I couldn’t help but wonder what signs these people are reading…

The gist of the article is that it might be time for small-cap investors to rethink their investment strategy. The author thinks that this year, the best bet for anyone with a dime in his pocket will be the big-name stocks that can ride out any bumps in the economy.

You see, his logic is that eventually, large-cap, blue chip returns must have a special year where they whip the Russell 2000′s returns. I’m sure some are eagerly anticipating this event as if it will somehow restore order to the stock market and promote world peace.

But as much as we humans enjoy synchronizing our watches and measuring significant events by calendar year, we tend to miss out on the bigger picture attempting to predict the unpredictable. Take, for instance, the AP article. The initial question posed is whether an investor should alter his strategy to focus on larger stocks since they are “poised to outperform” smaller ones.

The article states that the Russell 2000 posted a gain of more than 18% for 2006, officially beating the Russell 1000 Large-Cap Index for seven of the last eight years. However, the Russell 1000 caught a second wind and romped the 2000 for the second half of 2006.

So all of those investors who have been biding their time and are now claiming this is the year of the large-cap might have missed the boat. Ever since the Russell 2000 took a hit in May 2006, a lot of money has been flowing into large-cap stocks. The Dow Jones Industrial has soared while the Russell 2000 and the NASDAQ have lagged behind. Just look at the chart below:

Now we have the Dow squeaking out record highs seemingly every week. The Wall Street Journal reports that the Dow has posted 25 record closes since October 3.

So what are investors to do?

Well, there is a group of small-caps that are very attractive, but you must be selective…

A few months ago, our former value guru James Boric wrote that average investors are, in fact, buying garbage stocks, even in the small-cap arena. He determined this two ways:

The first, he searched for all small-cap companies traded on the NYSE at the 15 times earnings level or less, 1.5 times book value or less, 1.5 times sales or less, with positive free cash flow, revenue growth, and net income growth. This group would represent attractive small-cap value stocks. James watched as this group only appreciated 6.1% over the prior year — not much at all…

These stocks with good fundamentals are what investors should be clamoring for.

But it was another group of stocks that got all the attention…

The second group James followed were small caps on the NYSE that had negligible sales growth, no free cash flow, were trading at two times book value or more and had no earnings to speak of. The 19 stocks that made this list climbed 51% over the previous year as James watched…

Do you think that these stocks with rotten fundamentals will continue to rise? Well, we can’t tell you when they will stop, but we can tell you where we’d put our money.

Don’t get caught chasing the big returns, even if you are a devoted small-cap investor. We’ll be bringing you some of best plays on the small-cap market in upcoming issues of The Sleuth.

Best,
Greg Guenthner
January 22, 2007

Small-Cap vs. Large-Cap Returns in 2007 was originally featured in the Penny Sleuth.

*** The Russell 2000 has been feeling frisky of late. After dipping all the way down to 604 in late January, it closed at 626 yesterday. And last week it even reached as high as 647. I wouldn’t be surprised to see it make another run into the 640s — soon.

If you are a technical analyst, you will probably agree.

For the last month and a half, the Russell 2000 has been making higher highs and higher lows — a bullish sign. It says the buyers have been in charge — winning the tug of war match with the sellers. And it’s no wonder why…

The folks on the buying side of the market have far more muscle to flex than the puny sellers.

For the week ending March 4, major hedge fund and institutions (the folks with big bucks to spend) dumped over $1.4 billion in various small-cap ETF funds. That’s more money that those same institutions put in bond funds, mid-cap funds, global funds and growth funds — COMBINED!

Anytime the institutions are the ones doing the buying, chances are whatever they have in their sights will rise. And that’s why we’ve seen the Russell 2000 recover nicely from its January lows.

Of course, nothing rises forever. And investors have taken some profits after last week’s buying spree. After peaking at 647 last week, the Russell 2000 has fallen down to 626. And it is at a fork in the road today.

If the small-cap index can stay above 617, its temporary low from Feb. 23, it will remain in bullish territory. But if it falls below that key support level, look out. It could go on to test its lows for the year.

So which will it be?

*** If you are a speculator, I would bet that the Russell 2000 rises from its current levels. Good traders always trade in the direction of the primary trend. And if you look at the Russell 2000 over the last year, its primary trend is straight up. No question about it. So until the market shows some major signs of weakness, I wouldn’t bet against it just yet.

Still, just keep the 617 level in the back of your head. That will be a key figure in the coming days…

*** Speaking of key market figures, my friend and colleague Chris Mayer has developed an incredible system for spotting when the market (as well as 8,000 individual stocks!) is about to rise or fall. It’s based on the Dow Theory — which has correctly predicted EVERY major market move since the 1929 crash. And just last week, it gave a bullish
signal on the overall market.

