“The Next Big Thing: 3 Penny Stocks You Must Buy Now!” (Taste of the Friday File)

Rerun of Friday File Article from October 7, 2011

By Travis Johnson, Stock Gumshoe, December 9, 2011

During our Holiday charitable membership drive I’ve been getting quite a few questions about what it means to be a Stock Gumshoe Irregular — so I thought I’d share another older Friday File for all of you, this is a piece that was originally published in the Friday File in early October, and it so happens that this one was a “teaser reveal” about some “penny stocks,” one of which is down by 15% of so and one of which has doubled, so there’s a little for everyone! The article below has not been revised or updated since October 7.

I’ve been getting an ad from the folks at Penny Stock Publishing about a new (or newish, at least) letter called Penny Stock All-Stars. Edited by Gordon Lewis, and claiming to be an antidote to all the pump-and-dump penny stock letters out there that either take money from companies to write about their stock, or trade in the stock themselves as they’re manipulating it.

Which is nice, but it’s not so unique from most of the “legitimate” publishers — whether or not you like the promotional practices or stock picks of folks like Agora, Stansberry, or the Motley Fool, they’re pretty clearly making money (and lots of it) from subscriptions and advertising, not from pump-and-dump trades at your expense.

Which is as it should be, that’s why we follow the same general rules here at Stock Gumshoe that are standard with most of the publishers (don’t take money to write about stocks, and don’t trade stocks within a few days after we publish articles about them, on the off chance that we’d be profiting from the attention that we can sometimes bring to a stock — yes, we’re small, but even small websites and newsletters can move a penny stock pretty easily).

But anyway, I don’t know anything about this letter, other than the fact that it seems pretty new — and that they’re focusing on what they call “penny stocks,” which for some people means teensy weensy microcap stocks that actually trade for a few pennies but for most folks means stocks that are small caps (under $500 million or so in market capitalization) and trade for less than $5 or $10 — the kinds of stocks that are routinely ignored by institutional investors because they’re too small to trade or research efficiently.

Of course, us little guys have no such problems — which can theoretically give small investors an advantage if they’re willing to dig into little stocks, since you can sometimes find great operating companies or growth stories that investment banking analysts would have long since publicized if they were large enough to get that kind of attention. That, at least, is the argument behind pretty much any small cap newsletter, and the reason that many of us hear the siren song of the penny stock from time to time — the smaller they are, we hope, on bended knee and with clasped hands, the faster they can grow and make us rich … right?

So let’s indulge that “get rich” feeling for a moment, shall we? How do Gordon Lewis and co. pick these “penny stocks”, and which ones do they think are great stocks to buy now?

They say they have some special indicators and criteria for their picks — or, in their words …

“3 ‘X-Factors’ That Practically Guarantee You’ve Found The ‘Next’ Apple.”

And yes, I presume their copywriters have spent a few minutes with the lawyers — why else someone would put the word “next” in quotes, I can’t tell you.

But anyway, so what are those X-factors?

“X-Factor #1: You Better Have A Steve Jobs!

“People look at all kinds of crazy things when they’re deciding whether or not to buy a penny stock.

“Truth is, most could do a lot better by looking at just one key factor…


OK, I think we can all concede that there’s only one Steve Jobs — or there, was at least (rest in peace, Steve — and thanks for the great toys). But yes, management is important — lots of room for incompetence and fraud in little companies that don’t get lots of investor attention (though the little guys, of course, have no monopoly on ineffective management).

“X-Factor #2: Fire Up The Crystal Ball…

“This one is so simple, most penny stock investors completely overlook it.

“But recognizing a new trend or new market can spell ENORMOUS profits for small companies.

“This is how all the big boys like Apple, Amazon, and Google became big in the first place!

“It’s easy to apply this principle in the high-tech and internet sectors…

“But few realize you can also apply it to ‘old-school’ industries that have found a new market or use for their product.”

