syahrir maulana
In late September, I wrote a bullish follow-up article on the Royce Value Trust (NYSE:RVT), noting the manager’s long-term track record and positive seasonality for small-cap stocks heading into year-end. Since my article, the RVT fund has performed well, delivering 10% in total returns and outperforming the S&P 500 Index (Figure 1).
Figure 1 – RVT had a strong Q4 (Seeking Alpha)
As the calendar flips to 2024 in a few days, will small-caps and the RVT fund continue to outperform in the new year?
Brief Fund Overview
The Royce Value Trust Inc. is a closed-end fund (“CEF”) focused on small-cap investments that have been in operation for close to 40 years. The RVT fund is direct managed by Chuck Royce, a renowned expert in small-cap investing with over 60 years of industry go through.
Historically, the Royce Value Trust has outperformed the Russell 2000 on most time frames, from 1 year to 35 years (Figure 2).
Figure 2 – RVT has outperformed on most timeframes (royceinvest.com)
Compounding has been called the 8th wonder of the world by Albert Einsten and while RVT’s per annum outperformance may appear small, for example the RVT fund has returned 9.5% since inception vs. 8.8% for the Russell 2000 Index, when we compound this consistent performance gap over many years, RVT’s outperformance can turn into a large difference in total assets (Figure 3).
Figure 3 – Small outperformance compounded over 35 years can direct to large differences in assets (royceinvest.com)
Another main feature of the RVT fund is that it pays an attractive quarterly managed distribution set at a 7% annual rate of the average of the prior four quarter-end net asset values (“NAV”).
RVT’s managed distribution policy ensures that when the fund’s investment performance is strong, investors are rewarded with a higher distribution yield. However, when performance is poor, the fund will automatically shrink the distribution such that it does not deplete the fund’s NAV.
Seasonality Set To Slow Down
In the near-term, after a strong rally from the end of October where the RVT fund has delivered almost 20% returns and outperforming the S&P 500 Index by 700 bps, I believe small-cap stocks are set to take a breather (Figure 4).
Figure 4 – RVT has returned almost 20% since the end of October (Seeking Alpha)
This is because historically, small cap stock performance tends to be muted at the beginning of the year as they digest a pronounced October to December seasonal rally (Figure 5).
Figure 5 – Small-caps have strong seasonality (equityclock.com)
Soft Landing Could See Rotation Out Of Mega-Caps
However, looking farther out, if the Federal Reserve has indeed achieved a ‘soft landing’, whereby inflation moderates while economic growth remains robust, then I believe institutional investors may rotate out of the mega-cap ‘Magnificent 7’ stocks and into the rest of the markets due to valuation.
Comparing between the valuation multiples of the ‘Magnificent 7’ stocks to the rest of the market, we can see that the ‘Magnificent 7’ are trading at over 30x Fwd P/E while the rest of the market is trading at a much more reasonable 15x (Figure 6).
Figure 6 – Magnificent 7 are overvalued compared to the market (Financial Times)
In fact, we are starting to see this rotation happen in the last few weeks, as the Magnificent Seven ETF (MAGS) (an ETF that invests in the ‘Magnificent 7’ stocks in an equal weighted fashion), has been essentially flat in the past month while the RVT fund and the iShares Russell 2000 ETF (IWM) have returned 8 and 10% respectively (Figure 6).
Figure 7 – MAGS vs. RVT and IWM performance, trailing 1 month (Seeking Alpha)
Risks To RVT
What I have painted above is the bullish scenario for small caps. There is also a bearish downside scenario that we need to consider. While the consensus right now expects a ‘soft landing’, there remains the possibility that the economy falls into a ‘hard landing’ scenario with much slower economic growth and perhaps even a recession.
A recession is not as far-fetched as one might think. According to Fed economist Claudia Sahm, a recession begins when the three-month moving average of the unemployment rate rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months.
As unemployment rises and the job market continues to slow due to the Fed’s prior interest rate increases, we are currently at 0.30 on this Sahm regulate metric (Figure 8).
Figure 8 – Sahm regulate suggest rising risk of recession (St.Louis Fed)
In a recession scenario, small-cap stocks are expected to underperform. As I explained in a prior article on the Invesco S&P Top 50 ETF (XLG), when markets go through crises and / or recessions, mega-cap companies tend to outperform as they have the best balance sheets, resources, and political connections to weather the storm while small-cap companies with weaker balance sheets and uncertain revenues will struggle.
We saw this in effect in ample fashion throughout 2022 and 2023 as economic uncertainty herded institutional investors into mega-cap stocks while small caps languished.
Conclusion
The Royce Value Trust remains a best-in-class small-cap focused CEF with a long track record of outperforming the Russell 2000 Index. In the near-term, I believe the RVT fund is due a breather after a scorching rally since October. However, longer-term, if the Fed has indeed achieved a ‘soft landing’, I believe institutional investors may look to switch out of the ‘Magnificent 7’ stocks and into small caps, which are much more attractively valued.
For investors looking for small-cap exposure, RVT remains my preferred choice. I continue to rate RVT a buy.
