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Stocks Under Rocks: How to Uncover Overlooked, Profitable Market Opportunities

Peter Ricchiuti introduces his book, which explains how to master do-it-yourself research techniques for uncovering today’s best small-cap equity opportunities.
This chapter is from the book

“Wee” Willie Keeler was so good at hitting a baseball that he was inducted into the Hall of Fame in 1939. At only 5 foot 4 inches tall and 140 pounds, he credited not brawn but his brains for his success on the diamond. He said his strategy was simple: “I hit ‘em where they ain’t!”

In his case, “they” referred to fielders. At Tulane University’s Burkenroad Reports, our student stock researchers are employing that same strategy, but the “they” we are avoiding are money managers and securities analysts.

I will grant you that some stocks are ignored for good reason. But it still amazes me how many solid and attractively priced stocks have almost nobody following them. Most people assume that companies “orphaned” by analysts have horrible balance sheets, uninspiring growth outlooks, or are so small that investors would label them “penny stocks.” These characteristics would have me running the other way, too. But in many cases, they’ve slipped through the cracks because:

  • They operate in more than one business or industry.
  • They are based “out where the buses don’t run,” far from Wall Street.
  • They don’t have many shares traded on a daily basis and aren’t in need of corporate finance work. They don’t make very attractive clients for investment firms.
  • They lack an easily identifiable “peer group.” Most analysts compare relative valuations to determine a stock’s attractiveness. And for this, you need a peer group of like public companies. This is similar to the way real estate agents price homes by square footage, based on the sales of comparable nearby homes.

This is an especially important concept, so let me give an example. There’s a Morgan City, Louisiana, marine fabricator called Conrad Industries (CNRD). The vessels that Conrad makes are too big to compare the company to the public companies that manufacture pleasure boats, and too small to compare to those who build tankers or Navy ships. Only Burkenroad follows the stock. Such a “peerless” company often becomes an orphan stock, because analysts don’t have any valuation benchmarks.

You’re more likely to uncover these gems than any Wall Street professional.

Smaller companies tend to be overlooked by the big analysts, and my observation has been that the number of analysts following the stock seems to be inversely correlated to its potential performance. Apple (AAPL) has 65 analysts following it. Every time they drop a pencil, the analysts jump on it. If a horde of analysts are following a company, then the stock is probably priced efficiently and not a bargain. I look for companies where five or fewer analysts are following the stock.

Bayou Steel, a company that Burkenroad Reports followed, was profiled by The Wall Street Journal. They asked the CFO whether he liked having the Tulane students come over and write their reports. “Yes!” he replied. “Would we prefer to have analysts from Morgan Stanley follow us, sure, but they ain’t coming!”

The point is, people far from Wall Street run across business opportunities analysts would never know about. For my money, two of the greatest investors in history are Warren Buffet of Omaha and John Templeton, who spent his time in the Bahamas. If they had been operating out of big money centers like Boston or New York, they may have suffered from “group-think” and owned the same stocks as everybody else. Be grateful for “group-think”—it leaves a lot of opportunities for the rest of us!

When I was first thinking about starting Burkenroad Reports, I went to New York and was talking to a money manager, this big, gruff guy, and I was telling him what I planned to do—going to visit and write about these public companies headquartered in the South. And he said, “Peter, that’s a terrific idea. You know why?” He snorted. “Up here, they don’t know anything. You know what they know? They know Starbucks! They know delicatessens!”

It was actually an important message. You’re more likely to find a great company in your hometown or through the company a friend works for than the Wall Street in-crowd ever would be.

Individual investors can also have a lot more patience. Unlike professional analysts, individuals don’t need to report impressive short-term results at the end of each quarter to keep their jobs. This situation always reminds me of something my investor friend Fred Speece likes to say: “Genius is just a greater aptitude for patience.”

There are several reasons I think this is a great time for individuals to pick their own stocks.