In an alert to his readers this week, Chris said:

“The Dow Theory gave us a crystal clear signal on Friday, March 4. Really, you couldn’t ask for a better alignment. On that day, both the Dow Jones Industrial Average and the Dow Jones Transportation Average topped their Dec. 28 highs. Volume, too, was a smidgeon higher on the breakout.

“As if to provide further confirmation, the Dow Jones Utility Average also made a new high.”

That’s important.

Investors who have listened to the Dow Theory over the years not only avoided disaster several times, but could have made a lot of money as well. For instance, the Dow Theory not only alerted people that the market was due to crash in 1929, but it told investors to get back in the market in 1932 — just before it rose 365%. It also called the 502.4% rise between 1949 and 1966, the 30.7% crash in 1987, the bull market of the 1990s and the crash in 2000.

In fact, years ago, two analysts named Robert Edwards and John Magee put the Dow Theory to the test. They wrote about it in a book called Technical Analysis of Stock Trends.

The study tracked this system’s performance using over 59 years of live stock market data. They compared the results to how much you would have made with buy-and-hold investing over the same period.

Buy-and-hold investors would have turned a single $1,000 investment into $17,570. The Dow Theory turned every $1,000 into $112,360. Or about 112 times your money. That’s nearly seven times more than buy-and-hold investors made.

But that’s not even the best part…

While the S&P 500 has averaged about 11.3% over the last 34 years, this market-timing strategy helped investors move in and out of stocks skillfully enough to pile up average annual gains of 22.6%…for 50 years.

Those are Buffett-sized returns. And that’s why I am mentioning this to you today…

Recently, Chris took the ideas from the Dow Theory and created what he believes to be an even more powerful system. He figured out a way to use the same proven indicators — which predicted every major market move since the early 1900s — to predict individual stock moves.

Chris looks for what are called “crisis points.” These are the very points when a stock is set to leap — up or down.

That means in any given day, Chris is following about 8,000 potential moneymaking opportunities. And better still, he leverages those moves by up to 4-5 times by recommending appropriate puts and calls. And it works…

Chris has already racked up gains of 121%, 42% and 40% for a small group of investors. And now he’s asked that I invite you to join in the profit-making. But you have to hurry…

In 14 days, the price to join Chris will rise considerably. And I do have to warn you: There is a very limited number of people who can join Chris and his CrisisPoint Trader System. So please hurry, and reserve your spot today.

*** Next week, Chris will explain more about his Crisis Point Trader System as well as the Dow Theory. But today, he has some advice all small-cap investors need to pay attention to.

Chris, I pass the reigns on to you…

Jesus Make up My Dying Bed

Small-cap investors and traders, heed this message: You have a definite advantage over the likes of the world’s greatest money managers – yes, even Warren Buffett. This advantage may sound dry and boring, but it’s as real as the chair you are sitting in and every bit as useful. In essence, it is the ability to handle illiquidity. Don’t worry if that doesn’t make a lick of sense at this point – it will, if you stick with me here.

First, consider this quote from Jeremy Grantham, of Grantham, Mayo, Van Otterloo & Co.:

“[The] ability to handle illiquidity is a major advantage for long-term investors…Because everyone’s time horizons are shorter than they should be, liquidity is overpriced. A long-term investor should always try to exploit the other guy’s short-term horizon and be paid for taking illiquidity.”

What the heck is he talking about? I believe what Grantham is saying here is important, in particular for small-cap investors. In this essay, I’ll explain why.

For those who don’t know him, Grantham is a well-respected value investor, the type of man who adores timber and cheap foreign equities, as opposed to ritzy blue chips and nanotechnology.

Like most of the high-profile value money managers these days, Grantham believes there is little value in today’s markets. Anyone who wants a taste of Grantham’s analysis can head over to www.gmo.com and click on “Research & Commentary.” Occasionally, Grantham will post his comments on what he thinks of the market. The headline of one of his most recent pieces, “Apocalypse Not Now: Inevitable Pain Postponed,” gives you a flavor of what’s in his report.

But Grantham’s gloom is not his alone. Many of the great value managers complain about the same thing – the difficulty of putting money to work in today’s pricey markets. Warren Buffett, in his most recent letter, also talks about how he didn’t find many opportunities in 2004. Hence, Berkshire Hathaway is now sitting on $43 billion in cash – $43 billion! (Nice problem to have…I could think of some things to do with that cash.)

In reading many of the letters of value investors that I respect, I come across the same lament over and over. I feel like these guys are going to grab a guitar and start singing “Jesus Make up My Dying Bed.”

However, there is something we have to keep in mind when reading their comments: They have to put hundreds of millions (even billions) of dollars to work. Having so much money to invest limits the kinds of things they are going to look at. They can’t waste much time thinking about small caps, because they can’t take a meaningful position in many of these companies.

