2 Small-Cap Plays for 2006

A close friend of mine, Ray, works down the street from us at T. Rowe Price in Baltimore. Yesterday, over dinner he told me about an incident that happened a few years ago. Ray was at an investment conference in Chicago. Some of today’s top investment bankers and financial analysts were in attendance.

At 9 a.m., all the delegates gathered in a huge hall for breakfast. The long oak tables were decorated with baskets of fruit and the smell of fresh brewed coffee wafted in the air. It was unusually loud for a gathering of 40-something Wall Street types.

Ray, holding his orange juice, tried to navigate through the crowd. He hoped to find a seat at a quieter table. He found a spot and put his orange juice down. Ray pulled his chair out and settled down beside a man with a pink tie. The man had brown hair parted to the left and a neatly trimmed mustache.

Ray and the man got to talking. Like all financial people, they spoke about the economy, interest rates, real estate, the yield curve and Alan Greenspan’s monetary policy. Ray was enjoying himself; it was a stimulating conversation.

After breakfast, when Ray was ready to leave, he realized he was so into the conversation he hadn’t introduced himself.

“I’m Ray from T. Rowe Price by the way,” he said, offering a handshake.

“Bill Gross,” said the smiling man.

Bill Gross’ Investment Ideas: Bill Gross

Even today, Ray goes red with embarrassment, thinking of the event. Last night at the dinner table, an animated Ray was recounting the incident, “I had BREAKFAST with Bill Gross and didn’t know it!!” Then he put it another way: “I had breakfast with BILL GROSS and didn’t know it!!”

Both versions sounded equally embarrassing.

Bill Gross might be a humble man, but he is one of the smartest investors around. And when it comes to spotting macroeconomic trends, nobody can beat Bill. He is the director of PIMCO Bonds and is often called the “Warren Buffett of bonds.” Gross’ fund, the PIMCO Total Return Fund, has beat 95% of its peers this year. And through the fund, he manages a massive $88 billion asset pool.

Now, I’m not suggesting you go out and invest in bonds. We’ll stick to what we do best — small-cap investing. We will take Bill Gross’ macro ideas and turn them into small-cap stock picks for 2006. So keep reading…

In his June 2005 investment outlook (which is a must-read for any serious investor and can be found online at www.pimco.com), Bill Gross makes this prediction: “At some point it comes undone, either through a massive revaluation and dollar decline, a Treasury buyer’s boycott or a whimpering U.S. consumer beaten down by the cost and/or amount of their burgeoning leverage — much of which is housing related.”

In plain English, Bill Gross is predicting the following events:

1)    The U.S dollar will fall.
2)    The housing boom will cool off.

 It’s as simple as that. Since 2000, the U.S. dollar has fallen 26% against the euro due to concerns about a growing trade deficit. As for the housing boom, huge players like Toll Brothers have already announced that their 2006 earnings will miss Wall Street expectations, and 2007 looks even worse.

As a small-cap investor, here is how you can play Bill Gross’ predictions:

1) Buy small-cap gold. When the dollar falls, investors flee to gold. As a result, gold prices will go up. Since the year 2000, the dollar slid 26%. During the same time period, gold gained an incredible 69.6%. This is great news for gold stocks. In fact, it bodes even better for small-cap gold stocks that move up higher than their large-cap counterparts when gold prices increase.

Canadian gold exploration company Seabridge Gold (SA: AMEX) is trading for $6.82. Since May of 2005, Seabridge’s stock has gained an impressive 241%. Larger competitors like Barrick Gold have risen just 28.1% during the same period. That is your advantage as a small-cap investor — by investing in small-cap gold stocks, not only do you benefit from the dollar decline, you also make 10 TIMES more money compared to large-cap gold stocks.

2) Short small-cap real estate. And just like how by going small-cap you have an advantage on the upside, you also have an advantage while shorting small-cap stocks. You see, just like how small-cap stocks go up more, they also fall harder. And Bill Gross is expecting real estate stocks to fall. That means small-cap real estate stocks will fall further than your average real estate stock.

That is great news for you. The more a stock falls, the more gains your short position will make! Take Heartland Partners LP, for example, a tiny company dealing in selling its existing properties in Illinois, Minnesota and nine other states. In the last year, the stock has plummeted nearly 79.25%. Competitors like Toll Brothers have fallen just 27%. Clearly a short position in a small-cap real estate stock would have been more profitable.

In Bill Gross’ own words, “Housing prices will cool/stop going up very much/even go down in some cities, WHEN…

“a. Interest rates rise to a high enough level to make the purchase of a new home a burden instead of a boon for first-time buyers.

“b. Mild regulatory pressure begins to reduce the amount of funny-money lending.

“c. Speculators sniff the beginning of the end.

