However, investing in smallcap companies can be riskier than largecaps and, therefore, Wanger advises investors to perform a careful research before trying to spot established firms with an able management that have proven their abilities over time.
A sound balance sheet and a strong position in their industry is also an added advantage that investors can look for in a firm.
“I have a sort of ecological theory to explain the phenomenon of higher return from small companies. In any environment, some creatures are going to be more successful at adapting than others, and those are the ones that will thrive and prosper. In a tough, competitive business environment, new companies would struggle to survive by funding and exploiting their own special niche. Most fail, but the few that make it win big. The reason they make it is that the environment must be favourable. Often the big growth stocks reached their heights because they were boosted by some particular development at that time. Ecological changes create great opportunities for investors who understand them. Most investment gains are made during the development phase and not afterwards,” he said in the book
A Zebra in Lion Country: Ralph Wanger’s Investment Survival Guide.
Ralph Wanger is the founder of Wanger Asset Management and the former manager of the Acorn Fund. His investing style of holding small companies with financial strength for long allowed him to generate annualised returns of 16.3% with the Acorn Fund between 1970 and 2003.
He also authored one of the most famous investment books
A Zebra in Lion Country, in which he compares portfolio managers to Zebras, who stay in herds, look alike, think alike and stick close together and often have difficult-to-achieve goals.
Why are portfolio managers like zebras
Explaining his theory, Wanger says for portfolio managers the goal is above-average performance, and for zebras, it is to eat fresh grass.
He feels both portfolio managers and zebras dislike risk, as the former can get fired and latter can get eaten by lions. “If you are a zebra and live in a herd, the key decision you have to make is where to stand in relation to the rest of the herd. When you think the conditions are safe, the outside of the herd is the best. For, there the grass is fresh, while those in the middle see only grass that is half-eaten or trampled down. The aggressive zebras, on the outside of the herd, eat much better,” he says.
Wanger says there comes a time when the investment climate is not conducive for portfolio managers to make investment, and they have to weather the market storm just as a zebra has to survive when lions approach.
He feels the smart portfolio managers know how to react in troubled times, just as the smart zebra outside knows when the lions are approaching: they prudently move inside while the lions are around.
He believes the smart outside zebra knows there’s no point in becoming a lion’s lunch and they change their strategy to survive the lion attack and then move back to become an outside zebra – in search of more fresh grass when the lions go away.
Why Wanger prefers small companies for investment
He believes smaller companies can provide higher returns over long periods, as they have more room to grow. Also, he feels no company can sustain a high growth rate forever, and eventually its size would weigh it down.
Wanger says there are a number of triggers that can boost the prices of smallcap stocks. They include-
- Earnings growth
- Acquisition by a larger company at an above-market price
- Stock repurchases by the company,
- Increase in the price the market is willing to pay for earnings due to increased institutional interest.
Wanger offers a glimpse into his own investment approach in the book, which offers timeless lessons for young investors wanting to make it big in the investing. Let’s look at some of his priceless tips-
- Go for boring businesses with good management Wanger says a dull business run by good management is far better than a glamorous business managed by a mediocre management. He feels investors should include a stock in their portfolio if it has growth potential, financial strength and fundamental value.
Also, the company should have a simple business model, reliable sales and profit growth, ideally through an entrepreneurial management dominating a boring but profitable niche market.
Wanger feels a low debt level is another qualifying criteria that investors should consider before investing in a stock, as the impact of large debt is more pronounced in a smallcap firm.
2) Spot a major long-term trend.
Wanger says if investors are looking for a great investment for 5 years or more, they should identify a long-term trend that will give a particular company some sort of edge. He feels investors should look for the next major trend and then attempt to spot companies that will benefit from it.
He says if investors concentrate on smaller companies, they might have a better chance of catching the next trend.
“If you’re looking for a home run – a great investment for five or 10 years or more – then the only way to beat this enormous fog that covers the future is to identify a long-term trend that will give a particular business some edge. Invest in themes that will give a company a long-term franchise,” he says.
Revealing his philosophy, Wanger says he identifies social, economic and technological trends that he feels would last longer than a business cycle. Also, he avoids focusing on shorter-term predictions, as most of the information is available to everyone, which makes it difficult to outsmart competition.
- How to identify a major trend?
