Low-Cut Dresses and Ugly Ducklings

Who ever would have thought that making money in the small-cap market is comparable to finding with whom you could settle down? Well, that’s just the point that the great small-cap fund manager, Ralph Wanger, made to James Boric when they met last week…

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

If you are only looking to get some "action," 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.

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.

The Small-Cap Market: What Separates the Successful from the Unsuccessful

After clearing security, taking two elevators up to Mr. Wanger’s 30th floor 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 often than not, they come up empty, 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 a 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 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, which is 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 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.

The Small-Cap Market: Knowing When to Sell

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 will come out WAY ahead in the end. That’s exactly what Wanger has done time after time. 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 into 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 you had the day before…

Regards,

James Boric
for The Daily Reckoning

June 15, 2005

P.S If you really want to make money in the small-cap market, I suggest you read a copy of Wanger’s classic investment book, A Zebra in Lion Country. If you do nothing else but follow his advice, you’ll walk away richer, wiser and happier. And you might learn a thing or two about women.

"Why we’re going gaga over real estate," is the headline on this week’s TIME magazine.

The only reason the TIME’s reporter gives for the real estate mania is – because it is going up in price. The report is not unlike a love story written by a priest with no imagination; he has left out the exciting parts.

"I saw so many of my friends and colleagues getting rich," TIME quotes one speculator, "I wanted to get rich too."

All over the country, houses are flipped, fixed-up, sold, torn down, rebuilt, refinanced, and flipped again. Lenders, builders, agents, speculators, and people who put in granite countertops are all getting rich. One day a house sells for $150,000…two years later, it has risen to $250,000.

"I bought a house in Gaithersburg, Maryland, just two years ago," said a young colleague yesterday. "I paid $400,000 for it. Now, they’re selling for $600,000. I made $100,000 per year. Actually, more than that, because I mortgaged most of the purchase price."

Isn’t it amazing that an inert object – a consumer item – can become so much more valuable in the space of a few months, even though it has not really changed? The question never seems to occur to TIME or anyone else. People may be going gaga over real estate, but what has happened to the real estate market to cause them to lose their minds?

Here is where the priest blushed and lowered his pen. He decided to end the story there. Too bad, because here is where the tale turns a little steamy…and even sordid. Here is where we find out the original sin that engendered the rise in real estate prices.

Today’s news reveals nothing very interesting. Day after day, stocks go nowhere. They have barely moved for the last few weeks. The Dow is neither higher nor lower than it was eight years ago.

The euro did not rally as we expected; at least, it has not rallied yet. Instead, it sinks. Your vacation in Europe will be less expensive than it might have been, but still probably more expensive than you expected. The euro has gone down, but only to $1.20.

Gold did rally, however. People with wealth are probably getting a little wary of both paper currencies – the euro and the dollar. Yesterday, gold went down, but was still $4 above our $425 buying target.

None of this is very exciting, so we step back…back…and back some more, until we practically fall off the stage…in order to get a view of the bigger picture. The world is flooded with two things: money and labor. There are 3 billion people in Asia who are entering the globalized labor pool. Politicians can rant and rave all they want; there is no escaping this downward, deflationary force in the cost of labor. That is a large part of the reason why real labor rates in America are going down.

We pause a moment to ponder two questions: How can people who earn less money afford more expensive houses? And how is it possible that the world’s most flexible, dynamic and successful economy actually makes its typical citizens poorer over a quarter of a century? We ask both questions out of mischief, not curiosity. We already know the answers: They can’t and it isn’t.

More news, from our team at The Rude Awakening:

————–

Tom Dyson, reporting from Baltimore…

"Could the April job numbers possibly have been more horrid? I was stuck in gloomy woe on those numbers, saying, ‘Woe, woe, woe,’ until I saw analysis from Wachovia’s chief economist John Silvia…"

————–

Bill Bonner, with more views:

*** Now we turn to the second thing with which the world is flooded: money. The "glut" of labor is cutting prices – directly, for labor itself, and indirectly for the things people make and do with labor. But the "glut" of money and credit – thanks largely to the Federal Reserve – pushes prices in the opposite direction. For the present, the two forces barely meet. Chinese-made goods fall in price, while house prices all over the planet rise. How long this will last is anyone’s guess, but that it won’t last forever is certain.

Since we are bending over backwards to get a good view, we squint to see where this might lead. Surely, real prices on things that can be made and shipped are bound to fall. But nominal prices on things that cannot be easily duplicated are likely to rise – perhaps sharply.

Daily Reckoning reader Rolf Hackmann wrote a new book, Globalization, and you reading it, you get the feeling that he must have better vision or a more distant perch. He sees "a prolonged decline…[including]…crushing competition…falling prices, profits…high levels of unemployment…business and consumer bankruptcies…deflation of asset values…trade wars…major reductions in white- and blue collar workforces…rising long-term interest rates…perverse valuation bubbles coexisting with the generally weak economic conditions that seem poised to add more capital destruction and malaise coming from their inevitable implosion. Japan is setting an ominous example."

None of this occurs to TIME editors…or to the real estate speculators…or to the lumpinvestoriat in general. As far as they know, the real estate boom came into the world by some sort of Immaculate Conception – untainted by the lust for easy money.

Wait till they get to the juicy part!

*** Oil is still $55 a barrel. Yesterday, a friend recalled how completely imbecilic America’s financial policymakers can be.

"I remember when I was just a boy sitting in the back seat of my father’s Ford Torino waiting to buy gas. We had even-numbered license plates, so we could only buy gas on an even-numbered day."

In the early ’70s, there seemed no limit to the stupidity of public officials. First, the Nixon administration imposed sweeping wage and price controls – as if he, like emperor Diocletian – could control the economy by decree! And then, along came the oil crisis. Rather than allow prices to rise in order to clear the market, officials decided to try to control it themselves – by rationing gasoline according to one of the loopiest regulatory schemes ever imposed.

We remember it, too. You’d have to get up early to get in line in order to buy gasoline, just as people did in the Soviet Union in the 1980s and Zimbabwe today. You could only buy it on odd or even days, depending on your license tag number. It was mad. But people lined up then, as they do now – on the flimsiest pretext. Yet, we don’t recall a single senator wondering out loud what gave the federal government the right to tell on which day of the week they could buy gas. The great mass of Americans, we concluded, will go along with anything.

*** This week we’ve been in Baltimore, meeting with the DR staff that has flown into Charm City from London, Paris – and even our new office in Australia – for some brainstorming sessions.

We’ve learned some interesting things over the past few days…one being that you editor will not only be speaking at – but hosting our yearly conference in Vancouver, The Agora Wealth Symposium.

We’re pretty excited about the conference…and not just because it’s held in one of our favorite hotels in the world, The Fairmont (although that doesn’t hurt.) But it’s not very often that I get to be in the same room – or even the same country, for that matter – as Addison Wiggin, Dan Denning, Chris Mayer, James Boric, and Kevin Kerr…so we’re all looking forward to being able to get together and exchange ideas…and drink a lot of wine.