I GAIN a certain perverse pleasure from seeing smaller companies outperform the larger stocks. This has certainly been the case this year. Overall, the FTSE 100 index of Britain's largest companies is up around 8 per cent since January, and the next 250 shares have risen 25 per cent. Smaller stocks haverecorded a rise of nearly a third. Given the smaller company bias in my own portfolio, I consider this long overdue.

This trend has been accentuated this week by the poor performance of bank shares. These now constitute the largest part of Britain's headline index. Why are investors taking fright? Because the Government has said it will be investigating mortgage lenders.

The prospect of mortgages coming under the Financial Services Act has been around for some time. Mortgage lending is on the increase, fuelling an buoyant housing market. But the small print that ties in borrowers seems most likely to provoke changes to the rules. Whether it will mean a drop in profitability for the mortgage banks is another matter. Competition is severe. It is just as well demand is as high as it is.

But when you are in one of the longest bull markets in history, you do not need much of an excuse to find a reason to take profits. Only if selling extends to smaller companies should we believe the bear market has arrived. And the worry that share prices cannot rise indefinitely has been one of the factors behind the lagging performance of smaller shares. Difficult times usually mean a flight to quality, a factor in the shake-out a year or so ago.

The recovery in the fortune of smaller companies owes much to the valuation argument rather than a belief that bear markets are history. Small companies offer value - and value has been singularly lacking in the shares that make up the index of Britain's leading companies. The extent of this value is underscored by the rise in corporate activity at the lower end of the market. Buying a smaller competitor can be earnings-enhancing when yields and earnings multiples are as low as they were.

Will it continue? The manager of one smaller companies trust says we are seeing just the beginning. Smaller company shares have underperformed for years so it is not unusual to find industry equivalents on ratings that vary 100 per cent between the small company and its competitor enjoying a stockmarket value of many billions.

But the shake-out in bank shares may well have presented an opportunity for bargain hunters. Banks have reinvented themselves. They need to. Competition is emerging from the most unlikely quarters.

But with developments such as Lloyds TSB's purchase of a building society and a mutual life assurance company, you realise some banks are aware of the challenges. Lloyds TSB, with the highest return on capital in UK banking, could indeed be the FTSE stock to tuck alongside those smaller companies in your portfolio.

Brian Tora is chairman of the Greig Middleton strategy investment committee