Montanaro expects stocks to recover in the second half of 2009

"A lot of grief is being priced into those valuations," said Dan Harlow, fund manager at Montanaro, which has about 400 million pounds ($577.3 million) under management in its various UK and European smaller company-focused funds.

Last year was easily the worst-ever year for the FTSE SmallCap Index, which nearly halved in value. Yet Harlow remains more bullish for the coming year.

"2009 is a second-half story. Let's get the earnings season out of the way and see where we are ... but I'm more optimistic."

Some positive signs have already started to emerge that confidence is slowly beginning to return to the market, with credit spreads tightening in January and bad company data not being greeted with a run on shares.

"Companies are issuing disappointing updates and prices aren't falling and that's an important point. The market's anticipating it and that's a step to restoring a bit of confidence," said Harlow.

Battered consumer-related stocks and those associated with construction and building supplies are areas which could provide outperformance in the coming year.

"We're bottom-up stock pickers, looking for the right names ... It is about identifying businesses where balance sheets are strong, robust and cash generative," said Harlow.

The FTSE Small Cap Index finished 2008 on an upbeat note, rising 1 percent in December, only its second positive month since April, though it backtracked in January.

"There will be inevitable false dawns," said Harlow, but said investors now have a more realistic view of company earnings prospects, which can only build confidence.

"We look at medium- to long-term performance, three to five years, possibly longer, before choosing stocks," said Harlow of Montanaro's investment philosophy.

Harlow also says that with a defensive portfolio and a set of decent balance sheets his fund is unlikely to be hit by as many cash calls as others might be as companies look to the market for financing.

His philosophy couldn't be more evident in the top holding in his fund: Dignity, Britain's only listed funeral services company, which accounts for 3.5 percent of the trust. "It has pricing power ... and the death rate tracks office of national statistics forecasts so its pretty predictable".

Defensive support services stocks also feature heavily in the fund's top ten holdings, including Hargreaves Services, BPP and EAGA, which account for 27.5 percent of a portfolio with net assets worth 69 million pounds.

Liquidity has always been a problem for small cap stocks, an issue which has been exacerbated in the downturn.

However Harlow, whose fund is around 98 percent invested, said he sees those cautious fund managers being attracted back to the market, which makes him more bullish for the outlook.

"I don't think people are going to forget about them," said Harlow of small caps. "Historic data suggests that corner of the market will deliver outperformance as we come out of this bear market".