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To gamble or not to gamble with small cap stocks

More stocks will go down than up in 2008, says this small cap specialist, but online gaming stocks may bring investors a jackpot.

It has always been our contention that investing and gambling are not the same. Putting your money into a stock you’ve carefully considered and drawing to an inside straight with a large pile of chips on the table are two fundamentally different activities.

(On the other hand, if you got a great tip from somebody at a party and called your broker before giving it a sober second thought, we take it all back.)

But you can certainly invest in other people’s gambling, and one Canadian advisory thinks that’s not a bad idea in a market in which there isn’t a whole lot you can rely on.

The online gaming phenomenon has grown by leaps and bounds, says KeyStone’s Small-Cap Stock Report, and two Canadian firms appear to be staying ahead of the game, especially after withstanding a blow from the U.S. Congress.

The advisory also likes the prospects in the infrastructure and construction industries, and updates two stocks it is following in that area of growth.

And if investors have to sift carefully through badly shaken markets to find good stocks, this advisory doesn’t think that’s entirely a bad thing. There are some advantages to looking for needles in haystacks.

Dead cat bounce

The editor of KeyStone’s Small-Cap Stock Report believes that the U.S. Federal Reserve Board’s decision to make two quick rate cuts was not really in the best interest of investors.

In his opinion the resulting rally was a “dead cat bounce” rather than a sign of sustainable strength. The advisory will continue “to look outside the box to find positive returns in 2008 — a year we expect going in to present far less opportunities, broadly speaking, for positive gains.”

The stimulus package may warm the hearts of consumers enough to loosen the purse strings, adds the editor, but that is a false solution. It’s like a stiff drink of alcohol after a night of partying, which “may make you feel better in the short term, but it’s still long-term poison.”

Letting the U.S. economy slip into a mild recession may have been a good thing. In fact, it might have forced American consumers to start adopting the responsible strategy of paying down debt rather than using their homes as ATMs as they have for the past five years.

Fortunes are made in down times

“Heading into 2008, we believed that six straight years of market gains were unlikely and that, broadly speaking, more stocks would go down than up in 2008.”

But this is not say that there will not be opportunity, adds the editor. “In fact, when the herd is selling, the savvy investor can pick up some great long-term bargains. One must remember that fortunes are most often made in down times, not when all is rosy with the world.

“It is a true stock-pickers’ market and we will continue to turn to a few ‘Pockets of Strength’.”

One of these is gambling.

Staking a claim

We should acknowledge at the outset that there is an ethical issue. As with tobacco and alcohol, some may not be comfortable investing in gambling. That is strictly an individual choice, of course.

There is no doubt, however, than online gaming is a growth industry. The first site was launched in 1996 and the explosion of the phenomenon has pushed it into uncharted territory.

“As with many e-commerce businesses, the growth has outpaced the laws governing the activity,” says the advisory. This has caused a number of firms to drop out of the game. But companies that can handle this turbulent business environment “are able to stake a claim to the large and growing pie of revenue.”

The biggest blow to the industry was the Internet Gambling Enforcement Act, passed in a late-night session by the U.S. Congress and signed into law in October 2006 (the same month as our Finance Minister’s income trust tax announcement — it was a great time for clamping down, apparently).

The act made it illegal for any U.S. financial institutions to process transactions from online gaming sites. And the U.S. accounted for over half of total online gaming revenues. Not surprisingly, online gaming stocks fell 50 per cent overnight.

But the act was not without controversy. The World Trade Organization declared it illegal, since Americans were still allowed to bet on horse and dog racing with American online firms. The European Union agreed to compensation for revenue lost to the ban.

A bill to overturn the ban is currently before Congress. This bill would more effectively regulate online gambling in the U.S. rather than banning it across the board. It is now before a special committee, and no timetable for its possible enactment can be set.

Double the growth

Online gaming companies have shifted their focus to Europe and Asia where regulations, not bans, are in effect. This is probably the wave of the future, says the advisory, especially when you consider how many Americans have found ways to circumvent the ban (it’s the bathtub gin of the 21st century — prohibition is never easy to enforce).

The industry is certainly not shrinking. Its estimated value today, excluding the U.S., is over $7 billion. Growth should double that figure by 2012.

“Companies able to navigate through the challenging landscape and seize advantage of the growth coming out of the burgeoning middle class in Asia and continued growth in Europe stand to make a lot of money for their shareholders.”

