This is what they want you to believe: To be a successful investor, you should buy only big-name stocks and hold onto them for years. Nothing could be further from the truth. What they really want from you is control of your money. They want you to leave it with them and forget it.

And here’s why they hope you’ll never bother to challenge the myth…

Your broker makes money whether your portfolio soars or falls. All he cares about is that you’re buying or selling stocks. He takes his commission, and you’re left with stocks that could be profitable, but are more likely just the “hot pick” of the week that will lead your portfolio down the drain in no time.

But as you’re about to see, you can do a lot better. You can win at the stock market when you use the power of penny stocks to your own profitable advantage. And better yet, you can keep more of your money without worry that your broker’s advice might be costing you more than just your cell phone minutes…

Exposing the Lies

First, it’s important for you to know that the easiest way to make money in the stock market is by investing in penny stocks. And there are cold, hard facts to back up this claim.

The smallest stocks on the market — those with market capitalizations of less than $1.5 billion — have dominated the market recently, outpacing the large caps by a large margin so far this decade. But what many investors may not realize is that this is not a fluke. Historically, smaller stocks have always led the market.

A famous study conducted by Ibbotson Associates in the 1990s found that these small stocks outperformed all other stocks 56% of the time between 1926–1996 — including the blue chip stocks that get all of the media’s attention. The average return in any given year was 14% for small stocks. It was just 9% for large stocks. And the longer you held your small stocks, the better off you were.

Since 1926, there has never been a period of 25 years or more in which investing in large-cap stocks have proven to be more lucrative than investing in small-cap ones. Of course, there are many reasons for these great small-cap returns.

First of all, there are a lot more small-cap companies on the market. About two-thirds of all the companies on Wall Street have a market cap of $1.5 billion or less. So as a penny stock investor, you have a much wider universe in which to find moneymaking opportunities.

And because there are so many small companies, the major brokerage firms and institutions don’t have enough analysts to cover them all. So they simply ignore some of the fastest-growing companies on Earth. As a result, you can buy into some tremendous businesses trading for virtually nothing.

Smaller companies can also adapt to the changing marketplace and react quicker than their large-cap peers. Think about it this way: It’s a lot easier for a $200 million company to double than it is for a $255 billion company to do the same.

Best,
Greg Guenthner
September 12, 2008

Investing in the Small-Cap Market was originally featured in the Penny Sleuth.

Two days ago, I ran my favorite screen looking for solid small-cap companies worth owning right now.

Year-to-date months, the companies I have recommended from this (and a similar) list are up an average of 21% so far. But I expect that number will continue to grow. You see…

Unlike many small-cap companies, these all have solid business plans. They are all making money. They are generating cash from operations. They have little (if any) debt, tons of cash and, most importantly, they have gotten stronger and stronger over the last three-five years.

Each company on this short list had to have:

1. Positive cash flow in each of the last 3 years.
2. Rising net income in each of the last 2 years.
3. Rising net profit margins in each of the last 5 years.
4. Revenue growth in each of the last 5 years.
5. More cash than total debt.

Over time, these are exactly the kinds of companies that will make shareholders wealthy. So without further ado, here are the only six companies that currently meet all five wealth-generating requirements:

Diodes Inc. (DIOD:NASDAQ): DIOD is a global supplier of semiconductor products for advanced electronic devices including digital audio players, notebook computers, flat-panel displays, mobile handsets, digital cameras and set-top boxes.

DIOD has generated $102 million in cash from operation over the last three years. Its net income has increased from $5.8 million to $33 million while sales are up an average of 23.2% since 2001. The company has $100 million in cash on its balance sheet and virtually no debt.

Forward Industries, Inc. (FORD:NASDAQ): FORD makes cell phone cases, clips and accessories for major manufacturers like Motorola and Nokia. It has a clean balance sheet with $17 million in cash and zero long-term debt. Forward’s net income and sales have increased at a 46% and 124% clip, respectively, over the last three years. And the company has been free-cash-flow positive in each of those years as well.

Internet Security Systems, Inc. (ISSX:NASDAQ): ISSX is a security company that provides software, appliances and services to global enterprises and world governments to protect their information technology (IT) infrastructure against Internet threats.

ISSX is sitting on $219.8 million in cash and no long-term debt. Sales and net income have grown at a 10% and 178% clip since 2002. The company has $186.2 million in cash from operations over the last three years. And its profit margins have improved from 0.7% in 2002 to 11.7% today.

The Knot, Inc. (KNOT:NASDAQ): KNOT provides wedding products and services to couples. The company offers both online and offline services to the wedding market. For instance, guests can shop and register for their wedding at the company’s Web site, www.theknot.com.