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OK, so good management and in a business with a good “story” or uptrend to give them a tailwind. Can’t argue with that (it’s finding that crystal ball before everyone’s seen it that’s tough, I’m afraid).

“X-Factor #3: Everybody Wants You

“This one’s the holy grail of penny stock investing!

“Whether you want to call it a corporate buyout, acquisition, or takeover—it all means one thing…

“BIG BUCKS for the owners of the shares.

“These events are what create gigantic game-changing companies…

“When a small company is purchased by a larger, or better-funded company or institution, the shares usually skyrocket.

“When I look for companies to recommend in Penny Stock All-Stars, I only include those that are legitimate takeover targets.”

So those are the “X-factors” — good management, in a trendy business or sector, and a potential takeover target. Hard to argue with those as investment criteria, though I’m sure some folks might argue that other factors (profitability, dividends, business partners, insider ownership, luck …) might have at least as much to say about a tiny company’s success.

But really, what you want are the picks that he’s teasing … right? So let’s see if we can’t sniff through the limited clues we get and try to identify the stocks for you.

“The Next Google?

“Apps, short for applications, are simply computer programs that run on your mobile devices or even your computer. And thanks to companies like Apple and Research in Motion, the market for ‘apps’ has skyrocketed in recent years. Remember, whenever an area of technology takes off like this one has, you know there’s money to be made. Especially for companies focusing on putting apps on your toolbar and browser. This company has millions in cash in the bank and ZERO debt, which makes it a very tempting takeover target.”

You know what, I have no idea what stock this is. And I hesitate to make the Thinkolator churn too long on it, frankly — there will probably be a couple winners among software companies in the “app bubble” that is ardently promoted by Cody Willard at Marketwatch and by hundreds of small-time pundits at SeekingAlpha, but I have no idea what they are.

And pretty much every public software company that’s at the small start-up stage should have “millions” in cash and no debt (largely because banks aren’t aching to lend money to tiny tech stocks, which are much more likely to depend on equity investments), just having cash on the books does not make you a takeover candidate. There are tons of app stocks out there, from GLUU to MIMV to PNYTF to … and most of them will probably disappear or be quietly taken over or taken private without ever making any real money. If I see some more clues from these folks I’ll look into ’em, but this isn’t enough to sniff out a pick and, frankly, it might not be worth it anyway.

I’m delighted with Apps, but will keep my “App money” in Apple (AAPL) and Google (GOOG) for now, since they control the floodgates (and get a piece of the action) for most of these teensy stocks.

Next “penny stock?”

“The Next Dominos?

“It’s no secret that in tough economic times like this, low-cost providers of fast food see their revenue spike. And it’s no different for this chain that offers affordable pizza. Following the Domino’s model, this company has hundreds of franchised locations around the country. And you can find them in unconventional locations like food courts, college campuses, airport terminals and athletic facilities. It’s a terrific growth story with quarterly revenues growing at over 22% year-over-year.”

So … we toss that into the Thinkolator and learn that this must be … Pizza Inn (PZZI)

Yes, it’s a small fella — market cap is only 26 million dollars … yes, that’s “million” with an “m,” which might lead you to think (as it did me), what the hell is this company doing being public, anyway? Companies of this size shouldn’t be bothering with the stock market in most cases.

But it has been around for a long time — it started as a Texas college-town pizza shop in the 1950s and went public in the early 1990s, with a share price that has bounced around in anonymity ever since. They are profitable, though, as you might expect, with a profit margin (3.1%) that’s smaller than much larger competitors like Papa John’s (PZZA — 4.3%)) or Domino’s (DPZ — 5.8%).

