Small Caps Shine

History shows that small cap stocks outperform large caps over the long term. There are several reasons why this is true, perhaps most notably the growth potential for smaller firms contrasted with the law of large numbers catching up to big companies over time.

What is interesting is the stark contrast between the performance of these two groups in recent years. Since 1999, the S&P 500 has lost about 2% of its value. During the same period, the Russell 2000 index has gained an astonishing 56 percent. In fact, small and mid cap indices have been hitting all-time highs this year, even as the S&P 500 remains 20% off its 2000 high.

After the split of investment banking and research was solidified by New York AG Eliot Spitzer, small and mid cap research has become even less a focal point than it once was. The result has been many public companies flying under the radar screen despite excellent financial results. Now, even more than ever, a focus on undervalued small cap stocks can pay huge dividends for investors. And that's despite the fact that the market, as judged by major market indices like the Dow and S&P, haven't done anything in the way of advancement since this decade began.

The Roth 401(k) is Coming

While I'm surprised we have not heard more about them, I suspect that as 2005 comes to a close individuals will hear a lot more about the Roth 401(k) plan, set to be instated in 2006. The Roth IRA has truly been a boon for investors, allowing them to contribute as much as $4,000 per year in after-tax dollars to an account where profits are tax-free at age 59 1/2. Investment principal can even be withdrawn early tax-free with no penalty.

As great as this deal is for investors, the Roth IRA's glaring limitations (namely annual contribution limits and income limits that don't allow the wealthy to participate) do provide some discontent. However, beginning in 2006 employers will have the option of offering their workers a Roth 401(k) plan, which can take the place of an employee's traditional 401(k) retirement account.

The Roth 401(k) will have similar contribution limits to a regular 401(k), $15,000 per year in 2006, which far surpasses the Roth IRA limits. As with regular 401(k) plans, there will not be income limits with the new plan. Contributions will be treated just like a Roth IRA, meaning after-tax dollars are used (as opposed to the current plan that uses pre-tax dollars) and withdrawals after age 59 1/2 are tax-free.

For those with extra income who are looking to invest for their retirement in a tax-efficient way, the Roth 401(k) could be the single best way to accomplish that feat starting next year. That assumes of course that your employer will choose to offer it as an option, as it will be strictly a voluntary offering.

CEOs: Just Run Your Companies

Did anyone catch the Cyberonics (CYBX) conference call yesterday? I would never have noticed it as I don't follow the stock, but continuous coverage on CNBC got me wanting to mention it. The company's CEO went ballistic after the stock got crushed on news that the Senate is investigating the FDA's decision to recommend approval of the company's product after initially suggesting it be rejected.

Now I don't know the details of the story, nor do I really care, but I couldn't help notice how irrate the CEO was on the call from clips I heard on CNBC. He blasted short sellers for supposedly starting rumors and was infuriated that people were contacting the FDA to learn more about possible pressures applied to get the CYBX device approved.

After screaming at people on the conference call, the CEO spent more valuable time writing emails to CNBC criticizing their reporting of the story throughout the day. With a very important product under review by the FDA, doesn't he have more important things to do with his time than yell and scream at analysts, short sellers, and business reporters?

If you are a CEO, your job is to run your company. How well you do will determine where your stock trades. News reporters and short sellers do not determine stock prices over time. How much money Cyberonics earns does. Sure, a false rumor might send your share price down a dollar or two in a day. However, why be infuriated by this? As a CEO, it shouldn't matter if your stock is $30 on Monday, $28 on Wednesday, and $31 on Friday. Leave that for traders to worry about.

It's amazing how many CEOs hate short sellers and spend so much of their time trying to discredit them (Overstock.com's Patrick Byrne comes to mind as a perfect example). If you want them to feel pain, fine, just hit your numbers and those betting against you will lose their shirt. That seems like the best gameplan for those who are doubting you and your company.

Just do your job well, run your company correctly, and the stock price will take care of itself.

A Tale of Two Buybacks

There have been a lot of big name investors in the news recently, including the trio of Warren Buffett, Kirk Kerkorian, and Carl Icahn. The media tends to lump all three men into the same group of people investors should pay great attention to. After all, when Buffett disclosed he bought Anheuser Busch (BUD) stock weeks ago, the stock jumped from $45 to $48 in a single day. Kerkorian issued a tender offer for General Motors (GM) shares that resulted in the largest one day gain in the stock in more than a decade.

Icahn perhaps deserves less attention. His track record is not as solid as Buffett or Kerkorian, and Wall Street evidently realizes that his shareholder activism efforts with the likes of Blockbuster (BBI) don't always add any value for stock owners. In fact, when Icahn recently released a list of stocks in which he purchased stakes in recent weeks, most of the stocks barely budged.

Today I will focus on two stock buybacks, one of which was precipitated by Icahn's discontent with the management of Kerr-McGee (KMG), and the other non-Icahn related buyback that resulted from a huge cash stash at Motorola (MOT). As you can see from the chart of today's trading below, the stocks have reacted differently to the news of their respective buybacks.

motkmr.bmp

First, the good news. Motorola has $6 billion of cash on its balance sheet currently, net of debt. CEO Ed Zander today announced that the company will buy back up to $4 billion in stock, about 10% of the total outstanding shares. Both Motorola and Nokia (NOK) have huge cash balances that have contributed to Peridot's extreme interest in the stocks over the last year. Investors should always pay attention to balance sheets, in addition to earnings per share. When companies are flush with cash, they will usually do something good with it eventually, just be patient. MOT shares have been up between 3 and 4 percent today.

As you can see, Kerr-McGee shares are faring much worse today, falling by as much as 8 percent. Here's a quick synopsis of the story there.

