The old days of trading stocks was a wild-west show. Finding out how a stock has done over the past few years was one of the hardest things about it. There was virtually no record keeping. Even worse than that, no one had any clue what the market, itself, was doing.

That’s exactly what Charles Dow came to Wall Street to fix. Dow was a journalist with hardly any investing background. As an outsider himself, Dow came up with a system to let anyone understand what was actually happening on Wall Street. As you can guess, that system became what we now know as the Dow Jones Industrial Average.

Starting in 1896, the Dow became the first index to let outsiders understand what was happening in the stock market. You could pick up your newspaper and see whether the Dow was up or down. That may not sound like a lot. But, this index brought a lot of people into the market.

A century later, we find ourselves with hundreds of indexes that cover everything from Australian stocks to U.S. gold mining companies. But there is one that is more important to us small-cap investors than any other…the Russell 2000.

Back in 1984, Russell Investments launched the very first float-adjusted indexes: the Russell 1000, which includes the largest 1,000 companies in the U.S. and the Russell 2000, which encompasses the next 2,000 smaller ones. It’s impossible to be a true small-cap investor without religiously following what the Russell 2000 is up to.

The next logical question would be, “why would a small-cap investor need an index in the first place?” The answer is simple; the small-cap market is the most cyclical of any sector on Wall Street. Let me explain…

For years, small-caps were thought to be quite independent of economic conditions, investor sentiment, and any other macroeconomic element of investing. But with the introduction of the Russell 2000, it became clear that that’s not the case.

As you can tell from this chart, the Russell moves similar, but not directly in-line with the Dow:

Check out the market recovery in 2003. The Russell spiked up much faster and much higher than the Dow. That’s what small-caps do. If you can time when those spikes are about to occur, you can make big money. That’s the real point of staring at indexes day in and day out.

Why tell you about this today? Because we are on the verge of the next spike, and Wall Street doesn’t even see it yet.

You see, when we go through a severe correction like we have been going through the past nine months, the Russell is hit the hardest. But, by the time the Dow bottoms out, the Russell is ready to make a huge rally. You can see it post-correction 2002 above. And you will see it very soon in the post-correction 2008:

This chart shows the Russell leveling out ready for a rally. When the Dow finally finds its support, the Russell and almost every small-cap out there will surely lead the comeback rally.

Simply put… Now is the best time in years to buy small-caps. So go out there and do it…

Sincerely,
Jim Nelson
August 15, 2008

Russell 2000 Is Destroying the Dow was originally featured in the Penny Sleuth.

For 26 years, the symbol for Ralph Wanger’s small-cap Acorn Fund — which averaged 17% from 1970 to 1996 — was a squirrel. Not a bull. Not a lion. Rather, he used a small rodent that weighed about as much as my minuscule ThinkPad laptop to represent his mutual fund. Seems odd at first. But after thinking about it, a squirrel is a perfect metaphor for a small-cap company.

Squirrels, like good small-cap companies, are nimble, efficient and adaptable. They are quick to avoid danger. They can thrive in small niches that most don’t even think to look in. And if they do get in trouble, they can outrun their larger predators or quickly change directions.

Of course, not all squirrels survive.

Some make the dubious mistake of running into a crowded street. A few unlucky rodents plunge to their death after stepping on an exposed power line. And the slower, fatter squirrels end up tasty morsels for their hungry prey.

As Wanger said in his classic book, A Zebra in Lion Country, “you don’t see many three-hundred-pound squirrels in the park.” Squirrels that are slow and overweight can’t survive in the wild. And the same goes for over-leveraged and stodgy publicly traded companies.

Unless a company is the lion or tiger in its industry — meaning it is at the top of its game with barriers to entry that are too much for a smaller company to overcome — it better be nimble enough to adapt, to innovate and to avoid danger. Otherwise it won’t make it.

ROIC: Few Market Tigers Left

And folks, last time I checked, there aren’t many tigers left in the wild. And the same is true in the market.

Of the 5,877 companies that trade on the AMEX, NYSE and Nasdaq, there are only 784 large-cap beasts with a market cap of $5 billion or more. (Note: My guess is in the next year that number will decline as behemoths like GM, Ford and Kodak are added to the “extinct” list of publicly traded companies.) By comparison, there are 3,804 small-cap companies with a market capitalization of $1 billion or less. And while not every small-cap company will be around this time next year, the best returns will come from this list. They always do.

So how can you separate the solidly run small-cap companies with bright futures from the companies that will end up as Wall Street road kill?

One of the best ways is to look for businesses with a high return on invested capital (ROIC).

