Stocks Buck History in September

With just one trading day left to go, the market is about to wrap up a successful September – a month historically known as one of the worst for stocks. Instead, the Dow Jones is up 3% (on track to have risen 11 out of the past 12 months), the S&P is up 2.8% and the NASDAQ up 2.2%.

We can thank the Federal Reserve for most of these gains, whose highly-anticipated third round of quantitative easing on September 13 sent stocks rallying. But along with the weather, we’ve seen things cool off a bit here in the final days of the third quarter as Wall Street turns its attention to some big fourth-quarter storylines that are already having an effect on market performance, including ongoing global economic concerns and a new earnings season.

Still, the S&P managed to snap a five-day losing streak today, on hope of additional stimulus in China and on Spain’s release of economic reform plans. And despite some disappointing earnings pre-announcements, the market has held up relatively well, again suggesting that lower results are already been priced in to a large degree.

We may continue to see fluctuations in market activity as we begin the fourth quarter, but I still believe that as long as the situation in Europe is kept under control, any corrections will likely be short lived. We’ll talk more next week about what I see ahead for the final months of the year, but also keep in mind that corrections give us opportunities to put more money to work. Since the market rally began in June, we have pocketed gains in seven stocks with an average return of 38%, and we’ll look to take advantage of any pullbacks so we can add to that list!

Our most recent winner was LML Payment Systems (LMLP), which we sold on Monday after Digital River announced a buyout offer of $3.45 a share in cash. Since it’s unlikely a better offer would come in and shares were trading close to our $3.50 target, I recommended we cash in our gains of around 20%. We’d had our share of ups and downs with LMLP, but our patience in a company with favorable valuation and fundamentals paid off as we profited from the buyout. If you haven’t already done so, sell LMLP.

This was our fourth Breakout company to be acquired so far this year, joining eResearch Technologies (ERT, +73%), Presidential Life (PLFE, +57%) and EasyLink Services (ERT, +31%) on the takeover list. Acquisition activity can be an exciting aspect of investing in low-priced stocks, and I’d like to talk for a minute about how this factors into our strategy here in Breakout, as well as which stocks I see as our next potential takeover candidates.

How We Can Profit From Rising M&A Activity

As I talked about in my recent Town Hall video, I expect mergers and acquisitions (M&A) activity to heat up in the fourth quarter. Valuations right now are especially reasonable, interest rates are low and corporations have a lot of cash sitting on the sidelines. These factors mean we’re more likely to see exciting M&A moves over the next few months, and as low-priced stock investors, we are in great position to take advantage of this.

Now, I do not generally focus all my research on potential takeover candidates. While it’s great to uncover a stock that could be acquired at a much higher share price, it must also meet other criteria before I’ll recommend buying it. In fact, much of the time, takeovers are simply a byproduct of finding companies with sound fundamentals.  

Firms that have strong free cash flows, solid balance sheets or rapidly declining debt, consistent operating results and a favorable valuation – all traits that I look for in a buy – are often the targets of acquirers. These characteristics are desired by any investor, including other companies or buyout firms, who want to get a good return on their investment. So just by maintaining our strategy of going after solid companies at bargain prices, we are likely to find takeover targets.

However, acquisitions are not done by numbers alone. Interestingly, all four of our acquired companies this year were targeted by businesses in related industries. So in addition to good financial characteristics, a company that has a unique product in related or desirable industry also has a better chance of being acquired. In the case of LML Payment Systems, Digital River wanted LMLP’s Beanstream electronic payments division to help expand its e-commerce offerings.

There can be exceptions to this from time to time. For example, I recommended Cablevision (CVC) in part because I believe there will be consolidation in the cable industry. But I also see Cablevision adding value to shareholders over time in any event as it generates free cash flow and pares down its debt.

In addition to CVC, I believe we have several other acquisition candidates in our Buy List:

CBIZ (CBZ) is perhaps the cheapest stock in our portfolio, selling at less than 8X cash earnings of $0.80 a share. The company’s service businesses require little capital, and thus generate a lot of free cash flow. CBZ has a history of acquiring other companies, but a reversal in this trend to help cut down debt would make the company itself an attractive target.

Crown Media (CRWN) is owned 90% by a Hallmark Corporation subsidiary, HC Crown LLC. Hallmark is privately owned, and they could potentially increase their interest in CRWN to 100% and boost shares in the process.

Hackett Group (HCKT) already had a significant Dutch Auction this year, where 30% of the common shares were retired. As I mentioned in my recommendation last week, the company could do another large Dutch Auction once they pay back debt incurred from the transaction, or simply take the company private. A larger consulting firm could also have an interest in the company’s proprietary benchmarking data. We’ll talk more about HCKT in just a moment.

Magic Software (MGIC) is a very inexpensive company with a cash balance of over $1 a share. Not only are the shares attractive from a financial standpoint, but a strategic buyer could have an interest in the company’s UniPaas middleware, which deploys applications through a variety of IT platforms.

Warren Resources (WRES) is another potential acquisition candidate. The company has very substantial oil reserves in California, which could be very valuable to a potential acquirer. However, an acquisition here may happen until the reserves are further along the development process and there is greater confidence in the economy and the sustainability of the high price of oil.

