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A key attribute to selecting good growth stocks is to pay close attention to the underlying economic environment. This is seldom truer than in periods following the occurrence of major economic crises.

Looking towards 2010 we continue to live under a heavy burden of worry following the credit and economic malaise of 2008 and 2009. Invariably during times of heightened worry investors, lacking the appetite or the wherewithal to buy small undervalued stocks, gravitate towards large cap stocks. However, during 2010, especially in the second half of the year as the economy enters a period of definitive healing, investors will move more and more funds into undervalued small stocks. Getting ahead of the crowd and investing early in a selection of deeply undervalued well-chosen stocks should produce excellent returns during the next 12 months.

The main body of this note highlights three undervalued small cap stocks that are likely to double or more between now and the end of 2010. Also mentioned are three further stocks that have very strong upside potential although they do carry greater risk and volatility.

Before looking at specific stocks investors need a clear understanding of the economic and stock market backdrops about to evolve in 2010.

2010 Economic & Market Backdrop

Monthly unemployment data in the USA, whilst improving over the full year, will likely show some weak spots early in 2010 before a firmer growth trend emerges in the second half of the year. Similarly, it will be the autumn of 2010 before the housing market is finally seen as having fully stabilized. Overall, the US economy will continue to grow at a sluggish pace in the first half of the year. There will be no double-dip recession but the withdrawal of the government stimulus program will create a worrying mid-year scenario i.e. for a time it will feel as if a recession has again taken hold. In due course this temporary phenomenon will give way to more assured growth albeit still below cyclical trend.

These economic events and trends will have a stronger than usual effect on stock markets during 2010. In early 2010 stock markets will behave largely as in late 2009 i.e. gradual up-moves with manageable snap-backs. Not later than mid-year there is likely to be a significant stock market lull driven by worry associated with the expiring stimulus program, more difficult year-on-year earnings comparisons, higher interest rate prospects and by general market fatigue. However, as the economic data continues to show some firmness, even though it will be moderate, this stock market lull will transmute into a healthy buying opportunity. During the second half of 2010 markets will move noticeably higher, capped periodically by approaching higher interest rates.

Against this backdrop, the following individual stocks are set to perform exceptionally well.

China Security & Surveillance Technologies Inc (NYSE: CSR)

China Security & Surveillance Technologies Inc (CSR) is a manufacturer and installer of CCTV systems in China. The total Chinese security market is estimated to be worth in excess of $25 billion in 2009 and experts estimate that the country-wide penetration rate is currently about 20%. Considerable long term growth is expected during the coming years especially in higher-value recurring-revenue segments such as interpretative software and efficiency improving systems.

The largest and most profitable customers are government agencies and city authorities driven by the increasing need to control crime and disturbances across China. Having spent some years growing to become a one-stop shop for large enterprises, CSR achieved a significant economy-of-scale breakthrough in 2009 which saw the company awarded several unusually big contract wins in the last few months of the year, all of which are with major city authorities.

CSR’s stock is currently depressed by a combination of many factors: (1) The overall stock market preference for large stocks during turbulent times, a trait that is particularly pronounced when applied to non-US small companies; (2) CSR issued new shares in autumn 2009 to restructure its balance sheet and typically a degree of overhang remains embedded in the stock price until subsequent strong earnings dissipate it; (3) CSR missed brokers’ Sales & EPS estimates for the September quarter due to some late contract commencements, and, of lesser importance but still a factor; (4) CSR’s earnings guidance for 2009 and 2010 is on a GAAP basis whilst brokers’ estimates exclude non-cash compensation and goodwill write-off thus leaving investors to perform their own small but unwelcome reconciliations.

Against all this CSR reaffirmed 2009 Sales & Earnings guidance and issued improved outlook for 2010 during the most recent earnings announcement and the company tidied-up its balance sheet in August-October redeeming two tranches of cumbersome and restrictive convertible debt.

CSR now has no convertible debt, has $84 million zero-interest non-convertible debt, has 67m fully diluted shares, has guided 2009 GAAP EPS of $0.95-$0.98 on Sales of $600-$630million and has guided 2010 GAAP EPS of $1.15-$1.20 on Sales of $800-$820million. For Q4’09 this equates to EPS guidance of $0.36-$0.39 and Sales of $202-$232million against Q4’08 GAAP EPS of $0.23 and Sales of $145m i.e. top-end EPS and Sales growth of 70% and 60% despite the larger share count in Q4 2009 for EPS comparisons.