And therein lies the opportunity for the intrepid individual investor in small-cap stocks. The professionals have to worry about something called liquidity risk, whereas the individual investor doesn’t have the same kinds of problems. We’ve got other problems, like paying our mortgage and fixing leaky faucets.

So what is liquidity? It sounds like something you might find in Hunter Thompson’s trunk, along with mescaline and a pint of ether. But no, liquidity is simply the ability to buy and sell something quickly without moving the market price significantly. It’s the grease that keeps markets moving.

A large-cap stock, like Intel, is liquid. On average, about 70 million shares trade hands every day, or about $1.8 billion worth of stock. So you can buy large amounts of stock in Intel and not affect the market price much. Intel has a market cap of $155 billion.

However, look at Grupo Aeroportuario del Sureste (ASR:NYSE), an operator of nine airports in southeastern Mexico, and one of my favorite stocks. Dubbed ASUR for short, the stock has traded on average about 100,000 shares per day over the last three months, or about $3 million in stock per day. This is a company I recommended to Fleet readers in November, and it has soared since, but its market cap today is still just under $1 billion.

Professional money managers with hundreds of millions of dollars are going to miss a company like ASUR, not because of any reason having to do with the company itself, but only due to the fact that it is too small. Yet as individual investors, we can easily buy and sell shares in ASUR, just as easily as we could buy and sell Intel.

Professional managers value liquidity. They want the ability to buy and sell meaningful chunks of stocks quickly, without upsetting the market. In the case of ASUR, any large buying or selling of stock is likely to cause the stock price to bounce around quite a bit, so that the money managers can’t ever be sure about the price they are getting. That’s a risk they don’t like to take.

So now we can get to the point of Grantham’s statement at the top of this piece.

Grantham’s quote specifically addresses the issue of long-term versus short-term outlook. Long-term investors also don’t worry about the ability to buy and sell quickly, because they seldom do. They sit on stocks, like old Horton trying to hatch an egg in that Dr. Seuss story.

They buy and hold. Short-term investors are going to be more concerned about getting in and out, like car thieves. They want to make sure they can get to the highway in a hurry. As a result, they are also going to value liquidity. In addition to this, I think the same concept can be applied in thinking about small caps versus larger, more liquid stocks, as I wrote above.

Since liquidity is so valued by the “big money,” it is often overpriced in the marketplace. Conversely, the illiquid or smaller companies are more likely to fall through the cracks and be discounted or ignored, because they are too small to attract the big money.

The individual investor, with a long-term focus and without the constraints of a big professional money manager, should always be willing to dig around and explore the small-cap arena to take advantage of possible discounts. It is one area where you have a decided edge. Your investment universe is much larger than the high-profile professionals.

Over time, growing small caps can eventually capture that liquidity premium – as the professionals start buying. But the plucky small-cap investor will already have been in the stock for some time, with a nice gain. At that point, you just sit back and enjoy bigger gains as the big money rolls in after you.

Sincerely,

Chris Mayer

March 11, 2005

P.S. I can’t wait to tell you more about my Crisis Point Trader System next week. I know you will be very impressed. I’ve already helped a small group of investors make gains of 121%, 40% and 42% in a very short amount of time. And now I’d like to personally invite you to join me in this moneymaking quest. But I encourage you to hurry…

Jesus Make up My Dying Bed was originally featured in the Penny Sleuth.

*** In Tuesday’s issue, we told you that the smart money was flowing back into small-cap stocks. Small-cap exchange-traded funds received a $593 million infusionfrom institutional investors and hedge fund managers during the last three days of January – a reversal of fortune from earlier in the month.

Well, it looks like we’re on a roll. That’s because the leading small-cap indexes rose to 2.5% in the wake of the Fed’s quarter-percentage-point rate increase on Wednesday. The Russell 2000 closed up that day 3.84, or 0.61%, to 631.98 – while the S&P 600 finished the day at 326.02, an increase of 2.20, or 0.68%.

The news is actually better than it appears…

Since small-cap companies are generally considered a higher risk by lending institutions, they are forced to pay higher interest rates than large-cap borrowers. Naturally, higher interest payments mean lower profits. Still, Wall Street continued pumping money into the small-cap markets both before and after the widely anticipated
rate hike. Apparently, a sunny outlook on top-line revenue growth, hot IPOs and mergers-and-acquisitions consolidation is overshadowing the tedium of an incremental expense.

That makes me think that Punxsutawney Phil is wrong about six weeks more of winter …at least for small-cap investors.

*** Speaking of critters, the dragon may strike Nasdaq with a blockbuster Chinese IPO in the second half of the year. The company is Baidu.com, and it has everything going for it.

