*** The Russell 2000 index closed at 613 last night. That’s down 14 points from its all-time high of 627 — which it reached last Wednesday. It seems investors are taking some profits off the table. And I can’t say I blame ‘em one bit.

2004 has been a roller-coaster ride for small-cap stocks. From January-August, the Russell 2000 plunged from 600 to 515. It lost 14% of its value in eight months.

During that free fall, I received more hate mail than you can imagine, dear reader! But I didn’t panic. In a July 30 e-mail alert to all Penny Stock Fortunes readers, I said, “I am as passionate as ever about the small-cap stock market. Over the last 100 years, no group of stocks (including mid caps and large caps) have outperformed small caps. None. And that takes into account all the ups and downs of the market — like the Great Depression of 1929, the bull run of the 1990s and this recent downswing.

Over time, small-cap stocks will make you money. Period. And you can bet I will be here to help you find the best small-cap stocks on the market to boost your portfolio.”

Sure enough, the next month, small-cap stocks found their second wind. The Russell 2000 climbed back to 550, then to 575, 600 and eventually became the ONLY major index to eclipse its high from the bull run of the 1990s. And now, people are beginning to cash in — your Penny team included.

*** Angela Roberts, editor of Penny Stock Fortunes, advised her readers to take more than 50% profits on DURECT Corp. (DRRX:NASDAQ) and 12% on shares of AirTran Holdings, Inc. (AAI:NYSE). On top of those nice winners, there are seven other stocks in positive territory in the open PSF portfolio. Not too bad – especially considering just three months ago, people were ready to give up on small-caps altogether.

The secret to profiting on Wall Street is threefold. First, you must keep a level head at all times. If you get all worked up with every rise and fall of the market, you will drive yourself nuts. Plus, you will end up making irrational decisions — which never works out well.

Second, you can’t get caught up in the herd. The last thing you want to do is buy the same stocks everyone else is buying. The herd is always slow to react. And when they make up their minds to buy or sell a stock, you can bet they are way too late. Your best bet to make money is to have a contrarian attitude — to look at the fundamentally sound small-cap companies flying under Wall Street’s radar screen.

And finally, you need to have a diverse portfolio.

*** Jim Peterson, vice president of the Schwab Center for Investment Research, recommends having a 3-to-1 ratio of large- to small-cap stocks. He considers this to be a pretty neutral formula for investors — given the current market situation. And your small-cap editor thinks that sounds pretty smart.

This is NOT the time to be investing in wildly overvalued companies with no earnings, tons of debt and no real product launches in the works. Rather, it is crucial to stick to your fundamental guns. Look for companies with enough cash to survive the next few years — even as interest rates rise. Look for companies with growing sales and earnings — these will be the companies that rise even when most companies don’t. And look for companies with innovative ideas and products.

While it would be a mistake load up heavily on speculative small-cap stocks, it would also be a mistake to sell out altogether. There are still dozens of undervalued gems waiting to be discovered. In fact…

In a second, Irwin will tell you about two small-cap sectors that seem to house the most innovative companies on Wall Street. He’s done some digging around…and his findings are pretty darn interesting. But first, I have to share a moneymaking strategy with you that I developed two years ago…

*** Besides having a passion for small-cap stocks, I also like the thrill of options trading. It’s fun, fast paced and can be very lucrative. And what I like most about trading options is having the ability to make money in both up and down markets. Plus, options can give you small-cap-type returns in a few weeks — even days. You see…

When a stock is plunging, you can make money by buying puts (options that rise in price as a stock falls). And when the market rises, you can make money by owning calls (options that rise in price as a stock rises).

To help me find the best trading opportunities, I invented a trading system about two years ago that finds stocks on the rise and fall. I call it the MST Trader Alert System. It uses three of the most trusted technical indicators ever invented. And this year, I have had tremendous success. In fact, of the last 18 trades the MST System has found, 16 of them were winners. That’s an 89% win rate.

If you are a trader (meaning you are willing to gamble a bit and move quickly on a tip), I urge you to check out my MST System. It’s a great way to supplement your portfolio no matter which way the market moves. Check out my report…

http://www.agora-inc.com/reports/MST/janB19

*** Finally, I want to end on a personal note. As you know, I am a basketball nut. I love the game. Every Monday, I play hoops at a local gym. And yesterday at 6:30, I was at the gym ready to play. During the first game, I went up for a rebound and collided with another player. It wasn’t pretty. My forearm hit his nose dead on. There was blood and a lot of swearing. But eventually the situation was under control. (He is OK — just a bit sore).

Unfortunately, I angered the basketball gods.

The very next game, your Penny Sleuth editor tried to block a pass. Apparently, I didn’t react quickly enough. I stuck my hand up a bit too late, and managed to take the full impact on my middle finger. An ice run was made on my behalf. And I had to sit out a game while the throbbing pain took its course.

