Bottom of the Barrel: Small-Caps for Uncertain Times

At the brink of war, many readers have been asking which stocks in the Bottom of the Barrel portfolio will likely continue to work as the U.S. prepares for battle with Iraq.

Nobody knows what will happen once American soldiers are in harm's way. Almost everyone has an opinion, but war is uncertain by nature. Any predictions are based on probabilities, history and intelligence. And so my preferred small-cap strategy is to limit risk, focus on fundamentals and understand that the market's tenor will affect the direction of small-cap stocks.

The strategy is largely dictated by tenets of small-cap investing that I discussed in a January column. First, I want companies that show signs of moving toward profitability. Not every good small-cap idea will show earnings, but in times of uncertainty, I want companies that at least demonstrate earnings potential with honest management.

Second, today's most attractive small-caps are those with solid balance sheets. Given the precarious economic situation, I want more promises of balance sheet stewardship and fewer promissory notes. I also want simple stories: I want to be able to understand the product, the financials and the future.

It's not rocket science, but it's worth repeating when nerves can sometimes trump reason. With that in mind, here are some Barrel considerations as we move closer to war.

Energetic

I continue to like the stable of energy stocks in the Barrel portfolio. Although I think oil prices will settle in the mid-$20s and natural gas in the high $4 range, those levels are good for energy companies' earnings.

Therefore, I still like Energy Partners ( EPL), a small-cap player in the Gulf of Mexico that posted an impressive discovery record last year. It appears to be off to a similar start in 2003. The market will recognize the companies that can find and deliver natural gas, as investors wake up and realize that supply is tight.

The stock has slipped since Energy Partners announced last week that it would offer about $80 million in stock, around half from selling shareholders. Part of the proceeds will likely be used to pay off expensive notes left from the Hall Houston acquisition, and the offering will increase the float. Shares are likely to remain around current levels until the deal is done. As long as the company keeps showing success in its exploratory program, success should repeat itself.

In addition, Maverick Tube ( MVK) remains a reasonable play on the cyclical upturn in oil and natural gas drilling. Although the stock is up nearly 20% since being profiled earlier this year, demand for drill pipe continues to inch higher. Signs of a pickup in Gulf of Mexico activity should push Maverick's orders higher. Demand is already beginning to boost pricing, and that should help margins. Steel costs should be watched carefully, but Maverick is still a good early-cycle play in the oil patch.

Real Resources (RER:Toronto) is a small exploration-and-production company that has done little since its profile in late January. However, it too should post impressive gains in production, and with strong commodity prices, that should translate into solid revenue gains. It's tough to play the Canadian juniors unless you're north of the border, because of listing and liquidity constraints, but if you're in Canada, Real Resources is worth a look.

Finally, one name that breaks all the balance sheet rules but may be due for a bounce on a potential pickup in Gulf of Mexico activity is Trico Marine ( TMAR). It's been a great short since its profile last May. Trico continues to struggle with debt, but it also has significant earnings and cash-flow leverage to activity in the Gulf. Again, it's more speculation than a solid investment, but some smart energy money is beginning to consider a position ahead of the expected ramp in new offshore drilling.

Banking on Recovery

One small-cap bank may also deserve a look, especially if you believe in the postwar recovery scenario. Atlanta-based Fidelity National ( LION) is in the midst of cleaning up a big regulatory mess and its tarnished reputation. Yet, it also has a superior network of branches in metropolitan Atlanta, a decent lending environment and a real opportunity to gain market share from fallout related to the Wachovia-First Union merger. The stock has underperformed since its profile last May but now appears to have support at current prices. Fidelity has positioned itself to grow with a recharged economy, and, over time, it will likely come into play as an acquisition opportunity for banks looking to enter the Atlanta market.

Although other banks in the portfolio -- Coastal Bancorp ( CBSA) and Integra ( IBNK) -- would also benefit as investors return to financial services, Fidelity National seems to have the best profit potential given its focus on profitable business lines and completion of its restructuring program.

Beefing Up

Finally, I continue to like the performance of Rare Hospitality ( RARE), owner of the Longhorn Steakhouse chain. This casual, midpriced chain continues to increase the number of restaurants while also growing same-store sales, which are above their target level.

With a good management team, this solid "value" steakhouse should keep doing well and seeing even more improvement as the economy gets better. Trading at about 16 times this year's earnings estimates and about 13 times 2004 estimates of about $2.10 per share, the stock appears to have room to grow into its projected 20% earnings growth rate. Plus, for a quick, fairly priced steak, Longhorn is hard to beat.

Other names probably deserve mention, including the REITs in the portfolio I discussed last week. However, these names are all small-cap companies to consider in this uncertain time.

Christopher S. Edmonds is vice president and director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to Chris Edmonds.

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