Hosts David Faber and Gary Kaminsky, aided by contributor Herb Greenberg, mobbed Dave Gentry in a 3-on-1 attack in a segment titled “Peddling Chinese Reverse Mergers.”  During this interview, RedChip’s nearly 20-year history of publishing equity research was challenged as biased and hype. When Dave responded that our reports are written by CFA’s (Chartered Financial Analysts), Mr. Greenberg attempted to dismiss this fact by erroneously reporting that we had the business description of one of our clients wrong on our website.  We in fact had the client’s business description correct, and Herb later corrected himself on a follow-up “bonus” segment titled “Faceoff: Heat Over Chinese Reverse Mergers,” which was taped later that day at CNBC studios and released on CNBC.com.

In response to the attack by Mr. Faber, Mr. Kaminsky, and Mr. Greenberg on RedChip Research, RedChip analyst and portfolio manager Bill Matson, CPA, CFA composed the following e-mail:

Dear Mr. Greenberg and Mr. Faber,

CPA firms get paid for their opinions by the companies on whom they report, so why shouldn’t investor relations firms who employ CFA charterholders to render opinions? Especially when all compensation arrangements are fully disclosed.

I can honestly say that nobody at RedChip has ever tried to get me to be anything but 100% objective in my research – nor would such attempts ever have a snowball’s chance in hell of meeting with success. To imply that the RedChip business model compromises my work or that of the other CFA charterholders who create RedChip Research is to denigrate the CFA qualification itself, as well as the rigid ethical code at its foundation. We all worked very hard for the right to put those three letters after our names.

Am I being hypersensitive about this? I don’t think so. If RedChip is guilty of publishing tainted reports, its analysts must also be tainted. My name is on those reports, as well as on the RedChip web site. In no way can this possibly be good for my reputation or my money management firm’s business.

I wonder if you people at CNBC have any appreciation of the harm you cause when you attempt to create the illusion of scandal where none exists – and fail to give your guests anything resembling a fair opportunity to respond to your innuendo. Aside from slinging unwarranted mud at RedChip and ignoring the existence of the CFA Code of Ethics, to which over 100,000 professionals are bound, you are discouraging small companies from making themselves known to investors, both retail and institutional.

This ultimately winds up being a grave disservice to CNBC’s viewers. I’ve been one of your most loyal viewers since 2000, when I became a full-time investor/portfolio manager. In fact, my book, Data Driven Investing, devotes several pages (starting on pg. 349) to techniques for acting upon the information to be gleaned from CNBC. Yet I can’t recall anything more than passing mention ever being made on CNBC of microcaps’ tremendous long-term performance advantage over large caps. Your party line is that this has been “a lost decade” for stocks, but one wouldn’t know it from looking at the Russell Microcap Index (up 81% since 6/30/00). While I respect CNBC’s reluctance to avoid mention of specific thinly traded stocks, I find it disturbing that you would not only ignore the outperformance of microcaps, but also take actions, such as your irresponsible treatment of RedChip, that are likely to steer would-be investors away from small companies.

Small companies are important sources of job creation and innovation, and many have been starved for capital due to troubles in the banking system. It is particularly irresponsible at this time to illegitimize without basis an effective means of channeling objective analysis of these companies to investors who are likely to benefit from this information.

Bill Matson, CFA, CPA

Analyst, RedChip Companies, Inc.

Bill has over 30 years experience as a financial professional, including positions as a portfolio manager, author, analyst, and consultant. Bill was Series 7-licensed in 1980 with H.J. Tessier & Co., a small regional firm, before becoming a financial consultant with Dean Witter and Merrill Lynch. He provided independent equity research services from 1993 to 1997, then transitioned to IT consulting with Myers Holum, Inc., where he managed accounting and reporting systems projects for Fortune 100 clients. Later in Bill’s career, he co-authored Data Driven Investing, a book that analyzes 52 years of returns for 19 different strategies. Mr. Matson is currently the portfolio manager at Cognition Capital Management, LLC, where he has focused on small and micro cap value equities since 2005. Bill has earned a Chartered Financial Analyst (CFA) designation and is a Certified Public Accountant (CPA). He holds an MBA from Harvard Business School.

Why conventional investing wisdom is wrong and how you can improve your portfolio’s return over time with small cap stocks.

By Bill Matson, CFA

RedChip Analyst and Portfolio Manager at Cognition Capital Management, LLC

Despite decades of underperformance by corporate behemoths, the conventional wisdom has been that small companies are speculations and that serious money belongs in Blue Chips …. We at RedChip believe that this mainstream piece of conventional wisdom is 100% dead wrong.

I’ve always been suspicious of “conventional wisdom.” Too often it seems to be created by “experts” more notable for their smooth talk and political savvy than for the merit of their ideas. Even when contradicted by mountains of empirical data, their constructs not only maintain their status with the general public, but also within academia and other enclaves populated by those who should know better.    

Wall Street is, arguably, mankind’s richest vein of specious conventional wisdom. Among its canards are efficient market hypothesis (EMH), the positive correlation of company size with expected returns, and the applicability of “bell curve” mathematics in assessing portfolio risk.

Despite decades of underperformance by corporate behemoths, the conventional wisdom has been that small companies are speculations and that serious money belongs in Blue Chips like General Electric or Disney. We at RedChip believe that this mainstream piece of conventional wisdom is 100% dead wrong.

