How does one go about finding stocks that have future potential for increased sales and earnings? You can read the usual financial journals and newspapers and watch CNBC and Bloomberg for tips on what Wall Street thinks is hot, or you can take a contrarian approach and buy stocks that may not have yet garnered the interest of analysts and before the stock has appreciated in price. So how to you find these undiscovered gems?

One approach is to buy a company that has a great new product. For example, years ago I read an interview with one of Oprah’s friends (it might have been her best friend Gayle) who waltzed in to Oprah’s office showing off a pair of snazzy new running shoes made by an innovative newcomer into the athletic footwear business called Reebok. She raved about how much she liked them. According to Gayle, “Oprah was so impressed that not only did she buy a pair of shoes, she also bought the stock.” And, as they say, the rest his history. Oprah is not only the queen of talk, she’s an astute businesswoman as well.

Jim Cramer, on his show Mad Money, expanded on the “buy what you know and like” idea. He says that if you love a new product and see it flying off the shelves, that’s a signal to buy the stock. Jim is a contrarian when it comes to reading financial news. He claims that the best ideas out there aren’t in the financial section of the newspaper, but in the others such as the Arts & Entertainment and the Style sections where if you read a headline that goes something like “Ugly Plastic Shoes a Hit with Macy’s Customers” you might want to check into it further. (You know I’m talking about Crocs.)

Once you unearth a new company with an exciting product, what do you do next? Let’s look at a company I found yesterday while reading the National Enquirer. No, I don’t buy it but Fifi does. She especially likes the issues that feature photos of celebrity cellulite and plastic surgery gone wrong. But I digress…

While flipping through it eschewing the endless melodrama surrounding Brittany Spears and her family (clearly her parents don’t know how to discipline their children), I happened upon a blurb in the health section touting “an amazing libido-boosting drug for women” called LibiGel which is a testosterone based cream that’s applied to the arm. Apparently, Phase II clinical trials have been extremely positive and the drug is now undergoing two Phase III trials to determine safety and efficacy. The product is just one of many hormone-based drugs under development by a small pharmaceutical company called BioSante (NASDAQ: BPAX) LibiGel is expected to be up for FDA approval and launch by the end of 2010 or early 2011.

Researching BioSante this morning, I found many things to like. This isn’t a one-trick pony company where the success of it’s sole product could make or break it; it has many other products to offset a loss. (See my anecdote at the bottom.) Looking at the balance sheet, earnings have been rising over the past several years, it has an attractive profit margin and return-on-equity (21.7% and 15.3% respectively), and it holds no debt. More importantly, company insiders have been gobbling up the stock buying over 100,000 shares since December. The fact that Wall Street hasn’t glommed onto yet is reflected by the fact that less than 8% of the stock is owned by institutions, most notably Dimensional Fund Advisors who own about 2% of the outstanding shares divided among a half dozen of their small-cap funds. The people who run Dimensional’s funds are no dumb cookies–I pay attention to stocks they own. Calpers and Vanguard also have signficant holdings.

Technically, the stock has been trading in the $3.50 to $4 range. (Actually, the chart is a pretty good example of a channeling stock.) It bounced off of its $3.50 resistance level yesterday and is up over 2% today. Okay, say you like the stock and you think that the product will be a smashing success. The $64,000 question is: When should I buy it? For that, I don’t really have a definitive answer. You could buy it today at a relatively low price (historically speaking) expecting that perhaps nothing will happen for a year or two. You could buy it when it breaks above its $4 resistance. Or you could wait until the Phase III trials are completed next year and buy if the results are positive. If my crystal ball wasn’t on the blink I could give you a better answer. One reason to buy it earlier rather than later is the success of the Phase II trials could possibly entice a larger company to either invest a significant amount of money into the company or just take it over outright. That would be a slam-dunk!

I hope this example has opened your eyes to other sources of stock inspiration. Next time you’re stuck in the check-out line at the grocery store, pick up a tabloid and skim through it. If you don’t get waylaid by the cellulite photos, you just might find a golden nugget in the slag.

Valuable Anecdote: Last year a friend of mine was really excited about a company called Northfield Labs (NFLD) and urged me to buy it. The company had developed a red-blood cell substitute for use in trauma cases involving significant blood loss called PolyHeme, but as it turned out, PolyHeme was the company’s ONLY product. I pointed that fact out to him but he wouldn’t listen, claiming that the product was great! blah blah blah and there’s no way the stock won’t triple. “Maybe if you’re nice to me I’ll let you ride on my yacht when I buy it from the proceeds,” he gloated.

I didn’t buy the stock. As I said, I’m very cautious about one-trick pony companies. Well, he did have his comeuppance because last December Northfield announced the results of their Phase III clinical trials which showed that the use of PolyHeme significantly increased the number of deaths as compared to the control group. On the day of the announcement the stock opened at $14.33. The day following the announcement the stock opened at $5.81. Oops. Northfield is currently trading around $1. Guess my friend will have to settle for a rubber ducky, but it really is my loss–I was looking forward to taking a long cruise on a big boat.

Posted by Dr. Kris at 1:10pm PST

I’m at half-time watching the Super Bowl. Dimitri was conscripted to do some back-testing, but is nowhere to be found. Fifi is out somewhere with her current beau, probably chiding him that he knows nothing of fine cuisine. (Her paramours don’t seem to last long.) So, I’m left to my own devices, looking at charts. Like Tom Petty, who is singing at the moment, I’m “Free..Free Falling.”

