Last month, China cut its shipments of rare earth exports to Japan. China and Japan have a maritime spat going on and this ban is probably fallout from that. In any event, the ban alarmed Japanese manufacturers who depend on China for rare earths.

The term “rare earths” refers to a group of obscure minerals, such as cerium, rhodium and neodymium. They are critical to a host of cutting-edge technologies. We use them in everything from hybrid cars to low-energy light bulbs. They are also used in all kinds of electronics, from cell phones to laptops. You’ll also find rare earths in batteries, polished glass, exhaust systems and more.

Japan makes all these things. In fact, it is the world’s largest consumer of rare earths. China is the world’s largest producer of rare earths, with 95% of the market. So you can see this is a match up of heavyweights.

Japan has vowed to find new supplies.

New supplies are out there, but there is not much production coming on line until a couple of years from now, if all goes according to plan. In the meantime, rare earths prices are up as much as fourfold this year.

This has not had as dramatic an impact as, say, a fourfold increase in the price of oil would. That’s because for most applications, rare earths are only a small percentage of the cost of the final product.

Still, prices have gone up enough — and availability is tight enough — to cause some alarm in Japan.

I think the situation is alarming not only for Japan, but for users of rare earths everywhere. This will stimulate the search for alternative suppliers. And China may want it that way anyway. The production of rare earths is tough on the environment. As the FT reports, commenting on China’s approval to develop a new rare earths mine in Jiangxi province:

“For the industry as a whole… there are signs that the Beijing government does not wish it to get too big. The consolidation of China’s rare earths sector is part of a broader national effort to shift away from this type of low value-added, high environmental impact products.”

To that end, China has raised export taxes on rare earths as high as 25%.

Stratfor, too, points to the fact that China’s rare earths industry was often not profitable. Stratfor mentions some the other things China is doing that impact both supply and demand:

“That its prolific, financially profitless and environmentally destructive production of REE [rare earths elements] has largely benefited foreign economies is not lost on China, so it is pushing a number of measures to alter this dynamic. On the supply side, China continues to curb output from small, unregulated mining outfits and to consolidate production into large, state-controlled enterprises, all while ratcheting down export quotas. On the demand side, Chinese industry’s gradual movement up the supply chain toward more value-added goods means more demand will be sequestered in the domestic economy.”

So China’s production of rare earths may fall… and it may consume more of what it produces at home. That means less for the rest of world.

Most of the production went to China in the first place because it was cheaper. And miners didn’t have to worry about the environmental damage they caused.

Both those things are changing.

The Japanese are out looking for rare earths outside of China. The FT reports Japanese firms checking out deposits in Vietnam, India, Canada and Brazil. Most of these projects are still in the early stages. And even the near-term projects need significant funding. But when they come online, they will be significant new sources of supply.

Japanese firms are finding ways to use less rare earths in some cases. For instance, Japanese engineers found a way to use half the rhodium used to make catalytic converters. There are other experimental efforts ongoing that try different materials altogether. As Stratfor notes, the rare earths boom “means many industries are in a race against time to see if alternative REE supplies can be established before too much economic damage occurs.”

So there is a window of opportunity here. I agree with Junji Nomura, who is in charge of research and development at Panasonic. “Rare earths will be a big problem for two-three years, but in four-five years, the problem will be gone.”

That’s a wide enough window to make good money speculating in rare earths. There are a handful of quality deposits out there that will begin production in the next few years.

Keep in mind these are high-risk plays. If the rare earths boom unravels, these stocks will do poorly. But if the rare earths boom can hold together for a just a year or two, these small cap stocks could soar. These stocks are volatile right now, but I will be keeping an eye on rare earths to see how this story will all play out.

Sincerely,
Chris Mayer

Penny Sleuth

November 3, 2010

How to Play the Scramble for Rare Earths was originally featured in the Penny Sleuth.

That’s exactly what’s going on with the company I’m writing to you about today. While a few of this stock’s fundamental statistics look good on the surface, deeper digging reveals a very risky penny play. Here’s everything you need to know to avoid this stock…

Pre-Paid Legal (NYSE: PPD) offers what amounts to “legal insurance”, where customers purchase a membership subscription and in return receive legal coverage for such incidents as traffic violations, trial defense, will preparation, and identity theft.

Memberships are mainly sold to middle income individuals or families, and monthly fees range from about $15-25, with some products, such as the identity theft shield, extra. The company contracts with small legal firms around the U.S. and Canada, usually driving the bulk of business for these firms through customer referrals. This makes the relationships pretty solid, with most of the firms with PPD for over 8 years.

Pre-Paid Legal pays these firms a monthly fixed fee that does not change based on the benefits realized by subscribers. This fact eliminates nearly all claims risk that most insurance companies face, making Pre-Paid less of an insurance provider and more of a referral company.

