Note: Unless otherwise stated, the words in italics are extracts from the book “A Zebra in Lion Country”
Ralph Wagner’s investment philosophy have two essential elements 1) Buy small companies 2) Identify a major trend, and then buy companies that will benefit from the trend. He believes that we are living in a world where the environment changes at an increasingly rapid rate. He thinks by concentrating on smaller companies one can improve once chances of catching the next wave. Ralph Wanger insists that there are more than ten thousand listed companies and focusing on themes help us to narrow our search. This is different from pure bottom up investors who look for great stocks, irrespective of themes.
Identifying long term trends
If you’re looking for a home run – a great investment for five years or 10 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. Invest in themes that will give a company a long-term franchise.
Mr. Wanger seeks growth potential, and he does so first by determining broad areas for potential future growth. Thus, his approach starts with a top-down outlook: He first identifies general “themes”—strong social, economic, or technological trends that will last longer than one business cycle (at least five years or more). The advantage of focusing on long-term trends, he says, is that most other investors are focused more on shorter-term predictions of two years or less, and it is difficult to outguess the competition, particularly since most investors are privy to the same information. The other advantage of focusing on long-term trends is that you must be a long-term investor, which is particularly important in the smaller-cap area because of high trading costs. [From an article]
Micheal Moe, author of Finding the Next Starbucks echoes the same idea.
Megatrends effectively create a tailwind at the back of emerging industries. The tailwinds accelerate the opportunity and provide the fundamentals to grow at a high rate for a long time. Great growth opportunities are often found where megatrends intersect the growth sectors of the economy: technology, health care, alternative energy, media and education, and business and consumer services. In real time, however, megatrends tend to go underappreciated. The nature of megatrends is that they are relatively slow to develop, driven by bottom-up, “local” events that slowly gain in critical mass until they come to define large-scale and pervasive change.
Companies that operate in industries propelled by tailwinds will generally outperform the market. A tailwind occurs when a company and/ or industry benefits from the trends that are shaping society. Those companies that are capable of successfully capitalizing on growing markets, rather than simply relying on the favourable tailwind, will capture larger market shares, be rewarded with premium valuations, and ultimately deliver the greatest shareholder value.
I would speculate that Prof Sanjay Bakshi recent investment in companies like Ashiana Housing, Thomas Cook (India) & Relaxo Footwear are mainly based on LONG TERM TRENDS. Let’s see few of the comments made by Prof Sanjay Bakshi:
Ashiana Housing: As for scalability, given the rapid urbanization being experienced in the country (which is a very long term trend) and the very small current size of Ashiana, I have little worries on this front. The key risk is not scalability. It’s execution, in my view
Thomas Cook: Indians have only just started travelling out. Over the next decade or so the number of people who will go abroad on packaged holidays will grow many times over. There is huge growth potential for players who can offer consistently good quality offerings at affordable prices.
Ralph Wanger says
This kind of analysis [focusing on long term trends] tends not to rest on numbers alone. It certainly doesn’t involve trying to guess what the markets going to do; you are talking only about the company. Even when the numbers somewhat disappoint, you can ask yourself, “Overall, are the managers you bet on coming through pretty much as you had hoped?”
Buy Small companies….
At Acorn we had a clear philosophy – to be long-term holders of smaller companies with financial strength, entrepreneurial managers and understandable businesses – and we stuck to it. Don’t overpay, no matter how much you like a company.
I have a sort of ecological theory to explain the phenomenon of the higher return of small companies. In any environment, some creatures are going to be more successful at adapting than others and those are the ones that will thrive and prosper. In a tough, competitive business environment, new companies struggle to survive by funding and exploiting their own special niche. Most fail, but the few that make it win big. The reason they make it is that the environment must be favourable – but it is a useful way to think about what causes success or failure. …Often the big growth stocks reached their heights because they were boosted by some particular development at the time. Ecological changes create great opportunities for the investors who understand them.
Most investment gains are made during the development phase and not afterwards [Emerging moats]
Michael Shearn in his excellent book “Investment Checklist” says
It is important to remember that the greatest gains in a stock are usually made as a business is developing its competitive advantage rather than after it already has developed one. Ideally, you want to identify those businesses that are in the early stages of building a competitive advantage. It can take years and sometimes decades for a business to develop its competitive advantage, and it is difficult to see a competitive advantage building, because in most instances, the business is losing money during that time. The best way to distinguish whether a business is building a competitive advantage or wasting money is to monitor the number of customers a business serves.
