Ralph Wanger: How to make money in small-cap stocks

Mar 27, 2017

Making money in the small-cap market is like finding a woman. If you are looking for a one-night stand or a fling, you head down to a pub and seek out the woman with the low-cut dress and cheap perfume. Pay for her alcohol and you may find the immediate satisfaction you desire.

If you are looking for a wife, a life-long companion, you will pick the woman with morals and integrity. This time you may have to look in far more boring places –library, neighborhood coffee shop or the corner grocery store.

That is the crux of Ralph Wanger’s investment philosophy in his own words. According to him, small-cap speculators buy the hottest stock hoping to make a quick return – the sexiest story on Wall Street, the one everyone is talking about.

The more prudent way is to focus on the boring and beaten down companies that no one else is looking at. Some of his biggest winners were a brick maker, a slot machine business and a “boring” frying machine company.

He knows what he is talking about. Over the 33 years (1970-2003) of actively managing the Acorn Fund, he delivered an annual yield of 16%, ahead of the benchmark’s 12%.

A prime reason he managed such a feat was because his universe was restricted to the fertile ground of small-cap companies. His preference is grounded in the logic that smaller companies have more room to grow and hence the higher returns over long time periods. After all, no company can sustain a high growth rate forever, and eventually a firm’s size starts to weigh it down.

Dumbo could fly because he was a baby elephant. Adult elephants are aerodynamically unsound.

He likes to focus on long-term trends and change; and smaller companies can adapt more readily to change.

In any environment, some creatures are going to be more successful at adapting, those are the ones that will thrive and prosper.

Also, there are numerous occasions that could boost the stock price of a small cap: earnings growth, acquisition by a larger company at an above-market price, stock repurchases by the company, and an increase in the price the market is willing to pay for earnings due to increased institutional interest.

But investing in such stocks is fraught with risk. Here’s how he plays it smart.

1) Avoid sexy, go for boring.

A dull business run by good businessmen is far better than a glamorous business with mediocre management.

For the stock to end up in his portfolio, it must have growth potential, financial strength and fundamental value. The company should have an understandable business model, credible sales and profit growth, preferably through an entrepreneurial management dominating a boring but profitable niche market.

A low debt level was another qualifying criteria. The impact of large debt is most pronounced with small- and micro-cap firms. It is important to keep this at a minimum.

2) Identify a major trend.

If you’re looking for a home run – a great investment for 5 years or 10 years or more - identify a long-term trend that will give a particular business some sort of edge. 

A pure bottom-up investor looks for great stocks, irrespective of themes. Wanger looks for the next major trend and then attempts to spot companies that will benefit from it – more of a top-down look. By concentrating on smaller companies, he improves his chances of catching the next wave.

He identifies trends (social, economic, technological) that should last longer than one business cycle. His focus is not on shorter-term predictions of a year or so since most are privy to the same information making it difficult to outguess the competition.

Once a major trend is identified, the investment is not in that industry itself but the indirect beneficiaries.

In a transforming industry, the big money is made outside the core business. Going back to transistors, even though the transistor companies as a class didn’t do very well, TV broadcasting, Cable TV, Computers, and data processing have been tremendous businesses.

In an interview a decade ago, he cited the example of a $600 PlayStation that “has more computing power than you could have gotten 20 years ago for $100,000. So you don’t want to invest in the computing power itself; those prices keep dropping. You want what’s downstream from the technology. Years ago I bought International Game Technology, which took a simple microprocessor, packaged it with coin slots, called it a slot machine and sold it to casinos for $8,000. It was a great stock.” It was reported that the stock increased more than 40 times before he eventually sold it.

In another interview, he spoke of Liberty Media Group. While the technology that goes into cable television is sophisticated, it creates a big market downstream for cable TV programming. “As long as TV sets eat more and more channels, Liberty Media should be fine,” was his view. When he referred to this stock, cash flows were growing and the value of the business was rising.

