So Far, So Good For Small-Cap Earnings

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Includes: IJR, IWM, VB
by: The Royce Funds

Summary

Co-CIO Francis Gannon gives an update on the small-cap earnings season.

He discusses the most recent earnings news for small-caps, which so far has been encouraging.

We remain bullish about both the earnings and return potential for many holdings, especially those in cyclical industries.

With arrival of spring comes first-quarter earnings announcements throughout the stock market. Large-cap companies generally report a little earlier, business results are better than 1Q's GDP might imply, and the news so far for both small- and large-cap stocks has been encouraging.

It's not hard to see why. The U.S. economy continues to chug along, and the results from both developed and developing markets has been largely positive.

Of course, we recently wrote that some believe that the recovering global economy means that the best news in terms of earnings going forward will accrue mostly to large-cap companies-and thus give them a performance advantage over their small-cap cousins in 2017.

It's true that the majority of companies in the Russell 2000 derive the bulk of their revenues from domestic sources and are thus more tied to the fate of the U.S. economy. This is particularly true of many financial companies and of defensive areas such as utilities, REITs, and healthcare.

However, the earnings news for small-caps so far has been very good. Our friends at Furey Research Partners recently reported that, with approximately 49% of the companies having reported, 1Q17 earnings growth for the Russell 2000 was quite strong, up 9.7% year-over-year versus expectations of 5.9%.

Sectors seeing the top-earnings growth were in cyclical areas such as Materials, Energy, Tech, and Financials. Some companies in the first two sectors, according to Furey, are moving from, "either losing less money or going from a loss to a profit, though some companies, particularly in Materials, are actually growing positive earnings."

This encouraging picture could potentially benefit disciplined active managers like ourselves who believe that earnings will indeed be more important drivers of stock price movement than in the prior cycle.

As a bottom-up small-cap specialist, we look company by company. And our perspective on the small-cap market reveals a number of companies that are not only solid-to-strong earners but are also far more global in reach and revenue stream than many might think.

To be sure, most of these businesses are found in economically sensitive areas, including several in the aforementioned sectors, as well as industrial businesses, which are benefiting from many of the same global growth trends that are inspiring renewed confidence for much larger companies.

This includes Capex spending. After languishing for most of the post-Financial Crisis period, capital expenditures for many domestic companies have been on the increase so far in 2017, and we expect Capex investment to be a key driver of economic growth in the months ahead.

Finally, we also believe that ongoing higher-than-expected eps growth can potentially offset the contracting PE multiples that are common in rising interest rate environments.

So we remain bullish about both the earnings and return potential for many holdings, especially those in cyclical industries that are reaping the rewards of revived growth-both here in the U.S. and beyond.

Stay tuned…

Important Disclosure Information

Mr. Gannon's thoughts and opinions 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 Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 Index 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 Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.