Let’s address the positives first…

Financially, Pre-Paid Legal’s business model is an attractive one. Capital requirements are low for this kind of product, which allows the company to put up nice MFI return on capital (108%) and free cash flow (14% free cash margin) numbers. Management has been generous with this free cash flow, returning it to shareholders by aggressively repurchasing shares over the past 5 years. Shares outstanding have declined at a 6.7% per year clip in that period.

Competitively, there are virtually no prepaid legal plan providers that target individual families. Nearly all competitors focus on larger employer groups, creating a nice niche for Pre-Paid to operate in. The company’s marketing structure is very low cost and scales up and down naturally with the number of subscriptions sold.

Speaking of the marketing plan though, it’s a multi-level marketing (MLM) strategy – also known as a “pyramid scheme”. Pre-Paid recruits independent salespeople who sell the product and recruit associates to do the same, earning commissions on both their own and their associate’s sales. If you’ve ever been roped into Amway or Avon (AVP), you know how this works… it usually doesn’t! About 98% of its “associates” earn less than $250 per year selling product. As a result, Pre-Paid has to consistently renew its salesperson base, as generally over half of it turns over every year.

While this leads to new one-time enrollment fee payments for new salespeople, it also leads to a lot of inexperienced and unqualified people hawking the product. This turns prospective customers off to the company and creates a bad reputation.

Scour Google and you will find no shortage of complaints against the company. It’s not just the obnoxious MLM marketing, either. While Amway and Avon have respected products, Pre-Paid’s legal coverage is fairly narrow. Hours covered in pre-trial expenses are anemic, usually less than 3 hours, with the rest fully payable by the member. Alcohol related vehicle incidents, a rather common occurrence, are not covered at all. IRS audit protection and will preparation coverage are both of little value: audit protection is usually provided by tax prep firms, and will creation can be easily done using computer software. I just don’t see much value in these memberships. Few individuals or families will face a need for these protections in any given year.

Recently, the company has run into even more problems. The FTC and SEC are currently investigating the company. The FTC is concerned with the issues outlined above regarding the product and treatment of associates. The SEC is investigating the company’s stock repurchase plan, which as mentioned above is very aggressive.

One concern here is that Pre-Paid issues generous amounts of stock to management, who then sell it through the repurchase program at higher prices. Another concern is over the abrupt resignation of founder and long-time CEO Harland Stonecipher at the beginning of March. The timing is suspect, to say the least, as the government began to turn up the heat on what is clearly a questionable business strategy.

Add to these concerns the fact that operational metrics have been weak, and you have a MFI stock that is probably best avoided. Pre-Paid Legal has been seeing increasing weakness in their subscriber base numbers. New memberships have failed to cover the number of memberships cancelled, leading to slight declines in net subscribers. Legal services are increasingly becoming more available to individuals through online based providers. Revenue fell 1.3% in 2009, and sales growth will probably be right around 0% in 2010. I don’t see any compelling growth or moat argument for this company.

Last but not least, Pre-Paid Legal is not particularly strong financially. Cash is about $36 million, debt about $42 million, with the debt-to-equity ratio high at 110% (I like to see 75% or lower). While it is far from the biggest concern, it is yet another strike against the stock.

All said, Pre-Paid Legal is just not an attractive investment from any angle, and the recent run-up in the share price doesn’t help. I’d recommend that Penny Sleuth readers look elsewhere to invest.

Sincerely,
Steve Alexander
MagicDiligence.com
Penny Sleuth

April 28, 2010

Stay Away from This Small-Cap Legal Stock was originally featured in the Penny Sleuth.

But the most important piece of news for small-cap investors thus far has been overlooked…liquidity is returning to the market.

My colleague Greg Guenthner summed it up best the other day: “FINALLY, people are buying stocks again!”

We have battled low volume for months now. There was simply no one trading. In this economy, it’s understandable. It’s a common reaction to get rid of as much as you can and hold onto the rest as tightly as possible. Unfortunately, that’s not how people make money.

As Greg put it to his Bulletin Board Elite readers back in November, “Stock prices will not line up with a company’s performance. With high volatility and low trading volume on the bulletin boards, this just isn’t going to happen right now.”

The massive sell-off, followed by this severe liquidity drought, has given small-cap investors the largest headache over the past few months.

No one likes to lose money or see investments lose 40% of their value. But small-cap traders can handle it. After all, who cares if a few of your stocks fall a bit if you also own some multipliers? A single 300% gain wipes out a dozen losers.

The problem isn’t whether or not you lose money on some investments. The problem is whether you can invest at all. As Greg was referring to above, small caps — especially those on the bulletin boards — have completely seized up. No trading means no gains. If no one is willing to buy your stake of a company, you can’t cash in on any profits you might be holding.

We’ve stared at stock charts for hours and wished volume would pick up so we could recommend certain companies. As frustrating as it’s been, nothing compares with what it’s like to see so many insane bargains left untouched. Without volume, it doesn’t matter if a $20 company is trading for $3. We just can’t touch it without buyers and sellers.