Our new monthly column, The RedChip Advantage, is intended to prevent its readers from falling prey to these misguided notions, as well as to assist them in increasing their portfolio’s expected return while lowering its risk by incorporating exposure to small cap stocks in combination with other strategies.

The Fallacy of Efficient Market Hypothesis

Brought to fame by University of Chicago professor Eugene Fama in the early 1960’s, the efficient-market hypothesis (EMH) holds that nobody can consistently beat the market because all publicly available information is instantaneously incorporated into stock prices. EMH was the springboard for the careers of several Nobel laureates and is the intellectual foundation of the multi-trillion dollar index fund industry.  It became popular among academics because the simplifying assumption of an efficient market made it possible to apply a wide variety of mathematical tools to the construction of portfolios, as well as to the measurement and control of risk.

True believers in EMH don’t need to read corporate financial statements or press releases. So long as they stay well diversified, they don’t really need to know much at all about the companies they own, nor need they care how much they pay for their stocks. Somehow, in its infinite wisdom, the market will see to it that everything they buy or sell is properly priced.

Then, in the 1990’s, along came the dot.com craze, when the market ascribed astronomical valuations to companies that in many cases, had never produced a product or a dollar of earnings. But the idea of portfolio optimization through diversification, propagated by EMH, told investors to buy anyways.

Empirical Support for Small Caps

A book I co-authored, Data Driven Investing, thoroughly refutes EMH. Published in 2004, it is largely based on the tens of millions of data points in S&P’s Compustat data base, a multi-decade compilation of financial statement figures and daily stock price movements covering thousands of companies. In seeking to identify patterns within this data predictive of abnormally high (and low) returns, we found that small company stocks, on average, had consistently provided much higher returns than large company stocks.

Following a strategy of buying equal amounts of the 100 smallest companies with market caps over $10 million and reconstructing the portfolio every year would have resulted in a 441,700% return between January 1951 and December 2002.

Following an Extreme Small Cap Strategy (ESCS) of buying equal amounts of the 100 smallest companies with market caps over $10 million (in 2002 dollars) and reconstructing the portfolio every year on December 31 would have resulted in a 441,700% return between January 1951 and December 2002. While this figure is admittedly unrealistic, as it assumes executing buys and sells every year at the 12/31 closing price and incurring zero commissions costs, consider that given the same assumptions, your return from investing in similar fashion in the 100 largest market cap companies would have resulted in a 14,700% return.

The chart below provides a summary of the performance history of seven different market cap groupings.

As you can see, an investment of $1 in 1951 in the 100 smallest companies with market caps of at least $10 million would have increased to $4,418 in 2002. Conversely, an investment of $1 in 1951 in the 100 largest companies measured by market cap would have increased to just $148 in 2002.

The RedChip Advantage Portfolio

A typical small cap stock is, no doubt, riskier than a typical S&P 500 stock. However our thesis is that small cap investors can achieve returns comparable to the S&P 500 with significantly less risk through appropriate asset allocation, diversification, and hedging strategies.

Because many small cap stocks are so thinly traded, large price swings often occur for reasons having little or nothing to do with the value of underlying companies. Small cap stocks, as a group, are likely to produce significantly higher average returns than the S&P 500 over time. Thus, it is possible to increase a portfolio’s expected return – while lowering its risk – by replacing S&P 500 holdings with small caps in combination with other investment instruments.

Investing in small cap stocks is akin to playing poker; investors who stay rational and control their emotions tend to empty the pockets of those who do not.

If we learned anything from the 2008 and early 2009 evaporation of such blue chip stocks as Bear Stearns, Lehman Brothers, General Motors – and even General Electric (which lost over 80% of its value) – it is that there are no truly safe havens in the stock market. If we can reduce our risk by allocating more assets to cash, then further reduce our risk by investing in a market wherein we can more readily exploit inefficiencies, that would seem to be a more prudent course than making bets on the S&P 500 – a risky, relatively low return area of the market in which it is difficult for the average individual to gain any sort of edge over other investors.   

Our new monthly column, The RedChip Advantage Portfolio, will cover portfolio management topics, as well as a wide variety of strategies for exploiting inefficiencies in the small cap marketplace. By guiding your development of clear cut decision rules for buying and selling, our column will assist you in exploiting the irrational behaviors of others – while minimizing your own behavioral vulnerabilities.

The RedChip Advantage Portfolio will regularly examine individual small cap stocks from a variety of perspectives that few professional investors are in a position to consider. Though there may be money to be made from buying or selling the stocks we look at, our hope is that some readers will look beyond the companies presented and be inspired to use our methods in developing their own investment ideas.

The RedChip Advantage Portfolio will appear on the RedChip Blog site (Blog.RedChip.com) and the creation of a mock portfolio will be initiated on January 1, 2011 to exhibit our techniques and track our performance.

The number of people pontificating about the stock market is vastly greater than the number of those among them with verifiable records of outperforming market averages. With respect to pundits offering market-beating advice, “them that says don’t know, and them that knows ain’t saying.” My suspicion is that hundreds, if not thousands, of individual investors have built sizeable fortunes by quietly beating the major market averages for decades on end by applying the techniques to be described in The RedChip Advantage Portfolio.

