*** James Boric reports from Bloomington, Ind…

*** Investors can’t make up their minds if they are bullish or bearish on small-cap stocks. While I was in Orlando last week for the World Money Show, hedge fund managers and major institutions dumped $247 million into the Russell 2000 — as the market showed signs of strength. Now it seems they have changed their minds.

According to TrimTabs’ latest inflow/outflow report, $220 million of so-called “smart money” has exited the Russell 2000 in February alone. That means our favorite small-cap index just lost about $400 million in the last week. Poof, gone — just like that.

But I guess we should have seen the fall coming…

*** For weeks now, my partner in crime, Irwin Greenstein, has been telling you stories of the booming (read “out of control”) IPO market. That’s a clue to us small-cap investors.According to small-cap experts Christopher Graja and Elizabeth Ungar, “Since IPOs almost always have limited market capitalizations…they serve as a litmus test for the small-cap market in general. Companies typically do IPOs when the think the market is riding high enough to bring them a good price for their shares. If many issuers start rushing to market, they may be exploiting a window of opportunity before it closes. In other words, small caps may be due for a correction.”

Translation…

When terrible companies can sucker investors to lay down enough money to allow them to go public (read:personally cash out for big bucks), you should be wary. And that’s exactly what is happening right now.

Of the 13 venture-backed IPOs that hit the market since Jan. 28, eight of them have lost ground from their first-day close. The biggest loser was Chinese Internet company Hurray! Holding Co., which is down 12.2%. Not following too closely behind it was biotech sensation Icagen, which was off 6.6%. After that, the losses were somewhat minimal.

But are we really in an IPO bubble? I think so.

*** In all of 2003, only 79 companies IPOed. In 2004, 233 companies made the jump from the private market to the public. That’s a 195% increase. In fact, there were more IPOs in 2004 than all of 2002 and 2003 combined. Smells like a bubble, looks like a bubble and probably even tastes like a bubble. So let me be clear…

We are in an IPO bubble!

If Graja and Ungar are right about the correlation between IPOs and the small-cap market, the Russell 2000 may have peaked for a while. And companies that didn’t deserve to rise last year will be punished this year.

If you want my prediction for the small-cap sector most likely to be bashed, I’ll give it to you…

I predict small-cap REITS will be hit the hardest.

*** In 2004, 15% (or 12 of 80) of all the IPOs that hit the market in the fourth quarter of 2004 were in the real estate industry. So that seems to be the place where most people (read “poor, misguided souls”) are placing their money.

Anytime the herd moves in one direction, it’s time to get out.

*** You may have seen my essay in The Daily Reckoning yesterday — titled “The Specialization of Insects.” It was my follow-up message about the great debate that my buddy Dan Denning and I had in Orlando.

In case you missed it, Dan and I were going back and forth about whether or not you could find value in the U.S. markets. He said it may be hard. And I said there will always be value in the small-cap market — if you are willing to look…maybe even dig deep. Well, a fellow analyst chimed in yesterday. Dan Ferris, editor of Extreme Value, wrote to me and said…

“As for the question about value, anyone who’s done the work will tell you there’s nothing to debate: There’s plenty of value out there in small-cap land. I’ve got 50 names on a watch list for my own money. I own five of them right now. A typical stock I like sells for $8.50 and has $22 a share in cash and government bonds, no debt, is profitable every quarter, owns its whole market. Another one has $71 per share in cash and securities and a consistently profitable business, and it’s going for about $47 a share today. Another owns $20 million in real estate, holds no debt, plus is a business easily worth $30 million, the whole thing selling for about $35 million, and pays a regular dividend, too. One has $10 a share in cash, no debt, real estate worth probably $50 a share and a profitable engineering business. The whole thing goes for $24 a share. There are a couple dozen others similar to that. You’ll never, ever find them above $250-$300 million in market cap. Because they’re often closely held, there’s usually no option overhang, either. Not only is there value in small caps, but there’s more value there than anywhere else, and probably always will be.”

