*** I’m in a value state of mind. That’s because I just bought a ’95 Buick LeSabre with 101,000-plus miles on it, for $1,200, that I could use to bang around Baltimore — after my limited-production BMW M Coupe was hit and, about three weeks later, I was rearended in the insurance rental car. I found the Buick’s original window sticker in the trunk, and the car had listed for more than $24,000. Last night, I took a test drive in a snowstorm with Carl “The GRIPPER” Waynberg (www.the-gripper.com) and Justice Litle, the new contributing editor of our sister publication Outstanding Investments (check it out: http://www.agora-inc.com/reports/OST/edayF208). The front-wheel-drive Buick performed flawlessly both to and from Pazo, a hot bar in town.

As we talked about markets and personal excellence, over vodka, red wine and tapas, I decided that this morning I would revisit the leading small-cap index, the Russell 2000, from a historical value perspective. It’s easy to lose sight of your investment objectives in the minute-by-minute gyrations of fluctuating oil prices, fickle analyst recommendations and Washington’s flurry of economic indicators. The beauty of value stocks is that, like my Buick, they’re the kind of deal most people don’t notice.

When it comes to the value category, we’re looking for underappreciated small-cap companies whose assets and market niche are overlooked by the so-called gurus of Wall Street. Generally, these are long-term plays…stocks that skyrocket once the market gets wind of a company’s true potential.

So this morning, I compared the value style of the Russell 2000 to the comparable broad-market Russell 3000, the large-cap Russell 1000 and the Russell Midcap Index. Over the past three years, the Russell 2000 Value Index returned an impressive 14.47%, versus 14.27% for the Midcap Index, 8.20% for the Russell 1000 and 8.67% for the Russell 3000. The five-year returns were even more impressive, with the Russell 2000 scoring 16.93% — the closest rival being the Russell Midcap, at 14.35%. Over 10 years, the Russell 2000 Value did get beat by the Russell Midcap (14.77% compared to 15.13%), but outperformed the Russell 3000 (13.31%) and the Russell 1000 (13.28%).

That’s why it’s important for small-cap fans to stay the course. Small-cap stocks can consistently deliver over the long haul, like my ’95 Buick.

*** Kevin Kerr, editor of Resource Trader Alert, was in town yesterday for the monthly editorial get-together of the Agora Financial group. I caught up with him afterward on the 13th floor bar of the venerable Belvedere Hotel. We chatted as we looked out over the historic skyline, the talk ultimately turning to the emerging markets and China. Kevin said that shipping remains on his radar screen, since many shipping companies are benefiting from increased traffic of commodity carriers. “Demand for shipping and transport of all kinds is in high demand, and these equities will continue to reap the benefits,” he explained. Specifically, Kevin is bullish on OMI Corp. and General Maritime Corp. “Those two stocks have been phenomenal. OMI alone just traded back through $20 today, and when I told James Boric about it, you could have gotten it for $16 and change. Not bad! We think these shipping stocks have a lot further to go on the upside, too.”

So what else? “Well, in Resource Trader Alert, we just grabbed huge profits in soybeans and soybean oil. Grains are red hot right now, and there are a lot of opportunities in small-cap stocks related to the growing and harvesting of all kinds of crops. Major players like John Deere and Monsanto stand to make huge gains on demand for their support products by the burgeoning grains industry in China. I told you and James I will have a look at some of the smaller unpolished gems so they can pass them along to you. The really good news is there is tons of opportunity, and I will be sure to share my insight with your editors, as they do with me.”

Then Kevin was interrupted by his BlackBerry with another real-time trading opportunity. For more on Kevin’s insights, click here: www.rtalert.com

*** In the last issue (http://www.pennysleuth.com/alertholder/02-22-05), I told you about how our ace analyst Sala Kannan would be running the occasional screen for us. She started today with a screen she calls, “7 Small-Cap Cash Cows That Will Survive the Worst Bear Market.”

As we constantly advise, small-cap companies are the most vulnerable to failure in a bear market. With thin cash reserves and bootstrapped operations, it’s vital that they have a wad of greenbacks on hand to weather a stormy market.

Cash flow is pure liquidity. It is hard cash that can be reinvested in the company – just like with her November Penny Stock Fortunes (www.psfortunes.com) Farm Club pick, Service Corp. Intl. The company had invested its cash in itself by buying back its own shares. And this small-cap cash cow is up about 11% since she recommended it.

Financial analysts use a company’s free cash flow as an important barometer of future financial health. In fact, in investment circles, the price-to-free-cash-flow ratio is preferred over the standard P/E ratio. Cash is a better indicator of profits.

Sala screened for the best companies with the lowest price-to-cash flow (P/CF).  The ideal P/CF ratio varies by industry. But take a look for yourself at her happy small-cap cash cows…

*** Also in the last issue, I had mentioned that Chris Mayer, editor of Fleet Street Letter, would be introducing a new trading service today. My information was based on various rumors swirling about Penny Sleuth central. Although Chris had given me a sketchy description of the service that I passed along to you, he could neither confirm nor deny the official launch date. Unfortunately, I think we’re going to have to wait at least another week to see Chris’ latest moneymaking system.

