The Great Eight and the Blue Chip Myth

The Daily Reckoning PRESENTS: There has been a lot of chatter in the media lately about the return of blue-chip dominance…but our resident small-cap virtuoso points out that by passing over the small stocks, many investors are missing the big picture…and big profits. Read on…

THE GREAT EIGHT AND THE BLUE CHIP MYTH

In the few short months since the New Year began, eight investments have more than doubled.

There was no fanfare… There was hardly any mention of the gains in the Financial Times or on any financial television network… No major fund managers announced a drastic change in strategy to capitalize on the trend… And the average investor sat on his hands, settling for the mediocre returns he may or may not get through some index fund or assortment of familiar companies with household names.

These eight investments all have one thing in common. Along with 39 of their peers, they have been the most profitable picks of 2007, with the top returns ranging from 52% to a whopping 22,000%. That’s right…47 out of 50 of the biggest gainers of the past 6 weeks all belong to this one investment class.

The big-money secret? All eight are small companies…

The “Great Eight” I’ve been writing about all have market capitalizations of less than $1.5 billion. Just look at these stellar returns:

Top Eight Performing Penny Shares, 2007

1. Towerstream Corp. (TWER) – 22,174%
2. YTB International, Inc. (YTBL) – 266%
3. Optionable, Inc. (OPBL) – 192%
4. Onyx Pharmaceuticals, Inc. (ONXX) – 128%
5. Research Frontiers, Inc. (REFR) – 117%
6. China Precision Steel, Inc. (CPSL) – 112%
7. Hoku Scientific, Inc. (HOKU) – 107%
8. Overhill Farms, Inc. (OFI) – 105%

However, most investors have decided to ignore these stocks…

You see, there has been a lot of chatter in the media lately about the return of blue-chip dominance. One particular Associated Press headline caught my eye a few weeks ago. It read: “Signs Point to Good Year for Investing in Large-Cap Stocks.”

The article says it might be time for small-cap investors to rethink their stock picking strategy. The author thinks this year, the best bet for anyone with a dime in his pocket will be the big-name stocks. The logic is that eventually, large-cap, blue chip returns must have a special year where they whip the Russell 2000 – a benchmark group of 2000 stable small-cap stocks with proven, long-term performance.

This could very well happen… But this argument misses the bigger picture.

First, let’s get some stats out of the way. The Russell 2000 posted a gain of more than 18% for 2006, officially beating the Russell 1000 Large-Cap Index for seven of the last eight years. However, the Russell 1000 caught a second wind and slammed the Russell 2000 for the second half of 2006.

Ever since the Russell 2000 took a hit in May, a lot of money has been flowing into large-cap stocks. Meanwhile, the Dow Jones Industrial has soared while the Russell 2000 and the NASDAQ have lagged behind.

So that’s the whole story as far as most investors are concerned. The Dow is hitting record highs twice a week and small stocks are dead in the water. If the Great Eight prove anything, it’s that this is completely false.

In fact, only three members of the Dow Jones Industrials are showing double-digit gains so far in 2007: General Motors, Alcoa and Caterpillar (up 18%, 16% and 10%, respectively). While these early returns are nothing to scoff at, they hardly compare to the best performing smaller stocks.

The glaring problem with these over-quoted index-based statistics? They completely disregard any shred of stock selectivity. Instead, we find ourselves mired in the mathematics of probability…

And when it comes to mere statistical probability, you’ll win with a Dow stock over a penny stock nine times out of ten. After all, we’re talking about 30 of the most stable, well established companies on the market. The worst performer out of this group so far in 2007 is Microsoft, and it’s lost only a little more than 3% of its value.

Back in Pennyland, stables of small stocks have already logged double-digit losses so far this year. Many of these losers are boondoggles and broken companies trying to stay alive– companies that would never make it past a thoughtful selection process…

However, if your idea of an investment strategy is throwing darts at the thousands of small stocks on the market, the odds are decidedly against you.

That’s why comparing the Dow Jones Industrials to the gigantic world of penny stocks is bunk. Throw your darts at the DJI and you could lose 3%. Do the same with small stocks and you could lose your shirt.

