But before I get into the details, let me explain why I’ve been so reluctant to take a serious look at any Chinese stock, even those trading on major U.S. exchanges…

For almost a year, I’ve honored a self-imposed ban on the purchase of any Chinese stocks. I haven’t touched a single Chinese ADR since my ban — and I haven’t recommended a single one to my readers.

The saga began last year with a small Chinese travel stock called Universal Travel Group (NYSE:UTA). Back in September 2010, I recommended shares of the small-cap Chinese travel company to my readers, pinning hopes on a dirt-cheap valuation and breakneck growth in the Chinese travel industry. But the morning after I sent out the recommendation, a short seller published a report detailing why UTA was a fraud and why he was actively betting against shares. The stock opened for trading down 30%, and we quickly sent out an alert for readers to sit tight before buying while we investigated the claims.

After some digging, I felt the claims boiled down to a misunderstanding of the company’s business. Every argument for UTA being a fraud looked incorrect. Luckily, we were able to take advantage of the situation, re-issue the buy recommendation — and even ended up booking gains on the investment.

Even though we did well on the UTA investment, we were concerned about the power that unknown short sellers could have over Chinese ADRs. While there had been some rumblings about the abundance of fraud in China, UTA was one of the first major short attacks on a Chinese stock.

Then the floodgates opened. Fraud allegations appeared left and right. And short sellers eventually targeted another one of my recommendations, Advanced Battery Technologies (PINK:ABAT).

ABAT was a Chinese battery stock I recommended back in March 2010. It was up as much as 21% early last year — but that was before another short attack shoved shares more than 40% lower in a single trading day. I ended up closing the position for a loss — but was spared the 90% drop that eventually crushed the stock.

That’s when my ban went into effect. Even if Chinese fraud wasn’t truly widespread, the risks of a short attack were just too real to justify buying any of these ADRs — no matter how rosy the growth picture may have been at the time. Investors were eating up every fraud report that hit the web. There was no telling what stock would be the next target —or if the claims of fraud would even be legitimate…

But now, something has changed. I’ve found this new growth market in China that could have the potential to deliver early investors significant gains. It has the potential to be so powerful, in fact, that it could easily repel short attacks just like the ones I’ve experienced firsthand…

I’m talking about the Chinese pharmaceutical market. It’s growing faster than any other drug market on the planet right now, with some projections expecting it to balloon to $115 billion in the next three years.

Here’s the kicker: Because the Chinese government requires local testing of medicines — and because the cost for conducting the animal research to perform these tests is about half what it is in the U.S., domestic companies are beating down the doors of these Chinese drug research firms. They want to get their foot in the door so they can grab some of the profits of this red-hot growth market.

Because these Chinese-based firms are now buyout targets for major U.S. Pharmaceutical firms, we now have an extra margin of safety while exploring the sector for potential investments. If Big Pharma has sent its best people to China to investigate these businesses and their growth claims, I sincerely doubt a short-selling raid would hold up to the scrutiny.

That’s why the small-cap ADR WuXi PharmaTech Inc. (NYSE:WX) has caught my eye. Not only does WuXi grab 70% of its revenue from research for U.S. companies, it also was involved in a “near miss” $1.6 billion takeover attempt from U.S.-based Charles River Labs, according to Bloomberg. The only reason the deal went sour is because Charles River shareholders voted it down because they felt the premium was too high.

In my view, this was a huge mistake made by short-sighted Charles River shareholders…

A precedent was set by the offer — which represents a premium of more than 60% above WuXi’s market value right now. Analysts don’t see the company accepting anything less. Frankly, neither do I. WuXi is simply making too much money — and monopolizing too much U.S. business — to humor a lowball offer. According to data compiled by Bloomberg, WuXi’s profit margins are 5 times that of its U.S. counterparts. WuXi is eating their lunch, and they know it.

A buyout offer is not a matter of “if” but “when” at this point. Someone will come along with a massive offer for WuXi — or even one if its competitors in the research sector. An event like this should trigger a ton of activity in the sector. And anyone with the foresight to see the big buyout on the horizon stands to capitalize on the action.

Sincerely,

Greg Guenthner
for The Penny Sleuth

The Only Chinese Growth Story Worth Buying Right Now was originally featured in the Penny Sleuth.

We’ve entered a high-stakes election year, where the market should cycle into strength as those in power attempt to win the hearts and minds of the electorate…

The slow-burn of the Eurozone crisis is also beginning to fade. Negative headlines and poor economic data — the exact same information that paralyzed investors just a few weeks ago — just don’t seem to matter anymore…

Some analysts (including a few of my colleagues) are attributing recent market strength to the Facebook effect. But I’m not completely sold on this explanation at all. Your mom and her friends talking about the Facebook IPO does not trigger a broad market rally. Sure, stocks in similar sectors will see some buying. But no one is bidding up shares of Waste Management in anticipation of Facebook going public.

However, Facebook’s impending offering is a symptom of the market rally itself. The billionaires and soon-to-be billionaires behind the IPO weren’t going to float this stock to the general public while the rest of the market was having a fire sale. That’s not good business. Waiting until the market has its legs back will always trigger a rush of offerings that have been patiently waiting in the wings — this one just happens to be a biggie.

