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The opportunity to snap up good companies at basement prices has never been greater. We spot those most likely to sparkle

When stock markets are hit by economic and political turbulence, shares in smaller companies are often worse hit than their larger and allegedly 'safer' brethren. But, when fund managers and private investors feel they can look beyond today's problems to better times ahead, the smaller fry can suddenly come into their own.

Peter Webb, manager of the £150 million Eaglet investment trust, which invests in smaller companies, is one of those who have no doubt about the opportunities thrown up since markets bottomed on 21 September, 10 days after the World Trade Center attack. 'It is unbelievable', he enthuses, 'our ability now to buy good companies for less than they are worth is incredible.

'Today, we can buy companies at 10p or 20p per pound of turnover when they are achieving profit margins of 10 per cent. The big institutions, which bought them at 200p per pound of turnover, are now selling them large, sometimes at a tenth of what they paid, and there are now so many goodies in the sweet shop, I don't know where to turn'.

When, as now, the authorities react to the crisis of a slowing economy and likely defence-related spending increases by slashing interest rates, this both wipes out the attractions of fixed interest alternatives and brings welcome relief to the balance sheets of companies below the top of the credit rating tables. That is why professional investors and their advisers claim to be growing excited again about the potential of shares which have been shivering for a long time beyond the pale of the FTSE 100 and other institutionally favoured preserves.

Such a sea change has certainly not happened yet, but the chances that it could be on its way soon are being weighed increasingly seriously by those looking after their own and other people's savings. The Financial Times All Share and 100 Share indices are between 16 and 20 per cent down from their year's high and both have bounced by nearly 20 per cent from their 21 September low.

By contrast, the FTSE Small Cap index, representing companies below the London Stock Exchange's 350 most heavily priced issues, remains about 30 per cent off its year's high and has recovered by only 9.5 per cent from 21 September. The FTSE Fledgling Index is 25 per cent down from its 2001 high and 11 per cent up since 21 September, while the Alternative Investment Market Index is some 42 per cent off its high and has rallied by only 4.25 per cent since September's low.

This flight to apparent safety ? if not always quality ? within an uncertain market is perennial, predictable and understandable. But it is not expected to be permanent.

Will 'value' oust 'momentum'?

Robert Mitchell, fund manager for Friends Ivory & Sime's Aim Trust, says, 'I am feeling more confident about the future than at any time in the past six months. We are seeing through to the end and stock markets look ahead of the economy.

'Valuations have come back so far that companies are now looking really attractive. At the beginning of October, while the markets were waiting for the military action to start, the big stocks did not want to go down and some of the small ones were starting to revive'.

Ben Archer, smaller company strategist at broker Teather & Greenwood, admits the 'small cap sector has underperformed even in a falling market and it has not recovered'. But he cites a previous market setback in 1998: 'the small caps fell further, but afterwards they outperformed because they had further to catch up'.

His claim that there is now 'unique potential' for certain shares in the smaller company sector chimes in with the views of Alan Matthews of broker Beeson Gregory. 'The market is looking prepared to give more horizon, to look through another series of profit warnings after such a big markdown'.

Interest rate cuts often provide more relief faster to small companies than larger ones, with more financially elaborate arrangements, he contends. Moreover, such companies are frequently more tied to the domestic UK economy, which is seen as relatively well placed in the post-11 September world.

David Gorman of broker W.H.Ireland argues that some institutions have been trying to move discreetly back into smaller capitalised concerns, but are finding them hard to pick up in any quantity, which, he claims, 'suggests that some prices are artificially low...There is a lot of real value out there', he insists.

This echoes Peter Webb's view that a prolonged period of 'momentum investing' by institutions buying 'winners' in the bull market has led to serious distortions and is now going into reverse. 'Momentum investing made the big stocks more expensive than they should have been, leaving the small caps at half the ratings of Footsie 100.

'The p/e ratios are all under 10 and, unlike the early 1990s bear market, balance sheets are much stronger'. Webb insists he can buy companies with sales of £200 million a year and 10 per cent profit margins for between £15 and £20 million.

'Momentum investing has concentrated too much money into too few shares', he concludes. 'Now it is over and the small caps' day has come.

