That’s an understandable reaction. Futures are volatile, and they’re fraught with hypothetically unlimited risk. Futures have been known to wipe out multi-millionaire professional traders… so, it’s no surprise amateur investors prefer to keep their distance from them. But they’re also one of the best tools you have to predict what’s going to happen with stock prices.

Today, I want to show you how you can easily use futures to see what’s about to happen in stocks, as well as what’s on the horizon for the economy…

First off all, let’s start off with a definition: A futures contract is an agreement between two parties to exchange a specified asset at a pre-determined date for a pre-determined price. Futures have been around since the days of Aristotle, providing a way for farmers to lock in the prices of their crops ahead of time, erasing some of the uncertainty of their harvest.

If a farmer wanted to lock in a good price on his wheat crop, for instance, he could pre-sell all of that wheat to a baker with a futures contract, and avoid unforeseen price swings in the wheat market. The baker benefits too, because he’s able to lock in his wheat costs for a loaf of bread this year.

Futures are still used by major growers, but they’re not limited to soft commodities (stuff you can grow) anymore. Today, there are futures available for everything from stock indexes to interest rates to orange juice…

But I’m not suggesting that you start trading orange juice futures like Eddie Murphy and Dan Aykroyd in Trading Places. Instead, I want to show you how you can use these financial instruments as a prediction tool.

Because futures are available for financial indexes, such as the S&P 500 or the NASDAQ Composite, we can get some early insights about where the market is headed. You see, futures trade outside of normal market hours — while you have to wait until 9:30 Eastern for the NYSE to open for regular trading, futures on major stock indexes are trading almost around the clock. That means that futures prices can give you a preview of the day’s open hours in advance…

This morning, the S&P 500 opened down approximately 0.5%— but investors who were looking at futures this morning got a preview of today’s price action several hours in advance. In the real world, that sort of advance notice could be enough to tell you whether today’s going to be a good day to take on a new position, or whether a stop loss level is going to get knocked out. Having the extra time to prepare for a trade can be crucial.

To be sure, futures aren’t the only option for investors looking to get a preview of the day’s price action — pre-market trading can offer a similar glimpse at individual stocks’ likely behavior. Even so, because futures tend to be more liquid than most pre-market names, they’re a better indicator of what to expect.

Futures aren’t just good short-term predictive tools for stocks — they’re also a valuable way to preview economic data such as inflation.

Remember, futures got their start as a way to price commodities. Today, when people talk about the price of oil, gold, cattle, or timber, they’re typically talking about futures prices. Because commodities are directly related to inflation (increasing commodity/raw material prices means that you’re paying more for the goods you buy), they can be a good indicator of what’s going on with inflation…

So, if futures contracts for oil, timber, and silver are rallying, chances are that those increasing prices are going to get passed down to consumers and increase the rate of inflation. For income-focused investors, that’s an important observation; after all, high inflation eats away at the real yields you’re getting on stocks and bonds. (Of course, the opposite is true too.)

From stock prices to inflation, futures are the tool that can give you extra insights into the market. So, how do you actually use them?

While you can’t yet get futures data on popular sites like Google Finance, futures prices aren’t hard to find. If your broker offers futures trading, then they’re the best place to turn to get real time futures pricing data. Otherwise, a number of websites offer delayed futures prices for a number of different instruments (Bloomberg’s futures page is one example. StockCharts.com also offers free end-of-day charting for a number of different futures products here.)

Your preview of the market’s action may be as simple as opening your trading software, or logging onto your favorite financial site. It’s an effortless way to get advance notice if a major trading day is shaping up.

Whenever you’re planning on making a trade, I’d recommend sitting down early that morning and checking out what’s going on with E-mini S&P 500 Index Futures (if you can’t spot them right away, the ticker is usually ES or /ES depending on your data provider). If futures are pointing to an unusual open, you’ll have that much more time to plan your next move.

Even if trading futures isn’t your cup of tea, this tool can still provide a substantial amount of information to any investor. Whether you’re looking for a preview on inflation or just a jump on the morning’s open, you should add futures charts to your trading toolbox.

Cheers,

Jonas Elmerraji
for The Penny Sleuth

Preview Stock Prices Using Futures was originally featured in the Penny Sleuth.

But an announced price raise in the company’s cheapest content streaming and disc-by-mail package has attracted harsh criticism from users across the internet. Many customers are even threatening to cancel their subscriptions.

So, is this the beginning of the end of Netflix’s popularity and dominance of the movie rental biz?

Not likely.

