Garbage Stocks are Leading the Market

The Daily Reckoning PRESENTS: Small-cap superstar James Boric wishes for a lot of things. He wishes people hated small-cap stocks…and that these stocks were cheap. If that were the case, it would be a buyers market. But that is not at all the case today. Read on…


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. (XNR:NYSE) 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.

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.


James Boric
September 6, 2006

for The Daily Reckoning

P.S. I would like you to consider one of these opportunities this month.

Barring a massive war, natural disaster or total economic collapse here in the United States, it is almost unfathomable how you couldn’t make money owning this stock for the next 36 months.

The business is one of the best I have ever come across. It is the market leader in a growing $4.5 billion industry. It has next to no direct competitors. And on top of that, it is cheap, well run, and has a decade’s worth of superior results for you to mull over.

More importantly, this is the kind of stock that will not be crushed if a tornado touches down in small-cap land. It has a sturdy foundation that should be able to withstand 100 mph winds.

Editor’s Note: James Boric is Small-Cap Strategy Report’s editor in chief. Throughout his career, he has focused on fundamentally sound small-cap companies with market capitalizations of $1.5 billion or less.

Thanks to his renowned insights into the small-cap market, Boric has been featured in John Mauldin’s best-selling book Bull’s Eye Investing. He’s also been published on dozens of well-known investment sites, including The Daily Reckoning, Rude Awakening,, and

Today, Boric travels the world searching for the finest investment opportunities for his readers and writes about them in Small-Cap Strategy Report, Sleuth and Small-Cap Insider.

Swindled in the most gigantic flimflam of all history…

The thought has been growing in a dark corner of the lump’s mind like a poison mushroom in the shade – the average American is victim of monumental hornswoggle!

And now, adding a bucket of Miracle-Gro, John Crudele writes in the New York Post:

“Here’s a figure that I find stunning.

“When I was in college in 1972 (and paying about $3,000 a year total for an expensive private school), the average American had an average weekly paycheck of $334.60.

“Today, the figure is just $277.96 after it’s adjusted for inflation. And that is down about 90 cents a week from August of 2005.

“Don’t believe me? Look it up on the U.S. Department of Labor’s Web site –

“The tables go back to 1964, when average earnings were consistently over $300 a week.

“If you look around, you’ll see that Americans are obviously surviving and even thriving. But they are doing it by taking on additional jobs, or by having more than one adult in each household working.”

The poor man had already farmed his wife out to work. And now, he has got himself a wallet bulging with credit cards. And taken to Neg. Ams and Optional Arms like a Baptist preacher to hooch.

So, he keeps his place in society, but only by working harder and longer than he ever did before…and by going deeper and more inextricably into debt than any human being since Adam.

Our old friend Doug Casey:

“Median household debt grew by almost 34 percent between 2001 and 2004, while net worth went up just 1.5 percent, according to the latest Survey of Consumer Finances (a report issued only every three years). We suspect that since 2004, the numbers have gotten much worse.

“The household debt-service ratio hit a record high, just shy of 14%, in the first quarter of 2006… meaning that of every 100 after-tax dollars earned, 14 now go to servicing debt.

“The average American household now is carrying over $90,000 in debt, much of it as adjustable-rate mortgages. In fact, interest rates on 22% of the $8.7 trillion in mortgages carried by Americans are scheduled to be reset this year. According to one observer of the housing market, the typical ARM will bump up from a manageable 3.6% to an uncomfortable 5.6%, which would mean an increase of $800 a month on a $500,000 mortgage.

“It gets worse. In 2005, 40% of all new mortgages were adjustable-rate, and they will start resetting in 2008 and 2009. And Fannie Mae reports that almost two thirds of all sub-prime loans will be reset in 2006 and 2007. Many, perhaps most, of the borrowers will get squeezed, and more properties will hit the market after lenders repossess them.”

Oh ye heartless fates…

Consider the poor working man’s situation. He was a believer…he believed that prosperity really was just a matter of working hard and trusting in the American dream.

In his brief bouts of thinking, he must have felt lucky. He lived in a free, democratic and openly capitalist society…in what must have been a period of the most rapid technological and economic progress in history. If he couldn’t get rich, nobody could.

But the whiff of the dollar and the alluring scent of waiting wealth lured him into a trap.  Now, he has his himself in such a vise, the juice is getting squeezed out of him. Three decades of drudgery have taken him nowhere. He has actually lost ground. And when he turns his head to the East, he sees three billion Asians ready and eager to push him back even further. They’ll do his work for half…no, a quarter…no, a tenth of what he works for.

In the meantime, with his naïve faith in the American dream, he bought him himself a lifestyle bigger than his boots. With a wink and a nudge from his banker and his broker, he moved into a bigger house than he actually needed, further away in the suburbs than he could afford to be. Now, his new, upwardly adjusted mortgage is ballooning out of his grasp, the heating bills are piling up on top of the maintenance, and the big hunk of unpaid for steel in the driveway guzzles more gas than he can feed it.

