Today we’re taking a look at an under the radar small-cap stock that has the potential to reward investors with big profits in 2010. I recommended Lancaster Colony (Nasdaq: LANC) in Small Cap Investor Daily on December 4th and since then the stock is up 9%, with more gains on the way. This will be a fun stock to review since the company just reported strong second quarter fiscal 2010 results yesterday (note that the quarter ended December 31, 2009). 

Lancaster Colony won’t knock your socks off, so feel free to sit back and relax while you read this. But the stock should be trading at least 10% higher, and could even rise as much as 28% in the next six months. That should be exciting to investors.  

Our short term stock forecast has two very distinct parts. First, we believe the last week’s sell off we a little out of the ordinary in nature and strength (which is a very good thing for this inflated market) but still has brought us into an over-sold condition. As such we seen the S&P climbing quickly back near the 1,130 level in the next week or so. See intra-day chart below.

Now we all know that State of the Union addresses tend to spur market sentiment for the bulls – all the great rhetoric and speaking gets us all giddy inside. But the truth of the matter is that NOTHING is going right fundamentally. Yes maybe somethings are showing improvement but only because the government is pumping debt in left and right. This is NOT fundamental growth.

In addition, sentiment indicators show that over 85% of all investors are still bullish on the economy and markets – this is a big problem. We all know we should trade away from the herd mentality. With that we offer this opinion: The markets will move back to 1,130 area before hitting a brick wall and starting the slow and painful correction that could last throughout the rest of the year.

On December 4th I recommended a couple of small-cap consumer stocks because they had been passed over by investors who were seeking big returns in more glamorous companies. These two stocks have been good performers lately, so I want to give you an update on each.

The two companies I suggested you pick up on the cheap were National Presto Industries (NYSE: NPK) and Lancaster Colony (Nasdaq: LANC). I branded these two companies as ‘boring stocks’ and praised their attractiveness at that time. Here is what I wrote:

"I’ve been looking at a group of stocks that are about as flashy as a stack of corrugated cardboard boxes.  But don’t let their appearance fool you, inside their drab exterior lies a steady flow of cash.  And investors who are willing to step back from the glitz of high-tech companies and the glamour of Wall Street’s current darlings could be sitting on a boatload of profits in 2010 if they buy shares of boring stocks right now.

That’s because this group of stocks has been overlooked as investors sought higher returns from faster moving stocks.  But after the 60% rise for stocks since March, investors are going to start buying more shares in companies that have underperformed, but still have compelling business models and shares trading at reasonable valuations.  Both large-caps and small-caps in this category should fare well, but I favor small-caps because they typically rise more than large caps."

An old Wall Street adage tells us that the trend is your friend. And when it comes to evaluating potential small-cap investments this certainly rings true. Trends tell us where the company has been, and lend insight into where it is going. They can also help us determine what should be the fair value of a company’s stock, and our price target on shares. We can use two different types of analysis to evaluate trends: fundamental analysis and technical analysis.

Fundamental analysis focuses on data that can be found in a company’s financial statements, and also includes economic factors like the state of the economy and interest rates. If you like this type of analytical work you’re in good company – two of histories best-known investors, Warren Buffet and Peter Lynch, were staunch believers in the method.

I usually discuss small-cap stocks here in SmallCapInvestor Daily, but every now and then we need to be reminded that small-caps follow the broader trends. And last week was that reminder as downward selling pressure around the world drove small-cap stocks lower. So today I want to take a look at what is happening on a macro-economic scale and discuss the implications for small-cap investing.

The catalysts to last week’s plunge were many: U.S. banks reported losses, China raised bank reserves, and Google sparred with Beijing over censorship issues. Also, comments from President Obama calling for greater oversight of our nation’s banks and speculation that Fed Chief Ben Bernanke might not win another term helped send the Dow 436 points lower on the week.

After a moderate up day on Monday, the markets are now moving sideways. Some question the pace of Britain’s recovery after it reported quarterly growth of just 0.1%. And China continues to restrict bank lending. Reports out of the country state that Industrial & Commercial Bank of China was told not to issue any new loans in January. China Citic Bank suspended lending as well.

Option buyer sentiment signals lower prices to come as traders are speculating the S&P 500 Index will fall as much as 3 percent. Wagers that the COBE VIX Index will jump 46 percent to 32.5 were the most-active contract, data compiled by Bloomberg data. A surge to that level may herald a decline to about 1082 for the S&P 500 over the next two months or so.

Above is the most update option buyer sentiment index as of now. It clearly shows how bullish (i.e. foolish) people are right now trading.

Option buyer sentiment signals lower prices to come as traders are speculating the S&P 500 Index will fall as much as 3 percent. Wagers that the COBE VIX Index will jump 46 percent to 32.5 were the most-active contract, data compiled by Bloomberg data. A surge to that level may herald a decline to about 1082 for the S&P 500 over the next two months or so.

Above is the most update option buyer sentiment index as of now. It clearly shows how bullish (i.e. foolish) people are right now trading.

