 Ahead
of the Herd
James Boric
The
Daily Reckoning
May 3, 2005
The Daily
Reckoning PRESENTS: 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...
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...
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.
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
P.S. Remember...
Thoughout Wanger's tenure
as fund manager of the Acorn Fund he survived small-cap market's
many ups and downs. 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?
Editor's Note:
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 overlooked small-cap market.
321gold Inc
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