The bulletin board volume has been even worse. I’ll use an example from Greg’s Bulletin Board Elite service. One of his companies jumped from 16 cents to 32 cents on a single 2,000-share trade Wednesday morning. By yesterday morning, that same company fell back to 25 cents on another 2,000-share trade. That’s a 100% gain followed by a 22% fall on a little over $1,000 worth of trading.

While we may not be back to full volume capacity yet, this is still an improvement from the last two months of 2008. There were six full days in November and December (not including Thanksgiving and Christmas) when absolutely no shares of this company changed hands. There were many other days that only a few bucks worth of stock was traded.

We think this is the turning of the tide. Liquidity should continue to pick up, which will open up a brand-new stream of options for smart investors.

As volume continues to rush back into the market, small-cap investors must be ready to strike anytime. The market is starting to give us a chance to buy. You don’t want to miss it.

Sincerely,
Jim Nelson

January 9, 2009

Rise in Penny Stock Volume Spells Opportunity was originally featured in the Penny Sleuth.

Those shares rose steadily for the next 20 years and were worth more than $85 as recent as 2005. Taking into account Amgen’s five splits over the past 23 years, you can knock that original 1984 price down to about nine cents a share.

It’s almost impossible to believe that a company that would cost you pennies could turn into a $100 billion pharmaceutical giant specializing in the treatment of rheumatoid arthritis, anemia and psoriasis.

But Amgen did it…and investors who saw its potential laughed all the way to the bank.

That story — and so many others just like it — is pretty recognizable. Replace the company’s name and a few numbers and dates, and you have just about everyone’s reason for becoming interested in the stock market.

If you didn’t think the market could make you rich, why would you waste your time with it? The fact is, only two small groups of people actually do get rich with stocks…the brokers and the penny stock enthusiasts. Let me explain…

The brokers make money off of trading stocks. Whether you buy them or sell them, your broker takes his commission. He’ll take it on big winners and big losers. He’ll take it on trades that breakeven. As long as he gets paid, that’s all that matters.

So what does he do? He tells you to buy blue chip companies — the large, established behemoths that can only go up or down a few dollars here or there. Why would you want to do that, because the broker says it’s a good idea, and he has made a bunch of money in the market, so he must be right. Wrong! Ignore those suits.

What about the penny stock enthusiasts? How did they strike it rich? Well for starters, they don’t listen to some commission-hungry broker. They find companies like our example above. You can’t get much smaller than nine cents a share. While that one was truly the best of the best — a top tier example — it’s not alone. Many others have done just as well.

You already know the list of names that started out as penny stocks: Wal-Mart, Starbucks, Microsoft, etc… But, those aren’t flukes either.

In a famous Tweedy, Browne report back in 1983, every publicly traded U.S. stock was grouped by size. As the size of the companies in each group gets larger, the returns are smaller. The smaller the company, the larger the return. Obviously, those who invest in small companies do quite well. You could say small-caps offer a higher reward than their larger counterparts.

Let me put it this way: If you want to continue to break even (at best) while your broker gets ever richer, that’s fine. But if you want to invest in a few penny stocks and hope one becomes the next Amgen, I’m with you.

Sincerely,
Jim Nelson
September 3, 2008

The Two Money Makers in the Market was originally featured in the Penny Sleuth.

World markets collapsed everywhere over the weekend.

Tokyo’s major index, the Nikkei 225, fell 9%; the FTSE 100, London’s rule of thumb, fell 9.5%; and the Hang Seng Index, Hong Kong’s benchmark, sank 10%. The list goes on and on…

And when we look at what happened to the U.S. markets at the start of business yesterday, we saw some of the largest drops since the market opened September 17, 2001, following the 9/11 attacks. Not even the Fed could stop it with its 75-basis point cut in interest rates.

But what we pay particularly close attention to when we see the market moving so quickly is the Russell 2000. It is our benchmark. It represents the small-cap sector of the U.S. market. And unfortunately for us, we’ve seen that fall even further than the rest. It’s down close to 16% over the past month.

This always happens in bad markets. Smaller companies take larger hits. They live and die on liquidity, and without that, they dry up and fade away. Now, of course there are always exceptions to the rule, which we do our best to uncover here at Penny Sleuth. But finding that needle in the haystack isn’t exactly a cinch.

We’ve laid out strategies, screens and even specific companies to invest in that act as safety nets in bear markets, but that’s just protection…

What would you say if I told you that there was an insurance policy for small-caps that also lets you double your money as everyone else loses theirs?

I’m guessing you’d take it.

Well, with a special technique you can protect your investments by betting against stocks that you think are going to go down even further. Let me show you…

Here is a chart that shows how the Russell 2000 Growth ETF — which is just a way to invest in the performance of the Index — has done over the past month:

With this special strategy, your chart would’ve looked like this:

You can see that with this $4.25 insurance policy, you could have nearly doubled your money, while the Russell 2000 fell about 16%.

