2 Small-Cap Plays for 2006

A close friend of mine, Ray, works down the street from us at T. Rowe Price in Baltimore. Yesterday, over dinner he told me about an incident that happened a few years ago. Ray was at an investment conference in Chicago. Some of today’s top investment bankers and financial analysts were in attendance.

At 9 a.m., all the delegates gathered in a huge hall for breakfast. The long oak tables were decorated with baskets of fruit and the smell of fresh brewed coffee wafted in the air. It was unusually loud for a gathering of 40-something Wall Street types.

Ray, holding his orange juice, tried to navigate through the crowd. He hoped to find a seat at a quieter table. He found a spot and put his orange juice down. Ray pulled his chair out and settled down beside a man with a pink tie. The man had brown hair parted to the left and a neatly trimmed mustache.

Ray and the man got to talking. Like all financial people, they spoke about the economy, interest rates, real estate, the yield curve and Alan Greenspan’s monetary policy. Ray was enjoying himself; it was a stimulating conversation.

After breakfast, when Ray was ready to leave, he realized he was so into the conversation he hadn’t introduced himself.

“I’m Ray from T. Rowe Price by the way,” he said, offering a handshake.

“Bill Gross,” said the smiling man.

Bill Gross’ Investment Ideas: Bill Gross

Even today, Ray goes red with embarrassment, thinking of the event. Last night at the dinner table, an animated Ray was recounting the incident, “I had BREAKFAST with Bill Gross and didn’t know it!!” Then he put it another way: “I had breakfast with BILL GROSS and didn’t know it!!”

Both versions sounded equally embarrassing.

Bill Gross might be a humble man, but he is one of the smartest investors around. And when it comes to spotting macroeconomic trends, nobody can beat Bill. He is the director of PIMCO Bonds and is often called the “Warren Buffett of bonds.” Gross’ fund, the PIMCO Total Return Fund, has beat 95% of its peers this year. And through the fund, he manages a massive $88 billion asset pool.

Now, I’m not suggesting you go out and invest in bonds. We’ll stick to what we do best — small-cap investing. We will take Bill Gross’ macro ideas and turn them into small-cap stock picks for 2006. So keep reading…

In his June 2005 investment outlook (which is a must-read for any serious investor and can be found online at www.pimco.com), Bill Gross makes this prediction: “At some point it comes undone, either through a massive revaluation and dollar decline, a Treasury buyer’s boycott or a whimpering U.S. consumer beaten down by the cost and/or amount of their burgeoning leverage — much of which is housing related.”

In plain English, Bill Gross is predicting the following events:

1)    The U.S dollar will fall.
2)    The housing boom will cool off.

 It’s as simple as that. Since 2000, the U.S. dollar has fallen 26% against the euro due to concerns about a growing trade deficit. As for the housing boom, huge players like Toll Brothers have already announced that their 2006 earnings will miss Wall Street expectations, and 2007 looks even worse.

As a small-cap investor, here is how you can play Bill Gross’ predictions:

1) Buy small-cap gold. When the dollar falls, investors flee to gold. As a result, gold prices will go up. Since the year 2000, the dollar slid 26%. During the same time period, gold gained an incredible 69.6%. This is great news for gold stocks. In fact, it bodes even better for small-cap gold stocks that move up higher than their large-cap counterparts when gold prices increase.

Canadian gold exploration company Seabridge Gold (SA: AMEX) is trading for $6.82. Since May of 2005, Seabridge’s stock has gained an impressive 241%. Larger competitors like Barrick Gold have risen just 28.1% during the same period. That is your advantage as a small-cap investor — by investing in small-cap gold stocks, not only do you benefit from the dollar decline, you also make 10 TIMES more money compared to large-cap gold stocks.

2) Short small-cap real estate. And just like how by going small-cap you have an advantage on the upside, you also have an advantage while shorting small-cap stocks. You see, just like how small-cap stocks go up more, they also fall harder. And Bill Gross is expecting real estate stocks to fall. That means small-cap real estate stocks will fall further than your average real estate stock.

That is great news for you. The more a stock falls, the more gains your short position will make! Take Heartland Partners LP, for example, a tiny company dealing in selling its existing properties in Illinois, Minnesota and nine other states. In the last year, the stock has plummeted nearly 79.25%. Competitors like Toll Brothers have fallen just 27%. Clearly a short position in a small-cap real estate stock would have been more profitable.

In Bill Gross’ own words, “Housing prices will cool/stop going up very much/even go down in some cities, WHEN…

“a. Interest rates rise to a high enough level to make the purchase of a new home a burden instead of a boon for first-time buyers.

“b. Mild regulatory pressure begins to reduce the amount of funny-money lending.

“c. Speculators sniff the beginning of the end.

“Let me state categorically that the above sequence is barely questionable, almost inevitable, 99% unavoidable and in modern parlance — ‘slam-dunk.’”

Regards,

Sala Kannan
December 8, 2005

Bill Gross’ Investment Ideas: How to Invest Like Bill Gross was originally featured in the Penny Sleuth.