But before I get into exactly why Netflix should continue to grow its business, let’s take a closer look at the price hike that’s created so much negative attention.

The change is in Netflix’s cheapest service level. The original plan allowed customers to stream movies over the internet and rent one DVD at a time through the mail. For $9.99 a month.

Netflix has now nixed this plan. They are forcing customers to pay $7.99 per month for a streaming-only service. And then another $7.99 per month DVD-by-mail service.

Keep in mind that most newer releases are not yet available for streaming over the internet. If a customer wants to see a movie that came out within the past couple of months, he would have to receive it by mail. So someone wishing to have the same access as the old $9.99 plan would have to fork over almost $16 per month now – that’s a 60% increase.

Despite such a drastic change, I doubt the higher priced plans will dampen Netflix’s long-term success.

Consider this: Netflix has spent the last decade squashing the competition. Alternatives are few and far between. Remember Blockbuster? Netflix crushed its entire store-based business model. Sure, Blockbuster has DVDs by mail now, but no streaming service. Despite the lack of new releases in its streaming library, Netflix still enjoys little serious competition online.

Redbox, owned by Coinstar Inc. (NASDAQ:CSTR), could be considered a more formidable competitor when it comes to new releases. The company’s automated movie rental boxes are convenient and cheap (as long as you don’t hold on to the disc very long). But again, there’s no streaming option here either.

The new releases issue is where much of the frustration lies. Customers are craving new, constantly updated streaming content— yet there’s nowhere to get it. This is the hurdle Netflix will eventually have to clear. But it’s nearly out of the company’s hands. According to the Wall Street Journal, “many studios’ films are tied up by long-term deals between the entertainment companies and traditional distributors like Time Warner Inc.’s HBO.”

A mass exodus from Netflix seems unlikely at this point— especially since customers have few comparable options. The initial shock of the price increase will eventually dissipate. Consumers will reluctantly fork over the extra money, just like they do for the much-maligned cable and satellite providers. Entertainment commands a distinct importance in American homes— and and extra $7 isn’t going to be the ultimate deal breaker.

Sincerely,

Greg Guenthner
Penny Sleuth

The Beginning of the End for Netflix? was originally featured in the Penny Sleuth.

How quickly attitudes change…

Above is the updated weekly chart of the Russell 2000 – the same graphic I’ve annotated over the past several weeks. Note the near-perfect bounce off horizontal support as bullish investors plunged head-first into the summer trading season.

During the market’s six-week slide, I wrote at length on the powerful emotions traders and investors experience during a sharp market move. By following key trading rules, I detailed how you can avoid costly mistakes during a correction. Now, it’s important to maintain a similar outlook as the market has shifted gears.

Learn how to maximize your trading profits with these three easy tips:

• Don’t chase the sold-out bulls. As the market turns sharply to the upside, fear can become a devastating emotion for traders. The fear of missing out on the big move can lead to poor trading decisions – mainly chasing overextended rallies.

You have to assume that most traders and investors had parted with many of their positions sometime during the six-week correction. As the market woke up last week, many of these same traders were probably eager to buy back many of their favorite stocks. Inevitably, we are faced with extremely overbought conditions.

When you note the initial rally is reaching overbought stages, plotting your entry by waiting for a pullback is your best bet at generating market-beating returns. Chasing the sharpest rallies is a good way to get stopped out.

• Chose your targets carefully. Even during a broad market move, it’s important to be a picky trader. Throwing money at every stock that rallies will only pad your broker’s pockets.

Consider this: more than 100 stocks trading on the NASDAQ posted new 52-week highs yesterday. But do you really think all of these names will offer you the best returns over the next several weeks?

Instead of following these huge moves, I recommend searching for stocks that have developed a prolonged uptrend (preferably a year or more) that have corrected in an orderly fashion with the broader market.

You can strike for predictable gains once the corrective downtrend is broken:

• Take partial profits after a big move. Consider locking in half you position for gains after a major rally. No matter how strong the market may appear at any given moment, you have to remember that it cannot go straight up forever.

Also, locking in profits is good for patience – as well as your attitude. Once you have taken money off the table, you are more likely to make a smart decision with your remaining position, instead of a knee-jerk reaction to a temporary market reaction.

Sincerely,

Greg Guenthner
Penny Sleuth

Don’t Get Caught In An Emotional Market was originally featured in the Penny Sleuth.

You know how high oil prices tend to create boomlets in certain businesses?

Alternative energy, small car manufacturers and the like get a boost. Aircraft suppliers may also see a boost.