Now, I’m not saying that you should bet against small-caps. They are our lifeblood over here at Penny Sleuth headquarters. You should stay vigilant with your long positions. Don’t bail on them out of fear. Remember why you invested in the first place.

However, when the small-cap stocks take it on the chin, this highly profitable insurance policy that can erase whatever short-term losses the market delivers to your long positions.

A few of us around the office call this type of strategy an “insurance policy” because it allows protection and profit as markets crash. Others around the office refer to it as a “paddle strategy” because you will have to use it to paddle your way through the flood of falling stocks.

No matter what you call it, it’s still a little known strategy that you should look to take advantage of right away.

Sincerely,

Jim Nelson
January 23, 2008

Using the Bear Market Paddle Strategy was originally featured in the Penny Sleuth.

Small stock investments typically take one of three shapes. A rising star is a growth stock that evolves from a microcap to a megacap status, seemingly overnight. Another type of small stock is the fallen angel. Like Icarus, who, in Greek mythology, soared too close to the sun and fell because his wings melted, hyperactive growth can lead to disastrous missteps, which can cause a fall from grace. Small stocks that fall from the large-cap arena into the small or even the microcap world could be considered “damaged goods.” The third path of a small stock can be like the rise of the phoenix from ashes. It is a resurgent fallen angel or a stock into which market participants have priced too much risk. All investors want to partake in the first and third stages and avoid at all costs, buying into a falling angel. At one time or another, all stocks fall into one, two, or even all three of these categories.

One can reasonably argue that Oxford Health Plans, the health management organization, has, fortunately and unfortunately, moved through each of the three stages identified — it has been a rising star, a falling angel, and, possibly, a rebounding fallen angel. Cisco Systems, the networking hardware giant, could be seen as a rising star that gained megacap status in just seven years. Cisco has managed to step away from significant threats and nimbly avoid the second stage that rapidly growing companies can encounter. Detailed analyses of these two companies follow.

Oxford Health Plans

A managed care organization that embodied the hopes for a market-based solution to rein in health care costs, this start-up was founded in 1984 and successfully grew into one of the most profitable health management organizations (HMOs). Oxford Health Plans (OXHP) went public in 1991 at $45 million market capitalization and quickly issued an additional 30 million shares, pushing its capitalization to roughly $136 million by September 1991. The stock then rapidly became a star performer by gaining more than 68 percent in market capitalization in just 12 months (see Figure 1.2).

The demand of the market for accelerating growth stocks may have encouraged a more rapid expansion than was foreseen in Oxford’s original game plan. The firm had entered the Medicaid and Medicare markets by 1992 and introduced additional plans to broaden its customer base. Aggressive acquisitions in other related fields and regional markets allowed the company to deliver exceptional growth. The stock raced to new highs; by 1993, its market capitalization had shot up to more than $1 billion. Oxford became a midcap stock by late 1994.

Unfortunately, as companies gain growth momentum and become more sizable, the path to continued success becomes narrower. Oxford became a victim of its success. The rapid growth from which it benefited also made it very difficult to keep tight controls on internal systems. This fault became terribly relevant as expenses in the industry began to rise. Investors then became quite concerned and, in a single October day in 1997, Oxford lost 62 percent of its market value.

The stock continued to collapse in the subsequent year. From a high of over $6.5 billion, it fell to a mere $500 million by August 1998. In one fleeting year, a very large and successful firm with almost a blue-chip presence fell back into the small-cap market. The company has since attempted to stem the collapse by cutting costs, focusing on core businesses, and placing better internal financial and accounting controls. The stock has rebounded nicely; it almost doubled to over $1 billion by November 1999. For a second time, Oxford has been able to quickly double in size as a small-cap stock. This time, however, its path was not completely new.

Cisco Systems

Cisco Systems (CSCO), the data networking equipment company, is the classic Silicon Valley small-cap success story. The growth of this company lies in its uncanny ability to strategically focus itself on the changing demands of the data networking business. Cisco went public in 1990 with roughly $139 million in market capitalization. The stock subsequently jumped almost one hundredfold in nine years.

Cisco became known for its industrial-strength router equipment. Routers allow separate computing networks to interoperate by sharing data and functionality. With networking traffic beginning to accelerate with the rise of corporate interactivity and the profound increase of e-mail traffic in the late 1980s and early 1990s, Cisco became the dominant player in the router market (see Figure 1.3). In three years, Cisco had grown more than fourteenfold.

With the dramatic increase in the usage of network-based computing, Cisco recognized the need for additional solutions. The company smartly recognized that LAN (local area network) switches were desperately needed to alleviate network congestion. LAN switches allow traffic on a data network to be rerouted to underutilized links. Not being a player in the LAN switching business, Cisco aggressively used its highly valued stock to acquire three key players and enter this market. By 1997, Cisco had captured a dominant market share in the switching business. Since that first acquisition in 1993, technology companies, including Microsoft, Intel, and Oracle, took notice and also began using their rich stock to wield significant influence in the marketplace.

