Close

    Ralph Wanger's Survival Guide to Investing in Small-Cap Stocks

    by Wayne A. Thorp

    Ralph Wanger's Survival Guide To Investing In Small Cap Stocks Splash image

    Ralph Wanger, the founder of Wanger Asset Management and the former manager of the Acorn Fund (now the Columbia Acorn Fund), is a consistent promoter of small-stock investing.

    His investing style of holding small companies with financial strength, entrepreneurial managers, and understandable businesses allowed him to generate annualized returns of 16.3% with the Acorn Fund between 1970 and 2003, while the S&P 500 index gained 12.1% a year over that period.

    Wanger outlined his approach in his 1997 book “A Zebra in Lion Country: Ralph Wanger’s Investment Survival Guide.” This article focuses on AAII’s “revised” Wanger stock screen, which is an adaptation of the principles outlined in Wanger’s book.

    Wanger Overview

    Wanger believes that smaller-cap companies offer under-exploited opportunities because they tend to be beyond the focus of full-time investors. However, he also recognizes that investing in smaller-cap companies tends to be riskier than large-cap investing. Therefore, he performs a careful examination to find established companies whose management has proven their abilities over time and that have a sound balance sheet and a strong position in their industry.

    Screen Performance

    On a monthly basis, AAII.com lists the companies passing the Wanger screen and tracks the performance of these stocks in a hypothetical portfolio.

    Figure 1 illustrates that the Wanger screen has produced performance that easily exceeds that of large-cap companies over our study period, which started in January of 1998. In addition, the Wanger screen has outperformed indexes of small- and mid-cap stocks over the period, albeit by smaller margins.

    As of the end of February 2008, the Wanger screen has generated a monthly cumulative return 155%, for an average annual return of 9.6%, while the S&P 500 has gained a cumulative total of 37.1%.

    Figure 1.
    Performance of Ralph Wanger Approach
    (Through 2/29/08)
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Profile of Passing Companies

    Table 1 highlights the characteristics of the companies currently passing the Wanger screen, compared to the typical exchange-listed company.

    The median current price-earnings ratio (current share price divided by earnings per share for the last 12 months) is only slightly lower than that of the typical exchange-listed firm. In contrast, the median price-to-book ratio for the Wanger stocks is roughly one-third higher than that of exchange-listed stocks.

    In terms of historical earnings growth, the stocks currently passing the Wanger screen have easily outpaced the market. If you believe that top-line growth powers bottom-line growth, the Wanger screen’s requirement of positive and increasing sales over the last three years that also exceeded industry benchmarks may be a contributing factor.

    On a forward-looking basis, analysts do not believe the Wanger stocks will maintain their impressive earnings growth. However, they do believe their prospects are somewhat better than the universe of exchange-listed stocks.

    The companies passing the Wanger screen are larger than typical exchange-listed stocks, although not much more so. A median market capitalization of $540 million puts this portfolio of passing companies on the low end of the small-cap spectrum.

    On a performance basis, the stocks currently passing the Wanger screen stand out when compared to the universe of exchange-listed stocks. Over the last 52 weeks, the Wanger stocks’ median price performance has exceeded that of the S&P 500 by 17%.

    As of March 7, 2008, 36 companies passed the AAII Wanger screen. This is slightly above the historical average of 31. The monthly turnover of the Wanger screen is among the lowest of the screens AAII tracks at 27.1%.

    Table 1. Ralph Wanger Portfolio Characteristics
    Portfolio Characteristics (Median) Ralph
    Wanger
    Approach
    Exchange-
    Listed
    Stocks
    Price-earnings ratio (X) 15.5 16.0
    Price-to-book-value ratio (X) 2.2 1.6
    Price-earnings-to-EPS growth (X) 0.5 0.8
    EPS 5-yr. historical growth rate (%) 32.1 14.6
    EPS 3-5 yr. estimated growth rate (%) 17.6 14.3
    Market cap ($ million) 540.7 358.0
    Relative strength vs. S&P (S&P=0) (%) 17.0 –9.0
    Monthly Observations
    Average no. of passing stocks 31  
    Highest no. of passing stocks 56  
    Lowest no. of passing stocks 9  
    Monthly turnover (%) 27.1  

    Passing Companies

    Table 2 is a listing of the companies currently passing the Wanger screen. These companies represent a diverse collection of sectors and industries—from aerospace and footwear to food processing and software.

    The AAII Wanger screen isolates companies with a market capitalization between $100 million and $2 billion. Only 10 of the current passing companies have a market cap over $1 billion, with Phillips-Van Heusen (PVH) leading the way at over $1.8 billion.

     

     

    This screen also compares a company’s operating margin (operating income divided by sales) to its historical norms as well as industry benchmarks. When analyzing ratios such as this, you cannot compare companies across industries—certain industries have historically low margins. Among the companies in Table 2, Cherokee Inc. (CHKE) has the highest current operating margin of 74%. The company licenses its trademarks, including Cherokee, Sideout, and Molly Malloy, for men’s, women’s, and children’s apparel. In contrast, Dycom Industries (DY), a provider of specialty contracting services, has the lowest current operating margin at 5.6%.

    The AAII Wanger screen also requires companies to have positive sales growth over the last three years as well as have a 12-month sales growth rate that matches or exceeds its three-year growth rate. Of the companies currently passing this screen, Bolt Technology (BOLT), has achieved an average annual sales growth rate of 50.5% over the last three years. The company develops and manufactures geophysical equipment used in offshore seismic oil and gas exploration.

    Quantitative screens such as the Wanger approach represent a starting point in the investing process. They allow you to isolate companies with similar quantifiable characteristics. However, it is important to perform additional due diligence on any company that passes a stock screen such as this. The end goal is to find stocks that match your investing tolerances and constraints.

       What It Takes: Ralph Wagner’s Small-Cap Criteria
    • The market capitalization for the last fiscal quarter is greater than or equal to $100 million and less than or equal to $2 billion
    • The company does not trade on the over-the-counter exchange
    • The company’s stock has been trading for at least five years
    • The operating margin for the last 12 months is greater than the industry median operating margin for the same period
    • The operating margin for the last 12 months is greater than or equal to the average operating margin for the last three years
    • The growth in sales over the last 12 months is greater than or equal to the average growth rate in sales over the last three years
    • The growth in sales over the last 12 months is greater than or equal to the industry median growth rate in sales for the same period
    • The average annual growth rate in sales over the last three years is positive
    • Cash from operations for the last 12 months and for each of the last three fiscal years is positive
    • The ratio of total liabilities to assets for the last fiscal quarter is less than the industry median ratio of total assets to liabilities for the same period
    • The ratio of current assets to current liabilities (the current ratio) for the last fiscal quarter and for each of the last three fiscal years is greater than one
    • The ratio of the price-earnings ratio to the growth rate in earnings per share over the last five years (PEG ratio) is greater than or equal to 0.2 and less than 1.0



→ Wayne A. Thorp