Fuel is the largest expense for the airline industry – at 30% of operating costs. And the airline industry faces pressures to cut costs. Recently, the Air Transport Association forecast that the airline industry would make $4 billion this year, down 78% from last year. So there is pressure (again) to cut costs.

Airlines have already cut staffing costs. You can see this in labor costs as a percentage of operating costs. They now stand at about a quarter of costs compared to 35% in 2001. Airlines have also been smarter about pricing and routes, as airfare rates have stayed up.

The big opportunity for the airline industry, though, is to cut into that fuel cost number. The way to do that is with more fuel-efficient aircraft. A new A320, for instance, saves more than 25% on fuel costs compared with the older MD-80.

The old workhorses of the fleet, such as the 737s an 757s, also are lacking in fuel-efficiency.

What’s also interesting here is that the airline industry also has scrimped on investing in new planes. In fact, the world’s 50 largest airlines spent only 8% of sales on new aircrafts. That is the lowest total in a decade. I’d bet that number climbs in the next few years.

But there is an even more compelling reason to like aircraft suppliers. Actually, there are 33,500 reasons…

Boeing recently put out its long-term forecast for aircraft for the next two decades. This is a much-watched and commented-on forecast, as Boeing has as good an insight into the backlog of the industry as anyone.

They project that passenger traffic will triple by 2030 and the number of commercial aircraft will double. They estimate this will create a market need for 33,500 new planes.

The tab: $4 trillion.

Where is the growth coming from? I’m sure you could guess, and it fits well into our World Right Side Up thesis.

The idea behind the World Right Side Up is that the very large gap between emerging markets and developed markets is closing and will continue to close. We’re seeing this gap shrink now in aerospace.

Twenty years ago, 72% of all air traffic was on carriers from North America or Europe. Today, only 55% is. Boeing forecasts that figure will fall to 40% by 2030. It’s a different world than the one we knew in the 20th century. It will also create new and different opportunity sets for investors.

Boeing’s forecast is still a forecast and it could be wrong, as all such forecasts can be. But if it is wrong in the particulars, I think it will prove directionally accurate. Meaning, we’re going to need a lot more planes, and that creates a nice tail wind for a certain flock of businesses.

I tend to favor the suppliers over the manufacturers, as some of suppliers have better growth prospects and upside potential.

I continue to follow a group of aerospace-related stocks. I think it’s an attractive lot… and if the projections pans out, investors that take action could see large profits in the future.

[The Sleuth’s Note: You can start researching this sector too. Google Finance has some coverage of companies in this sector here. If the aerospace-related companies take off, you could add some real wealth to your portfolio.]

Sincerely,

Chris Mayer
Penny Sleuth

33,500 Reasons to Like Aircraft Suppliers was originally featured in the Penny Sleuth.

• Do your homework. The more charts you look at on a nightly basis, the better prepared you will be when the morning bell rings. I recommend familiarizing yourself with as many charts as possible, then assembling a short, manageable watch list from your trading universe. Starting your trading day with 30 or 40 stocks to watch just creates confusion— and increases the chance that you will miss a big mover.

If you consistently review charts and screen for relevant criteria every night, your stock vocabulary will increase as the months go by. Familiar names will begin to appear and reappear in your screens, and you’ll even get to know how certain stocks and sectors “behave” relative to their counterparts. This experience is invaluable, especially when it comes to making quick trading decisions. Once you begin to recognized stocks that made large runs in the recent past, you’ll be able to spot a new move and capitalize on it right away.

• Identify manipulated stocks. Some charts are too good to be true. When you see a perfect penny stock chart, you might be looking at a promoted stock. Promoted stocks can produce spectacular runs. But they all end the same way: the stock crashes, sometimes losing as much as half its value in just a few hours.

Anytime you come across a great looking OTC stock, you should run a quick Google search to see if anyone is promoting it. The promotions are fairly easy to spot, since they prominently feature the company’s ticker and boast outlandish “price targets.”

You can, however, still book strong gains with manipulated stocks. You just have to trade them carefully. There are several things you have to watch out for when trading them. One of them is the controlled shakeout. The shakeout is not the “dump” that so many people associate with pump and dump stocks. With a promoted stock, you never know when the dump is coming, but you know it when you see it. A dump occurs after the manipulation had ended. There’s no more support from whoever was involved in the pump, therefore no one left to support the inflated stock price with additional buying. When the dump happens, shares fall far and fast.

Controlled shakeouts happen when the stock loses a few points and then miraculously finds support. Manipulators usually walk the price back up by the afternoon or the very next day. The purpose of this move is to “shake out” weak hands and large positions, and to attract early short sellers. This can result in a short squeeze once the rise is restarted, producing a significant pop in share prices.

