Ahead of the Herd

Last week, readers were warned that now was the time to bet against small-caps. Today, you get the other side of the story – straight from the mouth of our small-cap superstar, James Boric. Read on…

From 1970 to 2003, Ralph Wanger, famed manager of the Acorn Fund, made his fortune investing in no-name, small-cap stocks.

Companies like Newell Industries, International Game Technology, Houston Oil & Minerals and Cray Research were the "heavy hitters" that made up his portfolio – the exact kind of companies most fund managers don’t have the guts to even look at.

Too bad for them.

Newell Industries rose from a low of $1.68 a share to as high as $52 a pop. International Game Technology catapulted from $1 to $40 while sitting in Wanger’s portfolio. And he didn’t do too badly with Houston Oil and Cray either – turning $220,000 into $5.3 million and $1.5 million into $20 million respectively.

As a result of outstanding performers like those, Wanger’s flagship, Acorn Fund, averaged a robust 17.2% compounded annual return from its inception in 1970 to 1996. To put that in perspective, the S&P 500 rose from 92 to 757 in that same timeframe – averaging an annual compounded return of 8.4%.

And in dollar terms, Wanger did even better…

Small-Cap Stocks: The Outside Zebra

Thanks to the miracle of compounded interest, he made over seven times more money than the average fund manager on Wall Street for more than a quarter of a century. And he eloquently describes in his book, A Zebra in Lion Country, he did it by mimicking the behavior of the "Outside Zebra" in the wild.

Zebras that reside on the outside of the herd are calculated risk takers. They know there is always a chance a lion could pounce out of the bush, wrap his gigantic paws around their neck and fatally sink his fangs into their jugular.

But the allure of lush green grass, fresh water and the cool breeze is worth the risk of an attack. You see…

Zebras that stay in the middle of the herd, the inside zebras (read: 99% of all fund managers in the world), are scared creatures. They don’t want be eaten by a lion. So they cower around hundreds of their closest friends. It’s a good strategy to stay alive. Problem is…

The inside zebras tend to be thin – gaunt even. The grass they graze on has been trampled on by hundreds of other zebras. What little there is to eat is up for grabs by the entire pack.

For the zebra, every move it makes is a calculated risk. And the same is true for investors. The question you have to ask yourself is, can you handle the risk of being an outside zebra investor? Or are you satisfied with the gaunt returns of an inside investor?

Wanger decided early on in his career he was an outside investor through and through.

He knew if he invested like everyone else and listened to the same investment advice everyone else did, he would consequentially make the same return as everyone else. So he sunk his money into small-cap companies (those with a market capitalization of $1 billion or less) that the mainstream analysts simply didn’t follow.

Sounds like an obvious thing to do – easy in fact. But it wasn’t. Wanger had the same problem small-cap investors have today…

Small-Cap Stocks: Strategy

He had to sift through thousands of companies that weren’t worth the paper their stock was printed on. So he developed a strategy to help him separate the good from the bad.

First, Wanger only invested in companies that had a strong niche in its industry. In other words, he wasn’t going to invest in an upstart software company that had no business competing with Microsoft.

Secondly, Wanger insisted the company be financially strong – with enough working capital to sustain and grow for years to come.

And finally, he had a defined exit strategy. Wanger invested in fundamentally sound small-cap companies that could grow one of four ways before he cashed out…

1. Internal Growth (meaning as earnings rise so will the stock price)
2. Acquisition (when a smaller company is bought be a larger one, shareholders are usually rewarded with a premium stock price)
3. Repurchase (if a company is trading for less than its true intrinsic value, it may purchase huge blocks of its own shares – causing the price to rise)
4. Revaluation (this is the idea that a solid small company will eventually be discovered by Wall Street and emerge from unknown to the top stock on everyone’s must-own list).

As Wanger wrote in his book, "Good quality smaller companies can produce stock market profits by any of these four mechanisms. The best hope for established, big-company favorites is the first – only one out of four. Large companies have so many shares outstanding that buyback programs seldom have a meaningful impact. And although in recent years we’ve seen giant companies swallowed by other giants, small companies are more likely targets – and the buyer almost invariably pays well above the market price in order to rake in the shares. Some of my best gains over the years have come from these takeovers."