By 1999, Cisco had made several acquisitions and entered into joint ventures to tap into the rapidly growing wireless and Internet market. Cisco has made nearly 30 acquisitions in a mere six years. By 1999, Cisco’s capitalization had reached over $200 billion. Is Cisco the next Microsoft? It is certainly off to a good start.

Cisco might be considered a best-case scenario for investors. The stock became recognized, even as a small cap, in a fairly quick fashion, and the investors were rewarded. Cisco is rare because it has been unwavering as a large-cap stock. The company has been quite able to focus on, predict, and satisfy new demands in a rapidly changing technology market.

Small-Cap Cycles Tend to Be Severe

The rapid growth of the Ciscos and Oxfords of the world not only reflected individual success stories, but also was part of a greater rebound of the entire small-cap market in the early 1990s — a rebound that illustrated the type of compelling returns this market can generate. After lagging the large-cap market for seven years, small caps bounded back to the forefront of market attention. The Russell 2000 small-cap index jumped 58.6 percent from the bottom of the cycle in October 1990 to the following year. Small-cap stocks jumped 28.2 percent annually for a gross of 119.7 percent over the entire cycle. Large companies also fared well during this period, but severely lagged the smaller-company market. At least 10 small-cap funds generated returns well over 60 percent during the course of that rebound period.

In the 1970s, the small-cap market had displayed a similar superior performance on a much more extended basis. The small-cap bull market of the 1970s lasted for approximately a full decade. Small stocks generated an astounding 19.4 percent on an annualized basis. By contrast, the blue-chip sector posted a paltry 8.5 percent in this same time frame.

Along the way, small-cap fans have also taken their share of lumps. The latter half of the 1990s perhaps represents one of the most painful chapters in small-cap history. During this time, the global investment village became entranced with mega-size global franchises. Incredible sums of money were diverted from all over the world to capture some of the wealth promised by these titan-size corporations. As a result, the large-cap blue-chip franchises posted spectacular results between 1994 and 1999. In a five-year period, large companies gained a whopping 187 percent, or 23.5 percent annually. Even though small-cap returns were favorable, they posted an annual gain of only 13.9 percent. They lagged the blue-chip sector by a sizable 10 percent annually. Smaller stocks also turned in paltry gains during the 1980s. The fledgling group lagged the large-cap sector as cheap large companies flourished in the then-ensuing disinflationary environment. Between 1983 and 1990, large-cap shares outperformed smaller companies by more than 5.0 percent each year.

The long-term performance figures support the existence of a premium for smaller stocks; conversely, the small caps’ periods of underperformance can suggest that a bias toward smaller companies is misguided. Yet it is difficult to accept the contrary argument for large caps — specifically, that safer assets are accompanied by higher expected returns. Ultimately, smaller companies have to carry a higher expected return simply because they are riskier assets. Unless the market is terribly inefficient, the small-stock premium is real. If the outperformance of small stocks over the long term were indeed ephemeral, then small stocks would be unable to come public. Investors would shun this asset class and turn to companies that are indeed likely to generate superior returns.

Excerpted from Small-Cap Dynamics (c) 2000 by Satya Dev Pradhuman. Reprinted by arrangement with Bloomberg Press.

Small-Cap Dynamics was originally featured in the Penny Sleuth.

Hong Kong’s Hang Seng Index rebounded 95 points Friday. However, The Standard reported that investors are dropping small-cap stocks because many do not expect the market to rebound to previous highs anytime soon.

Speculative shares were hit especially hard. The Standard reports that the losers were mostly smaller stocks. In fact, 18 of these small companies ended the day seeing their share prices drop under HK $1.

The mayhem spread to our markets as well.

Last week was a wake-up call for Wall Street. The Dow recorded its worst performance in over four years and the NASDAQ fell 5.9 percent. The Russell 2000-our benchmark small-cap index-couldn’t recover for the week, posting a 2% loss Friday.

Is this the beginning of a new, painful recession? I don’t have an answer to that question. But what I do know is this is not the time to run from the markets, stripping every last cent from the smaller stocks you were so excited about only a few short days ago.

When I wrote to Penny Stock Fortunes readers Thursday, I told them nothing has changed. All of our original reasons for choosing the stocks in the portfolio remain true. We’re not invested in the broad market, but rather in a handful of individual companies in which we see promise.

If we keep these thoughts in mind, we should be successful. And if recent bear markets have taught us anything, it’s that we can find profitable small stocks when the overall market sours.

In 2002, the Dow lost 16.76% of its value. The NASDAQ, still reeling from the brusting of the tech bubble, posted a 31% loss. The bear market continues through early 2003.

The first asset class to recover? You guessed it: small-caps.