Published brokers’ EPS estimates for full-year 2010 are reconciled with CSR’s GAAP guidance by backing out ~$0.36 Employee non-cash compensation and $0.24 Goodwill w/off, thus bringing brokers’ published EPS estimates of $1.72 - $0.60 = $1.12 conservatively into line with CSR’s GAAP guidance of $1.15-$1.20.

As to whether or not CSR will meet or beat brokers’ estimates going forward the indications are as positive as one could wish: In just the three months to end November 2009 CSR announced new business contracts valued at $700 million. During this time the company also listed on its Chinese language web site additional potential contracts valued at $950 million – historically CSR wins almost all its named potential contracts. Furthermore, CSR recently hosted high level delegations from 4 large cities (Nantong pop 7m, Weinan pop 5m, Liaocheng pop 5m, Tianjin pop 11m) which typically would be worth a few hundred million $ on top of the $700m announced and $950m potential. In all cases the project installations are over a 2-3 year period. A small amount of these contracts will have commenced during the three months to September 30, 2009 but on the other hand CSR has a policy of never announcing all project wins and never announcing mid/small value contracts. On balance all indications are that CSR will have won new business greater than $1.5 billion in late 2009/early 2010.

The stock currently trades at $7.35 (close, Dec 24), equating to a 2010 fully diluted GAAP p/e of just over 6. With further large contract wins inevitable in the months and year ahead, CSR should have little problem matching or beating its full-year 2010 guidance and this should propel the stock to over $15, being a modest 12.5 times 2010 EPS. Because CSR has been winning so much new business recently it would not be surprising if much of the stock’s rerating occurred between now and Q4 earnings release in early March 2010.

See CSR Investor Relations here.

China North East Petroleum Holdings Ltd (NYSE: NEP)

NEP is an ultra-low cost oil producer and driller based in North-East China. Its costs of drilling, production and administration are a small fraction of those in USA. And yet NEP reaps the full benefit of high global oil prices – it sells all its oil to PetroChina at arms-length prices as determined in Singapore. This combination of ultra-low input costs and full market selling price enables NEP to enjoy high profit margins, produce strong cash flows and expand vigorously by drilling more wells.

NEP recently acquired its own drilling company capable of drilling to 13,000ft. This is a significant profit generator in its own right and NEP has signed contracts keeping it at full capacity until mid 2010. Any spare capacity that may emerge can be filled by NEP drilling additional wells for itself.

I first wrote about NEP in 2008 when it was a $2 stock. Now the stock trades at $7.96 (close, Dec 24) and I have a high degree of confidence that the company and the stock will continue to perform strongly into the future. Management repeatedly under-promise and over-deliver and have achieved a great deal more than expectations in a relatively short period of time.

On Dec 15, NEP announced a placing of 2 million shares at $6.88/share with selected institutional investors raising $13.5m cash. The company advised it will use $8.5m of the proceeds to repay a secured debenture NEP entered into in February 2008 i.e. a time when NEP was quoted as a lowly OTC stock (CNEH.ob) and had few available financing options, thus the terms of that Feb 2008 financing were undesirably restrictive. Given that NEP had $33m cash on its balance sheet as at September 30, 2009, it would appear that NEP didn’t actually need to place 2 million shares in order to raise $8.5m to repay the debenture. What is more likely is that NEP is on the cusp of acquiring more acreage, a subject that management have discussed frequently in recent months. This would be yet another forward step for NEP and fully in line with the many positive developments the company has achieved this past couple of years.

At $7.96 the shares trade on a 2010 p/e of 6.3 based on broker EPS of $1.26. These broker estimates are calculated using $65/bbl oil. With oil priced above $80/bbl in 2010 NEP would produce EPS of nearly $1.50. Global economic metrics suggest that oil prices will strengthen in 2010 and again in 2011. There is every reason to expect NEP to have a p/e of 10 by late 2010, equating to a share price of about $15. If and when NEP uses some of its cash balance to acquire additional leases the stock should advance further.

See NEP Investor Relations here.

North American Energy Partners Inc (NYSE: NOA)

NOA is a provider of heavy construction, mining, piling and pipeline services in Western Canada with a principal focus on oil sands. Almost 90% of Sales in the most recent quarter, Q3’09, were generated from oil sands. With 20% of the world’s supply of heavy oils and bitumen located in Canada, and with upward pressure on global oil prices in the coming years, NOA is ideally positioned to take advantage of Canada’s abundant oil supplies and proximity to the USA.