And they haven’t seem particularly eager to grow all that fast, which is probably why they haven’t gone bust yet — there are any number of small regional pizza chains that develop a strong following, as PZZI seems to have done in some towns, and the world doesn’t seem like it’s had enough of the pizza franchise wars just yet, so there certainly could be room to grow — they’ve got about 300 restaurants now, essentially all franchises (they own five restaurants directly), which is tiny compared to 15,000+ for Domino’s or even 1,000-2,000 or so for smaller national chains like Little Caesars or Noble Roman’s. And they are opening new stores at the rate of a couple a year, so the profit seems decent but I don’t see any immediate likelihood of the growth rate giving you a nosebleed.

If they were to be taken over by someone, I would bet that it would not be a larger competitor — there’s no reason for a company like Papa John’s or Domino’s to spend a lot of money to grow when franchisees are happy to grow for them, and locations aren’t hard to come by in most towns. If they were to get a takeover bid it would be from a different kind of small restaurant chain that wanted to diversify, or an eager investor who wanted to grow the company much faster (like, say, Warren Buffett wannabe Sardar Biglari and his Biglari Holdings (BH), though they seem otherwise occupied with the Cracker Barrel fight at the moment).

But still, you don’t find tiny publicly traded chains that are growing and profitable very often — and it’s going to be a long time before you see an analyst report on PZZI, so you won’t have a lot of competition if you decide to research these guys.

The clues were clearly a bit sparse so I can’t be 100% sure this is the stock being teased, but I’m at least 90% sure … and it might be worth your time to do some research — from a cursory look here are two things to like in their filings: They’ve only lost money one year in the last ten, and they’ve reduced the outstanding share count during that decade, so they’re not diluting away equity to fund growth.

And what’s not to like? They might not grow substantially, and, no matter what else you learn, you have to know that growth matters more to investors than anything else — shrinking companies do not attract investment dollars unless there’s a turnaround in the offing, and steady companies rarely are inspired to turn around unless they go through some catalyst of suffering. They might go on as they are for a long time, they have not consistently increased earnings or revenue over that past decade (revenue, in particular, is down substantially from where it was five or ten years ago).

“The Next Las Vegas Sands?

“As we come out of the most recent recession, casino stocks will be some of the first to benefit. And we’ve found a well-run operator that’s ready to cash in! Based in Las Vegas, this small casino company has interests spread out all over the country. And its numbers look terrific. The industry average P/E is over 55, this company’s is 8– that means it’s ridiculously cheap. And when you combine its unbelievable profit margin of 22% and an operating margin of 56%, it also makes a nice takeover target for one of the bigger players!”

Well, on this one we can’t get the Thinkolator to quite spit out a perfect match for the clues — but we can make an educated guesstimation: I think here he must be teasing Full House Resorts (FLL)

Which does indeed come up at the top of the list for most screens on gaming stocks with high margins — they are very small, they are based in Nevada, they do have operations “across the country” (in terms of current operations, that means Lake Tahoe, Michigan, Delaware, and Indiana). They say that they’re aiming to serve local customer bases by buying market-leading casinos (in smaller areas, is the implication) and partnering with native tribes to manage their casino operations.

They’re doing both right now — they own the small Stockman’s Casino in Fallon, Nevada and a riverboat gambling complex called Rising Star in Indiana, near the Cincinnati Airport; and they manage the Firekeepers Casino for a native tribe in Battle Creek, Michigan and, just announced last month, have taken over management of a very small casino at a Hyatt resort in Lake Tahoe and are starting a management contract with Pueblo of Pojoaque to run their Buffalo Thunder casino and Cities of Gold sports book for three years.

Gambling is certainly a good business to be in on the house side — it fluctuates, particularly for small companies, as win rates rise and fall, but it averages out to a pretty great profit margin if you can keep people coming in the door and don’t have to lavish them with too many perks. I think the biggest risk to the destination resort casino business is that it’s not special enough anymore — here in Massachusetts they’re trying to legalize and set up some regulated casinos across the state, but one would think that there has to be some kind of limit on how many large-scale casino resorts can be supported in a region (Foxwoods and Mohegan Sun, both Vegas-size resorts in southern Connecticut, aren’t much more than an hour or two away from anywhere in MA).

