Halfway into the Forest

There’s an old saying that goes, you can only go “into” the forest halfway before you technically start coming “out” the other side. Based on the surge in volatility we have seen so far this month that culminated in today’s sharp sell-off, I think we are approaching the halfway point.

This is, of course, a mixed blessing, because while it means the sun is on the horizon, we could have another two or three weeks before what is already becoming a strong earnings season gets critical mass and sentiment fids a solid base on which to rebuild.

Early earnings have been solid but scattered, leaving the Federal Reserve to call the tune so far. In the meantime, the market is swinging wildly in comparison to the unusually complacent summer we just wrapped up.

Six sessions in the last two weeks ended with the S&P 500 up or down between 1% and 2%, compared to a historical average of roughly four equally volatile days in a typical month. While none of the action has yet to get more intense, it is probably only a matter of time before the benchmark starts printing 2%-3% moves again as well.

This is actually how the market behaves under normal and even healthy conditions. Of course, depending on how the big days stack up, specific positions can soar or suffer. We have seen four big bad days and only two big good days so far this month, so it is only logical that the market is down and investors are nervous. Naturally, smaller stocks like the ones that dominate the Breakout list have taken the brunt of the fall, just as in the past they led the way up.

In a season like this, traders simply need to commit themselves to either abandoning the market as a risky enterprise or else riding the waves in pursuit of long-term upside. We are obviously in the latter camp here, simply because we know that our stock-picking methodology delivers results and that the most reliable way to beat the market is to lighten up on dead money while concentrating bets on the stocks most likely to outperform.

That’s our goal right now, as we focus on using uptrends to close out of older, slower trades in order to free up capital for more robust opportunities. It’s important to have patience during this transition, since the S&P has some rebuilding of its own to do before we can assume the market has support under it. That may mean more rough days like today before a true rebound emerges. Bear moves of this scale are anything but rare. In fact, the last one we survived started almost exactly a year ago.

Looking back at that slide provides plenty of insight. The stocks we bought here in Breakout between September and November of 2013 when the market seemed to be unraveling looked battered and unloved at the time – but within six months, most had returned an average of 28%.

While I can’t promise we’ll see a repeat in 2014, I do have confidence that these are the market conditions we can use to our advantage and that buying on the dips will pay off for us over the long run.

With that, let’s turn now to our Quarterly Buy List Review for a look at where each of our Breakout names stand for the quarter ahead, and then I have two new recommendations to share with you.

Our Quarterly Buy List Review

We’ve spent the last couple of weeks talking about key adjustments to our strategy that will help us better navigate the small-cap environment and maximize our potential for profits. Part of implementing this approach is taking a good hard look at our current Breakout Buy List and determining which stocks have strong upside potential and which ones should be replaced with better opportunities. While the small-cap market has been volatile, the weakness is actually providing plenty of attractive bargains, so I don’t want our money sitting in older names that aren’t turning around fast enough when we could be jumping on these fresh trades poised to break out.

That’s why I’m excited to share this latest quarterly review with you. I’ve examined each of our positions closely and several of them look ready to make their exits. The fourth quarter is typically the time where our small-cap stocks begin to regain some of their footing and possibly even outperform the market, so I’m watching my screens carefully for the best opportunities to rotate out of older names and free up cash for new plays. I’m also keeping an eye on our winners so we can capitalize on near-term catalysts and lock in gains.

Let’s take a closer look at where our stocks stands and what I’m expecting from them as we march into the last quarter of the year.

Deep Value

Starting with the Deep Value category, where the real assets on our stocks’ balance sheets have provided a bit of a shield from the carnage in the rest of the small-cap universe, I am looking forward to upcoming earnings to alert Wall Street to the opportunities we recognized early on.

CBIZ (CBZ) struggled a bit after I recommended it in early August, but is showing signs of rallying off current levels. The chart appears to be in the early stages of a turnaround and I am looking forward to seeing how well it can wrestle with resistance around $8.40. The company is expected to report earnings before the end of the month, so we could see this near-term catalyst push the stock back into positive territory should the numbers outperform. Buy CBZ under $8.60 for our $10.50 target.

Entravision (EVC) has managed to make a nice comeback to start the fourth quarter, although shares appear slightly oversold at this point. However, the company is scheduled to report third-quarter earnings in a few weeks, and if shares can hold around $4.50, the chart looks clear to climb another $1 or so before losing steam. With signs of near-term upside ahead, buy EVC under a revised limit of $4.75 for our $7 target.

