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Where to find winning small cap stocks in a rough market

This Canadian small cap specialist has a well-defined approach to stock selection — look for strong sectors and you’ll find the best picks.

We’re just as tired as you are of watching the markets scramble up, then tumble back down. We’re equally appalled at the apparently bottomless pit of poisonous credit that lies in wait for more victims.

But we are determined to look for the silver linings that are out there. There are always winners in the market. It’s just a matter of knowing how to look for them.

According to one Canadian small cap specialist, the solution starts with a simple proposition. Look for well-defined areas of growth and you’ll find a much better selection of stocks that will grow.

Of course in the small cap world, you’re going to uncover stocks that the market probably hasn’t recognized yet. To recognize the ones with the right stuff, we turn to KeyStone’s Small-Cap Stock Report for an analysis of some small cap picks that have done well — and another that is expected to join them.

The areas that have paid off for their advisory are a motley group: gambling (the industry, not a wildcat approach to the stock market), infrastructure and construction, Chinese agriculture, and gold and metals.

And because there are exceptions to every rule, there are also a few “special situations,” stocks that are swimming upstream even if their sectors are treading water.

A contrarian position on gambling

Despite its ability to find winners, this advisory is not a beacon of shining optimism. “Because of our negative overall view of the North American markets,” says the editor, “it was our opinion that for above average returns the search would be long and hard, and may involve taking some contrarian positions.”

That led to the selection of two gaming software makers that had been tossed aside by investors after the U.S. Congress passed its anti-Internet gambling bill in October 2006.

But gambling is, for better or worse, a growth industry. And the advisory’s two choices have paid off. Cryptologic Limited (TSX-CRY; NASDQ-CRYP; LSE-CRP), a pioneer in the online gaming industry, is still well below its historical high. But the share price has pushed up in the last two months and stands at $16.32. The advisory keeps it as a buy.

The other gaming firm, Chartwell Technology Inc. (TSX-CWH) makes software applications for the Internet and mobile gaming markets. And it saw its share price grow in a hurry. After it leaped up 64 per cent from its March lows, the advisory moved it to a hold. It trades at $2.20.

Roads, schools, bridges and airports

This advisory was on to the infrastructure boom early. Canada’s roads, schools, bridges, airports, etc. are in urgent need of repair and upgrades, and the governments that must pay for them are in good financial shape.

Its two picks in this field have done well. Structural steel maker Empire Industries Ltd. (TSX/V-EIL) has tripled its capacity in the past 18 months and added a fat contract with SNC Lavalin Constructors Pacific Ltd. It trades at $0.51 and remains a buy.

Global Railways Ltd. (TSX-GBI) has done even better. With its ability to supply North America’s rebuilding railroad and commuter systems, it performed well throughout 2007. And now it has won a landmark 5-year contract to redo a fleet of 53 VIA Rail locomotives. It’s a long-term buy, trading at $3.81.

Chinese forests and fertilizer

What, on the other hand, do Chinese farmers and foresters have to do with Canadian investors? A lot, since several of the country’s leading agricultural firms are actually Canadian companies. That includes the biggest forestry firm in China, Sino-Forest Corporation (TSX-TRE) and fertilizer specialist Hanfeng Evergreen (TSX-HF). These two stocks did so well that the advisory decided to take profits.

It still holds shares in potash fertilizer firm Migao Corporation (TSX-MGO) however. Part of the position was sold after the shares ran up above $10, then went down. They currently trade at $7.74.

There’s still another fertilizer group this advisory likes. China Agritech (OTC-CAGC), which trades in New York, makes organic-release fertilizers. It has traded as high as $6.25 and as low as $2.00 since it was first selected. KeyStone’s makes it a Speculative Buy in its current range: it closed at $2.53 yesterday.

In gold and metals, the advisory has an interesting pick in mining services. Nordex Explosives Ltd. (TSX-NXX) is a “micro-cap winner” that blows things up for the mining, quarry and road construction industries. It posted strong year-end results and its revenues have gone up for six years in a row. It’s small and not very liquid, cautions the advisory, but it’s definitely a buy. It trades at $0.68.

The advisory has a recent addition to this list of up and coming small caps. This is decidedly a “special situation.” It’s a company with “paper” in its name that isn’t one of the victims in the battered forestry sector.

Counterfeiters and other fraudsters

Fortress Paper Ltd. (TSX-FTP) only completed its initial public offering (IPO) in the summer of 2007. Headquartered in Vancouver, it’s an international producer of security and other specialty papers. Security papers happen to be much in demand these days, thanks to the growing sophistication applied by counterfeiters and other fraudsters.

The company’s Landquart Mill in Switzerland has been turning out all of Switzerland’s bank notes since 1979, and makes bank notes for 25 other countries as well. It has also developed exotic-sounding security products with names like the biometric e-passport, the LQard identification card and the Q-Check verification system.

The firm’s other mill, the Dresden in Germany, deals in a more mundane but equally necessary form of paper, coated and uncoated wallpaper base. Its non-woven wallpaper is taking over from traditional wallpapers because it’s easier to apply. While the market for wallpaper is relatively flat, Fortress is winning a much larger share of that market.

Fortress had “impressive” fourth quarter results, says the advisory, and expects even higher growth, especially with the introduction of new products. The IPO was at $8.00, and KeyStone’s Small-Cap Stock Report liked the stock’s valuation at $6.70, which is less than 10 times annualized earnings. But in the brief time since this report was issued, the stock has shot up to $8.55. Somebody out there agrees that this is indeed a special situation.

The markets may look miserable again, but maybe this advisory has the right antidote. Keep your eye on the small picture, the little stocks that are making their way up, and don’t let the big guys get you down.