This trend-spotting strategy was founded on the view that ever since the Industrial Revolution, heading downstream has been the smarter strategy. What this means is that one should invest in businesses that will benefit from new technology rather than invest in technology companies itself. The logic being that big money does not necessarily go to the technology innovators, but to those who use it to create mass-market businesses.

He would also consider a company if it was not part of a theme but has a near-monopoly in a special market niche that is likely to last more than one business cycle.

The best company in a marginal industry is worth much more than the third best company in a major industry.

3) Write down your investing thesis.

An investment philosophy is important not in the abstract but because it will keep you on the right track.

He advocates writing down why you are buying a stock every time you do so. Spell out your buy decision clearly, not ambiguously. Keep it short – no more than a paragraph or two. And when the reason you bought the stock is no longer true, sell. In this way, your sell strategy is built into your buy decision.

He believes that this will save investors a lot of sleepless nights, costly transaction costs and wild price fluctuations that scare most investors.

Let’s say you buy shares of XYZ Corp. because you believe its profit margins will rise from 2% to 8% over the next 5 years.

  • Sell Scenario #1
    • After several years the profit margins haven’t budged.
    • Your investment idea –the company’s profit margins would rise – is false.
    • SELL
  • Sell Scenario #2
    • After 2 years, XYZ Corp.’s profit margins are at 5%.
    • Margins are rising. Your initial investment equation is still true.
    • HOLD
  • Sell Scenario #3
    • XYZ Corp.’s profit margins are at 9%.
    • Your initial reason for buying the company is false. The company’s margins rose above 8%. The company has exceeded your expectations. Time to book profits.

4) Give your winners time to compound. Cut the losers.

In the short term, even the best of small-cap stocks are subject to a lot of ups and downs. And the worst thing in the world is to sell a solid company just because the price went down. You have to hold solid companies for a long time so your gains can compound.

While Wanger’s average holding period was between 4 and 5 years, he held onto some winners for decades.

Let the winners compound, cut the losers.

According to him, in life, 99% of what we do can be classified as laundry - stuff that has to be done, but you don’t do it better than anybody else, and it’s not worth much. Once in a while, though, you do something that changes your life dramatically – get married, get divorced, have a baby. Or, you buy a stock that goes up 20-fold.

These rare events dominate.

At Acorn, he might have owned 300 stocks at any given time; most disappeared into the laundry basket. But 10 might have gone up many times in value, and they made all the difference.

5) Don’t get stuck up on growth or value.

He did not subscribe to the view that one must be a pure value investor or a pure growth investor.

Growth itself is one component of value. A growing stream of earnings is certainly worth more than a static stream of earnings. You could even say that growth generates value. It can disappear as growth slows, but so can any other part of the value equation. A low PE can disappear, if earning shrink. So can a low PB ratio.

He popularized the GARP strategy - Growth at Reasonable Price. He boldly scouted for good growing companies but did not want to overpay.

6) Do not overpay.

However much you like a company, don’t overpay. In other words, the stock must be reasonably priced in connection to earnings and cash flow.

Wanger believed that looking at numbers such as earnings growth and price multiples is less useful when evaluating small companies, with their shorter operating histories and more rapid change, than when judging big companies.

To help judge value relative to growth potential, he used a valuation model based on predicted earnings growth rate (not more than 2 years out), and a predicted price-earnings multiple (adjusted for the expected level of interest rates, since at high interest rate levels, multiples tend to be lower than when interest rates are at low levels). The model provided a price for the stock two years hence, and thus an expected rate of return over two years. This was then compared to what most analysts were expecting and a decision would be made.

Ralph Wanger is cited as one of The World’s 99 Greatest Investors. In 2003, Morningstar Inc., presented him with its first Fund Manager Lifetime Achievement Award in recognition of his outstanding long-term performance, for demonstrating the courage to differ from consensus and the ability to adapt to changes.

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