Small cap stocks have been financially rewarding to me over the years (including those since 2004), as well as a source of endless fascination. I hope The RedChip Advantage Portfolio can point its readers down that same path.

By Bill Matson, CFA

In his 2007 book, The Black Swan, Nassim Nicholas Taleb prophetically argued – prior to the 2008 market meltdown and the May 2010 flash crash – that the potential risks and opportunities in the financial markets are not nearly as limited as money managers employing conventional, bell curve-based assumptions would have us believe. In order to prosper in such an environment, he advocates a “barbell strategy,” wherein a significant percentage of one’s portfolio is allocated to extremely low-risk assets while the rest is invested in risky assets having the possibility of extraordinarily high returns.

According to Taleb, “A black swan is an event, positive or negative, that is deemed improbable yet causes massive consequences.” Seeking out exposure to positive black swans, while carefully controlling exposure to the negative, makes particularly good sense in view of the increasing frequency with which low-probability events are occurring in our financial markets.

It is in this context that NetSol Technologies, Inc. (NASDAQ: NTWK) (NASDAQ DUBAI: NTWK) must be viewed if it is to be properly evaluated. The company’s existential risks, most notably its operations in an unstable region, are well recognized and undoubtedly overly-discounted by investors. Its potentially game-changing opportunities, however, possess strong likelihoods of coming to fruition and have been systematically downplayed in management’s forecasts. 

Nobody will be shocked if NetSol ultimately nets tens if not hundreds of millions of dollars from contracts with the Pakistani government. Or, it could be the company’s Saudi Arabian joint venture that ultimately dwarfs the profitability of NetSol’s current operations.

If the company were seeking venture funding, these opportunities would certainly be reflected in its business plan and given serious consideration by the venture capital community. But Wall Street is understandably a far more cautious place than Sand Hill Road. Hordes of lawyers stand ready to initiate class-action litigation when quarterly earnings disappointments causing stocks to crater. And analysts are far more comfortable being wrong in the company of their peers than in taking bold positions diverging sharply from consensus views.

4Q10 was a tremendous quarter for NetSol in several respects. Its $0.04 EPS blew away our estimate of $(0.00), and its $10.7 million revenue figure far surpassed our $7.9 million estimate. Moreover, earnings quality has strengthened during the past year, with accounts receivable turnover for FY10 increasing YoY from 2.4 to 3.1 and management noting a sharply declining trend in bad debt expense. In addition, cash from operating activities jumped 603.9% on a YoY basis.

Having been overly conservative, along with our peers, with respect to 4Q10, we are developing a strong appreciation for the conservatism of NetSol’s management insofar as its guidance is concerned. So we listened especially carefully to the company’s 9/8/10 conference call for the soft pedaling of potentially favorable future developments, such as:

1) The omission of Pakistani government contracts from NetSol’s revenue forecast, due to the recent floods. None of the company’s Pakistan locations were affected by this disaster, but delays are anticipated in the country’s public sector projects. The company, however, remains a leading contender for significant contracts relating to Pakistan’s land records management system and the digitization of the nation’s military. To the extent that any of NetSol’s Pakistani government contracts result in FY11 revenues, this will be, in essence, a positive revenue surprise and likely trigger an upward revision of earnings guidance.

2) The company being likely to increase its ownership of NetSol Pakistan from 58% to 76% within the next two months, a transaction expected to be accretive to NTWK EPS. Again, the Company is exercising an abundance of caution in not reflecting this transfer of ownership in its current guidance.

3) Interest on the part of potential acquirers. Management acknowledged briefly that approaches had been made during the past year, but noted that the asking price would be in the range of $8.00 to $10.00 per share.

4) The extremely guarded approach NetSol has taken to publicizing the strengths, benefits, and revenue potential of its next-generation product.

NetSol’s management has given EPS guidance of $0.15 to $0.20 for FY11. But given the conservatism observed in the company’s management insofar as its forward-looking statements are concerned, we would not be surprised to see them far exceed these projections.

Consequently, NetSol’s status as a public company may harshly constrain the ability of management and analysts alike to pin numbers on its most enticing possibilities.

So black swans they will remain. At least for now.

Disclosure: The subject security is a client of RedChip Companies, Inc. RedChip Companies, Inc., employees and affiliates may have positions and affect transactions in the securities or options of the issuers mentioned herein. For full financial disclosures for all RedChip clients, please visit http://www.redchip.com/disclosures.asp?src=rcv.

In the United States, there is no shortage of for-profit choices when it comes to higher education. Private universities, vocational and specialized training programs offer a broad variety of programs from technical, business, and the liberal arts. Companies like Devry Inc. (NYSE: DV), which has been in the private education business for nearly 75 years, and healthy competition from companies like Apollo (NASDAQ: APOL), Educational Management Corp. (NASDAQ: EDMC) and ITT (NYSE: ESI) have broadened awareness of the sector among investors. Each one of these companies operate profitably, have experienced impressive growth rates and all claim high placement results as they target what employers are seeking and tailor their programs as they go.

