Harry Rady   CEO and Portfolio Manager   Rady Asset Management

Comments and Outlook

The economy is healing, but the market hasn’t acknowledged the plethora of risks related to uncertainty in the Middle East, Japan or even the US budget deficit. The Federal Reserve’s second round of quantitative easing will likely end soon, but investors are playing the momentum game, hoping to buy high and sell higher. That’s a myopic and dangerous strategy. It’s time to be cautious.

Recommended Strategies

If investors believe it’s time to be cautious and protect their portfolio, there’s nothing better than the VIX [S&P 500 Volatility Index]. During last year’s Flash Crash and the European sovereign debt crisis, the broad market declined by 14 percent from March to May while the VIX gained 181 percent. There are many ways to play the VIX, but we focus on two exchange-traded notes, iPath S&P 500 Short Term Futures (NYSE: VXX) and VelocityShares Daily 2X VIX Short Term ETN (NYSE: TVIX).

As contrarian investors, we like drug and biotech stocks. Many of these stocks trade at single-digit price-to-earnings ratios because of uncertainty surrounding President Obama’s health care reform. Their balance sheets are clean and people will take their medication no matter what happens in the economy.

What to Buy Now

Research in Motion (NSDQ: RIMM) shares trades at 8 times earnings and 70 percent of the firm’s revenue is garnered overseas. Overseas revenue has grown by 70 percent. Investors have focused on the firm’s domestic sales, which have slumped 12 to 15 percent. The company’s Blackberry line of communication devices is getting its lunch eaten by Apple’s (NSDQ: APPL) iPhone on the high end.

But the real opportunity for Research in Motion is in the emerging markets and the low end. We see at least 50 percent upside to the stock, and it could be an acquisition target.

Flir Systems (NSDQ: FLIR) has a virtual monopoly on the thermal and infrared imaging technologies used by the US military. Although defense budget cuts loom, the US military won’t cut back on its ability to see at night, especially because Flir’s products aren’t very expensive.

The vast majority of the firm’s sales come from the US defense industry. But the real opportunity for Flir is in the commercial and residential security space. Two years ago, Flir’s cheapest product sold for about $25,000 to $30,000. Those same products today cost about $1,500 to $3,000. The commercial and residential market could be 10 times the size of their defense business–that’s a strong secular tailwind. Flir is also a likely takeover target for one of the large defense companies.

Eric Cinnamond  Portfolio Manager  Aston/River Road Independent Value (ARIVX)

Comments and Outlook

We examine operating risk and financial risk when evaluating a small-cap business. Prices for small-cap stocks are at peak levels. Profitability has improved considerably, but margins are high and costs are starting to increase. The Russell 2000 has gained 43 percent since the end of August to April 6, and it’s done so with little volatility. But the greatest sin in investing is to extrapolate into the future. At some point volatility will return.

Recommended Strategies

Small-cap investors should recognize that earnings can be transitory. Avoid cyclical and industrial names in favor of companies with stable free-cash flows. Look for businesses with stable end-markets and stable end-demand. This is not the time to buy companies that are laden with debt. If there was a sector named “boring” or “consistent,” that’s where I’d suggest investors place their money.

What to Buy Now

Core-Mark Holding (NSDQ: CORE) is the No. 2 market leader in distribution to convenience stores serving 24,000 stores nationwide in a fragmented industry of about 145,000 stores.

The convenience store industry has historically delivered sales growth of about 6 percent, which provides recurring revenue and cash flows. The company generates about $35 million per year in free cash flow and has a market cap of about $390 million.

Arden Group (NSDQ: ARDNA) is a high-end grocery chain that operates only 18 stores, mainly located in the Los Angeles area. It doesn’t grow its store base.

The company generates $20 million each year in free cash flow and holds $54 million in cash. The company occasionally pays out an incredibly high special dividend. In 2004 it paid out $20 per share; in 2008 Arden paid a special dividend of $25 per share. The company could pay another special dividend either this year or the next.

We hold a position in one oil and gas exploration and production (E&P) company, Bill Barrett Corp (NYSE: BBG). The company’s stock sells at a discount to what it would cost to replace their reserves. Bill Barrett has 1,100 billions of cubic feet equivalent (bcfe) of proven natural gas reserves.