In terms of potential, it could be a mirror image of Google…simply because Baidu.com is the biggest search engine in China and the second biggest Web audience in the world – after the U.S. In fact, Google holds a minority stake in Baidu.com. Details of the impending IPO remain sketchy. But here’s what we have so far…

Baidu.com plans on selling about 25% of its capital, putting its valuation at some $800 million. The company has been profitable since 2004, with revenue growing about 150% annually. Revenues in 2003 were estimated at $12 million, but could dramatically accelerate with the estimated $200 million war chest it would get from the proposed IPO. That kind of money could buy a very serious marketing campaign to pull in advertising in an already superheated online market…as illustrated by Google’s recent fourth-quarter earnings.

Google reported that its ad sales hit $530 million, up 118% from the same quarter in 2003. The company’s profit was 71 cents a share. But since Wall Street excludes charges for stock option grants and other noncash items, Google actually raked in 92 cents a share. In any language, that’s huge.

The Baidu.com IPO will be a tough one to call. When Google went public at $85, skeptics cried that the company was overpriced. Now Google is north of $210, and the Street is euphoric over its dazzling fourth-quarter results. We’ll keep you posted on Baidu.com, but for those of you who missed my original story, “Chinese IPOs March on the Nasdaq,” click here: http://www.pennysleuth.com/alertholder/01.21.05

*** In the meantime, your ship may have just come in. At about noon yesterday, DRYSHIPS, Inc. started trading on Nasdaq. It was offered at $18, but opened at $19.28 and closed at $20.15 – an increase of 4.5% over the opening price in just a matter of hours. By day’s end, 10.2 million shares changed hands. Underwriters Cantor Fitzgerald originally intended to offer 7.1 million shares, but bumped it up to 13 million to satisfy demand. The $234 million from the IPO will go towards adding 11 new vessels to its fleet of six that carry coal, iron ore and grains.

As it turns out, I’d been talking with Kevin Kerr, editor of Resource Trader Alert, about the shipping industry. In his own words, “The shipping industry is red hot.I tend to focus on energy transport, but the same rules apply to all shipping. In my arena, companies like Teekay Shipping and OMI Corp. are perfect examples of stocks that are benefiting mightily from the growing demand for time charters and reliable, well-managed fleets that can live up to their commitments.”

Kevin explained that both Teekay and OMI were in his portfolio. Here, Kevin reports the latest on OMI…

“OMI rose 3.6% after the company said fourth-quarter earnings would come in above analysts’ estimates. The oil tanker operator expects earnings of $1.10 a share. Analysts were expecting earnings of 97 cents a share. OMI said that rates for its Suezmax vessels, which averaged about $84,500 a day for 80% of the days booked in
the quarter, are expected to fetch about $97,000 a day for the remaining unbooked portion of the quarter. Tanker companies are in a pretty good market right now. Oil demand is at its highest level since 1979.”

That’s one reason why Kevin is bullish on shipping in general.

“There is no doubt that all types of shipping are in the spotlight for investors these days,” he said. “No matter if it’s oil or petroleum products, foodstuffs, manufactured goods, etc. Cargo carriers, tankers…demand for all kinds of ships is surging. The shipping sector is ramping up for more and more profits from all directions. The astute investor will be sure to have some shipping stocks in his portfolio, as demand is far from shrinking.”

*** For many Sleuth readers, after-hours trading is like the Bermuda Triangle of Wall Street. Angela Roberts unravels this moneymaking mystery for you.

Shedding Light on After-Hours Trading

Sometimes, strange things happen. For instance, have you ever watched a stock close a mere 2 cents above your buy price with a strict plan to wait till the stock makes a little dip the next day to buy under your preferred buy price…But instead, you wake up to find that the stock is suddenly significantly higher in price at market
open than it was the day before at close?

Or the opposite happens. Overnight, the price of a stock you own drops. And for many small-cap investors, small price fluctuations can mean substantial percentage differences in gains. But don’t get confused, discouraged or angry if you see your profits evaporate overnight. Instead, what you can do is understand what’s going in the shadowy hours between 4:00 p.m. and 9:30 a.m. on Wall Street – and leverage the heck out of it.

The process itself is called after-hours trading. It isn’t a new phenomenon, but it’s constantly evolving and growing. After-hours trading is conducted by highly sophisticated electronic bulletin boards called electronic communications networks (ECNs). You may have heard of some of these ECNs: Archipelago, ATTAIN, INET, MarketXT and NexTrade.

These emerging networks are giving brokers and individuals more access to after-hours trading, boosting the frequency and volume of late-night trading. But as you know, this can end up becoming a nuisance.

Back in the days of Wall Street superstars like Benjamin Graham and Bill Tweedy, investors used the hours between 4 p.m. and 9:30 a.m. to contemplate companies, read the news, develop strategies and even sleep. In turn, companies used those hours to issue news alerts and update investors on corporate activities.