Joel Greenblatt, the Gotham Capital founder who made 50% a year for an entire decade, succinctly described ROIC like this in his latest masterpiece, The Little Book That Beats the Market:

“Buying a share of a good business is better than buying a share of a bad business. One way to do this is to purchase a business that can invest its own money at high rates of return rather than purchasing a business that can only invest at lower ones. In other words, businesses that earn a high return on capital are better than businesses that earn a low return on capital.”

Translation: Companies that spend, manage and invest their money well are companies you want to own. Those are the companies that are growing. Those are the companies that are creating new, innovative products that command high profit margins. And those are the companies that add to shareholder wealth over time.

So what is a healthy return on invested capital?

A recent study by Bin Jiang and Timothy Koller of McKinsey Global Institute found that from 1963-2004, the average ROIC for all publicly traded companies (excluding financial companies) with sales of at least $200 million was nearly 10%. In other words, over time, the average company on Wall Street will earn 10% for every dollar it invests in its business. But they are quick to point out that “companies that drive innovations in technology or business systems may earn above average returns…”

Investing in those “above average” companies is exactly how guys like Ralph Wanger, Joel Greenblatt and Curtis Jensen (the fund manager for the Third Avenue Fund) have been able to average high returns year in and year out — even when the market was weak.

So where are those innovative companies located today?

To find out, I ran a screen for every company on Wall Street with an above average ROIC of at least 30%. There were 165 companies (after excluding financial companies) that fit the bill. And after sorting through the data, here are some observations I made:

- 87 of the companies with a high ROIC were small caps with a market cap of $1 billion or less

- 51 were mid-caps with a market cap between $1-5 billion

- And 27 were large caps with a market cap above $5 billion.

Curiously enough, the textile (specifically, the footwear and clothing sectors), steel and iron, oil and refining and business and software services industries had the largest pool of companies with high ROICs — those above 30%.

Of the 165 companies on the list, seven were from the textile industry…seven were from the steel and oil industry…seven were from the oil and refining industry…and 17 came from the business services and software services industries.

ROIC: The Ten Small-Caps with the Highest ROIC

In weeks and months to follow, I’ll explore why those industries are so rich with well-run, innovative companies. And if you are a PSF reader, I’ll be recommending several companies from these industries in the months to come. But for now, I’ll leave you with a list of the top 10 small-cap companies with the highest ROIC:

1 ) Penn Octane Corp. (POCC:NASDAQ)…ROIC = 360
2 ) Unica Corporation (UNCA:NASDAQ)…ROIC = 250
3 ) Remote Dynamics, Inc. (REDI:NASDAQ)…ROIC = 157.1
4 ) Hollinger International Inc. (HLR:NYSE)…ROIC = 152.1
5 ) Diamond Foods, Inc. (DMND:NASDAQ)…ROIC = 146.2
6 ) CTK Windup Corp. (CLTK:PK)…ROIC = 119.3
7 ) Sun Healthcare Group, Inc. (SUNH:NASDAQ)…ROIC = 117.6
8 ) AFC Enterprises, Inc. (AFCE:NASDAQ)…ROIC = 112.4
9 ) REMEC, Inc. (REMC:OTCBB)…ROIC = 101
10 ) Genta Inc. (GNTA:NASDAQ)…ROIC = 86.3

These small-cap companies are the squirrels of the market. They are wily, nimble and creative. As an investor, those are the kinds of businesses you want to put your money in. In fact, they are exactly the same kinds of companies a guy like Wanger might look for as candidates for his Acorn Fund.

“A squirrel is…an interesting animal,” said Wanger in a 2000 interview. “It’s not the strongest or smartest animal in the forest, but it is a very successful animal. There are squirrels in every country, because they are adaptable and opportunistic. For a small-stock manager, that’s a good symbol.

“Tigers are brave and beautiful, but they’re nearly extinct. And bulls are strong and powerful, but they wind up as a beef patty between slices of bread. But squirrels are all over the place.”

Invest in the squirrels. That’s my advice.

James Boric
December 15, 2005

ROIC: Wall Street’s Road Kill was originally featured in the Penny Sleuth.

*** The small-cap market just keeps on keeping on. The Russell 2000 made a new all-time high again yesterday. It reached 636, before closing at 634.46. And there’s no telling how high it will go. Small-cap stocks have momentum on their side.

For the month of November, the Russell 2000 rose 8.8%. Folks, that’s impressive. The Russell 1000 (an index that tracks the 1,000 largest stocks on the market) only managed to rise 4.7% — which is still pretty darn good. If you annualized that out, you’d be looking at a 70% gain for the year. Not bad. But if you annualized the Russell 2000′s performance from November, you’d be staring at gains of more than 170%!