Of course, there are real risks involved with being an outside zebra investor. You aren’t always going to win. Eventually, you will take your lumps. That comes with the territory. And Wanger certainly took his over the years.

He admits to investing in Coleco and watching it fall from $65 to $12. And then there was Energy Reserves and Elscint which tanked from $36 to $6 and from $28 to $8 in a hurry.

Those losses hurt. But Wanger never deviated from his strategy – even when the market got ugly…like it is today. This is a very important point. Wanger never abandoned the whole market because it looked expensive from 30,000 feet. He focused on the details, on the merits of individual companies, where most investors don’t care to look.

You need to do the same right now.

Small-Cap Stocks: Not Time to Bail

Everywhere you look today, folks are bad mouthing the small-cap market. Its six-year reign over the large-caps is over. Run for the hills! SELL!

Even my respected colleague, Dr. Steve Sjuggerud, said that now is the time to bail on the small-cap market. He astutely pointed out that the average stock on the Russell 2000 currently trades for over 20 times earnings and two times book value – the highest level since the 1970s.

You can’t argue with his logic. Heck, I wouldn’t be running out to buy calls on the small-cap market right now either.

That would be stupid.

Even outside zebras in the wild wouldn’t deliberately walk up to a lion, sprinkle a little A-1 Steak sauce on themselves and roll over. Of course they would be eaten.

I am not saying you should buy the entire Russell 2000 right now. But you would be an absolute fool to give up on all small-cap stocks now – just because everyone else is.

There are still bargains to be found. Always have and always will be. Look at the individual trees, not the forest. Companies, not indices.

According to Multexnet.com, there are 5,910 companies trading on the major exchanges. Of those 3,993 have a market cap of $1 billion or less. That means 67% of the market is in the small-cap universe. And it also means 67% of the market is NOT being covered by most Wall Street analysts, hedge funds managers and mutual fund managers.

In other words, you still have an advantage as a small-cap investor – if you are willing to separate yourself from the herd. If you can do that, I guarantee you…

The next Newell Industries, International Game Technology, Houston Oil & Minerals and Cray Research are out there right now. And no matter what happens to the broad small-cap market, there will be hundreds of small companies that make investors a ton of money.

For example, my readers recently had the chance to buy shares of Forward Industries (FORD:NASDAQ) at $7.83 a share. That was pretty cheap, considering the company was a leading producer of soft sided electronic cases – for things like cell phones and PDAs. Couple that with the emergence of 3G cellular technology and it was obvious million of people would be buying new cell phones – and thus Forward’s new cases.

We were right.

Twenty-eight days later, shares of FORD jumped up to $15.90 a pop. And anyone who sold could have raked in a nice 103% gain.

With literally thousand of companies on the market right now, the next FORD is waiting to be found.

Regards,

James Boric
for The Daily Reckoning

April 28, 2005

P.S. Remember… Though out Wanger’s tenure as fund manager of the Acorn Fund he survived small-cap many ups and down. He lived (even prospered) through the 1969 to 1974 period – when large caps dominated small-caps. He even lived through the rough 1983-1990 stretch when no one wanted to invest in small-cap stocks.

Wanger didn’t roll over and die when the going got rough. He stuck to his guns. And in the end he had the last laugh.

I only wonder, how many of you will have the guts to follow in Wanger’s footsteps?

James Boric is one of the leading small-cap analysts in the country. He publishes Penny Stock Fortunes and Penny Sleuth – both of which highlight tomorrow’s powerhouse companies while they are still trading for pennies on the dollar today. Mr. Boric contends that two-thirds of all the great investment opportunities lie in the over-looked small-cap market.

It is a recession that America desperately needs and a recession that it desperately doesn’t want.

Why it needs one is obvious – it needs to deflate a huge bubble of debt. Why it doesn’t want one is obvious too – it has a huge bubble of debt to deflate. Thanks to quick and forceful action from public officials Americans are now deeper in debt than ever before in history. Credit expanded by $10 trillion between 2000 and 2004, says Kurt Richebächer, compared to nominal GDP growth of only $1.9 trillion.

If the country had been allowed to have a proper recession back in 2001, we wouldn’t be in this mess. But the Fed and the Bush administration couldn’t leave well enough alone. They rushed in with the biggest "stimulus" package ever.