Emerging moats are found more in small caps than in large caps…..
Note: I personally feel small cap investing is only for full time and experienced INVESTORS. Others should stick to large cap stocks.
What to do after finding small companies with favorable long term trends?
Focus on 4Ps
Focusing on long term trends is merely the first step in identification of prospective investment candidates. Selected companies need to pass the 4P test [People, Product , Potential, and Predictability] as laid down by Micahel Moe
After looking for industries driven by key megatrends and finding opportunities within these industries that have potential for a high and sustainable earnings growth rate, I use the four Ps to differentiate the stars of tomorrow from the ordinary companies.
I believe that more than 50% of the secret to success in investing in tomorrow’s big market winners is evaluating the people running a company. There is no shortage of interesting ideas, but it’s always the people that make the difference. In business, sports, or life, winners will find a way to win, and my goal is to find that winning team and stick with it. Often it’s the vision and passion of an entrepreneur that ignite the business opportunity.
In searching for great growth companies, I am looking to invest in companies that are leaders in what they do. Attractive companies need something that makes them special or great— they need a claim to fame. “Me too” companies— businesses that participate in the leader’s industry, but due to market share, growth, and/ or quality are imitators rather than innovators—are of zero interest to me.
There are numerous nice little companies that are clipping along, but they will always remain nice little companies because of the size of the market they are in. My framework for finding the stars of tomorrow, companies that have the biggest potential is to identify problems and pain in the marketplace.
Potential is critical for predictability because if a company’s market isn’t growing, its growth is hostage to variables that impact visibility. Even if a company is the leader and taking market share, if the pie is getting smaller, it’s challenging to have predictable growth. Recurring-revenue businesses almost always have big premiums to their multiples because of their visibility.
… Do not REJECT STOCK IDEAS merely on HISTORICAL NUMBERS or CURRENT VALUATION.
In the past I had rejected many stock ideas merely on the basis of analysis of historical numbers or current valuation. Analysis of historical numbers and current valuation are important, but this should be the last step and not the first. Michael Moe in his book Finding the Next Starbucks says:
Profits are critically important for a company to be successful. All companies are ultimately valued on future profits discounted back to today. I believe that through proper analysis with a disciplined application of the four Ps, an investor can prudently invest in a company when it has negligible profits today or none at all. Predicting what a company will look like three to five years from now is where art and science converge. While for a business to be successful and valuable, it needs to generate growing and sustainable profits, I think it’s possible to invest in a company with the four Ps before profits are self-evident.
I may not invest in companies with no profits. What I want to convey is HEADLINE NUMBERS ARE OFTEN MISLEADING. One needs to go beyond numbers and find out the reason for lower historical profits or lower and volatile ROEs. Just to clarify, I am NOT SUGGESTING preparing detailed projections, but focus on key assumptions that can change the profitability going ahead.
While investing in companies with high P/ E multiples is risky business and not for widows and orphans, the fastest-growing companies that produce the highest returns over time often have absolutely high P/ Es. If we are right about the earnings growth, over time we will be right about the stock. Remember, the average P/ E of the top 25 companies from 1995 to 2005 was 18.9x, hardly bargain basement.
I am NOT suggesting that valuations are not important. But current or one year forward PE or PB multiple is not the correct method to decide about under or over valuation. One should follow the method suggested by Prof. Sanjay Bakshi in his Final Relaxo lecture.
Aim only for multi-baggers by holding them for long term
While it’s exceptionally difficult to find truly world- class management teams , it’s just as difficult to find companies that have a truly great or unique product. So once you find a company which satisfies these criteria, its important to hold them for long term.
….. Hold them for long term
One fact is undeniable, you can’t make five or ten or twenty times your money if you don’t hold on to stocks. Most people are delighted when a stock doubles, and quickly sell to lock in their gain. If a company is still performing, let its stock, too, continue to perform.
….Aim only for multi-baggers……
I had always thought that to be a good investor you needed to hit a lot of singles and not strike out often. I was wrong. Investing, especially in small companies, is a home-run-hitter’s game. When people ask me how we have managed to get our results, I tell them that it’s not by avoiding disasters, because I have had my share of them. That’s understood with small-cap investing. But if you manage to own some stocks that go up 10 times, that pays for a lot of the disasters, with profits left over.