In those days, only stockbrokers could trade on the market, and the only trades going on in the after hours were big-block trades from professionals and institutions. In the 1990s, the stock market opened its doors to individual investors, and it wasn’t long until those investors wanted the same benefits as the large institutions and mutual funds, including equal access to after-hours trading. They got their wish in 2003.

Historically, all investors had a fair jump into the trading day when the bell rang at 9:30 a.m. With after-hours trading open to all investors, it is possible that a stock could experience a major price movement overnight. That means your stock might now open at a completely different price than the one you saw when you shut down your computer and headed home the day before.

But nighttime and daytime trading are as different as, well…night and day. Technically, after-hours trading isn’t so much trading as matchmaking. Shares swap on ECNs, but there is no human exchange of them. There is no verbal deal-making. So how are all those shares bought and sold in the middle of the night? Electronically. ECNs are like massive electronic bulletin boards that connect matching orders.

The major exchanges do have trades that go through for up to an hour after market close, and those trades are based on market close prices. And some NYSE-listed stocks are traded on foreign exchanges, in different time zones. But for the most part, post-4 p.m. and pre-9:30 a.m. orders go through an ECN. Even though they’ve been around for over 5 years, ECNs were off limits to individual investors until 2003. In simple terms, ECNs are subscription-based services that retail brokers can use to match buy and sell orders during the market day, and after hours.

One substantial risk in after-hours trading is limited volume. To avoid such a problem, the NYSE has specialists to control the trades between buyers and sellers. The Nasdaq is an electronic exchange, but it has market makers who are able to accept and give orders at slightly different prices between buyer and seller. That window of flexibility is called a spread, and the market maker will keep the profit or take the loss incurred by the spread. But ECNs have none of those built-in protections and can only match exact trades. Therefore, they can also only take limit orders.

Of course, the obvious problem with this system is that the ECN may not be able to match a buy or sell order. In that case, the order will remain unfilled until a matching trade materializes. If it doesn’t, the trade won’t happen. In regular market hours, this normally isn’t a problem, because there are specialists or market makers keeping track of everything. But when dealing with ECNs, your options for order execution are much more limited.

The obvious advantage to after-hours trading is that investors can respond immediately to news released after normal trading sessions end. But the resulting problem is that there are fewer buyers and sellers, and many trades are left uncompleted. And this limited liquidity is a greater issue for smaller-cap stocks, which don’t have as many shares in the open market to begin with.

Not to mention that after-hours trading is an unbalanced situation between the individual investor and largei nstitutions, with the individual investor in the weakest position. Individuals end up competing for limited liquidity with resource-laden institutions.

Compacting this weakness is the fact that individuals still depend on their broker’s relationship with the ECN. Some brokers don’t have the ability to trade on multiple ECNs and therefore can’t match orders across networks or even view quotes from other ECNs. As it stands now, there isn’t even a public ticker for after-hours trading.

Also, flexibility is sacrificed when it comes to the actual order itself. Most ECNs only accept limit orders, because the ECN is simply connecting matching buy and sell orders. If the stock you’re trading never reaches your limit buy or sell price, your transaction will not be executed. And because the order goes from brokerage to ECN and back, transaction times are much slower than what you find during normal market hours.

Already, we can see that as the world moves toward a truly global economy, after -hours trading is an integral element of the future. And there are initiatives to improve it, including talk of a public after-hours ticker.

For now, if you do trade on the ECNs, find a broker that has access to multiple ECNs. If you decide not to take your chances on the ECNs, you can still make after-hours trading beneficial for you. With the increasing participation of individual investors after hours, overnight price fluctuations will become more common. By simply monitoring the after-hours trading, you can pregauge the next regular trading session’s activity. Also, because there are stock markets all over the world, in dozens of time zones, after-hours trading can also serve as a way to monitor the effects of international markets.

By the way, INET has already applied to the SEC to be a new stock exchange. If that is approved, expect to see traditional exchanges like the NYSE suffer drops in activity. Along with the rest of the world, Wall Street is surging ahead toward a global, 24-hour market.

Best regards,

Angela Roberts

February 04, 2005

Shedding Light on After-Hours Trading was originally featured in the Penny Sleuth.

*** “The stock market is a study in cycles; when it changes direction, it remains in that new trend until the momentum weakens — a body in motion tends to stay in motion. Remember, don’t buck the trend. Don’t fight the tape.”

That quote is from Jesse Livermore: World’s Greatest Stock Trader by Richard Smitten. It is a fantastic book. I just finished it last weekend.

In case you don’t know, Jesse Livermore is regarded as the best trader ever to walk the Earth. He made (and lost) millions of dollars time and time again in the early 1900s. But his largest win came on Black Tuesday.

