In my last guest article I identified the most fertile ground for finding great investments -- small and neglected stocks. When searching for these high-quality micro-caps, I first use advanced screening techniques to help narrow the vast investment universe down to just a short list of high-quality stocks that meet many of my stringent investment criteria. From there, I dig deep into each company's fundamentals in order to evaluate its future business prospects. In the process of doing this analysis, I always keep the following items in mind:

-- Securities that have underperformed in recent trading action are likely to outperform in the months and years ahead. As such, it's often valuable to take a contrarian approach by looking for beaten-down, neglected stocks.
-- Investors often analyze companies without taking their debt levels and cash balances into account. However, this can be very misleading. Before investing, it's extremely important to analyze the full value that investors have attached to a firm.

With this in mind, in today's guest article I'm going to explore the following important investment concepts...

-- Mean Reversion
-- Enterprise Value

(Please remember these ideas should not be used in isolation, but instead should be employed in conjunction with other time-tested investing principles.)

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Mean Reversion
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Many academic studies of Wall Street's behavior have demonstrated strong evidence of something statisticians call "negative serial correlation." Very simply, this means that stocks that performed well in years past actually tend to underperform going forward.

This anomaly is most likely created by investors' tendency to overreact to positive or negative news. Based on all historical data, it's clear investors are incapable of insulating themselves from their emotions and embracing logic. The majority of investors tend to follow the crowd. Instead of acting in a logical, well-thought-out way, most investors are pulled along by fear and greed. I seek to capitalize on this irrational behavior.

"The product of the extremes tends toward the means."

You may have heard this old saying back in grade school --and for good reason. After all, there's quite a bit of truth to it, and it applies to a variety of different aspects of our lives. For example, on average, the offspring of tall parents are not as tall as their parents. Meanwhile, the offspring of short parents are generally not as short as their parents.

Why is this important for investors? Well, as you'll soon see, this principle also applies to the stock market when measuring returns over long periods.

Although the trend might indeed be "your friend" in the short-term, over the long run (let's say three years or longer) the reverse is actually true. Stocks that have delivered stellar returns over the past three years or so will often regress to the mean and underperform their peers in the coming years.

This concept is supported by a wealth of academic research. For example, in an important study, economists Richard Thaler and Werner De Bondt studied stocks that outperformed or underperformed the market averages over a three-year period. After doing so, they came to the conclusion that "extreme returns of stocks listed on the New York Stock Exchange were subsequently followed by significant price movement in the opposite direction."

With this in mind, instead of trying to ride outperforming stocks higher, I often prefer to look for unloved stocks that have underperformed the market in recent months or years. After all, while it may be tempting to latch onto today's hot trends and market darlings, these stocks carry a great deal of risk and are often prone to sharp reversals. I try to remind myself that trees grow upwards but never reach the heavens.

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Enterprise Value (EV)
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When attempting to gauge the overall value Wall Street has assigned to a firm, investors often look exclusively at market capitalization (calculated by taking the number of outstanding shares and multiplying this figure by a stock's current share price). However, in most cases this is not an accurate reflection of a company's true value. Instead, enterprise value is a much better gauge, as it measures the total value that all investors -- both equity holders and bondholders -- have assigned to a firm. Enterprise value essentially represents the current purchase price of the entire company.

Enterprise value is a simple, yet often overlooked, financial measure. It is calculated as follows:

Market Capitalization + Total Debt - Cash = Enterprise Value

The formula subtracts cash from market capitalization because if an investor were to actually buy the entire company, then that investor would acquire all of the firm's cash. This would, of course, reduce the cost of the purchased company. (Note: At times I also like to go a step further and adjust stock prices for current accounts receivable and liquid inventory.)

The media, Wall Street and major corporations often report certain statistics -- such as P/E ratios -- without mentioning the impact of debt obligations and cash. This is very misleading! Some companies may seem to have stellar financial numbers. However, when debt holders' claims are added into the calculations, these numbers sometimes prove to be very unimpressive, or in many cases even horrible. By contrast, some companies have healthy cash and accounts receivable balances, liquid inventory and little debt. However, ratios like P/E multiples don't take these important items into consideration at all, as the "price" value in this ratio reflects only the value of a firm's equity. At the very least, cash and debt must be included to adjust the reported price per share. Instead of looking just at equity prices, I strongly recommend investors always compare earnings, sales, etc... to enterprise value when analyzing a company's intrinsic worth.

Academic research also supports this view. For example, Nobel Prize winning economists Modigliani and Miller theorized that the effective capital structure of a company was the market value of its equity plus its debt. They proposed there was no optimum capital structure and concluded it makes no difference whether a company uses debt or equity to finance its business.

With this in mind, we must equally analyze both debt and equity when making an investment decision. Whether a company chooses to recognize its value all in debt, all in equity, or a combination of both, is the firm's choice. There is no capital structure that results in a higher total valuation. When calculating and comparing financial ratios, investors must include a firm's debt per share minus its cash per share.

Given all of this, we can see that the real, economic purchase price of a company at any given moment is the value of its stock (its market capitalization), plus the debt the company has incurred, minus its cash on the balance sheet. So, instead of looking at earnings in isolation, it's always wise to examine the total returns a business generates in relation to the cost of acquiring it.

Micro-Cap Investing Ideas

When searching for quality micro-cap investing ideas this week, I paid careful consideration to the key concepts of mean reversion and enterprise value. Below you will find an analysis of three of today's most promising micro-cap plays...