*** The truth of the matter is…

Dan Denning, Dan Ferris and I are all right. It is harder than it was three years ago to find value in the small-cap market. But as Mr. Ferris points out, there are a lot of opportunities to make money…always have been and always will be.

I only hope you will continue to read Penny Sleuth as we continue to explore where those opportunities are…and where they are not.

In terms of value, Irwin tells us why small-cap software companies are getting crushed.

Small-Cap Software Meets the Crusher

Picture a junkyard car crusher whose four steel walls exert pressure at 2,400 pounds per square inch. One wall is labeled “off-shore outsourcing.” Another wall says, “giant software companies.” A third wall reads, “open source software.” And on the fourth wall is written “deep discounts.” Into the crusher jumps the CEO of a small-cap software company. When the switch is thrown, the walls creep toward him.

Unless you want to join our doomed CEO, don’t buy shares in his company. That’s because small-cap software vendors that develop products for front-office applications (desktop productivity tools) and back-office applications (databases, e-commerce servers, payroll) are facing marketplace pressures that make them less desirable investments than even two years ago. And the squeeze is expected to last for the next three years at least.

Many small-cap software companies are getting destroyed by the very same forces that have shaped the entire tech industry: rapid innovation, increased competition and loss-leading products. But what’s really different today from a couple of years ago is that small-cap software companies are losing their influence with customers…and consequently, the leverage to demand the high-margin prices that they traditionally savored.

Historically, software vendors operated from a position of strength with their customers. If a business application could deliver real value, its widespread installation would eventually hold the customer hostage — giving the software vendor power to force-feed upgrades and training and maintenance packages. But since the tech bubble burst, the tables have turned.

That’s because corporate chief information officers are still digesting their 1999 grande bouffe of overpriced, overhyped software. Worse, the big IT budgets that had peaked from the Y2K fiasco and the Internet Revolution have not returned. So CIOs who are stressed out by a reduction in resources and relentless cyber attacks are no longer tolerating the arrogance of their software providers.

How bad is the problem for small-cap software companies? In December 2004, META Group, a technology consulting firm to both vendors and corporate users, laid out a gruesome scenario.

The ominous trends that META identified include software industry consolidation of 35% by 2008 (exerting agonizing pressure on undercapitalized software companies), competition from low-cost offshore developers that is expected to grow 20% annually through 2008 and declining prices for the first time in a decade over the next 3-5 years.

And the price wars are getting worse..starting with the biggest software companies and trickling down to the most vulnerable competitors — small-cap software providers.

For instance…

Documents pertaining to Oracle’s hostile takeover of PeopleSoft revealed that customers were able to extract discounts from both companies of up to 90% on the published list price.

If a small-cap software company must compete against a 90% discount, what about competing against software that’s free?

Called “open source,” it is developed free of charge by a global community of dedicated coders. While “free” is somewhat of a misnomer, the software is generally available for downloading off the Internet at no cost. It’s not exactly free because the CIO’s staff must then modify and maintain the software. Still, it’s usually much cheaper than comparable applications purchased directly from a software company.

Open source software has clearly penetrated the hallowed data centers of the largest corporations. It runs on servers, desktops and databases. Even IBM and Hewlett-Packard have launched multibillion-dollar open source initiatives as a means of cutting software prices — and opening doors for lucrative service contracts that can shut out a small-cap
competitor.

Of all the elements that make up a computer system, software is the easiest to discount. That’s because the purchase price can be marked down to lure investors into lucrative add-on sales that keep the applications current and reliable. And the very nature of software’s widespread presence in a corporate infrastructure means that major vendors can make up the loss through consulting and integration services that are too far-reaching for small-cap companies to compete against.

This became abundantly clear when IBM, for example, announced its 2004 fourth-quarter earnings.

The company’s revenues were up 7%, to $27.7 billion, from $25.9 billion in the same quarter in 2003. Specifically, revenues for IBM’s fast-growing Global Services consulting unit had increased 10%, to $12.6 billion, and it is sitting on a backlog of $111 billion. Why is this important to small-cap software companies?

