Smaller companies have led the recent pick up in share prices, adding almost 8 per cent more than their larger peers, and there are a number of reasons why small caps should perform well as the economic situation improves, according to Fidelity International.

The first among these reasons is that many of the weaker competitors in the small cap space have already been culled by the economic downturn, meaning that those remaining are in a stronger position. It is also the case, the firm notes, that incremental market share gains have a much greater impact on smaller companies' profitability and growth potential than they do for larger ones.

Secondly, some large cap companies are in a competitively weaker position as their profit margins may be compromised by the fact that they have government shareholders who may be looking to push a political agenda. The firm also argues that the management of small caps are more closely aligned to the company’s success and are therefore more incentivised to perform.

According to Fidelity, small caps now trade on more attractive valuations than larger companies as investors can buy into early stage growth at a discount to mature business.  The firm also believes that there is less risk of the small cap sector being crushed as investors move onto the next idea because although smaller companies outperformed in the bull market, this was not due to “hot money” chasing the asset class.

Investors should also be aware that it is easier to find pricing anomalies in the small cap space as fewer analysts cover the stock and so fewer buyers are simultaneously chasing the same idea – hidden gems abound, Fidelity argues.

The firm does concede however that investors’ reluctance to invest in speculative assets could impose a ceiling on how far small caps will rise and there may also be further cuts in earnings to come if the economic situation deteriorates. In addition, it needs to be acknowledged that illiquidity is a fact of life for small cap investors, and many would rather know they can get out if the going gets tough, but, on the other hand, Fidelity points out that it is often the contrarian trade which proves most successful.

Fidelity's conclusion is that investors with a longer-term horizon can pick up smaller companies’ equities at significant discounts to their historic valuation, as every small cap sector now trades at a discount to its valuation during the bull market years. Careful analysis is still necessary, the firm warns, but with rigorous stock selection the small cap space could prove to be a very appealing proposition.