Small-Cap Aficionado

Small-cap guru Ralph Wanger likens investing to the crafting of an opera. Consider "Don Giovanni," he says. Ask people to name who wrote the classic opera, and if they have a little cultural knowledge, their response will likely be "Mozart." But, Wanger points out, that's only part of the answer.

What just about everyone fails to remember, he says, is that a poet named Lorenzo da Ponte wrote the opera's libretto. He concludes there's a reason for da Ponte's anonymity: As essential as his words were, it was Mozart's music that made "Don Giovanni" a masterpiece. "If you think about it, stocks are kind of the same,'' says Wanger, portfolio manager of the small-cap Liberty Acorn Fund. "Analysts spend a lot of time looking at the numbers, and that's sort of the libretto of the opera. But the thing that's really going to make a difference is the tune."

So what does Wanger view as the "tune" in equity analysis? It's the "intangibles" about a company that lie behind the numbers, he says. "The reputation of a product, the ability of its management, the depth of the management team, their relationship with their customers-these are all intangibles," he says. Wanger says it is this philosophy that prompted him to largely shun the hi-tech and Internet sectors when they were flying high in the late 1990s.

"I would say all these Internet stocks were bought by the Smashing Pumpkins generation, or maybe Guns N' Roses,'' he says wryly. "The music is very loud, very catchy and very exciting, but that's the only good part." In that case, Wanger says, the numbers, or the "libretto," made no sense. Now, after watching many in that sector decline, Wanger senses a new beat creeping back into Wall Street. It's a return, he says, to an old-style tune that's a mix of both value and growth.

For Wanger and other value money managers, it's a comeback that is long overdue. Compared with the big boys of the market, blue chips and the technology sector, the small-cap market has been mostly in the doldrums since the mid-1980s. The long run has turned Wall Street into a virtual two-tiered market. For value investors, it's also been a raucous and befuddling ride, as long-established investing principals have crumbled in the face of volatility that can instantly wipe out 50% of capitalization just because of one iffy earnings report.

It's a market that's out of whack, Wanger says. So out of balance, in fact, that he sees a major correction as inevitable and imminent.

"The market is constantly going off on excursions of one sort or another," he says. "After awhile, they tend to come back the other way."

After watching the market slide in November and early December, Wanger says, "I think there's still more to go... It's going to take more than a couple of months." As for small caps, he says, "I have perfect faith that the next major move will be up."

Wanger has reason to be hopeful. He's been plucking opportunities the last three decades, even while the broader small-cap market has suffered. Since he was appointed portfolio manager of the Acorn Fund at its founding in 1970, steady long-term growth and resilience during down cycles have characterized Wanger's performance. It's growth Wanger expects to continue in the wake of the sale of the Acorn Fund and four other family funds, totaling nearly $9.2 billion in assets, to Liberty Financial in October.

"He's a really old-fashioned, roll-up-your-sleeves and go find growth-on-sale kind of guy," says Morningstar Senior Analyst Christopher Traulsen. "Typically speaking, they want to pick up stuff that other people haven't thought of yet."

That's why, through the late 1990s and into this year, you wouldn't have found names such as Amazon.com, Yahoo!, Priceline.com or even Dell Corp. listed among the fund's holdings. Instead, the predominant names have been companies such as Softbank, Harley Davidson, Dynegy and, more recently, the DSP Group and Callaway Golf. Not that looking for companies along the unbeaten track doesn't have its drawbacks. Wanger's suspicion of the tech sector has dampened the fund's returns the past few years. The Liberty Acorn Fund, for instance, has had an annual return of 21.21% over the past five years, compared with 28.56% for the S&P 500.

But, Traulsen points out, Wanger's conservatism has protected the fund during this year's technology downturn. He notes that March 1 through May 31, the period during which the tech sector began its turn for the worse, the average small-cap growth fund declined 22.6%. The Liberty Acorn Fund, meanwhile, lost 9.4%. For the period from September 1 to October 31, the average small-cap loss was 10.5%, compared with 0.9% for Wanger's fund. "They're not going after the real high-flying stuff at all," says Traulsen. "This is really somebody blocking and tackling and picking out long-term investments that grow over time. It will have years when it's a bit more sluggish than one focusing on the hot sector du jour. But when those fall off, this one will hold up a lot better."

Wanger acknowledges, however, that he's not totally immune to the allure of Internet equities. Softbank, a Japan-based Internet investment company, has lost more than half its value this year after a run as one of the fund's star performers. Wanger doesn't regret buying the stock. But he does regret keeping it a year ago, when he decided to sell off half his SoftBank holdings because of a stunning calculation. "We found that if its value increased another 20%, it would have had the same market capitalization as WalMart," he said.

It was an oddity that underscored Wanger's view of the so-called "New Economy." He thinks the Internet is revolutionary, important and a boon to productivity. But he considers dotcom valuations, even after their recent slide, "flights of imagination."

