Long Shot Leaders

 | Mar 22, 2014 | 8:00 AM EDT
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A warm welcome to all the visitors to our Real Money open house! This weekend you will have the opportunity to sample many investment strategies, from deep value to earnings momentum to technical analysis. The breadth and depth of knowledge of our contributors is impressive, and we believe you will want to spend every trading day with them. I have three specialties that I ply on these pages:

  1. I use earnings momentum to identify names with the best upside potential;
  2. I execute an income strategy I call "dividend rotation"; and
  3. I traffic in intriguing but risky small-cap names in our "Long Shot" columns.

For our last open house on Feb. 1, I described in detail the "dividend capture" strategy that I write about periodically under the column name "Diary of a Dividend Diva." This weekend, I want to highlight some of my best "Long Shot" ideas, which our more risk-tolerant readers are using to make a ton of money.

To set the context, recently the Street has been rediscovering some of the foundational investment precepts of Michael Steinhardt, one of the greatest hedge fund investors of all time. Blogs, emails and the like have been circulating interviews, articles and book excerpts describing his principles, the most important of which is "variant perception". Having a clearly elucidated variant perception on a stock was the key to successful investing, in his experience. Here is how he defines variant perception:

I defined variant perception as holding a well-founded view that was meaningfully different from market consensus. I often said that the only analytic tool that mattered was an intellectually advantaged disparate view. This included knowing more and perceiving the situation better than others did. It was also critical to have a keen understanding of what the market expectations truly were. Understanding market expectation was at least as important as, and often different from, fundamental knowledge.

The concept is not alien to most investors. The fundamentals are only half of the equation. To make money in a stock, you need to identify where the expectations for future performance are incorrect. This can be on the upside, meaning your assessment of future earnings is far greater than Street expectations, or on the downside, meaning that a stock is pricing in perfection -- a future that will never be realized. Buy the former, avoid or short the latter.

My "Long Shots" tend to take the variant perception meme to an extreme; I often hit pay dirt in names in which there is literally no market expectation. This translates into smaller, thinly traded names with no analyst coverage and little institutional ownership. These types of names are difficult to find, difficult to analyze, and difficult to trade. But when they work, you can make multiples of your money. This is an inefficient and profitable corner of an otherwise vast and highly researched, mostly efficient market.

Before I offer my best "Long Shot" names, keep in mind one other discipline practiced by Steinhardt -- that is, how he presents his ideas. His approach was simple yet elegant and efficient to boot. He described it thus: "Ideally [an analyst] should be able to tell me, in two minutes, four things: the idea; the consensus view; his variant perception; and a trigger event. No mean feat."

So using the Steinhardt format, let's peek at four names of which I am enamored at the moment.

1. Energy Recovery (ERII)

  • The idea: Energy Recovery is a classic turnaround story, with all the indicators pointing toward a turn in the right direction. Energy Recovery manufactures energy recovery devices that can help improve the efficiency of high-pressure fluid and gas processing systems. The principal application is water desalinization. The desalinization market collapsed in the recession, but it has since recovered, and Energy Recovery is winning most of the market share in these projects. Furthermore, the company is progressing rapidly into new markets in which its systems can recover heat from high-pressure fluid flow such as natural gas refining.
  • Consensus view: Many coverage analysts are overly cautious, feeling that the desalinization market is too lumpy and prone to delays and the oil/gas market is too far in the future to discount in the stock now.
  • Variant perception: I think the company is farther along in the gas-processing opportunity than investors realize and that revenue growth and earnings upside will come in 2015.
  • Trigger event: A steady progression of upside surprises combined with the announcement of large deals that have been in the works for years will cause some of the bears to flip sides and drive the shares higher.

2. Lihua International (LIWA)

  • The idea: An interesting company trading at net cash that has a strong balance sheet and exceptional growth. It makes copper wire for a variety of markets in China, such as residential and commercial construction, electronics and utilities. The company uses recycled copper, so there is a green element to the story as well. It has grown rapidly, as you would expect, given the breakneck pace of economic expansion in that country. Distrust of Chinese stocks is creating a great opportunity in Lihua. Unless the cash is simply not there, which I feel is unlikely, there is a cushion under the valuation. If the company can expand to meet insatiable demand and sustain its high growth rate, the stock could ultimately be a multi-bagger as the cash rises and the valuation expands to reflect the company's growth rate.
  • Consensus view: There barely is one. No one covers the stock, and no institutions really own it. Everyone hates the non-Internet Chinese stocks after having been burned by the wave of frauds in 2010 and 2011.
  • Variant perception: I have visited the company. It is real, the numbers have veracity, the growth is real, and the market opportunity is large.
  • Trigger event: Eventually the growth cannot be ignored, especially the valuation. The company intends to get out and tell its story more aggressively to Wall Street, and the heightened visibility should eventually attract buyers.