The Russell 2000 recovered faster and stronger than the Dow Jones Industrials or the S&P 500. This small-cap index is continuing its strength over the larger indexes to this day:

Blue = Russell 2000
Red = S&P 500
Green = Dow Jones Industrial

By far, the best way to prepare for recovery is by looking for beaten-down small stocks. These will be the picks that will lift your portfolio in the coming months.

A market downturn like this can only be viewed as a buying opportunity. As we mentioned before, if the fundamentals and your reasons for purchasing a stock have not changed, there’s no reason to panic and sell.

Stocks will be on sale for the time being. We’ll be bargain shopping over the next several weeks in the Penny Sleuth, as well as Penny Stock Fortunes. In the mean time, you’ll know where to look for the stocks that are the most likely to rebound from a lagging market.

Best,
Gunner
March 5, 2007

P.S.: Despite the market’s recent slump, many of Penny Stock Fortunes‘ newest picks are still showing some of their recent gains.

Volatile Small-Cap Stocks was originally featured in the Penny Sleuth.

Our routine was typical in Hong Kong’s single ex-pat scene. Young, ambitious men consistently file from the banks that line Queens Road up the hill to grab a pint(s) and swap outrageous stories detailing the “next big thing” to hit the Chinese market.

The atmosphere feels charged…someone knows something. If five minutes gets you nothing more than PetroChina or the Guaco Group, you instantly move on. Everybody has an “in” so to speak. Every banker and rouge hedge fund manager knows an angle. You sense this scene must be a replay of Wall Street in the 1920′s before the SEC and men like Elliot Spitzer rode into town.

When the clock struck 4:00am and the band at Dusk Till Dawn started to slow, Ted and I decided it was time to hang our hats. So back up the hill we went…Staunton Street was our destination.

I dropped to my bed fully dressed. Two hours of rock hard sleep passed when I woke up with a thirst that only multiple pints of the infamous Stella Artois could produce. I stumbled into the kitchen and checked out the fridge. All the water bottles were gone. This was not good.

At that moment, I would have walked to Shanghai for a bottle of water. But alas, even in a city of seven million, there wasn’t a bottle to be found. The 7-11′s are literally seven to eleven.

Desperation took over. Reason bowed to emotion. I stared at the sink with a squinting eye…is the tap water that bad? What are the chances? I mean, how dangerous could it actually be? The Chinese have relied on this water for decades.

Every time I leave the United States, my father always warns me to not drink from the domestic water supply… For a man whose dedicated a good portion of his life to municipal water projects, I chalked up this cautionary counsel as nothing more than professional hubris. Because at that point, any liquid short of maple syrup would have sufficed.

So without hesitation, I flipped up the tap, inserted my plastic bottle, and took down 32 ounces of Hong Kong’s finest.

What relief. After a couple more sips, I marched back bed to sleep off the last few minutes of darkness.

In fact, those were the last few minutes of any sort of respectable comfort your humble editor would experience for quite some time. Within an hour I was sprinting for the bathroom. The intensity of the pain rivaled the moment I crushed my left kidney under the axel of a John Deere hay wagon a few years back. Words don’t do this agony justice.

I’m serious… Really, I’m not kidding. In retrospect, it’s quite comical. But after two straight days of 20+ trips to the bathroom, I started to get a tad worried. Four days passed, no relief. I had no choice. Back in the red taxi I jumped. The nearest Hong Kong hospital was the destination.

The doctor spoke no English…not even a hello. Imagine trying to tell him your name is Kif.

After five minutes of pointing to every orifice on my shriveled, pale stricken excuse for a living corpse, he nodded his head and smiled. “Glad you find it funny,” I said. He kept smiling. Bastard.

He said something in Cantonese and left the room. Two minutes later I had a pack of pills. Now bear with me. If a mere thirty-two ounces of the local tap water did this, who in their right mind would accept an unmarked bag of white pills from a non-English speaking man whose credentials as a licensed M.D. were nothing more than a white lab coat and a stainless steel clipboard?

Someone with a mild case of dysentery, that’s who! It couldn’t get any worse. I thanked him, handed over the co-pay, and headed for home.

By the kind grace of God the pills started to work. The paid receded. Seven days later I was walking the streets of Soho once again.

The point: Clean water is a scarce resource in many parts of the world, especially China. Even in a city as cosmopolitan as Hong Kong, something so common to Americans as clean running water is one part of the American dream most countries can’t import.

I say this because the rising struggle for potable water has the potential to escalate to a magnitude similar to the current geopolitical conflicts over energy security.

China in particular has major problems. As Financial Times writer and author James Kynge points out: “Streams and rivers are drying up all over the northern half of the country, and water tables are falling precipitously as well, many of them illegally dug, are sunk even deeper into dwindling reserves of groundwater. Altogether, some 400 our of 668 large Chinese cities are short of water, and the incidence of rationing is growing.”