But it doesn’t matter who is right — it all comes down to this: the bears might win today or tomorrow, or even most of next week. But ultimately, they will suffer as stocks continue to rally, sparking short-covering that will push the market up even faster…

That’s the thing with early-stage market rallies. Buying is contagious. And when it spreads, those on the wrong side of the coin are unceremoniously slaughtered. The euphoria of stocks moving higher after months of declines lobotomizes traders. They will jump on the big move, shoving aside anyone who gets in their way.

Of course, this is not a friendly game. At the beginning of a new trend, there are winners — and losers. If you don’t properly position yourself in the early stages of a rally, you will lose. It’s a simple as that…

If you’re buying stocks that are the strongest movers off the market’s lows — with the intention of holding them — you could be setting yourself up for failure. These stocks that catch fire and outperform during an initial broad rally are usually the most heavily-oversold names on the market. Most of the time, it’s because these stocks don’t have the fundamentals to backstop any intense selling pressure.

To put this into perspective, take a look at this chart of Response Genetics Inc. from 2009:

RGDX is a micro-cap biotech with no earnings and very few assets. The stock jumped big in March 2009 as the broad market put in a bottom, but the rally couldn’t hold. Investors moved on to other stocks that offered a stronger financial cushion.

Fast forward to present day, and we’re seeing similar action in RGDX:

After a sharp selloff in 2011, RGDX is roaring back to life. But while this stock might make a fine day-trade, I don’t see it holding up as a viable medium- to long-term investment. History could very well repeat itself here — with RGDX ending up back at $1 before the market runs out of steam.

On the other hand, the stocks you can find that will ride this emerging rally will have the backing of solid fundamentals and tangible industry trends. You’ll still have the upside of an in-favor stock — but your risk will be mitigated by revenue and earnings growth and the powerful economic conditions that drive the particular sector or industry.

The week before Christmas, I laid out three major stock trends that I believed would shape the market in 2012. The first major trend revolves around a slew of pharmaceutical patents that are set to expire this year. That means Pharma stocks that are favorably positioned in the generics business should easily outperform the market.

Here’s one of the fastest-growing, profitable small-caps in the generic drug industry:

Akorn Inc. (NASDAQ:AKRX) might not be one of the best performing stocks so far this year. However, the stock continues to build on its market-beating trend from 2011 while the business consistently grows its profits and raises guidance. That’s why I recommended this stock to my readers last year — and why we’re still holding the stock today.

If you continue to seek out stocks like AKRX that have strong fundamentals and a steady, rising trend, you should have no problem avoiding the garbage stocks that sucker in so many investors during the early stages of a bull market rally…

Sincerely,

Greg Guenthner
for The Penny Sleuth

Finding an Edge When the Market Moves Higher was originally featured in the Penny Sleuth.

Surging stocks are attracting sold-out bulls to some of the most beaten-down names one the market. But it can be dangerous to swing trade an oversold stock— especially if you end up chasing the price during a melt-up move. If you’re looking to pad your portfolio by trading stocks on the rebound, just follow these three simple rules:

1. Don’t try to catch a falling knife — This is one of the simplest rules of trading any stock, not just bottom-bouncers. Inevitably, an inexperienced trader will find a beaten-down chart and proclaim that the stock couldn’t possibly go any lower.

News flash: it can go lower, and it probably will until the chart tells you otherwise.

You could even justify your speculation with an absurdly low RSI or even fundamental metrics. None of it matters. When investors want to sell, they will sell.

$8.86 and maybe lower — you don’t want to try your luck with this stock…

2. Learn how to spot a Key Reversal — Once you become familiar with bar charts, you should learn crucial reversal day patterns. A reversal day is defined as a day where a stock posts a new low followed by a higher close.

By itself, a reversal day is inconclusive. You would need additional evidence before entering a trade on the long side after identifying a reversal day. A key reversal day, however, is a clearer signal that a change in trend is near.

A key reversal day is identified when a stock makes a new low on the day, then moves to close higher than the previous day’s high.

3. Identify resistance areas — So you’ve found a stock that has shown evidence that it’s ready to bounce off a bottom and move higher. Now, you need to identify where the stock’s new-found trend will most likely slow — or even turn back. Resistance can occur at round numbers, trend lines, or near areas of congestion on charts:

Notice the gap down in early August. This marks an important area of resistance. If you were long this particular stock, it would be wise to watch how the stock reacts to the blue line. If it fails to attempt to fill the gap, it would be wise for the short-term trader to sell and move on to other opportunities…

Simply put, if a stock bumps into resistance and fails to move higher, it could be a good time to take profits off the table.

Sincerely,

Greg Guenthner
Penny Sleuth

3 Immutable Rules for Buying Rebounding Small Caps was originally featured in the Penny Sleuth.

On January 17th of this year Steve Jobs announced a leave of absence. Apple’s stock took a hit. By the time markets opened up on Monday the 18th Apple’s share price dropped from $348 to $326.

