After nearly three months of the year, investors already have witnessed stocks undergo a full range of motion. There was a parabolic up move in January, a dull stretch of low volatility in February and a dizzying decline in March. At its best, the Nasdaq Composite was up 8% in 2004; at its worst, it has declined 10% from its peak to post a 3% loss for the year.

If the market were a washing machine, we'd be ready for the rinse cycle. That makes this a good time to consider which stocks look brightest so far, and what their success suggests about the prospects for these and other stocks going forward.

Let's back up a moment first and consider why stock prices go up at all. The simplest explanation is that you are buying a nanoslice of a company's future earnings power. The question is how to estimate that power.

  • A public company with a modest ability to tread water with current customers should be able to grow earnings at the rate of growth of the U.S. gross domestic product, which this year means the stock should be able to advance 4% a year. An example is mass-market food manufacturer Wrigley (WWY).

  • A company making decent products or providing fair services in an industry with stronger-than-average demand should be able to double GDP growth or slightly better, so figure a stock advance of 8% to 12% a year for these stocks. One example is health care products giant Johnson & Johnson (JNJ).

  • A company selling unusually strong products or services in a popular economic sector should be able to triple GDP growth because it's selling more stuff to old customers, acquiring new customers and maybe even raising prices. Its shares should be able to advance 15% to 20% per year. Coffee retailer Starbucks (SBUX) is one example.

  • And if a company has been performing consistently well for a number of years, investors will typically pay a special premium that takes the form of an expanding price-to-earnings multiple, which could add another 10 percentage points or more to its nominal growth rate. eBay (EBAY) is one such stock.

So why are some stocks already up 60% to 200% or more in 2004, and how can you judge whether the move is a fluke or likely to continue?

Trading on Knowledge

The most common reason a company's shares rise a lot more than those of its peers is some sort of information disequilibrium: Buyers think they know something sellers and bystanders do not -- some call this a "variant perception" -- and are willing to make intensive bets with money.

The more buying power they have, and the more they can persuade others to join them, the more demand pushes shares up. If holders become increasingly reluctant to part with shares, they'll demand ever-loftier prices to let go.

In many cases, the information disequilibrium stems from a business change the market is slow to recognize or appreciate. Shares of Southern California real estate lender Fremont General ( FMT) are up 60% this year: 10% in January, 25% in February and 16% so far in March. Wells Capital Management, which bought its entire 4.7% stake in the company in the fourth quarter last year, accurately forecast that the company would successfully shed its past as property-and-casualty insurer and morph into a profitable industrial bank.

Fremont General has virtually no analyst coverage and is owned only by a few small-cap value mutual funds so far, yet earnings doubled in the last quarter. The price gain so far is probably the result of new small-cap or mid-cap value buyers, or an advance party of mid-cap growth funds.

Strangely diversified conglomerates and companies that emerge from bankruptcy, or acquire subsidiaries emerging from bankruptcy, are prime candidates for big info-disequilibrium trades. Here's a closer look at two of these.

  • Danielson Holding (DHC), up 223% in 2004 through March 15, has acquired holdings in marine transportation, insurance and energy production. In 2003, its American Commercial Lines subsidiary filed for bankruptcy along with related companies such as American Commercial Barge Line, Jeffboat and Louisiana Dock. Last month, the company completed its acquisition of Covanta Energy's municipal waste-to-energy business out of bankruptcy. Danielson's overall earnings fell 74 cents per share in fiscal 2001, $1.10 per share in 2002 and at least $2.14 per share in 2003.

    So why is this company -- sporting a ridiculous price-to-book value of 10.7, according to Media General -- up three times from the $2.90 where it started the year? Apparently, part of the attraction is the value of its tax-loss carryforwards. CEO Sam Zell and an affiliated investment company bought $6 million worth in the open market in December, and veteran vulture buyer Marty Whitman at the Third Avenue Value Fund had acquired up to 8% of the company through the end of last year. Whitman has been on Danielson's board since 1990; Zell is better known as a Chicago-based billionaire real estate developer.
  • Linoleum and tile flooring maker Congoleum (CGM) is up 218% this year despite filing for a prepackaged bankruptcy. Business growth certainly isn't behind the surge: Fiscal year 2003 sales of $220 million were 7% lower than in 2002, resulting in a net loss of $6.8 million. And Chairman Roger Marcus detailed five big problems: large set-asides for asbestos-related legal charges; a decline in key end market manufactured housing; substantial increases in medical, energy and insurance costs; the loss of a major vendor; and the margin-slicing reduction of inventories.

