26.8%: That is how much John Lewis’ small-cap hedge fund (Osmium Partners) has averaged every year since Nov. 1, 2002.

Yes, nearly every small-cap stock, fund and index is up since November 2002. But John outperformed most of them, including the Russell 2000, by a healthy 7-point margin.

This past month, John gave an intriguing 40-minute presentation at the second-ever Value Investing Congress, held in Los Angeles. The title of his speech was Tiny Companies, Big Value. It was about three small-cap companies that have been kicked to the curb by Wall Street but harbor some deep, unrealized value that could make investors a nice profit.

I’ll tell you what the three companies are in a second. But first, a word about the congress itself.

Only 475 of the Top Value Investors in the World Could Attend

The Value Investing Congress is a semiannual event that attracts about 450 hard-core value investors — mostly institutional — from all around the world. Last November, it was in New York City. This time, the three-day conference was held at the Los Angeles Airport Marriott Hotel. Admission was steep at $3,000 a head. But given the lineup of speakers, it was money well spent.

Daniel Loeb of Third Point was there. Mohnish Pabrai spoke about his single favorite investment idea. John Rogers of Ariel Capital gave a great presentation about the newspaper industry and the value he sees in companies like Journal Register and Lee Enterprises. Steve Romick of First Pacific Advisors (also featured in the June 5 issue of Barron’s) spoke about the difference between “value” and value traps. And small-cap expert John Lewis talked about his three favorite stocks as well as why he likes the small-cap sector so much — even today.

Lewis believes, as we do here at Small-Cap Strategy Report, that over the long haul, there is no better place to put your money than in the small-cap sector.

Lewis pointed out that since 1927, small-cap stocks have returned 14.8% a year, compared with the S&P 500′s 12.3% return. Yet despite the magnificent returns, Wall Street still routinely ignores these tiny outperformers.

Roughly one-third of all publicly traded companies have a market capitalization of $250 million or less. Nearly 50% of them are not covered by a single Wall Street analyst. And only 1% of all invested capital goes into the small-cap sector.

When you combine this distinct lack of coverage with the sheer number of small-cap stocks on the market, there are almost always opportunities to take advantage of. The key is to weed out the noise from the real value. To do that, Lewis screens for companies with lots of cash, hidden assets that Wall Street has overlooked, insider buying and low multiples.

Three of Lewis’ favorite small-cap companies right now are The Boyds Collection (BOYD:OTCBB), MOD-PAC (MPAC:NASDAQ) and INVESTools (IEDU:NASDAQ).

A Misunderstood Small-Cap Company With Tons of Hidden Value

INVESTools sells investment courses and seminars to people who wish to manage their own accounts. Their typical client is 48 years old, has a net worth of $1.1 million, has $500,000 invested in stocks and makes at least $100,000 a year. But he doesn’t have faith that his pension plan or Social Security will be around when he retires. So he wants to manage his own account.

INVESTools gives these high-net-worth DIY investors the tools they need to be successful in this (or any) market.

The company puts on a number of free conferences/events in major cities all over America. Hundreds of people come to these seminars to listen to qualified instructors teach courses about options, value investing, technical analysis, currencies, etc. The idea is to use the seminars as a gateway to the company’s products. Once their appetite is whetted, folks are encouraged to pay for the company’s more comprehensive instructor-led workshops and in-depth home study programs.

Depending on what products the customer chooses, he can spend anywhere from $495 for basic INVESTools workshops to $24,000 for advanced courses with one-on-one counseling. And thousands of people are happy to pay those prices.

More that 209,000 people have completed one of INVESTools’ basic courses. And the company has 68,000 subscribers to its various Web programs.

Lewis estimates an INVESTools’ customer will spend between $9,000-11,000 with the company from start to finish. This is known as the lifetime value of a subscriber.

The lifetime value is an important number in the publishing world. Once you know a company’s LTV per subscriber, you can make some rough estimates about how much a business is worth — factoring in historical growth figures and cost structures. And that’s exactly what Lewis does with INVESTools. Here are his assumptions for you to see:

Depending on which LTV you use — $9,000, $10,000 or $11,000 — and how many subscribers you assume the company will have, INVESTools is worth anywhere between $10.05-29.16 a share.

Yet as of today, the stock traded for just under $9 — less than John’s most conservative estimate of this stock’s intrinsic value. Why? Because Wall Street can’t see past what appears to be steady earnings losses.

At Least 53% Cheaper Than Its Peers

If you pull up an income statement for INVESTools, it is ugly. The company reported a loss in seven of the last nine quarters. That’s why people are staying away from this stock. They think it is a bad business. But it isn’t. The value is simply hidden away a bit.

Despite the routine earnings losses, INVESTools has generated $39.9 million in free-cash flow over the last three years. And its cash from operations is even more impressive – totaling $50.3 million.

So how can such a cash-generating machine take a loss every quarter?

INVESTools is forced to defer millions and millions of dollars in revenues every quarter. Because it sells subscriptions, seminars and one-on-one training sessions, it can’t realize any revenue until the services have been delivered. For instance, if a customer pays $4,000 up front for four coaching sessions, the revenue can only be recognized as the coaching sessions are completed. So after the first session, it realizes $1,000. But the remaining $3,000 is deferred.

Eventually, it will realize most of these deferred revenues. And that will have a positive impact on both the company’s top and bottom line.

For now, the best way to value INVESTools is on a revenue and cash basis.

INVESTools trades for less than half what its peers trade for on an EV/SALES basis. And on a cash basis, INVESTools is at least 53% cheaper than the cheapest company on its radar screen. In other words, INVESTools would have to rise to between $13.57-$18 to be fairly valued. That’s in line with John’s calculations. And because INVESTools is growing rapidly, it isn’t hard to see how it might trade for a premium to its peers.

Sales rose 42% from FY 2004-2005. Deferred revenues rose 91%. And the company’s subscriber base rose from 51,000 to 68,000 in the last year. Those are all well above the industry norm.

At the end of the day, Wall Street is put off by INVESTools’ “losses.” But once it wakes up to its strong cash position, healthy balance sheet (the company has almost no long-term debt) and growing customer base, this stock could rally quite significantly.

Put INVESTools on Your Watch List

Despite INVESTool’s upside potential, I wonder how the company will fare now that the market isn’t as robust as it was say a year or two ago? Now that money isn’t as easy to make, will customers continue to spend $9,000 a year? And if consumer spending weakens (which it is starting to do), will a company that depends on the consumer dollar take a beating?

I don’t know the answers to those questions. So I am not going to put INVESTools in our portfolio at this time. However, this is a company I will continue to follow. I like its business model. And I love the fact that it generates so much cash.

In addition to INVESTools, John also said he likes The Boyds Collection and MOD-PAC. Since BOYD trades over the counter and MPAC is extremely illiquid (average daily trading volume is just 7,000 shares!), I won’t cover those in this space. But I did contact John Lewis’ office, and he agreed to let me post his PowerPoint presentation on the Small-Cap Strategy Report website. If you are a SCSR member, you can access this presentation for free.

Regards,

James
June 22, 2006

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