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InfoNow (INOW, $0.95)
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InfoNow provides complex automated technology and service solutions to some of the most recognized companies on Wall Street. More specifically, the company's software helps firms organize their distribution channels, as well as gather information on who is reselling their products (and at what prices). Firms then use this information to manage their distribution networks and to generate new partners. InfoNow's client roster consists of over 70 blue-chip companies, including such high-profile names as Apple Computer, HP, UPS, Shell Canada, Bank of America, Visa, Avaya and many more.

InfoNow's customers are using the firm's products more than ever before. For example, in January 2005 the company's distribution channel management web site logged more than one billion hits -- over 2,000 per minute. In addition, the firm's clients tend to show an impressive increase in customer access after using InfoNow's solutions. That growth was measured at a +25% compound annual rate since the firm began tracking these statistics back in 2000. This statistic gives credibility to the significance of InfoNow's software products, as well as their importance to the firm's clients.

INOW's management is convinced that its products will ultimately revolutionize the way channel-focused companies operate. Currently, the firm is focusing the majority of its sales and development efforts on expanding its distribution channel software and becoming the dominant provider of this technology. Management believes this is a multi-billion dollar opportunity and the company is well positioned to capitalize on it. Even better, the firm boasts that no competitor can match the depth and breadth of the information it provides.

From a financial point of view, INOW has a market cap of just $9.4 million. However, this should be adjusted downward for an impressive cash balance of $3.9 million and accounts receivable of $1.5 million. The firm's total liabilities amount to just $2.2 million. So, for a company with an enterprise value of less than $8 million, investors are getting annual sales of $11.4 million and gross profits of $6.8 million.

When we couple these statistics with the firm's diverse customer base and its recurring revenue business model, we see a powerful platform for further growth. INOW has been profitable and cash flow positive since 2002, and I think the stock would make an excellent addition to a well-diversified portfolio.

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Midwest Air Group Inc (MEH, $2.66)
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I can safely say investing in an airline stock should be considered a contrarian idea. Today I'm going to ignore the obvious industry troubles here, including rapidly rising oil prices, a stagnant economy, distressed labor agreements, excess capacity, increased competition, lingering effects of 9/11, costly security measures, negative cash flows and large debt loads. The fact is that all of these items have already been priced into Midwest Air's shares over the past few years.

If the industry can make improvements on any of these current concerns, then MEH appears poised to capitalize on these positive changes. Although MEH lags its competitors in terms of top-line growth and profit margins, the firm's balance sheet looks fairly solid. This strong financial position, coupled with Wall Street's overreaction to the downside throughout the past several years, has provided investors with an interesting buying opportunity.

MEH is a small and ignored stock, and any positive industry or company-specific news is likely to move its price higher. It's also worth noting that several successful value funds, including Heartland Value and Al Frank Fund, have already invested in MEH. Although the stock is not for the risk-averse, investors with well-diversified portfolios may want to consider a small position in MEH.

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Catuity Inc. (CTTY, $3.85)
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Catuity provides loyalty application software and services to retailers, as well as to companies that provide services or hardware to retailers. The firm's programs provide real-time marketing services to customers at the point of sale. Large retailers use these solutions to help track and reward their most profitable customers.

Although the firm has a rocky past, including the loss of a large chunk of its revenue from key customers Target and Visa last year, Catuity is now in the very beginning stages of a turnaround. Catuity's long-term promise for investors lies partly in the value of several key patents. These relate to the storage and management of applications in offline consumer devices, as well as the systems used to manage those applications. Some of the most successful companies in their respective industries have been attracted by the value of Catuity’s solutions, most of which are based around these patents.

At this point the company is starting at ground zero with a newly developed and unproven strategy. The board has hired John Racine -- a proven industry turnaround specialist -- and appointed him CEO. Although at this point the company has not proven it can generate sufficient revenue to produce a profit, we nonetheless believe this stock has many merits as an investment.

Catuity has tiny market cap of only $3.0 million. However, we need to adjust this number to come up with the firm's enterprise value, which will give us a better sense for the total value investors have assigned to the firm at this time. Along those lines, CTTY has $2.6 million in cash and only $674,000 in total liabilities. By following the equation for enterprise value (shown above), we see that the company can be purchased for about $1 million (I also considered off balance sheet items such as lease obligations).

On the positive side of the ledger, I like a number of things about Catuity. For starters, the firm has demonstrated a strong desire to stay listed on the Nasdaq and Australian exchanges. For example, the company recently executed a 15-to-1 reverse split in order to meet the Nasdaq's listing requirements. Catuity also boasts the following positives:

-- Strong team of employees in both management and technology
-- Operating loss carry-forwards of $20,000,000 should help the firm to save on taxes for years to come
-- Three registered patents
-- Enough cash and little debt to give the company time to execute its turnaround strategy
-- Turnaround specialist John Racine, as well as the addition of experienced new board members
-- Several motivated key shareholders

Although these positive factors should help support the stock price going forward, keep in mind that CTTY is a fairly high-risk play. In addition, the company continues to lose money, posting a net loss of $0.71 per share in the most recent quarter. While it remains to be seen how long it will take the firm to reach breakeven levels, we are optimistic that Catuity will reduce its losses in the coming quarters.

The bottom line is that CTTY has some solid merits as an investment, and risk-tolerant investors might be wise to consider taking a small position here.

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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:
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