We hope we are not boring you with economics, dear reader. But here at The Daily Reckoning, we can’t pass up a good farce. We love to point and giggle.

What the Feds were doing, according to conventional analysis, was "priming the pump" for an economic resurgence. Economics is a dismal science at best…at worst, it is a hopeless fraud. One economist, Robert Lucas, explained that the whole idea of trying to fight a recession was claptrap. Recessions, like booms, were self-correcting, he said. As business activity declined, people gradually sensed the shift in the economic climate. They reduced prices…to the point where people were able to begin buying again.

Nice theory. In practice, people are reluctant to cut prices – especially the price of their own labor. They don’t know how long the recession will last. They don’t know what to do. So, along come the activists in Washington to tell them. Go out and buy a new SUV, said Fed governor McTeer. Rather than let the correction run its course, the Feds cut interest rates and boosted spending. They primed the pump so hard they practically broke the handle. But now people were more confused than ever. They had no more income than before…but their houses rose in price. They could "take equity" from their houses…and spend it. This extra consumer spending made GDP increase. But were they getting rich or poor?

"Rich!" said practically everyone. "Poor!" said we, at The Daily Reckoning.

During the period, 2000-2004, consumer spending on durables and housing, plus government spending, equaled 123% of real GDP growth, says Kurt Richebächer. Other parts of the economy – notably, business investment – went down. What the nation was doing was shifting from production to consumption. Its leading business was shifting from GM to Wal-Mart – that is, from making vehicles to selling paraphernalia from China. And its citizens were shifting too – from making things that they could sell to others…to selling houses to each other.

It’s too bad you can’t actually get rich by consuming. Otherwise, the IMF could hand out plastic cards with unlimited lines of credit to people in Third World countries. But like every government program that pretends to improve on what nature dishes out…it would not merely be a flop, it would be a disaster. People would stop working for 50 cents an hour and begin buying things. In no time at all, they would be deeply in debt with no way to make their payments.

And yet, absurd as it sounds, that is basically what the Fed did to Americans. It lowered the cost of borrowing below the inflation rate. Rates were so low and house prices rising so fast – it was as if every American had an unlimited line of credit. Naturally, Americans shifted from doing the things that might make them richer in the long run to doing things that were sure to make them poorer right away. Savings rates collapsed. Business investment collapsed. Debt soared. In 2000, $368.3 billion in mortgages were written. By 2004, the amount had more than doubled.

And here we are, dear reader, in 2005. What next? If only we knew…

More news, from our team at The Rude Awakening…

————–

Chris Mayer, reporting from Gaithersburg, Maryland:

"This is the tale of a man who, by making a few key investment decisions, converted a small fortune into a very large one during the difficult years of 2000 to 2005, even when most investors were losing money in the stock market…"

————–

Bill Bonner, back in the countryside…

*** The U.S. consumer seems to have hit a "soft patch," says yesterday’s press reports. Confidence is down. The price of gasoline is up – to an average of $2.32 a gallon. The price of housing is up too. Twenty years ago, an average household would pay about five years’ worth of earnings for an average house. Now they pay eight years’ worth.

*** "What no one expected," said a colleague the other day, "was the way capitalism and communism get along in the modern world."

People thought the two ideas were mutually exclusive. As recently as the Reagan administration, people with brains thought there would have to be a showdown…that the two ideologies could not live together; the world wasn’t big enough for them both. But look what has happened. Today’s the most dynamic economy on the planet – one with what appears to be the most freewheeling capitalism – is in a communist country, China.

And in America, which is supposed to be a "capitalist" nation, practically everything is regulated, collectivized and subsidized – especially in the economic sphere. Even when people eat too much and become fat, they blame McDonald’s…or the government…or society for their own obesity. Everything requires permission from some group…and when things go wrong, it’s always the fault of some group. Individual responsibility is disappearing.

Hilaire Belloc looked ahead and described the modern world back in 1912:

"The future of industrial society…is a future in which subsistence and security shall be guaranteed for the Proletariat, but shall be guaranteed…by the establishment of that Proletariat in a status really, though not nominally, servile."

People lose their independence. But so what? According to Belloc, they are "inclined to the acceptance of [their servile status] by the positive benefits it confers."

What do we make of this? The isms and ideologies are largely simpleminded humbug…human organization is infinitely complex, subtle, ironic and often paradoxical.