But the real story lies when Steve Jobs was forced to leave Apple in 1985. From 1985 to 1997, when Jobs was brought back on board, Apple was in serious trouble. They lost the majority of their market share to Microsoft and showed little hope of gaining it back. In 1996, the company was on the verge of bankruptcy.

But Steve Jobs came back and saved the day.

As I’m writing, Apple’s stock is already down 1.57%. Who knows where it is going from here? Apple’s dominance in the smartphone market is already under fire.

Ray Blanco, our resident technology expert, joined us back in June to talk about smartphone war between Apple and Google:

Google’s Android OS is an open source Linux variant. Android can run on devices offered by any hardware manufacturer that receives a certification from Google. iOS, on the other hand, runs only on Apple’s hardware.

This open nature has rapidly created a huge ecosystem for Android phones. It is a 21st-century replay of how the open PC platform came to dominate home and business computing in the 1980s.

Still, a great deal of credit has to be given to Apple. The iPhone and iPad devices have served as catalysts for new product markets.

And now with Steve Jobs gone…

Could this be Google’s final bite?

Fact is, who cares?

When asked today, Ray said:

The news wires are gushing with speculation over the impact the change in leadership will have on Apple.

My personal suspicion? Very little.

The innovative culture that propelled Apple to the highest capitalization on the U.S. stock market earlier this month isn’t going to disappear overnight. This is good news because Apple drives the entire industry. It makes everyone else have to bring their “A game” just to be able to compete.

In my opinion, the big news this week really isn’t Jobs’ resignation…

And if you are a true Penny Sleuther you already know the best way to profit from tech markets is not to invest in the giants like Apple. They have already established their place. You know that the best way to create fast gains is to invest in the tiny little companies. Stocks that could shoot up over night.

What you want to do is invest in the companies that will remain on top no matter who wins the smartphone war. Whether the recent news is the beginning of Apple’s demise. If this is the first step to Google’s take over. As smart small-cap investors, none of this even matters…

Stop paying attention to Apple and Google and start looking at small semiconductor companies. These small companies are providing the tools for all the major names in the business. They will continue to thrive no matter who ends up on top.

One example of the high growth in this industry is MIPS Technologies, Inc. Back in 2009 you would have had the chance to get in at $1.05 per share. As I am writing today the company is trading at $5.30 per share.

That is an astounding 504% gain!

With the accelerating growth in this market, these small semiconductor companies are the clear way to go.

Sincerely,

Jessica Comitto
Managing Editor, Penny Sleuth

Steve Jobs Resigns Again. So What? was originally featured in the Penny Sleuth.

Unfortunately, most investors get it wrong. We all fight to pile into a hot stock, retreating once the share price plummets. Of course, that’s the exact opposite of what a savvy investor should be doing. Remember — it’s not about calling a bottom. It’s about buying low and selling high. It’s a simple concept that’s goofed seemingly every day when we let our emotions creep into our portfolios.

Right now, the market is low. Some of the beaten down stocks deserve to be in the basement. But like any bear market, there are some deals out there. So who’s bullish?

Minyanville.com CEO Todd Harrison is. Harrison told Yahoo! Finance that he believes a “monster move” is in store for stocks by spring.  Harrison isn’t a perma-bull, either. In fact, he’s been quite bearish for the better part of the past year. Now, he’s telling the press that the S&P could hit 1,000 very soon.

Harrison’s prediction is closely linked to financials. He told Yahoo! that financial stocks could spark a rally due despite the intense negativity in the sector. While we find this interesting, we wouldn’t follow Harrison into his Bank of America, Morgan Stanley and Wells Fargo plays just yet…

Berkshire Hathaway captain Warren Buffett has not been so publicly bullish…but the legendary stock picker hasn’t exactly stayed quiet on the investing front. Buffett has spent his time sniping shares of the industry leading bottom-dwellers like General Electric, Goldman Sachs, and Swiss Re.

You and I may not be able to purchase preferred shares through private deals or buy up corporate debt like Buffett is doing these days. But for individual investors with a small-cap focus, there are ways to play the recession and come out on top…

• First, you need to think cheap. No, we’re not talking about fundamentals (although it’s always good to take a look at price-to-sales, debt, and other important metrics before buying a stock). In this case, we mean cheap goods sold by discount retailers. When consumers are stretched thin, cheap stuff rules the roost. Don’t believe me? Just look at yesterday’s drop. As of 4:00 p.m., only one Dow component had posted a gain: Wal-Mart. For the small-capper, screen for retailers with market caps less than $1.5 billion and you should find some interesting plays related to this idea. And for this screen, avoid specialty retailers and stores that primarily sell big-ticket items.

• During tough times, sin wins… Sin stocks are the comfort food of troubled times. A consumer who recently lost his job probably isn’t going to go out and buy a new car. But by the same logic, he isn’t going to give up his beer and cigarettes, either. In fact, the best performing stocks during past recessions have been tobacco and alcoholic beverages.

• Find the necessities. We’ve already talked about the top two recession gainers from the chart above. But what about household products? Yes, families are cutting back. But we seriously doubt they’ll stop buying toilet paper and bleach just because they’re stretched thin. There are plenty of items every family can’t live without. Companies that make the goods should do just fine…

Best,
Greg Guenthner

February 18, 2009

Three Steps to Turn a Profit in This Recession was originally featured in the Penny Sleuth.

