*** The IPO market is hot again…opening the spigot for a flood of small-cap
opportunities in 2005. But why now? Before I answer that question, let me recap 2004′s extraordinary action.

Last year, 205 IPOs raised some $41 billion — triple the volume of 2003…and shy of the 249 in the IPO mania of 1999. Unlike the bubble years, however, companies are more financially solid: 64% of companies that went public in 2004 were already profitable, compared to 2000, when only 26% were profitable. And the average 2004 IPO has risen 30% from its offering price — the best performance since 1999. That return beat the Dow, Nasdaq and S&P 500.

OK, so why now? I think that the increased IPO activity coincides with rising interest rates, which can really hurt small-cap companies. As lending institutions tighten their requirements for loans to companies with market caps of $1 billion or less, we’ll see more small caps turning to the public market for cash. Alan Greenspan signaled Wall Street far in advance of the first rate hike, giving the venture capitalists and investment bankers plenty of time to start filling the IPO pipeline…and the momentum is certainly there.

Is this a good thing? From my perspective, the answer is a resounding yes. Here’s why. In the 15 years I spent in Silicon Valley before moving to Baltimore, I saw just about every tech prophecy come true — eventually. All that nutty stuff we read about during the bubble, such as e-commerce, broadband to the home and streaming entertainment, are big hits now — long after Wall Street lost patience with many of those money-losing innovators. Well, I think everyone is wiser now. After all, hindsight is always 20/20.

But looking ahead, about 80 VC-backed companies have already registered with the SEC for IPOs in 2005. And we believe that this is going to be a great year for newly public companies. That’s why you can expect to see more coverage in Penny Sleuth of the IPO market as it pertains to small-cap opportunities. We’re all looking forward to the extra coverage here at Penny Sleuth central, and I hope that you are, too.

*** It’s 11:46 a.m. — almost midday. And as I write this, the big winner (relatively speaking) in this rabid bear market is the small-cap S&P 600.

The S&P 600 is down only 2.02%, to 310.98. Compare that to the S&P 500, which is down 4.73%, the Dow, which has taken a 41.03% tumble, or the Nasdaq’s decline of 10.94%. In fact, the S&P 600 is even beating the leading small-cap index, the Russell 2000, which so far has registered a decline of 5.26%, to 612.48.

One reason the S&P 600 is weathering this storm could be that compared to the Russell 2000, it has more stringent requirements. For example, S&P 600 criteria include financial viability, liquidity and an adequate number of shares available for trade — making it tougher to get on the index than on the Russell 2000.

While regular Penny Sleuth readers know that we love the Russell 2000, it’s times like this that remind us that the S&P 600 could be the small-cap index of choice when the bear comes knocking.

As James talks about in this issue, diversification is always important.  That’s why it would be wise to also spread out your investments across multiple small-cap indices (including the Wilshire 1750).  Each one has different standards for inclusion, and given the nature of stocking picking the best one can often depend on market conditions.

*** Speaking of James, he takes to task the chronic optimists of stock
commentators…everything’s good, everything’s great, never a bad year that ends in 5, blah, blah, blah.  Well, steely eyed James sees clouds on the horizon and provides us with sobering advice. James, pop open that umbrella of yours…

It Pays to Be Picky

Something just doesn’t seem right, my friends. I’ve spent the last week reading article after article on the small-cap market — getting people’s “professional” predictions for 2005. And most analysts are still calling for another bullish year for small-cap stocks. For instance…

Professionals from Mesirow Financial’s Investment Management and Real Estate divisions say, “In 2005, we expect to see high-single-digit returns from the S&P 500. Dividend income will, once again, be significant as payout ratios continue to rise. The outperformance of small-cap stocks and value stocks will continue in 2005.”

Diane Swonk, chief economist for Mesirow Financial, was even more optimistic, describing today’s economy as “virtuous” and primed for profit growth. And finally, Donald Luskin, writing for SmartMoney.com, titled his Dec. 31 article, “Get Ready for Another Strong Year.” He forecasts that (after a bumpy start to 2005), “By spring, stocks will have moved on to new highs.”

Jeez, you would think I’d be ecstatic about these predictions. But I’m not. In fact, I think they are all wrong. And you need to know that. You see, there are two reasons the small-cap rally, which began six years ago, started in the first place. And neither one of those reasons exists in today’s market.

Let me explain…

By the end of 1999, small-cap stocks were trading for a 30% discount to their larger peers. Throughout the 1990s, investors were dumping their money into companies like IBM, JDS Uniphase and Sun Microsystems. As a result, between 1995 and 1999, large caps enjoyed 20%-plus annual returns. Meanwhile, small caps lagged behind — big time. In August 1998, the small-cap market fell 18.3% — making it one of the worst plunges in over 70 years. Ouch! But that fiasco led the way for the start of a major buying spree that has lasted for six years now.

And the second reason the small-cap rally took off more than half a decade ago was the lowering of interest rates. Between July 2000 and June 2004, interest rates fell from 6.5% to 1%. As a result, smaller companies could borrow money much more cheaply. They had instant access to the capital markets that they didn’t have in the early 1990s (when all the money was being lent to the larger tech companies). And they could grow their own businesses through debt — which led to rapid earnings and sales for years to come. For example…

Earnings for small-cap companies grew a whopping 71% in 2003. That’s amazing, when you think about it. And because of the tremendous earnings growth, the Russell 2000 rose 46% in 2003 — beating every other major stock index in the United States.

Between 1999 and 2004, the equation for a small-cap rally was in place: value + low interest rates = small-cap rally. And what a rally it was. But that equation has changed now. And all the talking heads who proclaim 2005 is going to be another banner year for all small-cap stocks are out of their minds. (But that’s still not to say there won’t be a lot of great opportunities — there will. And I’ll explain in a second.)

Unlike in 1999, small-cap stocks aren’t cheap. In fact, they are more expensive than large caps now. The average company on the Russell 2000 trades for 21.5 times earnings. By comparison, the average large-cap company on the Russell 1000 trades for 19 times earnings.

And in case you haven’t noticed, interest rates (although still historically low at 2.25%) are on the rise. Alan Greenspan and his gang have raised rates in each of the last five Fed meetings. And general consensus is that rates will continue to rise in 2005 — eventually topping out between 3.5% and 4.25% by the end of December.

Sure, those rates are still low. But that’s not the point. The formula that was in place in 1999 has changed. Small-cap stocks aren’t cheaper than their large-cap peers anymore. And the interest rates are rising – slowly making it more expensive for smaller companies to borrow money and grow through debt.

The HUGE advantages that small-cap companies had a few years ago are gone.

So is it time to panic?

No. This rally isn’t going to come crashing down in the next month. It will correct a bit — which is happening now. So you should make sure you are properly diversified. You shouldn’t have more than 10-25% of your portfolio in small-cap stocks. And you need to consider what kinds of small-cap stocks you are holding onto. Obviously, the stocks that will crash the hardest are those with little in the way of cash, a ton of debt and weak fundamentals. Those are the kinds of companies that will need to borrow even more money in the future — just to stay afloat. Problem is, they won’t get that money as lenders become pickier and pickier about who gets their loans.

Still, let me remind you…

There are over 4,000 small-cap stocks to pick through today. I guarantee hundreds of them will rise in 2005. This isn’t a time to panic. Rather, it’s a time to be picky. And if you stick with Penny Stock Fortunes (www.psfortunes.com) and Penny Sleuth…we’ll help you find those companies worth owning.

Yours for Penny Sleuth,

James Boric

January 11, 2005

It Pays to Be Picky was originally featured in the Penny Sleuth.