Of course, I certainly don’t expect this torrid pace to continue. But let’s face it,
November has been an exceptional month for small-cap investors. And I wouldn’t plan on throwing in the towel just yet. Dennis Slothower, the editor of On the Money and Stealth Stocks (two small-cap newsletters), proclaims that "November has been a good month, and from what I can see, December is likely to follow in a similar course."

Dennis may have a point.

The small-cap market is in a solid uptrend right now. That’s important to recognize. Until some event (or series of events) causes the major trend to reverse, you will continue to make good money being a bull.

Or as Ron Rowland, editor of All Star Fund Trader, said… "When momentum is this strong, it carries forward, like the law of inertia."

As your Penny Sleuth editor, I am happy to ride out the small-cap rally for as long as it lasts. Which reminds me…

*** The golden rule of investing is to cut your losers short and let your winners ride. This is a rule most novice investors don’t have the discipline to carry out. People let their emotions get in the way of sound investment decisions. They hold onto losers far too long. And they take profits way too soon.

The worst thing you can do as an investor is to sell early — anticipating a fallout in prices before it ever happens. Folks…don’t anticipate anything. Let the market tell you when to exit. When prices start falling – that’s when you want to cash in. But you don’t want to sell while the market is making all-new highs.

Of course, nothing will last forever, dear reader. Prices don’t rise forever — just like they don’t fall forever. And it would be foolish to think this small-cap rally is any different.

As your dedicated Penny Sleuth editor, I have an obligation to make sure you are educated about all aspects of the small-cap market — not just the bullish facts. And I take that responsibility very seriously. People can accuse me of a lot of things. But being anything less than honest is not one of them. And as a small-cap investor, you do need to be cautious now.

***Dan Denning, editor of Strategic Investment, sent me a note last week that I want to share with you now. He noticed that company insiders around Wall Street are cashing in as the small-cap market is rising. Dan said, "Small- and mid-cap S&P stocks have rallied on equity fund inflows…small-cap insiders are selling like madmen." And his note isn’t without factual evidence.

According to Contrary Investor, the insider sell-to-buy ratio for small-cap stocks (with a market cap between $250 million and $1 billion) is 98.5. In other words, 98.5 times MORE smart money is funneling out of small-cap stocks than is flowing in. To give you a benchmark to compare that to…

The insider sell-to-buy ratio for large-cap stocks (those with a market cap over $5 billion) is only 34.7. In other words…

There is almost three times the amount of insider selling in small-cap stocks as there is in the large-cap market. Hmmm…

Is it time to panic?

I don’t think so. I don’t care what anyone does, as long as the market is rising, you should stay invested. Period. When the ticker tape tells us to exit, we will. Until then, just use common sense.

(By the way, Dan is one of the smartest investors I know. I’ve worked with him for years — in fact, he hired me! No one looks out for his readers more than Dan. He has a passion for the market…and a bigger passion for providing good work. I encourage you to check out his service. If you are looking for a truly contrarian opinion — that makes money — Dan is your man.

*** Now may not be the time to put your life savings in the small-cap market. But with the market in full bull mode, it would be foolish not to ride it up for as long as possible. After all…

Bull runs like this one don’t happen all the time. So my advice to you is…enjoy this rally while it lasts.

Speaking of rallies, my colleague Sala Kannan just identified a taboo sector of the stock market that is ripe for a rally next year. Thanks to a slew of new IPOs, there may be several opportunities upcoming for small-cap investors to make a big profit.

Is Small-Cap Porn the Next Big Thing?

Last weekend, I flew to New York for a friend’s engagement party held in a popular oyster bar that’s a favorite of the beautiful people on Wall Street. The women were straight out of central casting for Sex and the City, while the men, dressed in full-on Brooks Brothers, smacked of Harvard, Wharton and Stanford.

But there was a stocky guy in a double-breasted Italian suit who caught my attention…when I overheard him say in the same sentence: "sex," "small" and "money." I never expected that I’d meet at this party an insider who would turn me on to the next big thing in small-cap investments. Especially when the industry is…

Anyway, sitting on one of those retro Nelson Marshmallow sofas, he held court over his minions. He was boasting of his vintage Bordeaux collection, new house in the Hamptons and a huge divorce settlement in which his ex got his new Range Rover. I knew I needed to talk to him — and change the topic of conversation.

Noticing that the bartender had opened a bottle of 1996 Chateau Gloria St. Julien, I ordered a glass and brought it to him. He graciously accepted, and I introduced myself. He invited me to sit beside him.

As it turns out, I had heard him right the first time. He called himself an entertainment analyst, and as I had expected, he was on to the next big thing in small-cap investments. Once I established my credentials as a small-cap expert, we hit it off.

