Rapid change increasingly, and sometimes violently, creates gaps, or mismatches, between sources of supply and user demand. The result is dislocation of wealth brought about by volatile price changes. We happen to be in the camp of optimists and idealists who see true practical opportunities in every such gap.
We see significant mismatches at this time in natural resources, energy, and knowledge that will act as primary drivers of global wealth creation. Market sectors most affected include metals stocks (precious, base, and industrial), alternative energy (creation, storage, and management), and information technologies (communication, education, and business services).
Great advancements in these areas happen in the laboratories of blue chip companies every day, if television commercials are to be believed. The problem is that exceptional stock performance, or alpha, belongs to companies that exist in the shadow of the more visible, but sedentary blue chip groupings. Above average performance is found in the less efficient market and under-appreciated arena populated by small cap stocks.
Because of the shear number of small cap companies and the reality that the vast majority of research coverage is focused on the largest companies in the market, the potential for extreme undervaluation through market inefficiency exists in select, underfollowed, small cap stocks. These select small cap companies tend to possess a combination of intellectual know-how and entrepreneurial drive along with a key asset or assets that, though often unappreciated, have the potential to be market changing.
In our experience what sets apart the small cap stocks that outperform is the quality of management. We look for consistency of tenure of not just the CEO, but the entire management team. Those small companies that survive their wilderness years prove their potential, to some extent, just by sticking around. This is evidence of increasingly effective and cohesive management that will continue to mature and attract good people, including employees, investors and customers. Outsiders looking in may recognize the crucial factor as trust, but upon closer observation, an intense organizational focus becomes visible; the key for small cap companies to take their opportunity to move up to the next level.
Out top picks list includes a number of companies that we believe are well positioned to exceed market expectations and deliver superior market performance in natural resources, energy, and information technology. The following are just a few of our picks for 2007 that we believe have the management teams, vision and potential to appreciate 50% to 100% in the next twelve months.
NovaGold Resources Inc. (NG) has been our top pick in the resource sector for the past several years and has delivered exceptional performance over that time while remaining undervalued on a fundamental basis. Starting from scratch less than 10 years ago, NovaGold has become a magnet for top geologists and mine builders from around the industry. Of all bottlenecks to advance projects in the resource sector, attracting and retaining the scarce, skilled people assets may be one of the most challenging. NovaGold has been able to build its team of geoscientists and engineers due to the reputation of the core management team and the potential of the company’s pipeline of world-class precious and base metal projects.
Investors have found the transparency and consistency of management to be equally valuable. No greater recent example of this is necessary than to review the heads-down, shoulder-to-the-stone dedication, and in-the-game work ethic of NovaGold team during the failed hostile takeover attempt by the worlds largest gold company, Barrick Gold Corporation (ABX). More than 85% of NovaGold’s shareholders soundly rejected the hostile all-cash buyout attempt in exchange for the longer term potential they saw in the company.
We believe that NovaGold is poised to achieve a series of major development milestones over the coming year that will act as catalysts to outperform the sector in 2007. These milestones include: the start of gold production in Nome, Alaska; receipt of permits and initiation of construction on the company’s massive Galore Creek copper-gold project in British Columbia, and the substantial expansion and advancement of NovaGold’s Donlin Creek gold project in joint venture with Barrick Gold which may become one of the world’s largest producing gold mines.
NG 1-yr chart
Maxwell Technologies, Inc. (MXWL) also fits the bill of a battle hardened management team providing products that bridge broad disparities between supply and demand. We began covering Maxwell in 2000 when the company had over a dozen product types dating from its days as a defense contractor and subsequent initiatives to remake itself into a commercial electronics company. Management focused and turned the company around by shearing the product line down to three segments, each with solid long-term high margin prospects. The fastest growing opportunity with widest applications is Maxwell’s ultracapacitor product line which may enhance the efficiency of any system that consumes or generates electricity.
Ultracapcitors are energy storage devices that have the ability to rapidly and reliably store and release power over millions of charge/discharge cycles. This is highly complimentary to sources ranging from slower discharging units such as batteries, fuel cells, and solar, to more variable sources such as regenerative braking and wind energy. Ultracapacitors afford increased flexibility to engineers designing lighter, more compact energy solutions for transportation (autos, public transit and other heavy vehicles) and utilities generating and storing quality power. A recent announcement of sales of electrode material to China demonstrates that nation’s desire to close its energy mismatch which is evidenced by the scarcity of new petroleum discoveries at the same time at which China is experiencing dramatic economic growth driving its need for power.
MXWL 1-yr chart
Medis Technologies Ltd. (OTC:MDTL) is scheduled to begin fully automated mass production of its 24/7 Power Pack fuel cell for the enterprise and consumer markets. Medis is poised to deliver the first fully functional, non-toxic fuel cell for portable electronic devices with advanced technology. This product addresses the mismatch of sources of supply such as limited batteries, unavailability of portable charger devices and even locating wall sockets. The demand for power has grown tremendously with consumer demands for increased functionality of portable electronic devices including bandwidth, storage capacity and computing power, and video and graphics. The added requirements leave less room for even the most advanced battery.
The company has one of the largest short positions of any company on the Nasdaq. Naysayers earlier did not believe in the technology. Our discussions with those working on military applications seeking lighter and more reliable sources of power in the field have convinced us otherwise. The company’s products also recently received an Underwriters Laboratories (UL) Listing. The naysayers now question whether mass production is possible, but the company expects to reach full production of this product line in the third quarter. The next doubt will focus on demand. Dismissing broad applications for consumer and military markets, we see Medis’ product as important to the enterprise market as maintaining a spare tire in the trunk. It should good insurance for millions of potential users. Prior to production, the company may spin off its health research products CellScan and Cell Kinetics. The spinoff may be problematic for those who sold the company short.
MDTL 1-yr chart
Sonic Foundry Inc. (SOFO) is another company that took advantage of market cycles to sell off lower margin product lines to fund opportunities with higher revenue growth and expanding margins. Sonic Foundry Mediasite Internet recording devices are increasingly regarded as the “Rolls Royce” of the information super highway. The elegance and sophistication of both production and viewing of rich media (synchronized video, audio, and graphics) is years ahead of other distance learning solutions. In addition, Sonic Foundry’s advanced search capabilities by phonetic and contextual clues, as opposed to manual tagging, may herald a powerful new tool in individualized learning and research.
The ability to reduce the friction of learning, by both sharing rich media content, and content management and archiving, may provide the greatest opportunity for further progress in an increasingly complex world. This tool is recognized by institutions of higher education and is rapidly finding its way into corporate and government segments. While 2007 may be the year of video on the Internet, Sonic Foundry’s double punch appears to have secured a position in conveying and retrieving important and serious content on the Internet.
SOFO 1-yr chart
All four of the above companies in our top picks list are currently trading below their 52-week highs and have excellent potential through achievement of recognized milestones to move significantly higher than current valuations during the next 12 months. Each company has characteristics we value including underlying core value by positioning in long-term mismatches of supply and demand, market presence and opportunity with potentially large upside potential. These potential opportunities are welded together by effective management teams with unified and undivided focus, mitigating some of the risks inherent in picking small cap over large cap stocks. Over the coming year we will be expanding on the companies above, as well as others in the three broader areas of natural resources, alternative energy and information technology, that we believe have the potential to deliver superior investment opportunities.
Disclosure: The author is long NG, MXWL, MDTL, SOFO and has no positions in any other stocks mentioned in this report.