The one big advantage that individual investors have nowadays is the Internet (quick, Batman, to The Google). In the past, investment information was the province of the big firms that dominated Wall Street. Investors had to depend on brokers or dig through newsletters and stock guides to figure out how much companies were worth and what their earnings potential might be. I actually remember taking a friend from another firm to lunch so that he could slip me his firm’s research report on a company I was interested in.

These kinds of archaic stories, like tales of writing “order tickets” and having the order takers type them up and send them to the floor, drive my Tulane students crazy. (“How old ARE you, Professor Ricchiuti?”) In truth, a lot has changed in a relatively short period of time. Working with young people is great and invigorating, but sometimes it does make you feel old. I know I’m getting old. I’m now approaching that age when the term “pulling an all-nighter” pretty much means sleeping through the night without having to get up to go to the bathroom!

And change is hard. I had a tough time getting over the stock market’s 2001 move from fractions to decimal pricing. I was really good with fractions...and where can I use that skill set now? Recipes? (1/2 cup of sugar!) Racetracks? (He’s coming around the 3/8ths pole!) Math is tough for a lot of people. They say that a waitress once asked Yogi Berra if he wanted his pizza cut into six or eight slices. “Six,” said Yogi, “I’m not hungry enough to eat eight!”

Nowadays, investors can pull up company websites and find financial analyses, annual reports, investor slide shows, and even listen to archived conference calls. And whereas in the past, investors had to pay brokers hundreds of dollars in commission, these days ordinary people can make their own trades online for just a few dollars.

So, why aren’t people taking advantage of this wealth of great information? They just aren’t interested. Stock-picking is a lost art. I think it goes back to the mood of the investor. They’re terrified and don’t want to make a move. Or, they’ve been convinced that they need to let someone else manage all their investments, to go with the crowd.

Small Caps

I once noticed a solid, well-run company in Houston that made gloves, safety goggles, and other products that protected people who worked with dangerous chemicals. It was doing well, and I thought it would fit well in Burkenroad Reports. So, I called the company and got through to the CFO’s secretary, and asked to speak to the guy. I told her who I was, and how we followed small public companies.

The secretary read me the riot act. She said, indignantly, “We are NOT a small company! We are a large, multinational corporation!” It was funny to me, because she was using the term differently than I was using it. The company had a market capitalization of about $700 million. That is what Wall Street calls a small-cap company, and believe me, there’s nothing “belittling” about that description. Almost all of our best investments are small-cap companies!

The general public thinks of a large company as one that has a lot of employees, maybe, or has a lot of stores or big earnings. Investors, on the other hand, look strictly at what we call market capitalization. It’s easy to figure: It’s simply the number of shares outstanding in the company times the stock price.

For instance, a terrific, well-managed small-cap company we follow is AFC Enterprises (AFCE), better known as the fast-food chain Popeyes Chicken & Biscuits. AFC has a market capitalization of about $750 million and is currently a small-cap stock.

RPC, Inc. (RES) is an oilfield service provider we write about and has a market cap of about $3.5 billion. It is considered a mid-cap stock.

At Burkenroad Reports, we don’t follow any large-cap stocks, but a good example might be Microsoft (MSFT). It has a market cap of over $235 billion and is definitely a large-cap stock...and out of our league. We also tend to avoid high-tech stocks. Plenty of investors have made money in technology stocks, but we’ve been successful focusing mainly on low-tech companies, and we’ll continue to “dance with who brung us.”

Here’s a current rough gauge on market capitalization:

  • Large Cap = Above $10 billion
  • Mid Cap = $2 to $10 billion
  • Small Cap = $100 million to $2 billion
  • Micro Cap = Up to $100 million

Over long periods of time, small-cap companies have significantly outperformed their large-cap brethren. Over the last 30 years, the small cap Russell 2000 (RTY) has outperformed the large cap S&P 500 (SPX) by nearly 3-1.

Figure 1.1

Click to view larger image

S&P 500 Index vs. Russell 2000 Index

I can hear you wondering right now: If small-cap companies tend to be overlooked by Wall Street, how do investors eventually make money off them? What makes their share prices go up? Can’t they just linger forever as dreaded “perma-cheaps”?

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