• Don’t force your trades. Sometimes the market will work against you. Most or all of the picks from your watch list might open in the red due to a weak market. If this is the case, don’t force a trade. You don’t always have to be trading. In fact, a few carefully selected trades per months usually perform better than throwing darts. You have to pay your broker every time you buy and sell—so make all of your trades count.

If several of your potential momentum plays do open in the red on any given trading day, you should still keep an eye on them. Sometimes after morning profit taking, the stock will rebound into the green. This is a powerful technical move that can ignite a major surge in the share price. Buying when a stock moves from red to green is a great risk/reward play that many successful traders look for.

Sincerely,
Greg Guenthner
Penny Sleuth

March 23, 2011

How to Play Small Momentum Stocks was originally featured in the Penny Sleuth.

Over the past several weeks, I’ve written a great deal on strategies to help you manage your trades, along with set-ups to avoid as the market became overheated.

Today, I want to expand on this theme by discussing an ideal risk vs. reward trade. By incorporating this setup into your scans, I can all but guarantee that you will increase your winning percentage by limiting your trading to only the most favorable opportunities on the market.

We’re all aware that stocks will not go up indefinitely. Even the strongest uptrend needs a break to properly consolidate. You need to be able to find and exploit the best consolidation set-ups in order to successfully navigate current market conditions. These are the stocks that have the best chance at continuing their uptrends when the market rights itself. In order to help you properly identify the best pullbacks of uptrending stocks, I’ve listed some important tips below.

For our example setup, take a look at the following chart snippet:

First, I want you to note the moving averages. In this example, I’ve added the 10- (green), 20- (red) and 50-day (blue) moving averages. When planning a pullback trade, you always want to find the short-term moving average that the stock obeys.

Aside from a sharp break in November that quickly recovered, you can see that this particular stock is obeying its 20-day moving average. With this important point identified, we can use the moving average as a guide for our entry and stop loss.

Now that the uptrend’s support has been established, you have to examine the trading volume to ensure the stock is consolidating properly. Ideally, you are going to want a stock that shows fading volume as it retraces toward support (red lines). If you see any big red volume bars, you might want to reconsider the trade. For this strategy, the volume pattern is just as important as the price action.

In order to pinpoint the right time to buy, simply wait out the consolidation pattern. Your buy signal will occur on the day that the stock bounces off support (blue arrows) on higher relative volume (blue circles). In our example, there are two strong buy indicators flashing in December.

All that remains is setting your stop loss just a few cents below support—which in our example is the 20-day moving average. A low-risk trade following our example is the perfect maneuver in this choppy market. It gives you the opportunity to set a tight stop loss while reaping the benefits of a strong stock bouncing off support.

Sincerely,
Greg Guenthner
Penny Sleuth

February 2, 2011

Choppy Market Trading Strategies: Play the Pullback was originally featured in the Penny Sleuth.

When you break down the one, three and five-year returns of the 53 most established world markets, the results are appalling:

Again, I ask: How much money are you really making if your portfolio “beats” the market?

Take the S&P…the world’s benchmark index. Beating the S&P has become like a golfing handicap, a number that gets bandied about (and maybe embellished a point or two) to impress any financial “mind” polite enough to listen.

The reason is simple… For most, investing has become a game…a competition…a proverbial fight to the finish that separates the winners from the losers.

The goal is simple…beat the S&P.

But why does the S&P serve as the lone benchmark?

What are these guys winning at our expense?

When annualized returns are stacked up against one another, beating the S&P looks about as impressive as the No. 1 seeded North Carolina Tar Heels blowing out the No. 16 seeded Eastern Kentucky Colonels in the opening round of the NCAA tournament.

When an emerging markets manager pounds the fundraising pavement in cities like New York, Chicago and San Francisco, why must he validate his investing success relative to one particular market?

And why do we applaud an achievement that has zero correlation to the underlying investment in question?  If Taipan Capital Management’s 20% return stems from six small-cap Thai stocks, why should we care if these returns beat the American index?

That’s a mistake.

You see, over the past couple of years, more and more Americans have been shifting a larger percentage of their portfolios into foreign stocks. But they still judge their returns relative to what they would have earned here on the NYSE.

And the ones brave enough to open the Financial Times and scan the world equity markets section rarely shift their eyes much further than the G-7.

We need to take a closer look… What other infamous markets remain absent from these lists?

China appears only once.

India and Japan never even crack the top 10.

And what about Hong Kong, Germany or the U.K.?

