Small Cap Ideas as the Market Drops

by: Mark Gomes

Over the past decade, the average stock investor has experienced negative returns. Yet, fluctuations and opportunities (two things that are conducive to great profits) have rarely been more abundant. Like a roller coaster, stocks have taken investors on a wild ride, but have dropped them off more or less where they started.

Over the same time frame, savvy investors have been able to profit greatly by 1) taking advantage of big market swings and 2) jumping on relatively obvious opportunities. Here are some examples that exist today:

Sell stocks when the market is strong, while the environment is getting weaker -- An underrated way to make money is to not lose it. The 10-year return on the S&P 500 is about -30%. However, for an investor that missed just half of the 2000-2002 and 2008 declines, that number jumps to more than +20%.

The current market environment doesn't present as big an opportunity as 2000 or 2008, but it does seem to present an opportunity. Despite many warning signs, the market has remained incredibly resilient. Fundamentals always win in the end, so barring a major government or Fed intervention, the market is likely heading lower. If it is, selling now and buying at a lower price will prove to be a very prudent move.

If you like to stay in stocks at all times (buy and hold strategy), there are several ways to do that and still make outsized gains over time. Examples include the following:

Use volatile stocks to your advantage -- One of my favorites is Occam Networks (OCNW). Its customers have been awarded over $500M in government stimulus funds and a portion of that will be spent on OCNW gear whether the economy turns south or not. That means OCNW should do well no matter what happens to stocks or the economy.

However, like most stocks, OCNW typically moves with the market. Specifically, when the market drops 1%, OCNW tends to drop 2% (unless favorable news is announced). Because of this, investors can take advantage of big drops by buying OCNW cheap and waiting for some positive news (which is starting to come with increasing frequency).

Swap out of average-growing stocks and into ones with favorable prospects -- When the economy goes south, it will hurt most companies. An average company might see growth go from 5% to 0%. However, a company with improving prospects can continue to grow at the same rate...or even accelerate.

iGo (OTCPK:IGOI) is an example of this. IGOI makes products focused on energy-efficiency. It's products have started to be sold by more and more retailing giants, like Wal-Mart (NYSE:WMT) and Best Buy (NYSE:BBY). Simultaneously, the Department of Energy gave IGOI a big endorsement and purchased a large number of its "Power Smart Towers". This could be a catalyst for wins in other government agencies, as well as corporations. To top things off, it was recently awarded patent protection. Since IGOI is a small company, all of these positive developments should allow it to grow even if the economy gets weaker. It should enjoy ramping demand and an easier competitive environment for several quarters to come.

Another company with favorable prospects is Magma Design Automation (NASDAQ:LAVA). Lava makes software systems to improve the process of designing electronic components. Several years ago, LAVA went into a heavy R&D cycle. During that time, the stock suffered greatly. But now, the company is starting to reap the benefits of those efforts. New investors get to participate in the gain without having gone through the pain of the past several years.

As for its stock, LAVA is like OCNW -- it tends to drop 2% for every 1% the market falls (and vice versa). When a big market drop leads to a big drop in LAVA (like this week), that's the time to strike. Incidentally, I personally met with management this week and felt that the CFO sounded quite confident. Continued progress toward 20% operating margins could result in 60-cents of annualized EPS within 6 quarters. That could make LAVA a double from here.

Stick to stocks that offer downside protection -- When the economy declines, companies with lots of cash or a reliable revenue stream can ride it out better than those that don't.

Vital Images (NASDAQ:VTAL) has both. The company has a $180M market cap, but $140M of this is covered by cash and investments on its balance sheet. That will make it very hard for its stock to fall far, even if the market crashes. In the meantime, it has a large and loyal base of hospitals that pay VTAL an annual fee to support critical software associated with CT scanner systems. When the economy goes south, people continue to require medical care, so VTAL will continued to get paid for the support that it is uniquely positioned to provide. As if that wasn't enough, the company has a buyback program in place that will help to put a floor under the stock.

If the market is going to get crushed, consider buying stocks that have already been crushed -- Often times, companies go through difficult transitions during times when most companies are doing well. That causes their to stocks underperform during good times. The good news is that the reverse can quickly become true. The company can emerge from its transition and experience re-accelerating growth, even as the economy continues to suffer.

Intermap (OTCPK:ITMSF)
may fit the bill here. Over the last several years, ITMSF has spent over $125M building 3D maps of the U.S. and Europe. During that time, the company has struggles to generate revenue and stock has fallen from over $10 in 2007 to under $1 today. Meanwhile, ITMSF has completed building its maps and is ramping up efforts to monetize those efforts (potential customers include GPS vendors, the auto makers, and telecom companies). That means potentially explosive revenue growth, with significantly less expenses.

Even a moderate level of success should be favorable for the stock because Intermap will keep most of the cash it collects from selling the maps -- the cost of created the maps were incurred in the past! Despite this, the stock remains low, as investors remain focused on backward-looking earnings reports instead of its forward-looking opportunity. Like LAVA, new investors get to participate in the growth of a new product without suffering through the pain of developing it.

Disclosure: I own shares of OCNW, IGOI, LAVA, VTAL, and ITMSF