It's not just the big boys who can deliver a return

As the UK grappled with rising inflation and low economic growth last year, wary investors pulled money out of smaller firms, parking their cash in larger businesses that seemed more robust. But to dismiss smaller companies on the back of last year's performance would be a mistake. As many people have sold out of this sector, now could be a good time to snap up these unloved stocks at attractive prices.

Last year was volatile for smaller companies in the UK, which ended the year down by more than 15 per cent, in comparison with the FTSE 100, which had fallen just over 2 per cent. But Meera Patel, a senior investment analyst at financial adviser Hargreaves Lansdown, says smaller companies can offer some excellent growth opportunities, as they are more nimble and dynamic than larger concerns.

"They often come to the market with a niche product and, if successful, growth can be rapid," says Ms Patel. "Growth can also be sustainable if they conquer an untapped segment of the market and with the right management behind them, can make for a very successful investment."

Compared with the larger businesses out there, smaller companies are more able to grow their earnings, which drives up their share price. Patrick Connolly at AWD Chase de Vere says: "Over most reasonable periods, it is likely that UK smaller companies will outperform larger companies. Smaller companies are usually more dynamic and have greater growth potential than larger firms, which are often at the consolidation stage of their development."

But investing in smaller companies relies on expert stock-picking to find the gems, while avoiding the duds. Gavin Haynes, the managing director of Whitechurch Securities, says: "I would certainly favour investing with a good small companies fund, where the manager is focused on the intrinsic value of individual companies."

According to figures provided by Citigroup, 89 per cent of investment returns from shares in small companies are due to company-specific factors, compared with 29 per cent in the case of larger businesses. Indeed, the best route into this market is through funds, such as unit trusts or investment trusts, where an expert manager can sift through the thousands of companies, in an attempt to select the best stocks while providing diversity so you are not exposed to the same types of companies.

"Importantly, it is down to the stock picking skills of a manager and I would suggest investing in a fund with a proven management team at the helm," says Ms Patel. "This is very important as there are only a handful of proven smaller companies managers around."

Of those tried and tested managers, Ms Patel favours Giles Hargreave, who manages the Marlborough Special Situations and UK Micro Cap Growth funds, although she warns the latter is higher risk.

With the area of small company funds relatively under-researched, there are some real opportunities for fund managers prepared to go the extra mile by getting to know these companies inside out.

"I would recommend the Investec UK Smaller Companies fund managed by Philip Rodrigs," says Mr Haynes. Mr Rodrigs has a team of analysts who look at around 800 companies, in order to find those smaller businesses with auspicious prospects for growing profits, among other factors, from which the best 60-80 stocks are selected. "The performance track record has been very strong and it held up well last year despite the difficult climate," adds Mr Haynes.

The Standard Life UK Smaller Companies trust managed by Harry Nimmo is also a popular pick among advisers, and has grown over 60 per cent in the past three years. Mr Haynes says: "Performance has been very strong under Nimmo and this is an excellent choice if you are looking to invest in a pure UK smaller companies trust."

But if you don't want the risk of investing purely in UK small companies, you can look at those funds which invest in a mix of shares, including medium-sized and larger businesses. Leigh Himsworth, a fund manager at Eden Financial who invests in companies of different sizes, says he is finding some great opportunities in unloved smaller firms. "The key to this year is that if confidence comes back, small companies look incredibly good value."

Yet these funds, and investing in small companies in general, are not without risks. Mr Connolly says the performance of smaller companies can suffer large downturns in adverse economic conditions, as seen in 2008, when the average fund in this sector fell by more than 40 per cent. On the other side of the coin, though, the bounce-back can be swift when sentiment recovers, with smaller companies returning over 50 per cent in 2009 and 30 per cent in 2010.

"Smaller companies are often reliant on the UK economy, which is where they are likely to do most business, whereas larger companies can generate a significant proportion of their revenue from overseas," says Mr Connolly. "Smaller companies are also more sensitive to interest rate rises, and so faster than expected increases would be detrimental to them."

If the UK economy experiences steady growth this year, then smaller firms are on course to do better than their larger counterparts. But should the recovery stutter, or if interest rates rise significantly, then smaller companies are unlikely to do as well.

And given the uninspiring outlook for the UK economy, those businesses solely focused on the domestic market may struggle, as demand for their services or products fall. Mr Haynes says: "Smaller companies are traditionally seen as a higher risk area of the stock market and if risk aversion increases then this area may continue to remain out of favour."

Despite this, others would argue there are many smaller operations which have exposure to overseas markets, so if the UK starts to falter, these businesses could still hold up. But if you don't want to limit placing your money in small domestic firms, there are funds which invest in small companies around the world. Ms Patel says: "If you want to go global, it would be worth considering the Standard Life Global Smaller Companies fund, which is a new launch and is managed by Harry Nimmo."

Mr Connolly warns that you should not lump all your eggs into the small-company basket, as these stocks can be higher risk and should be held as part of a diverse investment portfolio.

Emma Dunkley is a reporter for citywire.co.uk

The managers to watch: Advisers' fund recommendations

Old Mutual UK Select Smaller Companies managed by Daniel Nickols. Ben Seager-Scott of Bestinvest says: "Daniel Nickols pays close attention to the broad economic environment in addition to detailed bottom-up stock analysis in a pragmatic, style-agnostic approach which allows the manager to adapt to a changing investment backdrop."

Marlborough Special Situations managed by Giles Hargreave. Meera Patel of Hargreaves Lansdown says: "We particularly favour Giles Hargreave – he has demonstrated an exceptional stock-picking ability over the longer term."

BlackRock UK Smaller Companies managed by Ralph Cox. Patrick Connolly of AWD Chase de Vere says: "Despite struggling in recent times, the fund has an experienced manager who has built up a long-term record of out-performance."

Investec UK Smaller Companies managed by Philip Rodrigs. Gavin Haynes of Whitechurch Securities says: "This fund provides access to the best ideas of Investec's well-resourced small cap team. Performance under the guidance of Philip Rodrigs has been excellent."

Standard Life UK Smaller Companies Trust managed by Harry Nimmo. Mr Haynes says: "Harry Nimmo has a very strong stock-picking track record, investing in high quality, profitable businesses."