"Priceline.com was not a terrible idea for a business, but it wasn't worth more than Delta Airlines," he says. The valuation of the company, he adds, at one point did exceed that of the airline.

Such blunt assessments are typical for Wanger, who prefers a sense of humor and homespun anecdotes to dry analysis. A lifelong Chicagoan, the 66-year-old Wanger writes periodic market updates called "Squirrel Chatter" for his funds' shareholders. His updates are more philosophical than technical, relying more on humor and everyday experience than dense investment theory. In one recent commentary, Wanger writes of the "boom and bust" of the 19th century railroad industry and how it may parallel what's been happening with the Internet sector.

In another essay, Wanger focuses on the scientific concept of "memes," which are, theoretically, human habits, skills, actions and ways of doing things that take on a life of their own, mutate and get passed on from person to person in the same way as genes and viruses. A sea of competing memes, Wanger concludes, drives Wall Street. "Investors coalesce into herds that believe a specific market strategy," he writes. "There should be profit to be gained by understanding what may be the dominant meme in the market for the next cycle."

He often uses plainer parallels than that, such as baseball. Commenting on his high expectations for the small-cap market over the next three to five years, the long-suffering Chicago Cubs fan says, "I also think the Chicago Cubs will win the pennant in the next 10 years. But I'd bet on the small caps first."

Explaining the reason for the Acorn name, Wanger describes himself as an "opportunistic feeder," like a squirrel. Observers note that it's hard to peg his fund and his investing style into any one square because his holdings range from value to growth, and from small cap to mid cap. Companies in the latter category, however, mostly consist of small caps that have grown into mid caps since they were first bought.

Wanger builds his portfolio selections around themes. One example is the fund's focus on companies that are "downstream from technology." By that, Wanger means companies that don't necessarily make the technology, but use it to enhance their businesses. One such holding is AmeriCredit, which uses advanced software to underwrite subprime auto loans. Another theme focuses on the aging of the baby boom generation and the fact that, as these people approach and enter retirement, there will be more disposable income and a greater demand for entertainment and recreation. This thinking led to the purchase of Harley Davidson Inc., one of the fund's most successful stock picks. "The average purchaser of a Harley is in the 44-year-old area," he says. "These are not your Hells Angels tattoo kids. These are people who are middle-aged, sensible people who love the Harley lifestyle."

Wanger acknowledges he's had his share of misses and near misses. For example, he was high on the video-conferencing industry a few years ago and was convinced it would be utilized by a broad array of businesses. He was on the verge of buying PictureTel, a video-conferencing system maker, but was talked out of it by in-house analysts. Not buying the stock turned out to be a wise move-the company subsequently declined.

"The technology was pretty good," he says. "But people just didn't use it enough."

A research study conducted last year indicates there's more than luck behind Wanger's track record. The study looked at the performance of 1,437 money managers between 1970 and 1996. After adjusting for the risk taken on by each manager, the study tried to statistically find the ones whose performance could be attributed more to skill than luck. Wanger and his co-portfolio manager, Charles P. McQuaid, ranked in the top five.

"If you believe that there are money managers out there who have skill, you have to start out with the belief that this is one of those guys," says study co-author Andrew Metrick, assistant professor of finance at the Wharton School of the University of Pennsylvania. Metrick, who says he didn't know Wanger "from Adam" before starting the study, says the hallmark of Wanger's record has been consistency. "He's shown the ability to understand management, understand companies and pick trends before other people recognize them," he says.

Despite an underperforming small-cap sector through much of the 1990s, Liberty Acorn Fund, currently with about $4.2 billion in assets, had an average annualized total return of 20.8% over the past 10 years, compared with 14.6% for all small-cap value funds and 19.4% for the S&P 500.

Wanger said his approach hasn't changed much during the past 30 years. It's a style grounded by heavy research, common sense and a strict adherence to long-term thinking. He noted that when the Acorn Fund was founded in 1970, a priority was placed on keeping administrative expenses to a minimum. That meant finding cheap stocks that could be held for five to 10 years to hold down transaction costs. As a result, the fund looked for small-cap stocks with long-term potential-the type of stock that is still the typical Acorn Fund holding. "We always liked smaller companies because they were cheaper and easier to understand," he says. The same holds true today, he adds.

There is continuity in other ways, as well. Irving Harris, whose Chicago-based brokerage house founded the Acorn Funds to serve its well-heeled clients, remains chairman of Liberty Acorn Funds at the age of 90. It was Harris who hired Wanger as a securities analyst in 1960 after bumping into him at a train station. Wanger, who went to high school with Harris' daughter, was working as a computer programmer with CNA Insurance, and Harris told him to call if he got tired of the job. He called a month later, and Harris hired him.