In the meantime, Chris comes through today with excellent trading advice gleaned from Wall Street legend John Neff…

The Dusty Rag And Bone Shop of the Mart

“The investment process must begin somewhere,” John Neff writes in his ’99 memoir, John Neff on Investing. “In my case, all ladders start in the dusty rag and bone shop of the mart, where the supply of cheap stocks replenishes itself daily.”

John Neff ran Vanguard’s storied Windsor Fund for more than 30 years, from 1964-1995, where he laid down an impressive whipping of the market averages. Every $1,000 invested in his fund in 1964 turned into $57,000 by year-end 1995, beating the return on the S&P 500 by a margin of more than 2-to-1.

For that performance, Neff earned himself a place in the investor’s pantheon. While Neff was not known for small cap investing specifically, his wisdom and savvy are applicable to investors of all stripes.

Neff is often characterized, perhaps too simply, as a low P/E investor. It is true that he sought out stocks with low price-earnings ratios. His portfolio did not harbor the technology darlings and high-tech growth stocks of his day. More often, you would find banks, homebuilders, autos and airlines in Neff’s portfolio. Needless to say, such self-imposed limitations did not hurt his investment performance.

But there was more to Neff’s performance than simply picking out stocks with low price-earnings ratios.

Neff began his search for investment ideas by scanning the list of stocks making new lows – a list which is available in The Wall Street Journal every day, often providing fresh names on a daily basis. In addition to this, Neff liked to scan the worst performers from the previous day’s action. These are stocks that have typically fallen by 8-30% or more. This was the “dusty rag and bone shop” that Neff talks about.

Then Neff uses what he calls the “Hmmmph” test. Every once in awhile, Neff would run into a familiar name on one of these lists. Some of these names would surprise him and their discovery would elicit an audible “Hmmmph.” These findings would spur Neff to investigate further.

Not all of these stocks would make the cut, of course. Nonetheless, Neff showed throughout his career a remarkable ability to take advantage of bad news, of temporary setbacks in the fortunes of good companies.

Admittedly, it takes some fortitude to be able to purchase these kinds of stocks. Most investors probably think they can buck the opinions of the crowd, but the evidence does not bear them out. Most investors, by definition, follow the crowd. It is extraordinarily difficult to buy a stock that just got whacked in the market.

Neff knows this and believes that it was a cornerstone of his success — his willingness to go it alone. In fact, despite his awesome track record, Neff recalls getting letters from irate shareholders and criticism in the press for some of his contrarian selections. Neff does not take his contrary philosophy too far, however. “Savvy contrarians keep their minds open, leavened by a sense of history and a sense of humor… Ready-made contrarian formulas supply prescriptions for failure.”

Windsor blazed its own path in other ways as well. While most investors, certainly professionals, think of their portfolio in terms of industry concentration (and decidehey want so much invested in oil companies, a little in tech, some in real state, etc.), Windsor threw all that out the window.

Neff went where the values were and felt no compulsion to make sure Windsor had
exposure across a wide variety of industries. If the oil sector did not offer any values for Neff, Windsor would jettison the whole sector. Most professional money managers keep some sort of asset allocation, which forces them to keep investing in sectors they do not particularly like. That’s why we have such terminology as “underweight” and “overweight” that you often hear professionals use. They can’t just sell it entirely, so they lower their exposure to that sector — or “underweigh.”

Windsor’s freedom in this regard allowed Neff to stick his neck out. While his competitors often automatically owned the 50 largest S&P 500 companies, Windsor would often own only a couple, and sometimes none at all.

This sort of approach spared Windsor shareholders horrific losses brought on by the collapse of the Nifty-Fifty stocks in the 1970s. The Nifty-Fifty were a collection of blue chip growth stocks — like Xerox, IBM and Polaroid — that seemingly everyone owned. Needless to say, these popular stocks came crashing down.

This kind of thing happens often in markets. Lessons from such catastrophes are useful only if investors remember them, which they often don’t. I’ll end with a short story Neff tells to make his point.

Two hunters hire a plane to take them to a remote wilderness to go moose hunting. When they reach their destination, the pilot tells them they can each take back only one moose, because any more weight than that would strain the engine, and they wouldn’t make it back.

Two days later, the plane returns to pick up the hunters, and both hunters have killed two moose each. Too much weight, the pilot says.

“Aww, you told us that last year, and we each gave you $1,000 extra, and you flew us back,” says one of the hunters. So the pilot agrees.

Sure enough, after a short while, the plane’s engine sputters, and the pilot is forced to make a crash landing. Once on the ground, the dazed but unhurt hunters stagger out. “Where are we?” asks one hunter. “I don’t know,” replies the other, “but it sure looks a lot like where we crashed last year.”

Regards,

Chris Mayer
Editor, The Fleet Street Letter

February 25, 2005

The Dusty Rag And Bone Shop of the Mart was originally featured in the Penny Sleuth.