I hope everyone had a good weekend after what was a rather bloody week in the financial markets. The price action was ugly, to say the least, with selling that only accelerated into the close on Friday. I was watching the Russell 2000 small-cap index, which was only down modestly mid-day Friday, but then dropped moving into the close to finish the day down 1.8%. 

For the week, the Russell fell 3.3%. Not too bad actually, considering the Dow dropped 4.1%, the Standard and Poor 500 was down 3.9%, and the Nasdaq declined 4.8%. Like I said on Thursday, I find the Russell’s resiliency in the sell-off to be encouraging for small-cap investing in 2010, since we would usually expect the index to fall more that the large-cap indexes.

I expect the Russell will hold around 620, or risk falling closer to 600. It closed last week at 617, right around my first support line. In the pre-market today, it looks like the major indices will all open higher on news that Fed Chief Ben Bernanke is closer to securing a second term.

With all the research and reports I’ve been putting together lately, I’m a little behind on looking at the stocks you’ve sent in over the last week. So today I’m going back into the mailbag to check out the small-cap stocks you’re thinking about putting into your investment portfolio.

Let’s keep in mind that the markets had a heck of a run in 2009, and big gains in 2010 will be a bit harder to find. This means we really need to find outstanding companies that are growing profits. I firmly believe the more speculative, lower quality companies that have yet to earn a profit will see their stocks under-perform in 2010. With this in mind, let’s go to the mailbag.

Matt W. subscribes to SmallCapInvestor PRO and writes:

“Ian, as a subscriber, I enjoy reading your daily newsletter.  Especially enjoyable is your commentary on your readers’ stock picks.  A company I have been thinking about investing in is ERF Wireless (OTC BB: ERFW), but would like to get your thoughts before doing so.”

I looked up ERF Wireless and found that it is a Texas based company that provides wireless broadband and other communications services in rural areas of the United States. Its primary customers are private residences, businesses and municipalities, and oil and gas companies. Shares of this company’s stock are trading at $0.23, and it has a market cap of $33 million.

I really like technology right now, and the wireless space is hot. But I recommend taking a pass on ERF Wireless.  The company has yet to earn shareholders any money, and has a lot of long-term debt. Let’s take a look at its financial statements so I can show you an example of a company I would avoid in 2010. 

Well it’s about time. The markets are selling off as investors book short-term gains that in many cases far exceed the long-term annual average gains of the market. If the Standard and Poor 500 index has averaged 6% since inception in 1957, and investors have beaten that by a fair margin in just months, even weeks, doesn’t it make sense to sell some shares to lock in gains? Of course it does.

Intra-day today the Standard and Poor 500 index is down 1.8%, while the Dow Jones Industrial Index is falling 2%. But the Russell 2000 small-cap index is only down 1.3%. This is somewhat surprising because usually small-caps lead to the downside when there is a sell-off. Of course, they tend to lead to the upside when the markets are rallying too. And that’s why I’m a small-cap investor, the potential for big profits.

But today’s market action runs counter to that trend, and the takeaway message is that investors have not lost their appetite for risk. While the selling may not be over, I find the markets movement to this point to be encouraging for small-cap investing early in 2010. The Russell 2000 could retreat back to 600 (a 4.7% decline) in the coming weeks, but it will find significant support there and frankly I think it’s unlikely that such a drop is on the horizon. I’m looking for the index to bounce off 620 (a 1.6% decline) if the selling continues.

Before the open Goldman Sachs GS will announce earnings. Futures are lower right now given that investors will be braced for fourth-quarter numbers from a number of other companies including American Express, Xerox, Capital One and UnitedHealth Group. For now though, here is a look at GS on a technical picutre for those option traders looking to make a buck off of earnings.

"When China’s tyrannical emperor, Mao Zedong, died in 1976 the country began a transformation process that continues today. Mao’s successor, Deng Xiaoping started to work with the Chinese Communist Party (CCP) to dismantle collective farming and begin the gradual transition toward a free economy. Prior to 1979, the Chinese government’s overarching goal for the undeveloped country was to make China’s economy self-sufficient – only goods which could not be made or obtained in China were imported.  It was a protectionist trade policy and as a result the economic lights in China were always dim.

Things have changed…"

This is the opening paragraph of my just released Special Report: China Energy Stocks for 2010. This just-released special report is now available to my SmallCapInvestor PRO subscribers. I encourage you to attend this evening’s online investing seminar China Inc.: Understanding China for Outstanding Profits. This is my latest video investment conference to help investors like you learn more about how to invest in China small-cap stocks, and its airing tonight at 6 pm ET.

Inside this Special Report is my complete investment report on a company that I just added to the SmallCapInvestor PRO portfolio.  This is an unknown, undiscovered, high growth energy stock. The company is building energy transformers that I believe will revolutionize China’s energy grid. I expect shares of this company will rise over 50% in 2010. The best news is that when you join my SmallCapInvestor PRO service, you’ll immediately get access to the special report.

Check out this excerpt from my report on this new stock:

"In 2009, total investments in China’s electric power grid will rise by 17.7% as $84.7 billion is spent to improve rural grids, speed up urban grid reform, and rebuild earthquake-stricken areas.