"He's just had good common sense," Harris said. "He's had a good record of picking stocks that were good and, for the most part, avoiding those that were traps."

As an analyst with the predecessor of the present-day Harris and Associates brokerage firm, Wanger says much of his work consisted of face-to-face visits with the people running the small-cap companies being researched. It's the same drill Acorn portfolio managers follow today. Wanger says the fund family's analysts and portfolio managers personally visit more than 1,000 companies each year.

At Harris' brokerage, Wanger says, "They always assumed if you want to buy 1% of a company, you should use the same techniques and knowledge as if you're going to buy 100% of the company."

Some factors the Acorn Fund looks at in assessing a company's long-term growth prospects are the strength of its brand and management, the reasons behind its share price, the type of market dominance it holds in its sector and the soundness of its fundamentals, he says.

The fund is also not shy about holding onto a stock even after a company grows into a mid-sized concern or delving into growth territory now and then-which is why some rating services have Acorn Fund listed as a small- to mid-sized growth fund.

The fund is not heavy in any one sector, as Wanger believes in spreading risk among a diverse assortment of holdings. The fund's current top sectors are finance, which represents 15.8% of holdings; cyclical consumer goods, 12.5%; and foreign equities, 11.2%.

Rather than picking stocks with a formulaic filter, Wanger says there's an individual story behind each of his holdings that led to its purchase. Ameri-Credit, the auto subprime lending company that heads the list of fund assets at 2.7%, was bought by Acorn because it uses advanced software to assess loan applicants in its auto-loans business, Wanger says. The fund bought the stock, despite the fact that the investment community views the subprime lending business, with its inherently risky loans to people with bad credit, as a "minefield," Wanger says. Research by Acorn, however, indicated Ameri-Credit's underwriting technology outweighed the risk, he says. The research was on the mark: The stock has risen 639% since the fund bought it in August 1994. "From a portfolio point of view, you can take risks, but if you own 250 stocks and the risks are not diversified, you pay for it," he says.

DSP Group, bought by the fund recently, is an Israeli company that makes signal-processing chips used in telephone-answering devices. Its customers include Samsung and Sony. "They're very fast growing, and it's gotten a little cheaper because of the riots in Israel,'' Wanger says. It's an example, he says, of a stock whose short-term prospects are questionable, but whose long-term prospects look brighter when you look past the current political instability.

Callaway Golf, first bought by the fund a year ago, continues to be accumulated by the fund because it's "the strongest brand in the golf sector," Wanger says. The share price has been hurt because of production problems at the company's new golf-ball subsidiary, he says. The problems have already cost the company more than $40 million this year, but Wanger believes the company's strong brand will mean long-term growth for the new golf-ball business. "We're not talking about Intel, we're talking about making golf balls," he says. "They will figure out how to do it right. When they do, earnings will improve and the stock will go up."

Wanger had a similar view of Harley Davidson two years after it went public in 1986, and it turned into one of the funds best buys, with a 6,655% gain over 12 years. At the time of the offering, the company was a mess, Wanger says. "It was a troubled company when we bought it. They had had a number of years of poor management and had a problem with product quality, their balance sheet and profitability." They had, however, one of the qualities that Wanger looks for. "They still had the Harley Davidson brand name," he says. That, and a new management team, were what made Wanger pull the switch on buying the company. Since then, the company has sustained consistent earnings growth and its stock has split five times. Its P/E ratio has also gone from about 8 to 40, which is why Wanger says the fund has been shedding some Harley Davidson stock.

The reason this pick succeeded, Wanger says, is that he bet the strong brand name would give the new management extra time to turn the company around. He won the bet. "The brand name gave it growth potential and stability, and new management gave it a chance to work," he says. Either of those two qualities alone, he says, "may not have been sufficient."

Has Wanger had to change his investing style to adapt to the market over the years? He does concede one point: He no longer is purely a value investor and does delve into growth investing. Or, as he puts it, "growth at a reasonable price."

He's had to adapt in other ways, too. Formerly a no-load fund family, Acorn Funds entered the fee channel when it was sold to Liberty Financial. Under the terms of the deal, Wanger and other Acorn portfolio managers agreed to remain with the company at least five more years. Now that the fund is in the fee channel, Wanger says he expects a greater inflow of money and more marketing muscle through fee-based brokers and advisors. The fund now carries a sales charge, but fees are waived for shareholders of record before the sale and clients of fee-based advisors.

Wanger, meanwhile, says he hasn't started to think about retirement. He still feels mutual funds are an ideal investment vehicle for individuals because of the diversity, accounting simplicity and professional management they provide. Plus, there's one other benefit, he says. "The best thing you get is a way to blame it on someone else," he says. "If your wife says, 'Why did we lose money on that darn stock?' you can answer back, 'It's not my fault dear, it was this stupid person in Chicago who lost the money.'"