It all begins with the struggling consumer: your neighbor. His home is worth 20% less than it was just a couple of years ago and he’s upside down on his mortgage. He was laid off from a good job back in November when everyone started to fear the worst—and was forced to take a job that pays much less.

During better times, your neighbor would pay lip service to the idea of saving money — without actually following through, of course… But the situation has now become far more serious. It’s time to save some dough and pay those bills on time… or risk losing it all.

But where to cut back? Here is a list of the average household’s top expenses, in order:

1. Social Security taxes
2. Mortgage
3. Car payment(s)
4. Groceries
5. Restaurant meals

Your neighbor can’t cut back on payroll taxes. And he has to pay the mortgage to keep a roof over his family’s head. He also needs to keep his car so he can make the drive to his job every morning. But he can always cut back on food… the easiest and most effective way to balance any family’s ailing budget.

Buying cheaper groceries is a start. But cutting back on restaurant food is crucial. As far as we’re concerned, there are three kinds of restaurant food: fine dining, casual dining, and take-out.

As you’ve probably already guessed, fine dining stocks are getting crushed right now. Morton’s Restaurant Group Inc. (NYSE: MRT) — the folks who brought us the posh Morton’s Steakhouse restaurants — have seen shares plummet more than 80% since September.

The other end of the dining spectrum is where we can make our money. As revenues at casual and fine dining establishments sag, cheap take-out and fast food joints will continue to attract cash-strapped customers. After all, a sack of burgers can sometimes be a cheaper alternative to buying groceries and cooking at home.

The ultimate in cheap food is pizza. You can’t go anywhere else and buy so much food for such a small amount of money. Your down-on-his-luck neighbor can even swing by a pizza chain on his way home from work and pick up dinner for his entire family for $10 to $15.

That’s why we’re turning to pizza’s fast food roots — Domino’s Pizza Inc. (NYSE: DPZ). This stock was $13 in September. Now, at about $7 per share, Domino’s is trading at seven times earnings and less than half sales.

Domino’s competitor Papa John’s Inc. (NASDAQ: PZZA) — also a small-cap—has seen share rise more than 50% since November. With a more reasonable multiple approaching more reasonable levels, Papa John’s has managed to sustain revenue throughout the 2008 fiscal year.

Be sure to add these names to your short list of recession-resistant plays. Both stocks warrant additional research.

Best,
Greg Guenthner

February 10, 2009

Recession-Resistant Restaurant Stocks was originally featured in the Penny Sleuth.

That interesting little quote comes from a great series of books titled Bloomberg Personal Bookshelf. My favorite in the series, naturally, is Investing in Small-Cap Stocks by Christopher Graja and Elizabeth Ungar, PhD.

That quote got us reminiscing about investments we’ve written about in other publications — stocks whose businesses are focused on lending money or investing directly in new and existing businesses. Those small-caps have done extremely well:

These two small-caps are business development companies (BDCs). Regulated by the Investment Company Act of 1940, A BDC must be organized in the U.S. for the purpose of investing in or lending to mostly private companies and giving them managerial assistance when needed. BDCs can receive capital from shareholders and other sources all in an effort to invest in long-term, privately held businesses. Ares and MCG are prime examples of a type of business where investors can buy shares in what are really a basket of privately owned companies.

While these can be great investments, you should be warned of their typical growth patterns…

When a private equity firm is in its infancy and only starting to develop its portfolio, its first few initial investments will probably have low or negative returns. It’s a phenomenon known as the J-Curve Effect.

Returns will be heavily impacted by management fees, which are taken out of the firm’s committed capital. It may take some time before the portfolio grows in value to overcome the fees and show just how good its managers are at making profitable private investments.

If you plotted the firm’s returns in the early years up to and past the point that management fees are overcome by investment profitability, it would form a “J” pattern.

Eventually, the private companies in which the firm has invested will hopefully appreciate, garnering a valuation for the private equity firm that’s higher than the sum of the original investments. Ultimately, big gains can be realized as some of these investments are sold off for large cash sums.

There are no guarantees here, of course.

Not all BDCs can be like the legendary Allied Capital (NYSE: ALD). On April 24, 2007, the company declared its 175th consecutive quarterly dividend! That’s almost 44 years of not missing a dividend payment. And for the last 10 years, Allied’s internal rate of return on its investments and loans has been approximately 22%.

BDCs can be a great source of high yields and high returns. We’ll be looking at several BDC candidates for upcoming issues of Small-Cap Strategy Report and Small-Cap Insider.

Until next time,
Craig
May 11, 2007

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

*** I went to the podiatrist yesterday and got a dose of bad news. It looks like I have arthritis in my right big toe and will require surgery. The doctor said it probably came from a combination of treadmill and cross trainer power workouts. It would be an outpatient procedure, about 2½ hours long, but I’d be on crutches for months. As I was leaving his office and feeling really sorry for myself, he broke some crushing news to me.