When the U.S. markets came crashing down in October 1929, in what turned out to be the start of the Great Depression, Livermore was prepared. Weeks before, he went short the biggest-name stocks of the day. His indicators told him the market trend was changing from bull to bear. And he was right.

While everyone else lost the farm — many literally — Livermore walked away with over $100 million in earnings. It was such an amazing feat that people literally blamed him for the crash. They were jealous with rage. So…

How did he do it?

Livermore studied the markets like you wouldn’t believe. And over the years, he
developed a set of rules — rules he lived by each and every day. One of his most important rules was, “Don’t fight the tape.” What he meant by that was simple…

As a trader, or an investor, your best bet to make money is to invest in the direction of the major trend. For instance, if you are in a bear market (when the indexes are in a sustained downtrend), your easiest money will be made going short. This is what Livermore did in 1929. Likewise, when the market is in an uptrend, like it is now, your best bet is to stay long…and let your winners ride. This is important to remember.

It’s so easy to overthink situations. For instance…

Is the small-cap market overbought right now? It may well be. But you know what? People are still buying. And until the tape says to get out, there’s no reason you should. Right now the “easy money” is being made by being long on small caps. Period.

When that changes, I’ll let you know. But for now, everything is sunny in the small-cap world…

*** The Russell 2000 is trading for 639.03 — just a shade under its all-time high (which it recently made, on Friday of last week).

*** Big hedge funds and financial institutions are buying into small-cap funds (ETFs) quicker than you can imagine. As Dan Denning showed us last week, funds that track the Russell 2000 and S&P 600 are being flooded with more “smart money” in the last month than in all of the second and, in some cases, third quarters COMBINED! In other words…

The major players on Wall Street are just now buying into the small-cap rally. Logically, that says small-cap stocks still have momentum on their side. In fact…

*** As I type, all 10 of the best performing stocks on Wall Street (that trade for at least $5) are small-cap stocks with market caps under $1 billion. Stocks like Sola Intl., Inc. (SOL:NYSE), Applied Digital Solutions (ADSX:NASDAQ) and 724 Solutions, Inc. (SVNX:NASDAQ) are leading the way with gains of 24.5%, 22.4% and 21.2%, respectively. Not too shabby.

By the way, if you want to learn to trade like Jesse Livermore, check out this report I put together for potential traders:

www.agora-inc.com/reports/MST/liverC00

In the spirit of Wall Street legends, Irwin writes this week about how Phil Fisher got in early on a certain car radio company. Although Fisher isn’t a household name like Warren Buffett or T. Rowe Price, he started one of the most successful money management firms ever, Fisher Investments. Read Irwin’s story to see how Fisher’s buy-and-hold strategy made him a fortune in a company that went on to revolutionize the electronics industry.

Irwin, crank it up…

Why the Galvins Rule

This American electronics giant built by the Galvin dynasty helped make necking in cars a national pastime…while empowering the police who cruised Lovers Lane with the first walkie-talkie. Forty years later, when Japan, Inc. had this company in its crosshairs, the Galvins dug in for the heavyweight match…and the company’s stock had climbed 1,400% when it was over.

In fact, it was the Galvins’ enormous strength of character that impressed one of the greatest investors of all time to buy stock in this company for the long haul…giving him a profit over 23,000%.

That company is Motorola — the name derived from its popular car radio that served as a backdrop to romantic interludes on Lovers Lane. But legendary investor Phil Fisher saw a more profitable opportunity with Motorola. It happened during a meeting with then-CEO and co-founder Paul Galvin…and cemented a relationship that would last half a century.

It was the late 1950s. Paul had rescued Motorola from bankruptcy by successfully mass-producing high-quality car radios. Fisher was interested in investing in Motorola (despite Wall Street’s negative outlook on the company), and he arranged a meeting with Paul. Fisher found Galvin forthright, competent and inventive — the kind of executive that a long-term investor knows could lead a company through good times and bad.

Shortly afterwards, Fisher paid $43 per share in 1,000-share blocks. By 1997, Fisher had turned that $43,000 investment into an INCREDIBLE $10 million…proving that it pays to HOLD great small-cap stocks.

Admittedly, that kind of commitment is not for everyone. You can’t cut your losses when the stock drops. Or cash in on a rush of good news. You really have to stick to your guns. But it’s the kind of investment strategy that works for Wall Street legends like Phil Fisher…and for captains of industry like the Galvin family.

For the Galvins, it started when brothers Paul and Joe bought a run-down electronics shop on the outskirts of Chicago in 1928. At the time, the company was called Galvin Manufacturing. The brothers were completely bootstrapped. Their only assets were $565 in cash and $750 in tools. The company’s first week’s payroll was $63.

