Ralph Wanger Part II: Have your own investment Philosophy, Value vs growth investors

You can read part I of this post here. Note: Unless otherwise stated, the words in italics are extracts from the book “A Zebra in Lion Country” 

IMPORTANCE OF HAVING YOUR OWN INVESTMENT PHILOSOPHY

“An investment philosophy is important not in the abstract but because it will keep you on the right track.”

You need to have a strategy, a way of looking at the world of stocks. A Haphazard collection of stories won’t help. Successful investors don’t operate that way. They have a philosophy that dictates what kind of stocks they want to own and they stick to their catechism.  When you think of the best-known names in the business – John Templeton, Warren Buffet, Peter Lynch and John Neff – you can immediately attach an investment style to each. Develop a set of convictions you adhere to, you can turn your back on thousands of stocks and concentrate on a manageable universe. A set of guidelines – and I urge you to put them down on paper – gives you confidence when time are rough. It helps you make the toughest decisions: when to sell. But it has to be YOUR STRATEGY [emphasis added], what’s right for you. Every singer must sing her own song.

Michael Sherne in his book “Investment Checklist” stress the same point.

When filtering through the many investment opportunities the stock market is offering at any given time, it is important for you to establish criteria of the types of businesses and management teams you are searching for. These criteria serve as a filter, so you don’t have to review thousands of investment opportunities and therefore can reject investment ideas quickly. If you have ever purchased a home, when you first started looking, you were probably overwhelmed by the number of houses that were available. At some point, you probably began to establish criteria for the types of houses and areas you were interested in, and this helped you narrow the list of houses that were potential candidates for purchase. The investment criteria you develop will work in the same way. Your criteria can be as simple as looking for a simplified business with a large market opportunity, managed by a great management team, and trading at a low price. You can also set criteria of what you do not want to invest in. For example, you may want to avoid businesses that have a high dependency on commodity resources, such as exploration and production (E&P) businesses, because oil prices are difficult to forecast. By articulating and following strict criteria, you can put the odds of making a successful investment in your favor.

I have already written in detail about the importance of having one’s own investment philosophy in my earlier post Return Per Unit of Time Invested.

VALUE VS GROWTH INVESTORS

People do seem to be born with a predilection for one style or the other. It’s a matter of personality. If you are pursuing a style that doesn’t fit your temperament, you won’t be happy. Show me an unhappy investor and I will show you an unsuccessful investor.The value investor is hitting for singles. He will be delighted if he doubles his money in a couple of years; few value ideas pay off better than that. If his analysis is correct and the company is worth more than the market recognises, however the downside is limited. The growth investor is going for home runs. He dreams of making 5-10 times his investment. And his downside is considerable, since high-multiple stocks can become average-multiple stocks at the drop of a penny in expected earnings. You never know for sure if a company’s going to do what you hope it will.

Growth itself is one component of value. A growing stream of earnings is certainly worth more than a static stream of earnings. You could even say that growth generates value. It can disappear as growth slows, but so can any other part of value equation. A low PE can disappear, if earning shrink. So can a low price to book ratio.

There is no reason to be a pure this or pure that. I look for – Growth at reasonable price. I want good growing companies, but I don’t want to overpay.

Whatever your style but focus only on multi-baggers.

Sometime back I had an interesting discussion with Manish Dhawan of Mystic Wealth on Moat vs Value investing. This is a never-ending debate and both sides have well articulated points. A mid-way could be focusing on multi-baggers. Whether one is investing in moat or broken businesses or nets-nets, the focus should be to earn 3-5x our initial investment and in terms of CAGR atleast 25% return. We can reduce the available investment universe to a much more manageable level by focusing on 3-5x returns.

Ofcourse, if one is investing in cigar-butt type of investment, purely on numbers, then one can buy even with 50-100% return expectations. But in that case one needs to do wide diversification [> 50 companies and no position more than 2% each]

Moat companies are resilient to bubbles and macro uncertainty

Having said that, my personal Investment Philosophy is to allocate most of my capital to companies having moats and 15-20% to situations which offers possibility of 3-5x returns in 3-5 years. Slowly, I have started focusing more on emerging moats rather than established moats. If a company has some sort of moat [whether established or emerging] then there is higher probability that it can grow at higher growth rate for long time. Another reason for my preference towards moat companies is that they are resilient to bubbles and macro uncertainty. Prof Sanjay Bakshi explained this point very well in one of his interview.

Investors should be cognizant about bubbles in various asset classes (real estate, commodities, equities, gold etc) and position themselves to not be hurt when the bubbles burst. That, by the way, is one reason why I like moats. Companies that buy commodities and sell brands, for example aren’t likely to be hurt by a commodity price bubble occurring or bursting. If the business has pricing power, then if commodity input prices rise, the business has the ability to pass it on to customers without fear of volume decline or loss of market share. If the bubble bursts, and commodity prices crash, then the business can either pass all of the benefit to customers to drive volume growth or retain some of it for itself. That’s the thing about moats. They are resilient. They can withstand shocks way better than other businesses which don’t have moats.

SHIT HAPPENS A LOT IN SMALL CAP INVESTMENTS

To avoid: Start-ups, Tiny techs, the near venture capital situations, marginal and unfinanced companies and turnaround situations.

In the words of Basant Maheshwari

A micro cap which hasn’t proved its business model is another type of company to ignore. One way of doing so is to filter out companies that have not reached critical mass [ He suggests a revenue threshold of INR 100crs for Indian companies]. The idea behind putting this filter of critical mass is because most small sized companies die a natural death without becoming large sized corporations and hence one should wait to see business reach some degree of scale before jumping in to buy.

In case of highly leveraged companies its important to manage position size [Whitney George of Royce & Associates] 

You can’t take a long-term view without confidence that the company’s financial condition will allow it to meet out-of-left-field macro or micro challenges. There’s an old saying that the balance sheet doesn’t matter until it’s all that matters, so we want to be ahead of that. That’s particularly important in smaller companies, which are generally built on more fragile foundations than big, diversified ones. We measure leverage fairly broadly by looking at the ratio of assets to stockholders’ equity. This allows us to see risk items that might not otherwise show up if we were primarily focused on long-term debt, like higher-than-usual levels of receivables , or bulging inventories, or increasing short- term bank lines of credit that may have a way of turning into more permanent debt. Our general rule of thumb, for non-financials, is to look for a 2: 1 ratio of assets to stockholders’ equity, which we consider a reasonable margin of safety.

DIVERSIFY YOUR HOLDING

No matter how selective you are, things still go wrong…. You should own atleast a dozen stocks if they are small cap, so a couple of winners can offset a couple of duds.

Whitney George of Royce & Associates echoes the same idea

Small-cap stocks by definition are more fragile, more likely to have one dominant product or one key executive or one big customer. Strange things happen , so you have to diversify no matter how much you may love individual names. When something strange happens in one of Johnson & Johnson’s or GE’s businesses, it’s a rounding error to the overall company. In a small-cap it can blow it up, so you don’t want to be overly exposed in any one name.

Even Philip Fisher suggests allocation between 5-10% to each small & mid cap stock, depending upon the risk involved. You can download detailed discussion by Philip Fisher from here.  This is one of  one of the simple yet most powerful discussion on diversification on small & mid-caps that I have come across till date.

Across market cap & Style

I have already covered this point in detail in an earlier post. You can read it here. [Under title “Diversification across Market Cap”]