*** In a second, I’ll tell you how I got a bump on my head the size of an Easter egg and spent an hour with the local EMS crew last night. But first, I have a recommendation for you…

If you do not own a copy of Ralph Wanger’s book A Zebra in Lion Country, you must get one — today.

Wanger was the longtime fund manager and managing partner at Wanger Asset Management in Chicago. Between 1970 and 1996 (when the book was written), Wanger averaged a 17.2% return on his now legendary Acorn small-cap fund. To give you an idea just how amazing this is, consider this…

If you started with $10,000 and averaged only a 12% return over 26 years, you would be sitting on $190,400. And that’s if you never invested a dime more than the original $10,000. Not too shabby. But check this out…

If you put $10,000 in Wanger’s small-cap fund in 1970 and let it sit until 1996 — earning 17.2% a year — you would have been worth a cool $619,609. Think about that for a second…

A five-point difference in your annual return, over a long period of time, means the difference of making $190,000 versus $620,000. That’s the miracle of compounded interest, fellow Sleuthers. That’s why small-cap stocks have always, and will always, be a better investment vehicle for you over the long haul. And that’s why Wanger’s track record will go down as one of the best of all time.

So how did Wanger manage to make 17.2% a year for so long? He invested in small-cap value companies that would rise in one of four ways…

1.Organic growth: a company that continually grows earnings, dividends and book value

2.Acquisition: a company that is eventually acquired by a larger company — usually paying a premium to shareholders

3.Repurchase: if a company is trading below its fair value, it may decide to buy back its shares — recognizing the true value in itself

4.Revaluation: once a small company gains institutional interest, it will grow rapidly — causing valuations and the stock price to soar.

Wanger goes on to say, “Good-quality smaller companies can produce stock market profits by any of these four mechanisms. The best hope for established, big-company favorites is the first — only one out of four.”

Basically, the crux of Wanger’s book is this…

Small-cap stocks are volatile creatures. When they fall, they fall hard. And most people can’t accept that. They can’t accept underperforming their peers (or the market in general). To avoid that ever happening, the average investor simply invests in the same stocks his peers do — the IBMs, P&Gs and GEs of the world. That way, they can never really lose — psychologically speaking.

Wusses!

As a small-cap investor, you are investing outside Wall Street’s comfort zone. If you were a zebra in the wild, you would be on the outskirts of the herd…

You would be one of the few zebras who opt to eat the green grass that hasn’t been trampled on by 1,000 other zebras. Of course, the risk you take is that a lion sees you…

It’s a real risk. But in the end, you have to determine your own tolerance for risk. Do you want to invest in the IBMs of the world — and seek the same returns as everyone else? Or do you have the guts to go against the herd and invest in small-cap stocks?

I doubt you would be reading this is you were an IBM investor…

*** By the way, I had to buy A Zebra in Lion Country through Amazon.com, because it’s out of print. I think I paid $7.98 for the book — shipping included! So it wasn’t too bad. I would strongly suggest reading it. You WILL be a better small-cap investor when you are finished.

*** Speaking of herds, I was playing basketball last night at Indiana University’s main gym. I was feeling good — kicking the crap out of the 18- and 19-year-olds. But then it happened…

My teammate put up a shot. It rimmed out and came down on the opposite side of the basket…

My eyes lit up and I jumped for the rebound — with nine other guys around me…all within about five feet. As I went for the ball, I collided with a player on the other team. I felt an intense pain on the top of my head. And then one guy yelled, “Holy s^&*, he’s bleeding like crazy!”

Turns out, the guy cut me with his front teeth — on my way up to get the rebound. The ambulance arrived to treat me. After getting some glucose back into my system, I felt fine. I just have a knot the size of an Easter egg. And I had to sleep with gauze strapped to my head. But it’s fine now…

(By the way, I did end up getting the rebound…and I put it back in for an easy bucket! But that’s a moot point now.)

*** All last week we told you how great Chris Mayer’s new CrisisPoint Trader is doing. Using his system he is able to make small-cap type gains in a few weeks — even days. Well, he hasn’t let us down. He booked 31% profits in 14 days on Whirlpool calls. Then, he just closed out 41% profits in Wynn Resorts puts in two days! His other two positions are currently profitable.

*** We all know about the big American holiday in July. But according to Irwin, there’s another date in July that will give small-cap investors a reason to celebrate. Party on, Irwin…

Eyeballing July 15

One reason Wall Street money managers pocket so much money is that they can state the obvious with enormous conviction. After all, if the so-called experts agree with each other, and they all do the same thing, then it becomes a self-fulfilling prophecy. But we think that come this summer, a bunch of money managers will instead be dead wrong — and we have history on our side to prove it.

