Investment Trusts: Small firms have a spring in their step: Alison Eadie finds that investing in little companies can hold out a promise of reaping some big rewards

THE STOCK market bounce since the UK pulled out of the Exchange Rate Mechanism last September has been more pronounced for small than for large companies.

The re-rating, after a prolonged period of neglect, has resulted in strong share price performances of investment trusts specialising in both small and unquoted companies, and also in a dramatic narrowing of the discounts to net asset value (NAV). Research done this month by NatWest Securities showed smaller companies' investment trusts were trading at a premium to the sector average. The weighted-average discount to NAV of all investment trusts was 8 per cent, but the average discount to NAV of the 31 smaller companies' trusts was 6 per cent.

Venture and development capital trusts have not yet returned to such favour. NatWest Securities put the weighted-average discount to NAV of the 26 such trusts at 20.3 per cent. But this compares with a far greater discount only a few months ago.

Electra, by far the largest trust in the venture sector, with net assets of pounds 551.4m at the end of March, was on a discount to NAV of around 40 per cent in December. It is now hovering just above the 15 per cent mark. Its share price has soared to more than 280p from a low earlier this year of 183p. Robbie Robertson of NatWest Securities says there has been a reassessment by investors in the past two months of weightings in the venture trust sector. Those with little or no exposure to the sector are questioning whether this is the right strategy.

Perceived as high risk when the market is failing, investors are now looking again as discounts narrow. Over-inflated valuations in pre-recessionary times resulted in writing down or writing off assets during the early 1990s. There is now much less risk in the portfolios, Mr Robertson says.

He adds that the NAVs of venture trusts tend to follow the economy rather than the stock market and that any pick-up of activity in the real economy will benefit the trusts.

Hugh Mumfords, Electra's managing director, believes small companies have the potential to benefit disproportionately from the economic recovery. When going into the recession, having a portfolio of small companies with high gearing resulted in some casualties, the reverse is now the case. Small companies with high leverage are a good bet, according to Mr Mumford.

The distortions of the private equity market are also working themselves out of the system, he says. The weight of money being thrown at private equity deals kept prices high even in the recession, but now that there is less money about deals are more reasonably priced compared with the market, he says. Some good investments have been made in the past 15 months, which should bear fruit in three to five years' time he says.

The good run on the stock market by smaller companies since September, which has flattened off since April relative to the FT AllShare index, is not the end of the re-rating, according to small companies' experts. Small companies, loosely defined as those with market capitalisations up to pounds 300m, underperformed the stockmarket for four years to 1992, according to the Hoare Govett smaller companies index.

Bob Armstrongs, director of Fleming Investment Management and manager of the quoted UK equity of Fleming Mercantile investment trusts, points out that despite the recovery small companies are still slightly below peak levels reached in 1987. Their lack of international exposure meant they were more exposed to the ferocity of the UK recession.

He believes over the next two years small companies will continue to outperform even if they pause for breath along the way. He says during the recession a lot of costs have been taken out of business, requiring only that volumes stop declining for there to be a significant upturn in earnings per share. The tide of sentiment is running in favour of small companies as demonstrated by the investor interest in the recent run of new issues, he says.

The tide of sentiment running in favour of smaller companies since September is expected to continue even if there are hiccups along the way. Any signs of a stronger pick up in the economy should fuel the re-rating.