How to Avoid Bears in the Small-Cap World
By The Penny Sleuth Editorial Team

In times of bear markets, many small-caps get crushed. When this happens, these small companies get unfairly thrown aside for the “safer” blue chips. We all know that this is without justification. Many people say that smaller companies don’t have the backing or financial security to deal with a bear market. There is so much wrong with that line of thinking, but there’s no need to go into it. After all, we already know why we like small-caps.

But since this is how the market usually deals with bad times, we have to be prepared. So to do so, we laid out the three most important things to do to protect your investments in times of trouble:

• Find companies in strong financial situations that can deal with a downturn in the market
• Find companies that can take advantage of niche markets even when everything else looks bleak.
• And finally, if that doesn’t stop a stock from dropping, know how to set trailing stops to prevent complete disaster.

Financial Health is the Key in a Bear Market

Here at The Penny Sleuth, we sometimes lean toward the more risky investments because of the better payoff, but that’s not always the case. We like solid companies, with strong balance sheets and considerable growth. In times of market turmoil, that’s exactly what you should look for.

There are a few criteria that we look for to get us through tough times in the market. The first thing we have to look at is how well the company is growing. I like to use a hearty 25% revenue growth rate to make sure the company is still in the high growth stage we like.

The second thing to look for is the balance sheet. To make sure the company is in a financially healthy position, I always consider the debt to equity ratio. Here I want to have less than half the debt to the shareholders’ equity.

Finally, just like any investor or mutual fund, it’s sometimes smart to have a larger portion of your investment capital in cash. Regular companies are no different. If the market is acting up, it might be smart to wait for the bottom before reinvesting that capital in investments or even acquisitions. So here, I look for a cash position to be 50% of the company’s total assets.

With these three criteria we get a small-cap screen that looks like this:

I ran this screen just to see what would come up, and I wasn’t surprised. Of the 30 stocks that came up, many had done very well in the past three months, when everything else seemed to tank.

Three names stuck out to me from the list: Life Partners Holdings Inc. (LPHI: Nasdaq), AspenBio Pharma Inc. (APPY: NasdaqCM), Basin Water Inc. (BWTR: Nasdaq).

I had recently seen Life Partners on a list of market performers, and sure enough in the past 3 months it had rocketed up 95%. Life Partners isn’t what you probably think it is. It’s a financial services and life insurance company, which I tend to shy away from because of the risks associated with it. This one specializes in life insurance policies for the terminally ill and the elderly, which can be a pretty risky play. However, this one seems to be doing just fine.

The second one, AspenBio, is a biotech company with their entire product pipeline in the development stages. Fortunately, the stock just got a boost by jumping from the Bulletin Board to the Nasdaq Capital Markets

Exchange last month. This shot shares up 15% in a week.

The third company that matched our screen was one called Basin Water. It is a water treatment company in the right place at the right time. With the water concerns we have here in this country and everywhere else in the world for that matter, this well-water-treatment company has made its mark at just the right time gaining 68% return over the last 3 months.

The point being, no matter what the market throws at us, we just have to be prepared with a back up plan. As long as a company has a strong balance sheet and some top-line growth, it should be all right. It might even make you a buck or two.

However, even with strong financial health, not every company will perform well in markets like these. You have to find one that offers an absolutely required service no matter what the economy looks like…

Finding a Safe Alcove During Financial Storms

Many people we’ve talked to outside the financial world have looked at the state of the stock market recently and declared it a disaster. It’s not just the folks on Wall Street who are shook up, but the general public as well.

No matter how the markets move, there’s still money to be made in uncertain or dangerous times, whether you’re talking about the stock markets or society as a whole.

After all, someone needs to be there to pick up the pieces…

It’s the rallying cry of any experienced politician after disaster strikes: “We will rebuild, no matter what the cost…”

When the World Trade Center towers fell on Sept. 11, 2001, there wasn’t a soul in New York — or anywhere else in the United States, for that matter — who believed Manhattan’s streetscape would be left with two gigantic vacant lots. We would rebuild, of course, no matter what the cost.

The same holds true for natural disasters. Two years after Hurricane Katrina battered the Gulf Coast, the government, private enterprise and charities continue to pour billions into cleanup efforts. As of last summer, the federal government alone shelled out $3.6 billion to cart off nearly 100 million cubic yards of debris from the area. And cleanup efforts continue to this very day.

Many companies have been making money hand over fist, while at the same time rebuilding New Orleans and other areas that got blasted. You may already be familiar with a company named Home Solutions of America, Inc. (OTC:HSOA). This is the company that is currently in a very heated battle with a short seller that has been slandering the company in the news this past year. But you may also know of this company as one of the leading restoration companies in the rebuilding of New Orleans.

