The Volatile Nature of Smallcap Stocks

by: Dave Gentry

Writing research on small-caps is an activity for the strong-willed. It takes more than imagination; it takes discipline, courage, and the ability to sort the good and the bad from the just plain ugly.

We have four basic criteria that companies must meet or exceed to warrant RedChip Independent research. Our system is not fool-proof, but it works most of the time as our 15 year track record demonstrates.

The four RedChip criteria

Effective Management: encourages innovation, ensures high morale among its workforce, and executes business strategy to create maximum shareholder value.

Mass Appeal: guarantees that the investment in a new product or service will be rewarded by a large market opportunity.

Growing Sales: provides visible proof of the market’s acceptance of the Company’s product offerings.

Improving Margins: testifies to management’s ability to translate new sales to bottom-line profits.

On four occasions our system has failed over the last 18 months, that is to say, though all of our stocks went up after we blessed them with the RedChip seal of approval (the same seal we put on Starbucks (NASDAQ:SBUX), Daktronics (NASDAQ:DAKT),, and Winnebago (NYSE:WGO) years before they became Blue Chips) the downhill slide on each of the four would have crushed many a nest egg if it were not covered with the upside of the other stocks in the RedChip portfolio.

Might I be man enough here to admit our mistakes: Merge Technologies Incorporated (NASDAQ:MRGE), Global EPoint, Inc. (OTC:GEPT), One IP Voice, Inc. (OTC:OIVO), and I/OMagic Corporation (OTC:IOMG). In these four, we did not live up to our raison d’être: “Discovering Tomorrow’s Blue Chips Today.” I suppose one could say these companies, with the exception of possibly MRGE, were not, as the business guru Jim Collins would put it: “Built to Last.”

OIVO went bankrupt and GEPT is a shadow of its former self, having been delisted to the pink sheets. MRGE lost 86 percent of its value after the SEC determined that it iced its books for 2005 and 2006, forcing the Company to restate two years of their financials. IOMG, down over 50 percent since we initiated coverage, may eventually get it right. Our analyst covering the stock refuses to give up on the Company and there is nothing I can do about that.

On that dour note, I am reminded by Jim Collins that the great companies have many things in common. First, and most importantly, the great companies have leaders who possess humility. Having personally met the management of three of the companies above, I can tell you with certainty that hubris is in no short supply.

In his book Good to Great Jim Collins writes of a remarkable but little known story of Bill Hewlett of Hewlett Packard: in 1972, many years after the Company had established itself as one of the most successful companies of all time (having outperformed the market by at least 3x over a 15 year period, which is Collins’ criteria for a great company), Hewlett remarked in an executive council meeting:

“Look, we’ve grown because the industry grew. We were lucky enough to be sitting on the nose when the rocket took off. We don’t deserve a damn bit of credit.” And then, as Collins describes the scene, a few moments of silence passed and David Packard said: “Well, Bill, at least we didn’t louse it up completely.”

If I were to possess that kind of humility, I would be a far better man than I am today.
Humility at the top could cure a lot of small-cap companies of what ails them. Under-promising and over-delivering is still a virtue, as is giving credit where credit is due.

We have seen some absolutely astounding appreciation on companies under RedChip Research coverage, both on the Independent and the Visibility sides. For those of you not familiar with the RedChip model, we also perform company-sponsored research. We call this research RedChip Visibility. Companies pay us to write and distribute research on them.

The major difference in the two models is quite simple: we hold the Independents to a higher standard. They must meet and exceed our four basic criteria, while the Visibility clients must meet at least two of our criteria. The Independents have outperformed the Visibility clients, holding their gains considerably longer than the Visibility clients. Now that would make sense. However, both indexes are up nearly 70 percent on a post-coverage high basis. Click here for the indexes. That’s not to say that savvy investors have made a buck or two on our sponsored research clients. That’s not also to say that sponsored research isn’t a valuable commodity, given it is written with integrity – we are not compensated in stock for the sponsored research product.

Now to show we haven’t loused things up completely, here’s a snapshot of some our biggest gains over the last 6 -18 months.

LKQ Corporation (LKQX): auto parts provider: $16.59 - $25.39, a sweet 53.0% gain

LJ International, Inc. (NASDAQ:JADE): A China jewelry play: $3.51 - $12.56, a 257.8 % gain, or if you were still holding today, a dynamic 161% gain

Drinks Americas Holdings, Ltd. (OTCPK:DKAM): developer, producer, marketer, and seller of premium alcoholic and non-alcoholic beverages: $ 0.60 - $3.55, 491.67% gain on its post-coverage high, still up nearly 300% today if you were still holding.

Greenfield Online, Inc.
(SRVY): leading provider of Internet survey solutions worldwide: $5.00 - $16.20, 224% gain

Newtek Business Services, Inc
(NASDAQ:NEWT): provider of quality financial products and business services to small and medium-sized businesses: $1.75 - $2.69, 53.71% gain

Boots & Coots Intl. Well, Inc. (WEL): emergency response services for oil well blowouts and well fires: $1.67 - $2.49, 49.1% gain

Bovie Medical Corporation (NYSEMKT:BVX): a medical device company which manufactures and markets electrosurgical medical devices: $7.25 - $10.04, 38.62% gain