Can Stocks Avoid Another Bear in Spring?
by Francis Gannon, Royce Funds
After back-to-back double-digit return quarters, the equity markets paused in April. Uncertainty and volatility returned on renewed concerns about a slowdown in economic growth in the United States and China, and the never-ending debt crisis in Europe. Interestingly, these are the same issues that unsettled investors during the spring of 2010 and 2011, and there remains widespread fear that this year could play out the same way. After falling close to 30% in the first quarter, the CBOE Volatility Index (VIX) spiked 20% and the Russell 2000 Index fell -1.54% during April.
Many investors remain spooked by the last two cruel Aprils. They can easily recall how well stocks, especially small-caps, did during the early months of the past two years, only to peak in 2010 on April 23 before dropping 20.3% through July 6, 2010, and then peaking on April 29, 2011 before plunging 29.1% through October 3, 2011.
Whatever the combined reasons for the change in the market's fortunes, we have been struck by the consistently optimistic tone we are hearing from corporate managements following first-quarter earnings. From our perspective, while many are once again questioning the sustainability of earnings and fear that peak margins are at hand in the face of renewed economic concerns, we think there is a long way to go.
It's probably not surprising that, lost among today's uncertain macro headlines and the seemingly endless fear of equities falling (as measured by sustained actively managed equity mutual fund outflows), is the reality that high-quality smaller companies not only have strong balance sheets, but also continue to expand in what can only be described as an anemic economic growth environment.
While popular opinion seems to be calling for margins to reverse, we have been hearing about continued productivity gains, expanding profit margins, and sound capital allocation in many of our recent conversations with corporate management teams. In fact, for many companies, the spread between the cost of capital and return on capital has never been wider, which should continue to drive capital formation and therefore growth and margin expansion.
Remarkably, small-cap operating margins remain significantly below prior peaks, and there is ample room for continued expansion. According to Chip Miller of UBS, "S&P SmallCap 600 operating margins are roughly 180 basis pointsâor 20%âbelow last cycle's high." To be sure, smaller-company margins in general have been solid, but we think they have room to improve.
The immediate issue, then, is whether or not the market can avoid a third consecutive bearish spring. Will the third time be the charm? For the moment, the market is caught in a tug of war between better first-quarter corporate earnings and a string of disappointing economic news. Could this be the beginning of another economic growth scare and equity correction? We are not sure. We do know, however, that corrections happen. From our perspective, they are part of the small-cap landscape and occur on a regular basis. They are neither unusual nor unprecedented.
"Price corrections serve an important function
in our investment process, allowing for the accumulation
of well-run companies at attractive prices.
After all, total return is a function of entry price."
Using the Russell 2000 as an example, the small-cap index has experienced 18 downturns of 10% or more since its 1979 inception, including the most recent one in 2011. While calendar-year declines have occurred about every third or fourth year, downturns of 10% or more have happened about every other year. Without a doubt they are unpleasant, but in our view they remain a key component in building higher long-term returns.
Price corrections serve an important function in our investment process, allowing for the accumulation of well-run companies at attractive prices. After all, total return is a function of entry price.
We have always believed in the old adage that "great companies create their own success," which is especially true today as many smaller companies position and prepare for better economic times in the not too distant future. It is also true, from our perspective, that there is an abundance of high-quality small-caps trading at a discount not only to their fellow small-caps but to their larger-cap siblings as well.
Stay tunedâŚ
FDG
Important Disclosure Information
Francis Gannon is a Portfolio Manager of Royce & Associates LLC. Mr. Gannon's thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above, will continue in the future. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.
The CBOE Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity and industry grouping, among other factors. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The S&P 600 is an index that covers roughly the small-cap range of stocks selected by Standard & Poor's based on market size, liquidity and industry grouping, among other factors.