As the private education market in the U.S. matures, becoming more crowded and competitive, the market in China is only starting to develop. Established Chinese companies like New Oriental Education Technology Group (NYSE: EDU) and ChinaCast Education Corp. (NASDAQ: CAST) and newly formed players like HQ Global Education Inc. (HQGE.OB) and China Bilingual Technology & Education Group Inc. (CBLY.OB) are benefitting from the demand for higher education and the desire to earn better wages.

These companies vary in both their product lines and delivery systems, with some offering diversified product lineups and others targeting specific categories:

• Children: Younger consumers from grade school to high school with a variety of programs including traditional education, online e-learning and targeted programs.
• Vocational: As China develops as a consuming nation, and income and demand for foreign products rises, China remains one of the largest exporters of manufactured goods. Their relatively cheap labor pool has attracted many companies to build facilities in China to take advantage of the lower costs. Vocational training schools have sprouted up near both the source of the labor pools and their potential employers. These companies have the advantage of working hand-in-hand with employers to tailor their training programs to fit employers’ needs and claim placement rates as high as 100%.
• Professional/Executive: As China becomes a larger force in the global economy, its professional and executive workforce is expanding as well. Companies are now offering programs geared specifically to advancing business skill sets including sales, marketing, negotiation and public speaking courses designed for and targeted to both seasoned and up-and-coming professionals.
• Language: There is a higher interest for Chinese citizens to expand their language skills to be more competitive. Companies are taking note of this and delivering programs to teach language skills and prepare and assist students in their quest to study abroad.

Here are six publicly held Chinese companies, each with their own history and strategy:

HQ Global Education Inc. (HQGE.OB): While incorporated a little over two years ago, HQGE has reportedly enrolled 85,000 students since its inception in 1994. The company provides vocational skills training and education to students in China and claims a 100% placement rate for its graduates due to the company’s targeted approach. HQGE locates its schools near sources of labor pools and their potential employers. They provide 60 programs, each ranging from 1-4 years, in 17 categories.   The HQ name carries some brand recognition, which the company plans to leverage off of as they expand their schools, enrollments and educational programs. This branding surrounds HQGE’s “Order-oriented Educational Mode,” which is essentially a form of target marketing to its customers, who in this case are both students and future employers. HQGE’s most recent reported financial results seem to coincide with its student growth trends, which are in the 17-18% range, with top-line growth and net income growing by around 20% in year-over-year nine-month reporting periods. This type of growth rate in any industry would be envied.

China Executive Education Corp. (CECX.OB):   CECX has a more niche defined target of executive education. The company targets its training and educational services to the successful and up-and-coming professionals who want to advance to new levels in what most U.S. business schools strive to provide beyond their traditional classroom topics. CECX offers proprietary courses in modern business practices, including but not limited to: public speaking, sales and marketing, negotiation and people skills. CECX is a relatively new company (officially formed in 2009) but has reportedly served over 2,000 students. While in its early stages and yet to survive a market cycle, its business model is nothing short of unique and specifically targeted at well-heeled customers. The company offers a much higher priced service to customers who can afford to pay up front to work with what CECX considers to be leaders in their field. This business model is similar to what some Executive MBA programs offer in the U.S. for working professionals, where the educational staff consists of working professionals alongside tenured professors. As China develops its professional leaders, there is a demand and desire for those who have worked primarily in China to learn advanced skill sets with a global focus.

China Bilingual Technology & Education Group Inc. (CBLY.OB): Newly formed from the acquisition of two companies that have been providing private education since the late 1990s, CBLY plans to expand its grade- and high school-level programs with a bilingual emphasis. The company plans to extend what it considers “high profile and high standard” state-of-the-art facilities with a high teacher-to-student ratio. China Bilingual’s experience and history of modern learning facilities have already proven effective, and the company reports college enrollment admission rates at 90%. China Bilingual has also won numerous awards for its results. While this newly formed company will need to prove itself as a publicly held company, with these achievements China Bilingual may be a strong competitor with a focus on high standards of education.

ChinaCast Education Corp. (NASDAQ: CAST):  ChinaCast was founded in 1999 and employs approximately 2,200 employees in various locations across China and Hong Kong. The company delivers diploma and secondary degree programs at the university level. Its business is divided into both the traditional classroom settings on college campuses and online e-learning programs. Its on-site accredited programs are located at the Foreign Trade and Business College in Chongqing and the Lijiang College in Guangxi Normal University. Typical of any state or private university in the U.S., ChinaCast offers programs for language studies, advertising, business, hospitality, economics, computers, arts and music, IT and law.  With recent advances in computer technology and easy access to the Internet, ChinaCast has expanded its e-learning programs to enhance its product line beyond the traditional degree-based educational programs. Because of the reach of the Internet, they are able to extend these services to grade schools from k-12, local and national governments and some corporate facilities.

Similar to other companies in this industry, ChinaCast is experiencing what would be considered high growth rates in top- and bottom-line growth. Some of this is from organic expansion and some through its strategic acquisitions like that of LJC in late 2009, which is projected to be accretive. Like any company in a growth stage, growing a business comes at a cost as top-line revenues grew last quarter above 40% while operating and net income grew at about half that pace but were still impressive. If this industry, like most at this stage, becomes a landscape of M&A and acquisitions, ChinaCast has one of the stronger balance sheets with significant cash on hand and has maintained impressive profit margins through a global recessionary period. 