First Acceptance Corp. (FAC) regained momentum toward the end of the quarter, bouncing 13% off its summer lows all the way up to $2.80 before pulling back to current prices just above our buy limit. As always, this stock is a slow mover, but the November earnings release should give us a better idea of what to expect from the name so I recommend that you continue to hold FAC for our $2.90 target.

Reading International (RDI) has pulled back slightly since my August 19 recommendation, and is now testing long-term support levels. A successful bounce could be the breakout move we’ve been waiting for. Earnings are not expected before mid-November, giving the shares plenty of time to move on purely technical factors. Buy RDI under $8.70 for our $9.50 target.

Silver Standard Resources (SSRI) is looking oversold right now and the shorts are fighting to keep it in this territory. At this point they need days, if not weeks, to cover their bets. However, you’ve seen the potential the chart shows from a position like this and I have no reason not to believe history will repeat itself. Buy SSRI below $6.50 for an $8.30 target.

Growth

The positions in our Growth category have been out of favor, which is to be expected in a more volatile market. However, those of you with a higher risk tolerance can use the pullback to add to your positions for a bigger payoff ahead.

Lionbridge Technologies’ (LIOX) recent momentum hit a rough patch this week, but I believe we’ll see the shares lift as news or the company’s latest $80 million supply contract is digested. Earnings are also due out at the end of the month, and could serve as another near-term catalyst. I see the stock making a run at $5 on its next upward swing, so I’m keeping LIOX as a Top Buy below $5 for our $7.50 target.

MiMedx Group (MDXG) is one of the better performing stocks on our Buy List right now, trading only slightly negative despite the overall small-cap weakness. After recently testing support levels, the stock managed to remain strong and has continued climbing back toward being positive. Earnings are due October 30 and the chart looks promising in the meantime, so buy MDXG under $7.50 to my $8.25 target.

Napco Security Technologies (NSSC) has taken longer than I would have liked for its story to play out, so I’m keeping a close watch for an opening to rotate out of the name. Right now, it’s trading just a few percentage points higher than its September 52-week low, making a near-term bounce likely. Continue to hold NSSC and I’ll let you know when to make a move.

PRGX Global (PRGX) is another story that has taken its time, but I believe it has the potential to provide us with a better exit as well. The stock bounced 10% from its 52-week low just a few weeks ago before pulling back slightly in the market weakness, so I’m hopeful we will see another push toward $6 before we need to cut our losses. Wall Street anticipates that this company will swing back to profitability before the month is over, so hold PRGX.

Technical Opportunities

Our Technical Opportunities stocks are a mixed bag as some of their stories play out faster than others, but as we shift toward a more trading-oriented approach here I think we will see more quick moves to glory or off the list entirely.

Innovative Solutions and Support (ISSC) took a huge hit on Tuesday, falling 44% by the end of the day after announcing that its Delta contract is in serious trouble. If you missed my post in the Update Center, you can check that out here. After struggling to find strength in the third quarter, Tuesday’s news certainly did not fall on accepting ears but I think the stock is being unfairly punished. I’m waiting for the shares to stabilize and recover a little before finally pulling the trigger on this name. Hold ISSC.

Rite Aid (RAD) is building a nice base at current prices around $5, and its chart has started firming up faster than I anticipated. There’s still plenty of time for the stock to develop, but we may see a nice pop toward $6 soon, so buy RAD below $5.20 for our $5.80 target.

Supreme Industries (STS) actually managed to gain some ground in the third quarter, popping 20% in the three month period. A strong second quarter and momentum in both heavy and medium truck sales helped boost the share prices, pushing our large negative position into a slight positive before getting hit by market volatility. I believe this stock has one more bounce in it, and upcoming earnings on October 23 could provide a catalyst. Hold STS for our $9 target.

Zhone Technologies (ZHNE) has been a casualty of the market sell-off, but my conviction remains high and there is still time for Wall Street to catch on here. We’re now in oversold territory, but this is the type of stock that can make a solid bullish run-up in a matter of weeks or days on the right news catalyst. The company is scheduled to release third-quarter earnings next week, with consensus estimating a loss of $0.03 a share. Running the numbers against management revenue guidance, I actually think we could see breakeven here. Any upside surprise or signs of improvement could help boost this stock back up for us. Buy ZHNE under $3.70 to a $4.50 target.

New Technical Opportunities Buy: SFXE

When it comes to undervalued and unappreciated stocks, SFX Entertainment (SFXE) rises to the top of the list. The company was chartered as a vehicle for entertainment impresario Bob Sillerman – who largely built what would become Clear Channel and generated billion dollar paydays for shareholders in the process – to consolidate the electronic dance music (EDM) genre. This is essentially what the old rave culture grew into and is now easily a $6 billion global industry concentrated in Europe, India, Thailand and especially Las Vegas.