Which leads me to have some concern about regional gambling operations — you have to think that in all the presentations these casino operators put together for local planning boards, politicians and investors, someone adding up those numbers is making the assumption that “there better not be a better and bigger casino 20 miles away in three years.” But still, casinos know how to get cozy with local regulators in a way few other businesspeople do, so perhaps it will work out fine. I do think that local casinos that are built for folks who live nearby are a less frightening bet than Las Vegas casinos right now, so there’s something to be said for the properties managed by Full House and their ilk.

But that said, they haven’t posted exactly 22% profit margins or 56% operating margins as teased in any quarter I’ve checked — those are in line with their results, for sure, and that beats the pants off of any other casino company I checked, but the numbers don’t match exactly. They also traded for a minuscule PE of 8, both trailing and forward, a few weeks ago (that PE ratio is down to about 7 now, thanks to the falling market and a dropping share price). The stock trades at $2.80 right now and analysts think they’ll earn 40 cents a share next year, roughly in line with this year (they have three analysts covering the stock, which is unusual for a $50 million company, so they may well be investment banking clients of those analysts’ companies, I haven’t checked).

I do think this company is a bit interesting in large part because of the opportunity that might be available in reorganizing local and regional casinos — there are quite a few decent-sized casinos that were built by native tribes around the country over the last five years or so, and I suspect that quite a lot of them are in trouble right now if they built their casinos based on 2006 economic assumptions.

That was the case for the Sante Fe casinos that Full House just got a management contract with the Pueblo to oversee (at $1.2 million/year in fees for three years) — those casinos opened in the late 2000s and were essentially bankrupt, so they had to bring in someone to reorganize and shake things up. That might be a pretty good fee business with some incentives built in if they can get similar deals with other flagging properties, and that’s presumably also a way to maintain their high profit margins (management contracts can be very nice: much higher profit margins if you run someone else’s casino for fees and/or a cut than if you have to borrow and put up capital to build and and operate your own place). It looks like Full House strategy is trying to leverage their expertise in managing these kinds of operations to grow the base of the company — using the management fees they get from these deals to buy into more local casinos.

And they do have pretty strong insider ownership (though there’s been some heavy selling over the last year or so, mostly at higher prices), and a nice flagship guy on the Board of Directors in Lee Iacocca to smile down on investors and shake hands with local governments, so that probably doesn’t hurt.

Full House carries about $20 million in net debt and trades right about at book value, by the way, so that helps to buttress the “value” argument.

There are some other decent-looking values in casino stocks if you’re looking at relatively moribund US casinos (as opposed to the Asian casinos, which remain huge growth engines), but none of them look as cheap as Full House — a list might include Ameristar Casinos (ASCA), for example, which has a forward PE down around 8 (though they’re in turnaround mode apparently — the trailing PE is well over 200) or Isle of Capri (ISLE) or Boyd Gaming (BYD), which are a bit more expensive but are (unlike ASCA) low-priced enough to be considered “penny stocks” by some.

I think I might still prefer our old favorite NagaCorp, the Cambodian casino operator — they’ve had challenges too, and a list of risk factors to be sure, but they’ve got good ties to their local government and a good dividend yield to go with their similar trailing PE of about 7, but I will say that Full House looks better, on paper, than any of the other little casinos — maybe there’s something uglier under the surface, I hadn’t ever heard of the company before I read this teaser and started looking into them this morning, but it might be worth that deeper look.

So there you have it for your Friday edutainment — an Apps company I can’t identify, a pizza joint that looks reasonably priced if they can figure out how to grow, and a cheap casino company. Not a lot of definitive answers, but I think we’re probably on target with our two teaser IDs and they’re certainly interesting companies for more research if you like sub-$100 million companies that no one has ever heard of. We’ll keep an eye on Gordon Lewis and see where those teases take us, and whether or not the newsletter lives to tease another day.

Have a wonderful weekend, everyone!