IBM’s Global Services arm provides consulting and integration expertise that helped drive the company’s $4.5 billion in software sales for the quarter, a 7% increase over the fourth quarter of 2003. The added value of a full-service software provider becomes abundantly clear when looking at revenues of IBM’s WebSphere software, which
interconnects applications, data and the operating systems that drive the computers themselves. WebSphere revenues were up an amazing 18% over the same quarter in 2003.

Importantly, IBM’s return on assets is high at 8.19%, while its return on equity is a phenomenal 29.2%. Remember these numbers, because they become important when considering the long-term viability of small-cap software investments.

For example…

On Feb. 3, Ascential Software Corp. announced results for the fourth quarter. For this provider of software for sharing data across large corporations, revenue surged 21%, to $78.2 million, from $64.5 million in the same period of 2003, while net income plunged. For the fourth quarter, Ascential’s net income was $2.4 million, versus $17.3 million for
the fourth quarter of 2003 — a decline of 86.1%.

If you look at the company’s third-quarter 2004 results, its revenues rose 47%, to $67.6 million, from the same year-ago period. Net income increased 235.3% to $2.3 million from a $1.7 million loss posted in the third quarter of 2003.

The company’s second-quarter 2004 revenue was $64.7 million, up 62% from $39.9 million in the second quarter of 2003. Net income was $1.2 million, compared with net income of $700,000 in the second quarter of 2003 — or up 71.4%

But check out Ascential’s return on equity and return on assets. Its ROE is a crummy 2%, while its ROA is 1.59% (ouch).

Now, before you accuse me of making an apples-to-oranges comparison, this is highly justifiable when you transpose it to Ascential’s stock performance. The 52-week change for the stock is MINUS 33.7%.

Informatica Corp. is another shocker. The small-cap company sells data integration software that helps companies make their information more useful across systems that would otherwise be incompatible.

Informatica’s revenues for the fourth quarter of 2004 were $60 million, up 6.8% from the $55.9 million recorded for the same quarter in 2003. That’s certainly better than a poke in the eye with sharp stick, which awaits you when you read that the company’s net loss for the quarter was a whopping $105.8 million — a 97% drop from the $3.2 million net income posted for the same period in 2003.

Informatica’s revenues for the third quarter of 2004 were $52.4 million, up 3.4% compared with $50.6 million recorded in the third quarter of 2003. The company widened its net loss by an astounding 2,766.7%, to $8.6 million, from a net loss of $300,000 for the same period.

For the second quarter of last year, revenues were $53 million, a 4.5% increase from the $50.6 million posted in the second quarter of 2003. Net income for the second quarter was $1 million, down 69.7% from the $3.3 million in Informatica’s second quarter of 2003.

But comparatively, Informatica had a pretty good first quarter 2004. That’s when revenues had surged 10.7%, to $54.2 million, from $48.4 million in the same quarter the year before. The first quarter’s net income was $1.9 million, up an impressive 90% over $1 million during the first quarter of 2003.

As Informatica’s performance slipped last year, so did its return on assets, which was a miserable minus 27.1%, and its return on equity, a minus 42.6%. The company’s 52-week stock performance is a negative 21.5%. This is black hole territory, folks.

In examining the ROE and ROA of these small-cap software ventures, the story that comes out is of two companies reduced to competing on price and features — at a LOSS.

Informatica and Ascential are representative of small-cap software companies that were launched and went public before seismic shifts in the industry wrecked their strategies, business models and balance sheets.

Facing eroding margins, buyer’s remorse and angry customers, small-cap software companies providing front- and back-office solutions have found themselves in the crusher. The demolition will be long and painful — with their ROE and ROA taking the brunt of it.

So when it comes to investing in small-cap software companies, the first thing you should do is turn off your computer…and then grab a cup of coffee.

Happy investing,

Irwin Greenstein

February 11, 2005

James Boric

James Boric began his finance career by successfully picking winning stocks. With time and experience, James realized his goal- to figure out how an average, everyday investor with little capital could become wealthy. The trick, he discovered, was to look to the quickest moving, most exciting and lucrative group of stocks in Wall Street history — small-caps.

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