He prophesized that porn companies are soon going to be trading on mainstream indexes. "People spend a lot on porn, you know. It’s a big big business," he said. He predicted that there were going to be a surge of porn IPOs as soon as 2005. "Wait and see," he said, and winked at me. "We wouldn’t have touched them before, but things might be changing."

Would our readers really be able to cash in on a slew of new porn IPOs next year? Is porn the next big small-cap idea? I was skeptical, but intrigued. I rushed to work the next day to tell Irwin all about my conversation with the banker. "Lets investigate," he said.

So we Sleuths delved into the economics of porn…and we came to one interesting conclusion: The entertainment analyst was absolutely right, dear reader. One hundred percent.

Here’s what we found…

The porn industry grosses $11 billion in annual sales. Family Safe Media reports that porn revenue is larger than the combined revenues of all professional football, baseball and basketball franchises. Americans spend about $10 million on adult entertainment each year. The entertainment analyst was quite right to call adult entertainment a big, big business. In fact, it’s bigger than big…it was enormous.

But here’s the surprise…

Even though it is an $11-billion industry, there are only two stocks publicly traded in the major stock exchanges. Playboy (PLA:NYSE ) came out with an IPO in 1971, and it’s up so far this year, at $11.93. Lesser-known New Frontier Media (NOOF:NASDAQ ) went public in 1997. In the last two years, the stock is up nearly 700%. There are a few others, but they’re true penny stocks that are traded over the counter.

I had to ask myself: Why, out of the scores of porn companies, are only two of them public? And if porn is such a huge business, shouldn’t there be more public companies? To answer this question, I asked myself why companies go public.

Mainly, because they need cash. In other words, public financing. But most adult entertainment companies are cash rich and extremely profitable. New Frontier had $15.4 million in cash last year alone and reported a profit margin of 26.20%. Playboy’s balance sheet shows that it is sitting on $31.3 million of cash.

Frederick Lane, author of Obscene Profits: The Entrepreneurs of Pornography in the Cyber Age, writes, "One of the things about pornography that’s consistently true across the board is that, because there’s a social stigma still attached to it, you can charge a premium for these materials. And because you can charge a premium for it, the profit margin is higher. So it makes pure economic sense."

It does indeed make economic sense. There is no economic reason or real need for outside financing through IPOs. Adult entertainment companies are self-sufficient.

Another reason why porn companies are not mainstream is Wall Street itself. "We wouldn’t have touched them before," the analyst confided. Wall Street prefers not to be associated with porn. Vivid Entertainment’s president Bill Asher agrees: "Someone like a Goldman [Sachs] wouldn’t touch our business."

Even companies that do dare to go public are forced to resort to untraditional means. For example, take NuWeb Solutions, an operator of adult Web sites. It trades over the counter and went public through a reverse merger. In this process, a private company merges with an already public but bankrupt shell company. The new entity then makes a second offering of shares. Because no investment bank would touch them, NuWeb had to finagle this backward deal.

So why do we think the (thus far) murky business of adult entertainment is going to emerge from its exile in the investment backwaters?

Because of the advent of broadband.

America has faced a communications revolution over the last 50 years. Porn was first available only in the print media and shady movie houses. Then the invention of the VCR made videos and movies possible. Then came the Internet. Porn went online. Broadband is next.

Pornography is one industry that has embraced new platforms of communications very efficiently. It is essential to its survival. The Internet is a classic example. Adult entertainment companies have stormed the Internet with such success that they now occupy 4.2 million Web sites, or nearly 12% of the Internet.

But in order to take porn to broadband, companies need financing to invest in the technology. We suspect that adult entertainment will start turning to public financing through IPOs.

Vivid Entertainment is one such company. It is in early stages of going public and hopes to use the money to develop technology that will put porn on broadband. Broadband and the Internet is a lucrative mix. Analyst Dennis McAlpine estimates that AT&T Broadband alone makes $180-240 million a year from adult entertainment!

Where will this industry be two years from now? Asher says, "In the last 10 years what you’ve seen is extreme growth simply because of distribution channels’ technologies." He says the industry has only scratched the surface, and the increase in distribution is going to offer a huge increase in revenues for the industry.

Two years from now, we will see more small-cap porn companies in the market. They are likely to be cash rich, profitable businesses. They will tap into broadband technology for even more profits. And it just might be our friend, the entertainment analyst, who helps take these companies public through traditional Wall Street channels.

Have a profitable day,
Sala Kannan

November 30, 2004

Is Small-Cap Porn the Next Big Thing? was originally featured in the Penny Sleuth.