Low Cut Dresses and Ugly Ducklings

Making money in the small-cap market is like finding a
woman.

If you are only looking to get laid, you’ll head down to
the smoke-filled tavern and seek out the woman with the
low-cut dress, cheap perfume and a nearly empty drink. Buy
her enough rum and Cokes and you may find the immediate
satisfaction you desire. (Of course, God only knows what
you may come down with in the process.)

But if you are looking for a wife, a life-long companion,
you’ll pick the woman that has morals, integrity and a
friendly smile. Instead of scouring the seamy bars and
nightclubs, you have to look in far more boring places –
like the local library, the neighborhood coffee bar or your
corner grocery store.

That’s the basic metaphor Ralph Wanger, the finest small-
cap fund manager of the last 50 years, used to describe
investors last Tuesday when Chris Mayer and I flew to
Chicago to interview him.

We met at 227 West Monroe Street at 11:00 sharp. Both of us
were giddy with excitement. Wanger is to the small-cap
market as Buffett is to value investing. There is no one
better – and we were about to meet him.

From 1970 to 2003 Wanger ran and managed the Acorn Fund – a
small-cap fund that invests in fundamentally sound
companies that the rest of Wall Street turned their noses
to. During his tenure at Acorn, he averaged a robust 17.2%
return. A mere $10,000 investment in 1970 was worth
$174,059 by 1998. Not too shabby. And when Chris said he
was able to get an interview with him, I wasn’t going to
pass up the opportunity to pick his brain.

After clearing security, taking two elevators up to Mr.
Wanger’s 30th floor at office (that overlooked the Chicago
skyline and Lake Michigan), and introducing ourselves, I
asked Wanger what separates successful small-cap investors
from those who lose their shirts. He put it to me like
this…

Small-cap speculators (those who tend to lose a ton of
money in the market) buy the hottest biotech or
semiconductor stocks hoping to make a quick return. They
seek out the sexiest stories on Wall Street – the stories
everyone is talking about– and lay their money down. If
they are lucky, they walk away with a bundle of cash. But
more than not, they come up empty and wishing they wouldn’t
have indulged in the first place.

Wanger referred to these people as "loony." They are the
same people who go to the bar looking for the one night
stand with the girl that is being swarmed with dozens of
drunk men. Their chances of winning are slim to none. Yet
most people who dabble in the small-cap market take this
approach.

The more prudent way to make money in the small-cap market,
Wanger contends, is to focus on the boring and beaten down
companies that no one else is looking at. And that’s
exactly how he averaged a 17.2% compounded return for 30
years as the fund manager for the Acorn Small Cap Fund.

Some of his biggest winners (which he proudly shared with
Chris and I) were a brick maker, a slot machine business
and a "boring" frying machine company. If those companies
were women, they would be buried in the back of a library,
wearing a turtleneck and a cardigan sweater reading the
latest edition of Home and Garden. At first glance, they
may be what you or I would consider an ugly duckling. But
Wanger loves his ugly ducklings. As he said in his classic
book A Zebra in Lion Country"…

"My favorite ugly duckling stock is Newell Industries. It’s
in the most mundane business you could imagine. It makes
frying pans, knitting needles, curtain rods and drapery
hooks, paint rollers, a whole catalog of routine hardware
and home decorating items. We’re not dealing with
integrated circuits here."

Wanger bought shares of Newell for as little as $1.68 a
share in the mid 1980s when no one else was paying
attention. But thanks to deals with Home Depot and Wal
Mart, business boomed for little hardware company. And the
stock rose as high as $52 a share. That’s a 30-bagger win.
Impressive – the stuff legends are made of. But most small-
cap investors won’t ever see those kinds of gains. And it’s
not because they aren’t smart enough. It’s because they
aren’t disciplined enough.

To truly make money in the small-cap market you have to be
willing to invest – not speculate. You have to be willing
to look at the ugly ducklings versus the sexy vixens that
everyone is watching. And you have to hold solid companies
for a long time so your gains can compound.

Wanger’s average holding period for was between four and
five years. But as he was quick to point out to Chris and
I, he held onto some winners for decades while he cut
others loose after a few months.

This is key.

What separates a great investor like Wanger from a schmuck
who loses money every year may be one or two investments
over the span of several years. You may only have one, two
or three grand slams in a career – those 30 baggers that
you can write books about. And the guy who can walk away
with three 30-baggers versus one will come out WAY ahead in
the end. That’s exactly what Wanger has done year in and
year out. He let his winners compound (a la Newell) and he
cuts his losers.

The net result has been a 17.2% compounded return for his
famed Acorn fund. So how can you achieve similar results?

You have to know when to sell – something most investors
don’t have a clue about.

Wanger said your sell strategy is actually built-in to your
buy decision. Unlike most amateur investors, he doesn’t
necessarily use stop-losses or trailing stops to figure out
when to exit a position. Instead, he creates a simple
spreadsheet for each investment he makes. He writes (in
plain, simple English) why he is buying stock in a company.