The good doctor has lost a bundle on small-cap stocks. Knowing that I cover the beat, he asked my opinion about what to do. I asked him about his trading practices, and I was absolutely floored when he told me that he traded on chat room gossip. Suddenly, it all became painfully clear…

He might as well be stopping strangers in the mall and asking them what they think about the market. In fact, he’d probably be better off, because at least he could look them straight in the eye. OK, fellow Sleuthers, a word of caution…

NEVER TRADE ON CHAT ROOM CHITCHAT. If you read about the world’s best traders, they always stick to their own counsel. In fact, Jesse Livermore, considered by many to be the best trader who ever lived, followed a sacred rule to ignore tips from chumps. Every time he broke that rule, he lost a bundle.

Chat rooms are just that…chat. And for all you know, it could be chat from a slobbering psychopath, an irate employee or a 9-year-old who broke into his parents’ liquor cabinet.

The only way to make big bucks on small-cap stocks is to conduct thorough due diligence, be patient and follow your stop losses (and, of course, read Penny Sleuth every Tuesday and Friday).

And talk about losing money…

*** Buy.com is planning a comeback IPO. Get this madness…

Buy.com, a self-proclaimed Internet superstore, had gone public in 2000 at $13 per share. The stock peaked at $25.13, but when it tanked to 17 cents in 2001, founder and CEO Scott Blum took it private. Now Blum is looking is to take it public again… EVEN THOUGH THE COMPANY HAS NEVER TURNED A PROFIT.

While this could be a sour deal for investors getting in after the IPO, it’s a sweet one for Blum. Since Blum paid $23.6 million for Buy.com and holds 98% of the company, a proposed IPO at $13 per share puts the company’s valuation at some $86 million. With the IPO, Buy.com will repay Blum $25.8 million that he loaned the company while it was private. And you thought sailing was an expensive hobby.

How has Blum done so far?

The S-1 filing submitted to the SEC reports that in the year ended Dec. 31, 2004, Buy.com incurred a loss of $15.4 million, down from its loss of $25.6 million in 2003. Meanwhile, operating expenses declined to $43 million last year from $166.8 million in 2000. So it looks like Blum cut losses by cutting overhead. Blum has been experimenting with various pricing formulas, but still hasn’t cracked the code…because Buy.com is losing 5 cents on every dollar of revenue.

While Buy.com may be a long-term small-cap play that capitalizes on the strength of the e-commerce wave, forget about the IPO. Instead, think crude…

*** Standard & Poor’s just issued a report under its “Small-Cap Dynamics” banner, which includes an analysis of small-cap energy stocks. When it comes to both commodities and equities, S&P believes that the segment is undervalued. Core assumptions include supply constraints, fewer existing wells primarily from a lack of investment and political instability. The shortage is expected to worsen due to greater consumption by emerging economies such as China and India.

After reading the information, I checked in with Kevin Kerr, editor of Resource Trader Alert. For those of you who haven’t heard of Kevin, he’s a regular on MSNBC.

Kevin’s take on small-cap energy stocks is that they’re offering stellar opportunities for investors to jump on the energy profits bandwagon in an affordable way.

Kevin pointed out that small-cap domestic energy stocks sold like hotcakes when crude oil backed off its highs initially Monday. It didn’t matter whether a company was focused on the Permian Basin, the Gulf of Mexico, oil, coal, gas or drilling services. If it was small, up a bunch this year and reeked of fumes, it was a candidate for indiscriminate selling.

“This sell-off really just goes to show the volatile mix of insanity and capitalism that trading is sometimes, especially since many of the names that sold off don’t normally trade on the basis of crude oil prices,” Kevin said. “Some actually explore for natural gas, for instance, which is as different from crude oil as an orange is from a potato.

“The move was largely emotion driven, as many late-coming shareholders hit the panic button when the International Energy Agency recently suggested that high crude prices would erode demand. Uh, absolutely wrong!”

I know that Kevin has a lot more on his mind….that’s why you should click here: http://www.agora-inc.com/reports/RTA/WRTAF111

*** Small-cap exchange-traded funds (ETFs) recovered from a January thrashing as institutional investors and hedge fund managers pumped $593 million into them during the last three days of the month, according to research firm TrimTabs. This begs the question, are we seeing the so-called January effect?

The January effect posits that stocks (especially small caps) have historically risen during the period starting the last day of December and ending on the fourth trading day of January. The ensuing sell-off is for tax write-offs, capital gains and Christmas present bills (after all, sweetie, the new Aston Martin V12 Vanquish S does cost $255,000).

Anyway, two research firms found there is something to the January effect. Ibbotson Associates concluded that small cap stocks performed better in January in 56 of the 69 years between 1926 and 1995. Instinet cites academic studies that show smaller stocks on the New York Stock Exchange outperformed larger ones in January by almost 11 percent from 1926 to 1981. From 1982 to 1995, the gap narrowed to 4.48 percent. Citing its own research, Instinet concluded that between 1996 and 1999, the performance difference was only 1.98 percent.

