Ralph Wanger Lunch

I had the privilege this week of having lunch with Ralph Wanger (former manager of the Acorn fund and member Morningstar investor hall of fame) ... well it was me, Ralph and 100 other close friends! You can see Ralph's influence on my portfolio in several stocks -- UEPS, NVT, ILMN, FLIR as well as some not so obvious choices like GOOG.

Ralph was a small cap manager because he thought small caps had the best growth opportunities (true) and were the least followed or least efficiently understood by wall street -- meaning you had the best chance to outperform benchmarks, while investing in small caps. He used a strategy often called GARP -- growth at a reasonable price although in the end he would rather focus on value then growth -- value reduced risk and increased returns.

He has written a book called a Zebra in Lion Country, which I would highly recommend to anyone interested in investing in stocks -- especially small caps. Ralph is unusual in the investing world because he is so funny -- while I didn't learn too much new at the lunch that wasn't in his book or other things I have read about him, it was well worth it because of how funny he was.

He is also humble -- at lunch I asked him the question what steps he took to try to avoid large declines in small cap growth stocks (a common problem because when a company misses their stock often declines 30% or more in a single day due to the lower liquidity and higher company risk within small cap stocks) and his response included the comment that of all the analysts and portfolio managers at his firm, he had recommended the highest number of stocks with big declines -- something he could get away with because it was his firm and because his winners were more important.

He explained how small cap stocks is a winners game -- slugging percentage matters. Your home runs offset your strike outs. He mentioned IGT -- slot machine maker as a stock his fund made 100 times its money in. wow -- that is a home run I would like to hit!. Best I have done is MSFT or about 14X my money. (if I had not been stupid in 1999 and sold my shares of BEN, I would have a 25X gain on my first shares and a 10X gain on my average cost but alas I sold.....)

Ralph uses secular themes to manage his fund -- he said turnover costs for a small cap fund are so high due to the price impact when you try to buy and sell small cap stocks. He would try to keep turnover around 20% -- equates to a 5 year holding period on average -- to minimize trading costs. No one can predict a company's earnings a few quarters out let alone 5 years! So he uses themes as a way of identifying stocks that he can be comfortable owning for 5 years and still be reasonably confident they will have good earnings growth over that time.

One of his themes he mentioned at lunch that was really interesting was to avoid technology companies themselves but instead target users or beneficiaries of technology such as IGT.

IGT buys microprocessors from some tech company for $40 -- that semi company makes $10+ in gross profits on that chip sale. IGT takes the chip and adds other stuff to create a $2000 cost slot machine, which they sell to a casino for $8000 or about $6000 in gross profits -- great business. But the casino buys the slot machine, puts it on the floor and makes $300 per day from gamblers who are bad at mathematics. That means the casino has a 3 month payback on that slot machine -- that's why there are so many casino operators on the Forbes 400.

One other interesting comment he made during lunch was how does he spend his time between existing holdings and new ideas. He said they have a database of stocks covering all the small cap stocks they could buy. For each stock they have an estimated future return potential based on a growth estimate and the valuation. He argued to look at the outliers -- the stocks that looked the most attractive were most likely using estimates that were too optimistic while the stocks that looked the least attractive were likely using estimates that were too pessimistic. Everything in the middle was probably fine -- if you owned them, then leave them alone because they are doing ok. If you didn't own a stock in the middle, it was probably fairly priced so not the best opportunity. That's a great idea although its not one that I have used I think it would be a great way to help with your time.

He didn't really answer the question of what themes he is playing now other than to say energy looks good -- thanks for that tip! not unexpected given that many managers like to keep their cards close to their vest -- why give away good investment ideas for free? one of his firms top holdings? number 12 is FLIR.