The last time I was in Las Vegas, all of the hotels carried EDM channels on the in-room televisions and blasted the music through all of the clubs and restaurants. Top-name performers were given seven-figure residencies to host late-night parties at all of the “hottest” spots. Clearly this genre of music was screaming for a home, and Mr. Sillerman spotted an opportunity.

Unfortunately, Wall Street didn’t see the light quite so quickly. SFXE made its market debut about a year ago at $13 per share, and due to a lack of coverage, Mr. Sillerman’s somewhat unorthodox style and a few delays on the ramp to profitability, the stock became an easy punchline for the shorts and eventually dropped to an all-time low of $3.52 just this past week.

If anyone other than Mr. Sillerman was backing the name, it likely would have fallen off my radar a long time ago. But his reputation goes a long way, and if he can follow through with his plans to build a new generation music empire, I believe SFXE can turn into the comeback of the decade.

Shares are bouncing today after Mr. Sillerman finally put his estimated $975 million net worth to work and bought another 575,000 shares on the open market to demonstrate his confidence. With the chart finally moving out of oversold territory, there is now plenty of room for a technical bounce that would make short-term traders a lot of money.

The latest reading on short interest in SFXE indicated that investors betting against this stock need at least 30 days of normal trading volume in order to cover their bets, book their profits and get out. If they can’t do that, the odds of a reversal begin weighing against them and the potential loss on a short-gone-sour is theoretically infinite.

From a pure technical standpoint, a squeeze could take SFXE back up to $6.20-$6.25 without even cracking a single resistance level. Given the overall trend of 200% growth per year here and the seasonality of this company’s evolving business, the summer quarterly numbers certainly have the potential to demonstrate that this stock is a profitable enterprise.

I believe we could see revenue around $160 million and an earnings loss of $0.01-$0.02 per share when SFXE reports sometime in mid-November. And even if the shorts start covering now, they won’t be able to hit their deadline without moving the stock price. That movement alone will make the shorts even more nervous, so while a chain reaction may not necessarily push SFXE back up near its IPO price, the action could certainly heat up quickly.

Buy SFXE below $4.60 for a $6.20 target. Currently trading at a 34% discount to enterprise value and with earnings only one month away, this is a great opportunity to get in for the next bounce higher.

New Growth Buy: MEIP

The recent market volatility has taken its toll on stocks that have won big for us in the past and beaten them down to attractive levels. Several of them are popping back onto my screens as a result, and one in particular caught my eye as its chart is already improving and the underlying story has not changed.

Right in the midst of the last broad market downturn that we talked about earlier, we sold MEI Pharma (MEIP) for 55% gains. Most of that profit has now been eroded in the sell-off, giving us another opportunity to get back in the name at an attractive price.

MEIP is on the smaller side of our trading range with a market cap of barely $150 million, but the cancer-suppressing therapies in its pipeline can easily generate more than $200 million in milestone payments from development partners, so the risk is certainly manageable.

These cancer treatments have the potential to become world-changing drugs. In fact, the most advanced of these products recently demonstrated full remission in 33% of acute myeloid leukemia cases as well as significant benefits for another third of Phase II clinical trial participants. Earlier trials showed improvement in 89% of patients suffering from another form of blood cancer, so the efficacy and applicability here is shaping up extremely well.

Many more of the company’s treatments are moving through the FDA testing process also, hoping to cure different types of lung, ovarian and blood cancers. In short, all of these drugs are helping to transform this little company. (You can learn more about them in my original recommendation here.)

Right now, MEI Pharma is a somewhat battered biotech play that is rebounding nicely from this summer’s biotech crash. With few assets and no real revenue yet, this is a pure growth prospect that still depends on clinical milestone payments for short-term cash flow. But as those milestones approach, I believe this stock has the potential to climb back up to $10 levels and beyond.

Buy MEIP under $7.55 for my $10 target. The chart has firmed up from a low of $5.50 and recent price action makes me believe we are out of the woods for now, giving us additional exposure to the biotech boom.

Sincerely,

Hilary Kramer
Editor, Breakout Stocks Under $10

P.S. I hope you’ll join me and 40+ of my fellow financial experts at The World MoneyShow in Toronto, October 16-18. I’ll be sharing my insight on how to position for your portfolio for profits in the year ahead, including value and options plays. Click here to register for free!