The Rise of the Speculators?

We have noticed with increasing wariness a seeming abandonment of appreciation of risk in the investment world. This rise in speculation is the result of too much savings chasing too few good investment ideas and it is a global phenomenon. It spreads like a cancer from market to market as ever more desperate investors refuse to come to terms with the low return environment we find ourselves in. Hot money is chasing recent performance wherever it can be found. If ever there was a time to hew to a strict valuation methodology and framework, this is it. Before getting to performance on individual stocks on our list, I wanted to review how we see the global economic and investment landscape and make a few observations.

VIXX is at its lowest levels in a decade.
Investors are using margin loans to pay tax bills, children’s tuition, and to buy real estate and cars.
Emerging Markets funds saw inflows of $5.4 billion in Q4:05 (second largest inflow in category history), and $6.3 billion in the first two months of 2006.
Venture capital funding in the first quarter of $6.02 billion was the highest since Q1:01.
The syndicated loan market is up to $1.5 trillion and lenders are dropping covenants from loan terms.
What each of these have in common is a disregard for risk. The VIXX index is perhaps the cleanest and clearest view of the price of risk as an indicator of implied volatility in the options market. In the face of arguably overpriced markets and rising interest rates, such complacence is difficult to explain. Markets are becoming more inefficient as millions of individuals are moved from defined benefit pension plans run by professional institutional investors to self directed defined contribution plans such as 401Ks. Investors weaned on the 20%+ returns of the 1980s and 1990s are using more leverage and seeking out riskier investments such as Emerging Markets. Institutional investors are not immune either as fiduciaries seek higher return ways to meet their liabilities and obligations. Torrents of cash flooding the Venture Capital market and easing of lending covenants confirm this.

Dow is at a six year high.
Nikkei is near a 5.5 year high.
NASDAQ is near 5 year high.
The $1.5 trillion hedge fund market is now competing with the $261 billion venture capital market to finance private companies, driving up valuations.
The number of stocks on our Cocktail Party screen used to identify speculative overpriced stocks has more than doubled to 34 names from just 16 at year-end.
After a difficult period following the tech stock bubble collapse, markets are roaring back to life and hitting new highs, nor is this phenomenon limited to the United States by any stretch. Hedge funds, looking for ways to justify their ample fees, are muscling into new arenas such as the venture capital market. Our own proprietary indicators of overvaluation are flashing caution as well.

Oil prices are at record highs.
Silver is approaching levels last seen when the Hunt brothers cornered the market.
Gold is at a 25 year high.
Strong global economic demand is driving up the prices of many raw materials such as oil, copper and steel. Yet, here too, there is speculative froth as precious metals prices hit new highs, not explained by industrial uses. Individuals, led by ETF enablers, are piling into precious metals funds chasing recent performance. Another interpretation, equally menacing, is that with GDP growth rampaging ahead at 4.8% and unemployment down to 4.7%, investors are seeking traditional safe harbors from inflation, such as gold.

Interest rates are rising, not just in the US but aboard, as central banks raise overnight rates. Stocks seldom do well in the face of rising interest rates.
Corporate profit margins are at historically high levels.
We’ve had 10 quarters in a row of double digit profit growth, longest streak in over 30 years.
The very fact of recent impressive corporate performance makes the future that much more difficult. Rising interest rates mean the tsunami of excess savings circling the globe will find enticing alternatives in fixed income instruments and cash, rather than stocks. Corporate profit margins have expanded nicely as excess capacity has been brought back on line and costs have been cut. However, demand is rising and companies must add new staff which may mean falling profit margins in future quarters. Falling profit margins may spell the end of double digit profit growth, making it even more difficult for stocks to advance.

So what does this mean for our clients? One conclusion is the relative attractiveness of earning 5% risk free in money market accounts. Another, is a hedged portfolio such as ours. Last year, we returned 37%, with every short call we made beating the S&P’s paltry 2.5%. However, shorting stock carries its own peculiar risks. Speculative and pricey stocks can become more speculative and pricier and the loss is open ended. In April, we experienced this with Travelzoo Inc. (TZOO:SELL).