This advisory has two such Canadian companies in mind. One is a battle-tested survivor, the other a growing concern.

Playing its cards right

Cryptologic Limited (TSX-CRY; NASDQ-CRYP; LSE-CRP) was a pioneer in the development of online gaming. It was founded in 1995 and listed on the TSX in 1998. As you can see by its ticker symbols, it draws shareholders internationally, even in the U.S., whose citizens can invest in online gambling, even if they can’t do it.

The company provides online gaming sites with the software they need, in many languages and currencies. Its clients include the ever-popular power poker rooms as well as over 200 casino and multi-player bingo games. The clientele reads like a who’s who of international gaming: InterCasino, Playboy, William Hill and Littlewoods Gaming.

Cryptologic played its cards very cannily even before the U.S. ban came down. Anticipating the move, it began shifting its revenue stream away from the U.S. When the bill was signed into law, Cryptologic already had 70 per cent of its revenue coming from outside the United States.

This could not completely deflect the blow from Congress, as the company suffered unavoidable losses in revenue. But Cryptologic has recovered, and quarter-over-quarter revenue and profit growth are beginning to surface once again.

“Cryptologic has weathered the storm,” says the advisory, “and management is optimistic to return to pre-Act performance numbers and targets, which includes 20% revenue and net income growth year over year. The company is a leader in its markets and has developed important relationships with its blue chip customers.”

Trading at $16.05 when this issue went to press, the shares opened today at $17.80.

From mobile games to soft games

The next Canadian firm on the advisory’s list is a Speculative Buy. Chartwell Technology Inc. (TSX-CWH) makes and markets software applications for the Internet and mobile gaming markets (i.e., gambling on handheld mobile devices).

Chartwell was first into the market with commercially usable Java-based gaming systems and also turns out Flash-based products. It offers online casino, bingo, poker and soft games (basically, pure chance gambling games, like online scratch cards). These are licensed to clients for integration into their existing software.

When the Gambling Enforcement Act came down in October 2006, Chartwell was not directly affected, since it served the European market. But it still suffered collateral damage, since most of its customers had some connections to the U.S. market.

The plan for growth at Chartwell includes working greater liquidity into online games to attract more players, developing poker game variants and increasing its market share by adding new products and diversifying those it has. Following the inevitable fourth quarter hit in 2006, Chartwell has chipped in with three consecutive quarters of profitability.

“The company trades at attractive valuations,” says the advisory, “and has a strong balance sheet, which includes a cash balance of $14.1 million and no debt. The industry continues to consolidate as larger operators look for growth through acquisition; this along with the recent adoption of a shareholder’s rights plans leads us to believe that Chartwell may be an acquisition target in the future.”

The shares stood at $1.45 when the advisory went to press. They opened today at $1.68.

Needed improvements

We conclude by leaving the poker game and heading over to the construction site (not that you couldn’t find a poker game on most construction sites).

KeyStone’s Small-Cap Stock Report believes that another “Pocket of Strength” investors should examine closely is infrastructure. “After years of underinvestment and neglect, bridges, schools, roads, airports, etc. are in dire need of upgrades and repair. Within Canada, and in particular, within Western Canada, governments are in far better shape than in decades to pay for these needed improvements.”

The last time we visited this advisory (Daily Buy Sell Adviser, January 16), it had two stocks in this area to recommend. It still likes them.

Empire Industries Ltd. (TSX/V-EIL) makes structural steel, modules and plate steel that are used in tanks, vessels, bridges, pipes and oilfield production equipment and elsewhere. With limited capacity in western Canada to fulfill large complex projects, this steel fabricator is in an excellent position to grow.

A month ago, it traded at $0.43. It opened today at $0.55.

Global Railways Ltd. (TSX-GBI) is an indirect participant in the infrastructure boom, as a supplier of products and services to the North American railroad and commuter systems which are in crying need of an overhaul. It recently signed a fat contract to remake a fleet of 53 VIA Rail locomotives, “a landmark contract,” from the advisory’s point of view.

$4.60 a month ago, Global opened today at $4.65.

We still insisit that investing isn’t the same as gambling. Even investing in a gaming stock isn’t the same as gambling. Others do the gambling, you take the profits. They fold, you hold. What could be a better bet than that?