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.

It worked for the stockbrokers who used it to bring in hundreds of millions of dollars in client assets. It worked for their clients, too, who were making an average 17.7% per year following this system. And on top of being profitable, it had the extra-added bonus of being extremely easy to follow.

All you had to do was look at the 30 industrial companies that make up the Dow Jones Industrial Average. By selecting the 10 Dow stocks of the 30 with the highest dividend yields, the five cheapest of that bunch — according to the system — represented the best values amongst this high quality group.

It was called the “Dogs of the Dow” Strategy.

It was simple. Of the Dow 30, the five cheapest of the 10 highest yielders were the ones to buy — and hold — for one year. In one year’s time — the “anniversary day” of the day you bought them — you took all of the dividends those stocks paid you, sold the original Dow 5, and rolled all of that money into the new Dow 5. The beauty of the system was that the money you invested at the beginning appreciated, and along with the dividend income, allowed you to buy even more stock in next year’s five.

Simple, right? It was. And it worked for years.

Eventually, though, as with many successful stock market strategies, it collapsed under its own weight. Once “everyone” knew the secret, it got harder and harder to make a profit doing it.

I have a strategy designed to harness the power of small-cap stocks — and I’m confident that it could be just as successful as Dogs once was. And right now, only a few people know about it. But before we get into that, let’s check out another great stock market system…

Joel Greenblatt, Founder and Managing Partner at Gotham Capital, has his own strategy he calls the “magic formula.” Using this formula over the last 17 years, you would have beaten the market in every single three-year period since 1988, turning $11,000 into over $1 million.

Greenblatt’s formula is remarkably simple: He devised a point system ranking the companies with the best earnings yields and returns on invested capital. He then invests in the companies with the highest scores.

Your own system doesn’t have to be complicated; it just needs to keep you on track. The reason I recommend you use a set strategy for your investments is simple: It trumps your emotions. If you have a system in place, you won’t rush to your broker to buy every “hot stock” on the market or carelessly sell a lagging stock because it feels like the right time.

Taking your emotions out of your investing is the perfect way to avoid making the most common mistakes of every other investor out there — buying high and selling low. You know how it works: You get a tip from the television/a friend/a co-worker, you buy the stock when everyone else is buying, and the price drops a few months later and you sell for a loss.

Not anymore…

I’ve been busily perfecting a 10-point small-cap stockpicking system and its 10-point screen for more than a year now. And while it’s tough to improve on a screen that’s been so successful in the past, I’m still working to adapt it to flag stocks that could produce the biggest gains.

I’ve wanted to share this with you for some time now, but I refused to publish it until it was near perfection. It’s taken many early morning brainstorming sessions and plenty of coffee, but I’m confident that this system has the potential to open your small-cap portfolios to the best (and most overlooked) companies out there.

Here are the nuts and bolts:

1. Market capitalization must be less than $1.5 billion — We’re only interested in the smallest, fastest growing companies on the market.
2. Must trade on a major exchange — We’ll only be looking at stocks that are easy to buy and provide timely financial updates to investors. Stocks listed on the NYSE, NASDAQ and AMEX are held accountable for their financial practices, so you can be sure you’re getting a fair look at the financials.
3. Share price must be $10 or less — Let’s look at stocks that are affordable for every investor to buy a reasonable position.
4. The stock must exceed $1 million in trading volume every day — We want to look at liquid stocks that don’t experience wild price fluctuations.
5. Revenue growth should be up year over year — As I mentioned before, we’re searching for fast-growing companies that can show us massive gains.
6. Net income must be up year over year — The business should be making money and keeping it.
7. Gross profit margin should be up year over year — Don’t forget, the business should be improving its margins along with its sales.
8. Price/Sales should be less than 1.5 — A company trading at a price close to its sales could be undervalued.
9. Price/Book should be less than 1.5 — Again, a company trading near its book value could be undervalued by the Street.
10. Price/Earnings should be less than 25 — We don’t want to be chasing after stocks that could already be overvalued by investors.

Those are the criteria. However, the system I use to make my picks is proprietary. The good news is that my readers are the sole beneficiaries of my work. I don’t have to answer to investment bankers or institutional traders and salespeople. My job is simply to make the best recommendations possible, and publish them for you.

This screen is so selective that it only yielded six companies. That’s six out of the 5,585 public companies with market caps under $1.5 billion. The system is obviously very selective — and it should be. After all, in order to maximize your returns, you’ll need to find the fastest-growing, undervalued, “underground” stocks on the Street. Then you can ditch your broker and laugh all the way to the bank…

I’ll break some of them down for you next week, as well as the origins of this successful system and where you’ll be able to find it in the near future.

Until then,
Gunner
October 23, 2006
P.S.: You have only seven more days to secure your copy of a brand new, 8-page report with the next two stocks that are set to outpace the markets by 19-fold or more. The report will come out at 11:00 a.m. sharp on November 1 and will never be re-published.

