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Bat Like Babe Ruth with These Three Small-Cap Stocks

We've found some picks with home-run potential.

John Owens, 02/28/2007

Morningstar's 100 stock analysts cover 1,800 companies. Their full analyst reports are available through Morningstar Principia Stocks Advanced and Morningstar Advisor Workstation Office Edition.

Would you rather invest in a portfolio in which more than half the stocks go up, or one in which only 40% of the stocks go up? Well, if you chose the former, you wouldn't be alone, but you might not end up any wealthier. The reason you wouldn't be alone is that people want to avoid losses--so much so that they often feel more pain from losing money than satisfaction from gaining an equal amount of money. The portfolio with fewer winners, however, could have included a few stocks that rose dramatically in value, which frequently results in better overall performance.

This is what Michael Mauboussin, chief investment strategist at Legg Mason Capital Management, refers to in his book, More Than You Know, as the Babe Ruth effect: Even though Ruth struck out a lot, he was one of baseball's greatest hitters. From 1918 to 1934, Ruth led the American League in batting average just once and finished either first or second in strikeouts in 12 of those years. However, the hall-of-famer finished first in slugging percentage (calculated by total bases divided by at bats) for 13 consecutive years due to his home-run-hitting prowess.

Just like the Babe, swatting a few home runs in a portfolio could have a much greater impact on your future performance than your batting average. We think that stocks with market values below $2 billion can offer exceptionally fertile ground for finding home-run opportunities. After all, most large, successful firms could have been purchased as small caps when they first got started. With that in mind, we're highlighting three small-cap stocks with home-run potential.

Of course, you could end up striking out with one or more of these stocks (each has an above-average risk rating), but a substantial rise in just one could very well lead to superior investment returns. Given that risk profile, we'd recommend considering a portfolio of small-cap stocks; this will help diversify some of the stock-specific risk, and if things turn sour, it will prevent any one stock from taking too big a bite out of your portfolio.

James River Coal JRCC
Business Risk: Above Average
Economic Moat: None
Price/Fair Value Ratio*: 0.41
Consider Buying: $12.10
Consider Selling: $22.90

The outlook for coal producers is certainly compelling. Natural gas is quite expensive, and coal-fired plants are running flat out to take advantage of wide margins. In addition, demand for coal should rise as new coal-fired capacity comes online and as existing bottlenecks with railroads get resolved, allowing for smoother delivery. These factors should add up to solid demand growth for coal over the next several years.

Analyst Elizabeth Collins believes that James River Coal, which emerged with a fresh start from bankruptcy in 2004, should benefit from these strong industry fundamentals. She pegs the value of James River's shares at $19, nearly 3 times the current share price. Still, this investment is not for the faint of heart. Collins points out that her fair value estimate is extremely sensitive to coal price assumptions. The company has more leverage than the other coal companies we cover and is also grappling with rising input costs and with increasing competition from producers in the Powder River Basin of Wyoming. Still, the risk/reward balance looks very attractive here.PAGEBREAK

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