Small-cap stocks in the UK are prepared to perform

With recent strong performance surpassing that of the large-cap indices, UK small-cap stocks may be poised for a multi-year bull market

It's common knowledge that "elephants don't gallop," as the late investor Jim Slater put it. However, large-cap stocks have easily surpassed small-cap stocks for a long time. In the past five years, the FTSE 100 has returned 84 percent, while the Numis Smaller Companies index (excluding investment trusts) has only returned 36 percent.

It is easy to see why. More than 75% of the FTSE 100's revenue comes from overseas sources, whereas the Numis index is more reliant on the faltering UK economy, with a figure closer to 50%.

Passive funds and foreign investors, who prefer larger companies, are increasingly controlling the British market. Smaller businesses are more labor-intensive, less liquid, and less well-researched than larger ones, even with active funds. Lastly, even larger UK companies have improved their performance, but the phenomenal growth of US mega-caps has demonstrated that elephants can gallop.

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Indications that small-cap stocks in the UK are turning around.

However, small-cap stocks saw a turnaround in January, outperforming large-cap indices not only in the UK but virtually everywhere. Fund managers believe that this will go on.

For the first time since the 2008 financial crisis, the managers of the value-focused Aberforth Smaller Companies Trust (LSE: ASL) report that the Numis index now outperforms the market overall. Simultaneously, smaller businesses have stronger balance sheets, higher dividend cover, and better dividend growth (63 percent since 2015, compared to 29 percent for larger businesses).

They state, "There is good reason to believe that the UK economy may turn out to be better, or at least less bad, than commonly perceived." Given how little is expected of small UK quoted companies, particularly those that are more economically sensitive, this would have a significant impact on their valuations. Additionally, they cite the high rate of mergers and acquisitions and share buybacks as important variables.

Aberforth's own portfolio of 78 companies yields 4.3 percent compared to 3.4 percent, and trades at a multiple of 10.5 times earnings compared to 13.8 for the Numis index. The 1.5 billion trust's shares trade at an 8% discount to net asset value (NAV), despite the trust's returns of 16% over a year and 59% over five.

Performance improves.

With a five-year return of 150%, the 220 million Rockwood Strategic (LSE: RKW) has long been the star of the subsector. In an effort to spur improvement, this "active-value" trust aims to purchase sizable shares in extremely undervalued and possibly undermanaged businesses. With two-thirds of the portfolio consisting of the top ten holdings, it is extremely focused.

The 150 million Strategic Equity Capital (LSE: SEC) employs a similar approach. With a 25% return over the last year, it has outperformed Rockwood, but it is still far behind five.

With a one-year return of 17%, Rockwood's 250 million sibling Odyssean (LSE: OIT) is improving after a slow period.

The FTSE 250 mid-cap index typically spearheads small-cap recoveries, which then trickle down to small and micro caps. Thus, it should come as no surprise that the 250 million Schroder UK Mid Cap Trust (LSE: SCP) has also done well, rising 18% over the past 12 months. Over the past year, even the more growth-oriented trusts from BlackRock, Henderson, and JPMorganincluding the largest in the industry, the £1.8 billion Mercantile (LSE: MRC)have generated double-digit returns.

Naturally, this comeback might only last a short while before bigger businesses start outperforming them again. However, there is a general belief that small businesses can no longer be expected to gallop faster, valuations are low, and pessimism is pervasive. In this situation, the risk of regretting missing out on a multiyear small-cap bull market is greater than the risk of participating.