The Galvins’ extraordinary perseverance and courage turned that dingy little shop into a $27 billion conglomerate…and changed the way people live. The company that became Motorola brought mobile radios to police departments, rectangular TV picture tubes into living rooms and cell phones, well…just about everywhere. Within 76 years (three generations of Galvins), Motorola had matured into a global leader in wireless, broadband and automotive communications technologies

But the Galvins’ innovations weren’t restricted to technology. They had amazing
foresight when it came to employee relations. Before there was ever such a thing as a benefit plan, Paul helped Motorola workers with medical bills and college tuition. Under his management, Motorola was a pioneer in profit-sharing.

After Paul’s son Bob moved into the executive ranks, in 1948, he started Motorola University – the company’s training and education center. Bob knew that Motorola’s long-term success depended on employees who could think ahead…and not repeat past mistakes. It was that kind of thinking that saved the company in the mid-1980s.

At the time, Sony had penetrated the U.S. market with innovations such as the Walkman, Trinitron color TVs and VCRs. Panasonic had achieved global domination in consumer electronics through advanced product development, manufacturing, marketing…and low-ball pricing. By the time they had set their sights on Motorola, both companies had already laid to rest major competitors in the United States and Europe.

Bob acted quickly. He enforced a world-class quality-assurance program that dramatically cut semiconductor defects…while speeding up production lines. He was now able to produce more products, at lower prices…successfully fending off a frontal assault by the Japanese.

Bob’s lasting faith in superior quality and shorter manufacturing times produced miraculous results. From 1980-1997, Motorola’s sales climbed from $3.3 billion to $29.8 billion…and earnings jumped from $192 million to $1.2 billion. Wall Street was impressed. The stock soared from $6 per share in 1980 to more than $90 in 1997 — an increase of 1,400%

But what if Bob had just focused on quarter-to-quarter results, like so many investors today? Chances are the name Motorola would have been changed to…Panasonic? And consider that if the company had gotten into the hands of offshore management, Chris Galvin would never have taken over the reins as CEO…and rescued the company in the true Galvin spirit.

Because when Chris moved into the corner office, in 1997, the company was once again facing a crisis. A glut of chips and pagers was collecting dust in warehouses. And by 1998, Motorola’s worldwide markets were in fierce decline.

All at a time when Asian competitors embarked on another wave of cutthroat pricing tactics.

As his father and grandfather before him, Chris made the tough decisions. Plants were sold, divisions reorganized and…he INCREASED R&D. Chris’ aim was to strengthen leadership through long-term innovation.

By taking the long view, Chris managed to reverse the company’s slide. The stock jumped from a 1998 low of $38 per share to $149 in 1999.

Through it all, the generations of Galvins remained levelheaded. They never panicked when the stock tanked. Or kicked back during the peaks. Instead, they always charted a course that would add long-term value to the company and its shareholders.

For the Galvins and for celebrated investors like Phil Fisher business is much more than a quarter-to-quarter roller-coaster ride. Making big returns in small-cap stocks, like Fisher did with Motorola in the 1950s, takes real stamina and determination.

That’s why for some small-cap investors, a buy-and-hold strategy can often turn a few hundred dollars into tens of thousands. They have what it takes to ride out the tough times and wait for the big payoffs. Not everyone can become the next Phil Fisher or Paul Galvin, but one way to think about having a great ride in the small-cap market is to cruise your way to profitability.

Happy investing,
Irwin Greenstein

December 07, 2004

Why the Galvins Rule was originally featured in the Penny Sleuth.

*** “James, did you know that $153 million was dumped into the IJR exchange-traded fund (ETF) yesterday? That’s $153 million in one day. Not a week or a month…but one day!”

That’s what my colleague and good friend Dan Denning told me when he called this morning from London.

This is incredible information for us small-cap investors. You see…

IJR is an ETF that tracks the S&P 600 – one of the most popular small-cap indexes. And yesterday alone, institutions and retail investors dumped $153 million bucks into the small-cap fund. That’s huge!

(In case you aren’t familiar with ETFs, they are “baskets” of stocks that track the performance of a specific index, sector or country. They are similar to mutual funds in that regard. But unlike mutual funds, you actually buy and sell ETFs like stocks. In other words, they trade on a major exchange. You get updated bid and ask prices. You can trade them intraday. And they even have ticker symbols.)

So why should you care that major financial institutions spent $153 million to buy shares of IJR yesterday?

It says the hedge funds and financial institutions, the “smart money,” are betting that the small-cap rally will continue. It says the professionals want to pad their returns heading into the last month of this year — and are looking to the small-cap market for results. And it says there is still money to be made in the small-cap market — especially in small-cap value funds. That’s good news for you and me!

Dan went on to show me some more jaw-dropping stats…

*** Another popular small-cap ETF is IWN. It tracks the value stocks on the Russell 2000 (the other major small-cap index). And folks, just like the S&P 600 fund, the major institutions can’t buy into it quickly enough.

