Garbage Stocks

Garbage Stocks Are Leading The Market
A Penny Sleuth Whitepaper Report for the Daily Reckoning

Today, the average company on the Russell 2000 trades for 23 times earnings, versus 17 for the average large-cap company on the S&P 500. In other words, small-cap stocks are more than twice as expensive as they were four years ago, while large-cap stocks are selling for 50% off their early 21st-century highs.

Instead of people hating small-cap stocks like they did in 2002, everyone loves them now. Most have made countless amounts of “easy money” over the last several years.But the days of easy money (when you buy anything and get a 30% return in three months) are over.

Unlike four years ago, interest rates are on the rise. It isn’t as easy (or as cheap) for smaller companies to get that $50 million loan they need to stay in business. On top of that, political unrest seems to be the rule, not the exception, in 2006. We are still fighting in Iraq – and will be for years. Israel is at war with Lebanon. And a slew of other countries (Iran, Syria and North Korea) are unstable at best.

Every sign that pointed to small-cap stocks rising in 2002 now points to them falling over the next three years. Whether you like it or not, we are at or near the top of the current small-cap cycle. The writing is on the wall.

Over the last seven months, the worst small-cap companies, aka “garbage stocks,” have led the market. They are up 8.71%, while the fundamentally sound companies are down 18.8%.

This kind of irrational buying always occurs at or near the end of a bubble period – just before it goes “pop.” People get used to making easy money. They forget about fundamentals – things like earnings, cash, growth and price. Instead, they opt for story stocks with great promise, but no real businesses. How else can you explain why companies like Applica, Inc. (APN:NYSE), CryoLife, Inc. (CRY:NYSE) and Xanser Corp. (NYSE:FRM) are up 191%, 76% and 23% since the beginning of the year? None of them make a dime in earnings or throw off any cash whatsoever.

Garbage Stocks: Tornado Warnings

My friends, exuberant buying can only end one way – badly. Just think back to the dot-com blowout of 2000. It wasn’t Berkshire Hathaway that was bid up 400% in 12 months. It was the worthless tech companies with no real businesses to support such a stock run-up. And when people finally realized this, millions of people lost 80%, 90% and 100% of their investments in a matter of months.

While the small-cap sector hasn’t been bid up the way the Nasdaq was in 1999 and 2000, it is overinflated. Small caps are trading at a premium to the rest of the market. And with rising interest rates, political unrest all over the world and garbage stocks leading the pack, you need to be careful going forward. All the warning signs point to a sell-off.

On July 17, John Hussman (one of my favorite money managers) published an essay called “Tornado Warnings.” He leads off by saying, “Tornadoes are more likely to strike when a tornado warning is in effect.”

This is not rocket science. When certain conditions exist in the atmosphere, the chances a tornado will strike improve dramatically. When those conditions exist in your area, a tornado warning is issued. And when a tornado warning is issued, you need to prepare for …well…a tornado.

Of course, just because a warning is issued doesn’t mean a twister will knock your house down. But it is smart to take some simple precautions during such an event.

For instance, during a tornado warning, you should take shelter in the basement. You should make sure you have enough water and food to last a day or two in case the roadways become impassible. And you should make sure you have a couple spare batteries so you can get the news on your radio in case the electricity goes out.

This is all common sense, right? Well, the same kind of logic applies to the markets. All the signs point to the possibility of a tornado touching down in the small-cap sector.

Now is the time to prepare for a sell-off. Now is the time to take profits on the speculative small-cap stocks in your portfolio you wouldn’t be comfortable holding should the market fall 10%, 20% or 30% in a year. Now is the time to insist on investing in fundamentally sound companies with great-looking balance sheets, tons of cash, growing top and bottom lines and niche products or services that won’t fade into oblivion just because the market takes a breather. And now is the time to think about holding good stocks for years, not months.

Of course, the million-dollar question is: Is there anything in the small-cap sector worth owning these days? Do these fundamentally sound companies exist?

Despite the pitfalls that exist, the answer is a resounding YES.

In the small-cap sector, there are still solid companies for you to invest in. Remember, two-thirds of all stocks on the market have a market capitalization of $1.5 billion or less. And one-third of all equities have a market cap of $250 million or less. So, you have numbers on your side. That explains why: 73% of all stocks trading for 10 times earnings or less are in the small-cap sector, 93% of all stocks trading for less than book value are in the small-cap sector, 80% of all stocks trading for less than one times sales are in the small-cap sector.

And when you combine these stats with the fact that 50% of these undervalued small-cap companies have no analyst coverage whatsoever, there are plenty of opportunities for us to sift through in the small-cap sector.

Regards,

The Daily Reckoning

Here are other Daily Reckoning articles on Garbage Stocks:

The Value Of Garbage
Dan Ferris discusses The Feds Index, an index created by Guardian Life Insurance Company of companies that are under investigation for possible wrongdoing.

Flight To Garbage
Marc Faber discusses the Dollar’s Weakness — and wonders at the large number of people who think that their chosen branch of the market is either immune or will last long enough for them to make money.

The Scariest Scenario Imaginable
Steve Sjuggerud explains that when Corporate Insiders sell, the smart money does likewise, and other reasons to be pessimistic about the market.

More useful links on Garbage Stocks:

Not All Junk Stocks Are Garbage – From Businessweek…Lower rates could boost high-yield bonds, … Other than technology and foreign stocks, junk proved to be last year’s best …
Garbage Stocks – 321 Gold Archives
Lay Surrenders, Pleads Not Guilty – Motley Fool’s Take …Is Eliot Spitzer protecting the folks who put “strong buy” on garbage stocks they hoped little old ladies would buy? Once former Enron Chief Financial …