There nowhere to be seen either.

Instead, we find countries like Egypt, Pakistan and Colombia boasting annual returns well over 50%!

For better or for worse, the markets are global today.

If a private investor in Belgium…or a money manager in Germany has made 80% investing on the Cairo exchange, then that’s the standard that Wall Street should be measuring itself against, not the 9.82% five-year return of U.S. exchanges.

It’s time for a different benchmark of success, whether we like it or not…

That’s why we’re launching a new research service that provides a more global view on investing and on the financial markets.

By just focusing on the U.S. and U.S. exchanges, we’re limiting ourselves to less than 50% of the investing opportunities in the world.

Meanwhile, our friends in Germany and Belgium are getting ahead, at our expense.

This service will grant you access to the best performing stock markets in the world. And to keep things simple, we’ll stick to securities that are traded right here at home.

So if you’re content riding the 52nd best market over the past five years, this service may not be for you. But those looking for an edge… Those that want their money to work for them, global markets are the place to be, bar none.

Until Next Time,
Christopher Hancock
March 23, 2007

P.S.: Get ready for the worst property-led recession of the last 76 years. Nobody’s money is safe. The “Second Wave” housing tsunami of 2007-2011 is about to hit, and smart investors are already battening down the hatches.

Benchmarks for Global Markets was originally featured in the Penny Sleuth.

“There is no great mystery in this matter,” he said, taking the cup of tea which I had poured out for him; “the facts appear to admit of only one explanation.”

“What! You have solved it already?”

“Well, that would be too much to say. I have discovered a suggestive fact, that is all. It is, however, very suggestive.”

- Sir Arthur Conan Doyle, The Sign of the Four

The greatest investment ideas often turn on a simple insight. Yet the simple insights are hard to find, which makes them rare and special. Useless information and noise often obscure them, like a carapace of barnacles stuck on the hull of a ship.

The origin of a good investment idea often begins when an investor has scraped away what doesn’t matter and has found what lies beneath. A simple “suggestive fact,” as Sherlock Holmes would say. The search for suggestive facts is worldwide and crosses many boundaries.

A hardscrabble camel dealer with 20 years in the business in the dusty outskirts of Cairo knows a few very good things about camels. He is easily able to separate what really matters from what is not so important. He is hard to fool with predictions and fancy talk. He knows what he is looking for and he knows what he will pay for it – or sell it for.

So too does the determined and hungry gold prospector working his pans on the steamy banks of the Amazon River deep in the jungles of Brazil. There is not much you can do to throw him off. He knows exactly what he is looking for. And he knows what it is worth.

All around the world, from the fishing waters of Vietnam to the mountains of South Africa, you find gritty indomitable spirits hunting for very specific things, for suggestive facts that may lead to their next payday.

One of my favorite “suggestive facts” is when you find a big difference between what private buyers are paying for whole companies versus what people are paying in the public markets for shares of these same companies. I’ve found many such disparities – and they’ve often become recommendations for readers of my Capital & Crisis newsletter and my newer service, Mayer’s Special Situations.

For example, take a look at Pioneer Companies, Inc. (PONR: NASDAQ).

Pioneer emerged from bankruptcy in 2002, a victim of the last downcycle. New management, especially CEO Mike McGovern, took over in autumn 2002. So began a process of cost cutting and selling off non-core assets. Also, the company dramatically paid back debt such that it is essentially debt-free as I write, with no net debt. It’s a new company today. I probably don’t need to say this, but it’s pretty hard to go bankrupt again when you have no debt and lots of cash. That’s the situation Pioneer is in today.

Pioneer is the sixth largest producer of chlor-alkali products in the U.S., with 5% of the North American market (which makes up about a quarter of the global total). It has productive capacity of 725,000 electrochemical units (ECU).

In Pioneer’s capacity of 725,000 ECU is where you find the disconnect between the public markets and the private markets.

It runs about $1,000 to create one ECU of capacity. In other words, if you were going to build Pioneer’s chlor-alkali production from scratch, it would cost you about $725 million. The whole enterprise value of Pioneer right now – that’s market cap plus debt less cash – is about $340 million. So that’s a 47% discount to replacement value.

Think of it this way: If you wanted 725,000 ECU of chlor-alkali capacity – that’s about 1.5 million tons – you could build your own factories from scratch for $725 million. Plus, you know it would take time to get the whole thing running. You would need to find workers and managers and all that.