It’s simple to take the two groups separately, pull together averages and call it a day. But – unless you’re heavily into index funds – this is probably not a reflection of how you are selecting stocks.

When you narrow your focus to the universe of smaller stocks, then narrow it again to your specific investment parameters, your chances of seeing the biggest possible gains improve drastically. It’s that simple.

Sincerely,

Gunner
for the Daily Reckoning
February 21, 2007

P.S. At Penny Stock Fortunes Headquarters in Baltimore, we’re looking for the select few small companies that could change the way the world does business. It’s as simple as that.

The new PSF is firing on all cylinders right now and the recommendations are plentiful. In fact, all eight stocks we’ve covered so far are near recommended buying ranges. That’s four CXS selections and four bonus picks from our brand new special report.

It’s a diverse bunch, complete with a defense contractor, an energy company, a software provider, a biotechnology firm, and more…

Editor’s Note: Former beat reporter Greg Guenthner uses his newsroom experience to dig up the hard-to-find headlines that could lead to big gains for your penny stock portfolio. After leaving the newspaper industry, Greg decided to dedicate his career to researching the most promising small public companies in the world.

In addition to his work with Penny Stock Fortunes, Greg is also the managing editor for The Sleuth. The free daily e-letter dedicated offers insight into strategies, news, technology and trends of the small-cap market. In his Sleuth columns, Greg has written extensively on everything from alternative energy to biotechnology.

Oh la la…

We’ve been down in the tropics for a couple of days. At first, the Internet didn’t work. Then the power went out. It is paradise down here; but the butter is melting and the milk has gone bad.

“This seemed like the beginning of a horror movie…” said visitors last night, as we dined by candlelight. “When we came down here, the place looked like a set from Jurassic Park. And then the power went out. We could just imagine the raptors getting through the electric fence.”

This morning, there is still no electricity. And we’re running out of battery, so we don’t know how much reporting we’re going to be able to do today.

So we’ll come right to the point:

There is a lot more money around than there used to be. And people are much more free with it…as if they expect it to keep coming. A generation ago (and even a few years ago) they wouldn’t have considered spending so much on so many things. They would have wanted more margin for error…some savings, in case times got tough.

But now, no one cares about savings; everyone has credit. With no need to stockpile money, people can spend it more freely. Besides, interest rates are low. Borrowing is cheap and painless. And since prices on all assets tend to do nothing but go up, people figure that almost any investment will be worth more in the future than it is now. Save money? You’d have to be crazy.

That change in attitude alone accounts for some of the money you see around you. It just circulates more freely. But where does the rest come from? It is almost as if people really were richer…as if they actually had more money.

And indeed they do. They have more money because the monetary authorities and the financial industry give them more. The money supply is increasing three times as fast as the supply of goods and services. But now, thanks to globalized markets, the supply of goods and services can easily be increased. Leave it to the Chinese…they’ll put out just about anything in such monstrous quantities that its price will go down.

Supplies of land…artwork…oil…gold…and even shares of real businesses, on the other hand, are more limited. Naturally, those are the things that seem to be reacting to all this extra ‘money.’

In fact, a recent study of the housing market in the United States shows that most of the increase in house prices was in the price of the land itself. The actual price of the house barely increased…which makes sense; it is easier to reproduce plywood and cement than it is land.

The point is, what we really have is not a case of runaway prosperity…but a case of runaway asset price inflation. What comes next? Typically, asset price deflation. How and when remains to be seen…and remains the subject of so much interest here at the Daily Reckoning. At least, when we’re not on vacation.

