But that’s not stopping scores of new motorcycle riders from risking road rash or worse just to enjoy 50 miles per gallon or more. Some cruisers even get well over that. It must be nice when a full tank of gas is only 4.8 gallons and costs about $14.40.

But it really comes down to cost per mile. BMW motorcycles, for example, get outstanding fuel mileage, but have Sedan-like price tags. And the technology they carry easily rivals that found on their own 3-Series road cars. Look for 3-Series-like maintenance bills on occasion, too.

For most of us, motorcycles aren’t a viable option as daily transportation. And for areas where public transportation is almost equally unviable, we’re stuck with moving at least a ton-and-a-half of steel, plastic and rubber between two points as fast as possible twice a day.

AAA’s 2006 Driving Cost Guide says that it costs the average American driver $0.62 per mile to operate their car 10,000 miles a year. Now, there are a million ways to calculate that — you can include some expenses, eliminate others. But doing it the AAA way, we see a yearly expense that’s been increasing some years much more than inflation:

Here are the technologies most likely to keep driving costs at bay today and in the future:

Turbos — Power in a Small Package

Once the domain of sports cars, Mercedes diesels and 18-wheelers, the turbocharger is making a big comeback. It allows engineers to use a smaller engine to achieve what a much larger, non-turbocharged engine could. A smaller engine is lighter, more fuel efficient when the turbo is not in use, and often times cheaper to produce.

Engine Sizing on the Fly

General Motors introduced this concept back in the early 1980s and it was not a success. The idea was to have a large V-8 engine that could electronically activate and deactivate cylinders as needed. So, when there was no acceleration needed, the car could run on four cylinders, and could go up to six or eight as your right foot commanded. The problem was it drove horribly. However, nearly 30 years later, modern electronics make this cylinder deactivation idea viable. It’s one way to gain greater fuel efficiency and decrease emissions.

Gears and Gearlessness

Until recently, automatics were frequently three- or four-speeds. Fives have now become common, sixes are seen in more sporty and high-end luxury models, and now at least one manufacturer is boasting a seven-speed automatic transmission. Then there is the CVT (continuously variable transmission) that has virtually an infinite number of speeds. Big mileage gains are possible here.

But that’s only the beginning. Tires with lower coefficients of rolling friction could have a huge mileage and driving cost impact in years to come. And we could even see major steps that make running your car’s air condition systems cheaper as well.

On that final note about air conditioning efficiency, there is an interesting company in that field called Amerigon (ARGN: NASDAQ). Amerigon produces a climate control seat for truck and car occupants. On the surface, the shares look pretty pricey at the moment, but this is one that we’d take a closer look at a more attractive price.

Until Next Time,
Craig Walters
May 21, 2007

Automobile-Based Small-Caps was originally featured in the Penny Sleuth.

It was a situation where the price of gold had risen 32% to $583 per ounce in the previous twelve months, but three interesting small-cap gold stocks were selling for the same prices they were when gold was trading around $430 an ounce.

We presented our readers with three stocks: a small-cap, a mid-cap, and a large-cap. Buyers of shares of the small-cap and the mid-cap only had to wait two months before they were up 30.5% and 45.3%, respectively. The large-cap, coincidentally, was actually down half a percent for the same period.

The stocks that performed so well were IAMGOLD Corp. (IAG: NYSE), which is now the tenth largest gold company in the world, and Kinross Gold (KGC: NYSE), the eighth largest.

These situations for quick profits don’t happen very often, but when they do we need to jump on them.

Well, there is a very real chance that the gold bull market is poised to continue. Even if you only look at it from a chart perspective, much of 2006 saw gold trading sideways with higher trends now looking likely.