Or you could go buy Pioneer. Now, you wouldn’t be able to buy Pioneer for $340 million. But you could pay $500 million for Pioneer. That’s a 47% gain for Pioneer shareholders. That would make them happy. And you’ve saved yourself another $225 million in the process. Not to mention that you don’t have to wait – Pioneer can start producing for you right away.

That, faithful reader, is the most compelling reason to buy some shares of Pioneer.

Even if the industry tanks, you’ve still got a lot of productive capacity that someone will want for when the market gets good again. Players like Dow Chemcical are well financed. It can write the check tomorrow without batting an eye.

So you’ve got definite downside protection to help you stomach the stock market volatility. You own a real asset here. And unless chlor-alkali products somehow go out of style, you’ve got capacity, which is worth something.

The second reason to own Pioneer is that it is so cheap, both on an absolute basis and compared with peers. Granted, Pioneer is cyclical – so is the whole industry. Therefore, there does not seem to be a lot of justification for a 40% discount from peers based on cash flow and earnings. But that is what we have. Pioneer sells for less than three times trailing EBITDA. So it seems the bearishness on Pioneer is overdone.

Some discount may be warranted because Pioneer is small and there are advantages of scale. But Pioneer has decent advantages of its own.

Its Becancour facility in Quebec is a low-cost producer because of the abundance of hydropower. Pioneer’s St. Gabriel plant, in Louisiana, has three pipelines to transport chlorine to the area efficiently. Chlorine is tricky to ship. And finally, its Nevada plant, located in Henderson, is the only chlor-alkali plant in the Southwestern U.S. Now I may be going out on a limb, but I think water treatment is bound to be a hot topic in the arid Southwest.

As an aside, more than 75% of the North American production for chlor-alkali comes from the Gulf Coast region. So if another hurricane rumbles up that way, expect chlor-alkali prices to shoot up.

Finally, about a third of sales are directly tied to water treatment. These sales get the benefit of the whole water emerging crisis I’ve talked about many times in other places. In the world of specialty chemicals, most companies have some exposure to water, but it is hard to say that the broad trends in the water industry are important. Many companies have rather low exposure.

Pioneer is a company generating gobs of cash flow. For 2007, it could generate $4 per share in free cash flow. That’s a 13% cash flow yield based on a $30 stock price. This cash flow could be used to pay a dividend or buy back stock – either of which would boost the stock price. It’s also a target for the bigger fish. And if the consensus is wrong and the current chlor-alkali cycle has legs yet, this company is going to earn a lot more cash. That could also help create value in the stock.

These are the kinds of suggestive facts (as Holmes would say) I spend countless hours searching for. These little nuggets form a compelling portrait of a potentially great investment. Finding such disconnects have led to many successful investments for my readers, and myself, over my investing career.

Sincerely,
Chris Mayer
February 1, 2007

P.S.: Recently, we’ve made 50% in a water pipe company in six months, 55% in a water utility in six months and we’ve doubled our money on a shipping stock I recommended in June.

Successful Small-Cap Investment Strategies was originally featured in the Penny Sleuth.

Our routine was typical in Hong Kong’s single ex-pat scene. Young, ambitious men consistently file from the banks that line Queens Road up the hill to grab a pint(s) and swap outrageous stories detailing the “next big thing” to hit the Chinese market.

The atmosphere feels charged…someone knows something. If five minutes gets you nothing more than PetroChina or the Guaco Group, you instantly move on. Everybody has an “in” so to speak. Every banker and rouge hedge fund manager knows an angle. You sense this scene must be a replay of Wall Street in the 1920′s before the SEC and men like Elliot Spitzer rode into town.

When the clock struck 4:00am and the band at Dusk Till Dawn started to slow, Ted and I decided it was time to hang our hats. So back up the hill we went…Staunton Street was our destination.

I dropped to my bed fully dressed. Two hours of rock hard sleep passed when I woke up with a thirst that only multiple pints of the infamous Stella Artois could produce. I stumbled into the kitchen and checked out the fridge. All the water bottles were gone. This was not good.

At that moment, I would have walked to Shanghai for a bottle of water. But alas, even in a city of seven million, there wasn’t a bottle to be found. The 7-11′s are literally seven to eleven.

Desperation took over. Reason bowed to emotion. I stared at the sink with a squinting eye…is the tap water that bad? What are the chances? I mean, how dangerous could it actually be? The Chinese have relied on this water for decades.

Every time I leave the United States, my father always warns me to not drink from the domestic water supply… For a man whose dedicated a good portion of his life to municipal water projects, I chalked up this cautionary counsel as nothing more than professional hubris. Because at that point, any liquid short of maple syrup would have sufficed.

