Switching from Momentum to Micro Cap Companies

by: Bill Cara

Five weeks of trading has taken the Bulls to a place they have never been before, with the Dow at 13000, crude oil about 65 and gold almost 700. If you are thinking there is no place to hide here, then you must be thinking very short-term.

Rather than dither, why not switch your thinking from "MO" (as in momentum) to "Micro" (as in ultra small cap companies)?

I believe the character of the stock market in North America and Western Europe will soon change (is changing!) to a stock pickers market, and that the best deals out there are names you have never heard of, companies that have all the elements in place for 3 to 5 year success. They are companies whose:

(i) balance sheet is financially strong, with little debt
(ii) P&L shows very high gross margins
(iii) management has a lot of skin in the game, hence won't be leaving with golden parachute deployed
(iv) main product or service has "an unfair advantage"
(v) customers who will stay through years of economic hardship, if needed

If you can think of public companies (reporting issuers with SEC/OSC filings) that meet this criteria and have a market cap of maybe $100 million as a minimum and $1 billion max, then send them to me and I will put them into the mix for consideration.

Except for too large a capitalization to warrant consideration, a company that measures up is Interactive Brokers, known in the industry as IB (with a new IPO in the works). There are hundreds smaller than IB that qualify.

Because they are fast growing and will need capital, venture capital firms monitor these companies. Investors expect them to be the next bright lights on the world stage, and possibly super-stars.

Searching for Micro Superstars
This search is a difficult one, as you know; full up with near-psychotic promoters. But, as a rational group, we are looking at situations here where traders are interested in building long-term commitments. Each month we will review the performance and the company situation and rank them in decile groups top to bottom as to our outlook. A lot of the stories will not hold up under our scrutiny, I feel.

Presently I am trying to organize a Cara Micro-cap 100 that fits the "Bill" (weak pun, I know). I have been building a list of volunteers who will monitor one or two stocks each and send me their collection of news, research, ideas, once a month. I'll put the list in a spreadsheet linked to the free blog (starting June), and also offer a premium (low cost) monthly report where I will detail key changes occurring in each company during that month.

Re the Team Cara Micro-cap 100, I invite anybody from the readership to join. The only pre-requisites are one’s motivation and objectivity. If you want to participate as a volunteer, please send me an e-mail to bcara@billcara.com. Include the names of some recommended companies if you wish.

Ultimately, these 100 companies, to be selected by late May, will not be my picks, but the Team’s picks, and rankings. I am going to use a survey form where the Team members get to rank the candidates as to their assessment of future prospects. Then the final result will be like the “crowd” speaking.

My job is to plan, organize, oversee and write about it – in my usual “brutally honest” fashion.

As to those of you who are awaiting my “Wealth Preservation Portfolio,” I am working on it and now have a scheduled publishing date of June 1, in conjunction with this Micro-cap 100 list because that list will comprise a large part of the portfolio.

I will say today that 33% of anyone’s total Wealth Preservation Portfolio ought to be in companies that would be suitable candidates for inclusion in the Cara Micro-cap 100 List, as it will be for me.

The End of the Momentum Play
You see, I think the “Mo” game is over. The immediate future belongs to stock pickers who can pick the gems. The large-cap companies have loaded up on debt, merged at humongous cost or are preparing to sell out to private equity, or built up their cash position, but withheld the essential long-term capex spending programs they needed to sustain future growth.

At this point, I also think there is no place for bonds, and there hasn’t been a need to be there for a couple years, as you know from reading my blog. But, in time, the cycle will turn as it does for all asset classes.

Mostly, as you also know, I continue to believe in precious metal bullion and coins as well as shares of the junior and mid-sized miners that are bringing on relatively large production in the next 3 or 4 years, like Gold Reserve (GRZ), Western Goldfields (WGDF.OB), Khan Resources (OTC:KHRIF), Aurelian Resources, and companies like that, or quality exploration plays, like US Gold (NYSE:UXG). That makes up another 28% of my total Wealth Preservation portfolio, with the majority of these assets held in bullion, preferably in physicals (no ETF) offshore (e.g. Switzerland).

Until I see a long-term cycle peak in commodities, I still believe in ETFs for the BRIC countries plus Canada and Australia, which presently, in total, is at a portfolio weighting of 30%.

The remaining bits and pieces are cash accounts (Euro and USD), T-Bills, Swiss francs either in physicals or in a Swiss bank account, and some high dividend payers (U.S. or possibly even some of the Canadian business trusts). The total for this group is about 9%, bringing the total to 100%.

Preparing My Portfolio for the Future
I want to prepare my portfolio for the coming breakdown in the PM and commodities group. While we are just not there yet for a major pullback, I recognize the risks are rising, just as they are in the broad market.

Then at the point I believe is the commodities and precious metals cycle peak, which is where I no longer want to be well-overweight PM (i.e. the late stages of what I define as the Distribution Zone), which I expect sometime between this summer and next Spring, I would change the portfolio to move from 23% down to 4% for bullion and coins (all physicals), and the miners from 5% to 3%. Simultaneously I would move the 30% in the commodity-sensitive BRIC, Canada and Aussie ETFs down to 12%, while moving into ETFs for the U.S., U.K., Europe and Japan/S. Korea, from zero up to 15% at that point.

