Chuck Royce: Undervalued & Unstoppable: Quality Small Caps Poised for Dominance

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In his latest Q&A session with Francis Gannon, Chuck Royce discussed his optimism about the future of small-cap stocks, especially those with quality fundamentals, due to their undervalued status, expected stability from normalized rates, and potential for significant outperformance.

His key notes include:

  • Stability from normal rates: More typical interest rates are seen as beneficial for most stocks, especially for low-leveraged businesses with strong cash flow and capital allocation skills
  • Small-cap quality zone: These high-quality small-caps with strong returns, competitive advantages, and sustainable franchises are expected to benefit the most

Here’s an excerpt from the Q&A session:

Royce: We were surprised to some degree, yes. On the one hand, we had been waiting for a meaningful small-cap rebound for some time and really felt as though it was long overdue by the time the fourth quarter rolled around.

We’ve also been showing data over the last few years which highlights how undervalued the Russell 2000 Index is relative to the large-cap Russell 1000 Index—even at the end of 2023, small-caps were still trading close to their 20 year lows based on a valuation metric that we often use, the last 12 months of enterprise value to earnings before interest and taxes (EV/EBIT).

In addition, we thought that the Fed’s decision to pause rate hikes would spur an increase in stock prices. Based on all of that, the 14.0% 4Q23 advance for the Russell 2000 was not a surprise.

But in light of how dominant large- and mega-cap stocks have been over the last several years—and how stubbornly they’ve clung to leadership—it was very satisfying to see the Russell 2000 beat both the Russell 1000 and Russell Top 50 in 4Q23.

I think it’s also worth noting that the Russell Microcap looks, if anything, even cheaper based on EV/EBIT—which really reinforces Frank’s (Gannon) point about the long-term opportunities’ patient investors can source within the small- and micro-cap asset classes.

Both are much broader and more diverse than large-cap—and receive far less analyst coverage. This lack of institutional attention creates challenges—but these same obstacles have often given us—and our investors—rewards over the long run.

First, I think a more historically normal level of rates ultimately helps a lot of stocks, if only from the standpoint of stability.

Companies fear uncertainty and instability more than almost any other factors, so I think the end of the Fed rate hike cycle should be viewed as a positive for most equities other than the most highly levered businesses.

Of course, this has as much if not more to do with the end of the fastest rate of increase in history as it does with where rates are currently sitting.

But in any event, I think that companies with low leverage, the ability to generate free cash flow, and proven capital allocation skills are poised to benefit most.

And it’s true that we find those attributes most frequently in the small-cap quality zone—that is, companies that also have high and consistent returns on invested capital, discernible competitive advantages, and a sustainable franchise.

You can read a transcript of the entire Q&A session here:

Royce – Why Small-Caps Can Keep Going Strong

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