New Oriental Education Technology Group (NYSE: EDU):  Originally founded in 1993, EDU is one of the longer-standing leaders in this field and cemented a strong foundation early in the industry’s cycle.  EDU trades on the NYSE with a market cap of $3.4B and has been delivering impressive results to shareholders since it began trading. At over $100 per share and a P/E of around 50x, its success has been well recognized by investors as a company with a strong foothold in the education space. Like some of the other companies in this arena, EDU offers a diversified delivery system but focuses on language-based educational products consisting of multiple language courses, including English, Japanese, Spanish, French and Korean, to name a few. The company assists its students in preparing for admissions and assessment testing to help them move ahead of their peers. EDU delivers its products and services though primary and secondary schools in multiple formats and delivery systems including online e-learning, books, periodicals and CD-ROMs. In addition to its core business, EDU also offers consulting services to students seeking to enter other learning institutions, providing guidance on applications and the admission process for local and overseas institutions.

EDU has continued to provide shareholders with impressive top- and bottom-line growth rates and deliver profit margins that any company would be proud to have. The recognition of these stellar growth and margin rates has not gone unnoticed by the investing community and is reflected in the strong demand for their shares. While there are at least nine analysts covering the stock with positive ratings, there is no shortage of commentary on why this stock needs to continue to deliver similar results to maintain the expectations and the valuation. EDU could be considered a model for newcomers to the industry who are also taking advantage of a high-growth business.

China Education Alliance (NYSE: CEU):   One of the larger companies in the private educational landscape, China Education Alliance, Inc., generates over $30M in revenue, operates profitably on a net basis and trades on the NYSE with a market cap of approximately $130M. This is impressive for a company that was originally founded less than 7 years ago.  While operating in the private educational sector, their services span all age groups and educational areas from elementary to higher education and both vocational and professional areas. As with others in this space, CEU combines e-learning with on-site delivery. In addition to teaching, CEU provides product lines of study materials in print and audit formats and traditional and non-traditional testing services. One of its most profitable divisions is marketed under the Famed Instructors Test Paper Store, in which the company maintains and delivers a database of over 350,000 courses, test papers, study materials and exams. CEU has developed a diversified delivery service that includes networks of websites, on-site, magazine and newspaper outlets. There seems to have been a significant amount of planning and development since their inception to be able to be a sort of one-stop shopping center of education of all sorts.

Similar to other private educational companies in China, CEU is in a rapid growth phase. Over the recent six-month period ending June 30, 2010, CEU experienced revenue and net income growth rates at or above 20% with the largest growth in the company’s training center and online delivery systems, where its margins are higher. Because of dilution from an almost 50% increase in outstanding shares, their EPS increased at about half of their revenue and net income growth rates, yet was still impressive. From a forward-looking capital picture, CEU has maintained a healthy balance sheet with approximately $75M in cash, has no long-term debt on its books and has increased shareholders’ equity over the last 12 months. CEU trades approximately 100k shares on the NYSE each day, trading at a relatively low multiple to its peers and the general market.

While each of these companies is experiencing very impressive growth rates, the business of education in China is competitive and reputation is important.  As with any industry in rapid growth stages, companies must choose at some point to compete on price or product differentiation. Some of these companies have chosen to target specific areas of the market while others are choosing a diversified product line. For now both the established and newly formed companies are delivering results that shareholders are looking for and profit margins any company would die for.  For those private education companies in China that make the right choices, remain flexible as the market changes and capitalize on controlling costs as they grow, there could be a bright future ahead.

Disclosure: The subject security is a client of RedChip Companies, Inc. RedChip Companies, Inc., employees and affiliates may have positions and affect transactions in the securities or options of the issuers mentioned herein. For full financial disclosures for all RedChip clients, please visit http://www.redchip.com/disclosures.asp?src=rcv.

More than a year after its introduction, the Securities and Exchange Commission (SEC) has officially adopted its proposed change to the federal proxy process in what it claims will “facilitate the rights of shareholders to nominate directors to a company’s board.” This decision was not passed unanimously by the SEC, but was passed nonetheless on Aug 25, 2010. The decision was significant, as it means that shareholders, regardless of size, can potentially have a direct effect on the proxy process and the composition of their companies’ boards.

The proxy process change is one of many ideas the SEC has put in motion to present itself as a more investor-friendly agency and to combat some of the negative views expressed by the public in recent years.

There seems to be widespread acceptance of this proxy process change among investors, which may impact small companies the most. The change may eventually mean more to them than they yet realize, because it could potentially have a larger impact on the board composition of small companies than large companies. This change allows anyone, whether an individual or group, with at least a 3% investment stake in a company to place their own choice for board seat candidates on proxy materials that will go out to shareholders. This change varies dramatically from the current process in which investors must essentially wage a war at their own expense to get their candidates on the ballot. This is one of the most significant changes the SEC has made to the proxy process in almost 30 years and does not come without dissension.

Some who oppose this change, including two of the five voting SEC members, argue that large shareholders with an agenda can use this opportunity to manipulate companies  for their own benefit rather than that of all shareholders.  Others feel a “one size fits all” solution may lead to increased expense in compliance to all registered companies.  Mr. Russ Weigel III, a former SEC attorney, stated, “I cannot say that I am a fan of increased regulation that creates additional compliance duties with little upside for corporate America. The only scenario that I can see where this rule is of benefit to anyone is in the context of the company having a widely disparate shareholder base where a 3% shareholder’s interests may be of some influence on management.”

