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Stock Strategist

The Babe Ruth Portfolio Takes a Big Swing

We make a purchase and update our small-cap portfolio's performance.

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With the World Series a week away, we've decided to get in the mix by taking a swing at specialty retailer  Finish Line (FINL). We believe this stock has home-run potential. 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 than your batting average on your future performance. We think that stocks with market values below $2 billion can offer exceptionally fertile ground for finding home-run opportunities. (For breaking news and updates on the Babe Ruth Portfolio, be sure to sign up for our free e-mail alerts.)

After reaching a high of $23.55 in March 2005, Finish Line's stock price has fallen more than 80% to its current level of around $4. The stock initially became cheap in late 2006 after a severe drop in operating margins following a missed fashion trend. But, after announcing plans to acquire casual shoe retailer and competitor  Genesco (GCO) this summer, the stock fell even further. Analyst Brady Lemos believes Finish Line is overpaying for Genesco and thus destroying a lot of value. But, even after accounting for this, Lemos' $10 fair value estimate is more than 2 times the current stock price.

Like several of the stocks in the Babe Ruth Portfolio, Finish Line carries a lot of risk. First, it operates in a tough business where competitive advantages are nonexistent and customers are fickle. Second, there's integration risk with Genesco. Meshing corporate cultures, staff, and operations is almost always more difficult and costly than management expects. Lastly, Finish Line is taking on a significant amount of leverage to buy Genesco. Total debt/EBITDA could be approximately 5 times when the deal closes. This increases potential returns to shareholders but also brings considerable financial risk. Furthermore, the debt terms may change before the deal is closed, as the lead creditor,  UBS (UBS), has been dragging its feet following the credit market shakeup.

Although the aforementioned risks could force Finish Line into bankruptcy, we feel that outcome is unlikely, and the potential upside is high enough to warrant an inclusion in the portfolio. The current $10 fair value estimate is based on some conservative assumptions--6% top-line growth and 5.5% operating margins--in our opinion. If we assume slightly better sales growth and operating margins closer to the historical level of 6.5%, the stock could be worth more than 3 times its current price.

Performance Update
The market turbulence over the past two months has caused the Babe Ruth portfolio to give back some of its gains. But we remain comfortably ahead of our benchmark, the Russell 2000. Since inception on Feb. 27, 2007, through Oct. 17, the portfolio has delivered a 25.2% time-weighted total return (which is independent of the amount of cash flows invested over time), versus 4.9% for the Russell 2000. Our raw return on the portfolio is positive 6.7%, as our portfolio's performance since adding additional positions has not been as strong.

 Babe Ruth Portfolio: Performance Update
Company Name
(Purchase Date)
Shares Cost
($)**
Value
($)***
Total Ret
(%)**
P/FV
(%)****
Star
Rating****
Cheniere Energy (LNG)
(2/27/07)
362 9,982.43 14,403.98 44.29 72.3
Radware (RDWR)
(5/10/07)
804 9,990.59 13,266.00 32.78 82.5
Angiotech (ANPI)
(2/27/07)
1,499 9,996.29 11,302.46 13.07 53.9
James River Coal (JRCC)
(2/27/07)
1,455 9,994.25 10,548.75 5.55

111.5

Fuel Tech (FTEK)
(7/20/07)
304 9,978.07 10,190.08 2.12 63.2
Vimicro (VIMC)
(7/20/07)
1,849 9,997.55 9,707.25 -2.90 52.5
BankAtlantic (BBX)
(5/10/07)
1,056 9,992.15 8,279.04 -16.71 52.3
Ruth's Chris (RUTH)
(5/10/07)
554 9,990.49 7,539.94 -24.53 48.6
Cash*     43.30      
Total**   79,921.82 85,280.80 25.2 68.9%  
* Cash received from BankAtlantic dividend.
** Total return through 10-17-07. Total return for the portfolio is a time-weighted return.
*** Based on closing price on date of purchase times number of shares plus $12.95 commission.
**** Price/Fair-Value and Star Rating as of 10-17-07.

We like to remind folks that small-cap stocks are inherently volatile, and we wouldn't be surprised to see a significant amount of volatility in the individual stock prices of our holdings. In fact, shortly after the initial publication of this article at 6 a.m. on Oct. 19,  Angiotech (ANPI) cut its outlook for 2007, resulting in a more than 30% decline in the stock price (which would reduce our portfolio's total return since inception to approximately 20%). Analyst Julie Stralow is digesting this latest news and will provide an update shortly. To keep abreast of the situation and our take on it, we'd encourage you to sign up for our free e-mail alerts. We plan to send out an alert on Angiotech early next week.

Angiotech is not the only stock to have experienced volatility in our portfolio.  James River Coal (JRCC) dropped nearly 45% on a single day in early August after turning in abysmal second-quarter results (the portfolio was actually up for the day, despite this). Analyst Michael Tian subsequently cut James River's fair value estimate to $6.50 from $15 after reviewing his assumptions. We warn investors that our confidence interval around the fair value of this stock is extremely wide--a 50-cent variance in gross margins per ton swings our fair value estimate by about $1.50--or 25%. With the stock currently trading above its fair value estimate, we're keeping it on a short leash, and we may consider selling if operating performance continues to weaken. If we do, you'll be among the first to know by signing up for our free e-mail alerts.

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 it. 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.

John Owens, CFA, CPA, contributed to this article. Owens owns shares of the following securities mentioned above: FTEK

Justin Perucki has a position in the following securities mentioned above: FTEK, VIMC. Find out about Morningstar’s editorial policies.