Balance your portfolio with shorts, small caps

By Steven Bulwa

Trading and investing are inexact endeavors. There is no way to know what someone is willing to pay for stocks in the short run. No matter how many formulas investors try to construct, nothing can numerically replicate the dynamics of human greed and fear.

To deal with this uncertainty and to gauge risk in the market, I keep track of a group of stocks that I deem to be leaders of each bull or bear cycle. These tend to be large- or mid-cap momentum or growth stocks. In this recent cycle, it was a group of consumer semiconductor stocks, including Marvell Technology Group (MRVL, news, msgs), Broadcom (BRCM, news, msgs) and SanDisk (SNDK, news, msgs).

As this group of stocks gets more overvalued on the basis of historical benchmarks, I increase my short-side exposure; if the group becomes more investable by those same standards, I get longer and reduce short exposure. It's not a precise mechanism, but it has proven effective for me. When the market falls apart, these stocks have beta far greater than 1 and offer significantly larger short-side returns.

Having these shorts in the portfolio can also mitigate gains on the way up, but I have had no problem outperforming the indices in bull markets, even with a 1:1 ratio of long-to-short dollar value in the portfolio.

The beauty of small caps

The reason a portfolio can perform well even when it's overexposed to the short side is the even greater beta of speculative small-cap stocks, which should be in everyone's portfolio. In a bull market, these stocks can go up tenfold, while the best-performing large-cap stock may go up two or three times. Again, the inverse is true in a down market, so it's important to gauge the risk in the market to properly assess how much small-cap speculative exposure is prudent.

When the leading semis started trading six to eight times revenue, which is at least twice the historical norm, I started to refocus my portfolio. I added shorts in this sector and sold some of the speculative names. As we have continued to move lower, I removed some shorts and added back some speculative exposure. Two speculative names I am currently building positions in are WorldSpace (WRSP, news, msgs) and On Track Innovations (OTIV, news, msgs).

WorldSpace is an overseas satellite radio provider, basically an international version of Sirius Satellite Radio (SIRI, news, msgs) and XM Satellite Radio (XMSR, news, msgs). The company had its IPO in August at $20, and the stock has been heading lower ever since, settling under $5.

If we look back, Sirius and XM were hated before they gained a significant number of subscribers. There are definitely hurdles for this company to overcome. The price points in its end markets are lower than in North America -- in places such as Africa, many people can't afford its radios, let alone cars to put them in. (The service is still young and not yet available for cars, but it will be in the near future.)

On the positive side, the company has spent $1.3 billion to establish infrastructure to deliver satellite radio into fast-growing economies such as India and China, where it is the sole company licensed to provide satellite-radio services, and European countries such as the U.K. and Italy.

WorldSpace is currently focusing on India. In its latest 10K, the company states that it's in discussions with regulators to install terrestrial repeater networks in several major metropolitan areas in India. This will allow it to offer a mobile subscription service for automobiles and enhance home reception.

While this is a highly speculative investment, I believe it offers a tremendous risk/reward scenario. For upside, the company's market cap is $183 million, whereas Sirius and XM sport market caps of $6 billion and $3.8 billion, respectively. While North America may be richer now, those two countries have roughly eight times as many people and their economies are growing rapidly. If the opportunity is equal to that of XM or Sirius, this stock could go up at least 10 or 20 times. If you want to reduce risk, use a stop-loss 20% lower than today's quote.

Accelerating demand

On Track is a small Israeli company that sells microprocessor-based "contactless" smart-card systems. Its technology allows cardholders to tap or pass their cards in front of a reader, shortening transaction time. It has partnered with MasterCard for that company's Paypass system, and it offers a contactless parking-payment system called Easy Park. It sells card systems to gas station operators, such as BP (BP, news, msgs), who use them to offer loyalty programs to customers and help corporate customers manage the fuel usage of their vehicle fleets. On Track also offers national ID cards and other secure identification documents.

The company is experiencing accelerating demand for products in all its markets. Its contactless cards are more durable and last longer than credit and ATM cards, and OTI readers offer secure transactions and are relatively tamper-proof.

CVS drug stores have installed contactless readers across the company's stores and found there was a 20% increase in the average customer purchase vs. cash; the average transaction took 12 seconds vs. 33 seconds for cash. Homeland security initiatives should also increase demand for microprocessor-based smart card IDs capable of sophisticated identity verification.

Given the prospects for On Track's businesses and the company's impressive and growing customer list, I believe it's a value-priced growth stock. In the most recent quarter, revenue grew 38% year over year to $9 million, and the company was cash-flow positive. The company has $52 million in cash and no debt. With a $130 million market valuation, excluding cash, that translates into roughly two times current-year revenues.

According to Yahoo! Finance, three analysts cover the company, and the average 2007 earnings estimate is 87 cents a share. That translates to a P/E of roughly 12 for a company exhibiting a 30% growth rate. I am looking for On Track's stock to make contact with the mid $20s over the next 12 months.

Look at the risk factor

I think it's important to assess the risk in any market situation. The leading large-cap momentum stocks can give a pretty good indication of how frothy things are. When those stocks get out of line with historical precedent, it's time to pare down the speculative component of your portfolio and add some short exposure.

Conversely, when the stocks that should be leading the way start to look like buys, it's time to get more aggressive. I believe eBay (EBAY, news, msgs), Yahoo! (YHOO, news, msgs) and Google (GOOG, news, msgs) are those stocks. I wouldn't buy them, but I could make an argument for each one at current levels.

Based on that, I'm reducing some short exposure and reintroducing some speculative names. On Track and WorldSpace are two of the most promising.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider On Track and WorldSpace to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Steven Bulwa was long WorldSpace and On Track and short SanDisk, although holdings can change at any time.

Bulwa is an independent portfolio manager based in Toronto. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.