As a direct result of the oil price collapse in late 2008 a number of large Canadian potential oil sands projects were deferred by oil producers. Consequently during 2009 NOA has had to rely on existing long-term recurring projects for revenue generation.

However, with global economies now beginning to emerge from the biggest downturn in decades and oil demand visibility improving for the next few years, oil majors in Canada are restarting new oil sands projects. NOA, as the largest construction and mining contractor in the oil sands sector, is assured to benefit strongly. Very little, if any, of this upside is reflected in NOA stock price.

At $6.57 (close, Dec 24), the stock trades on a 2010 p/e of 7.3. During the next 12 months, especially when contract wins are announced, and as brokers provide visibility into 2011 Sales and EPS, the stock should trade comfortably into the mid teens. Whilst NOA is a cheap strategic oil play, currently the shares are thinly traded and investors should not chase too vigorously.

See NOA Investor Relations here.

Other stocks

Many other stocks were considered for 2010 but none appear to be as sure as the above three. Here is a quick-fire selection of three other candidates. Again, all should double before year-end 2010 but the journey will probably be more difficult.

ADRs of two main Irish Banks; Bank of Ireland Plc (NYSE: IRE) and Allied Irish Bank Plc (NYSE: AIB). Both stocks have been negatively affected by Greek and Austrian banking and sovereign debt issues as well as the Dubai overhang. This leads to higher funding costs for Irish sovereign debt and for IRE & AIB – they will mostly be funded in 2010 with Irish government’s debt via the ‘bad bank’ agency known as NAMA. Both banks will also have to issue a further large block of equity and there is a threat of increased government ownership from the current ~25% to the sub-50% level.

On the plus side the Irish government has introduced a commendable austerity budget in December 2009, both banks are generating healthy operating profits, further asset write-downs should become a non-issue by mid-2010 because of asset transfers to NAMA, the Irish economy is forecast to revert to growth during 2010, AIB has substantial salable assets, and the banks are being given a time frame of some years to fix capital adequacy during which they will boost capital via earnings.

ADRs for IRE and AIB are currently trading at $8.36 and $3.81 (close, Dec 24). They may go lower but are also likely to bounce hard when they turn. The stocks’ current death-spiral is reminiscent of the March 2009 plunge that affected bank stocks in USA and worldwide. The difference this time being that solutions are on offer for IRE and AIB and that the overall economic backdrop has improved very significantly since March 2009. These two stocks are speculative, they will surely be volatile, but on a 1+ year horizon they should pay off handsomely.

General Steel Holdings Inc (NYSE: GSI). GSI is a Chinese steel producer, especially rebar for the Shaanxi market. It is a well run company, has experienced and well connected management, employs efficient western production technologies and it has a stated goal of being a major consolidator within the disparate Chinese steel industry.

GSI invested $220 million in new high-efficient production lines in 2008 and the benefits are showing in 2009 with Gross Margins of 4.2% in Q1, 5.5% in Q2 and 8.2% in Q3.

The risk, from an investment point of view, is that China has serious excess steel capacity. Steel producers have repeatedly ignored central government edicts to cut back production, hence steel prices have remained depressed except for a brief spike in mid 2009 that helped GSI’s Gross Margins in Q3 – for Q4 2009 GSI’s Gross Margins and EPS should be noticeably below those of Q3. Still, GSI is a low-cost producer and doesn’t have significant competition in its main Shaanxi market and, as such, the company should continue to generate adequate if unexciting profits for the time being. However, if the government does succeed in eliminating outmoded producers, especially as the global economy improves in the next year, GSI stock has the potential to be highly successful in 2010 albeit subject to those capacity reductions.

GSI is trading at $4.57 (close, Dec 24), having had a ~20% haircut on Dec 24 due to the company announcing the issuance of ~10% new equity for $25 million gross cash. Most probably some of this cash will be used in consummating GSI’s acquisition of 60% stake in ‘Baotai’ as per the LOI signed November 17. Traditionally GSI acquisitions are effected on exit p/es ranging from 2 to 5 although the final pricing of Baotai is not yet known.

Disclosure: Author holds long positions in all stocks as part of wider portfolio.

Source: Six Undervalued Stocks for 2010