Return of the small fry

Lean years could be over for modest-sized companies, says Rachel Fixsen

Small isn't usually beautiful in the world of investment. Shares of big companies seem safer and easier to trade, and in a recession small businesses are always first to go belly up. But with shares of the country's 100 biggest companies now teetering at record highs, some experts say it will soon be the turn of medium-sized and smaller company shares to grab the action.

The FTSE 100 share index has risen over 30 per cent during the last 12 months while smaller companies have languished. The FTSE small cap index has risen a mere 2.2 per cent in the same period.

This outperformance of the FTSE 100 will come to an end at some point, says Geoff Douglas, smaller companies analyst at investment house Barclays de Zoete Wedd. "At that point you will get passive outperformance of small companies and mid-sized companies," he says.

Investing directly in the shares of small firms can be much riskier than buying shares of major companies like Marks & Spencer and ICI. Smaller companies tend to be far more exposed to trading risks, with many of them marketing only two or three products.

So buying part of a collective fund of smaller company shares makes sense as a safer way to get into this market. There are about 40 investment trusts and 80 unit trusts specialising in UK smaller companies to choose from. That is, if their performance records don't put you off first.

"Of late they've been fairly terrible ... in the last six months most of them haven't made any money," says Tim Cockerill, investment director at financial advisers Whitechurch Securities in Bristol. If you take an average of all unit trusts in this sector, a pounds 1,000 investment made a year ago would have shrunk to pounds 982 by now, according to financial information provider MoneyFacts.

But the fact that recent performance has been so appalling is precisely why some experts say now is the ideal time to buy into these funds. "This underperformance is unprecedented for non-recessionary conditions," says Andrew Crossley, director of Invesco. "What we're saying is small company shares are now cheaper, compared with blue chips, than at any time in the last 15 years."

Mr Crossley predicts that something will happen to jerk small company share prices out of their depression. The trigger might be a general realisation that these stocks are undervalued, a pick-up in takeovers of smaller firms or the release of business results for the first half of the year, which are due in September.

"Once it turns it will turn very quickly - because it always does," he says.

Picking your unit trust is key. Investment policies of unit trusts in the UK smaller companies sector vary widely. Some hold shares of companies which are not very small at all - just below the largest 250 companies in the country. Others invest in tiny businesses listed on the Alternative Investment Market rather than the main stock market.

The quality of manager is all-important. "The blanket approach isn't going to pay dividends. You need someone who can pick stocks - someone who really knows," says Mr Cockerill. He recommends HSBC's UK Smaller Companies unit trust. It only started last September, but has done well so far. Roddy Kohn of financial advisers Kohn Cougar in Bristol rates Gartmore's UK smaller companies unit trust highly. It has a longer track record and has been among the top 10 consistently over the last 10 years.

Whatever the short-term prospects, it is always worth keeping a proportion of your assets in smaller company unit trusts, advisers say. They tend to perform well at different times, often responding to different economic conditions from those which affect larger companies.

If it has a really astute fund manager, a smaller companies fund can arguably make even more money than a fund which focuses on major stocks. Most of today's corporate giants started in a small way. "Somewhere out there is the next Microsoft," says Justin Urquhart Stewart of Barclays Stockbrokers. But the next Polly Peck is also lurking somewhere, he warns.