But no matter what you believe about gold’s immediate future, there are some things you need to know before you go out and buy a gold stock. The four that I’m about to highlight are critical:

• Evaluate the Level of Sales and Earnings: Many risky exploration companies exist in the marketplace today that have no real sales or profitability. They may have been clever enough to attract lots of cash in the hopes of making a large discovery, though. Unless your risk tolerance is extremely high, you’ll want to own the companies that are actually generating cash flow from selling gold.
• Examine the Company’s Reserves: The amount of gold a company has is measured by its reserve level. The higher the reserve, the more gold that can be translated into sales and earnings. It’s important to pay close attention to a company’s proven and probable reserves numbers. This will clue you into the possible amount of gold the company can reasonably expect to extract and turn into a product for sale.
• Location: It’s important in real estate, and it’s important in gold investing. Well, it’s not so much the location per se, but the politics that control it. It’s better to pay a slight premium for gold in a politically stable area than to risk having a dictator seize your company’s mine, leaving your investment worthless. Obviously, gold plays in North America are among the safest in which you can place your money from a political perspective.
• Funding: It’s important to look for gold companies that are able to self-fund their operations. That is, they are generating positive operating cash flows, and hopefully positive free cash flow as well. A gold company might have to tap the equity and debt markets from time to time to fund major new projects, but we don’t want to invest in companies turning over sofa cushions to stay alive.

We already have small-cap gold plays in Small-Cap Strategy Report, and you can rest assured that we will be examining all future gold additions with those four criteria above, as should you.

Until next time,

Craig Walters
February 22, 2007

Small-Cap Gold Stocks was originally featured in the Penny Sleuth.

If a company wants to return value to shareholders, the buyback is the way to go.

Don’t get me wrong. Dividends have their place. And some investors will always be attracted to that cash every quarter.

But ideally, buybacks are extremely efficient ways to distribute wealth back to the shareholder. Here’s why:

1. No immediate tax hit. When you receive a dividend check, within the year you will be paying 15% of it to the Federal Government. And President Bush actually lowered it to that rate from a high of 38%. Who knows what that rate will be when a new administration moves in. But with a buyback, there is no immediate tax hit. When you actually sell shares, you’ll pay taxes on the gain you’ve made (if any), and that’s it. So, after tax, a $100 dividend is worth less to you than $100 of stock repurchased by a company from you.
2. You’re in control. The more you think about it, dividends are a bit of a burden. The company throws them off with regularity and you have to deal with the tax consequences. Of course, there’s that old saying about it actually being a blessing to have tax problems… But wouldn’t it be better if you were able to tell the company when you wanted a dividend? With a buyback, shareholders can choose to get involved or to ignore it. The shareholder gets a choice.

For a lot of high-profile companies, big buybacks are reducing share counts and giving loyal investors a bigger slice of the pie…

IBM, Intel, and Oracle have been very active purchasers of their own company stock. Of course, there are other factors at play. But the bottom line is that over the last 10 years, these large-cap players have brought down their share count and increased their earnings per share.

But what is happening when a company keeps buying back their stock, and shares outstanding keep going up?

Well, one of the causes could be that the company is buying back stock in an attempt to counter the exercise of employee stock options. And if you watch how investors react to these kinds of buybacks, they clearly hate them. That’s because this type of buyback is a knee-jerk reaction to try to maintain a consistent share base. It has nothing to do with whether or not management thinks their stock in under-priced or not.

The bottom line: Watch out for companies with share bases that increase despite massive buybacks, and avoid companies who buy back shares indiscriminately. If management buys its own stock back when it is expensive, it is destroying shareholder value, plain and simple.

Until next time,

Craig Walters
February 8, 2007

Value of Buybacks vs. Value of Dividends was originally featured in the Penny Sleuth.

House Democrats have made it clear that they intend to repeal a provision in the 2003 Medicare drug benefit law that prevents the government from being involved in negotiations of prescription drug prices.

While opinions are split, some surveys say this legislation could find favor with voters.

A new poll conducted by the Kaiser Family Foundation shows that 65% of Americans strongly favor having the federal government negotiate prescription drug prices for Medicare. An additional 20% are somewhat in favor of this change.

Incoming House Speaker Nancy Pelosi said Democrats intend to make this legislation one of the very first things they pass come January. The president, however, is against it.

We’re against it, too, and we think quite a battle is in store. And here’s why…

Right now, dozens of private insurers offer Medicare drug plans in every state. The way each plan competes for enrollees is through 1) competitive monthly premiums, 2) favorable choices of drugs and 3) convenient access to pharmacies. The onus is on the insurers to hammer out the best deals, and they use their pharmacy benefit managers to negotiate the lowest drug prices with manufacturers and pharmacies.