Wanger says to identify trends, investors must develop an observant mindset that can draw generalisations from many different particulars. He says trends can best be spotted from reading and one’s everyday general experience, including the work environment.
“You have to train yourself to make generalisations from random particulars to keep asking yourself ‘what does it mean’,” he says.
An investment philosophy plays an important role in keeping investors on the right track. Wanger says one should write down why she is buying a stock every time she does 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 it. In this way, your sell strategy is built into your buy decision,” says he.
Wanger believes an investing thesis can save investors a lot of sleepless nights, costly transaction costs and wild price fluctuations that haunt most investors. He says successful investors always have a strategy and a different way of looking at stocks. They have a philosophy that dictates what kind of stocks they want to own and they stick to their conviction.
“Develop a set of convictions you adhere to. You can turn your back on thousands of stocks and concentrate on a manageable universe. A set of guidelines – and I urge you to put them down on paper – gives you confidence when times are rough. It helps you make the toughest decisions: when to sell. But it has to be Your Strategy, what’s right for you. Every singer must sing her own song,” he says.
Wanger says it’s exceptionally difficult to find a world- class management team with a truly great or unique product. So once investors find a company that satisfies these conditions, it’s important to hold them for the long term.
“I always thought to be a good investor, you need to hit a lot of singles and not strike out often. I was wrong. Investing, especially in small companies, is a home-run-hitter’s game. When people ask me how we have managed to get our results, I tell them that it’s not by avoiding disasters, because I have had my share of them. That’s understood with smallcap investing. But if you manage to own some stocks that go up 10 times, that pays for a lot of the disasters, with profits left over,” he says.
- Hold on to stocks for long term
Wanger says investors can’t make 10 or 20 times their money if they don’t hold on to stocks. “Most people are delighted when a stock doubles, and quickly sell to lock in their gain. If a company is still performing, let its stock, too, continue to perform,” he says.
Wanger says rather than building a broadly diversified stock portfolio, it is better to determine a limited number of themes that will be played out over the next several years and then identify a group of stocks that reflect those themes. “My portfolio may comprise a considerable number of stocks, but most of them by far will fall into half-dozen or fewer themes,” says he.
- Give winners time to compound
Wanger says in the short term, even the best of smallcap stocks are subject to a lot of ups and downs and the worst decision investors can make is to sell a solid company just because the price went down.
He feels one needs to hold solid companies for a long time so that the gains can compound. He says the average holding period of a stock should be between four and five years and some winners can be held on for decades. “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 like you buy a stock that goes up 20-fold. These rare events dominate,” says he.
- Don’t get classified as a growth or value investor
Wanger says investors should avoid getting classified as a pure value investor or a pure growth investor. “There is no reason to be a pure this or pure that. I look for – growth at a reasonable price. I want good growing companies, but I don’t want to overpay,” he says.
He says growth itself is one component of value and 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 earnings shrink. So can a low PB ratio,” he says.
Wanger says investors do seem to be born with the fondness for one style or the other based on their personalities. One should pursue a style that fits her temperament, otherwise she won’t be happy.
“Show me an unhappy investor and I will show you an unsuccessful investor. The value investor is hitting for singles. He will be delighted if he doubles his money in a couple of years. Few value ideas pay off better than that. If his analysis is correct and the company is worth more than the market recognises, however, the downside is limited. The growth investor is going for home runs. He dreams of making 5-10 times his investment. And his downside is considerable, since high-multiple stocks can become average-multiple stocks at the drop of a penny in expected earnings. You never know for sure if a company’s going to do what you hope it will,” he says.
Wanger says no matter how careful and selective one are, things can still go wrong in investing. “You should own at least a dozen stocks if they are smallcap, so a couple of winners can offset a couple of duds,” he says.
Wanger says investors may be very fond of a company but they shouldn’t overpay for it. He feels the stock must be reasonably priced in connection to earnings and cash flow in order for investors to buy the stock. HE says looking at numbers such as earnings growth and price multiples is less useful while evaluating small companies, as they have a shorter operating history and undergo changes quite often.
Wanger is respected in the investment circle for his outstanding long-term performance. His courage to stand against the herd at the right times and his ability to adapt to changes has helped him become a deserved part of the elite group of
The World’s 99 Greatest Investors.
(Disclaimer: This article is based on Ralph Wanger’s book “A Zebra in Lion Country: Ralph Wanger’s Investment Survival Guide.”)