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

*** Who say’s there’s no way to make money in this ugly market? Yes, it’s true the major indexes have been trending lower since January. Yes, it’s true oil prices have skyrocketed to over $54 a barrel this week. And yes, it’s true the Fed has been increasing interest rates since June. But your faithful Penny Sleuth editor isn’t panicking. In fact, he’s sick and tired of listening to this crap! Despite the doom and gloom smell in the air (my office is right next to The Daily Reckoning headquarters!), there are stocks making good money — especially in the small-cap market. Take Nastech Pharmaceutical (NSTK:NASDAQ), for example…

*** Nastech, a small-cap pharmaceutical company with a market cap of less than $200 million, is up 68.3% since Sept. 24. Not bad considering the Dow Jones is down 1.4% in the same time. So why the massive rally?

*** The company announced drug giant Merck will license its nasal spray, Peptide YY3-36. Sounds like something out of a bad sci-fi movie.

*** It releases a hormone directly into your bloodstream that suppresses the feeling of being hungry. Spray, and the hunger goes away. Sounds like an absurd idea at first. But with 31% of all Americans now obese (that’s 86 million people — crikey!), you can imagine what kind of market potential this drug has. Merck is obviously excited about the opportunity. It just forked over $5 million to license Nastech’s spray. In addition, Nastech is eligible to receive up to $131 million in additional funds if certain milestones are met, up to $210 million in sales plus a percentage of royalties.

*** Folks, $5 million here, $131 million there and another $210 million down the road may not sound like a ton of money. But for a small-cap company with a market cap of $190 million, it’s huge. And that’s what’s so exciting about being a small-cap investor. It really doesn’t take a blockbuster deal to make you a nice profit. A new contract, a new drug release or a solid earnings announcement can cause a stock to shoot up — just like Nastech has in the last three weeks. Imagine making a 68% gain in less than a month. That’s the potential you get as a small-cap investor. And the longer you are willing to hold small companies like Nastech, the better your returns will be.

*** Over time, small-cap returns have far exceeded all others — including those of large, mature blue chip stocks. On average, small-cap stocks return 14% a year versus 9% for large caps. Doesn’t sound like a huge difference. But over time, it makes all the difference in the world.

*** A $1,000 investment in a basket of large-cap stocks in 1926 grew to $1.76 million by 2000. That same $1,000 invested in a group of small-cap stocks grew to $3.96 million. That, my friends, is the power of compounded interest. And if the thought of making $3.96 million isn’t enough to get you excited about being a small-cap investor, I give up!

*** Of course, not every small-cap stock is guaranteed to make you money. Let’s not go overboard. There are far more companies that go belly up than to the moon. You need to do your research before investing. You need to snoop around a company’s balance sheet. You need to look for key indicators — things like sales growth, fundamentals and insider buying by top executives. You have to do some serious detective work to be successful.

And our resident Penny Sleuth, Irwin Greenstein, is no stranger to detective work. He just got back from New York City, where he attended The Wall Street Transcript’s Small-Cap Conference. After mingling with some of the top small- cap gurus in the nation, he put together a list of four things all small-cap investors must know. Check ‘em out…

All you, Irwin…

Small-Cap Experts Gather at the Harvard Club

New Yorkers aren’t shy about expressing their opinions. Especially when it comes to two things: stocks and pizza. Every New Yorker has a favorite pizza joint, and I did, too, when I lived in the East Village during the ’70s and ’80s. So when I returned recently for The Wall Street Transcript’s Small Cap Conference in midtown Manhattan, I immediately grabbed the subway for my own slice of pizza heaven, Saint Marks Pizza. But it was gone. Swept up in a wave of yuppie redevelopment.

With Saint Marks Pizza now history, I had to find another great place. The beauty about New York pizza is that in a city of some 6,000 restaurants, a slice of pizza is one of the best values. It’s quick, hot and cheap. Being a native New Yorker, naturally I don’t take pizza by the slice lightly.

It was a gorgeous autumn evening, so in the interest of research, I decided to walk uptown to my hotel — about  2½ miles. And take my word for it, I must have passed 20 pizza joints…plenty of opportunities to find that perfect slice. I would stop in front of the window of each one, looking for a thin layer of cheese, delicate crust, sauce with a faint pinkness of sugar, a sweet fragrance wafting through the open door…and most important, who was kneading the dough and sprinkling the toppings.