Icahn, unhappy with the management of KMG (despite the stock's rise from $50 to $80 with the last 12 months), threatened last month to attempt to get elected to the company's Board of Directors. Icahn agreed to abandon the effort after Kerr-McGee launched a "Dutch Auction" tender offer for 46.7 million shares. The move would cost $3.97 billion based on a purchase price of $85 for each KMG share, in order to avoid a proxy battle with Icahn.

With KMG shares trading at $74, Icahn basically has forced Kerr-McGee to buyback 29% of its total shares outstanding for $85 apiece. Today, the stock opened at $69. How exactly is buying back stock at $85, when your share price is $69, good for shareholders? That's a $16 per share premium to the price on the open market. Icahn evidently thinks that is a good investment of nearly $4 billion for the company.

You know what makes it even worse? KMG doesn't even have the $4 billion to buy the stock with, so they are borrowing the money. The company secured a $5.5 billion credit facility to fund the purchases. So, in addition to the $16 per share premium it is paying (an extra $747 million above market value) Kerr-McGee also has to pay interest on the entire amount.

Something tells me Warren Buffett would never force a company he owned a significant stake in to throw away money like that, let alone money they needed to borrow to do so.

Despite Headwinds, Record Short Interest Suggests Future Strength

Short interest on the New York Stock Exchange rose to record in the month through April 15, according to figures released in late April. The NYSE said short interest rose to 8.44 billion shares, up from the previous record of 8.42 billion shares on March 15, and was equal to 2.3 percent of total shares outstanding.

Despite $50 per barrel oil, higher inflation, and a Fed that many believe will continue to raise the Fed Funds rate to 3.5% or 4.0%, these numbers from the NYSE are too glaring to ignore. Bearish sentiment is one of the most reliable historical indicators of future price appreciation in the stock market. In fact, the 2005 short interest record shattered the mark set in late 2002. A quick look at what the market did after that makes the case even more compelling.

What Bull Market?

I'm still trying to figure out why I keep hearing investment strategists proclaiming that the bull market remains intact. Do these people really think we are in a bull market? Do the numbers support that conclusion? Does this market feel like it's going gangbusters? I have to say "no" on both counts.

First of all, the market is down since the turn of the millennium, and we're more than halfway through the decade already. I hate to break it to everybody, but the bull market in stocks ended in 1999. It was the greatest bull market of all time, lasting a full 18 years beginning in 1982. During that stretch, the S&P 500 returned an average of 19% per year and recorded only 1 down year (a 3% loss in 1990).

It takes more than a couple of down years to get the bull running again. If stocks average 5% a year for the rest of the decade (which I think is entirely possible, if not probable), the average return for the decade will be 2% per year. When stocks fail to keep pace with inflation, it's not a bull market.

That said, there is no reason investors can't attain double-digit returns in a bear market. It just means that index funds won't do the trick. Superior stock selection will.

Treasury Bond Yields Soar on Fed Speak

Yields on 1o-year treasury bonds hit levels not seen since mid-2004 on Wednesday, after the Fed hinted that further interest rate hikes were on the horizon. Greenspan and Co. even added language to their policy statement that highlighted recent increases in inflationary pressures in the economy.

With oil prices over $55 a barrel and the housing market remaining robust, it's quite possible the Fed will continue to raise rates throughout the remainder of the year. The areas impacted the most will be the fixed income and housing markets. If inflation picks up, the TIPS market should shield investors from some of that risk. Gold may do well too, but I think other commodities should outperform gold due to increased demand worldwide and limited capacity.

The stock market likely won't be able to make any meaningful move higher until the Fed is finished raising rates. On that end it would be better if they raised 50 bp at a time, as many have suspected they might if inflation fears don't subside, just so we get to their target rate faster. The quicker they get to a point where they can stop raising rates, the quicker investors can start to make good money in the stock market again.

Why Do Companies Give Guidance?

If I was running a public company, I would not give investors and analysts any type of precise financial guidance. Giving such sales and profit estimates stems from the implementation of Regulation FD, which required companies to divulge all meaningful information to the public, not just Wall Street analysts and boards of directors. No longer faced with having the luxury of "guiding" analysts to how a particular quarter was tracking, companies began issuing financial guidance in their press releases for everyone to see and interpret.

Unfortunately, earnings guidance plays right into the hands of those who focus too much on short-term financial performance, as opposed to building long-term shareholder value. CEO's should not make business decisions in order to ensure they can make their numbers every quarter, but instead because it is in the best interest of the company and its shareholders long-term.

Making sound decisions that succeed in hitting both short-term and long-term goals is not always possible. Sometimes corporate managers have to make short-term sacrifices to ensure long-term stability and growth. Examples of these actions might be a dilutive acquisition, or price cutting to prevent a key customer from bolting to a competitor. Price discounts and dilutive deals will cause many companies to miss a quarter or two, but investors will be much better off five years later.

The fact remains that Wall Street focuses too much on quarter-to-quarter financial results. Investors see this every day when companies miss their EPS numbers by a penny or two and their stock drops 10, 20, or 30 percent in a single day. As a result, CEO's begin to manage their business just to make sure they hit their numbers.

Taser (TASR) shipped out a $1 million order on December 31, 2004 to ensure they hit Q4 profit estimates. Pharmaceutical companies convinced wholesalers to take delivery of more product than they needed (a tactic called "channel stuffing") so sales would be on target. According to court records, former WorldCom CEO Bernie Ebbers agreed to cook his company's books because they needed to "hit their numbers to keep the stock price up."

Finding companies that manage their businesses based on strategic plans, and not their public financial guidance, will do a much better job over the long term, and that's something investors should look out for.