Business has been good for KNOT over the last several years. Sales are up an average of 18% since 2003. And its net income has followed suit — growing from $1.06 million to $3.95 million over the last two years. During that time, its profit margins have more than tripled. And the company has raked in over $11 million in cash from operations.

Currently, KNOT has $34 million in cash (to use to grow the business or reward shareholders) and $0.11 million in long-term debt.

Palomar Medical Technologies, Inc. (PMTI:NASDAQ): PMTI designs, manufactures, markets and sells lasers and accessories for use in medical and cosmetic procedures such as hair removal, cellulite and wrinkle reduction.

The medical device company’s sales and net income have grown at a CAGR rate of 44% and 658% since 2002. Profit margins have surged from minus 0.2% to 22.9%. And the company has generated $32 million in cash.

PetMed Express, Inc. (PETS:NASDAQ): PETS is the leading online pet pharmacy in the United States. It sells all the most popular items (medicine, leashes, collars, etc.) at a discount to what you would pay at the vet.

Over the last five years, business has boomed for this late-1990s online survivor. Sales and net income have grown at an incredible 43% and 95% rate over the last four years. The company has generated cash from operations in each of the last five years. It has no debt and $33 million in cash on its balance sheet. And its profit margins have grown from 2.2% in 2002 to 8.8% today.

Despite the fact that these companies are solid businesses with great numbers, investors are opting not to invest in them. Rather, they are putting their money into far more speculative companies with no real business plans. You can see that is the case if you take a look at the following chart (comparing fundamentally sound companies with companies with “garbage” fundamentals):

Eventually, this trend will change. Companies like the six mentioned in this Sleuth will make a handful of people a lot of money. Hopefully, you will be one of them.

Here’s to your wealth,
James
October 19, 2006

Companies with Solid Business Plans was originally featured in the Penny Sleuth.

*** What a rally! Ever since good old George “Dubya” was elected to his second term as president, the markets have been on steroids. The Dow Jones is up 2.6% in the last couple of trading sessions. The Nasdaq is up almost 1.5%. And the often-forgotten Russell 2000 is up 2% as well. But the million-dollar question on everyone’s mind is…

How long will the rally last? And for small-cap investors, are we near the top of what could be a nasty bubble? Those are the questions both Irwin and I ponder in today’s Sleuth.

*** I reported on Tuesday that small-cap stocks are set to outpace their large-cap peers for a fifth straight year. Over that time frame, the Russell 2000 has averaged a 7.41% return for small-cap investors, compared to an annual loss of 1.3% for large-cap investors who dumped their money into the S&P 500.

So isn’t it about time for the small-cap rally to end? Let’s weigh the evidence…

Dating back to 1932, there have been six extended periods in which small-cap stocks have dominated the mighty large-caps. And it turns out the average period was 5.7 years. If you only believe in the law of averages, it seems we may be approaching the end of this recent run-up. But as your Penny Sleuth editor, I don’t rely on just one set of numbers. I like to look at the big picture.

Matthew Patsky, with Winslow Management Co., reported this past week on Forbes.com that the six small-cap runs have lasted anywhere between 3.3 years and 8.5 years.

Let’s see…8½ minus 5 is 3½. (Yes, your faithful small-cap sleuth tore up first-grade math).

Will this rally last for another 3½  years? I don’t know, dear reader. All I can do is look at the facts. And right now, small-cap stocks are still cheap compared to their larger counterparts.

*** Satya Pradhuman, a small-cap expert at Merrill Lynch, recently reported that small-cap stocks are trading for a 36% discount to large-cap stocks based on a revenue multiple. He went on to say, “In the extremes, this group has bottomed at roughly a 60% discount and peaked at almost parity. Note, current levels are roughly in line with the bottom reached in 1990, the start of the last small-cap bull market.”

As long as small-cap stocks are cheaper than anything else on the market, I expect the rally will continue. But that isn’t to say you shouldn’t be careful.

Because small-cap stocks have been generating such rich profits for so long, more and more people are getting greedy – especially people with money in their pockets. As Irwin points out below, venture capitalists raised $5.54 billion in the third quarter. That’s up 78% from the second quarter. And guess what? Irwin also found that up to 60% of the highest-risk IPOs this year have so far lost investors money. In other words…

Now is not the time to speculate in companies with no real business model, no cash and no growth. My guess is a lot of small-cap companies will come to market in the next 12 months – and most won’t be worth the ink I am using to write today’s Sleuth.