A disaster like Katrina is devastating. It leaves hundreds of thousands and, sometimes, even millions out of their homes. And it’s not easy to think about making money off of it, but you can’t see it that way. Even in disasters like this, the companies that help people can also bring investors huge profits. Take a look at what happened to Home Solutions’ stock price when they were rewarded with New Orleans restoration contracts:

Of course, there is even more work to be done after the debris is swept under the rug. Hazardous and toxic wastes from mining operations, industry and the like are routinely leaked onto agricultural land, city streets and residential neighborhoods during flooding. In fact, this type of cleanup is almost always necessary whenever flooding occurs.

From catastrophes to local disasters, there’s money to be made in making things new and livable once again. After all, catastrophes and disasters of all sorts don’t stick around and wait for the stock market to go up before striking. That’s just one example of a niche market that isn’t affected by a downturn in the economy.

But there is one question that remains: What if your stock still goes down?

Well, we hate to think about losing money, but it’s the name of the game. Even the best investors sometimes take losses, especially in bear markets. So what do you do when this happens?

How to Protect Your Portfolio from Plummeting Stock Prices

Ben Hogan said, “Reverse every natural instinct and do the opposite of what you are inclined to do, and you will probably come very close to having a perfect golf swing.”

Investing sometimes feels as counter intuitive as that perfect drive you some how luck into when there are only two holes left to play.

But the two endeavors have two very important keys in common if you are to be successful at either: Minimize your errors and maximize the things you do right.

In golf, hitting balls into lakes or beyond the out-of-bounds markers are akin to sitting idly by as your stocks drop to zero. Very few portfolios can weather catastrophic losses and still provide attractive overall returns.

You’ll hear some brokers, fund managers, and analysts proclaim that they just aim to be right 51% of the time. That might work out for them…as long as the 49% of the time they’re wrong doesn’t bankrupt them (or you)…

In investing — or in most other things in life — it’s not about how often you’re right or wrong, but by how much. The magnitude of your triumphs and defeats are of paramount importance.

Michael Mauboussin, chief investment strategist at Legg Mason Capital Markets, calls this the “Babe Ruth Effect.” In his book More Than You Know, Mauboussin says that Ruth was one of baseball’s greatest hitters, as we all know, despite the fact that he did strike out a lot. He magnified his triumphs, however, by hitting 714 homeruns.

Minimizing the magnitude of your mistakes within your own portfolio, and allowing your winners to dominate your results, is easier to achieve than you might think. In fact, it can be an almost automated process…

I’m talking about trailing stops — the emotionless selling of stocks in your portfolio when they drop a predetermined percentage from their highs.

By placing, say, a 25% trailing stop on each stock in your portfolio and only allowing yourself to invest a maximum of 4% in any one stock, you are limiting yourself to a maximum loss of only 1% of your investment capital for each stock that stops out. That’s pretty good protection. Several 1% losses, while nothing to jump up and celebrate, are acceptable as you allow your winning positions to climb.

Below is an example of exactly what I’m describing…

Above is a worst-case scenario. You have a few winning positions and many more losers that plummet the moment you buy them. The portfolio illustrates that if you limit your position sizes to a maximum of 4% of you investment capital (here we assume that to be $100,000), and use trailing stops on all of your stocks, you can actually have a lot more losers in your portfolio than winners and still make money. In fact, this portfolio contains only 40% of stocks that actually rose compared to 60% that stopped out. Despite that, the portfolio is up 7.02%.

Well, hopefully your portfolio looks better than that. Even though it’s up, I’m sure you don’t want to be wrong 60% of the time. But, it’s still a good safety device to save you from losing everything.

So, even though we seem to be going through a different bubble every few years (dot-com, housing/credit, etc.), these techniques are about the best way to protect your small-cap portfolio against disastrous bear markets.

Until Next Time,

The Penny Sleuth Editorial Team

P.S.: Our “Big Sister” newsletter, Penny Stock Fortunes, applies all three techniques during both good times and bad. By doing so, we have seen some huge rallies in our recommendations. Editor Greg “Gunner” Guenthner can explain better. Check out this free report he wrote up explaining his strategy, as well as his scientifically-selected penny stock system that he uses to find his big winners. Read on…

Additional Resources

Investing with Pink Sheets -Penny Sleuth Special Report

Why We Will Always Love Small Caps by Jim Nelson, Penny Sleuth

US Small Cap Stocks on Seeking Alpha

Top Five Small-Cap Stocks – News & Analysis – TheStreet.com

Small Cap Stocks – SmallCapNetwork.com