In other words, he spells out his buy decision. But he also
makes it easy to figure out when to sell. When his reason
for buying is proven false, he sells. Here’s the example he
shared with us…

Let’s say you buy shares of XYZ Corp. because you believe
its profit margins will rise from 2% to 8% over the next
five years. That’s your investment strategy. It’s
simple…to the point…and falsifiable. There are only
three possible scenarios that could cause you to sell.

Sell Scenario #1: If after several years the profit margins
haven’t budged, you sell. Your investment idea – thinking
the company’s profit margins would rise – is false. Time to
lick your wounds and move on. You were wrong.

Sell Scenario #2: If after two years XYZ Corp.’s profit
margins were at 5%, you would continue to hold. The margins
are rising. Your initial investment equation is still true.
So there’s no reason to take profit yet – a mistake most
investors make. Hold this baby…it could make you famous.

Sell Scenario #3: If XYZ Corp.’s profit margins are at 9%,
you would also sell. Once again, your initial reason for
buying the company is false. The company’s margins rose
above 8%. Time to take profits and sell. The company has
exceeded your expectations. Congrats.

It’s a simple strategy – one I suggest you use in your own
investing.

Every time you buy a stock, write down why you are buying
it. Keep it short — no more than a paragraph or two. Make
sure the reason you are buying is simple and clearly laid
out. And when the reason you bought the stock is no longer
true, sell. This will save you a lot of sleepless nights,
costly transaction costs and wild price flucutations that
scare most other investors.

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. That’s what speculators do. And you know you
can’t make a lot of money being a small-cap speculator.

Wanger built his fortune by investing in boring (ugly
duckling) stocks. He kept his buy and sell strategies
simple. And like a good woman, he held onto solid companies
for a long, long time.

If you aren’t willing to do the same, you should stay away
from the small-cap market now. With valuations neutral at
best, your chances of getting lucky aren’t very good.
Chances are, you’ll end up sleeping alone and have less
money in your bank account than your had the day before…

A guaranteed investment scheme…

You and I buy up all the nickels we can get our hands on.
Since the underlying metal in a nickel today is worth about
six cents, we lock ourselves in at a guaranteed 20% profit
by selling short the coin’s metal in the financial markets
today.  Then all we need to do is melt down the nickels…

Okay, so it’s not so easy.  And there’s probably some sort
of law against this.  But the reality is, at current metals
prices, it costs the U.S. government about six cents to
produce a nickel…

Leave it to the U.S. government to LOSE money by PRINTING
money…

In fiscal year 2003 (ending in September), it cost the U.S.
government 3.78 cents to produce a nickel.  In fiscal year
2004, it cost the government 4.56 cents to produce a
nickel.  And so far this fiscal year (from October 1, 2004
to present), the price of copper (which is the most
prevalent metal in a nickel) is well above its fiscal year
2004 levels, meaning that it’ll likely cost the government
about 6 cents to produce a nickel.  Take a look:

How can you LOSE money when you MAKE the money?

Of course, the government will not lose this game… The
government will eventually be the one to earn the profit on
the melt value of the coins as it takes them out of
circulation.  And no doubt, the government will soon change
the metal content of the nickel and the penny, debasing the
intrinsic value of the coins, as governments have done for
centuries.  (At the amazing rate of the destruction of the
value of a dollar, chances are we’ll be spending plastic
poker chips instead of metal coins in the not too distant
future.)

So what’s the right thing to do?

It’s not to bury a mountain of pennies and nickels in your
backyard.  And commandeering a fleet of trucks to collect
nickels and melt them for their metal content seems pretty
extreme, and will probably run afoul of government laws
somewhere along the way.

THE RIGHT THING TO DO IS SIMPLY TO HAVE LESS PAPER, AND
MORE METAL, IN YOUR ASSETS.

The government can debase money.  But it can’t mess with
your metal.  Two years ago, a nickel cost less than 4 cents
to produce.   Last year, a nickel cost almost 5 cents to
produce.  And this year, a nickel will likely cost the
government 6 cents to produce.

The reality is, our paper dollars become more and more
worthless every day.  Based on the government’s own
inflation statistics (the CPI), the dollar has already lost
80% of its purchasing power just since 1970.  Said another
way, what cost $2 in 1970 now costs $10 today.  (See for
yourself: http://www.westegg.com/inflation/ )

They say "a nickel ain’t worth a dime anymore" and it’s
true.  A nickel back in 1970 is actually worth 25 cents…
a quarter… today.

The more I look for "no-brainer" assets, the more I’m drawn
to metals / commodity plays, including gold.  While every
other asset out there (stocks, bonds, and real estate) has
appreciated dramatically over the last 25 years,
commodities, and gold in particular, have gotten cheaper
and cheaper.  Adjusted for inflation, gold is unbelievably
cheap.

Commodity plays, even though they have risen, are still
worth owning.  At the very least, I feel that you must own
some of my recommended commodities and gold plays, simply
to hedge your risk of the hidden loss in value every year
of owning paper assets…