The smaller and more obscure a security, the more likely it is to be undervalued by the market. With this in mind, why would anyone attempt to beat the market by investing in giant large-cap companies that are already efficiently priced?

The sad truth is that most investors do this every single day. They chase after lumbering giants like Wal-Mart (WMT), Cisco Systems (CSCO) and Intel (INTC), and as a direct result they usually earn lackluster returns.

In my own personal investing I take an entirely different approach to the market -- one that is not only well supported by a wealth of academic research, but that has also proven to be wildly successful over an extended period of time.

Let me suggest you start by ignoring Wall Street, CNBC, and other mainstream sources of financial information. These widely available, traditional media outlets aren't going to provide you with the edge you need to outperform the broader market. After all, the financial press devotes nearly all of its coverage to gigantic domestic and multinational corporations. With so many analysts and pundits following each of these corporate behemoths, their share prices tend to be very efficiently priced. As a result, they almost always reflect all publicly available data.

In general, the more closely a stock is covered by institutional investors, Wall Street analysts and the financial press, the more efficiently priced that stock will be. It's extremely difficult to get an edge when trading or investing in these securities because it's almost impossible to uncover data that other folks have missed.

We need to put the odds in our favor. With this in mind, I focus my efforts exclusively on discovering inefficiently priced micro-cap stocks. These tiny companies are largely ignored by Wall Street's major players, and as a result, their underlying prices often do not reflect all publicly available information. By taking advantage of these mispriced micro-cap securities, I've managed to develop a lengthy track record of impressive gains.

Throughout the past several years I have published my analysis and original investment ideas on my own web site and have distributed this content to thousands of individual investors. Along the way, I have successfully introduced my readers to numerous inefficiently priced micro-cap stocks. Below you will find a few examples of high-quality micro-cap stocks I have analyzed over the past year and half. Keep in mind that these stocks represent only a small sample from a much longer list of winning investment ideas!

How do I uncover ignored micro-cap gems?

Although the firms I invest in are involved in a wide variety of different markets and business lines, they all tend to exhibit the following common characteristics...

-- Low or no institutional ownership
-- Little or no brokerage research available
-- Market caps of less than $100 million (and typically under $25 million)
-- Low public float
-- Out-of-favor companies or stocks that have overreacted to recent news
-- Often selling below their breakup value (market value of all assets versus all obligations)
-- Quality earnings supported by strong cash flow
-- Reasonable valuation levels
-- Strong insider buying my several key executives

Many hedge funds, mutual funds and institutional investors are prohibited from investing in the small companies I analyze on a regular basis. As a result, my research gives me an important edge because it simply does not exist in this market segment. This gives me a much better opportunity to uncover undervalued companies before the rest of the public catches on.

The bottom line is that by investing in micro-cap stocks, you are much more likely to outperform the broader market indices. This simple, yet effective, approach to investing is supported by a wealth of academic research. For example, $10,000 invested in stocks with market capitalizations below $25 million on December 31, 1951 would have grown to over $29 million in value as of the end of 2004. That equates to a compound annual growth rate of over +20%! Those returns were far superior to the broader market averages, most of which have delivered historical returns of just +12% or less over the long haul.

Three Undiscovered Gems Poised for Big Gains

In future articles I will discuss the specific techniques that I use to select only the best opportunities from the broad universe of micro-cap stocks. In the meantime, however, I'm pleased to introduce you to three undiscovered micro-cap gems that I believe are poised to deliver tremendous returns in the coming months. In searching for today's picks, I focused on companies with excellent value on the balance sheet, as well as stocks that have recently overreacted to bad news. These three high-quality companies include...

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TRANSNET CORP. (TRNT.OB, $1.59)
Market Cap = $7.6 million

TransNet is a provider of information technology products and technology management services. The stock offers classic value investors a compelling opportunity. I believe investors have mistakenly lumped TRNT in the same group as its competitors, most of which have weak balance sheets and limited access to the financial capital they will need in order to grow, or in some cases even stay in business.

TRNT, as well as other firms in this industry, is facing problems of tougher margins and slower sales growth due to increased competition and soft technology spending. However, the big difference between TRNT and its competitors is the firm's stellar financial position. TransNet boasts $0.79 per share in cash, $1.44 per share in net current accounts receivables and $0.33 per share in liquid inventory. In addition, the company has no long-term debt and the rest of its balance sheet looks very clean.

Lets do some math (all values listed on a per-share basis)...

$0.79 cash +$1.44 receivables + $0.33 inventory

= Total current liquid assets of $2.21 per share

Now compare this number to the firm's total liabilities of $0.35 per share and its current stock price of $1.59. From this analysis, the company's shares clearly look undervalued in the marketplace. After all, the firm's assets (minus liabilities) alone should be worth $1.86 per share.