So without hesitation, I flipped up the tap, inserted my plastic bottle, and took down 32 ounces of Hong Kong’s finest.

What relief. After a couple more sips, I marched back bed to sleep off the last few minutes of darkness.

In fact, those were the last few minutes of any sort of respectable comfort your humble editor would experience for quite some time. Within an hour I was sprinting for the bathroom. The intensity of the pain rivaled the moment I crushed my left kidney under the axel of a John Deere hay wagon a few years back. Words don’t do this agony justice.

I’m serious… Really, I’m not kidding. In retrospect, it’s quite comical. But after two straight days of 20+ trips to the bathroom, I started to get a tad worried. Four days passed, no relief. I had no choice. Back in the red taxi I jumped. The nearest Hong Kong hospital was the destination.

The doctor spoke no English…not even a hello. Imagine trying to tell him your name is Kif.

After five minutes of pointing to every orifice on my shriveled, pale stricken excuse for a living corpse, he nodded his head and smiled. “Glad you find it funny,” I said. He kept smiling. Bastard.

He said something in Cantonese and left the room. Two minutes later I had a pack of pills. Now bear with me. If a mere thirty-two ounces of the local tap water did this, who in their right mind would accept an unmarked bag of white pills from a non-English speaking man whose credentials as a licensed M.D. were nothing more than a white lab coat and a stainless steel clipboard?

Someone with a mild case of dysentery, that’s who! It couldn’t get any worse. I thanked him, handed over the co-pay, and headed for home.

By the kind grace of God the pills started to work. The paid receded. Seven days later I was walking the streets of Soho once again.

The point: Clean water is a scarce resource in many parts of the world, especially China. Even in a city as cosmopolitan as Hong Kong, something so common to Americans as clean running water is one part of the American dream most countries can’t import.

I say this because the rising struggle for potable water has the potential to escalate to a magnitude similar to the current geopolitical conflicts over energy security.

China in particular has major problems. As Financial Times writer and author James Kynge points out: “Streams and rivers are drying up all over the northern half of the country, and water tables are falling precipitously as well, many of them illegally dug, are sunk even deeper into dwindling reserves of groundwater. Altogether, some 400 our of 668 large Chinese cities are short of water, and the incidence of rationing is growing.”

And what water does exist remains highly contaminated. The Chinese industrial machine spews around six hundred tons of mercury into the air each year, accounting for nearly one-quarter of the world’s non-natural emissions.1

Chinese mercury emissions are so destructively ubiquitous that the United States Environmental Protection Agency has warned that a third of the nation’s lakes and a quarter of its rivers are now so polluted with mercury that children and pregnant women are advised to limit or avoid eating fish caught there. One-third of that mercury comes from China.2

Readers of The Economist may recall a small blurb in the December issue highlighting Beijing’s appetite to fund the world’s largest artificial rainmaking program. That’s right… the Chinese government has entered the business of controlling the weather. The method: “weather-modification offices” dispatch rocket-launchers and airplanes loaded with silver iodide directly into the dilapidated clouds themselves. Peppering these clouds with this particular mixture theoretically enhances the probability that rain droplets will form and fall on the parched Chinese soil.

The real fear for Chinese officials isn’t so much water to drink; but more importantly, they need more and more water to irrigate the massive food supply needed to feed roughly one-fifth of all humanity. Around half of China’s landmass is uninhabited, so what farmland they do have must be utilized to its full capacity.

Above all political and economic ambitions lay the fundamental need for domestic stability. China can’t afford another famine. You see, for many Americans, the sole Asian tragedy of the 1960s was the Vietnam War. But less we forget the famine that followed Mao’s Great Leap Forward claimed the lives of more than 30 million Chinese.

And the 1960′s famine piggybacked a similar disaster a mere twenty years prior when some three million peasants in Henan died of starvation.

While most pundits illustrate China’s burning desire to scour the earth for oil, most fail to mention the fluid natural resource the Chinese need even more: water.

For investors, the day when water stocks steal the headlines from energy stocks may not be too far off. For many, that may be hard to imagine…especially those who live in regions of the world where and endless supply of fresh running water is just a faucet away.

But for those whose history with drought and starvation in the last century alone entails the loss of life of nearly 40 million of its own people, potable water becomes just as precious as the air we breathe.

I’ve touched on this theme before…and you’ll see it come up time and again here and in other publications I’m sure. My recommendation at this point is to keep our eye out for potential solutions. Will the Chinese buy millions of acres of South American arable land? Will water infrastructure be the next big thing for multi-national’s like GE and Siemens? Who’s to say?