As the gap narrows, there’s a growing consensus that the January effect may become as outdated as the Druid calendar. We’ll see…

In the mean time, just before the month closed bargain hunters swooped down to drive small caps back up. For example, the Russell 2000 small-cap index received an infusion of $286 million on Jan. 31, although the index still had a negative cash flow of $773 million for the month. Obviously, the smart money is warming to small caps again. Does the January effect mean plenty of new opportunities for us in February and beyond? At this point, we’re remaining cautiously optimistic about the upswing. Stay tuned…

*** He’s back! Carl “The GRIPPER” Waynberg writes about technicals, tea leaves and rugged individualism. Let’s say that Carl has a sixth sense about these things. CUT TO:

Bulls and Bears and Pigs, Wolves and Sheep and Eagles, and One Dead Frenchman

Gustave Flaubert, the French novelist best known for his scandalous portrayal of an adulteress (published 20 years before Tolstoy’s scandalous portrayal of an adulteress), despised stupidity and cliche. His Dictionary of Received Ideas pokes merciless satirical fun at bourgeois banality. It’s a testament to overused catchphrases and a kind of anthology of the stupidity of French society during the Second Empire.

Since there was then, as now, no shortage of stupidity, it was an ever-expanding work that likely would have worn its own dust jacket – had Gus not succumbed to cliche by doing just what we all do at the end of our lives: dying. It seems his hypocrisy knew no bounds.

Human nature being what it is – and not being what it could be – Flaubert could have kept himself very busy with just this one work, and I can imagine he would have devoted at least a chapter to our friends on Wall Street. Let us pick up where Gus shuffled off.

A STOCK PICKER’S MARKET: Often preceded by “the market is at a crossroads,” “time will tell” or a fluffy, exasperated “well,” it indicates its utterer is completely stumped and has, like Gus himself, thrown in the towel.

It’s not that it’s wrong – it’s just not very helpful and there’s a troublesome implicit admission behind the cliche. Most markets are a stock picker’s market, so why make a special note of this one? The only reason would be to lower expectations. It’s a way for money managers to confess to clients, “Look, I learned how to make money in a bull market, but not in a stock picker’s market. I suppose I could work harder, but frankly, it won’t help, ’cause I’m just not that smart, so don’t expect much.” It’s kind of a welcome, even if only implied, warning coming from a crowd that hoodwinked us into believing in buying a stock when it’s rising and selling when it’s falling – a strategy Ben Graham
described as “the exact opposite of sound business sense everywhere else.”

Certainly, there are plenty of reasons to be bearish – that’s true. But the evidence is so clear – the evidence supporting a bearish view on the one hand, and the evidence telling us how to deal with it on the other – that there’s no reason to be stymied.

First, evidence of the bear…

We can start with an economy that’s beginning to look just a little winded. The yield curve has been flattening – meaning the gap between short- and long-term interest rates is narrowing – and bonds, which typically weaken when the Fed tightens short-term rates, are instead showing atypical strength. If short-term rates overtake long-term rates, you have at least part of the recipe for a recession.

If it’s true that earnings drive growth, the market’s fortunes still don’t look good. Because corporations have managed better-than-average earnings growth during the current expansion, it’s going to become increasingly difficult for them to expand their earnings moving forward, a difficulty that’s compounded by the relative dearth of technological innovation. In other words, quarterly comparisons will be much tougher this year than last.

The technical picture is crystal clear, too, with the trend having turned definitively short-term bearish just a few weeks ago. Between November and December, the Dow, S&P 500, Nasdaq and Russell 2000 all had bullish crossovers of their 50-day moving averages through their 200-day moving averages, beginning with the Russell 2000 on Nov. 1 and followed by the S&P 500 a few days later, the Nasdaq a week later and the Dow at the beginning of December. These crossovers produced the anticipated strong performances that followed. But a few weeks ago, all the indexes breached their 50-day moving averages. This looks like a classic rotation, with what was once support now offering resistance. In addition, each market rally – most recently, the three-day rally between the 13th and the 18th of January and the four-day rally from the 24th through the 27th – has been summarily sold off, indicating a top has been put in place.

Speaking of rotation, the Amex Drug Index is trading below its 50-day as well, but over the past two months, it has outperformed both the S&P 500 and the Nasdaq. This rotation in favor of drug stocks, a group that’s considered defensive, is, then, considered bearish for the broader market. Investors’ preference for drug stocks over tech stocks is an indication they’ve grown more averse to risk, an interpretation supported by the lack of new money being put to work. (Mutual fund inflows have been uncharacteristically low for a January.)

Despite all the blather you’ve probably been hearing, the one recent bright spot has been small caps. The Russell 2000 is off 6% for the month, but the ratio of the Russell 2000 (RUT) to the S&P 500 (SPX) has been in a gentle uptrend since Dec. 12. Small caps ceded market leadership to big caps in the first week of January and are now struggling to wrestle it back. If they are unsuccessful, this would be bearish – another indication of increasing aversion to risk. Indeed, big caps tend to fare best when they are being outperformed by small caps. The more likely scenario, however, is that neither will lead for the short term. The RUT/SPX ratio got a boost in November, thanks to one of those bullish 50-day crossovers. But there’s no such bullish technical indicator at work today, and the 50- and 200-day moving averages look to be leveling out into a horizontal channel that signals performance parity between small caps and big caps.