“Let me state categorically that the above sequence is barely questionable, almost inevitable, 99% unavoidable and in modern parlance — ‘slam-dunk.’”

Regards,

Sala Kannan
December 8, 2005

Bill Gross’ Investment Ideas: How to Invest Like Bill Gross was originally featured in the Penny Sleuth.

*** Just as I warned last week, small-cap stocks have taken the brunt of the beating in recent trading sessions. Yesterday, $717 million flowed OUT of small-cap ETFs. Couple that with the $480 million that was yanked out last week, and we are just barely net positive since the beginning of December. As a result, the Russell 2000 has already given back nearly half of last year’s 17% gains.

So where are investors putting their money right now?

I looked through all the major ETF funds this morning — noting where the largest inflows were gathering (where major hedge funds and institutions were putting their money). And here’s what I found…

Global international funds, value funds, gold funds and large caps are among the early winners in January. They have collected $230 million, $273 million, $386 million and $456 million, respectively — which should come as no surprise to you.

In the last Penny Sleuth of 2004, I wrote, “From a value perspective, small-cap stocks have almost caught up to their large-cap mates. And when that happens, investors will likely take money out of the small-cap market and invest in larger, less volatile companies.”

I went on to predict that…

– It would be the boring companies with solid fundamentals and 10-25% growth rates that outperform the rest of the market

– Investors with the patience to follow the insiders would beat the rank-and-file investors who blindly invest in the same kinds of stocks that rose big in 2004

– And emerging markets (places like Mexico and India) would beat the major U.S. indexes — hands down.

These predictions are already coming true. Folks are taking money out of speculative companies and investing it in international companies, value funds and gold. Expect this trend to continue well into 2005.

Remember, as a small-cap investor, this is NOT a time to sell the farm. Please don’t get me wrong. Rather, it’s a time to make sure you are holding onto solid companies (with growing businesses, lots of cash and low debt). Those companies will do just fine in the weeks, months and years to come.

And if you are looking for some specific opportunities to make some money in 2005, check this out…

*** I have been doing a lot of research (along with Penny Stock Fortunes editors Angela Roberts and Sala Kannan) on both emerging markets and gold in the last couple days — specifically the blossoming gold market in China. I thought I’d share some of our findings with you. You see, I have a feeling a lot of small-cap opportunities will arise for those who listen…

China only recently opened up its gold market to free trade — both domestically and from abroad. It created the Shanghai Gold Exchange in late 2002, which let bankers, miners, refiners and retailers trade spot gold — creating a viable gold market that never existed before in China. That means there is a ton of upside for gold in China in the coming years.

As it stands now, Chinese demand for gold on a per capita basis is very low — at just 0.16 grams. The world average is 0.7 grams per capita. And it makes sense this number is so low in China. Until very recently, people in China either weren’t allowed to buy gold, or they simply couldn’t afford it. But that is changing — quickly.

The Chinese government has since halved the consumption tax on gold — so it’s more affordable for the growing Chinese middle class to buy at retail level. And the Chinese do have more money to spend — on things like gold necklaces, rings, bars, etc.

Right now, the Chinese have $1 trillion (that’s trillion with a “T”) sitting in savings accounts. If just 0.1% of that were spent on gold (whether in the form of jewelry, bullion or even coins), the market would be flooded with $940 million!

By my calculations, $940 million would buy about 2.2 million ounces of the shiny metal! Seems like an opportunity to me. And Angela, Sala and I are all working hard to come up with some possible small-cap investment ideas for you. Stay tuned.

*** Finally, I made a bet with you last Friday. I showed you that there were 12 times more people betting the IWM (the ETF that tracks the Russell 2000) would fall than people betting it would rise. As I pointed out…when the herd thinks something is going to happen, they are usually wrong!

Turns out I was right.

A week ago, the February $123 calls on IWM were trading for $2.90. And the February $120 puts were trading for $2.35. As I type, the calls are trading between $2.95 and $3 a contract. And the puts are trading between $1.95 and $2.05.

So despite the up-and-down market, the people who went against the crowd made money. What a novel idea! Look for more novel ideas in the next Sleuth.

*** If you are looking for seven contrarian ways to make money in 2005, you have to check out my colleague Chris Mayer’s free report. Talk about going against the crowd. Chris has everything figured out — from what will happen to the U.S. dollar and the stock market to the stocks you should get rid of today! And I have a feeling he is dead on. Check him out..

http://www.agora-inc.com/reports/FST/WFSTF109

Irwin, I’ve written enough today. Take us home…

Small-Cap Railroads: Sissies Beware

Baltimore is haunted by the sprawling ruins of factories, warehouses and shipyards, many with weed-covered rail spurs that dead end in America’s golden age of manufacturing. That’s why I was shocked to learn that regional railroads, an icon of the industrial age, could provide investors with an overlooked small-cap opportunity that hit 52-week returns of 49.2%.