This morning, my finger is the size of a brick. I tried to think of a metaphor to compare my mishap to the stock market. But I couldn’t come up with anything. So the moral of the story is simple…

Don’t block a pass with just one finger. It doesn’t work. And it’s brutally painful!

Irwin, I pass the ball into your half of the court…

Innovation + Risk = $$$ in Biotech

If you want to find where the hottest small-cap companies are these days, you may have to visit 600 Dulany St. in Alexandria, Va. That’s the address of the U.S. Patent and Trademark Office, where the best and brightest inventors protect ideas that are worth millions to their shareholders. But if you can’t make it to Alexandria, just continue reading. Because I discovered one of the hottest (and most volatile) small-cap opportunities…and the secrets to its success are in those vaults.

Upstart companies are a tremendous source of innovation – and small-cap profits. They take the biggest risks to either create a new market or squeeze into an existing one by providing a better mousetrap. And given the flexibility of small-company cultures, inventors can get their products into the marketplace much faster than at big companies — where committees of product managers, marketing experts and lawyers tie up new product introductions with bureaucratic red tape.

Find it hard to believe that a small company can beat a big company to market?

Then turn to a study published in January 2002 and sponsored by the Small Business Administration’s Office of Advocacy. Conducted by CHI Research, it shows that from 1997-2002, 488 U.S. companies were awarded anywhere from 15-44 patents. And approximately half of them had fewer than 500 employees.

The ability of young companies to produce such a high percentage of patented products gives small-cap companies the hidden value, which, once discovered, can send a stock soaring. And it just so happens that most of these innovative companies reside in two related sectors — biotech and medical devices.

I know that you may be skeptical. After all, the Bush administration is fighting stem-cell research legislation tooth and nail. But forget about that for now. Because the real kingmaker in biotech is the FDA…and once a company puts out a press release that announces a key FDA approval or development, its stock can go straight up.

For example…

Cyberonics, Inc. makes implantable medical devices for the treatment of epilepsy and other debilitating neurological disorders. When the company announced on June 16, 2004, that the FDA had approved its patented epilepsy treatment, its stock shot up the next day by $15.23, or a whopping 78%.

Encore Medical Corp. closed out 2003 on a high note by announcing on Dec. 31 that the FDA gave it premarket approval for a ceramic hip replacement. By the time Wall Street returned from its New Year’s hangover, the stock rose to $9.05 on Jan. 8 — up 10.9% from the day of the news.

Encore’s year-end surge reflected an overall great year for biotech in 2003. That’s because there were 37 products approved by the FDA last year — a 25% increase over 2002, according to the Biotechnology Industry Organization (BIO), biotech’s leading advocacy group. And those new products added to both shareholders and corporate bottom lines.

If you want to put a dollar value on those FDA approvals, BIO asserts that they translated into a 46% increase in the Nasdaq Biotech Index in 2003 — turning a $1,000 investment into almost $1,500 in 12 months. And that incredible performance helped fledgling biotech companies — the future small-cap stars — raise $16.4 billion in financing, or 56% more than in 2002. You can bet that the money is being used for the R&D that leads to patent filings. And if you look at the number of companies coming up with new ideas, small-caps have a highest score.

Look no further than the SBA study conducted by CHI. It noted that in biotech, 71% small companies held patents, compared to 45% of big companies. And those are just the kinds of companies listed on the Nasdaq Biotechnology Index — a supermarket of small-cap upstarts. Digging a little deeper, you’ll see that of the 155 listings on the index, 115 are small cap. The bottom line is that 74.2% of the Nasdaq Biotechnology Index fits the profile of patent-rich, small-cap investments.

That may be why the Nasdaq Biotech Index has trounced the Nasdaq market in 2004. As of Nov. 23 at 9:53 a.m., the value of the Nasdaq biotech index was 710.68 — a 353.7% improvement over Nasdaq’s 156.53. In fact, Nasdaq Biotech has completely hammered the Nasdaq market for most of the year, registering a 52-week range of 622.01-851.44 versus 130.19-158.18 for the Nasdaq.

Now, it’s extremely important to remember that the biotech landscape is littered with has-beens, flameouts and wannabes. There are bad companies in any sector — biotech included. But if you are looking for some of the most innovative companies in the world, you have to at least pay attention to the small-cap biotech and medical device companies that are leading the way in the field of discovery.

While it can be dangerous to blindly invest in any biotech company, I do have two suggestions how to increase your odds of hitting that home run.

You can either drive to 600 Dulany St. and pore over the patent documents…or let James Boric, Angela Roberts, Sala Kannan and the CXS System find the best picks for you.

From all of us here on the Penny Sleuth team, have a wonderful and safe Thanksgiving holiday.

Happy investing,
Irwin Greenstein

November 23, 2004

Innovation + Risk = $$$ in Biotech was originally featured in the Penny Sleuth.