But one thing is for certain. The world conveniently churned along for many years without abundant stockpiles of oil. However, that same world has never survived a single year without abundant stockpiles of water.

Sincerely,
Christopher Hancock
January 19, 2007

P.S.: Last year in the water industry, there were nine major takeovers. This company, with its small $300 million market cap, is a perfect candidate to be next in line.

1 James Kynge, China Shake the World: A Titan’s Rise and troubled Future – and the Challenge for America (New York: Houghton Mifflin Company, 2006) pg 152.

2 Ibid

Small-Cap vs. Large-Cap Returns in 2007 was originally featured in the Penny Sleuth.

They all went on to rise between 6,184-23,666%. And today, Price’s company manages over $269 billion in assets.

Jim Oberweis, a famous portfolio manager from Chicago, used the same investment strategy that Price did. Since 1987, his flagship fund has averaged a 12.48% gain. A $10,000 investment with Oberweis in 1987 is now worth $111,833.

The investment strategy that made both of these men (and their investors) wealthy many times over is known as GARP — growth at a reasonable price.

GARP combines value and growth investing into one neat little package. A GARP investor wants to own high-growth companies. But he doesn’t want to overpay for the right to own that growth. For instance…

Price bought companies with expanding profit margins, quarter-over-quarter sales increases and a history of accelerated earnings growth (both year over year and quarter over quarter). If a company met these requirements, he wasn’t so concerned if it happened to have a high P/E ratio or not. The theory was simple…

If a company was growing quickly enough, it would narrow the gap between earnings and price over time.

Oberweis has a similar, but more stringent, philosophy. As he said in an interview a few years ago, “We’re looking to buy companies for a P/E not higher than half the rate of growth. So if a company is growing at 50% annually, we don’t want to pay a P/E higher than about 25.”

In addition to buying growth companies for a reasonable price to earnings, Oberweis also insisted on:

1. Rapid earnings growth
2. Future growth potential
3. Earnings acceleration
4. Low relative price/sales ratio
5. Quality earnings
6. Top quartile of relative strength
7. Rapid revenue growth

These criteria make up what Jim calls his “Oberweis Octagon.” Each investment decision must pass his octagon test before it makes it into his portfolio. And while the name is somewhat silly, the results he has racked up are nothing to snicker at. Some people would sell their firstborn son for a 12% annual return over 19 years.

So what stocks might Price and Oberweis buy today?

To answer that, I created a GARP screen of my own (based on both Price’s and Oberweis’ investment criteria). I looked for:

1. Market capitalization of $1.5 billion or less
2. Net profit margin had to improve in each of the last two years
3. Earnings per share growth of 25% or more in each of the last two years
4. Sales growth of 25% or more in the last two years
5. Quarter-over-quarter sales growth
6. P/E of 40 or less
7. Relative strength in upper quartile

Only five companies came up on this GARP screen. They are:

• American Oriental Bioengineering, Inc. (AOB:AMEX)
• Epicor Software Corp. (EPIC:NASDAQ)
• First Regional Bancorp (FRGB:NASDAQ)
• Pinnacle Financial Partners (PNFP:NASDAQ)
• TALX Corp. (TALX:NASDAQ)

(Note: All of these stocks rank in the upper quartile in terms of relative strength.)

If you are looking for a short list of growth stocks at reasonable prices, I would start here. Each of these companies has awesome growth numbers. And unlike many so-called growth opportunities, these actually have real earnings and improving profit margins to boot. That says they have established products, services or brands that command premium prices. It also says management runs the business with the shareholder in mind.

That is a rare combination on Wall Street these days. Just remember one thing if you decide to invest with a GARP bent…

Both Oberweis and Price made their fortunes by holding onto their stocks for years, not months or weeks. You don’t walk away with 23,000% gains in a few weeks. As Price once famously declared:

“Buy stocks of growing businesses, managed by people of vision, who understand significant social and economic trends and who are preparing for the future through intelligent R&D. Sell when the company no longer meets your buying criteria.”

Good investing,
James
October 26, 2006

P.S.: Jim Oberweis is still alive and kicking. In case you are interested in the top holdings in his Emerging Growth Fund, here they are:

1. Focus Media Holding (FMCN:NASDAQ)
2. Ceradyne (CRDN:NASDAQ)
3. Carrizo Oil and Gas (CRZO:NASDAQ)
4. aQuantive (AQNT:NASDAQ)
5. Aspreva Pharmaceuticals (ASPV:NASDAQ)

Investment Strategies of Famous Investors was originally featured in the Penny Sleuth.