In November alone, $250 million poured into IWN. To give you an idea how much that is, check this out…

In the entire second quarter of 2004, institutions invested $207 million in IWN. In other words, more money was dumped into this small-cap value fund in November than in all of the second quarter. Amazing. Think Wall Street thinks this rally is hot now?

You bet they do. In fact, Wall Street is so sure this small-cap rally isn’t over with that it is actually putting more money in small-cap funds like IWN and IJR than into large-cap value funds.

*** As Dan pointed out, investors only spent $47 million on the IWB exchange-traded fund in November. That’s the fund that tracks the Russell 1000 — the 1,000 largest companies on the market. If I am doing my math correctly, that means…

Investors put 5.3 times MORE money in small-cap value funds than in similar large-cap funds last month alone.

Folks, I don’t know how much longer this rally will last. But it sure as heck isn’t going to end right now. People are dumping millions of dollars into the market. And it shows…

As I type, the Russell 2000 is trading for 644 — a new all-time high!

By the way…

I’ve said it before, and I’m gonna say it again. Dan Denning is one smart guy. If you are into macro analysis, ETFs and great stock advice outside just the small-cap market, I STRONGLY encourage you to sign up for his service, Strategic Investment. You won’t go wrong with it at all.

Use this link to get quite a deal…

http://www.agora-inc.com/reports/DRI/chinaB33

*** I asked Chris Mayer, editor of Fleet Street Letter, to share a small-cap story with you. It’s one of my favorite stories of all time. And it goes to show you how profitable small-cap stocks can be. Chris, all yours…

Secrets of the Templeton

“I want you to buy me a hundred dollars’ worth of every single stock selling for no more than one dollar a share on both major exchanges.” In 1939, a young man from Tennessee gave just such an order to his broker.

He was sure that the stocks were cheap, and he reasoned that the best values must be in the most neglected and misunderstood part of market — the smallest companies trading on the exchanges. He bought about $10,000 worth of penny stocks. He borrowed all of the investment money from his boss.

Four years later, he sold the stocks for about $40,000.

The young man was John Templeton, and he was well on his way to becoming one of the most successful investors of the 20th century. His bold stroke in 1939 set the blueprint for his career. If you had to sum up Templeton’s investment credo in one sentence, you would have to say this: He bought only what was cheap. He insisted on value, and he often found that in small companies.

The Templeton Growth Fund was a small fund. Templeton liked it that way, because he wanted flexibility — the flexibility to buy the stocks of small companies. An investor who put $1,000 in his fund at inception had $20,000 20 years later, making it one of the best performing funds of all time and putting Templeton among the all-time greats in the pantheon of great investors.

What can small-cap investors learn today from the career of the old master? What follows is a short review of Templeton’s investing secrets.

First, it must be said that Templeton was a rover — his interests ranged over all markets, in a variety of countries. He loved small specialty companies and showed no desire to stick with well-known names. He owned dozens of small companies that his clients never heard of.

Investment writer John Train talks about the time he went to see Templeton and the old man challenged him to see if he knew even one-third of the names in his portfolio. Train did a bit better than that, but not by much. Nevertheless, Templeton had made his point — profits are to be found not in the main streams where the mob swims, but in the shallows where most people don’t think to wander.

A fondness for bargain prices in small companies and a willingness to invest internationally were hallmarks of Templeton’s style. He was also patient, holding on to his investments for several years.

Templeton also had a standard list of questions he liked to ask companies. Why should the future be different from the past? What are your problems? Who is your ablest competitor? Why? My favorite is this one: If you couldn’t own stock in your company, which of your competitors would you want to invest in…and why? Try that next time you talk to an executive whose company you are interested in.

When a stock Templeton bought got expensive, he found a better buy, then sold the expensive stock and bought the other. This kind of continuous comparison shopping was another of Templeton’s methods.

Today, Templeton (who turned 92 on November 29) lives in Nassau in a stately white house overlooking the serene grounds of the Lyford Cay Club. His surroundings reflect his desire to stay off the beaten path, to stay away from the noise of Wall Street. Instead, he finds time to study and think in the quiet confines of his library.

Not that the foregoing snapshot will make you into the next Sir John Templeton.
Nonetheless, there is no better way to learn to invest or improve your own results than to study the methods of the most successful investors.

For Penny Sleuth,

Chris Mayer
Editor, Fleet Street Letter

December 03, 2004

P.S. Three of my last four picks have been small-cap stocks in companies with global businesses. I’ve not followed Templeton’s model consciously, but in reading about the old fellow, I am reassured about the direction I’m taking Fleet Street Letter. The idea I’m working on now is also a global small cap, a specialist in its field with big opportunities in front of it.

Secrets of the Templeton was originally featured in the Penny Sleuth.