This is one of the few books that dwell on art of investing smaller companies. The book becomes even more important to read when written by small cap mogul Ralph Wanger.
A contrarian and an ardent supporter of small-cap investing Wanger has earned a lot of fame for successfully managing small cap portfolio for a very long period of time.
In fact, his fund the Columbia Acorn fund, which he managed for the first 23 years, since its inception in 1970 was one of the best performing funds. The fund outperformed the S&P, having delivered a 16.5% CAGR over a 20-year period ending March 20004, vis-à-vis 12.5% return by S&P.
He later founded Wanger Asset Management, which is again largely a small-cap focused fund.
When one thinks about investing, common prudence is to gauge the rewards versus the risks. One therefore tends to neglect small cap stocks and stick to the safer albeit low return large cap stocks.
In his book Wanger has likened the behaviour or dilemmas of portfolio managers with those of Zebras. He uses the Zebra metaphor to drive the idea of small-cap investing. According to him, both dislike risks but set high goals for themselves.
The portfolio manager looks for above- average returns while the Zebra wants fresh grass. The portfolio manager is at the risk of being fired while the Zebra is at the risk of being eaten by a lion. Secondly, both move and follow in herds. The Zebras always move in herd and look alike and think alike.
The key decision for a Zebra is where to stand in a herd. The centre of the herd is the safest in case a lion attacks but then the grass is not fresh and green there.
On the other hand, the outside of the herd has the best grass but the Zebra risks being attacked by a lion. Similarly, for a portfolio manager especially those managing insurance or pension funds, a low risk strategy is to keep on investing in popular stocks (low returns) so that he does not go wrong. i.e. he has to stay in the centre of the herd. But then he cannot hope for extraordinary returns.
If he wants above –normal gains he has to look at unfamiliar stocks leaving him susceptible to losses and investor criticism as he has to be an outside Zebra.
The big takeaway here is that the Wanger supported a contrarian thinking.
“If you go with the consensus, your performance will be consensus. If you want to buy a stock you have to go against the grain. Similarly, when a stock is skyrocketing you have to got to question the prevailing euphoria, too”
Investing in smaller companies could be fatal and no matter how selective we are things could still go wrong. The author suggest that disappointment in the smaller companies is normal, which can be adressed with proper diversification.
It may be risky. Investors might be exposing to the risk of going out of the pack, but that is where the most money is made.Do not worry he has a detailed discussion on mitigating risks in the subsequent chapters.
“When people ask me how have we have managed to get our results, I tell them that it is not by avoiding disasters, because I have had my share of them. That is understood with the small cap investing. But if you manage to own some stocks that go up ten times, that pays for a lot of the disasters, with profits left over."
Wanger has talked about the several advantages of investing in the smaller companies. He has backed this with the independent studies comparing the share price return of smaller companies as against the big companies done for a period of about 75 years. Smaller companies have delivered far better.
According to Wanger, investing in small cap stocks is advantageous as small companies are better placed to sustain higher growth rates.
Smaller companies with one or two lines of businesses are easier to understand than large companies with multiple business lines. While Wanger has been a supporter of smaller companies the other important point of his investing style is he completely avoided tiny micro capitalisation companies.
“Small is good, micro is not. For the lettlest companies, it is like auditioning for a chorus line: one misstep and you are out”
Investors have a lot more advantage. A Smaller company may be less discovered by the market. If we can discover things that others do not know we have an abselute advantage. And since people do not know, we may find a bargain or a stock available at quite a cheap valuations.
“At big companies you talk to executives. At smaller companies you talk to owners”
A great company which has reached its optimum size or growth rate however, might not be able to provide investors with very high rate of return. This is because great companies are almost always backed by good research coverage and hence most of the information is already publicly known and hence factored in the stock price. On the other hand, small companies aren’t always supported by research coverage. So one can discover a lot of new things which are hitherto not known to the market.
Large companies are weighed down by their large size and limited ability to grow fast. What is even more difficult is that as they grow they several layers of businesses which are hard to understand and predict. Owner led companies are driven they tire lessley working for you particularly because they also own the large chunk of the stake in the company.
