Another dismal summer has dawned with spring having brought a wave of worries back to the market for the third consecutive year. Karl Marx—as canny an observer of the global scene as he was a checkered prognosticator of its future—wrote in 1852 that all events in history occur twice: the first time as tragedy, the second as farce.
Allowing for the accuracy of this observation, what are we then to make of this third round of wobbly recovery, sluggish markets, panic-stuffed headlines, and the by now reflexive anxiety about the potential horrors of European debt for the world economy? What lies beyond farce, other than lousy returns, high correlation, and growing numbers of investors disenchanted with equities?
To this kind of question, too many investors have no answer, having lost not only their belief in the viability of investing in stocks, but also in the prospects for the global economy.
Indeed, one unfortunate result of the contagion of uncertainty has been the erosion of confidence in the ability of equities to deliver returns that will beat inflation and build wealth over the long term.
On May 7, a USA Today headline asked and answered, "Invest in stocks? Forget About It." It was not quite as damning as the now infamous Business Week cover from August 1979 that proclaimed "The Death of Equities," but the overall message was not much happier: "Wall Street's long-running story about how stocks are the best way to build wealth seems tired, dated and less believable to many individual investors." And the USA Today piece was published early in May, just before the current bear bit down most sharply.
The implicit assumption that the best days for the stock market may be (way) behind it seems to us to be the distinguishing feature of this third round of poor results for most equities. Panic has given way to a shrug of resignation. This stance sees equity investing as a mug's game, even if the alternatives—Treasuries, bonds, money markets, etc.- are not much more attractive or profitable.
Such a belief—as ultimately wrong-headed as we think it is—has the advantage that recent history, as far back as five years, is on its side. With a few exceptions, there is simply not much of a defense for equity investing as a whole since the respective index peaks in 2007.
The explanation for why the market has been so troublesome and unprofitable seems simple: The world is still emerging from the most serious economic crisis since the Great Depression. Yet this account may be in equal parts true and unhelpful, at least to anyone who had been looking for a way to safely and effectively grow capital during the last few years, which helps to explain why panic and resignation are symptoms of the same fatalism that has gripped investors since the early days of the mortgage and banking crisis in 2008.
We understand the pessimism and the unwillingness to take risks on the part of so many investors today. At the same time, we still see many of the same positive signs that have been inspiring our confidence about stocks and the economy as a whole since the spring of 2010. By taking the long view (a common perspective for us), we can offer, in addition to a Nostra Culpa for much recent fund performance, the benefit of nearly 40 years of small-cap value investing.
Our collective experience tells us that this highly volatile, tightly correlated, range-bound market will be remembered as being as anomalous as it has been painful, one that tends to occur once or twice a century. It does not, in our view, change the fact that stocks remain the single best way of building wealth over the long run.
We know that in the current environment these words may sound hollow or even self-serving. We are more than willing to assume that risk in the hope that investors will continue to look to equities (and to our portfolios) as effective and ultimately successful ways to invest in the years to come.
'They've been going in and out of style'
The kind of dynamic rally that ushered out the first half of 2012 is always guaranteed to raise a smile, even if it could not completely erase earlier losses in the second quarter, losses that spoiled a promising upswing that lasted through most of the year's opening quarter.
Indeed, lack of direction has arguably been the most distinguishing characteristic of the recent market. Still, the major U.S. indexes finished the year-to-date period ended June 30, 2012 in decent condition, as did their overseas counterparts. Domestic small-caps brought up the rear. The Russell 2000 Index was up 8.5% in the first half, compared to respective gains of 9.4% and 9.5% for the large-cap Russell 1000 and S&P 500 Indexes and an electrifying 12.7% for the Nasdaq Composite.
It was an interesting road for each index. The first quarter extended a rally that began following the October 2011 lows. Small-cap trailed, though its 12.4% gain was its best opening quarter since 2006. It was also not far behind its large-cap counterparts. The Russell 1000 rose 12.9%, and the S&P 500 gained 12.6%. The Nasdaq was especially impressive, notching an 18.7% increase for the quarter.