3. Gencor Industries (GENC)

  • The idea: Gencor is small, with an $86 million market cap, yet the $90 million of cash and liquid investments on the balance sheet gives me great comfort that I am taking little risk in buying this stock. The company makes machinery equipment used in road construction, mostly related to asphalt production. The cyclical nature of the business certainly argues for a discounted multiple but not to value the business at zero. The company should be able to sustain margins in this down cycle, and road building will rebound eventually because of the inevitable need for repairs.
  • Consensus view: Why is the market missing this one? I am trying to figure that out myself. The company seems to make no effort at investor relations, there is no analyst coverage, and the only press releases are the earnings releases. There is high insider ownership, meaning a low float, which hurts trading but is welcome when management eats its own cooking. Insiders own 40%, and the only major active institutional investor appears to be Fidelity, which owns 5%.
  • Variant perception: The risk/reward here seems compelling. When you buy this stock, you are buying a portfolio of liquid investments with a call option on a nearly 45-year-old business that is profitable, has earnings from operations not the portfolio and has a committed management team. The business exposure is to an industry whose long-term viability is not in doubt. With a business valuation of zero, the odds of making money seem reasonable.
  • Trigger event: This stock is going to move every time the company puts up the numbers. The stock spiked in February off a solid first-quarter earnings report, and I think more will follow. From the release --
    Gencor Industries ... announced today net revenues for the quarter ended December 31, 2013 of $10.0 million, a 102.5% increase over the $4.9 million in net revenues for the quarter ended December 31, 2012. Gross margin increased to 15.3% for the quarter ended December 31, 2013 from 8.4% for the quarter ended December 31, 2012. Selling, general and administrative expenses decreased $225,000 to $1,734,000 for the quarter ended December 31, 2013. Operating loss for the quarter ended December 31, 2013 was $(0.6) million, compared to an operating loss of $(2.0) million for the quarter ended December 31, 2012. The Company's first quarter is usually the lowest in revenues and income recognition due to the cyclicality of our industry whereby during this quarter contractors tend to place orders for equipment for Spring delivery. Thus, our Engineering and Manufacturing operations, and cash outflow, are at peak, while revenue recognition tends to be deferred.
    Look for more of the same -- namely, improving results -- in the quarters ahead. The stock was up 18% on that release alone.

4. Pingtan Marine (PME)

  • The idea: The story here is simple -- this is an undiscovered and unloved China play that has a profitable business with visibility to long-term growth. Its history was complicated, because it came public via a Deutsche Bank-sponsored special purpose acquisition company. It also had two marine-related businesses that needed to be rationalized. The chairman bought the marine dredging business from Pingtan Marine, in the process cleaning up the balance sheet and creating a pure play fishing company. The company is projecting net income of $85 million in 2014, putting the valuation at 3x earnings.
  • Consensus view: Another Chinese company with no consensus view. In addition to being Chinese, it came public via a complex path through a SPAC, and it had a daunting structure with two marginally related businesses. No one follows it, and no institutions own it.
  • Variant perception: The company will get recognized over time as it puts up the numbers and attracts investors and coverage. Importantly, the guidance is visible and believable, and the company can build trust as it achieves guidance.
  • Trigger event: Similar to Lihua, a combination of growth and incredibly cheap valuation will attract investor attention -- always does. One of the company's goals for 2014 is to get out and tell its story more aggressively to Wall Street. Now that it is a pure play with a vastly improved balance sheet, I think Pingtan will start to raise its visibility via non-deal roadshows and the like.

A final thought: All of us here at Real Money invite you to subscribe. The level of discourse and insight are impressive, and I am continually amazed at the breadth and expertise of the contributors to the site. I also invite you to follow my "Long Shot" postings as well as my regular "Dividend Diva" columns. Our goal is to guide you toward progressively better levels of wealth generation. Such results really are within your reach.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider ERII, LIWA, GENC and PME to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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