Getting the government involved could be a nightmare, and there is no guarantee that it will lower drug prices as originally intended.

Here’s what could happen if Democrats get this legislation passed: The federal government could use the considerable muscle of having 43 million Medicare beneficiaries to radically reduce prices on some medications. The way that might happen is that a few drugs will get highly favored by negotiators over all others. This could dissuade new drug development, limit choices, saddle patients with certain side effects that would not have been there with other drugs, etc.

The White House is opposed to the plan, and Congress would need a two-thirds vote to overturn the executive branch veto. We think that the Democrats might not be able to swing this.

Democrats argue that the U.S. Department of Veterans Affairs has had great success with allowing the federal government to directly negotiate lower drug prices for veterans, so they believe it should also work for Medicare. But that’s not an apples-to-apples comparison. The value of the VA’s drug spending is one-fortieth of Medicare, as you would imagine. Plus, the structure of the VA’s drug buying is different, as it runs its own pharmacies and has a much smaller number of drugs with which it deals.

So how do you play this with small caps? And how do you do it so that you win either way this legislation goes?

Well, let’s first look at the top five most used drugs for people who are both eligible for Medicare and Medicaid:

The principal developers and manufacturers of these drugs are the major players of Big Pharma, and have large-cap stocks. However, some of the contract manufacturing and generic producers of these drugs are small-cap public companies.

You would think that government negotiators would focus on the top-utilized drugs to get the best pricing…not necessarily.

The government would likely copy the VA model — which focuses on older drugs and has policies in place to virtually ignore newer, more expensive therapeutics.

Whatever happens, here’s a way to win:

If we invest in the most attractive small-cap drug producers of popular, older drugs for Medicare enrollees, we win if the Democrats get their way or not. Here’s how: If the federal government negotiates all pricing for Medicare prescriptions, some small-cap suppliers will be preferred over others, stifling competition and creating a moat for those lucky companies. On the other hand, if the Democrats lose, we will likely see more spending on drug development, which will increase the net present value of these firms long term, not to mention simply lifting a “black cloud” that hangs over these stocks right now.

If we invest selectively — looking for value — we should win either way.

We’ll be exploring this in much greater detail in upcoming issues of Small-Cap Strategy Report, and we’ll be offering specific investment strategies to profit from this.

Until next time,

Craig Walters
December 21, 2006

Investing in Medicine was originally featured in the Penny Sleuth.

It’s alarming… It hits you in your very core. One would think such a tremendous downturn in a single day was reserved for movies like Wall Street and Trading Places…images of brokers in white jackets screaming “Sell! Sell! Sell!”…flashing fingers, scribbling numbers on little white pads in a desperate attempt to clear their clients’ positions.

But let me assure you, this is the type of action you can expect to experience once in a very great while in the world of small-cap pharma and biotech stocks.

This industry lives and dies on FDA approvals… There’s no getting around it. Even when you believe the odds of obtaining the FDA’s green light are greater than the probability that the leaves on the trees will bloom come spring, you’re still never 100% sure… Anything can happen. It’s a world of tempered expectations.

Sometimes then highly unlikely happens. And when it does, your investment takes a dramatic turn for the worse. That’s what happened in the Small-Cap Insider portfolio yesterday with one of our holdings, NeoPharm (NEOL: NASDAQ).

But let me start from the beginning…

This past October, we found a very speculative drug company whose insiders were simply snapping up its stock. It had a drug in Phase III trials and, if successful, the stock would either rocket or fall virtually to zero. It was like an option, in a way, and not priced too much more than one.

It was a very “binary” investment opportunity — the company would win or lose, and our fortunes would ride in lock step.

We made the necessary checks, made the appropriate calls to our pharma experts in the field, and we felt comfortable in making a speculative recommendation on this company’s shares. We felt the term “speculation” was appropriate label for this idea — and we made it clear to our readers. After all, for every successful company in the drug world, there is a sea of failures.

But things seemed favorable about this company…

NeoPharm had its lead drug, cintredekin besudotox (CB), in Phase III clinical trials. Their drug was intended to prolong the lives of adults who suffer from particularly aggressive brain tumors.

