*** What a rally! Ever since good old George “Dubya” was elected to his second term as president, the markets have been on steroids. The Dow Jones is up 2.6% in the last couple of trading sessions. The Nasdaq is up almost 1.5%. And the often-forgotten Russell 2000 is up 2% as well. But the million-dollar question on everyone’s mind is…

How long will the rally last? And for small-cap investors, are we near the top of what could be a nasty bubble? Those are the questions both Irwin and I ponder in today’s Sleuth.

*** I reported on Tuesday that small-cap stocks are set to outpace their large-cap peers for a fifth straight year. Over that time frame, the Russell 2000 has averaged a 7.41% return for small-cap investors, compared to an annual loss of 1.3% for large-cap investors who dumped their money into the S&P 500.

So isn’t it about time for the small-cap rally to end? Let’s weigh the evidence…

Dating back to 1932, there have been six extended periods in which small-cap stocks have dominated the mighty large-caps. And it turns out the average period was 5.7 years. If you only believe in the law of averages, it seems we may be approaching the end of this recent run-up. But as your Penny Sleuth editor, I don’t rely on just one set of numbers. I like to look at the big picture.

Matthew Patsky, with Winslow Management Co., reported this past week on Forbes.com that the six small-cap runs have lasted anywhere between 3.3 years and 8.5 years.

Let’s see…8½ minus 5 is 3½. (Yes, your faithful small-cap sleuth tore up first-grade math).

Will this rally last for another 3½  years? I don’t know, dear reader. All I can do is look at the facts. And right now, small-cap stocks are still cheap compared to their larger counterparts.

*** Satya Pradhuman, a small-cap expert at Merrill Lynch, recently reported that small-cap stocks are trading for a 36% discount to large-cap stocks based on a revenue multiple. He went on to say, “In the extremes, this group has bottomed at roughly a 60% discount and peaked at almost parity. Note, current levels are roughly in line with the bottom reached in 1990, the start of the last small-cap bull market.”

As long as small-cap stocks are cheaper than anything else on the market, I expect the rally will continue. But that isn’t to say you shouldn’t be careful.

Because small-cap stocks have been generating such rich profits for so long, more and more people are getting greedy – especially people with money in their pockets. As Irwin points out below, venture capitalists raised $5.54 billion in the third quarter. That’s up 78% from the second quarter. And guess what? Irwin also found that up to 60% of the highest-risk IPOs this year have so far lost investors money. In other words…

Now is not the time to speculate in companies with no real business model, no cash and no growth. My guess is a lot of small-cap companies will come to market in the next 12 months – and most won’t be worth the ink I am using to write today’s Sleuth.

As a small-cap investor, its more important than ever to keep investing in what works – companies with growing top and bottom lines, fair multiples and a unique product line. If you are disciplined enough to stick to your guns, I can easily see fundamentally sound small-cap stocks leading the way for another three years – or more.

Only time will tell.

Until then, I have to leave my desk for a few minutes. My colleague Greg brings his pit bull puppy, Ajax, into the office every morning. Ajax perches himself on the chair next to my desk and stares at me until give him food. Luckily for him, I just gave him half of my muffin. Unfortunately for me, Ajax must have gas. Crikey! I gotta go.

All yours, Irwin…

How Not to Lose $650 Million

A new generation of small-cap companies is getting ready to invade Wall Street…and they absolutely scare the devil out of me. So I want to warn you right now: Anyone who invests in them could lose as much as $650 million – just like the last time these companies rocked the exchanges.

What are these money-losing monsters?

They are the overhyped, overvalued and overfunded companies that went bust in 2000. You know the ones I’m talking about – the dot-coms that were in fashion for a decade and then fell off the face of the Earth. Well, this new generation may not have the dot-com moniker, but they’re brought to you by the same slick venture capitalists who caused the tech wreck of the 1990s – wiping out millions of investors.

But it seems no one really cares about that anymore. Get this: In the third quarter, VCs raised $5.54 billion, or 78% more than in the second quarter. Now I know that there are no 12-step programs for reckless VCs – and that’s cause for my concern. Because flush with all that new cash, VCs are bound to go on another wild bender…that could only spell trouble for small-cap investors

Here’s why…

With the millions that VCs have raised from insurance companies, banks and other big institutional investors, they have to deliver huge profits – or they can’t go back to the well for more. At the same time, VCs have been sinking their money into increasingly perilous companies – for example, health sciences startups. So far this year, young companies involved in biotech and medical devices have absorbed 25% of all VC funding – hitting historical highs. Yet if you examine the track record of health sciences IPOs from January-August this year, 60% are trading lower than their initial offering price.

That’s not exactly sobering news. Now, with their pockets overflowing with a fresh cash infusion, things are bound to get worse. And that means by 2005 or 2006 we could see a graduating class of newfangled small-cap investments that appear too good to be true.

Sound familiar? It should. Because I’m talking about the same breed of VCs that brought us the greatest crash-and-burn investments in a century…ridiculous concept companies such as WebVan, eToys and Pets.com. Combined, those three fiascos laid waste to $650 million in the time it takes to get an MBA.

Check out the numbers…

eToys peaked at $84.25 in October 1999, then dropped to 3 cents some 18 months later. And those pitiable investors who held WebVan stock got annihilated – especially if they rode it all the way down from a high of $127.50 to a pathetic 6 cents. While Pets.com didn’t reach the rarified heights of WebVan, it plunged from $14 to 22 cents – an excruciating loss of 98.4%.

If VCs want to sink someone else’s money into lamebrained companies run by arrogant SOBs, well, as the saying goes, it’s a free country. But the reason investors got burned so badly in the late 1990s was that they strayed from the basics…from believing in the business fundamentals that make for a great new public company.

And it’s the fundamentals that we’re always emphasizing here at Penny Sleuth. In our Oct. 22 issue, James stressed, “Persistence, persistence, persistence.” But that doesn’t just mean perpetual optimism. It also means sticking with the best investment fundamentals, and by doing so, ending up a winner…big time.

As you start to see the VC graduating class of 2004 and 2005 hit the public markets within the next year or so, we’re advising that you stand firm on your investment criteria.

For example…

Look for money in the bank and a healthy cash flow. Small companies that are still developing products rely on cash. If they manage to generate sufficient profits to fund their day-to-day operations plus R&D, that helps ensure their long-term success – and profits for you.

Look for growth and value, two critical attributes that Warren Buffet said are “joined at the hip.” Growth will be driven by sold quarter-after-quarter sales. And better yet, these sales will come from increasingly larger customers. Value is rooted in one of the basic tenets of small-cap investing: that the top small-cap companies are ignored by Wall Street – depressing the stock price of a fundamentally sound company.

And look for insider buying. If you see that the people who know the company better than anyone else on the planet are spending their own hard-earned cash to buy the stock on the open market, that’s one of the best bullish indicators around – and a signal that you should consider getting in on it yourself.

When it comes to small-cap stocks, there will always be companies that are touted as overnight successes. And we know that it’s tempting to load up. But beware. If it sounds too good to be true, it is too good to be true.

Happy investing,

Irwin Greenstein

November 05, 2004

How Not to Lose $650 Million was originally featured in the Penny Sleuth.