    But stock prices are more about the future than the past, and that might be brighter. In a press release, Congoleum said it's optimistic that 2004 results will be "significantly better" due to the company's actions to reduce its cost structure, including job cuts in 2003. After bankruptcy, some investors are clearly betting the worst is behind Congoleum.

Opportunities Persist

Information disequilibria can persist for a long time, even after a company makes a full recovery from whatever ailed it, as skeptics irrationally fear a return to darkness. A typical example is TRM Corp. ( TRMM) -- up 64% this year through March 15 -- which owns and operates a global network of 25,000 photocopiers and 3,500 ATM machines placed in grocery, convenience and drugstores.

Insiders were buying hundreds of thousands of dollars' worth of company shares throughout last year at prices ranging from 75 cents to $8.98, and institutional investors at Calpers, Driehaus Capital Management, Wellington Management and Friedman Billings began to join them.

The TRM turnaround story: After several years of losing money as it built out its network, the company had declared profitability as a goal and achieved it last year, earning $5.5 million in 2003 after losing $4 million in 2002. The business obtains recurring income from the basic insight that despite much high-tech hype, we live in neither a cashless world nor a paperless world.

Instead, there is a regular need on the part of consumers to have cash and make photocopies, and they will pay a small premium to do so at a convenient location. Retailers refill the copiers and ATMs with paper and cash and receive a revenue cut; TRM services them with a branded sales force. The company has grown so far without making acquisitions, but said it may pursue some this year to grow its market share.

In addition to these oddball micro-caps, several medium-sized and large companies have outpaced their peers this year. AT&T Wireless ( AWE) and Sepracor ( SEPR), up 69% and 87%, have done it through the irreproducible feat of buyout offers. Sprint PCS ( PCS), up 52%, has done it through the knockoff belief that it could attract a buyout.

More memorable is Elan ( ELN), a horribly beaten-up big Irish biotech -- down to around $1 in 2002 from $65 in 2001 on accounting concerns -- that has returned from the dead. The stock is up 136% this year as investors came to appreciate its credible new management and focus more on its terrific drug pipeline than its big long-term debt. The stock is not as cheap as it was, obviously, but is still somewhat undervalued for a major biotech.

Another great story this year among mid-caps is Research In Motion ( RIMM), the Canadian maker of the popular BlackBerry wireless email devices. It's up 39%. The stock is wildly pricey now, but instructive in that shareholders have benefited from one of the few persistent technology innovations of recent memory. (Companies are buying them for traveling employees as an inexpensive substitute for laptops.)

In summary, the best stocks of the year are either special situations in which new shareholders are betting on hidden virtues; dramatic turnarounds; acquisition candidates; or blue-ribbon technology innovators. We'll keep an eye on all of them as the year continues.

The Year's Winners -- So Far
Highlighted top stocks of 2004
Company % Change YTD Price/Sales Ratio March 16 Close Market Cap
Danielson Holding (DHC:NYSE) 217.87 1.12 $9.25 $283 million
Elan (ELN:NYSE ADR) 144.99 7.49 $16.88 5.8 billion
TRM Corp. (TRMM:Nasdaq) 68.46 1.01 $14.37 100 million
Sprint PCS (PCS:NYSE) 51.42 0.72 $8.51 8.9 billion
Fremont General (FMT:NYSE) 59.43 2.63 $26.96 1.9 billion
Research In Motion (RIMM:Nasdaq) 39.32 15.59 $93.11 7.3 billion
Congoleum (CGM:NYSE) 210.29 0.08 $2.11 17.5 million
Source:Source: MSN Money

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Danielson Holding, TRM Corp. and Congoleum to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at At the time of publication, Markman had positions in the following securities mentioned in this column: TRM Corp., Fremont General and Starbucks.

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