Two other potential targets have also made interesting moves recently, so let’s take a look at those now.

Breakout Stocks on the Move

CryoLife (CRY) has bucked the weak market trends and is higher by 20% since our last update. While there was no specific news story that sparked the rally, the gains did come on very heavy volume. CRY was upgraded last week by TheStreet.com from a ‘hold’ to a ‘buy,’ citing strength in revenue growth, attractive valuation and a solid financial position with reasonable debt levels. Positive analyst coverage is always a good thing for a stock, so this may have helped support shares on their move up.

Another stock that has shown strength recently is FutureFuel (FF), which is up over 21% in the past two weeks. Again, there was no significant news behind the upward momentum. The company was at an investor conference on September 19, but no new developments were announced. FutureFuel, which manufactures bio-diesel fuel, may have benefited from the recent rise in gasoline prices in recent months, and could also have gotten support from the recent sharp rise in oil refining stocks.

Both moves have pushed CRY and FF closer to their targets of $8.50 and $14, respectively, and each hold gains in excess of 20%. Although the stocks have been on a run, I see further gains ahead and I also cannot rule out a potential acquisition. I’ll continue to keep a close eye on both and keep you updated on further developments. Continue to hold CRY and FF for now.

The Hackett Group (HCKT) has jumped around a bit in a series of rallies and pullbacks since I recommended it in last week’s update. Despite the movement, the stock still looks good from a technical standpoint and I’m very confident in its growth potential going forward. I was also encouraged that it did not sell off sharply in a week when concerns about Europe were high, especially since fear that a weak Europe would undermine earnings was the primary reason for the stock’s decline since we sold it in April.

The movement may have made it tricky to get in, but shares are trading at attractive prices right now. If you weren’t able to buy last week, I recommend you buy HCKT below $4.50.

Breakout News & Notes: CRWN, WIBC, WTSLA

Crown Media (CRWN) has been making good on one if its primary strategies of producing more original programming. On September 8, the Hallmark Channel premiered “Puppy Love,” a romantic comedy that is part of the network’s series meant to raise awareness of pet adoption and proper pet care.

Puppy Love did well in the ratings, drawing numbers that were good enough to make it the highest rated movie of the week on a supported cable channel. The rating was also strong enough to allow Hallmark to be the fifth-highest rated cable network that day in primetime. This success argues well for the company’s plan to produce their own shows, and the increased advertising revenue they could bring in.

CRWN may have gotten a little ahead of itself, as shares have slipped from their highs of early August, but remains above our buy limit. The company’s prospects remain bright, and I still like the stock as a more conservative play in a volatile environment. Buy CRWN on any pullbacks below $1.65 as we target $2.25.

Wilshire Bancorp (WIBC) was recently featured in a Wall St. Journal article that referred to the bank as a star of Los Angeles’ Koreatown, and discussed a possible merger between Wilshire and fellow Koreatown bank Hanmi Financial (HAFC). The two banks are very similar in terms of market capitalization and asset size, so a merger would make sense. Since this would likely be a merger of equals without a significant premium, it’s important to remember that there would not be a large and quick pop to WIBC’s share price like we typically see in an acquisition. However, the chance to cut costs would make the deal compelling for WIBC and also support its business.

I believe even the potential of a merger should add support to WIBC stock price, which has risen 19% since I recommended it in June, despite a slight sell-off in recent weeks. The company had an excellent second quarter and the credit outlook is bright. Loan growth and higher long-term interest rates as the economy grows should push the stock toward our $7.50 target, so continue to hold.

Wet Seal (WTSLA) has issued a letter urging shareholders to reject hedge fund Clinton Group’s attempts to place their own slate of directors on the Board. A week after making some concessions to the value-oriented group, including a cut in directors’ pay and the elimination of a shareholders’ rights plan, the retailer is accusing Clinton of being short-term oriented and lacking a viable strategic plan to turn the company around. WTSLA also pointed out that they offered Clinton a seat on the board, as well as a seat on a three-person committee that would conduct a CEO search.

Two leading proxy advisors agreed with WTSLA’s directors, and also urged shareholders to reject Clinton Group’s nominees for directors. The firms cited a lack of detail and substance in Clinton’s plan, and the concessions WTSLA has already made.

WTSLA has indicated that its annual meeting will occur no later than April 19, 2013, so there will likely be plenty of time for shareholders to judge how effective management’s return to “fast fashion” merchandising is before making a decision. Shares have been stronger in the last week, helped by an analyst upgrade on the company’s recent moves to turn things around. This remains a cheap stock, and any sign that a return to fast fashion is paying off will boost shares further. Continue to hold WTSLA for our $3.50 target.

Sincerely,

Hilary Kramer
Editor, Breakout Stocks Under $10

P.S. It’s been a good quarter for our Breakout companies, with our Top Buys returning solid gains. I’ll have all the final numbers for you next week when we review the results, and I’m also excited to share my new list of Top 5 Buys for the fourth quarter with you then!