When it comes to making New York pizza, you can tell the pros by the way they work. Hunched over slightly, focused on the circle of raw dough, they spread the cheese by rotating their wrist and sprinkling it through their fingers. I was almost back to the hotel, my feet aching, resigned to a New York strip steak for dinner when…

Finally, I spotted the place. It was on West 44th Street, off 6th Avenue. I entered tentatively…scrutinized the last slice of cheese pizza on the aluminum tray. The slice looked perfect. I pointed and nodded. The middle-aged guy with a moustache behind the counter nodded in acknowledgement. He slipped the slice onto a big spatula, drew open the heavy oven door and tossed it in. I got a soda. He wiped his hands on the dirty white apron to ring up the sale — $3.65. About four minutes later, the slice sat before me on a paper plate. I took that first bite…

IT WAS TOTALLY INCREDIBLE!!!!!!!

It just goes to show that research pays off. And that was the message from the experts who presented at The Wall Street Transcript’s Small Cap Conference.
For two days, Wall Street’s best small-cap analysts, fund managers and company executives met in New York’s Harvard Club and shared their expert opinions aboutthe market and, more importantly, small-cap stocks. It was the perfect setting…steeped in the finest capitalist traditions.

Over breakfast and lunch in the conference room, I managed to get quality face time with the best and brightest in the small-cap ecosphere, including Jean-Pierre Conreur, portfolio manager of the world-famous Tocqueville Small Cap Value Fund, and with one of the top small-cap attorneys on Wall Street, Bruce Strzelczyk, a partner with Eisner LLP. (Strezelczyk had some incredible insights about the impact of small-cap companies’ conformity with the Sarbanes-Oxley Act, which I’ll talk about in the near future.)

Bottom-Fishing for High Profits

The presenters at the conference were hard-core, deep-discount value investors. Sounds counterintuitive, doesn’t it — small-cap and value combined? You rarely hear the major market analysts ever refer to value stocks as anything except large, mature, blue chip stocks. But in reality, 79.1% of all the true value stocks on Wall Street right now are small-cap stocks with a market cap under $1 billion.

As one of the fund managers said, there’s nothing wrong with bottom-fishing for these true gems as long as you don’t pull up a tire. After all… Small-cap value stocks have proven to be the most lucrative stocks to own dating back to the turn of the 20th century — even more lucrative than the best large-cap stocks. Still, investing in any stocks (especially small caps) can be risky business. And no one wants to pull up a ‘tire.’ So to help you find those winners, the small-cap experts I met with in New York last week had four criteria for finding solid small-cap investments.

Here’s what they look for…

First of all, there has to be an outstanding management team. Track records are important to the sages of Wall Street…and they should be to you, too. Has a CEO already launched a new company? Can he successfully introduce major new products? If the company is in turnaround mode, has he done it before, and if so, how much money has he stuffed into shareholders’ pockets?

Once you have established a solid management team, you need to determine how the company spends its most important asset — cash.

Small-cap companies rely much more on cash than large-cap heavyweights. Becausesmall-cap companies are sometimes run on a wing and a prayer, it can be very expensive for them to borrow money…with high-interest payments draining vital resources like R&D and marketing. Check to see if a company refinanced its debt while interest rates were at historic lows…enabling the company to be smart with its cash.

When it comes to cash, one thing to look for is the current ratio. It’s a quick and dirty way to see if a company has potential liquid asset to cover short-term obligations. You can calculate this important number by dividing the current liability of debts due over the next 12 months into current assets. The number you’re looking for is greater than 1 — a margin of safety for debt service. Also check the company’s balancesheet for both cash (money in the bank) and cash flow (the amount the company spends compared to what it takes in).
The third criteria to check out in a high-quality small-cap investment is insider buying. It is one of the best indicators for future success. If management is scooping up stock at retail prices (meaning they are spending their own money to buy a larger stake in their company), something is likely pop…big time. After all, no one knows a company better than the people who run it. And when the CEO, CFO, VPs and directors are all spending their own money to buy company stock, you should pay attention. It is almost always a bullish sign.

Finally, to successfully invest in small-cap stocks, you need to pay attention to earnings. Does a company continue to meet or exceed its earnings estimates? Like it or not, the ability to successfully communicate with Wall Street is one of the most important things that a managementteam must have. Consistently meeting projections quarter after quarter says a lot about credibility, commitment and execution. A stock price (especially for a small-cap stock) can get decimated if a company disappoints Wall Street. So make sure the company you are investing in has an impeccable earnings history. After all, this will be the company that, over time, grows from small cap to mid cap and onto large cap. And that will be the stock that makes you a fortune in any market — bull or bear.

So if you really think about it, finding a great slice of New York pizza and a great small-cap investment really do have something in common. You need to establish vital criteria and follow them closely. Patience and selectivity are key to the big payoff. Because just as I searched long and hard for the right combination of cheese, crust and proper form, you need to do the same with management, earnings, insider trading and cash.

Happy investing,
Irwin Greenstein

October 15, 2004

Small-Cap Experts Gather at the Harvard Club was originally featured in the Penny Sleuth.