How To Find Sustainable Small-Cap Growth Stocks

In this article I cover the Wanger stock-picking strategy and give you a list of stocks currently passing our screen based on the approach. Ralph Wanger’s investing style of holding small companies with financial strength, entrepreneurial managers and understandable businesses allowed him to generate enviable returns while managing the Acorn Fund between 1970 and 2003.

The Wanger strategy focuses on limiting the risk of investing in small-cap stocks, using value, size and growth to find small-cap companies that exhibit long-term growth characteristics. As of October 31, AAII’s Wanger screening model has an annual gain since inception (1997) of 7.7%, versus 7.5% for the S&P SmallCap 600 index over the same period.

Wanger Strategy Overview

Wanger believes that smaller-cap companies offer underexploited 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 with management that has proven its abilities over time and that have a sound balance sheet and a strong position in their industry.

Wanger likes small-cap companies because they have more room to grow. No company can sustain a high growth rate forever and, eventually, a firm’s size starts to weigh it down. Large companies simply cannot sustain the high growth rates achievable by a smaller, fast-growing company.

There are also actions that can cause the prices of small-cap companies to rise. Wanger offers that a company’s stock price will typically increase for one of the following reasons:

• Growth—A stock’s price reflects the level of earnings, dividends, book value, etc. Even a neglected stock will eventually see its price rise if these factors grow.
• Acquisitions—Acquisitions typically occur at a premium to the current stock price; if the overall market does not recognize the value of the company, another firm may offer to acquire the company.
• Repurchases—Share buybacks typically benefit shareholders by providing some price support and reducing the pool of stock that must share factors such as earnings and dividends.
• Revaluation—Companies trade at varying established price multiple levels to factors such as earnings, cash flow, book value, etc. An increase in the expectations for a firm will lead to higher institutional interest and higher multiples.

Large-cap stocks, on the other hand, will typically only see their stock prices increase because of share repurchases, while small caps are more likely to see increases from all these possibilities. Wanger points to numerous academic studies indicating that smaller-cap stocks have provided higher rates of return over long periods, even after adjusting for risk.

Investing in small-cap companies is riskier, particularly since misjudgments are bound to occur. Therefore, Wanger believes that risk reduction lies in the careful selection of small-cap companies. However, he does draw the line at “micro” companies, which he believes carry too much risk. We therefore added a requirement for a market-capitalization minimum of $100 million.

Identifying Growth Potential

Wanger seeks out small companies that have the potential for strong growth well into the future. Instead of immediately seeking out individual companies, he follows a top-down approach that begins by identifying “themes” that will play out for the next several years. Once he has done this, he looks for those market areas that may benefit from those themes and selects the attractive stocks within those groups. Specifically, these groups and their respective companies are those whose earnings should benefit the most, given the expected trend.

The themes Wanger looks for may be social, economic or technological trends that he expects to last for at least one business cycle (four to five years). By looking beyond the next quarter or year and instead focusing on long-term trends, Wanger is attempting to avoid what he calls the “forecasting horizon trap.” He explains that most investors focus more on shorter-term predictions for the next quarter or year and, for that reason, it is more difficult to outguess them and achieve superior results, especially since these investors are privy to the same information.

The question then becomes what are these trends or themes? One example Wanger points to is his investment in Western Water Co., which he made after recognizing the tremendous growth that was taking place in the desert southwest and the resulting increase in the demand for water. Other themes he discusses include:

• The investment by underdeveloped countries in telephone systems
• The growth in the middle class of underdeveloped countries and the resulting rise in discretionary income of these countries
• The internet
• Expansion of communications and transportation networks worldwide
• Outsourcing of services and jobs that require technological and skilled personnel
• Money management, especially as public pension systems are privatized
• Rebuilding of infrastructure in countries worldwide

Financial Strength

Wanger avoids marginal, underfunded companies of any size. He instead seeks out companies he feels will be able to sustain their growth over the long term. He feels that financial strength makes corporate growth sustainable. Wanger looks for companies with low debt, adequate working capital and conservative accounting practices. Financial strength tends to be a characteristic of established companies, which is why Wanger avoids turnarounds, start-ups and initial public offerings (IPOs).

We screen out firms that have higher levels of total liabilities to total assets than their industry median. The ratio of total liabilities to total assets is more encompassing than just looking at long-term debt to equity.