And what water does exist remains highly contaminated. The Chinese industrial machine spews around six hundred tons of mercury into the air each year, accounting for nearly one-quarter of the world’s non-natural emissions.1

Chinese mercury emissions are so destructively ubiquitous that the United States Environmental Protection Agency has warned that a third of the nation’s lakes and a quarter of its rivers are now so polluted with mercury that children and pregnant women are advised to limit or avoid eating fish caught there. One-third of that mercury comes from China.2

Readers of The Economist may recall a small blurb in the December issue highlighting Beijing’s appetite to fund the world’s largest artificial rainmaking program. That’s right… the Chinese government has entered the business of controlling the weather. The method: “weather-modification offices” dispatch rocket-launchers and airplanes loaded with silver iodide directly into the dilapidated clouds themselves. Peppering these clouds with this particular mixture theoretically enhances the probability that rain droplets will form and fall on the parched Chinese soil.

The real fear for Chinese officials isn’t so much water to drink; but more importantly, they need more and more water to irrigate the massive food supply needed to feed roughly one-fifth of all humanity. Around half of China’s landmass is uninhabited, so what farmland they do have must be utilized to its full capacity.

Above all political and economic ambitions lay the fundamental need for domestic stability. China can’t afford another famine. You see, for many Americans, the sole Asian tragedy of the 1960s was the Vietnam War. But less we forget the famine that followed Mao’s Great Leap Forward claimed the lives of more than 30 million Chinese.

And the 1960′s famine piggybacked a similar disaster a mere twenty years prior when some three million peasants in Henan died of starvation.

While most pundits illustrate China’s burning desire to scour the earth for oil, most fail to mention the fluid natural resource the Chinese need even more: water.

For investors, the day when water stocks steal the headlines from energy stocks may not be too far off. For many, that may be hard to imagine…especially those who live in regions of the world where and endless supply of fresh running water is just a faucet away.

But for those whose history with drought and starvation in the last century alone entails the loss of life of nearly 40 million of its own people, potable water becomes just as precious as the air we breathe.

I’ve touched on this theme before…and you’ll see it come up time and again here and in other publications I’m sure. My recommendation at this point is to keep our eye out for potential solutions. Will the Chinese buy millions of acres of South American arable land? Will water infrastructure be the next big thing for multi-national’s like GE and Siemens? Who’s to say?

But one thing is for certain. The world conveniently churned along for many years without abundant stockpiles of oil. However, that same world has never survived a single year without abundant stockpiles of water.

Sincerely,
Christopher Hancock
January 19, 2007

P.S.: Last year in the water industry, there were nine major takeovers. This company, with its small $300 million market cap, is a perfect candidate to be next in line.

1 James Kynge, China Shake the World: A Titan’s Rise and troubled Future – and the Challenge for America (New York: Houghton Mifflin Company, 2006) pg 152.

2 Ibid

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

I understand what Warren means.

If you are a long-term, buy-and-hold investor, the odds are you will do well in the market. And I can show you a mountain of data that would say that if you are a small-cap, long-term, buy-and-hold investor, you might do very well, indeed.

But if you’re too laid back in monitoring your portfolio, you’re going to have a few questions when you finally do get around to reading your brokerage statements…

“Why are Lucent and NCR in my brokerage account?” (Working at a brokerage a decade ago, I’ve yet to hear a single question asked more than that one…)

“Why do I now have more shares of Garmin in my account than a month ago?”

“What is this Rights Offering that I now have?”

It’s happened to all of us at least once.

A spin off, stock split, or rights offerings hits our account out of the blue, and we missed the news of its impending arrival. Of the three, though, the rights offering is the one you have to be really on top of…

A rights offering is simply another way for public companies to raise money. It gives current shareholders a chance to maintain their percentage stake in the company, and usually also a chance to buy shares at a discount to current prices.

Let’s take a recent example of this from our Small-Cap Insider portfolio, cosmetic company Revlon (REV:NYSE).

On December 18, Revlon revealed the terms of a $100 million rights offering. All Revlon shareholders of Class A and Class B shares, as of December 11, 2006, would receive rights to buy .2308 shares of Revlon Class A stock for each share they already hold. The rights would allow the stockholders to buy these shares at $1.05 a share. That’s a steep discount to the $1.31 where the stock trades today.

As a rights holder, you have three alternatives:

1. You can exercise your right and buy additional shares…which means you might have to find a substantial amount of cash you otherwise might not have planned on investing.
2. You can simply ignore the offering, and your position in the stock will be diluted. Dilution can be a real issue for a large institution or corporate insider with millions of shares, but it’s obviously less of an issue for small individual investors.
3. Finally, your last alternative is to sell the rights. Some rights, including these Revlon rights, are tradable and carry their own value. But like an option, they only have a value for a limited time. They will stop trading on January 18 — the last business day before the January 19 expiration. That’s why shareholders need to be on top of this…

Let’s walk through the Revlon example…

Let’s say you have 1,000 shares of Revlon, and you want to exercise all of the rights you’ve been granted. You can buy up to 230 shares (.2308 x 1,000) of Class A at $1.05 each, for a total of $241.50.