We were among those hopeful souls who saw a nearly six-month bull run and thought that maybe the market was ready for some consistent recovery. Yet April and May were cruel months, the latter especially so, as the now-traditional spring downturn caused by concerns about European debt and the state of the American and Chinese economies spoiled the party and tamped down returns. (If not for the rally on the final trading day of June, that month would also have been less solidly in the black.)
That rally was welcome—they always are—but second-quarter returns were still negative. The Nasdaq led on the downside, falling 5.1%, while the Russell 2000 slipped 3.5%. Large-caps held their value a bit better, with the Russell 1000 losing 3.1% and the S&P 500 declining 2.8%. So the first half concluded with a bang, but still left investors whimpering about the future.
Looking at longer-term returns, this uncertainty has been well-earned. While three- and 10-year average annual total returns for the major indexes were solid-to-strong, one-, five-, and 12-year results for the periods ended June 30, 2012 were generally poor. The 12-year period—not a period that we, or anyone else, usually discusses—is instructive because it encompasses the Internet Bubble, the subsequent recovery, the recession that was followed by the financial crisis, and the market's herky-jerky, volatile aftermath.
So we think it is worth pointing out that for the 12-year period ended December 31, 2011, the average annual total return for the S&P 500 was its the lowest since the end of World War II (beginning with the period from the end of 1945 through the end of 1957).
Small-cap returns for that same period ended December 31, 2011 for the Russell 2000 and the CRSP 6-10, a small-cap proxy that dates back to the 1920s, were among the worst for both since the launch of the Russell 2000 on December 31, 1978 and since the end of 1945 for the CRSP 6-10.
Recent performance for the two non-U.S. indexes that we track followed patterns similar to their domestic cousins, though with more muted results. This was not entirely surprising considering both Europe's ongoing travails and worries about the pace of growth in China.
Non-U.S. small-caps enjoyed an advantage over their large-cap siblings, with the Russell Global ex-U.S. Small Cap up 4.8% for the year-to-date period ended June 30, 2012 versus a 2.7% gain for the Russell Global ex-U.S. Large Cap Index.
Both indexes enjoyed strong first-quarter results. The Russell Global ex-U.S. Small Cap Index rose 14.4%, and the Russell Global ex-U.S. Large Cap Index was up 11.5% in the first three months of 2012. Each index's second quarter was far more difficult, as Europe's troubles registered more dramatically outside the U.S. Small-cap lost a bit more in the downturn, with the Russell Global ex-U.S. Small Cap Index falling 8.5%, while the Russell Global ex-U.S. Large Cap Index was down 7.9%.
U.S. mid-caps performed well on an absolute basis, though they were behind the domestic micro-cap, small-cap, and large-cap indexes in the first half. The Russell Midcap Index gained 8.0% through the end of June. Like the domestic indexes, they enjoyed a strong first quarter, up 12.9%, before slipping in the second quarter with a loss of 4.4%.
Considering both the significant volatility and the unpopularity of stocks, the strength of micro-cap stocks was something of a surprise in the first half. Year-to-date through June 30, 2012, the Russell Microcap Index gained an impressive 13.0%. That the index accomplished this feat with stronger and steadier quarterly performances was equally notable: the Russell Microcap climbed 15.3% in the first quarter and fell only 2.0% in the bearish second.
'The act you've known for all these years…'
Our goal has always been strong absolute performance over long-term periods. If we met that standard, then relative results would most likely not be an issue, at least over long-term time spans. We have also been glad to accept the historical trade-off in which underperformance was more common for our Funds during short-term periods of 18 months or less, while outperformance was more typical over full market cycle and other long-term periods of three years or more.
For too many time periods ended June 30, 2012, however, that history has become too exclusively long-term, even for us, with strong relative and absolute results coming only in periods of 10 years or longer.
