In grips of the bear, some small company stocks start to attract

NEW YORK (Reuters) - After a brutal selloff that sent shares of small companies reeling, some investors have been starting to come back selectively to some of those stocks, but for the group as a whole, recovery could take a while.

The so-called small cap stocks of the Russell 2000 index <.rut> are seen as the canaries in the economic coal mine. When the economy is expanding, these stocks tend to lead the market higher faster. But when recession looms, they tend to do worse first, possibly because more of them live on narrow margins and borrowed money.

Right now, they are still signaling gloom ahead. The index

is down 27 percent from its June 2015 high and three quarters of the companies in that index have lost at least 20 percent, which puts them officially in bear market territory.

But some investors are starting to sift through the wreckage for bargains. Managers of so-called "all-cap funds", who are free to invest in companies of all sizes, have shifted their allocations towards smaller companies to an average of over 20 percent, the highest in the last three years, according to Lipper data.

"In the U.S. at least, it is probably the most compelling place to be looking right now," said Bryant Evans, investment advisor and portfolio manager at Cozad Asset Management in Champaign, Illinois.

With the crumbling prices, shares have become more affordable.

Stocks in the Russell 2000 now are priced at an average of 20 times their expected earnings for the next 12 months, well in line with traditional valuations for smaller companies and cheaper than the 25.8 during the June high.

But the risks of prolonged economic weakness and stock market selling have investors fearful of buying the whole group. Instead, it becomes a cherry-picking contest. Investors such as Steve DeNichilo, portfolio manager of the Federated Kaufmann Small Cap Fund in New York, looking carefully at corporate metrics to choose purchases.

"In this type of market you can’t make a sector prognosis, it is always going to be stock-specific," said DeNichilo, who as of his most recent report was buying molecular diagnostics company Veracyte and home security technology company Alarm.com , and said he looks for companies that have clear pathways towards free cash flow growth.

"Really, truly in every sector we are finding stock-specific opportunities - from industrials to U.S. housing stocks to technology to biotech," he said.

While more volatile, small-caps are generally more insulated from currency fluctuations as they are domestically focused, which helps negate any potential hit to earnings due to the strengthening dollar, as seen in large-cap companies.

They can also get a boost from heightened volatility. When the CBOE Volatility Index <.vix> - now at 28 - climbs above 15, the small cap S&P 600 <.spcy> tends to outperform the S&P 500 over the next two and three months, Jonathan Golub, chief U.S. Market strategist at RBC Capital Markets in New York, said in a recent note to clients.

To be sure, small cap stocks carry additional risks, said Dan Suzuki, senior U.S. equity strategist at Bank of America Merrill Lynch in New York.

For starters, small companies often tend to rely more on credit and have weaker balance sheets than big companies. With the current market penalizing companies with weak credit positions, "that is going to tend to have pretty negative implications for the relative performance of small caps" for some time, he said.

(Reporting by Chuck Mikolajczak; editing by Linda Stern and Nick Zieminski)