News Analysis date published New: 
Friday, December 10, 2010 - 07:00
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Friday, December 10, 2010 - 07:00
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Friday, December 10, 2010 - 07:00

4 Small Caps That Could Pop

Friday, December 10, 2010 7:00 AM

It always pays to scroll through stocks that have taken a recent pounding, Most of the time, they've deserved to take a hit. But sometimes, investors simply over-react to seemingly bad news. And that creates opportunity.

Let's take a look at four stocks from the Russell 2000, all of which have shed at least 25% of their value in the past month to see which one is the most likely to rebound.

MELA Sciences (Nasdaq: MELA)
Talk about a false dawn. This biotech lost more than half its value on November 16 after the FDA issued a preliminary report that threw doubt on MELA's skin cancer detection device. Skin cancer, or melanoma, is the fifth-most lethal form of cancer in the United States. Investors quickly understood that the FDA would be rejecting a pending application to market the device. Just a few days later, though, an FDA panel did approve the device, by a very slim 8-7 vote. Shares nearly doubled on the news.

That would have been a great time to book profits. Investors seemingly misunderstood that a positive vote from the FDA advisory panel is not the same thing as FDA approval. It still seems quite likely that the FDA will ask MELA to conduct further tests, and that will cost money the company doesn't have and moves any hoped-for sales ramp out by at least a few years -- that is, if it gets to market at all.

SWS Group (NYSE: SWS)
Executives at this Dallas, TX regional brokerage would like a "do-over." SWS thought it would be helpful to raise nearly $100 million in a convertible bond offering, which would have helped shore up a flagging balance sheet that was being weakened by stubbornly high losses on its loan portfolio. Investors started to dump the stock in late November, presumably as word circulated that a dilutive stock offering would soon be announced. That announcement finally came earlier this week, and shares took another deep hit. With shares now down nearly -50% since mid-October, management threw in the towel and announced on Wednesday evening that the capital-raise would be cancelled. Shares staged a quick +10% rebound on Thursday, but are still well below recent levels.

The question now is whether SWS can live without that $95 million. Yes, although don't be surprised to see a deal for a far smaller amount, perhaps $30 or $40 million. That means SWS may look to the PIPE market (private investment in a public equity). These deals are often done at a -5% or -10% discount to the current share price, but can be done quietly and quickly. Considering that we are probably talking about far less dilution, and also considering that SWS shares are now very cheap in relation to most other brokers, investors should be quite relieved.

DynaVox (Nasdaq: DVOX)
In keeping with the notion of regrettable management decisions, this developer of software that aids the disabled with typing and other forms of communication shouldn't have bothered going public in 2010. A $15 IPO in April now trades for just $4. By the end of the summer, it became apparent that sales were slumping badly, reversing impressive sales trends that had been seen in the quarters heading into the IPO.

When DynaVox announced on November 11 that fiscal first quarter sales were -11% below year-ago results, any remaining bullish investors finally gave up, leading to a -28% one-day plunge. And that's where we stand a month later.

The sales weakness is fairly obvious -- in hindsight. DynaVox's customer base largely consists of school systems, and severe budget pressures have led schools to defer spending on non-essential items. Investors can now conclude that it will be quite some time before school systems are in spending mode again.

Even as it's unwise to expect a near-term rebound, DynaVox's cash burn is likely to be modest. So the company must now sit and wait for an eventual rebound. For those with a long-term view, this is a remarkably cheap software stock, now trading for less than half of sales. Larger software firms that are focused on the educational market would do well to snag this company on the cheap, as its products still appear to be held in high regard by educators. Put this one on your watch list.

Alnylam Pharma (Nasdaq: ALNY)
I took a look at this company in late November, and after chronicling a set of bad news in terms of Big Pharma partnerships, concluded that "shares still hold long-term promise."

I still think that's the case. The company has a boatload of cash, and even though its focus on RNA manipulation has yet to pay off in a big way, it's still considered to be a very intriguing approach by many scientists. Even though the loss of a relationship with Roche Holdings really hurts, Alnylam still has three drugs in clinical trials and alliances with companies like Takeda Pharmaceuticals, GlaxoSmithKline (NYSE: GSK), Cubist Pharmaceuticals (Nasdaq: CBST) and Medtronic (NYSE: MDT).

At this point, the onus is on Alnylam to recapture lost buzz by providing progress reports on clinical trials. That information should be rolling on over the course of 2011. So shares may sit in the penalty box for a few more quarters, but this is certainly an intriguing name at this point for those who like cash-rich biotechs.

Action to Take --> And the winner is...

SWS for a short-term trade as shares rebound from the ill-fated capital-raising efforts. DynaVox certainly bears a placement on your watch list, although it could be a number of quarters before sales pick up. Before then, don't be surprised if the company gets some interest form strategic buyers. In the long-term, Alnylam looks to have the greatest potential upside -- that is, if the clinical data in the next 18 months proves to be impressive.

P.S. -- When you get in on the ground floor of a promising new trend or technology, the profits that can follow can change your life forever. Andy Obermueller's Game-Changing Stocks is entirely devoted to finding the next big, life-changing investing idea. See his latest report, The Hottest Investment Opportunities of 2011, to find even more ground-breaking investment plays.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.