Making Money Despite the Climate

• ByTim Melvin, RealMoney.com Contributor
• On 8:01 am EST, Friday January 9, 2009

I am often asked why I continue to write about stocks I like when I am so bearish on the market overall. The truth is I am still very concerned about the market, perhaps even more so after reading the latest outrageous predictions from the very smart guys at Saxo Bank and watching the incoming president's speech on Thursday.

I have a real fear that public money being pushed into society will freeze out private capital and innovation, prolonging the pain. Government intervention has never fixed the economy -- the rise of new industries and innovative thinking has. The creative destruction of old obsolete businesses and industries has during past recessions paved the way for new ones to arise.

With the government funding industry and controlling the bulk of lending, it may well take longer this time. The result will be rising unemployment and continued stagnation in retail spending. One correspondent yesterday said that everything will be OK because the government will take the place of the consumer in the economy. That will not work; it never has before.

So why continue to suggest stocks? Because if we focus on stocks that trade for less than their economic and asset value, there will be opportunities to make money regardless of the climate. Remember that I emphasize staying small, moving slow and being smart. I may have a list of stocks I like but unless the market is falling, I am not buying. If the market has been up for a period, I am probably selling calls and buying inverse funds. I am willing to buy all the way down if I am sure of my valuation.

Take one of my favorite stocks: Darling International . I bought a little at over $7 when I started following the stock back in October. Because I stayed small and moved slow, I was able to add as the stock fell all the way below $4 in December. The company is worth somewhere in the high teens, so I was comfortable with the volatility and making it work for me.

More than ever, I look for potential catalysts that might move my cheap stocks one direction or the other. The infrastructure trade has been on fire since mid-October as details of the stimulus plan became known. Because I had a pretty strong opinion of the value of LB Foster , I was confident that even if my short-term direction was wrong I would suffer no permanent loss because the company was worth more than I paid for the shares. The stock has soared on the various announcements and, even as the market fell, I made money on the long side.

Because of the absolute cheapness of REITS like Hatteras Financial and Redwood Trust , when Doug Kass pointed out that the Fed was going to try and gun mortgage rates to 4.5%, I was able to suggest small positions with a high degree of confidence that short-term quotational losses would not become a permanent loss of capital.

The other reason to focus on valuation and stay small is that sometimes things are just not going to go your way. My single biggest loss last year came from Atlas Pipeline Partners . I started buying in the high teens and the shares dropped as low as $5 as analysts expressed concern over the dividend. Falling crude prices and the tumultuous capital market have hurt the company, and the outlook is far less certain in the short term. I think the long term still plays out favorably (by long term, I mean three to five years or more) and, because I stayed small, the overall effect was not that damaging in the short run.

I was wrong in my estimate of how low oil would go as well. Because I paid such close attention to valuation, my short-term losses in Rowan do not bother me at all. I am so confident that the company is worth a lot more than the market price that I hope it goes lower so I can buy more.

The market is going to go lower, and there will be stocks like LS Starrett that fall to such ridiculous valuations that you almost have to buy. Down around $10 earlier this year, you were buying a profitable cash-rich company for 40% of asset value.

Some companies, like Adaptec last year, will trade for less than cash. My experience suggests that if a company trades for less than cash and is not bleeding money, buying shares will work out profitably regardless of market conditions.

I suspect the economy is worse than the bulls realize and it will take the stock market down with it. The bull case is built on government intervention and that is a very weak platform indeed. Despite this, there will be opportunities on the long side as well as the short side this year. Investors and traders who stay small, move slow and make the market work for them will profit. The key is not to make the big bets that lead to disaster and a permanent loss of capital. Valuation, caution and a long view are the way to survive and possibly thrive in this market.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider L.B. Forster, Darling, Atlas Pipeline, Hatteras, LS Starrett and Adeptco 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.

Buzz up!