SMALLER companies in recent years have seen some pretty interesting disasters. The sector has been a place where more investors have been burned than have made money. In fact, when institutional fund managers talk about the small-company sector, it begins to sound like some small, dark, smelly place where only the cavalier roam. After all, smaller companies often seem to turn up in the court pages or on the wrong end of a Securities and Futures Commission (SFC) inquiry than on the right end of a buy recommendation from a steely blue-chip brokerage. The slowdown in earnings momentum among Hang Seng Index constituents, however, is forcing fund managers and brokerages to hunt for new pastures in which to invest. From 1991 through 1993 it was easy. Year-on-year corporate earnings growth from Hong Kong's top 10 capitalised firms was double-digit in percentage terms. More recently there have been a clutch of reports, issued from some of the top broking names, recommending stocks with smaller capitalisations. The new focus of attention on these smaller-cap stocks has opened its own debate. In the raving bear corner there is strategist Paul Schulte who has been working overtime on his computer database, looking at the propensity of portfolios with a small-cap component to underperform or outperform against a portfolio of well-known and apparently reputable blue chips in stock markets around the region. In the bulls' corner there are recommendations regarding smaller-cap stocks from Barings, S G Warburg and Smith New Court, which has recently launched a new index covering the sector. At Smith New Court, P J King has developed a smaller companies index, tracking the bottom 10 per cent of the Hong Kong stock market by value. His index shows there has been a five-year bear market in smaller-cap stocks. But after looking at a number of factors affecting smaller-cap valuations, Mr King argues a pull-back in the sector from the present undervalued position could be on the cards. 'There are good quality small companies which are professionally led and prepared to listen to and talk with shareholders and have not listed just to take the money and run,' he said, adding that ASM, Johnson and Nam Hing were examples of good companies in this category. The bursting of Hong Kong's asset-inflation bubble last year has removed blue chips from the exciting investment agenda. Their main source of earnings, in many cases, looks uncertain in the dodgy property market. Companies lurking around the bottom of the pond, bottom fishers will find, are in manufacturing and exports, making them a lot less asset-inflation dependent for performance in profit and share price terms. The prolonged decline of the US dollar has had a major beneficial effect on the relative competitiveness of these already lean and mean firms. According to Mr King: 'This will eventually feed through to earnings. Investors will realise that this is a better basis for future returns than asset inflation, and will switch into smaller caps, causing a re-rating of the sector against blue chips.' Not surprisingly, Smith New Court is recommending investors start buying smaller caps now. The bottom for the sector might not be hit for 12 months yet, but catching the bottom would be extremely difficult, the brokerage said. Two indicators to watch out for are directors and corporates buying back their own shares and a crop of privatisations, such as B & B Asia, Novel, Tungtex and Fountain Set. '[These] must be one of the best indications that company values are very cheap, in contrast with companies coming to the market at the top of the small-cap cycle,' said Mr King. At S G Warburg Securities, analysts Alexander Mackesy and Alwyn Pang said many of the more interesting smaller-cap stocks in the manufacturing sectors were being hurt by rising costs and falling margins. In a May report Warburg said it favoured Esprit Asia, Four Seas Mercantile and Varitronix. Both Warburg and Baring reported smaller firms were exploring vertical integration to secure cheaper supplies. For example, car aerial and accessories producer, Innovative, established a battery-making joint venture in China to secure its own supplies. Previously dependent on imported PVC from Taiwan, World Houseware boosted operating profit margins from eight per cent to 13 per cent by installing its own PVC sheet production lines. Watch out, though, because these types of moves and diversifications can be the undoing of a group. Warburg said Lamex was a case in point as the costs of a $140 million regional expansion of its office furniture distribution operation, with increased costs of depreciation and interest costs, caused the collapse of first-half operating profit margins to 4.9 per cent, from 9.4 per cent over the same period in 1994. 'Not before time perhaps, Lamex has recently appointed a new finance director,' said the brokerage. The smaller cap road is definitely not paved with gold and more often than not it is pitted with pot-holes. Mr Schulte at CS First Boston issued this warning in a recent report - Performance Enhancers: Just say No. He said there was nothing wrong with specialising in smaller company investment, but investors seeking to outperform the index by adding a little spice from the smaller stock sector could be in for a disappointment. Stock picking in the sector was tough. It was difficult and high risk and when things went wrong there was a liquidity problem. 'In challenging times, the temptation to seek out performance enhancement is indeed great,' Mr Schulte said. He said it was a waste of time to try to enhance the performance of a core portfolio of the top eight to 11 stocks by market capitalisation, by hunting for great smaller cap stocks. 'In every case throughout Asia Pacific, gathering 0.5 per cent of the float of the top eight to 11 large stocks and 0.5 per cent of the top performing 20 to 30 smaller-cap stocks leaves you with a portfolio whose performance is almost entirely dependent on the large cap stocks (85 to 90 per cent of the portfolio),' said Mr Schulte. If, over the past two years, you held every one of the 20 to 25 best-performing smaller-cap stocks in Hong Kong, Malaysia, Singapore and Thailand you would only have enhanced your performance by a few per cent. SHIFT PRINT - To 5/F proofer (All) CTRL PRINT - To 5/F proofer (No Dummy) CTRL/SHIFT PRINT - Bromide (No Dummy) Given the time it took to get the stake - two to four times longer than for a big cap stock - the aggravation and risk (twice as high), Mr Schulte questioned whether it was worth it. If you have to do the smaller company beat then there are some guidelines to follow. Random selection is too risky; check out the sector cycles and look at past trading patterns because they give a guide to relative value. And avoid buying at the expensive top of an inflated cycle.