And now, here come the bankers and the brokers again….to foreclose on his house.

“It is already starting,” Doug continues. “The U.S. Foreclosure Market Report shows that in the first quarter of 2006 alone, over 320,000 properties went into foreclosure, a 72% jump over the same period the year before. In Colorado, where I hang my hat about a third of the year, nearly 4,200 properties went into foreclosure in May, accelerating to 10,500 properties by mid-July.

“In the second quarter, year-on-year new home sales fell, on the average, by more than 25%. In some markets the bubble is deflating even faster. In the Los Angeles/Long Beach area, for instance, new home sales in the second quarter were off 50%, and in Tucson they were off 46%.”

“Home Prices Most Sluggish in 3 Decades,” CNN reports.

But the lump is no longer sluggish. Suddenly, the fog in his head is beginning to clear. Suddenly he is asking sharp questions: “How come I’m earning not a penny more than I my father did 30 years ago?” “What is wrong with the American economy that it can’t provide the average American with a decent living?” “How can you talk about economic growth or technological progress when I’m not making any progress at all?”

At last, the brain is working. Capitalism…democracy…empire…

Wal-Mart…ATMs…deficits…ARMs…suburbs…credit cards…401(k)s. He swallowed the whole thing.

And now, it’s beginning to leave a bitter aftertaste in his mouth.

Views from London…

*** Last night, we strode home from the office in such a contemplative funk that we were practically run down by a double-decker on its way to Islington.

We were doing a little independent research – on vice. So, we took a detour through Soho to have a look.

“Come on in…you’ll like what you see,” a woman in a shocking outfit beckoned to us.  Her décolletage was so décolleté she might as well not have bothered with colletage at all.

“Give us a try,” called out another, dressed in what looked like an office costume, a gray business suit, probably targeting out-of-town businessmen looking for a little fantasy in the big city.

We saw bookstores flaunting “Super Sex Videos…18 or older,” and bars opening their doors to us. Casinos and gaming parlors flashing their lights. And out on the street, people stood around with beer in their cups, time on their hands and idle money in their pockets.

Our interest in vice is, needless to say, purely professional – like smoking marijuana for medicinal purposes…or gambling to keep – it gives us a chance to enjoy a look at the low life without getting ourselves muddy. Besides, we were so deep in thought, we barely noticed the provocations.

When economies go soft, financial experts counsel investors to switch to “defensive” positions….and “vice stocks” are a favorite. When times get tough, people turn to drinking, smoking, gambling, and sex, say the experts.

We doubt that is true. Good men are loyal to their football clubs and their vices. They don’t give up on them when times get tough, but neither do they favor them when they are in the chips. A man needs a well-developed vice. One he can stick with through thick or thin. Otherwise, he is prey to every fad that comes along. He can’t, for example, be a womanizer and a drunk at the same time.

As soon as he starts picking up the bottle too much, the woman dumps him. She’s not about to share. Nor is heavy gambling compatible with heavy drinking. A drunk is wiped out too fast; he never gets a chance to develop a serious gambling addiction. No, a man has to find a vice that suits him and stick with it.

So, when the economy goes sour, he doesn’t give up smoking, drinking…or loose women. Instead, he gives up fair-weather spending, to which he has no attachment, and sunny-day stocks, that he owes no fidelity. By comparison, the “vice stocks” do pretty well. Business doesn’t slack off. And stock prices hold up.

Is this the time to buy vice stocks? Well, not necessarily. It is a comment on our era that prices of tobacco, liquor, sex and gambling companies are already high. Usually, they can be counted on to be fairly low. Why? Because in normal times, the vice investor is a little timid…a little reticent to mention it. He gets no extra status by admitting that he makes money from vice company.

You see, there’s more to money than money, and when people buy stocks, it’s for reasons often having little to do with getting rich. Some want to feel hip with the latest technology companies.

Others want to support products and causes they like.

And what almost all of them really want is status. They only want money because money buys them status, which means they want to be sure that the stocks they buy don’t undermine their search for status.

Who wants to tell his neighbors that he makes his money by exploiting slum tenants in “Section 8” housing? Who feels his chest expand and his chin rise ever so slightly when he admits that his money is invested in on-line gambling or companies that sell booze, 24 hours, on-off?

But these are not normal times. As the public’s money has thinned and stretched, so has its sense of propriety. Today, a man says he has bought an on-line pornography company with the same pride as he announces his daughter’s first birthday. Shame has almost disappeared…as anyone who watches television reality shows can verify. And so has hypocrisy; people no longer even pay lip service to virtue.

Which means that the prices for “vice” stocks are not as low as you might think. Wait for a down draft in the stock market…or an up draft in hypocrisy.

Then, it will be time to buy.

The Daily Reckoning