them.
Q3 2019 hedge fund letters, conferences and more
Francis Gannon: Chuck, it was an interesting third quarter this year with the Russell 2000 down 2.4%. But it seemed that underneath there were a lot of crosscurrents specifically around value and growth, and a lot of shifts, almost regime shifts within the overall market. What are your thoughts?
Chuck Royce: Absolutely. It was a very interesting quarter from a lot of standpoints. August 27th, there appeared to be a major regime shift. We had momentum and growth go down on that very day, and we had value, micro, cyclical, all the underperforming areas do much better from that day and right up ‘til now.
FG: But haven’t we seen these kind of shifts in the market before? I mean we’ve seen them several years ago when value all of a sudden started to do well and then faded back to growth. What’s different this time in your eyes?
CR: Well, that is the question. Is this just a one-trick, one-day thing? My sense is it is a major change. And I sort of think it relates to the mega-caps having sort of their own bubble. They actually had a peak moment in July, they actually reversed in a very big way on that August 27th. So I think it has something to do with that.
FG: So one of the things we’ve noticed over the past 15 months through the end of the third quarter is that as you go up the market cap spectrum, performance has gotten better. So for example, the upper end of the mega-cap type stocks are up over 14%, while you have micro-cap stocks down 15% over that 15-month period. Is that going to change? Is that what you’re talking about?
CR: Yeah. That is a dramatic, probably unprecedented divergence; something I can’t remember has happened before. I can sort of relate that to the influence of ETFs. ETFs are very prominent in the upper range of cap and not prominent at all in micro-caps. So I think micro-cap, you know, has done very poorly on that one reference point. But actually, that reversed also on August 27th.
FG: So if you go back and think about the small-cap world, we’re still down roughly 11% in the Russell 2000 from its all-time high in the end of August of 2018. Small-caps continued to underperform for that period. Why do you think small-caps are struggling?
CR: Well, it’s not just small-caps. It’s actually around the world virtually everything other than mega-cap has, has struggled. Small-caps aren’t much different than many of the other equity assets around the world.
FG: So the anomaly is with the mega-cap stocks doing extremely well.
CR: Yes.
FG: And everything else doing quite poorly.
CR: That is exactly what’s happening.
FG: What do you think’s driving that?
CR: It’s just I think the fashion of the moment. The mega-caps are sort of what everyone has come to think of as the most important enterprises around the world. They are very dominant, very important. They’re very disruptive. So for good reason they’ve achieved a global status. But I think they’re in a kind of bubble as to their specific stock market performance.
FG: One of the more interesting things that we’ve measured this particular quarter was the two largest companies in the world, which represent over $2.1 trillion in market capitalization versus the market capitalization of the Russell 2000, which is about $2.2 trillion at the end of the third quarter. What changes that dynamic in your eyes?
CR: That’s a fun number to play with, that two equals 2,000. Now we did go back and look and apparently that ratio more typically is in the 50% zone most of the time, where the top, top few companies equal to the Russell 2000. So this is a dramatic change, there again pointing perhaps to a bubble in price performance. Not a bubble in that these companies aren’t real.
FG: Why do you like small-cap industrials today? And perhaps more importantly, what do you see that other people are missing?
CR: It’s a great question. We’ve always preferred that particular zone, probably because it’s often the intersection between quality and value. So we have, we have always mined in that zone. But in today’s world, we’re finding fascinating companies who are serving their customers with high-productivity types of products ranging from automatic machine learning equipment to help factories run faster, better, with less people.
We love a particular food service company that has fabulous products to be engaged in the food industry at a much higher productivity level. So we’re finding companies that actually look over the recession fears and are solving problems.
FG: So in a world where people are focusing on the mega-caps because of their innovation, we’re finding an enormous amount of innovation in small-cap cyclical businesses?
CR: Absolutely.
Article by Rouce Funds
