Finding Diamonds in the Rough

How does one go about finding stocks that have future potential for increased sales and earnings? You can read the usual financial journals and newspapers and watch CNBC and Bloomberg for tips on what Wall Street thinks is hot, or you can take a contrarian approach and buy stocks that may not have yet garnered the interest of analysts and before the stock has appreciated in price. So how to you find these undiscovered gems?

One approach is to buy a company that has a great new product. For example, years ago I read an interview with one of Oprah's friends (it might have been her best friend Gayle) who waltzed in to Oprah's office showing off a pair of snazzy new running shoes made by an innovative newcomer into the athletic footwear business called Reebok. She raved about how much she liked them. According to Gayle, “Oprah was so impressed that not only did she buy a pair of shoes, she also bought the stock.” And, as they say, the rest his history. Oprah is not only the queen of talk, she's an astute businesswoman as well.

Jim Cramer, on his show Mad Money, expanded on the “buy what you know and like” idea. He says that if you love a new product and see it flying off the shelves, that's a signal to buy the stock. Jim is a contrarian when it comes to reading financial news. He claims that the best ideas out there aren't in the financial section of the newspaper, but in the others such as the Arts & Entertainment and the Style sections where if you read a headline that goes something like “Ugly Plastic Shoes a Hit with Macy's Customers” you might want to check into it further. (You know I'm talking about Crocs.)

Once you unearth a new company with an exciting product, what do you do next? Let's look at a company I found yesterday while reading the National Enquirer. No, I don't buy it but Fifi does. She especially likes the issues that feature photos of celebrity cellulite and plastic surgery gone wrong. But I digress...

While flipping through it eschewing the endless melodrama surrounding Brittany Spears and her family (clearly her parents don't know how to discipline their children), I happened upon a blurb in the health section touting “an amazing libido-boosting drug for women” called LibiGel which is a testosterone based cream that's applied to the arm. Apparently, Phase II clinical trials have been extremely positive and the drug is now undergoing two Phase III trials to determine safety and efficacy. The product is just one of many hormone-based drugs under development by a small pharmaceutical company called BioSante (NASDAQ: BPAX) LibiGel is expected to be up for FDA approval and launch by the end of 2010 or early 2011.

Researching BioSante this morning, I found many things to like. This isn't a one-trick pony company where the success of it's sole product could make or break it; it has many other products to offset a loss. (See my anecdote at the bottom.) Looking at the balance sheet, earnings have been rising over the past several years, it has an attractive profit margin and return-on-equity (21.7% and 15.3% respectively), and it holds no debt. More importantly, company insiders have been gobbling up the stock buying over 100,000 shares since December. The fact that Wall Street hasn't glommed onto yet is reflected by the fact that less than 8% of the stock is owned by institutions, most notably Dimensional Fund Advisors who own about 2% of the outstanding shares divided among a half dozen of their small-cap funds. The people who run Dimensional's funds are no dumb cookies--I pay attention to stocks they own. Calpers and Vanguard also have signficant holdings.

Technically, the stock has been trading in the $3.50 to $4 range. (Actually, the chart is a pretty good example of a channeling stock.) It bounced off of its $3.50 resistance level yesterday and is up over 2% today. Okay, say you like the stock and you think that the product will be a smashing success. The $64,000 question is: When should I buy it? For that, I don't really have a definitive answer. You could buy it today at a relatively low price (historically speaking) expecting that perhaps nothing will happen for a year or two. You could buy it when it breaks above its $4 resistance. Or you could wait until the Phase III trials are completed next year and buy if the results are positive. If my crystal ball wasn't on the blink I could give you a better answer. One reason to buy it earlier rather than later is the success of the Phase II trials could possibly entice a larger company to either invest a significant amount of money into the company or just take it over outright. That would be a slam-dunk!

I hope this example has opened your eyes to other sources of stock inspiration. Next time you're stuck in the check-out line at the grocery store, pick up a tabloid and skim through it. If you don't get waylaid by the cellulite photos, you just might find a golden nugget in the slag.

Valuable Anecdote: Last year a friend of mine was really excited about a company called Northfield Labs (NFLD) and urged me to buy it. The company had developed a red-blood cell substitute for use in trauma cases involving significant blood loss called PolyHeme, but as it turned out, PolyHeme was the company's ONLY product. I pointed that fact out to him but he wouldn't listen, claiming that the product was great! blah blah blah and there's no way the stock won't triple. “Maybe if you're nice to me I'll let you ride on my yacht when I buy it from the proceeds,” he gloated.

I didn't buy the stock. As I said, I'm very cautious about one-trick pony companies. Well, he did have his comeuppance because last December Northfield announced the results of their Phase III clinical trials which showed that the use of PolyHeme significantly increased the number of deaths as compared to the control group. On the day of the announcement the stock opened at $14.33. The day following the announcement the stock opened at $5.81. Oops. Northfield is currently trading around $1. Guess my friend will have to settle for a rubber ducky, but it really is my loss--I was looking forward to taking a long cruise on a big boat.

Posted by Dr. Kris at 1:10pm PST