Smart Profits Report #511
By Karim Rahemtulla
Investment Director Small cap stocks is one area you absolutely want to be the first guy in the door, so you can grab the most money. For months now, I've been trying to analyze the current small cap stock market conditions. Often times, I show up early to the party. But you know what? That just means more profits while the others catch up. Let me give you some examples - and show you the next best place for profiting from small cap stocks... While every investor dreams about uncovering "the next Microsoft," investing in it very early, and riding it all the way to the bank for millions, it doesn't happen often. But many times, it's not just a case of identifying hot stocks. It's about spotting hot trends. For example, in late 2005, we jumped on board a fast-growing technology company called Immersion (Nasdaq: IMMR) - a leader in the "haptics" and force-feedback field. We've since mentioned their cutting edge technology many times. May 2006, I wrote about the increasing shift towards the ethanol industry and the investments within it. I then made a specific recommendation for Xcelerated Profits Report subscribers on a "stealth" ethanol play (in order to reduce our risk in what was, and still is, a young and volatile area), which we cashed out of for a 35% gain. In October 2006, I sounded the alarm bells about an impending real estate collapse and then followed it up with more advice in June 2007. We also grabbed 54% gains in August 2007 on the ultimate contrarian play at the time: Downside in the Chinese market (via the iShares FTSE/Xinhua China 25 Index - FXI). Believe me, very few people were calling for a China decline back then - and you should have seen the baffled enquiries I received from some colleagues when I recommended the play! So how about the current market? What small cap stock opportunities do we have now? While you'll find many commentators labeling the current crisis as one of liquidity, I look at it differently. I'm adamant that it's more of a crisis of confidence, not liquidity. After all, while fear and greed are the two primary forces that drive the stock market, if investors don't have confidence, then there's a problem. Here's what many rookies don't understand, though: The huge dips that we've seen in the market - especially in some of the financial sector stocks - have presented great opportunities to buy, not sell. Here's why I take this contrarian stand on financials, housing, China, and the U.S. dollar: Because of my experience and the knowledge that the system is rigged in favor of the opportunistic investor. And here's one area with some major moneymaking opportunities... Story Continues Below...
If you've looked at the small cap sector recently, you'll know that it's suffered a serious pummeling over the past six months. By definition, small cap stocks are those with a market cap of less than $2 billion. But many have endured declines between 30% and 60%. This is much worse than their large-cap peers and the major stock indexes. But this isn't surprising. Here's why: - Small-Cap Stocks Are Less Liquid: When investors stop buying and start selling, small-cap stocks do not have the kind of institutional support to avoid huge price movements, or set a floor under the price. Consider that when a large-cap like Lehman Brothers can fall 40% in a day, only to rise 30% the next, the small cap stock market is exhibiting "normal" volatility.
- Economic Slowdowns Affect Small Caps Stocks More: By their very nature, small-caps are companies that are just beginning to grow. Any dent in the economy will dent their efforts.
- SmallCap Stocks Move Higher During Bull Markets: This being the case, it makes small-caps attractive targets to sell on the way down because they have more built-in profits.
- Small Cap Stock Investors Are The Market's Biggest Gamblers: They buy on the way up, margin at the top and sell at the bottom.
- The Small Cap Stock Market Is Awash With Rumors And Crooked Players: This is the nature of the small cap game. When share prices fall, market makers and short-sellers step in and exacerbate it. Consider the Bear Stearns fiasco. If "they" can take the Bear down to $2, they can certainly take Small-Cap Stock XYZ down, too - and with a lot less effort. The market is not efficient... you can bet (or lose) your bottom-dollar on that.
I know... it's sounds totally backwards and ultra-contrarian. But when small cap stocks collapse en masse - as they are doing right now - it gives you some huge opportunities. You see, while you can still buy big caps and make money, if you really want to smash the ball out of the park a few times, there are no better bets right now than some select small-cap stocks. Here are four factors to look for when separating the great from the grisly: - No Fundamental Change In The Business: While there might be a slight slowdown for a couple of quarters, if the main business model stays intact, this is usually just part of the process. Companies to consider: Healthcare firms and medical device makers.
- Strong Balance Sheet & Lots Of Cash: Quite simply, not only does this mean a small-cap firm is better-equipped to weather a financial storm, it also means that it will have plenty more opportunities when the economy picks up. Companies to consider: Certain small-cap technology firms.
- Innovators In The Field: Firms that offer added value to bigger companies competing for market share are a major attraction. Companies to consider: Specialized technology firms and those with patented ideas.
- Takeover Targets: Small-cap companies that enjoyed healthy sales growth before the crisis and were providing services, technology, or even drug partnerships to bigger players make for tasty takeover targets. Sometimes, it's cheaper to buy your supplier when the price is right. Companies to consider: Ones that boast strong technology platforms, or medical successes
The bottom line is this: While the current crisis is significant, it will be solved given time. However, it's during that time that you can either take the opportunity to make money, or just temporarily sit on the sidelines and watch. And yes, it may be stressful at times. But like I said, I often hit the stock market parties early, so I won't blame you if you watch! That's because while some opportunities are very exciting, I often take the elevator down a few floors before zipping higher to the penthouse. And believe me... small-caps are on sale right now. Pick your targets carefully and count on history and the business cycle to guide you to profits in the months and years ahead. In a market like this, you have to have staying power - and selling into weakness will damage your portfolio. When you feel that queasy feeling that only small-cap investing can produce, dig deeper... it may be time to buy. Until next time... Karim Today's Smart Profits Notes: - Wall Street can be great at missing the boat on the best stories and small-cap investment opportunities. But when the crowd eventually warms to them, it's game on with regard to profits. While the masses twiddle their thumbs, it means many small-caps are often not widely followed and can thus be undervalued. In addition, because the SEC has some pretty tight restrictions on mutual funds' ability to invest in small-caps (it doesn't want large funds gobbling up millions of shares in lightly traded stocks and artificially driving the price higher), it gives early investors a great opportunity to buy shares at a cheap price before the stock is big enough for the big boys to get involved.
- And if you're looking for a great way to judge whether a small-cap stock is undervalued and gauge how volatile it is, take a look at these two indicators:
- PEG (Price-To-Earnings-Growth) Rati This takes earnings growth into account when evaluating a stock's potential value. Like the P/E ratio, a low PEG ratio indicates that the stock is undervalued. Look for PEG ratios under 1. It means the stock is likely to correct itself in investors' favor.
- Beta Rati This measures a stock's volatility against the broader market. A beta of 1 means that the stock's price will move in line with the market. If less than 1, it means the stock will be less volatile than the market. A beta over 1 indicates the stock will be more volatile than the market.
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