We are not the only ones that have noticed this undervalued situation. Back in August 2003, Integrated Data Corp. (ITDD.OB) attempted to acquire TRNT, offering shareholders a total package of $3.50 per share ($1.25 in cash and the remaining $2.25 payable in common stock). TransNet issued a press release and quickly refused the offer, stating it was not in the best interest of its shareholders. 

I'm also optimistic about management's recent comments. In November 2004, after reporting a small profit for the quarter, management stated that its marketing efforts resulted in increased client demand for project-based business. They went further, stating all demand was positively impacted among a number of different customer segments -- from large and medium sized commercial organizations, to K-12 and institutions of higher learning, as well as state and local governments. Enthusiastic about the firm's prospects, management explained that interest in the firm's services is now at an all-time high and that they expect this trend to continue.

With all of the above factors in mind, we believe TRNT offers a reasonable risk/reward profile for value-oriented investors.
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PERVASIVE SOFTWARE (PVSW, $4.50)
Market Cap = $100.3 million

Pervasive Software has a strong niche in the data management and integration segment. The firm's flagship product, its Pervasive SQL database, has attracted more than 6 million users since its inception in 1994. I personally have used their products, and in doing so I quickly realized that they have taken full advantage of a unique and important market niche.

The company's real strength, however, is evidenced by the size and diversity of its customer base. Pervasive sells its products worldwide in more than 150 countries and boasts a customer base of more than 35,000 primarily small and mid-sized companies. The firm's growth prospects are excellent thanks to its focus on inexpensive data solutions that will work regardless of which ERP (enterprise resource planning) system or software solution is in use. Data integration will become more important than ever in the years ahead as companies will be forced to develop inexpensive solutions to maximize the value of their existing software.

A solid financial position, positive free cash flow, profitable operations, and a growing recurring revenue stream support the company's strong business fundamentals. The stock is trading well below its 52-week high of $7.68, and I believe the shares are selling at a discount to Pervasive's intrinsic value.

In conclusion, I'm optimistic about the future of this well-managed company because of its impressive, highly practical product line. Demand for Pervasive's database products should continue to increase in the years ahead, helping to boost its share price over the long haul. Not many software companies boast significant working capital, stellar balance sheets, growing revenues, a history of profitable operations, a diversified customer base and a solid product mix. However, Pervasive earns high marks on all of these fronts, making the stock a solid choice for aggressive investors.
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ADAMS GOLF (ADGO.OB, $1.41)
Market Cap = $31.8 million

Adams Golf designs, assembles, markets and distributes golf clubs. The stock has performed well over the last two years, which makes is a bit hesitant to introduce it at this time. However, the considerable advancement in the firm's business fundamentals, coupled with its improved financial position, has forced us to take notice.

Adams' annual EBITDA (earnings before interest, taxes, depreciation and amortization) of $4.50 million compares very favorably to the company's enterprise value of only $16.8 million. In addition, the company boasts an outstanding balance sheet. Let's take a quick look at some of Adams' important balance sheet items (all items listed on a per-share basis)...

$0.62 in cash + $2.30 receivables + $2.14 inventory

= Total current liquid assets of $5.00 per share

Now compare this number to the firm's total liabilities of $1.84 per share and its current stock price of just $1.41. From this analysis, the company's shares clearly look undervalued in the marketplace. After all, the firm's assets (minus liabilities) alone should be worth $3.16 per share ($5.00 in assets minus $1.84 in liabilities).

Another positive that must be considered is the future tax benefits the firm will generate due to the losses it has posted in prior periods. As a result, the firm's cash balance and financial position will benefit in the coming quarters.

The stock is cheap due in large part to its obscurity. Making matters even worse, the company does not issue press releases at this time, so it gets very little coverage (even among micro-cap investors). In addition, because the stock is listed on the bulletin board (OTCBB), many institutions are unable to purchase the shares.

Like any other investment, however, ADGO carries a certain degree of risk. In this particular case the risk comes primarily from the competitive nature of the golf equipment industry. In order to stay in business, ADGO must continue to produce new lines of successful products. Competition in this industry is fierce and competitors are quick to copy any popular new designs. However, because the firm's balance sheet is so strong, management has plenty of room for error. As such, the stock should perform quite well going forward.

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Important Note: The above article was merely a small excerpt from a recent issue we sent to subscribers of our premium value investing service -- Margin-of-Safety Investing. In each issue of that newsletter, editors Nathan Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted stocks that should provide investors with a solid margin of safety at current prices. To receive your copy of our most recent issue of Margin-of-Safety Investing, as well as other guidance similar to this twice per month, you'll need to subscribe to this publication. To learn more, please visit:
https://www.streetauthority.com/subscribe-msi.asp

Thanks for reading!

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