• ESP Day 6: The REAL reason stock prices jump higher (and plunge lower)
• No bang for our borrowed buck
• Why deficits ‘don’t matter’

By Härje Ronngard in Albert Park

Welcome back to your Extreme Small-Cap Profits email course.

We’re now on Day 6 of 12.

If you missed yesterday’s email, we had a look at where you might find super profitable small-caps.

The ones that skyrocket in months are usually found in high growth industries. Of course, that’s not always the case.

But if you can get on the other end of an emerging high growth stock, you can potentially double your money in less than a month.

This is exactly what happened to sensor technology company, Panorama Synergy Ltd [ASX:PSY].

Before the first month of 2018 was over, Panorama climbed 100%!

The only way to capture such explosive small-caps is to consider their application, potential, and the size of the market they serve.

Today, you and I are going to take a deeper look into the businesses behind the small-caps. After all, small-caps are not just pieces of paper gyrating up and down.

Behind every one is a business.

More than just a piece of paper

In my day trading hay day, all I cared about was numbers.

I wanted to buy something at three and sell it at nine. It didn’t matter what I was buying. I simply reacted to price movements, buying and selling numbers.

I see people do this all the time.

They buy stocks because they ran up in the past and are still only worth only a few cents. Or their decision to buy is based on some type of ratio, like the price-to-earnings (P/E) or price-to-book (P/B) ratio.

This isn’t how you should approach small-caps. They’re not just prices on a graph.

Forget about prices for a moment.

A far better way to think about it is that you’re buying and selling businesses. And what you’re buying is a business’s earnings potential.

Consider you had the option to buy two businesses, Microsoft Corporation [NASDAQ:MSFT] or IBM [NYSE:IBM].

I know both aren’t small-caps, but humour me for a moment.

Both produce products in high demand. Microsoft creates software, IBM creates computer hardware.

For Microsoft to sell one more copy of software, it costs almost nothing. For IBM to sell one more computer component, they’ve got to manufacture and ship it.

Now, which business would you prefer to own?

Of course you’d rather own Microsoft.

Not only do they have products in high demand, selling one more copy of software after it has already been developed costs the company almost nothing.

Thanks to their favourable business model, Microsoft has a profit margin (how much of revenues flows into profit) of 23%, whereas IBM only has a profit margin of 14%.

Clearly the more valuable business is Microsoft.

What is valuable?

Now it should be easy to answer the following question. What makes a business valuable? Why could it potentially be worth a lot more than its current price?

Earnings!

Why are earnings valuable?

As a shareholder, you are often entitled to earnings. Therefore, it’s in your best interest that a business earns as much as possible by spending as little as possible.

That’s why when a business dramatically increases earnings, the stock price usually skyrockets.

To see what I mean, let’s take a look at GetSwift Ltd [ASX:GSW], the logistics management software small-cap.

In 2017, the company was signing deals left right and centre.

They signed contracts with Fruit Box Group, Cross Town Donuts, Commonwealth Bank, Pizza Hut, and 10 other companies.

Before listing in 2016, GetSwift generated revenues of just over $100,000. One would expect 14 new customers to significantly boost sales and earnings.

So investors jumped on the stock while they had the chance.

Then in December last year, GetSwift inked an agreement with online giant Amazon.com, Inc. [NASDAQ:AMZN].

The mere association with Amazon made investors think GetSwift had something great.

Source: Google Finance
[Click to enlarge]

That year, GetSwift’s share price rose more than 1,100%. It put the stock in the top five of the ASX’s biggest gainers in 2017.

As small-cap investors, we want to jump on these kinds of opportunities early.

That means we need to first identify companies with great products or services, which can service an extremely large market.

But what if we miss the boat?

Whatever you do, don’t overpay

No business is worth an unlimited amount of money.

Sometimes it’s easy to forget this when talking about the explosive potential of small-cap stocks.

Investors end up paying dollars for a stock that might only be worth cents. They come up with ridiculous growth assumptions to justify their purchases. They don’t end up buying growth. What they’re buying is inflated expectations.

If we cast our eye back to GetSwift, this could be one stock investors have over hyped. The company is being accused of poor market transparency, according to the press.

GetSwift’s lack of information has encouraged investors to sell the once darling stock.

In 2018, the software logistics firm dropped more than 20%.

It’s not a massive drop. But it just goes to show because a stock is going up, that doesn’t mean you should jump on.

Source: Google Finance
[Click to enlarge]

This doesn’t mean all rising stocks are too expensive.

