When interest rates decline, investors in closed-end funds (CEFs) such as the Royce Small-Cap Trust (RVT) are often drawn to these investments due to their attractive yields. RVT currently pays a 7.3% dividend and is trading at a discount of 10.3% to its net asset value (NAV). This low valuation can tempt investors to view it as a bargain. However, the question remains whether this discount signifies a good investment opportunity or if there exists the potential for even further declines in value. To answer this, it is essential to understand the context of small-cap stocks.
In general, small-cap companies can benefit from falling interest rates as they typically lead to increased consumer spending. Additionally, lower borrowing costs allow investors to take on more risk and invest on margin. Small-cap firms, which often innovate more than their larger counterparts, can use these savings for expansion. Because they are more domestically focused, small-cap stocks are somewhat sheltered from global economic fluctuations. However, despite these advantages, small-cap stocks have not performed well this year, lagging behind large-cap stocks as measured by the performance of the iShares Russell 2000 ETF (IWM) compared to the S&P 500 ETF.
Lower interest rates can drive consumer spending, but they can also coincide with economic downturns. While lower rates usually stimulate spending, they often do so during recessions when consumer spending is already low. Current economic data suggests that consumer spending remains strong despite interest rates having dramatically increased recently. As a result, the anticipated boost in consumer spending from lower rates may not materialize as expected this time around. Moreover, the previous patterns of margin borrowing have returned to their pre-pandemic norms, suggesting that the speculative investments in small-cap stocks that characterized earlier eras of low rates may not be repeated.
Additionally, the relationship between small-cap stocks and their larger counterparts has shifted over the years, particularly influenced by the technology sector’s dominance. High-tech firms have driven significant innovation, causing dependency across various industries. Smaller companies must now allocate resources towards adopting technologies, such as artificial intelligence, that their larger competitors have already deployed. This trend further complicates the outlook for small-cap firms, which may find themselves pressured on profit margins as they invest in advancements to stay competitive with major players in the market.
Regarding RVT specifically, while its 7.3% yield may seem appealing, it’s worth noting that this yield is lower than the average yield of 8.2% among similar CEFs. Advanced analytics suggest that RVT’s historical performance would suggest it should be priced lower, seeing that it has generally tracked the performance of the small-cap index closely. The average discount of 11.1% has been RVT’s long-term norm; therefore, its current discount of 10.3% may not constitute a compelling investment opportunity. A more favorable entry point could arise if that discount were to widen to around 15% or lower, presenting a better buying scenario for potential investors.
In conclusion, while small-cap funds typically attract attention during periods of declining interest rates, the current economic landscape and performance data may not lend favorably to such investments. The anticipated consumer behavior shifts may not materialize in the expected manner, and small-cap firms face unique challenges in keeping pace with larger technologically advanced companies. For RVT, its yield may not provide adequate compensation for potential risks, and current pricing doesn’t present a strong value proposition. Investors would do well to remain cautious and consider waiting for more favorable conditions before committing to small-cap investments.