While there seems to be plenty of dissenting opinions on this ruling, there is really no way to tell until it goes through a complete proxy cycle, which could start in early 2011 for mid- to large-cap companies first.

The Current Process:

As has been the process for many years, current board members can nominate new board candidates, and this information is passed along to investors in the proxy materials. During the nomination period, shareholders have little or no say in the process, and their choices for board nominations have little or no chance of getting on the ballot prior to proxy release. Most investors, including institutional holders, find it more convenient to vote for the candidate presented to them in the proxy materials rather than attend the annual shareholder’s meeting and vote personally. In fact, most investment groups have dedicated teams for this purpose alone.

Since shareholders, in most situations, have to attend shareholder meetings to nominate their own candidates, you don’t have to be anti-big business to see the apparent flaws in the current system.  There is and has been a sort of “old boy” network going on in corporate America, and many boards have been criticized for this – in particular, those companies that have failed or gone through significant financial problems or scandals under the so-called watchful eyes of board members. In the defense of current boards, the current system legally allows board members to take on these often lucrative seats in multiple companies and in some cases sit back and vote with management and not get too involved. The process by nature creates an almost disinterested party, as there is not much incentive for independent boards to get very involved as board members, and it makes it easier to just vote with management.  In addition, board members are rarely held directly responsible for company failures and scandals. Part of this is due to the fact that their powers to actually run the company are limited and after their term they just move on to the next appointment.   

What this means for all parties involved, including small-cap investors

Since this adopted change excludes what the SEC considers “smaller reporting companies” (those with less than $75M in float, or if not able to calculate float, those with less than $50M in annual revenues) for three years, the new policy will have a temporary mid- to large-company bias at first.  Once the change has endured a few cycles of feedback and revisions, smaller companies should be able to participate as well. This could have similar implications to how someone with the means and political agenda is able to become an elected public official, often referred to as “buying the election”. While the SEC has imposed rules as to who can be nominated, and although a nomination in no way guarantees appointment, imagine how an influential one or more newly nominated board members could be.  Here are a few examples:

• More frequent turnover for board members as shareholders are offered more voting options
• If elected, shareholders’ interests could theoretically be represented on boards with significant influence
• Boards could have dramatic changes in their composition, from the typical career board member to members who have direct interest in the company’s long-term plans
• Increase in the comfort level of those investors who have blamed some corporate boards for failures, scandals, and involvement in the recent financial crisis
• The introduction of a voice from someone who would not normally even be considered for a board appointment

While the implications have grand scale positive indications, the dissenters and opposition to this change have reasonable concerns, such as:

• An increase in administrative and legal costs to all companies, as this will eventually be a one-size-fits-all change
• The risk of abuse: even with significant government oversight and the requirements of SOX, if a company’s intention is to bend the rules, deceive, or cook the books, no board has the power to much more than question management’s practices. A well-organized fraud will always be difficult to detect from the board level.
• Too much power in too little hands – currently the composition of boards is designed to create a diversified panel of people from various backgrounds and affiliations. If enough investors in a small company are successful, they could in theory take over a board.

There seem to be enough positive reactions from investors and their advocates to understand why the SEC has made this change. The change to the proxy process will inevitably heighten awareness of board composition, provide more transparency to the entire process, provide opportunities for change in the construction of traditional boards, and help investors of all size stakes know where to direct their anger or praise rather than just blaming the system.

2009 Annual Return of 71.99% Outperforms Most Major Indices

The RedChip Review’s Independent Index outperformed the 2009 annual returns of many major benchmark indices including the Dow Jones Industrial Average, up 19.61%; S&P 500, up 24.26%; NASDAQ, up 44.82%; and the Russell 2000, up 26.82%.

The RedChip Review’s Independent Index includes stocks in diverse sectors such as A-Power Energy Generation Systems, Ltd. (Nasdaq: APWR), a leading provider of distributed generation power systems in China; Trina Solar Ltd. (NYSE: TSL), a manufacturer of photovoltaic products for worldwide solar energy markets; and Sharps Compliance, Inc. (Nasdaq: SMED), a developer and manufacturer of products used in the collection and disposal of medical wastes.

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For over 17 years, The RedChip Review™ has been a trusted source of independent small-cap equity research and information. Dedicated to “Discovering Tomorrow’s Blue Chips Today”™, its analysts seek out up-and-coming and undiscovered small-cap companies before they show up on Wall Street’s radar screen. Each company under research coverage is assigned a 12-month price target and investment rating: Strong Buy, Buy, Speculative Buy, Hold or Sell. In addition to the analyst reports, The RedChip Review also includes feature stories covering market conditions, analyst blogs, and instant news alerts on small-cap companies.

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Of the 26 small-cap IPOs done through the end of October, the average valuation was $244M and the average IPO size was around $120M. 

The fact that IPOs are getting done is very encouraging, however a noticeable shift is occurring in the IPO landscape. Companies considering an IPO today have an increasing number of stock exchanges around the world from which to choose and must now decide if listing on a U.S. exchange is the best decision for their company and shareholders.