Some stocks trade at more than 50 or 100-times their earnings. Meaning investors are paying $50 and $100 for each dollar of current earnings.

Even at such a price, they could make for amazing investments. It really depends on a case-by-case basis.

And it would seem online retailer, Kogan.com Ltd [ASX:KGN] might be one of those stocks.

At the start of 2017, Kogan had a P/E ratio of more than 170-times earnings. Yet in that same year, the stock almost quadrupled.

Source: Google Finance
[Click to enlarge]

Investors bought the stock because revenues were growing by double digits, profits grew by more than 360% and the company was using cash to aggressive grow operations.

Of course, Kogan’s story is long from over. But for now, the business is heading in the right direction.

That about does it for Day 6.

You’re half way through. Only six more days until you graduate and become a small-cap investing master.

Today was just an introduction to looking at the business behind the stock. On Monday, Day 7, we’re going to dig even deeper.

Don’t worry if you’re not a number person. I’ll explain how you can find out if a small-cap has legs in less than 10 minutes with nothing but elementary maths.

Stay tuned.

Cheers,

Härje Ronngard,
Editor, Markets & Money

No Bang for Our Borrowed Buck
By Katie Johnson, Editor, Markets & Money

‘Nothing lasts forever.’

Plain spoken and no-nonsense, this is a saying that governs all aspects of our lives. And when it comes to the markets, this impermanence is the shadow that is always lurking behind the scenes.

Vern Gowdie, author of The End of Australia, hammered in this point throughout his speech at Port Phillip Publishing’s Paradox of Prosperity conference. An event where influential financial thinkers from all over the world have come to put in their two cents about the state of the markets. 

As Vern began his talk, the realist attitude that he’s known for in his writing shone through. And the questions he posed reflected both the concerns of many Australians, and the critical tone that pervaded the speeches of the day.

‘Now that we live to 100, how are we going to afford it? It’s a very good question.’

Economic sustainability is a topic that Vern cares deeply about. And with rapidly evolving technology, rising debt and a changing economic landscape, he believes it’s a topic we should all be paying attention to.

As Vern pointed out, the consequences of our rapid innovation are easy to see. With Netflix came the death of video rental stores. Newspapers disappeared as our screens multiplied. And with the rise of robotics, traditional labour will likely vanish as well.  

But even with all of this innovation, our economic growth is slowing. The reason for this, Vern argues, is that we have failed to be adaptive in our economic model. And now we are drowning in debt and are struggling to keep our economy stable.

Although we are accustomed to our GDP always rising, and our living conditions becoming ever-better, it’s an expectation that we need to rethink. As decades of economic prosperity has come with trillions in promises from the government. We are now left with an unsustainable welfare system, falling productivity and non-productive debt.

As Vern confirmed: ‘Borrowing our way to growth is a model with a finite life. It’s impermanent. We know that.’

Vern then noted that increasing immigration and debt to drive growth was a Ponzi scheme. But as it’s political suicide to suggest any drastic change to our financial system, things are unlikely to change anytime soon. And Vern believes that this complacency will likely lead to the next recession.

How to solve the economic dilemma?

Dr Marc Faber, coined Doctor Doom, couldn’t agree more. Taking the stage after Vern, he lamented Vern’s point that we need to adjust our expectations:

‘If you want the government to give you everything, they will take everything from you.’

In our delirious state of economic boom, Dr Faber argues that we have become unproductive and greedy. And as a result, GDP outperformance in the Western world has come to an end.

He noted that China is slowly but surely becoming top dog. They’re consuming roughly 50% of commodities, hold some of the world’s top brands and have increasing geopolitical influence. They’re doing so well in fact, that they couldn’t care less about the looming US tariffs.

Dr Faber sombrely conceded that the Western world is fast falling behind. And that in these times of rapid change and global uncertainty, it can be very difficult to know where to look as an investor.   

But even in these challenging circumstances, both Vern and Marc proposed practical solutions for Australian investors. Outlining how you should invest in this environment and how to protect yourself in the event of a recession. I can’t specify the details here, but if you’d like to access the presentations in full, it’s not too late to grab your virtual seat at the Paradox of Prosperity conference.

Our camera crew has recorded all the speeches, questions and ideas from the conference, which include notable financial figures including Greg Canavan, Jonathan Pain, Gerard Minack, and Tim Murray. If you get in before midnight tonight to get your 20% discount.

You can secure your copy, here. 

