Microcap "Gems"

08/26/2005 12:00 am EST

Focus:

Paul Tracy

Editor, The StreetAuthority Market Advisor

"Our latest newsletter, Undiscovered Microcap Gems, looks for small neglected companies that aren’t followed by Wall Street," notes Paul Tracy. "There is just not a lot of research into the micro-cap area, and that’s where we are looking to get an advantage."

"Many small- and micro-cap companies trade at values that are significantly lower than their actual intrinsic value, and in some cases, even below the value of their assets. One of the key principles of this newsletter is to find companies trading at a significant discount to their actual value. We do so not by looking at Microsoft or Dell or other large-cap companies that are followed by lots of analysts and journalists, and therefore, tend to be very efficiently priced. It is extremely difficult as a small investor to uncover something that all of these analysts have missed.

"But micro-cap stocks is one area where you can get an advantage over Wall Street, by looking at some of these smaller companies. One advantage of these smaller companies is that a lot of hedge funds, mutual funds, and institutional investors are barred from investing in these companies based on regulations, etc. In addition they tend to avoid these companies because due to their small size, mathematically it doesn’t make sense for them to take a significant position as it would likely push up the share price.

"Diedrich Coffee (DDRX NASDAQ) operates more than 200 coffeehouses in the US. Although Diedrich is the country's #2 coffee chain, it operates in relative obscurity under the shadow of its much larger rival, Starbucks. Currently, investors are shelling out more than $3 for each dollar of revenue at the Seattle-based giant. That compares to just $0.50 for each dollar of revenues for Diedrich. Inexpensive stocks often trade at rock-bottom prices for valid reasons, and an attractive valuation alone is not sufficient to warrant a spot in my portfolio. Fortunately, there are a number of other reasons to take a closer look at the company. To begin with, Diedrich has a healthy balance sheet, with $18 million ($3.41 per share) in cash on the books against very little long-term debt. Though the company's stock has lagged the industry over the past five years, I believe management has taken the right steps to bring DDRX more in line with competitors.

"Sport-Haley (SPOR NASDAQ) designs and markets an array of upscale golf apparel under the Haley and Ben Hogan brand labels. I believe this company represents value in an overlooked and generally disliked apparel business. With valuable brands and a strong balance sheet, though, the firm could be an attractive takeover candidate. Even without the prospect of a buyout, Sport-Haley should appeal to value-minded investors. Currently, Wall Street is valuing the stock at less than 60% of its $5.84 per share book value, including $2.53 per share in cash. Considering its tiny size and costs involved to remain listed on the Nasdaq, there is always the possibility that the firm could go deregister its shares and list them on the pink sheets. It may take time for Wall Street to fully recognize the true value of its assets, but Sport-Haley could ultimately be worth the wait.

"Discovery Partners Intl. (DPII NASDAQ) offers research products and services to Pfizer, Merck, and other clients in the drug and biotech industries. The company does much of the behind-the-scenes work to help other firms bring new drugs to the market. I strongly believe that Discovery Partners merits a closer look. For a tiny market cap of just $81 million, the firm has a hefty cash stockpile of nearly $80 million, which leaves an enterprise value (share price adjusted for cash and debt) of only a nickel per share. In other words, for a price of just $3.11 per share, owners have a claim on cash of $3.06 per share, not to mention receivables totaling another $5.7 million. With the stock trading at just 80% of its book value, and with an unheard of Enterprise Value/Revenue ratio of just 0.04, any improvement in Discovery Partner's financial results should soon be reflected in the company's shares."

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