In the words of Basant Maheshwari, author of the book “The Thoughtful investor” :
Most investors get rich because they target large gains. Buying or selling a stock for a 20% gain will not yield anything as the margin for judgmental error isn’t enough to protect the investors for a miss hit An investor should look at buying stocks that have potential to go up 5-10x if he has any desire to be rich because even if he gets his computation partially correct then also he makes a lot of money.
You can also read Mr. Basant Maheswari interview, where he talked about importance of focusing on multi-baggers.
[Anil: Anything which offers possibility of less than 3x returns is NOT ACCEPTABLE TO ME].
One of the most important advantage of aiming at multi-baggers is You can Buy Low and then You Buy Higher. Ian Cassel says
My personal investment philosophy is to buy microcaps that I think can be 5-10x in a few years. It might sound insane, but I don’t buy stocks where the peak potential return is less than 100% [Emphasis mine]. I’m trying to find and buy undervalued companies that have the potential to get very overvalued. That is my margin of safety. If I’m initially buying a $0.50 per share stock, I’m likely buying it because I think it can be a $5.00 stock in a few years. So who cares if I’m buying my last third at $1.10 after the investment has been greatly de-risked by management execution.
Can focus on long term trends help to ride macro uncertainty?
Read the following extract from Howard Mark’s Sept 2014 memo, who kept warning about last credit crisis, as early as 2004/05
In my earlier post , I quoted Tweedy & Browne views on how to deal with macro uncertainty:
In the current uncertain environment (2011) it is necessary to have portfolios that are designed to weather virtually any kind of turbulence that may come our way, and that is precisely what we have tried to do. Our Fund holdings today continue to be comprised in large part of larger, less cyclical, steadier companies with more sustainable demand characteristics that are globally diversified, have solid balance sheets, sell products to an aspiring and growing middle class, and pay an attractive dividend yield while we wait for value recognition.
Combining the thoughts from Ralhp Wanger, Howard Mark and Tweedy Browne I would say
You cannot predict the coming demand destruction but you can be prepared. Focus on long term trends like companies which sell products to an aspiring and growing class or is beneficiary of other long term trends. Buy only when you see possibility of making 5-10x returns within next 5-10 years. STOP waiting for another BEAR MARKET because YOU CANNOT PREDICT.
HOW TO IDENTIFY LONG TERM TRENDS?
Mr. Wanger says that to identify trends, you must “develop an observing mind-set,” that can draw generalizations from many different particulars. He suggests that trends can best be spotted from reading and one’s everyday general experience, including the work environment. You have to train yourself to make generalizations from random particulars, to keep asking yourself “What does it mean”. Eg. The growth of a middle class in developing countries is a very simple but powerful way to think about the future. First the newly well-off want bicycles, then motorcycles and then five years from now automobiles. Another change that occurs when you become middle class is that you start to take vacations. [From an article]
Basant Maheshwari, has given some additional pointers in his book:
Identifying the next big trend is all about looking for the ‘new’ whether it is a new sector, new stock, new high, new promoters but as investors like to be with the tried and tested the new is not something that catches their attention immediately. Most investors would rather buy a stock in an old company from an old sector, run by an established promoter and available at old prices than go in for the ‘new’ making the identification of a new trend a little more difficult than what is normally is.
One of the easiest ways to spot a new trend is to test whether the business has done well anywhere else in the world. While India lags the world in development, most of the new businesses that come to India do so after having already established themselves in the developed parts of the world.
Most companies that start a new trend are incubated by first generation entrepreneurs. So whether it was Microsoft, Dell, Facebook, Infosys, Bharti, Pantaloon all the promoters were first generation entrepreneurs without too much of a historical background with them. Established promoters are not the best place to look for a new trend because a new trend generally starts with the new blood. Even if a established promoter is starting a company in a new sector he will never sell his shares cheap.
WORK WITH A LIMITED NUMBER OF THEMES ELSE YOU WILL KEEP TAKING CARE OF WOBBLING PLATES IN A SPINNING SHOW
Rather than build a broadly diversified stock portfolio, I believe in determining theme I think will be played out over the next several years and then identifying group of stocks that reflect those themes. My portfolio may own a considerable number of stocks, but most of them by far will fall into half-dozen or fewer themes.
Ralph Wanger had covered a lot of important topics in his book. Its not possible to cover all the topics in one post. I will try to cover few more in next post