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Stock Strategist

The Babe Ruth Portfolio Flexes Its Muscles

We pitch two more small-cap stocks and update our portfolio's performance.

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With the second half of the baseball season in full swing, we thought it would be fitting to pitch two more 5-star small-cap stocks and to update you on the performance of our Babe Ruth Portfolio.

As we discussed in our first article, "Bat Like Babe Ruth," 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.

Unlike baseball players, investors are not limited to fourbaggers. There are opportunities for investors to make 10 times their money or even more. Peter Lynch credits such tenbaggers for his remarkable run as Fidelity's manager of the  Magellan Fund  (FMAGX), which was the best-performing fund in the world under his leadership from May 1977 to May 1990. In his book "One Up On Wall Street," Lynch says: "The more right you are about any one stock, the more wrong you can be on all the others and still triumph as an investor." We couldn't agree more and will continue to search for potential tenbaggers.

Two New Picks
 
Fuel Tech  (FTEK)
Business Risk: Average
Economic Moat: Narrow
Price/Fair Value Ratio*: 0.63
Consider Buying: $40.90 or below
Consider Selling: $66.40 or above
We're very bullish on Fuel Tech, which has grown quickly in recent years to become a leading provider of clean energy technology and solutions to the engineering industry. We thought this sounded like an interesting opportunity when analyst John Kearney highlighted it as a compelling investment idea several months ago. And while the stock has appreciated handsomely since then, we now think there's even more potential for growth. This air pollution control and slag reduction company recently formed a partnership with Itochu, which could accelerate the firm's ability to sell its products into the large Chinese market. While competition could emerge that would call Fuel Tech's position into question, we think there is a lot of potential in this narrow-moat firm.

 Vimicro International ADR  (VIMC)
Business Risk: Above Average
Economic Moat: None
Price/Fair Value Ratio*: 0.54
Consider Buying: $6.40 or below
Consider Selling: $12.10 or above
We're also excited about the prospects for Vimicro, despite a difficult first quarter. The firm's multimedia chips are used in webcams and mobile phones, and Morningstar equity analyst Andy Ng thinks Vimicro's chips could have advantages over those of its competitors. The firm dominates the webcam market with a 60% share and has been working to diversify into other areas with its technology as well. We think there's a lot of growth potential for this company, and the downside seems relatively limited, given that the firm has more than $3 per ADR in cash on its balance sheet. It remains possible that the firm may not recover from the weakness that plagued it during the first quarter, but we like the risk/reward opportunity, given the firm's solid cash position.

* Based on closing price as of July 18, 2007.

Performance Update
We're happy to report that since inception on Feb. 27, 2007, the Babe Ruth portfolio has delivered a total return of 33.1% through July 18, easily surpassing the S&P 500 and Russell 2000, which finished up 11.3% and 7.2%, respectively, over this period. As you'll notice in the table below,  James River  (JRCC) and  Cheniere  (LNG) continue to shine.  Radware's  (RDWR) stock, one of three picks featured in our last article, is also off to an excellent start.  Angiotech's (ANPI) shares have delivered a modest gain, but are still trading at around half of our fair value estimate.  Ruth's Chris  (RUTH) and  Bank Atlantic  (BBX) have been the laggards in our portfolio, but we remain bullish on both of these companies.

While we are pleased with our portfolio's results, this is a very short time horizon of just over four months. Small-cap stocks tend to be volatile, and we wouldn't be surprised to see significant fluctuations in their share prices. We continue to see further upside in all six of our stocks, but we would note that both James River and Cheniere are now trading above our "Consider Buying" price.

 Babe Ruth Portolio: Performance Update
Company Name
(Purchase Date)
Shares Cost ($)** Market
Value ($)***
Total
Ret (%)
Price/Fair
Value***
Star Rating***

James River Coal (JRCC)
(2/27/07)

1,455 9,994.25 15,772.20 57.8

72.3%

Cheniere Energy (LNG)
(2/27/07)
362 9,982.43 14,613.94 46.4 79.2%
Radware (RDWR)
(5/10/07)
804 9,990.59 11,666.04 16.8 72.6%
Angiotech (ANPI)
(2/27/07)
1,499 9,996.29 10,672.88 6.8 50.9%
Ruth's Chris (RUTH)
(5/10/07)
554 9,990.49 9,711.62 -2.8 62.6%
Bank Atlantic (BBX)
(5/10/07)
1,056 9,992.15 8,257.92 -17.4 52.1%

Total*
  59,946.20 70,694.60 33.0    
* Total return for the portfolio is calculated using time-weighted return.
** Based on closing price as of the date of purchase times number of shares plus $12.95 commission.
*** As of 7-18-07.

Methodology
We've assumed that almost $10,000 was invested in each of our initial positions, based on the closing price of each stock on the eve of the publication in which we first recommended buying the stock. We've also assumed that each of our transactions costs us $12.95, a standard online commission rate. In calculating our portfolio's total return, we've used a time-weighted calculation, which is a common performance methodology applied by mutual funds.

Heather Brilliant contributed to this article and has a position in the following securities mentioned above: RDWR

John Owens does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.