Right now I’m looking at charts of penny stocks. Looking at how they are bid up and down. I know that in penny stocks there’s a lot of manipulation, not only on the part of market makers trying to drum up interest in the stock, but also with traders looking to make a quick kill. It doesn’t take a lot of capital to move penny stocks. But with the gazillions of bucks behind major brokerage firms, I’m sure they’re doing the same thing, only with on a bigger scale. Being a chartist, I see that reflected everyday in the price movement, and if these price manipulations were illegal, even if the SEC had all of the attorneys in the world, it still couldn’t prosecute everyone. Even if they could, we’d have to build a prison the size of Montana to house all the offenders.

I remember the Enron scandal and the oil futures going crazy. The Los Angeles Times did an article on “The Bunny Slipper Lady,” the woman who worked out of her Long Beach condo (presumably in her bunny slippers hence her name) who was part of the Enron scandal. She was a skilled futures trader employed by Enron and others to make money for them. What she did wasn’t ethical, but it wasn’t illegal, either. The funny thing is that what she was accused of is done on Wall Street all the time. Her only error was that her clients finally got caught and went down in a spectacular flame of publicity.

The LA Times journalists had as much of a hard time understanding her manipulation of the futures markets as did the courts. I don’t know what they couldn’t grasp–her technique was pretty simple: buy low, sell high. On Wall Street, her fantastic profits would have granted her a partnership, a corner office, and, possibly, a cool house in the Hamptons. She was calculating, informed, experienced and manipulative–all cornerstones for success in the investment world.

What she had at her disposal was a lot of money. What she did was wake up in the morning (presumably in her bunny slippers–ha ha! LA Times!), watch the oil futures market, and, at the right times, start buying in dribs and drabs. Eventually someone on the sparsely populated futures floor (we’ll call him Mr. Market) would scratch his head and think, “Hey, there’s some interest here. I don’t know what, but something must be going on. I’ll be smart and buy now before the price goes higher.”

He buys more and Ms. Bunny Slippers buys more. The movement attracts the attention of other Mr. Markets and they jump on the bandwagon. Because of the escalating buying pressure, the price starts going up. Thus, the futures are bid up to an unreasonable price for no apparent reason other than people are buying.

That’s when Ms, Bunny sits back, kicks off her slippers, runs her fingers through her hair, and says, “I am woman, hear me roar!” She starts selling her positions for a tidy profit as the oil market starts to tank. If she performed her act well enough, she made a ton more on the way down than on the way up. Buy low, sell high.

Ms. Bunny Slippers did this for a good while. And nobody caught on to it. As the Enron scandal devolved, her actions finally came to light but she wasn’t convicted of anything because technically she didn’t do anything wrong. What she did was unethical, but it wasn’t ruled to be illegal. This type of thing is what Wall Street is made of. Buy anything saleable (whatever is mispriced and/or hot at the time), artificially run it up, then, on the basis of this fantastic run, sell this over-priced dog to your clients and pocket the profit. I’m wondering how many unsuspecting victims have been snookered into buying into their brokers’ recommendations at, or near, a stock’s high only to see their investment subsequently lose value? In his famous and hilarious book Liar’s Poker on bond-trading at Salomon Brothers during the late 70s and 80s, Michael Lewis says that this type of stuff was done with regularity by the firm’s bond traders.

The moral of this musing isn’t anything more profound than caveat emptor: Let the buyer beware! The point of my relating this story is so that you, the individual investor, can be armed with this knowledge before you act on any investment advice. Knowledge is, indeed, power.

Super Bowl update: Congrats to the Giants. Who knew the game would be this exciting? After you read this, I hope you’ll be more circumspect. As Tom Brady is now saying during the post-game interview, “You need to have the ball in your hands.”

I hope I’ve tossed the market ball into your hands. At least, you’ll have a heads-up, and not be free-falling like Tom Petty.

Posted by Dr. Kris at 11:53am PST

Unless you’ve just crawled out of a cave, you know that Microsoft has today made another bid for Yahoo. The proposed deal is worth $44.6 billion which translates into $31 a share for Yahoo. Wall Street analysts hailed the move, but the merger is fraught with anti-trust issues both here and overseas. In other words, it’s not a done deal. However, if you think that it’s likely to happen, then you might want to pounce on writing a covered call on Yahoo.

As I write this at 10:30am PST, Yahoo is trading around $28 and still climbing. Writing an April 30 call that is currently being bid in the $1.50 – $1.60 range would yield an assigned return of around 12% and an unassigned return of over 5% if the stock doesn’t move between now and expiration. I generally only write calls one to two months out max, but in this case, choosing the April call is the right move given that the merger is probably months away. The worst case scenario is that the regulatory hurdles prove too much and the deal falls through. Yahoo shares take a nasty tumble, and you’re left with a loss, but at least not as large a one as if you just owned the shares. The covered call provides some downside insurance. The break-even point is the price you paid for the stock less the price of the call.

As I keep mentioning, if you’ve never traded options, please do not attempt this or any options strategy.

Ya-hooo!!!

Posted by Dr. Kris at 10:52am PST