Stronger markets have emerged across the globe, specifically in developing economies that present high-growth potential and lower regulations for public stock listing. With IPOs in emerging nations returning about 15 times more than in developed countries, companies from China to Brazil to India are increasingly choosing to list on their local exchanges or on foreign exchanges outside of the U.S.

But why would public companies be loosing their zeal for listing on America exchanges?

For one, regulators outside the U.S. are less strict overall compared to American regulators. The Alternative Investment Market (AIM) of London is the paragon example. The AIM does not require a company to have a minimum market capitalization, stockholder’s equity, trading volume, or share price, unlike in the U.S. Nor does it require the lengthy, costly regulation procedures required to make a company public. The AIM uses “Nominated Advisors” that handle the prospectus, gain admittance for the company into the market, and provide coverage and research. This process is considerably cheaper and faster than traditional government regulations. There are also fewer regulatory filings on AIM, no U.S. governmental reviews of the prospectus, and of course, no Sarbanes Oxley (SOX) compliance laws.

Over 1,300 companies are listed on the AIM with a combined market cap of about £57 billion ($94 billion). The AIM was hit hard when the market crashed in March 2009, but it is still an attractive option for small-cap companies wishing to go public. HipCricket, a US mobile marketing company, chose to list in 2007 on the AIM. With revenues of just $860,000 and a loss of $2.39 million for the six months through June 2007, HipCricket had little hope of listing on an American exchange, but in London on the AIM, the company raised $17 million and sold only 11% ownership. (Note: HipCricket de-listed from the AIM earlier this year when the market crashed.)

Asian companies similarly have found more reason to list on exchanges outside of the U.S.

This year alone, 134 Chinese small-cap companies went public; only 10 of them listed on an American exchange, according to  Dealogic.

Unlike in the U.S., Chinese markets are geared more towards helping innovation grow and succeed, rather than just attaining capital and liquidity. For instance, on October 30th, 2009 the Shenzhen Stock Exchange launched ChiNext, a new market platform intended for China’s 10 million small to mid size companies. According to the Shenzhen website, ChiNext utilizes its own unique mechanisms of financing, investment and risk management and applies them at various stages of a company’s development, rather than attributing them to size alone.

The ChiNext got off to a roaring start with many stock prices of the 28 initial listings rising over 100%.  In fact, the market capitalization of the 28 listed companies reached $20.5 billion with an average price to earnings (P/E) of 111x earnings on its first day of trading. This stratospheric result has attracted 188 companies have submitted applications to seek a listing on the board.

In a financial system that has been geared towards large, state-owned enterprises, the ChiNext represents a new strategy for small but growing Chinese companies looking to list on a stock exchange. And Chinese innovation for alternative stock exchanges does not end at ChiNext. Shanghai launches an international board, expected next year, according to Reuters. The international board has already attracted global giants like the UK’s HSBC Bank plc and even other stock exchange companies including the NYSE EuroNext and NASDAQ.

While other countries are creating new and interesting ways to invest in emerging companies, the U.S. has taken a different route by creating new and interesting ways to place further regulations on listing and investments. The Sarbanes-Oxley (SOX) Act of 2002 set new or enhanced standards for all U.S. public company boards, management and public accounting firms. Section 404 of SOX requires companies to file a management assertion and auditor attestation on the effectiveness of internal controls over financial reporting. The Financial Executives International’s 2004 survey of costs related to Sarbanes-Oxley reveals that total costs of first-year compliance with section 404 costs an average of $2 million for small-mid size companies. Hardly a low hurdle for a small start-up company looking to go public.

Furthermore, on December 11th, the House of Representatives passed a new bill that would create a Consumer Financial Protection Agency (CFPA). This interagency council would oversee and regulate financial firms and activities that could “threaten” the financial system. If the Senate approves the bill next year, U.S. listed companies could see their already high regulation costs increase even further. With such a welcoming set of rules and regulations, is it any wonder foreign companies are opting for domestic exchanges?

Stock exchanges around to world must now compete for new business and the U.S. exchange giants of NYSE and NASDAQ can not rest on their laurels if they wish to attract quality listings. So to must investors develop a far-reaching vision of world markets in order to capitalize on what once could be achieved only in America.

Sowani noted in the report:

“With a unique business model and rapidly growing demand for child security, we believe that DPDM is capable of emerging as an important player in the child Internet security market. The Company’s signature product, Dolphin Secure, utilizes biometric fingerprint authentication technology to provide a safe alternative to social networking sites such as MySpace or FaceBook, which offer little to no security.

“With more than 30 million children in the United States vulnerable to predators on the Internet, the estimated market for DPDM’s product is over $1 billion. The relative low cost of its subscription along with the high importance attached by parents to their child’s safety is likely to ensure strong demand for DPDM’s products.”

Cyberbullying, unsolicited chat requests from strangers, and inappropriate content are all dangers that children face when using social networking sites. Nearly all social networking sites including the big two — MySpace and Facebook — forbid children 13 and under from utilizing their product as the companies cannot guarantee the safety of children.

But the ability of these sites to combat threats aimed at children is disappointing to say the least. Consider that MySpace, in an agreement reached with 49 states and the District of Columbia, recently reported purging 90,000 known sex offenders from its Web site over the last two years. This uncomfortably high number confirms parents’ and law officials’ fears about the dangers of sexual predators on popular social networking sites and underscores the need for a better way to combat these threats.