After the switch, the biggest new weighting would be in USD or T-Bills, going from 2% to 14% and long-term European government bonds from zero to 10% at that point. I would also increase the weighting of the long-term oriented ultra small caps (Cara Micro-cap 100) from 33% to 40%.

Then, after a crash or severe pullback in Gold, but before the bond market starts to sag again, I would make small changes by increasing the bullion from 4% to 9%, and the miners from 3% back to 5%. I’d keep the ETFs for U.S., U.K., Europe and Japan at 15% total but increase the BRIC, Canada and Australia ETFs from 12% up to 16% total, with the purchases happening in the faster growth BRIC ETFs.

I’d also go back to a long-term weighting in the micro-cap group of 38%, figuring that some of the first selections were not panning out as hoped. Remember, this is investing, and investors hope; traders merely trade prices with as little emotion as possible.

The USD/T-Bill position would drop from 14% to 10% and the long-term bonds from 10% to 5%. You see, during the crash in PM and broad markets, and in the months following, I believe interest rates will begin dropping, which would lift bond prices, and I want to be selling into that strength during those months. Ultimately I know I don’t want to be in bonds because as global economies grow in the future, there will be a renewed demand for capital in a background of tight money policies from central bankers, so rates will be rising. I’m planning ahead.

I then expect a long dragged out stock market decline like 1973-74 or 2000-2002 where, at the cycle bottom, I would expect to have been fully out of bonds and holding just 1% in cash/T-bills. My gold bullion and coins would eventually also have dropped down from 9% to 5% through this period. There too I would be selling into rallies. My thinking is that real wealth will be growing faster than money supply in the next long cycle, so I want to be long non-resource company stocks for the most part.

The reason I want to retain some gold physicals permanently is to prevent any sovereign government taking control of my unencumbered physical assets, for whatever reason. I still would not be satisfied that governments and central banks could be fully trusted. The offshore market of Switzerland will be safe, and so too will be Bahamas, which is why I have looked into starting a bullion vault there (for offshore trust and IBC owners).

The next Bear cycle could be a difficult one. During the stock market cycle bottom phase, it might be advisable to switch into real estate with a large part of the 14% in cash – even ahead of stocks. I have a belief that the real estate market will be a complete and total mess at that point, and, like a similar period in 1990, ‘cash is king’ and can be used to pick up bargains.

You remember my story of my parents buying their neighbor’s property ($1.1 million value with a $950,000 mortgage) on a bank repo at $300,000 cash. I think we’ll see more of that in the next couple years.

Not being a real-estate investor, I would, at the next long cycle bottom, increasingly re-direct cash into more U.S. and European ETFs, especially the smaller cap, higher beta ones. The majority of my cash, however, would go back to other ETFs, mostly BRICs, and, of course, to Cara 100 companies (i.e., those in the Accumulation Zone).

Let the Market Come to You
This is a theoretical model in which I am explaining decisions I expect to make if and when the anticipated conditions arise. A word of advice; you cannot rush the market.

At the end of the day, if you are prepared to wait for markets to come to you, you will do well by selling in the Distribution Zone (after the RSI-7 values reach extremes or (if there happens to be no spike top) when the Daily RSI-7 drops below 70. You will start to buy long positions in the Accumulation Zone, under the exact opposite conditions.

If my portfolio plan is too complicated, I recommend sticking to Cara 100 companies only – sell them in the DZ, buy them in the AZ, and ignore the media and Talking Heads. Even quality companies go through price cycles – from oversold to overbought. Just make sure you are doing the selling when they are overbought and are buying only when they are oversold.

It’s really that simple: Buy Low and Sell High.

But following a plan such as this for years, you will not worry about making the absolute top of the market’s long-term price cycle or suffering through to the bottom. And your portfolio performance will stay in the top quartile when measured against professional capital managers.

In a Bear market, your concern is to clear off all debt so that a friendly banker does not ever come looking to take assets to meet your obligations. I have been there, and done that. So for years I have carried no debt whatsoever other than in a securities trading account, which is ok because these markets are liquid.

The Need for Market Cycles
How long it will take market prices to move from DZ to AZ is always a matter for the “crowd” to decide because “we” are the market. Governments, central banks and HB&B are powerful forces in the broad market, especially at intermediate trend junctures. But, combined, those players are never 100% on the same page, and they too stand back when global markets want to fall. You see, everybody recognizes the need for cycles when there is a time to buy and a time to sell, etc. (Ecclesiastes 3).

Within the Bearish long cycle, there will be numerous lower highs and lower lows. I do think the next Bear will be a big one – and a long one because there are so many financial excesses that corporations, businesses and society must purge.

That is unfortunate for traders who cannot make decisions. As you know, there were traders in 2000 who hung on through these declining cycles until selling out in 4Q02 and 1Q03, near the cycle bottom. So, you have to make decisions and your timing has to be based on market logic.

By the way, as long as there are salespeople, "Mo" will always be part of the market. My point is that our values are changing. Serious Bear markets do that. We are soon going to be primarily looking to take a risk on quality assets rather than stories told to us by people we no longer trust.