Bat Like Babe Ruth with These Three Small-Cap Stocks

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 your 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.

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

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.
Full Analyst Report: James River Coal

 Angiotech Pharmaceuticals 
Business Risk: Above Average
Economic Moat: None
Price/Fair Value Ratio*: 0.43
Consider Buying: $10.20 or Below
Consider Selling: $19.30 or Above

As one of few firms focused on combining medical devices with pharmaceutical products, Angiotech is well positioned to take advantage of the convergence between these two treatment media. Health-care companies are looking for better and more specific ways to treat patients, and products like drug-eluting stents have become increasingly popular. Angiotech helped develop Taxus, the drug-eluting stent sold by  Boston Scientific (BSX) for the treatment of clogged arteries, and receives royalties on sales of Taxus.

Some new data has recently called into question the safety of drug-eluting stents, and this has dealt a severe blow to Angiotech's stock price. However, analyst Julie Stralow thinks that sales of Taxus will stabilize now that the Food and Drug Administration has weighed in with its opinion that drug-eluting stents are safe and effective for most patients, especially with long-term use of a blood thinner after the procedure. Further, she places $5 per share of value on the rest of Angiotech's pipeline, the results of which should start to benefit the firm's bottom line in the next few years. The risks are not small when dealing with health-care pipelines, and Angiotech's balance sheet sports a hefty amount of debt for the time being. But we think the potential reward will outshine these risks.
Full Analyst Report: Angiotech Pharmaceuticals

 Cheniere Energy (LNG)
Business Risk: Above Average
Economic Moat: None
Price/Fair Value Ratio*: 0.55
Consider Buying: $32.50 or Below
Consider Selling: $61.50 or Above

Backed by a belief that a  natural-gas shortage is imminent in the U.S., Cheniere Energy has been making a substantial investment in building liquefied natural gas terminals, including three wholly-owned proposed terminals and a 30% stake in a fourth terminal. While there are more than 20 such terminals proposed in and around the Gulf of Mexico, Analyst Justin Perucki believes that Cheniere is best positioned. The company has already presold capacity (at an attractive return, by his estimates) to high-quality customers like ConocoPhillips through long-term contracts at two terminals expected to be operational by the end of 2008. The company also plans to sell a portion of capacity at its other two terminals, but it is reserving the remainder in an attempt to generate even higher fees from spot cargo, short-term contracts, and other arrangements.

Based on the long-run fundamentals of natural-gas supply and demand in the U.S., Perucki estimates that Cheniere's shares are worth $51, nearly double the current share price. There are sizable risks with this investment, including the possibility of construction cost overruns, increased competition, supply-chain delays, and a long-term collapse in natural-gas prices. But once again, we like the trade-off here between the potential risk and reward.
Full Analyst Report: Cheniere Energy

* Price/fair value ratios were calculated using fair value estimates and closing prices as of Feb. 23, 2007.

Heather Brilliant contributed to this article.