'The big stocks won't lead the market recovery ? who wants Vodafone now? I shall never in my life see such good investment opportunities again.

'Smaller company directors are buying their companies' shares: they know the City is run by nutters. As far as I can see, the bear market is over'.

Sifting the gems

Not everyone is as gung-ho as Webb about prospects for smaller companies, but there is renewed interest in identifying the pick of the bunch, those which could score most in a switch to neglected value. Companies with some combination of defensive qualities, strong market position and good management, in the 'old' at least as much as in the 'new' economy, look likely to fit the bill.

Fully-listed Radstone Technologies, an information technology group with an exposure to missiles in the US, at 163.5p seems as well placed as many to benefit from current military preoccupations. From a peak price of more than £3, the company obtained fresh funding not so long ago at 40p (from Eaglet and others).

Biotrace International has been strong lately at around 80.5p because it claims to be the only company with a continuous biological weapon detection system. The company recently launched an air sampler system with the Ministry of Defence and is encouraged by US President Bush's expressed wish for detection systems in every American city.

Elsewhere, consulting engineer Waterman at 128.5p, with earnings rising at 24 per cent, could score from moves to regenerate the urban environment. White Young Green, another engineering and environmental consultant, could benefit from recent acquisitions.

Food equipment maker Enodis has its fans as a recovery stock with strong market share, despite admitting this is a 'challenging' market. A post-11 September switch away from scheduled air flights could provide a fillip to leading corporate air charter broker Air Partners, now depressed at 237.5p.

Bold spirits looking for recovery stocks might consider some of the Lloyd's insurance groups hit by prospects of huge World Trade Center claims, since those which can ride the storm will benefit from soaring future premiums. Goshawk at 68p, Atrium at 51p and Kiln at 55.5p could offer some bounce, while even one of the biggest victims, Wellington, has restored its underwriting muscle with £1 billion of new capacity.

Gooch & Housego, the Aim-listed maker of precision optical instruments, is regarded as a long-term bid target at a depressed 135p. International Greetings, which makes Harry Potter wrapping paper as well as cards, is already talking to the likes of Tesco and Matalan about Christmas 2002 and at 333.5p on Aim, has earnings 'visibility' and a 50 per cent management stake.

Another Aim share down on its luck is Transense Technologies at 362p. Fans insist its sensor technology for car tyres is winning it increasing recognition and business.

Leading car dealer Pendragon at 215p is seen by some as poised to gain from the problems of weaker brethren.

Analysts and fund managers are also looking for companies with exposure to public works spending, which is seen as relatively immune in the current climate. One such is Aim-listed Mears, which specialises in maintenance of housing and buildings.

Mears shares currently stand at 76.5p and have traded between 30p and 98.75p over the past 52 weeks. Recent interim figures show profits rising at more than 40 per cent.

The company has been winning some useful contracts. One of these is a £40 million 'partnering' deal spread over eight years with Welwyn Hatfield council in Hertfordshire.

Under the terms of the contract, Mears is to provide maintenance services to the local authority, social housing and Ministry of Defence sectors. The Welwyn deal follows similar contracts agreed with the local authorities of Dover, Warrington and Croydon.

Medical enthusiasts like the look of Alizyme at 51.5p, working on new drug delivery, and AorTech, bombed out at 124.5p, which is developing cardiovascular treatment devices.

Pursuers of special situations are enamoured of Unite, which provides accommodation for students and 'key' National Health Service personnel, with its interim profits up 14 per cent and a relatively robust share price of 369p. Kingsbridge, which provides financial advice to entertainers and sportsmen and women, is viewed as offering interesting growth possibilities.

On the natural resources front, Aim-listed Gold Mines of Sardinia is languishing at a lowly 14p, but its recent new finds on the Mediterranean island suggest its prospects could be fair. Angus & Ross at 22.5p, Conroy Diamonds & Gold at 16.5p and European Diamonds at 161p ? all also on Aim ? retain appeal for gamblers.

Among investment trusts, Eaglet at a depressed 321p is clearly a candidate for attention, if Webb's enthusiasm is borne out by events. Murray Global Return at a lowly 48p could also be worth a punt.