As a small-cap investor, its more important than ever to keep investing in what works – companies with growing top and bottom lines, fair multiples and a unique product line. If you are disciplined enough to stick to your guns, I can easily see fundamentally sound small-cap stocks leading the way for another three years – or more.

Only time will tell.

Until then, I have to leave my desk for a few minutes. My colleague Greg brings his pit bull puppy, Ajax, into the office every morning. Ajax perches himself on the chair next to my desk and stares at me until give him food. Luckily for him, I just gave him half of my muffin. Unfortunately for me, Ajax must have gas. Crikey! I gotta go.

All yours, Irwin…

How Not to Lose $650 Million

A new generation of small-cap companies is getting ready to invade Wall Street…and they absolutely scare the devil out of me. So I want to warn you right now: Anyone who invests in them could lose as much as $650 million – just like the last time these companies rocked the exchanges.

What are these money-losing monsters?

They are the overhyped, overvalued and overfunded companies that went bust in 2000. You know the ones I’m talking about – the dot-coms that were in fashion for a decade and then fell off the face of the Earth. Well, this new generation may not have the dot-com moniker, but they’re brought to you by the same slick venture capitalists who caused the tech wreck of the 1990s – wiping out millions of investors.

But it seems no one really cares about that anymore. Get this: In the third quarter, VCs raised $5.54 billion, or 78% more than in the second quarter. Now I know that there are no 12-step programs for reckless VCs – and that’s cause for my concern. Because flush with all that new cash, VCs are bound to go on another wild bender…that could only spell trouble for small-cap investors

Here’s why…

With the millions that VCs have raised from insurance companies, banks and other big institutional investors, they have to deliver huge profits – or they can’t go back to the well for more. At the same time, VCs have been sinking their money into increasingly perilous companies – for example, health sciences startups. So far this year, young companies involved in biotech and medical devices have absorbed 25% of all VC funding – hitting historical highs. Yet if you examine the track record of health sciences IPOs from January-August this year, 60% are trading lower than their initial offering price.

That’s not exactly sobering news. Now, with their pockets overflowing with a fresh cash infusion, things are bound to get worse. And that means by 2005 or 2006 we could see a graduating class of newfangled small-cap investments that appear too good to be true.

Sound familiar? It should. Because I’m talking about the same breed of VCs that brought us the greatest crash-and-burn investments in a century…ridiculous concept companies such as WebVan, eToys and Pets.com. Combined, those three fiascos laid waste to $650 million in the time it takes to get an MBA.

Check out the numbers…

eToys peaked at $84.25 in October 1999, then dropped to 3 cents some 18 months later. And those pitiable investors who held WebVan stock got annihilated – especially if they rode it all the way down from a high of $127.50 to a pathetic 6 cents. While Pets.com didn’t reach the rarified heights of WebVan, it plunged from $14 to 22 cents – an excruciating loss of 98.4%.

If VCs want to sink someone else’s money into lamebrained companies run by arrogant SOBs, well, as the saying goes, it’s a free country. But the reason investors got burned so badly in the late 1990s was that they strayed from the basics…from believing in the business fundamentals that make for a great new public company.

And it’s the fundamentals that we’re always emphasizing here at Penny Sleuth. In our Oct. 22 issue, James stressed, “Persistence, persistence, persistence.” But that doesn’t just mean perpetual optimism. It also means sticking with the best investment fundamentals, and by doing so, ending up a winner…big time.

As you start to see the VC graduating class of 2004 and 2005 hit the public markets within the next year or so, we’re advising that you stand firm on your investment criteria.

For example…

Look for money in the bank and a healthy cash flow. Small companies that are still developing products rely on cash. If they manage to generate sufficient profits to fund their day-to-day operations plus R&D, that helps ensure their long-term success – and profits for you.

Look for growth and value, two critical attributes that Warren Buffet said are “joined at the hip.” Growth will be driven by sold quarter-after-quarter sales. And better yet, these sales will come from increasingly larger customers. Value is rooted in one of the basic tenets of small-cap investing: that the top small-cap companies are ignored by Wall Street – depressing the stock price of a fundamentally sound company.

And look for insider buying. If you see that the people who know the company better than anyone else on the planet are spending their own hard-earned cash to buy the stock on the open market, that’s one of the best bullish indicators around – and a signal that you should consider getting in on it yourself.

When it comes to small-cap stocks, there will always be companies that are touted as overnight successes. And we know that it’s tempting to load up. But beware. If it sounds too good to be true, it is too good to be true.

Happy investing,

Irwin Greenstein

November 05, 2004

How Not to Lose $650 Million was originally featured in the Penny Sleuth.