Dolphin’s signature product, Dolphin Secure, is a groundbreaking family Internet solution that gives parents the tools to protect their children from such online threats. The service is intended specifically for the under-18 “teens and tweens” market, where growing independence and emerging social skills necessitate a safe environment for learning.

Once registered on Dolphin’s site, a log-in page is triggered each time an Internet browser or an Instant Messaging application is opened on a Dolphin Secure computer. Children simply enter their username and scan their fingerprint (the software works with most available USB fingerprint readers and the company sells an optional fingerprint reader on its site for just $15). The system identifies each child by matching their fingerprint to a unique number inside Dolphin Secure — no more passwords to share, steal, or even remember. Upon identification, each child’s personal, customizable home page within “Dolphin Surf” (the company’s social network site) is promptly loaded. From there, the child is free to explore the Internet and seek new friends within the parameters established for that specific child by their parent. These parameters can vary from child to child within the same household, which allows for older children to have greater access on the net than younger kids.

DPDM’s business is a subscription-based model with the ability to generate additional revenue through the sale of value-added services. Customers pay an affordable monthly or yearly fee for each child using Dolphin Secure (about $60 per child per year) — with discounts given for multiple child families and clubs or organizations. In the future, additional revenue may be generated from another lucrative revenue stream — advertising.

Currently, Dolphin is ramping up its sales force in anticipation of a “back-to-school” launch of its social networking site, Dolphin Surf, and plans to market its product to schools and youth organizations that can benefit from a secure online community. 

The company has high hopes for the next few years. DPDM aims to sign one million children in the next 18 to 21 months. RC Visibility expects the company to attain about 73,000 subscribers by the end of 2009, with growth expected to ramp up from referrals and renewals as word-of-mouth grows.

Although Dolphin faces stiff competition, it already has two leading edges over other companies marketing Internet security products to protect young web surfers:  (1) their biometric fingerprint reader prevents the hacking of user accounts and (2) their service ensures that only children are registered within the established online community.

To learn more about Dolphin Digital Media or to access the full RedChip Research Report, visit http://www.redchip.com/visibility/investor.asp?symbol=DPDM.

Disclosure:  DPDM is a client of RedChip Companies, Inc. RedChip Companies, Inc., employees and affiliates may have positions and affect transactions in the securities or options of the issuers mentioned herein. To view full financial disclosures, please visit http://www.redchip.com/disclosures.asp?src=rcv.

As noted on the NYSSA website, the panel discussed such questions as:

• How is independent research defined, measured, and valued by research purchasers?
• Which alternative research methods are in the greatest demand?
• Which business models are working and which ones aren’t?
• How will independent and alternative research firms be compensated for their work?
• Are distribution models in place that accurately measure and collect revenue based on contribution?
• How will companies view the loss of sell-side coverage and the growth of alternative research providers?
• What are the potential conflicts of interest and how are they managed?

In 2003, the Securities and Exchange Commission, New York Attorney General Elliot Spitzer, the New York Stock Exchange, and state securities regulators brought a $1.4 billion Global Settlement against ten of the nation’s largest investment firms to address conflicts of interest. Now that settlement is about to expire, and companies that offer independent research may reap the benefits.

The settlement came from allegations of conflicts of interest occurring between the investment banking and analysis departments of financial institutions Goldman Sachs, Bear Stearns, Credit Suisse, J.P. Morgan & Chase and others; one example of inappropriate actions was the spinning of “hot” initial public offerings by CSFB and Salomon Smith Barney, and the issuance of fraudulent research reports by same. UBS Warburg and Piper Jaffray were alleged to have received payments for investment research without disclosing the payments to the SEC. In addition to paying penalties under the terms of the settlement, banks were required to physically separate their research and investment banking departments and set up firewalls to ensure isolation.

What does this have to do with independent research?

The result of the settlement forcing apart research and investment departments was the creation of numerous small businesses offering unbiased, independent research, from whom the Big Ten regularly make research purchases. Now, these small businesses rely on the purchases the Big Ten make, and since the expiration of the settlement means the separation of research and investment departments is no longer required, the large banks will have no need to purchase independent research information from the small businesses. More than likely, many companies will be forced to close down, or find some other niche to fill.

RedChip was not among the 70 or so independent research firms who received monies as part of the settlement; and our unique business model, which includes both company-sponsored and independent research in addition to other lines of business, will allow RedChip to thrive beyond the settlement. However, it is the individual investor who will lose the most from the expiration of the settlement as smaller research firms close down and access to quality unbiased research is made more difficult. Of course, many quality analysts will find other outlets for their investment opinions, and you may even see some new additions to our own team of analysts.

Research remains a valuable tool for companies and investors; and, ultimately, the increased competition will narrow the field of available information sources, ensuring that the best research remains. RedChip looks forward to continuing our 17-year history of providing independent research, and we welcome you to join our investor community.

To learn more about RedChip’s independent research and our research magazine, The RedChip Review™, please visit http://www.redchip.com/research/researchmain.asp.

To learn more about the Global Research Analyst Settlement, visit http://www.globalresearchanalystsettlement.com/.