The Wall Street pack registered its collective voice in a quarterly survey dated March 2005 conducted by the Russell Investment Group (the folks who brought us the small-cap Russell 2000 Index). Of the nearly 100 buttoned-down prognosticators, 71% were bullish on large-cap growth stocks. Only 32% were bullish on small-cap growth. And small-cap value stocks ranked the least favorite of our consensus-happy experts, garnering a bullish rating of merely 29% (compared to 45% who favored large-cap value).

What’s the point of the survey?

On Wall Street, the process of surveying the professionals is called “sentiment,” and it’s typically used to build forecasting models based on the opinions of people who, as it turns out, generally think alike. After all, with all that responsibility resting on their shoulders, imagine how much easier their jobs are when they can point to a million other money managers who all made the same mistake.

This time, they have turned their sentiment against small caps. Actually, since early last year, Wall Street has been warning us that large caps are about to overtake small caps — after an incredible small-cap joy ride…

For the past five years, the small-cap Russell 2000 index returned a profit of 4.3%, versus a loss of 2.73% for the large-cap Russell 1000. Over the past three years, the Russell 2000 generated a profit of 8.03%, while the Russell 1000 coughed up a paltry 3.35%. But over the past year, the tables turned hard, with the Russell 1000 returning 7.24%, compared with the Russell 2000′s 5.54% — the contrast becoming notably stark in the year-to-date returns, a 1.90% loss for the Russell 1000 against the Russell 2000′s bloodbath of minus 5.37%.

But come July 15, we think that the past and the future will collide to decimate popular sentiment…igniting an afterburner of small-cap enthusiasm. That’s because the onerous Sarbanes-Oxley Act will take effect that day for many small-cap companies.

Sarbanes-Oxley was enacted in July 2002 as a post-Enron legislative cure for executive fraud. The new law beefed up requirements for record retention, financial controls and a higher level of accountability for CEOs, CFOs and directors. Sarbanes-Oxley is very expensive to implement, and small-cap companies are eating the expense big time —
resulting in missed earnings, lowered earnings and reduced profits. Relatively speaking, the cost of compliance is much higher for small caps than for large caps, hence the longer grace period.

For example…

The law firm of Foley & Lardner said that under Sarbanes-Oxley, the average cost of being public for a company with annual revenues under $1 billion (think small cap) will surge 130%, or $1.6 million. That covers everything from accounting and audit fees, computer systems, liability insurance and higher director compensation to offset the
increased personal financial risk.

The fallout is already impacting small-cap companies and souring investor sentiment. In the CSX Alert from March 30, Angela Roberts wrote that Harvard Bioscience turned in depressed results. Even though the company’s 2004 revenues were up 6% over 2003, net income was down $2 million due to Sarbanes-Oxley compliance. And when another
small-cap company, OCA, Inc., delayed reporting its 2004 results as it struggled to implement Sarbanes-Oxley, the company’s stock plunged 10%.

While the Wall Street wingtip crowd gives small-cap CEOs a punishing knee to the groin, we wonder if they see the long-term benefits for small-cap investors that arise from Sarbanes-Oxley…such as unprecedented transparency, stronger corporate governance and stricter reporting by foreign-based small-cap operations. Because while the analysts focus on quarter-to-quarter growth, we’re expecting a small-cap renaissance after July 15.

In part, that’s because we believe that small-cap investing will never be safer. All you have to do is look back to the Securities Act of 1933, which ensured the reliable disclosure of pertinent information relating to publicly offered securities. The following year, the Securities Exchange Act of 1934 focused on secondary markets, ensuring that the parties that trade securities — exchanges, brokers and dealers — act in the best interests of investors. The Securities Exchange Act established the Securities and Exchange Commission as the primary regulator of U.S. securities markets. In this role, the SEC gained regulatory authority over securities firms — eventually hunting down the likes of Michael Milken, Bernie Ebbers and Kenneth Lay.

And small-cap stocks boomed…

Large caps registered gains of 46.5% in 1933…but small caps more than doubled, rising 104.2%. Small-cap stocks jumped 41.5% in 1935 and then gained another vigorous 36.4% the year after. So can history repeat itself with similar run-ups after the important small-cap compliance deadline of July 15?

As of that date, a portion of the 2,959 small-cap companies with valuations between $75 million and $1 billion must meet the Sarbanes-Oxley compliance deadline. It applies to companies that we categorize as small-caps that have not yet met the initial compliance deadline of Nov.15, 2004, due to the SEC’s revised schedule, based on corporate fiscal calendars, annual-report distribution and other criteria. That’s why we think July 15 is a significant milestone for investors looking for reliable, small-cap opportunities.

So let Wall Street turn bearish on small caps and leave the winners to us. Our sentiment forecasts a busy (and lucrative) summer.

Happy investing,

Irwin Greenstein

April 1, 2005

P.S. In mid-April, Angela Roberts will publish an in-depth report on the impact of Sarbanes-Oxley on small caps. Stay tuned at www.psfortunes.com.

Eyeballing July 15 was originally featured in the Penny Sleuth.