This may seem like a great deal, but remember that once the rights expire, there will be a lot more shares of the stock on the open market. Therefore, Revlon’s price will drop to a kind of weighted-average between the shares already outstanding and the newly issued ones offered at a lower price.

For Revlon shareholders with these rights in your accounts, they’re currently trading around $0.06 a piece under the symbol REVRT.

Note: If you have trouble finding a quote for these rights, I suggest going to the New York Stock Exchange’s Web site at http://www.nyse.com.

Until next time,
Craig
January 11, 2007

P.S.: Here’s the only investment secret (and the only two stocks) you may ever need to know to become truly wealthy.

This report is so exclusive and powerful, only 65 people can get in at this time. You see, these stocks are very small…far too illiquid for thousands of people to jump in at once.

Small-Cap Stocks Rights was originally featured in the Penny Sleuth.

Don’t believe it. Not only do I have it on good authority that these “predictions” some people are making about the market are foolish, I’ve also found a little restaurant chain that is experiencing some explosive growth. This small-cap stock could see huge gains in 2006, while some big casual dining chains continue to struggle… more on this in a minute.

First, let’s take a closer look at the naysayers. As Business Week points out, much of what the big guys are saying is pure nonsense.  

“For the past six years returns on small caps — companies typically worth less than $3 billion — have handily beaten those of large caps. And for much of that time, Wall Street strategists have been predicting that the situation would reverse itself. But the Russell 2000 index of small-cap stocks trounced the large-cap Standard & Poor’s 500-stock index by 19 percentage points in 2003 and eight points in 2004, and eked out a third-of-a point win in 2005.”

So much for dire predictions. The real question is, why is it that small-cap stocks consistently outperform the bigger fish? The answer is obvious: These smaller stocks have more potential to grow.

Forbes.com agrees: “According to researchers at Prudential Equity Group, December-quarter earnings for small and midsized companies should be up 17% or 18%, versus about 15% for large companies. The median company in the Russell 2000 Index of small companies is expected to deliver growth of roughly 18% in per-share profits this year, versus a median of less than 13% for the large companies in S&P 500 Index.”

In other words, if you want to find big growth, think small, like the company mentioned briefly by Business Week’s Aaron Pressman in his article “It’s a Small Cap World After All.” It deserves a spot on your watch list.

That company is Buffalo Wild Wings (BWLD: NASDAQ), a “wing joint,” restaurant, and sports bar rolled together in one building. So they serve more than just wings and beer. The restaurant also has a full menu and is a great place to watch the big game.

If you haven’t heard of Buffalo Wild Wings, you probably will very soon. It’s one of the top 10 fastest-growing restaurant chains in the country. In fact, a BWW (or B-Dubs, if you’re hip) just opened here in suburban Baltimore, and I went to check it out.

I had visited the restaurant several years ago in Virginia, so I thought I knew what I was walking into…but was I ever wrong. Long gone were the small dining areas and overcrowded bar. The new BWW is all about open space, with big-screen and projector TV’s everywhere. The “bar” area is a little less than half the size of the dining area, with more TVs and tables. You can even call ahead and the staff will be sure you have a good view of any of the games they have available on satellite.

And the place was packed. I was worried that the wait would be too long (at a lot of casual dining places out in the suburbs, a weekend wait can be an hour or more around dinner time) but was told that a table would be ready in 10 minutes. It’s hard to complain about that.

Of course, just because you have a good time at a bar and grill isn’t a good enough reason to lay your money on the line. But with a little research, I discovered great growth potential and some solid financials at BWW. Just take a look at some of the highlights from Buffalo Wild Wings fourth quarter earnings report, released in February:

– BWW’s total revenue increased 21.3% over the prior year to $59 million
– Company-owned restaurant sales were up 21.3% over the prior year to $52.3 million
– The company’s fourth quarter same-store sales increased 2.5% at company-owned restaurants and 2.6% at franchised restaurants over the prior year

The third highlight is very telling. Being one of the fastest-growing restaurant chains out there, it’s a given that Buffalo Wild Wings is opening tons of new locations. But the restaurant is also winning new customers at its stores that have been open for a while. It’s hard to argue with results like that…

And this $346 million restaurant chain has some more ambitious plans that are already being put into action this year, including a newly designed menu with four new wing sauces and a year-long partnership with ESPN — what president and CEO Sally Smith calls their “first step into national advertising.”

Not bad for a neighborhood wing joint. With so much going its way, maybe B-Dubs can prove some more people in the blue-chip cheering section wrong.

Until next time,

Gunner

Small Cap Revenge and One Spicy Stock That Could Fly was originally featured in the Penny Sleuth.