NeoPharm appeared to be near a breakthrough in a better treatment than the current standard of care, the Gliadel Wafer.

Early on, results looked promising: Patients treated with NeoPharm’s CB lived for an average of 55.6 weeks versus 28 weeks with standard treatments. Because of these early positive results, CB earned orphan drug status in Europe. The FDA fast-tracked it.

And the company’s insiders seemed equally optimistic about NEOL stock.

When we wrote our initial report, company insiders had snapped up over 300,000 NEOL shares at prices ranging from $4.86 to $10.20. The company’s CEO, CFO and chairman of the board were very active buyers.

But the bottom fell out on the morning of December 11.

NeoPharm’s drug didn’t meet the benchmark level of performance, and you know the rest.

We knew the risks, and we made them abundantly clear…

We wrote: “Action to take: If you are a speculator who understands the risks, buy shares of NeoPharm, Inc. (NEOL:NASDAQ) for $7.35 or less. Use a limit order. And only invest money you can afford to lose.”

But I’m not writing this Sleuth as a defense of our recommendation. I want to highlight the fact that — yes — small-caps can be risky. They are more risky by their very nature than large-caps because they are typically younger companies in an earlier phase of their growth cycle. And that phase sometimes means that they’re vulnerable. They might not have other products to fall back on if one fails, or they don’t have the financial flexibility to dig themselves out of trouble.

That said, early-stage pharmaceutical and biotech companies are even more risky than your average small-cap.

In fact, the same day NeoPharm reported its Phase III results, Nuvelo, a development partner of Bayer Healthcare, plummeted 79% in its own failed Phase III trial.

But over time, and using a portfolio approach, small-caps can bring great rewards to investors.

If we look back to the 1920s, small-cap stocks have gained, on average, nearly 13% per year versus 10% for large-cap, “blue chip” stocks. Over many 10-year periods, small-caps have beaten large-caps by as much as 50 to 60 percentage points.

Of course, the risk of small-caps explains, in part, why their returns are superior. With greater risk come greater expected returns.

But if we look back again over the last century, we see that small-caps really shine over large-caps when the U.S. economy is growing. And for the majority of the last 80 years, the U.S. economy has been growing. There was only about a decade-and-a-half from 1926 to the present day when we were officially in recession.

So, loyal readers, the events of this week will not test our resolve.

Until next time,

Craig Walters
December 14, 2006

Pros and Cons of Small-Cap Investing was originally featured in the Penny Sleuth.

But The Sleuth is very important, too. In fact, it’s just as important as each and every newsletter issue I write. It’s the only chance apart from end-of-week reviews that I can communicate with my SCSR and SCI readers between issues. It’s also a chance to contact those readers who only read The Sleuth, so I like to present compelling ideas suitable for a very large audience.

Since Sleuth readers easily outnumber SCSR and SCI readers put together, I need to take great care in the stock recommendations I write about each Thursday afternoon. They can’t trade too lightly or else we’ll create a lot of unnecessary volatility, and readers will never be able to establish a position. Also, it’s pointless to recommend stocks that are too small or have too few shares available. It’s a tricky balancing act.

But, so far, so good.

In the last three issues of The Sleuth, we’ve written about three stocks: One we warned you to steer clear of, another we were waiting to buy when it got cheaper, and the third we thought was a great speculation.

Well, for those of you who stayed away from our “steer clear” stock, I’m happy you did. That stock, of course, is Midway Games (MWY: NYSE). This is the video game maker that hasn’t made a profit since it was churning out coin-operated arcade machines 10 years ago. And, as I wrote last month, this is a company that missed out on the previous “video game bull market”…and it doesn’t look like they will catch the current one as Playstation 3, Xbox 360 and Nintendo’s Wii usher in a new gaming cycle:

With Midway shares closing at $8.66 on November 9, we warned you to stay away from this one. Since then, MWY has dropped to $7.64 — a 12.2% drop in three weeks. This one might get some sympathy if the rest of the video game group rallies, but it’s clearly the runt of the litter right now.

