*** 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.