If you’re like me, you probably believe that American railroads have sustained a long decline into economic despair — as immortalized by country legends Johnny Cash, Jimmie Rogers and Boxcar Willie. But guess again…

Because there are more regional freight lines than ever…and many are financially robust. Called short-line railroads, they are generally used for linking regional businesses to national railroads or for hauling local loads.

Of the 545 U.S. short-line railroads, three are bona fide small-cap opportunities. They are Genesee & Wyoming, Inc., Kansas City Southern and RailAmerica, Inc. Like many successful short lines, they control local railroads in a combination of countries — typically the U.S., Latin America and Canada.

The bread and butter of the short lines is transporting commodities such as lumber, agriculture, chemical, metals, coal, minerals and petroleum products. It’s the growing demand for these commodities (plus a hidden asset that I’ll get to later) that makes them an attractive long-term play.

For example…

Short-line railroads cashed in on the housing boom of 2003-2004. In 2004, lumber output increased 4.8%, to 59.7 billion board feet, shattering a record set in 2003, according to the Western Wood Products Association. So although 2005 lumber production is expected to dip by 4.2%, to 57.2 billion board feet, that volume will be the second highest ever.

When it comes to hauling wood, Genesee & Wyoming saw its third-quarter 2004 lumber business skyrocket to 19,861 carloads from 13,652 carloads during the same period a year earlier — a boost of 45.5%. So even though 2005 lumber car loads may not be a record-breaker, think of it more as a correction than a downturn.

In addition to lumber, crude oil production could be another gusher for short-line railroads. Utility Savings & Refund LLC, an energy consulting firm, expects crude production to rise by 160,000 barrels this year over last year.

That would allow RailAmerica’s petroleum business to continue on a roll. From November 2003 to November 2004, it carried 34.3% more petroleum products. Meanwhile, Kansas City Southern’s third-quarter 2004 chemical and petroleum business rose 11.7% compared to the same period in 2003.

But while some commodities such as coal slip as a percentage of revenue, it hasn’t hurt the earnings of our three short-line railroads. Across the board, RailAmerica, Kansas City Southern, and Genesee & Wyoming have posted strong revenue gains for the third quarter 2004.

On Nov. 2, Genesee & Wyoming said its net income had risen 33.2%, to $10.1 million, compared to $7.6 million for the same period in 2003. If you think that’s impressive, check out the 158% gain by Kansas City Southern. In a press release dated Oct. 28, the company announced a net income of $11.1 million, up from $4.3 million in the third quarter of 2003.

Now before I get to RailAmerica’s third quarter numbers, I have a word of caution…

Railroads are not for sissies. They are extremely dangerous. Accidents can flatten people, villages and balance sheets. That’s why the headline on the company’s earnings press release of Oct. 28 reads “RailAmerica Reports Third Quarter 2004 Loss of 84 Cents per Share From Continuing Operations.”

RailAmerica’s revenue had actually increased 11%, to $100 million, from $89.9 million in the third quarter of 2003. But there had been a few accidents. The company set aside funds to cover repairs for a tunnel fire that could exceed the insurance deductibles. Worse, an extraordinary number of derailments had cost the company big time. While RailAmerica incurred other quarterly charges related to executive departures and debt retirement, it’s easy to see how safety mishaps can also wreck the bottom line.

But a hidden asset can act as an “insurance policy” for small-cap shareholders if these railroads suffer a reversal of fortune. And that hidden asset is in plain sight: land…

…the land under the rails and along the tracks (also known as right of ways). Wall Street analysts tend to ignore this sleeping asset, but you can figure out the value pretty easily. It involves digging into the annual report and finding a section that’s titled something like “Property, Plant and Equipment.” Then compare that to the long-term debt of the company. If it’s pretty close, that’s great, because remember that railroads have other assets, such as trains, tracks and warehouses. But land is probably the only APPRECIATING asset of them all.

For example, Kansas City Southern Railroad owns 1,025 acres of waterfront property in Port Arthur, Texas, including deep-water frontage and three docks. It also owns 5,500 acres along its routes. And RailAmerica, Inc. holds an impressive 6.4% of its assets in real estate.

So I’m glad to report that America’s railroads are not dead — by any stretch. In fact, they are very much alive as great small-cap opportunities.

I’ll keep you posted on how these small-cap railroad companies perform. But don’t be surprised if they keep rolling along.

Happy investing,

Irwin Greenstein

January 14, 2005

P.S. I just came across an amazing story about the “King of the Rails.” In 1854, this young lawyer left behind his pregnant wife to build an American fortune.

Small-Cap Railroads: Sissies Beware was originally featured in the Penny Sleuth.