On November 16, we wrote about HEICO (HEI: NYSE), a small-cap aerospace/defense company. Two weeks ago, it was trading at $39.56. We said we needed to wait for a pullback in its share price because we thought it was trading too high for us to get in. Yesterday, it closed up at $38.31…after dropping to the $37 level earlier this week. We have this one in our crosshairs, but haven’t seen the valuation levels that will make us squeeze the trigger…yet.

Our big winner so far has been Mobility Electronics (MOBE: NASDAQ). We recommended this as a speculative buy last Thursday at a price of $3.21. It closed yesterday at $4.14 — a gain of 29% in just four trading days! In fact, Tuesday it was up 10.5% alone! This actually highlights one of the powers of small-caps — a $0.38 rise in this stock was worth 10.5%:

Mobility remains a good speculative buy at $4.14.

That’s it for this week. Next week, we hope to have another good buy for you to round out your 2006.

Until then,

Craig Walters
December 7, 2006

Profiting from Small-Caps was originally featured in the Penny Sleuth.

Until someone comes up with a commercially successful method of wirelessly distributing electricity, we’re going to be charging our mobile devices with something connected to a cord.

It really shouldn’t be that way.

In Colorado Springs back in 1899, Nikola Tesla demonstrated that you could wirelessly transmit millions of volts without electrical lines. In fact, he sent 100 million volts through the air, lighting up 200 light bulbs and a motor. If this piece of history is hard to imagine, it is dramatically presented in the recent film The Prestige, in which Tesla is a character.

Mystery has always surrounded the wireless transmission of electricity. J.P. Morgan backed Tesla’s invention, spent millions building transmission facilities…only to walk away from the investment and the facilities destroyed. More recently, a small upstart company in 2002 began marketing their ideas for wireless chipsets that could receive electricity to charge cell phones without the use of a power cord. After a lot of press attention, the story went quiet and the company’s website now redirects you to an Internet backbone provider.

So, for the time being, we’re stuck with power cords for every portable device we want to charge. But at least one company has come up with a better charger. The company: Mobility Electronics (MOBE: NASDAQ). Their device: The iGo power adapter.

The iGo line of chargers bills itself as an all-in-one way of charging all of your portable devices. So, if you’re on a trip and your lugging a laptop, a cell phone, a PDA and an iPod, you only need this one charger to charge them all.

The device is getting rave reviews. And while it has a high level of utility, it’s pretty sleek looking, too.

Mobility Electronics is not a one-trick pony, though. They were a part of Energizer’s new push for inexpensive battery-operated chargers for cell phones and hand-held video games.

It seemed like a great deal for both companies — Mobility Electronics builds a device that’s distributed at Wal-Marts and drug stores everywhere, and Energizer gets a product that has a voracious appetite for its own batteries

Oh, yeah — Mobility also forged a deal with Dell to produce A/C adapters for their laptops.

This seems like a dream company, doesn’t it? Well, er, now it kind of is a dream…

Two months ago on October 6, Mobile preannounced its upcoming results for the third quarter. Management said that they expected 3Q06 sales to be about $2.5 million below what Wall Street was looking for. And if that wasn’t enough of a shock to the Street, management also said that the Dell relationship is coming to an end, and their Energizer relationship is not expected to bare any fruit going forward in the form of sales for Mobility.

Mobility’s shares, which had previously traded in a fairly tight range, retreated back to their mid-2003 levels:

OK, Mobility is losing some major revenue sources and strategic alliances, but is this really a bad company?

MOBE has a market value of $107 million, and 19.2% of that value is cash it has on the balance sheet. It also has zero debt, making the balance sheet look pretty spotless. And right now, the company has only about $1.1 million in employee stock options.

For its 7-year public history, Mobility has averaged 20.4% average sales growth each year, giving it a very strong top line. And gross margins, despite a drastic dip in 2001, have largely stayed in the high-20% to mid-30% range:

But that’s where this story kind of falls apart. High annual selling, general, and administrative expenses have made this company unprofitable right from the start. Only last year did the company ever turn an annual profit, however the trailing 12 months after 3Q06 look to be a disaster once again:

While this isn’t an ideal investment for Small-Cap Strategy Report or Small-Cap Insider, I do think it makes for a pretty good speculative buy.