Technicals not your bag? How ’bout tea leaves?

AS JANUARY GOES, SO GOES THE YEAR: A perennial favorite among cliches. Every year – almost like clockwork – the Street breaks out into impromptu choruses of, “As January goes, so goes the year.” And to be fair, there is some statistical evidence that January does possess some unique predictive power (it’s been particularly accurate since the ’40s). But the reason for this power has escaped explanation, and more rational people think it’s a lot of hooey – “robust to data snooping,” as researchers might describe it, which means that if you set out with the idea of finding a pattern, you’ll probably find one. In investing, data snooping has given rise to all sorts of “trends” – like the January Effect – that are really just a matter of coincidence, but that doesn’t stop investors from trying to exploit them. The comforting (and kind of unnerving) thing about a trend, like the January Effect, is that it need not be real to exist. Yes, it may be a figment of the Street’s imagination, but if enough investors come to believe in it, it becomes a self-fulfilling prophecy.

Anyway, if this one holds up, we’re in for a rough ride. January’s lowlights: The Dow – lower in the first three weeks for the first time since 1982, a recession year – and the S&P 500 both down 3.5%, the Nasdaq lower by 6.8%.

One other “trend” does offer a few photons of hope, however, but it requires the Eagles of Philly to soar on Sunday. According to the Super Bowl Indicator, a win by a team from the old NFL is bullish, while a win by a team from the old AFL is bearish. Hey – it’s been accurate 30 of 38 Super Bowls! It was notably wrong last year, though, thanks to that November-to-December surge, which saved the Pats from being the market’s patsies. Perhaps another Pats victory portends not pecuniary peril, but profits.

Still, that’s not much to hang your helmet on. Another cliche comes to the rescue…

BULLS CAN MAKE MONEY, AND BEARS CAN MAKE MONEY, BUT PIGS GET SLAUGHTERED: The contrarian response to the kind of massive weakness we’re seeing is (a) to protect the downside by setting up specific exit strategies for your stocks and (b) to become more active in the search for investment candidates – not less. Contrarians look on such a decisively bearish market as not an obstacle, but an opportunity – an opportunity to search every outhouse, doghouse, cathouse, henhouse and no-tell motel for any stocks that have been unfairly punished by the bear. If you’re a contrarian, this kind of weakness is to be exploited, not feared.

And by combining a contrarian search for the undeservedly downtrodden with a search for momentum stocks that are bullishly bucking the downtrend (especially those with current or imminent bullish 50-day crossovers), a player in today’s market can be both investor and trader, setting up market-beating long- and short-term positions.

IF YOU CAN’T GRAB THE BULL BY THE HORNS, GRAB THE BEAR BY ITS CLAWS: I’m not sure what that means, either, but I do know that you can start exploiting the bear by employing some of the strategies James outlined in Sleuth just a few days ago – all value strategies and all, therefore, manifestations of a contrarian ideology. For most investors, despite all the evidence favoring it, contrarianism is still not easy to embrace. It can be unnerving to be the lone wolf, to act alone against the herd of investors. You may find comfort in the fact that those who can muster the courage tend to benefit in the long run.

WHILE THE CHICKEN AND SHEEP ARE SLAUGHTERED, THE FOX FEASTS: Now that’s a trend worth playing.

This has been…

Carl Waynberg
The GRIPPER

February 01, 2008

Carl Waynberg is editor of The GRIP, a unique contrarian investment strategy for investors who prefer the road less traveled. The GRIP targets young companies that trade on the OTC Bulletin Board. Over the past two years, his portfolios of just such stocks identified 18 companies that went on to the fame and fortune of the NASDAQ and AMEX.

Bulls and Bears and Pigs, Wolves and Sheep and Eagles, and One Dead Frenchman was originally featured in the Penny Sleuth.

*** It’s amazing how little people really know about the small-cap market. To most, investing in small-cap stocks is no different from gambling. You put your money down on a stock you think will rise. Then, a day, a week or a month later, you either cash out big or walk away poor and broken.

Thanks to this misconception, you almost never see small-cap companies featured in the mainstream media. For instance…

I got my December issue of Money magazine in the mail yesterday. The first thing I did was look at the list of companies featured. No small caps seemed to be highlighted. Thinking I missed something, I thumbed through the 196 pages anyway. I mean, come on…

Small caps have dominated this year.

By the time I reached page 105, I had some hope. I found an article called “Build the Goof-Proof Portfolio.” I thought, “There has to be at least a mention of small-cap stocks here.” After all…

Everyone knows at least 5% of your portfolio should be in small-cap stocks. That’s just simple asset allocation. But apparently, Money magazine and Michael Sivy (the author of the article) didn’t get that memo.

Sivy wrote about the five “essential principles” all investors should follow to fine-tune their investing results. I knew it was going to be ugly when his first principle started out like this…

“Focus on shares of the largest companies. Blue chips are easy to follow because the companies are closely tracked by the media and by stock analysts. Giant companies are also generally more stable than smaller ones, which often depend on a narrower range of products.”