Secondary screens should include an examination of the balance sheet to compare the levels of liabilities over time, a study on the relationship of inventories and receivables to sales and the exclamation of financial statement notes to analyze the size of pension liabilities, etc. A rise in inventories as a percentage of sales—inventories growing faster than sales—may point to a shift in the buying habits of customers to products of competitors.

Working capital is traditionally calculated as current assets minus current liabilities. As a proxy, we use the current ratio, which compares current assets to current liabilities. As screens for adequate working capital, we require a current ratio greater than one for the last fiscal quarter and for each of the last three fiscal years. A current ratio value above one indicates that current assets exceed current liabilities.

As a further test of working capital, as well as confirmation of the quality of earnings, we screen for positive operating cash flow over the last 12 months and each of the last three fiscal years. Cash from operations is the sum of net income, depreciation and the change in accounts payable minus the change in accounts receivable. Earnings can be influenced by many management assumptions trickling through the accounting books. Cash flow is less influenced by these types of varying assumptions, making it more comparable across a wide range of companies. A study of cash flows has the added benefit of being more comparable across industries and countries.

Fundamental Value and Growth at a Reasonable Price

When determining if an investment represents an attractive purchase, it is important to separate the company from the stock. While Wanger seeks out sound companies, he will only consider them for purchase if they are available at an attractive price. He therefore looks at the company’s fundamental value and buys them only if they are cheap.

The “cheapness” of a stock can be measured in two ways: the stock price in relation to the company’s replacement cost and a company’s earnings-growth prospects. The asset value of a company is different from its book value. It refers to the real market value and takes into account long- and short-term liabilities as well as intangibles.

In examining the earnings-growth prospects for a company, Wanger points out there are a number of valuation methods one can use. They include the price-earnings (P/E) ratio, the price-to-sales (P/S) ratio, and the price-to-cash-flow (P/CF) ratio.

When looking at the price-earnings ratio, however, low price-earnings stocks often become even lower price-earnings stocks, while growth stocks with high price-earnings ratios can become average price-earnings stocks with any bad news. The key is to buy growth at a reasonable price.

For our screen, we decided to focus on the price-earnings ratios. The price-earnings ratio (stock price divided by earnings per share for the most recent 12 months) embodies the market’s expectation of future earnings potential for a company. Typically, companies with higher growth potential trade with higher ratios because investors are willing to pay a higher multiple of current earnings for the prospect of higher future earnings.

The ratio of price-earnings-to-earnings-growth (PEG) is a common valuation tool that equates the assumptions built into the price-earnings ratio to the actual earnings growth rate of the firm. Firms with price-earnings ratios equal to their growth rate (ratio of one) are considered fairly valued. When the price-earnings ratio is above the growth rate (ratio above one) the stock is considered overvalued, while a price-earnings ratio below the company’s growth rate (ratio less than one) may point to an undervalued stock.

We screen for companies with a PEG ratio below one. We also specify a floor to this ratio, accepting only those companies whose PEG ratio is above 0.20. By imposing such a floor, we are eliminating companies with high earnings growth rates in relation to actual earnings.

Wanger in Summary

While Wanger makes a strong case for investing in smaller-cap stocks, he does not feel that these should be an investor’s only holdings. Instead, he emphasizes the need to diversify holdings among larger-cap stocks. Aside from simply ensuring you get adequate performance at all times, he notes you are more likely to stick with a small-cap approach during lean times if other parts of your portfolio are doing well.

Wanger is also a strong proponent of international investing and, in fact, many of the growth opportunities he seeks are international in nature. However, he points out that investing in foreign markets directly is very difficult for individual investors to accomplish and he suggests the mutual fund route for most investors who want to invest overseas.

Lastly, Wanger states that his own approach is not necessarily the only approach to successful investing. The most important aspect of investing, he says, is to stick with stocks that you really understand and to stick with a disciplined approach that suits your needs and personality.

Screening is the first step in the stock selection process. Selection of final candidates requires careful analysis. First, you must understand the company’s products, industry position and financial statements. The sources of company profit and growth must be well understood. You must also consider the negatives that might impact the prospects of the company. You then invest only if the market price does not fully reflect the company’s position and its prospects.

Top 15 Companies Passing the Wanger Strategy (Ranked by PEG Ratio 5-Yr)

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

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