Let’s look at the facts…

First, there have been some insider buys lately, in fact, by an extremely loyal buyer who has been picking up shares for several months — Adage Capital. And they have been accumulating blocks at prices much higher than levels today:

Adage now holds over 7 million MOBE shares, or just about 22% of the shares outstanding.

Second, Mobility makes several great power charger products that are in demand. On top of that, their designs seem pleasing to the eye as well as functionally effective, and the bulk of the reviews we’ve read from reputable sources have been very favorable.

Third, this is a small company, but the balance sheet is just about pristine. And it has a proven ability to grow sales at a fairly strong rate. Plus, it’s small enough to be a takeover candidate by just about everyone. It’s float of 27 million shares on 31 million outstanding make the chances that it’ll be swallowed up at a possible premium a real possibility.

Fourth, it may be losing Dell, and the Energizer relationship may not have delivered on its potential, but Mobility’s products are being sold in some of Cingular Wireless stores in the southwest United States, with the possibility that the pilot program could be greatly expanded. Punch up BestBuy.com and the iGo products are there. Same with Amazon.com. The company’s distribution channels are clearly strong.

And fifth, while MOBE is a risky play, we won’t be paying a lot for it. It’s trading at 1.9x book value and 1.1x sales.

Remember, this is a speculation on Mobility gaining traction with Cingular or a possible buyout. The only thing offering us a little bit of downward protection is Adage Capital buying up lots of shares. In fact, their second-largest buy was done at levels similar to today.

Mobility could be a profitable end-of-year surprise for your 2006.

Until next time,

Craig Walters
November 30, 2006

Speculative Electronics Stocks was originally featured in the Penny Sleuth.

Voters in the U.S. made their feelings known about the Iraq War and seemingly swept aside as much Republican influence as they could last week.

Political pundits didn’t see this coming. Equity analysts were shocked, too.

And markets always love to react to changes in expectations.

In March 2006, the Department of Defense published details of the defense budget President Bush took to Congress. It projected a U.S. defense budget for 2007 about $28.8 billion less than the one for this year. It also estimated that we would not see defense spending on par with 2005 levels for at least the next three years:

With a lull in budget growth already expected even before last week’s Democratic sweeps, defense stocks would seem like a place you would not want to have money.

In fact, over the last week, that sector has seen some bloodshed — with the minnows of the group taking it the worst.

Our scan of performance in the aerospace and defense sector over the last week shows that eight of the top 10 losers since the November 7 elections have been small-cap and micro-cap names:

VirTra Systems, a manufacturer of military simulation systems, took the biggest hit, dropping over 23% in the seven-day period. Moller International, down 11%, designs and builds vertical take-off and landing (VTOL) airplanes. These are similar in concept to the Hawker Harrier Jump Jets the British military has used for decades. Down almost 9% was United Industrial Corporation — makers of many defense-related products, including systems for drone aircraft.

The major defense companies, like Lockheed Martin and Northrop Grumman, held up well to the Democratic win. The reason is most likely because the 2007 defense budget will still be the largest portion of the total Federal budget. Another major reason is that no political party would want to be seen denying troops of their necessities while they are on the ground in a combat theater. So until the Democrats engineer a troop withdraw, adequate funding should remain in place.

Not all defense stocks took this shift in power badly, though:

One of the big winners of the week was small-cap Hi-Shear Technology (HSR: AMEX). This is a diversified company that makes many aeronautical components, but one of the more interesting military products it makes is laser ordnance for the U.S. Army. It was up almost 26% on the week. Military aircraft engine-part maker Kreisler Manufacturing (KRSL: NASDAQ) was up over 8%. This micro-cap announced huge sales and profit increases for their September quarter.

So the big question is: Are defense stocks a good play these days or should investors now stay away?

The answer: You need to be selective, as always… Let me show you.

Take HEICO (HEI: NYSE), for example. It’s a $1 billion, small-cap aerospace and defense company that provides engine parts and services for commercial aircraft, and an extensive suite of test systems for military applications. And with the specter of a falling defense budget in the near term, the company is actually prospering. On August 30, the company reported 3Q06 results, which included record net sales and record operating income. This was the sixth consecutive quarter in which they did so. And in the last six months, its stock has gone up 25%.

