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Here's how Ralph Wanger opens the first chapter of his book "A zebra among lions":
"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 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 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 herd may eat less well but they are alive.
A portfolio manager for an institution such as a 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 he continues to buy the popular stocks, he cannot be faulted.
On the other hand, he cannot afford to try for large gains or unfamiliar stocks that would leave him open to criticism if the idea failed. Needless to say, the Inside Zebra philosophy doesn't appeal to me as a long-term investor."
Write down your investment philosophy
Wanger believes you must formulate your own investment philosophy - one that you have most conviction in - and write it down. Writing it down is a powerful way to help you stick with it, through different phases of market cycles. Sticking with your philosophy over market cycles vastly improves your wealth creation potential.
An interesting take on growth vs value
Its all about your personal convictions. In Wanger's thinking, a key decision to make is whether you are the type who goes for the singles or for home runs (in cricket, that would translate to singles or sixes). This he believes is a matter of personality. Some naturally prefer accumulating singles while others naturally gravitate towards the big shots. His take on the value vs growth investing debate is that it comes back to your own personality. A value investor usually looks for the singles, while a growth investor looks for the home runs. When you hit for a single, your downside is limited and so is your upside. When you aim for a big shot, your downside is larger, but so is your upside. Value investors don't dream about multibaggers - that's what growth investors aim for.
Combine aggression with prudence
Wanger believes in going for the big shots, and built an investment philosophy that not only helped him hit scores of home runs in his career, but also one that limited the downside of what he recognized is an inherently riskier approach.
Identifying multibaggers
How do you identify a potential multibagger? Here's a quote from Wanger: "If you are looking for a home run - a great investment for five to ten years or more - then the only way to beat this enormous fog that covers the future is to identify a long term trend that will give a particular business some sort of edge."
Life is driven by strong economic, social and technological trends. So are corporate profits. The key lies in identifying a lasting macroeconomic trend - one that will last beyond a market cycle - and then identify smaller companies that will benefit from / ride this trend.
Most fund managers have a one to two year view and have access to the same information. Outperformance then boils down to outguessing the others. You need to think differently, to give yourself a chance to meaningfully outperform.
Keep asking "What does this mean?"
But how do you identify these long term trends? Wanger says you need to develop "an observing mind-set that can draw generalizations from many different particulars". You need to keep asking yourself "What does this mean". So, when you see the middle class growing in an emerging economy, you need to ask yourself "what does this mean?". It means more demand for houses, for automobiles - those are the obvious ones. But it also means for example that when people come into the middle class, they begin taking vacations. And they will continue taking vacations, every year. That's just one example of discretionary spending that can help you identify your next big multibagger.
Think downstream
Identifying a long term trend is the first part - thinking downstream is the second part of his stock picking strategy. So, when he looked at the mobile telecom revolution that took place a decade ago, he didn't go for the big mobile telecom companies - instead he placed his bets on companies that made components that went into mobile handsets. When he looked at the gaming revolution in the Western world in the 1980s, he didn't invest in the big gaming companies or casinos or amusement parks - he invested in the biggest manufacturer of slot machines.
Why small stocks?
Wanger says small stocks typically have many more stock price drivers than large stocks. A small stock's price can increase on earnings growth, or due to re-rating when institutional interest comes into it or when it becomes an acquisition target of a larger company. Large companies usually have to depend only on the first driver - earnings growth.
Earnings growth tends to be the highest when a company's moat is emerging - when it is in the process of taking advantage of a favourable macro trend to build scale and move into the next league. Most of the investment gains occur during this transformational phase, not afterwards. To catch a company in a transformational phase, you need to think small - you need to look at small and midcaps.
Controlling risks in small cap investing
Investing in small and midcaps is fraught with risk. Wanger applied strict filters to help him de-risk his stock picks. He never invested in businesses with weak financials - however exciting the growth opportunity seemed. No turnarounds for him. He believed strongly that sustainable growth can only come from a strong balance sheet. He also never chased a stock and never bought at a price that was outside his comfort zone. He looked at PEG as his favoured valuation metric for his stock picks. The way he would typically value a stock is to look at his earnings forecast for 2 years hence and his forecast P/E for that stock two years out. Based on his projected stock price 2 years out, he would look at the current price and determine whether it represented good value to him. "A great company can be a lousy stock" - he was a firm believer in this old market adage.
Wanger never ventured into micro caps - he felt their business models were too frail and nascent and often their balance sheets lacked the quality he aspired for in his stock picks. In the Indian context, this would translate to a preference for midcaps and staying away from what we refer to as small caps.
Adapt to market's big picture
Wanger was a firm believer in buy and hold. He disliked trading, but was smart enough to understand that one cannot ignore the market's big picture. When the market went into a long sideways range bound period, he developed what he calls the "thermostat" approach to fine tune his investment strategy. Nothing changed in his stock picking style and process. What changed was a subtle shift from buy and hold to "sell in rallies and buy in declines" to generate value in a range bound market.
Wanger - the outside zebra - knew when the lions were approaching, and prudently moved inside while the lions were around. No point in becoming lion lunch - better to change strategy, survive the lion attack and then move back to become an outside zebra - in search of more fresh grass.
Content is prepared by Wealth Forum and should not be construed as an opinion of HDFC Mutual Fund.
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Wise Advice: Learn
By the time he retired in 2003, Ralph Wanger was widely acknowledged as the guru of small cap investing. In his career from 1977 to 2003 managing the iconic Acorn Fund, Wanger delivered an astounding 16.3% annualized return - more than 400 bps alpha over benchmark across a 25 year period - in a market where most fund managers struggle to eke out any alpha. Wanger discussed his winning investment strategy in his book, "A zebra among the lions". Wanger's approach was starkly different from most institutional fund managers. He was aggressive, but knew how to blend aggression with prudence in stock picking and portfolio strategy - a quality that set him apart from most.