Small cap investing: The Ralph Wanger way

Recently I finished reading a lot of available stuff on Ralph Wanger including his book, A Zebra in Lion Country. Ralph is popular not only for his success in investing, but also for his wit and metaphors.

If there are any doubts, this is how he describes Portfolio Managers:

“Zebras have the same problems as institutional portfolio managers like myself. First, both have quite specific, often difficult-to-obtain goals. For portfolio managers, above-average performance; for zebras, fresh grass. Second, both dislike risk. Portfolio managers can get fired; zebras can get eaten by lions. Third, both move in herds. They look alike, think alike and stick close together. 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 that 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.

On the other hand-or hoof- there comes a time when lions approach. The outside zebras end up as lion lunch. The skinny zebras in the middle of the pack may eat less well but they are alive. A portfolio manager for an institution such as bank trust department, insurance company or mutual fund cannot afford to be an Outside Zebra. For him, the optimal strategy is simple: stay in the center of the herd at all times. As long as he continues to buy the popular stocks, he cannot be faulted. On the other hand, he cannot afford to try for large gains on unfamiliar stocks that would leave him open for criticism if the idea failed.

Needless to say, this Inside Zebra philosophy doesn’t appeal to us as long term investors”

Active Years

Ralph Wanger was the sole or lead manager to Columbia Acorn Fund from its inception to September 2003. According to Investor’s business daily, the Columbia Acorn fund did averaged a 16.5% CAGR over a 20 years period ending March 2004.

Style of Investing

Growth at Reasonable Price

Investment Philosophy of Ralph Wanger

There are 2 essential parts of Ralph Wanger investment philosophy

    1. Focus on finding small cap companies that have good fundamentals

 

    1. Buy the companies that are the ‘downstream’ beneficiaries to a major trend.

 

There are few important things to note here. First, the success of the strategy lies in identifying a trend. Secondly, once a major trend is identified, the investment is not in that industry itself but the indirect beneficiaries. If we have to venture on an example, if one spots a major trend in e-commerce, it warrants investments in logistics companies that will be indirect beneficiaries and not in e-commerce companies themselves.

An example from Ralph:

“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.”

Let us now give time to understand both the parts 

Small cap companies with good fundamentals

First component here is small cap companies. According to Ralph, there are many reasons for sticking mostly to small cap companies. He refers to two studies which display the outperformance of small cap companies

  1. Small Firm Phenomenon documented by Rolf Banz (Professor at University of Chicago). You can read that paper here
  2. Study on 70 years stock return by Ibbotson Associates which found out that small companies give 2 pc higher annual returns than large companies. Over a longer period that is a phenomenal gap.

Besides that there are 2 other reasons as per Ralph to stick to small cap companies

  1. His theory of ‘Darwanism in the Marketplace’, which states that “the managers of small companies respond better to change
  2. “Large companies are well understood by the market, while one can find out things about small companies that the market doesn’t now”

Now, the question is what does Ralph looks in a good company. Please refer to this chart below, which is self-explanatory as to what all things Ralph considers important.

To find the value, Ralph prescribes something called the “Quit Test”

“ Assume that one of your eccentric friends who runs a large bank has just offered to lend you a great deal of money at about 10 % interest with which you may tender for all the stock of the company you are studying at current market price. If you study the company and say, ‘Boy, this is terrific! Give me the loan and I will do it. I’ll quit my job and go run that company. It’s a tremendous bargain’, then there’s not enough in that stock and perhaps you’d better look somewhere else”

The Second part of the philosophy is Spotting of Trends

To identify trends, you must “develop an observing mind-set,” that can draw generalizations from many different particulars. He suggests that trends can best be spotted from reading and one’s everyday general experience, including the work environment.  You have to train yourself to make generalizations from random particulars, to keep asking yourself “What does it mean”.

A Very important point that Ralph makes is

“This kind of analysis (focusing on long term trends) tends not to rest on numbers alone.”

Starting step is to see the areas of the market that looks attractive and then look for stocks in that area.

The characteristics of the investment should last for five years or longer.

He first identifies general “themes”—strong social, economic, or technological trends that will last longer than one business cycle (at least five years or more). The advantage of focusing on long-term trends, he says, is that most other investors are focused more on shorter-term predictions of two years or less, and it is difficult to outguess the competition, particularly since most investors are privy to the same information. The other advantage of focusing on long-term trends is that you must be a long-term investor, which is particularly important in the smaller-cap area because of high trading costs.

 Markets of Ralph’s is Interest

During his time as the sole manager of the fund, the fund was primarily invested in US Listed Equities. Around 8-12% of the fund was outside US as per an article in 2004 (just after Wanger stepped down from Sole manager responsibility). Within the US listed equity space, Ralph was more focused on finding the small cap ideas.

 More Learnings from Ralph (Statements I would like to remember)

Don’t try to time the markets. Stock market is a reliable indicator of where the economy is headed, but there it’s no help trying to look at events the other way around.

If one concentrates on the long term basic trends that move smoothly and steadily over a multiyear time spans, following intraday moves of the market is of no use and can be safely ignored.

If you want to stand out from the pack, you have to stand outside the pack.

When researching smaller companies, one must talk to owners as they are most important.

Since small companies will be illiquid, it’s best to hold the companies that you don’t have to sell for long.

Never confuse a great company with a great stock.

What it takes to invest like Ralph Wanger

Ability to take a lot of misses. Since once is dabbling into outside the herd and looking for undiscovered companies, the chances are that there will be a lot of misses. The outsized returns in the ideas that will work should compensate for the one that didn’t. One line from the book that says it all:

“We have tried to be Outside Zebras most of the time and there are plenty of claw marks on us”

I am researching on such trends and companies and will post my findings in another blog post soon. If you guys have inputs, I am all ears!!!

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