Insiders have been making many purchases recently of HEI shares. Four directors and the chairman of the board made purchases at the end of August — many of which represented substantial percentage increases to their HEI holdings.

HEICO’s debt-to-total capital is a very attractive 12%. However, the company has been making a lot of acquisitions, which has been eating into its ability to produce free cash flow. The market, though, is looking beyond this, and sees the cash-generating ability of this business when it does stop its growth-through-acquisition phase.

Unfortunately for us, HEICO’s strong performances over the last several years have attached a premium to its shares — and the stock is now pretty pricey. This is a stock, though, that I would consider recommending if its price pulls back. Make this “one to watch.”

In the meantime, we’ve found a similar company to HEICO — a company posting record results and gaining a lot of recognition in the defense arena. It’s already rocketed to huge gains this year, but a careful examination is starting to reveal that this could be only the first leg of its assent.

The next issue of the Small-Cap Strategy Report will focus on this defense play, and a couple of ways to play it.

Until next time,
Craig Walters
November 16, 2006

Small-Cap Defense Stocks was originally featured in the Penny Sleuth.

The room to which I’m referring was just about 15 miles north of Baltimore at the Timonium State Fairgrounds. The event was a coin-operated video game and amusement auction, temporarily located in a building that each year plays host to the livestock exhibition of the Maryland State Fair.

That day, though, it was more of a video game burial ground than anything else. At least one model of every video game ever produced was up for auction or for immediate sale at a fixed price. Their conditions ranged from a few pristine models to mostly those that had seen heavy use. Bidders were encouraged to bring their own extension cords to test that the games did indeed function. The panels to the coin slots on the machines were open so that savvy buyers could activate the games without actually dropping in quarters.

One of the facts that struck me in this room was that Midway Games had a stranglehold on this industry throughout the 1980s — when arcade games were big business. Today, I think arcades only exist at beaches and amusement parks.

But back in the ’80s, arcades were popular. The big names in this business, along with Midway, included Taito, Atari, and Williams, just to name a few.

Midway, however, had a significant number of top titles back then that have ultimately been modernized and transferred to Playstation and Xbox. You might remember Spy Hunter or one of their more contemporary titles like Mortal Kombat. These games have spawned sequels, spinoffs, and some have become franchises that are still alive 25 years later.

If Midway sounds like a dynasty in the electronic entertainment industry, its stock is clearly on the ropes…

Midway Games (MWY:NYSE) is a small-cap that’s been cut in the last 12 months. It’s down 54.7% and now has a market cap of $785 million:

Midway started to fall apart in mid-December 2005. During that month, the company’s largest shareholder, Sumner Redstone of Viacom, shifted a substantial amount of his direct holdings in the video game company to off-load personal responsibility of over $400 million in debt to a holding company. While Redstone wasn’t really dumping Midway stock on the open market at the time, it did turn a lot of negative attention on the game company. Analysts began to pile on with negative statements about its lofty valuation, Redstone’s ownership making it basically an illiquid stock, and the company’s inability to post positive earnings.

I’ll admit I was very hopeful of finding a compelling investment in Midway at these depressed levels. It’s still somewhat of a powerful name in a very big market, and we’re entering another cycle where lots of dollars are going to be thrown at new video game consoles from Sony and Nintendo. I at least had to see if Midway was going to be a smart buy for this new cycle…

There have been a lot of opportunities for Midway to capitalize on surges in video game sales, but the company has consistently failed to execute. The first Playstation was launched in 1994 and 1995 in Japan and the U.S., respectively. Playstation 2 was launched globally in 2000, and Playstation 3 will be launched in Japan and in the U.S. in about two weeks. Overlapping these releases were new entrants from Microsoft in the forms of Xbox and Xbox360, Nintendo’s 64, GameCube and the upcoming Wii. A few entrants fell by the wayside — notably Sega and their Saturn console.

Midway didn’t just hitch their wagon to one game company, either. They have produced software for virtually all of the systems, and yet profitability has been elusive:

As you can see from the income statement, Midway’s been losing money since 2000 up through 2005 — arguably the greatest “video game bull market” in this industry’s short history. A big drop in revenue from 1999 to 2000 occurred when Midway exited the coin-operated arcade business…and they never posted an annual profit since.