Three-year results were fine on an absolute basis in most cases, but trailed on a relative score, while the five-year returns were more mixed on a relative basis and underwhelming at best using the absolute standard that we prefer. This was particularly bad news for our newer portfolios, which lack history. With significant investments in all of our Funds, we share our investors' frustrations with recent results.
Those areas of the market in which we have seen both high quality and compelling valuations during the last three-to-five years—energy and mining companies, in particular—were among the worst performers in the first half, with net losses in some cases stretching back even further.
Many of these stocks remain in our portfolios, as their attractive valuations and our ongoing high regard have combined to keep turnover low. In many cases, we have been building, or at least maintaining, positions in those businesses in which we have the highest conviction.
As has been our practice since the 1970s, we are keeping our focus on company fundamentals. We seek companies that look capable of surviving adversity and flourishing when their fortunes change.
Those that generate free cash via high returns on capital can give investors a return in the form of dividends, take advantage of their low valuation by buying back stock, or make acquisitions to grow their business when organic growth is harder to come by. Strong fundamentals mean these companies have the necessary tools to make it through difficult periods and emerge stronger.
While many of our recent efforts have not been successful, nothing about the way that we select stocks has changed, including our insistence on rock-solid fundamentals in the companies that we choose. Selectiveness, patience, and discipline remain our watchwords.
Getting better
We do not know how much longer markets and economies will remain so uncertain. The fiscal turmoil that continues to haunt Europe has been hampering equity markets across the globe and contributing to the tight range of returns that have nonetheless demonstrated ample levels of volatility. The fragile recovery here in the U.S. has also played a role, as has the recent deceleration of the Chinese economy.
These major macro events, which have been the dominant influence on investors' behavior over the last three years, largely account for why stocks have struggled to create any direction for longer than a few months. Instead, markets have been mired in a pattern of short-term swings in which they have moved straight up or straight down, and for no longer than a few months at a time.
One consequence of this closely correlated, range-bound cycle is that our Funds have not had the time to create the spread that we would usually seek to build through a full market cycle. However, we think that as Europe meets its challenges and as the U.S. begins to get its own fiscal house in order, which is not likely to happen until after the election, we will escape this range and move toward a more lasting upswing.
Our expectation is for a less extreme, more historically normal phase, without so many of the stomach-churning drops followed by equally steep upticks that we saw last summer and fall and have seen so far in 2012. It is worth noting that a more historically normal range is one in which we think our Funds can generate strong absolute and relative performance over the long run. We would like to think that long-term history is on our side in this assessment.
Good morning, good morning
Obviously, we would all like to reach a more hospitable market climate soon. As always, patience is critical.
Indeed, the ability to be patient is probably the single most important quality that an investor who seeks strong long-term returns can possess. It is easy to talk about the importance of patience and discipline when markets are solid and portfolios are doing well. Yet at some point, these things will change, and both will be tested, as they have been in this market. It has been a very difficult time, but we believe it will pass. When it does, our disciplined approach will remain and, we believe, be effective.
As we approach our 40th anniversary as a firm this coming November, we look back at what we have seen—the "Nifty Fifty" market of the '70s, Black Friday in the '80s, the first stirrings of the Internet boom in the '90s, the horrific events of 9/11, our current era of uncertainty, and much, much more.
Through all manner of markets—many of which were thought to establish a "New Normal"—we have never wavered in our convictions. We still believe that equities remain the best way—maybe the only way—to beat inflation and build wealth over the long term. (We also think that equities are capable of beating the fixed income markets over the next five years.)
Our guess is that stocks can deliver returns in the mid- to upper-single digits, which we think would be respectable on an absolute basis and, equally important, higher than the rate of inflation.
When things are working well, the underlying parts of an equity portfolio, the companies themselves, can act as compounding machines—compounding book value, returns on equity, etc.
We are confident that we have created portfolios that can grow commendably, especially in the more historically typical market climate that we believe we will eventually see.
Chuck Royce is the president and co-chief investment officer of The Royce Funds. This commentary originally appeared on the firm's website.
