“The market doesn’t reward fools for long.”
– Timothy Vick, author of How to Pick Stocks Like Warren Buffett

Four years ago, I waited to go onstage in San Francisco at the second-ever Agora Financial Wealth Symposium. I was invited to speak about the opportunities I saw in the small-cap sector.
I recall being absolutely terrified.

I wasn’t terrified because I had to speak in front of 200 people (although public speaking is never a relaxing chore). Rather, at that time, the market was beaten to a pulp. The United States was still in the wake of 9/11 and the tech blowout. And the last thing the audience wanted to hear was some guy making a bullish case for why they should buy small-cap stocks right now.

No one liked stocks in general at that point in time — let alone “risky” small-cap stocks.

Still, I went onstage and delivered my speech. I talked about how small-cap stocks were dirt-cheap. They were trading for nine or 10 times earnings compared with the big blue chips — which traded for 35 times earnings. In addition, interest rates were falling. Small companies had direct access to cheap loans — which is the lifeline for any company. And the war in Iraq was thought to be just a short-term problem: a bullish catalyst for stocks at the time.

Given the circumstances, I explained it would be the cheap, fundamentally sound small-cap stocks that would lead the market out of the recession and into the recovery period — just as they had done decades and decades before in similar market conditions. And I was right. Small-cap stocks went on a tear.

Between July 20, 2002 and today, the Russell 2000 is up 81%. Small-cap stocks have outperformed their large-cap peers by 30 points over the last four years. Everything I talked about in San Francisco came true. Small-cap stocks made a lot of people a lot of money — for those who listened:

Now, fast-forward to this year’s Agora Financial Wealth Symposium — which took place July 25-28 in Vancouver, British Columbia. Once again, I was invited to speak about the small-cap sector. But that’s about all that was the same from four years ago.

This time around, there were 600 people in the audience, instead of 200. Instead of being terrified about going onstage, there was a calm in the air. People wanted to know what stocks I liked. In fact, many of them shook my hand before I went on — thanking me for past picks that doubled or tripled in value over the years.

Those people were most likely surprised by what I said next…

As I got up onstage at the Fairmount Hotel, the first thing I told the audience is that I wished it were 2002 again. I wished people hated small-cap stocks. I wished no one wanted to hear my small-cap speech. And I wished small-cap stocks were cheap. If that were the case, it would be a buyers market. But that is not at all the case today.

Small Caps Are Twice as Expensive as They Were Four Years Ago

Today, the average company on the Russell 2000 trades for 23 times earnings, versus 17 for the average large-cap company on the S&P 500. In other words, small-cap stocks are more than twice as expensive as they were four years ago, while large-cap stocks are selling for 50% off their early 21st century highs.

Instead of people hating small-cap stocks like they did in 2002, everyone loves them now. Most have made countless amounts of “easy money” over the last several years.

But the days of easy money (when you buy anything and get a 30% return in three months) are over.

Unlike four years ago, interest rates are on the rise. It isn’t as easy (or as cheap) for smaller companies to get that $50 million loan they need to stay in business. On top of that, political unrest seems to be the rule, not the exception, in 2006. We are still fighting in Iraq — and will be for years. Israel is at war with Lebanon. And a slew of other countries (Iran, Syria and North Korea) are unstable at best.

Every sign that pointed to small-cap stocks rising in 2002 now points to them falling over the next three years. Whether you like it or not, we are at or near the top of the current small-cap cycle. The writing is on the wall.

Garbage Stocks Are Leading the Market

Over the last seven months, the worst small-cap companies, a.k.a. “garbage stocks,” have led the market. They are up 8.71%, while the fundamentally sound companies are down 18.8%:

This kind of irrational buying always occurs at or near the end of a bubble period — just before it goes “pop.” People get used to making easy money. They forget about fundamentals — things like earnings, cash, growth and price. Instead, they opt for story stocks with great promise, but no real businesses. How else can you explain why companies like Applica, Inc. (APN:NYSE), CryoLife, Inc. (CRY:NYSE) and Xanser Corp. (XNR:NYSE) are up 191%, 76% and 23% since the beginning of the year? None of them make a dime in earnings or throw off any cash whatsoever.

My friends, exuberant buying can only end one way — badly. Just think back to the dot-com blowout of 2000. It wasn’t Berkshire Hathaway that was bid up 400% in 12 months. It was the worthless tech companies with no real businesses to support such a stock run-up. And when people finally realized this, millions of people lost 80%, 90% and 100% of their investments in a matter of months.

While the small-cap sector hasn’t been bid up the way the NASDAQ was in 1999 and 2000, it is overinflated. Small caps are trading at a premium to the rest of the market. And with rising interest rates, political unrest all over the world and garbage stocks leading the pack, you need to be careful going forward. All the warning signs point to a sell-off.

A Tornado Warning Is in Effect for the Small-Cap Sector

On July 17, John Hussman (one of my favorite money managers) published an essay called “Tornado Warnings.” He leads off by saying, “Tornadoes are more likely to strike when a tornado warning is in effect.”

This is not rocket science. When certain conditions exist in the atmosphere, the chances a tornado will strike improve dramatically. When those conditions exist in your area, a tornado warning is issued. And when a tornado warning is issued, you need to prepare for a…well…tornado.

Of course, just because a warning is issued doesn’t mean a twister will knock your house down. But it is smart to take some simple precautions during such an event. For instance…

During a tornado warning, you should take shelter in the basement. You should make sure you have enough water and food to last a day or two in case the roadways become impassible. And you should make sure you have a couple spare batteries so you can get the news on your radio in case the electricity goes out.

This is all common sense, right? Well, the same kind of logic applies to the markets. All the signs point to the possibility of a tornado touching down in the small-cap sector.

Now is the time to prepare for a sell-off. Now is the time to take profits on the speculative small-cap stocks in your portfolio you wouldn’t be comfortable holding should the market fall 10%, 20% or 30% in a year. Now is the time to insist on investing in fundamentally sound companies with great-looking balance sheets, tons of cash, growing top and bottom lines and niche products or services that won’t fade into oblivion just because the market takes a breather. And now is the time to think about holding good stocks for years, not months.

Of course, the million-dollar question is: Is there anything in the small-cap sector worth owning these days? Do these fundamentally sound companies exist?

Despite the pitfalls that exist, the answer is a resounding YES.

Amid the Doom and Gloom, Opportunity Exists

There are still solid companies for you to invest in the small-cap sector. Remember, two-thirds of all stocks on the market have a market capitalization of $1.5 billion or less. And one-third of all equities have a market cap of $250 million or less. So you have numbers on your side. That explains why:

– 73% of all stocks trading for 10 times earnings or less are in the small-cap sector

– 93% of all stocks trading for less than book value are in the small-cap sector

– 80% of all stocks trading for less than 1 times sales are in the small-cap sector.

And when you combine these stats with the fact that 50% of these undervalued small-cap companies have no analyst coverage whatsoever, there are plenty of opportunities for us to sift through in the small-cap sector.

I just recommended a stock that I absolutely love.

The business is one of the best I have ever come across. It is the market leader in a growing $4.5 billion industry. It has next to no direct competitors. And on top of that, it is cheap, well run and has a decade’s worth of superior results for you to mull over.

More importantly, this is the kind of stock that will not be crushed if a tornado touches down in small-cap land. It has a sturdy foundation that should be able to withstand 100 mph winds.

If you are willing to buy this stock and forget about it for three years, I can all but guarantee you will walk away with more money than you have today.

Best regards,

James
August 31, 2006

Penny Sleuth Contributor

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