View from City Road: Trusting in smaller firms

HOARE GOVETT'S smaller companies index underperformed the market as a whole for the fourth year running in 1992. That is far and away its worst run in the 38 years for which figures are available. Shares in companies representing the bottom tenth of the market by capitalisation registered a total return last year of 8.5 per cent. The All-Share managed 20.5 per cent.

While there have been worse years - the difference in 1989 was a whopping 25 percentage points in favour of big companies - it was a depressing reminder that the long-term trend of smaller company outperformance can suffer prolonged hiccups. Strange, then, to see John Houlihan, Hoare Govett's smaller companies guru, in such ebullient form yesterday.

He thinks 1993 will see the tide turn. Already, small company shares are 17 per cent higher than at the beginning of December, while the Footsie has added just 2 per cent. Volumes are well up.

There are four good reasons for believing the gloom is over. First, yesterday's cut in interest rates will favour small companies more than large ones thanks to their bigger debts.

Second, small companies are more exposed to the domestic economy than their larger brethren. They will get a bigger kick from recovery here and will not get hurt as much by recession in Europe and Japan.

Third, tiddlers also have a greater exposure to cyclical sectors like building materials and other capital goods than the market as a whole. Defensive sectors, such as pharmaceuticals and utilities, which should underperform if there is a pick-up, contain few small companies.

Finally, the marketability, or lack of it, of smaller shares means that, when investors start to show an interest in the sector again, share prices tend to move sharply.

A word of caution. Forty three of the index's 1,519 companies went belly-up last year. Investors who cannot afford to spread their risk adequately, by buying enough individual shares, should take a look at the many smaller company investment trusts on the market, some of which are even now trading at attractive discounts to net assets. These include County Smaller Companies, I&S UK Smaller Companies, Throgmorton 1,000 and Fleming Mercantile, the largest.