Wanger who is often called both as value and growth investor is happy with the tag. He elaborates that growth is one of the component of value. Growth is important and growing earnings is far more worth than a static. But then price is equally important when it comes to investing or buying stocks.
Momentum, sentiments, liquidity can drive stock prices higher or above their intrinsic values. And in these cases what price we pay becomes critical. He is thus a GARP (Growth at Reasonable Price) investor looking for growing companies and not willing to over pay. He seldom buy super growth stories or companies growing 25-30% annually because he believes such estimates rarely come true.
The tree do not grow to sky. Value investors also face the music when stocks considered value stocks turned into a value trap because of the erosion of underlying value. Instead of expecting a recovering the patient actually dies.
“The greatest investment profit comes when and ugly duckling becomes a swan”
While selecting a small company it is important to focus on its growth potential, financial strength and fundamental value.
Secondly, the success of his investment strategy lies in identifying a long-term trend (preferably 5 years)
Once a trend is identified, the investment is to be made not in that industry but in the indirect beneficiaries. for eg: if one identifies a major trend in say e-commerce, playing with a logistics company could be great idea and not directly the e-commerce players.
Wanger has a distinct investment philosophy largely pillared on the following tenet:
Wanger puts the four important criteria looking for seasoned companies (established) with financial strength, dominence in their market segments, entrepreneurial management, and understandability.
Stay away from the marginal and under financed companies.
According to Wanger, while the stock market is a reliable indicator of the economy, the converse does not hold true i.e it is no use trying to time the market,based on social, economic or political events, as market tends to overreact to news whether good or bad. Hence looking at long-term trends and focusing on individual opportunities could be far more rewarding.
Wanger would rather spend time talking to the owners of companies figuring out future growth of their business. He would spend more time looking for stock price drivers like earnings growth, expansion strategy, new product launches etc.
“If you believe you or anyone else has a system that can predict the future of the stock market, the joke is on you.”
According to Wanger, the key lies in picking out fundamentally sound companies which will benefit from strong social, economic or technological trends. And these trends should last 4 years or more. Hence, there is no need to look at short term trends and timing the markets. If the company is right it will keep on performing irrespective of the market trend.
Most investors vie for above average returns but are reluctant to invest in lesser popular stocks. According to Wanger, one has to be willing to identify a new trend, bet on it and then appropriately select the beneficiaries of such a trend, only then can we attain high returns. More often than not it is the risk of criticism or losses which prevents us to invest in lesser known areas and stick to the known or the safer bets.
According to him, the best company in a marginal industry is worth more than the third –best company in a major industry. Similarly, investing in companies which are downstream or the indirect beneficiary of a larger trend is the smart strategy. If we limit ourselves to where the herds gather, we would be losing out on a large universe of hidden stocks.
A portfolio of well-researched small companies are no riskier than a portfolio of large well-known companies-The fundamental principle of any investment decision is to back-it with proper research. Wanger goes a step ahead and believes a portfolio of well-researched small cap companies is no more riskier than a similar portfolio of large cap companies, as long as it has been thoroughly researched.
According to him, a small cap company which is financially robust or has a market dominant position and whose stock can be bought at a reasonable price, should make for a good investment. His premise is that even a large cap company with numerous business lines or whose future businessprospects are not clear should make for a risky investment.
Don’t be excited if the company’s earnings forecast beat analyst estimates in the short-term, look at the long-term trend.
Investors often mistake relaying too much on Street estimates. Companies are not forced to meet expectations and businesses go through cycles. According to Wanger, unless and until one looks at the company with fresh perspectives we cannot find value stocks.
While earnings, future growth rate, etc all are the obvious parameters to look at while picking a stock, a crucial aspect is to visualise the bigger picture. Does the company operate in an industry which will benefit from a long-term trend. Or does it have a niche product or market position? These considerations are much more important rather than buying and selling stocks based on quarterly estimates.
“One cannot make five or ten or twenty times your money if you do not hold on to stock. Most people are delighted when a stock doubles and quickly sell to lock in their gains. If a company is performing, let its stock, too, continue to perform ”
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