The adage that “elephants don’t gallop” – as the late investor Jim Slater put it – has become accepted wisdom. Yet for many years, large-cap stocks have comfortably outstripped small-cap stocks. The Numis Smaller Companies index (excluding investment trusts) has returned just 36% in the last five years, against 84% for the FTSE 100.
It’s not hard to see why. The FTSE 100 generates more than 75% of its turnover overseas; the figure for the Numis index is closer to 50%, which means it is more dependent on the struggling UK economy.
The British market is increasingly owned by passive funds and overseas investors, who favour larger companies. This applies even with active funds – smaller companies are less liquid, less well researched and more labour intensive than large ones. Finally, the phenomenal growth of US mega-caps has shown that elephants can gallop, while even larger UK companies have improved their performance.
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Signs of a turnaround in UK small-cap stocks
Still, January saw a turnaround in small-cap stocks, with strong performance ahead of the large-cap indices, not just in the UK but almost everywhere. Fund managers are optimistic that this will continue.
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In the latest results for the value-orientated Aberforth Smaller Companies Trust (LSE: ASL), the managers note that the Numis index now yields more than the market as a whole for the first time since the 2008 financial crisis. At the same time, smaller companies’ dividend cover is higher, their balance sheets are stronger and their dividend growth has been better (63% since 2015, against 29% for larger companies).
“There is good reason to believe that the UK economy may turn out to be better, or at least less bad, than commonly perceived,” they say. “This would be significant for the valuations of small UK quoted companies, especially the more economically sensitive businesses, since so little is expected of them.” They also point to share buybacks and the elevated rate of mergers and acquisitions as key factors.
Aberforth’s own portfolio of 78 companies trades on a multiple of 10.5 times earnings against 13.8 for the Numis index, and yields 4.3% against 3.4%. The £1.5 billion trust has returned 16% over one year and 59% over five, yet its shares trade on an 8% discount to net asset value (NAV).
Performance picks up
The star of the sub-sector has long been the £220 million Rockwood Strategic (LSE: RKW), with a five-year return of 150%. This is an “active-value” trust, seeking to buy significant stakes in severely under-valued – and perhaps undermanaged companies – to catalyse improvement. It is highly focused, with the top ten holdings accounting for two-thirds of the portfolio.
The £150 million Strategic Equity Capital (LSE: SEC) has a similar strategy. It has out-performed Rockwood over the past year, with a return of 25%, although is far behind over five.
Rockwood’s £250 million sibling Odyssean (LSE: OIT) is picking up after a dull patch, with a one-year return of 17%.
Small-cap recoveries are usually led by the FTSE 250 mid-cap index, with recovery then filtering down to small and micro caps. So it is no surprise that the £250 million Schroder UK Mid Cap Trust (LSE: SCP) has also performed well, up 18% in the last year. Even the more growth orientated trusts from BlackRock, Henderson and JPMorgan – including the £1.8 billion Mercantile (LSE: MRC), the largest in the sector – have produced double-digit returns over the past year.
Of course, this recovery could prove to be just a flash in the pan, with the out-performance of larger companies soon resuming. However, valuations are low, pessimism is widespread and there is a common view that small companies can no longer be expected to gallop faster. In this climate, the risk of regret from missing out on a multiyear bull market in small caps outweighs the risk of being in it.
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