Kind regards,

Katie Johnson,
Editor, Markets & Money

Why Deficits ‘Don’t Matter’
By Bill Bonner in Normandy, France

Bitcoin is making itself useful. Bloomberg is on the case:

‘Bolívar to Bitcoin Market Hits Record $1 Million Per Day’

‘The Venezuelan bolívar to bitcoin market reached a record on Tuesday, as the dollar-starved nation increasingly seeks the digital token in exchange for its nearly worthless currency.’

Venezuela is a disaster. Inflation is expected to hit 13,000% this year.

But disaster isn’t sedentary. It’s nomadic. And our guess is that it is headed our way.

Doom index

First, let’s turn to the research department to find out how close it might be…

What’s up with the Doom Index?

As you recall, our researchers — led by the indefatigable Joe Withrow — came up with a way to tell when a crash was likely to happen. We call it the Doom Index.

No guarantees, because these things are unpredictable. But a measure based on a broad group of indicators should be more reliable than your editor’s hunches, right?

Well, who knows.

Here’s an update from yesterday:

‘The Doom Index spiked up to 7 — our extreme warning level — back in January…and it will remain at 7 for at least another three months based on first-quarter numbers.

‘But it is not signalling the crash alert flag…yet.

‘What has kept the crash alert flag in storage — and perhaps what will keep the markets chugging along for another quarter — is an uptick in credit growth. After falling to 1.6% last quarter, credit growth increased to 2.4% during Q1 2018.

‘Remember, we are leaning on economist Richard Duncan’s analysis here. Duncan says that the modern economy requires at least 2% credit growth to avoid recession. So 2.4% is just enough to avoid a Doom Point.

‘On the flip side, there was a sharp drop in non-farm payrolls. Non-farm payrolls steadily increased for 29 consecutive quarters — that takes us back to 2010. But they plunged 1.2% during Q1 2018. 1.2% sounds like a small move, but that’s the biggest drop in non-farm payrolls since the start of 2009.

‘So we saw an uptick in credit growth, but a fall in wages this past quarter. Perhaps those two moves are related…I don’t know…But we find ourselves right back where we were in January.’

Okay. ‘Extreme warning’. But no crash yet.

Got that?

Real catastrophe

And while the data is giving us an ‘extreme warning’, so are the fundamentals — which is why a catastrophe may be headed towards us…and why there may be no way to avoid it.

Markets go up and down all the time — sometimes sharply.

People never know what things are worth. They discover prices by bidding against one another. And human beings tend to overdo it.

They get overly optimistic or overly pessimistic…driving prices too high or too low…causing mini-booms and panics.

Between the end of the War Between the States and the Great Depression, there was the Panic of 1873, the Panic of 1884, the Panic of 1893, the Panic of 1901, the Panic of 1907, and the Depression of 1920–21.

The pain and damage done by these setbacks varied. But generally, they came and went. Markets quickly adjusted. Prices fell. Companies went broke. Entrepreneurs and speculators picked up the pieces…and got back to work.

Anyone can make a mistake. But if you want a real catastrophe, you need the government. The feds began to ‘do something’ about these periodic overshoots following the crash of ’29. The result was the Great Depression.

Then, the Federal Reserve got in on the action.

Taking away the punchbowl

The Fed was set up in 1913. At first, its job was modest: to protect the currency and make sure the big banks made money.

This it did cautiously, at first, by ‘taking away the punchbowl’, as former Fed chief William McChesney Martin described it, when the party started to get out of hand.

It wasn’t until the 1980s that the Fed became the life of the party itself. By then, the US had a new currency (the ever-stretchy, post-gold-backed dollar)…and the politicians had realised that ‘deficits don’t matter’.

They didn’t seem to matter because beginning in the late-’80s, the Fed was no longer restraining excess spending…it was enabling it.

Deficits used to draw down the nation’s savings. That’s because the feds had to borrow to fill in the hole. And when you borrowed, you borrowed what someone else had saved.

No more. The new dollar and the Fed’s low interest rates made real savings irrelevant. The Fed dropped interest rates to make saving unattractive…and covered the deficits with fake savings — credit it invented ‘out of thin air’; it bought US Treasury bonds itself.

Back when the feds had to borrow real savings to close the gap between outlays and tax receipts, there was a natural limit on what they could spend.

If they borrowed too much, they ‘crowded out’ private borrowers. Interest rates rose. Savings increased. The economy cooled down. And tax receipts fell.

Every lawmaker knew that the federal government had to manage its finances responsibly. Neither party wanted to get a reputation for incompetence with money.

But now, all that has changed. The illusion of abundance — provided by the Fed’s EZ-money policies — has bamboozled them all.

More to come…

Regards,

Bill Bonner,
For Markets & Money

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