The Entertainment Software Association (ESA) reports that consumers spent $7 billion on video and computer games in 2005. That’s double what was sold in 1996. If we look at Midway’s home video game sales during the period between 1998 and 2005, it’s sales dropped 34.7% while the industry’s sales as a whole marched forward 45.8%. And for most of those years, this company was losing money.

While one could make the argument that Midway shares are hated assets and there is rarely a better time to buy an asset then when no one else wants it, this is one I would avoid.

In the last 12 months, Midway has taken on more debt than they have in the last 10 years combined, and the company is not cash flow positive on any level. Many of their key franchise software titles are getting very long in the tooth and may not remain marketable for much longer.

Management just reported a loss for 3Q06 that was an improvement over 3Q05. However, they did guide full-year earnings to be a loss of $73 million, which is a greater loss than they had previously told the Street.

Traditionally, the months leading up to a new generation video game console’s launch is tough on gamemakers who are still producing titles for the existing platforms — the ones that no one is going to want in a few months. That’s why Midway’s management is telling investors that recent losses are associated with their efforts to gear up for a strong 2007.

If I were convinced that Midway is going to make a massive turn to consistent profitability, now would be the precise time to take a position. But I’m not convinced.

Until next time,
Craig Walters
November 9, 2006

P.S.: When I’m not following the bigger trends affecting the small-cap market, I’m tracking the smart money. One of the best (and most misunderstood) ways of making money in the stock market is by following the insiders. As one famous fund manager said: “Insiders might sell their shares for any number of reasons, but they buy them for only one: They think the price will rise.”

Investing in Video Games was originally featured in the Penny Sleuth.

It’s like any other brokerage firm, but it’s analysts cover stocks as ideas primarily for institutions, mutual funds and hedge funds — the buy side.

The buy side guys are the managers who are pulling triggers on large share positions each and every day. Traditionally, the buy side has its own analysts, but the workload is usually too great for them to cover all of the stocks they need to, so fund managers utilize sell-side analysts to come up with additional, fresh investment ideas. If a manager likes what a particular sell-side analyst provides him, he repays him by directing a certain amount of trades through that analyst’s trading desk. Frequently, trading desks make only pennies per share on institutional trades, but in sizable volume it can be a lucrative business.

That’s where the aversion to small-caps comes in.

If sell-side firms make a sizable portion of their money based on how many shares they trade, a small-cap stock trading 30,000 shares a day won’t be too attractive to them. They won’t want their analysts to waste time covering it…unless there is a lucrative banking deal attached to it…at which point you might question that analyst’s objectivity.

Let’s look at a sample of small-cap stocks and large caps:

The list of small-caps at the top has companies with market caps of around $250 million. Only one trades more than a million shares a day, but most of them trade less than 100,000 shares daily. The list of large-caps includes the largest companies traded on U.S. exchanges. The market caps of theses companies are in the hundreds of billions of dollars, and average trading volumes are many millions of shares a day.

As you can see, more sell-side analysts are covering the bigger names. The large-caps have more transactional value and greater banking needs. In short, there’s more money to make off of them than the minnows.

But how much value can one analyst in a sea of 34 others add about Microsoft? How much additional insight can be gleaned about Wal-Mart with 22 analysts already scrapping over every bit of information? How much time can any of the large-cap CFOs devote to speaking to any of these analysts? The answer to all of these questions is: Not much.

That’s one of the main reasons why I love small-caps.

There are a lot of truly undiscovered, or under-discovered gems, in this space. There are lots of opportunities for us to add value through our research. There is also the tendency for small-caps to outperform large-caps over long periods of time.

But forget about history for a moment.

Let’s just look back year-to-date at the top performing stocks so far in 2006:

Of the top ten performing stocks so far this year, nine of them are small-caps. On top of that, half of them have no sell-side analyst coverage!

So, when you see little or no analyst coverage on a small-cap you really like, don’t be scared away necessarily. It just could be the best opportunity around.

Until next time,
Craig Walters
November 2, 2006

Unnoticed Small-Cap Stocks was originally featured in the Penny Sleuth.