Small-Cap Liquidity Surfing

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While you can survey the market on high to see the general strategic flow of things, there are some times when it pays to get down in the trenches and look at it tactically, from a data perspective. Today is one of those days. For example, yesterday Oxiana (ASX: OXR), itself the subject of multiple takeover rumours, swept in on Australia-based gold producer and explorer Agincourt (ASX: AGC), whose shares promptly arched high in the sky.

Agincourt, incidentally, is also the name of one of history’s important strategic battles. Henry V’s outnumbered English decimated the flower of the French nobility at Agincourt in 1415. The English long-bow was the decisive factor.

The long-bow, at least in medieval and early renaissance terms, was a strategic platform, allowing the English to project deadly force from a distance and from above. It was, if you will, the b-52 Superfortress of its Day. It was also an example of how air superiority can turn a battle, which is something to think about given China’s recent demonstration that it can shoot down a satellite (the United States having enjoyed unchallenged global air superiority since World War two, and satellite communications being key to America’s new ‘network-centric’, information intensive way of war.)

But back to gold and uranium. We suspect Agincourt was named with an ironic nod to the strategic significance of the long-bow, or being able to hit an important target from a long way off. It requires good vision, but more importantly good foresight, which is what good management provides a mining company-especially a mining company looking for two of the most valuable metals of the next fifty years, numbers 79 and 92 on the periodic table, respectively.

Oxiana’s bid-which values Agincourt at $415 million-is a 34% premium to the share price of $1.44 on January 24. Clearly Oxiana’s management believes that Agincourt’s gold projects in Indonesia and its 57% stake in WA uranium explorer Nova Energy is worth paying a little more than market value for today. We don’t know enough about Nova to agree. But we know enough about Oxiana to have recommended to readers of Outstanding Investments. If gold doubles and uranium goes on to $100, the 34% premium will probably be a small price to pay for the new assets, provided the assets don’t get too expensive to produce, and provided they are really there.

“Follow the money,” goes the old investment advice. If you wanted to slap a fifty-cent word on this basic advice, you’d call it liquidity surfing. Money flows move markets. Follow the money and you’ll find what’s moving up.

If you want to find what’s moving up-before it moves up-you have to work harder. You have to investigate more closely. Namely, you have to be able to spot one dollar’s worth of earnings selling for fifty cents, and do it before anyone else does. Then you wait for the money flows to arrive. Sometimes they never do.

Other times, the money does arrive, and you are then engaged in what we’ve dubbed ‘liquidity surfing.’ Incidentally, the best liquidity surfers we’ve ever seen are investors in small stocks, which by definition are prone to being swept up, up and away by new money flows.

The advantage small stocks investigators tend to have is that small companies are too small for big, lazy, money-flow managers to invest it. How, for example, could an institutional fund manager make a $500 million investment in a $250 million company? Too much beer, not enough schooner.

So the small companies are mostly left alone to be picked over by individual analysts, like prospectors patiently panning for penny stock gold in a small creek. What you are looking for are the nuggets that indicate a richer vein. What most investors find is mud, and a swirl of confusion. But if you want the big strike, that’s where you must do your work, finding a good, well run business on the cusp of its hockey-stick growth phase.

Then you have to have the nerve and the patience to ride out your bet until the money comes flowing your way-if it ever does. You’ll forgive our extended riff on this, we hope. But today reminds us of 1998, when we broke into the business of independent investment analysis with a newsletter on small capitalization stocks. It was called “Penny Stock Fortunes.” We were brand new to the game then. But it didn’t take us long to realize that most of what we were reading about how to get rich in tech stocks was plainly, flatly, almost deliberately wrong.

Investors were urged to buy shares in companies that had already gone up, like Microsoft (NASDAQ: MSFT), Cisco (NASDAQ: CSCO), Intel (NASDAQ: INTC), and Sun Microsystems (NASDAQ: SUNW). That’s what Wall Street was selling. That was the story and theme. And so powerful is the Wall Street hype machine that those same tech stocks-many of which are lower today than they were five years ago-remain the most actively traded stocks in the market. If you follow the money, you’ll find it’s still chasing the last bull market, not the next one.

We bring it all up because we think the next wave of liquidity will be away from blue chip stocks and into smaller stocks. We don’t know when it will happen. But we do know why, or at least have an idea. The low-hanging fruit and easy money has already been made in the resource market. There is still money to be made. But companies will have to work harder for it, and the growth rates will be smaller, not worth paying steep premiums for.

The companies with the greatest growth rates ahead of them in the next five years are companies that are small today, perhaps brand new, and in some cases with very little operating history. This makes it difficult to measure management’s performance, when there’s not much track record to go. But there are other ways of measuring a business’s potential. More on that in the coming weeks. It’s a worthwhile exercise because it should, we’re hoping, lead us to the next generation of stock market winners, which we enjoy writing about as much as we enjoy writing about as much if not more than the battle of Agincourt.

This just in from our web headquarters, the guy who punched the shark is still in the lead with 32% of the vote in our informal poll for Australian of 2006. Steve Irwin comes in at second, the firefighters third, and Ian Thorpe fourth. The big shock is that Sheik Taj el-din al-Hilali leads Shane Warne in the voting, which we’ll close later today. Warne needs to hit for six, and quickly.

We’ll leave you with a geopolitical observation to ponder. France, England, the United States and Russia will all have new elected leaders in the next two years. That should shake things up and make for some more political instability, don’t you think?

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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