I almost pulled my hair out. (And folks, I’m losing it quickly enough as it is.) This guy is typical of what you see in the mainstream press. They only recommend the safe stocks – the stocks they know everyone else on the damn planet will invest in anyway. And as I made my way to the next page, I had to laugh. Sivy listed what he calls “America’s Best Stocks.” Making this list were real long shots like Amgen, Texas Instruments, Lowe’s, Dell, Cisco Systems, Nike, IBM, Wyeth and Citigroup.

Way to go out on a limb, Sivy!

He obviously isn’t reading Penny Sleuth. If he did, he’d know that the Russell 2000 is reaching new highs – not the S&P 500. He’d know that over time, it’s the small-cap stocks that outperform even the best blue chip stocks. And he’d know that when everyone wants to invest in the same stocks at the same time, they are usually too late. Which reminds me…

My colleague, Carl Waynberg, who follows the OTC Bulletin Board market, has a saying…

“Most people are wrong most of the time.” In other words…

When the herd finally decides to react to an opportunity, they always do it way too late. So as a small-cap investor, your best bet is to stick to your guns. Invest in the fundamentally sound small-cap stocks that no one else is talking about or writing about in Money magazine. Go against the herd.

Some call this gambling. But it’s the only proven way to make money on Wall Street.

And speaking of avoiding the herd, my buddy Irwin has a stern warning for all investors looking to “strike it big” this holiday season. You can’t afford not to read what he has to say.

All yours, my friend…

Holiday Nutcracker: Avoid E-Commerce Insanity

Go ahead, call me a Grinch, a Scrooge, a sourpuss. But I’m fed up with the holiday parking lot insanity, surly “sales associates,” and endless cash register lines that evoke the Soviet Union. Rather than fighting the department store crowds this holiday season, I’ll be among the 86 million Americans expected to shop online – stoking a projected hot fourth quarter for e-commerce companies.

You can bet when its all said and done, this will be a record year for small-cap online retailers like Overstock.com, 1-800-FLOWERS.COM and Shopping.com. But let me warn you…

Now is NOT the time to buy into the e-commerce craze.

Despite overcoming the years of management missteps, consumer dread and bad press, the gushing sentiment pouring out of the research firms is very positive this year. The consensus is that the e-commerce companies have fixed their problems, consumers have come to appreciate the e-commerce value proposition (me included) and the bad press about hackers, scams and spam doesn’t outweigh the pleasure of shopping in your pajamas.

Even the stats look good.

Last year, e-commerce rang up $114 billion – and that’s with a “B.” The results, compiled by the National Retail Federation, showed a 51% increase from 2002. Better yet, the survey of 150 retailers found that e-commerce merchants actually rang up profits of 21% – after breaking even in 2002.

So why not invest now? After all, we are entering the most lucrative time for e-retailers. Surely, there is some money to be made. Right?

Your faithful Penny Sleuth did some digging, and the numbers just didn’t add up – especially for small-cap investors. Take a look at what happened this time last year…during a record-breaking stretch for these two small-cap e-stores.

On Nov. 3, 2003, 1-800-FLOWERS.COM closed at $10.79. But come Feb. 2, 2004, the price had slumped to $9.97 – a decline of 7.6%. Investors loaded up this time last year thinking that this stock would have to rise during the holiday. It didn’t.

The same seasonality hit small-cap superstar Overstock.com. On Nov. 4, 2002, it closed at $10.00. On March 31, 2003, the stock closed at $9.75 – a decrease of 2.5%. Again, the herd all rushed in anticipating huge gains in a quick period of time. But they, too, lost out.

This year, who knows what will happen? E-stocks could rise. At least that’s what Wall Street wants you to believe. In fact…

In anticipation of this cyclical performance, Shopping.com went public on Oct. 25 at a strike price of $18 per share. Today, as of 11:29 a.m., this small-cap wonder is trading at $25.12 – a phenomenal increase of 39.6% in only three weeks. Clearly, it’s time to buy, right?

Who knows? It may be. But I sure wouldn’t buy. Because even though I think that Shopping.com may eventually be a great opportunity, you NEVER want to buy with the herd.

Remember, the time to buy stocks ISN’T when everyone and their uncles are buying. If you want to make the most money, stick to the proven fundamentals. The best stocks of all time have been those of small-cap companies with growing sales and earnings (and NOT just during the holiday season) that are trading for a fair price. Period.

The worst mistake you can make as an investor or a trader is to buy into an idea or a company just because everyone else is. There’s a reason most people never beat Wall Street. People all move in droves. They buy the same stocks at the same time. As a result, they have similar tales to tell.

So if you want to do what everyone else is doing this holiday season – go ahead and invest in e-retailers right now. But remember what happened last year. Instead of making a little extra cash to pay for some of those pricey holiday gifts, investors found themselves in more of a hole.

While you can be sure I’ll be doing most of my holiday shopping online this year, you won’t find me in line waiting to call my broker. Hopefully, I won’t see you in line either.

Happy investing,

Irwin Greenstein

November 19, 2004

Holiday Nutcracker: Avoid E-Commerce Insanity was originally featured in the Penny Sleuth.