More news:

————–

Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…

“With growth at 4.8% in 2006, the BOJ had better step up the ‘gradual’ rate hikes, before inflation becomes a problem! That’s right, the country/economy that endured 10 years of deflation, could very well see inflationary pressures…”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig

————–

And more views:

*** A little tidbit from Whiskey & Gunpowder’s Greg Grillot…

“A little note before I take off for the less-populated Argentine West:

“Chris Mayer and I remarked on the leisurely pace of Argentine life after it took him what seemed like an hour to retrieve his carry-on luggage at the Buenos Aires airport.  Lunch at a sidewalk café-brewery confirmed our new theory.  An eternity passed before our waitress offered us drinks – an eon flew by before the food order – and then at least 3 millenia crawled along before we finally dined.  Same with dinner, though accompanied by cold Quilmes draft beer.  Of course, after all that, your meal may taste far more fulfilling.

“When you’re surrounded by deeds performed at such a sluggish pace, your concept of time distorts.  You measure minutes in hours, hours in half-days.  It may even seem that your lungs expand with breath in a similar way.  Or that could be a symptom of the good airs naming this fine city.

“Since nearly everything bears a somnolent façade here, I have tentatively named this way of life a ‘lucid siesta.’

“Now, the considerable contrast to the sleepwalking is the mad, adrenalized city driving.  Drivers disregard the concept of lanes, a massive bus will bully its way right into traffic, cabs drive at night without headlamps and motorcyclists snake in and out of the mass at high speed.  I suppose one wants to get to their destination quickly so they waste no time in resuming their normal relaxed pace.

*** The media is speculating as to what the Bush administration will do next. The general tone of the guesswork is this: Just how dumb are these people?

So widespread is the belief that the country is run by idiots, we feel compelled to rush to their defense. They are morons, maybe…but not idiots.

There are two major parts to the administration’s program: Deficit spending and war. Either one would be ruinous in itself. But what is remarkable is that neither seems to take any notice of the other. Normally, in times of war, the whole budget is put toward winning it. Citizens see the necessity of sacrifice. They cinch up their own belts and resign themselves to living lean until the battles are over and the boys come home.

But this war breaks all the rules. Spending on non-war items continues to go up, even though the war itself is incredibly expensive. And even though the nation lacks the money to pay for it, no ‘war bonds’ are being offered. No collections for scrap tin or iron are taken up. No ration tickets are distributed.

Guns or butter, Lyndon Johnson was warned. You can have one or the other, but try to go for both and you will make a mess of things. Of course, Johnson did try for both. His Great Society was also the society that was trying to kick butt in Vietnam. As it turned out, it got its own butt kicked…and the economy went into the worst period of inflation in its history, followed by the worst recession since the Great Depression.

The Bush boys knew these facts as well us. Even better known, since Donald Rumsfeld and Dick Cheney have been Capitol Hill insiders since the Nixon Administration…and hardly a major blunder in Washington has been committed since the 1970s without their help.

The war in Iraq was such an obvious error. The French said it wouldn’t work. Maggie Thatcher said she’d have no part of it. Even we saw the calamity coming. As far as we can tell, only three groups come out ahead: Osama bin Laden, who now has the Great Satan pinned down in the Middle East where it is wasting its resources while radicalizing Muslim youth; the Israelis, who now have the United States just where they want it (if anyone wants to destroy Israel now, they’ll have to do it over the U.S.’s dead body); and U.S. defense contractors, who are making off with a fortune in war booty.

Still, the Bush Administration is not so dumb. It knows that there’s more to life than just peace and prosperity. There’s also glory…and buffoonery. Who would remember Caesar if he had merely done his job in Gaul…and then retired to grow turnips in a far-off Cisalpine village? Who would make a movie about Alexander, had the young man kept to his little empire in the Peloponnese? He might have lived to be an old man, bouncing grandchildren on his knee. He might have allowed his camp followers to stay at home…his farmers to fructify their land with the help of their sons…and his soldiers to die from old age. His people might have sung his praises for what…a generation or two? Instead, by daring…by taking the bold action…he made a place for himself in history. Cities were named for him (one of them next to Washington, D.C., no less)…mothers named their boys after him…poets took his name to describe their verses. And what’s more, he’s the lead character in a major Hollywood movie!

No, dear reader…the Bush administration is not just plain stupid. It is stupid in a more complex way. Will it now turn its stupidity on Iran? We don’t know. It would be a very stupid thing to do. But put that way, it sounds like a certainty.