The Singular Research list declined 2.4% in April vs. the S&P 500 which returned 1.2%. Year to date, our list is up 11.5% versus the S&P 500 which is up 4.8%. Our best call in April was Acacia Technologies (ACTG:BUY) up 26.6%. While the company did not meet our aggressive assumptions for Q1:06, it is well positioned for explosive and lucrative growth in the coming years. Investors can see the long and full pipeline of patent portfolios which have not even begun to be exploited. Q1:06 revenues grew 153% and we project GAAP profitability in 2H:06. The company is already cash flow breakeven.

Amrep Corp (AXR:BUY) reported a 68% upside surprise in March and the stock has never looked back. Our analyst raised his estimates and price target in early April only to see the stock test his new price target. The company is monetizing its vast real estate holdings in New Mexico. Amrep is up 111% since we launched on it February of last year. McDermott International (MDR:BUY) gained 11.7% in April as the supply of oil rigs continues to lag demand. McDermott International is now up 50% from year end when we launched on it.

On the down side, our call on Travelzoo Inc. (TZOO:SELL) lost 96.73% moving up from $19.58 to $38.52. It had been as high as $52 before giving back some of the gains. It was a classic short squeeze. After missing estimates for three quarters in a row, the company reported EPS of $0.24/share for Q1:05 versus our estimate of $0.18 and the First Call consensus of $0.14. We continue to believe the stock is worth around $16, representing 58% upside to our target.

IRIS International, Inc. (IRIS:BUY) declined 24.3% in April. The company announced it had acquired Leucadia Technologies, Inc., a molecular diagnostics company, for $10.1 million in cash and stock. While the acquisition gives Iris entrée into the fast growing $1.5 billion Molecular Diagnostics market, it was dilutive, and as a result, Iris lowered its 2006 guidance to $0.45 versus our projections of $0.53. The stock is now as cheap as it was a year ago. Meanwhile, revenues have grown 44% and earnings have grown 141% over that time frame. Our price target implies 111% upside.

Parlux Fragrances (PARL:BUY) declined 15.4% for the month on no news save the signing of a worldwide license for Paris Hilton sunglasses. While we are wary of the probable need to fund increasing working capital balances to meet the company’s growth plan, the stock is ridiculously cheap. Our FY:06 estimates imply 91% revenue growth and 103% earnings growth yet the stock trades at just 12.6x FY:06 earnings. Span-America Medical Systems (SPAN:BUY) reported a disappointing Q1:06, and the stock fell 15.1%. The company missed our estimate by 3¢ as higher foam prices and an inventory correction at Wal-Mart hurt reported results. However, the company is just beginning to sell its new safety catheter product which we expect will excite investors once it reaches meaningful sales volumes.

Excel Maritime Carriers (EXM:BUY) declined 13.4% as the dry good bulk shipping industry remains an unpopular sector. We loved the company when it traded at 0.75x book value, and now love it even more at 0.58x book value. The company stands to benefit from global economic growth especially in the Far East where Excel ships grain, coal, and iron ore. Industry dynamics are complicated. High scrap steel prices lead shippers to scrap older ships, yet many new ships are coming on line in the next few years. This is a deep value play and we expect the next catalyst will be the announcement of a share buyback program.

While we never like to have a down month, we are focused on long-term results. Since we started, our average recommendation has returned 60.3%. We have never had a quarter where we did not beat the S&P 500, and April marks only the fourth month we have underperformed. We continue to believe that in a low return market environment, stock selection is more important than ever. Opportunities abound in the Microcap space for those diligent and savvy investors willing to put in the work. Here at Singular, we do that work for you. As always, we thank our clients for having faith in us and hope that we continue to earn your trust.

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