As a research engineer, John Montgomery trained at MIT and in his first jobs immersed himself in quantitative methods and transportation theory. But he was curious about investing. After inheriting a sum of money in 1982, he studied investment management at Harvard Business School, and with money left over he, of course, invested it. “I figured since I was in business school maybe I should learn how to invest,” he laughs. “I took a handful of investing courses and my grades indicated I should go to Wall Street.”
Today that is exactly where you can find him–sort of. Bridgeway Capital Management, the firm that Montgomery founded in 1993, is based in Houston, and is home to Bridgeway Ultra-Small Company Tax Advantaged Portfolio (BRSIX) and the five other mutual funds he created and still manages. “We have some actively managed products and two passively managed products,” he says. “BRSIX is one of our passively managed products.”
Bridgeway Ultra-Small is based on the CRSP Cap-Based Portfolio 10 Index and invests only in “ultra-small” companies. Its success has been noteworthy: For the five-year period ended November 29, 2002, BRSIX had an average annualized total return of 9.7%, compared with a total return of 3.2% for all small-cap blend funds, according to Standard & Poor’s. For the same period it also had an average annualized total return of 9.7%, versus a total return of 1.0% for the S&P 500 Composite Index. The fund has earned five stars from S&P and four stars from Morningstar.
His “ultra-smalls” come from the bottom 10% of companies from the NYSE, the American Stock Exchange, and the NASDAQ, and places BRSIX in the $115 million-to-$125 million market cap range. With a universe of about 2,000 companies to choose from, Montgomery generally maintains 400 holdings. “The companies we invest in may have 30 to 100 employees,” he says. Through these companies, BRSIX offers tax-harvesting opportunities, and is intended to act as a diversifier in a long-term investor’s portfolio. This fund is meant for an investor with a time horizon of “10 or 20 years,” he says, “which is [the time horizon of] every pension fund and most IRAs.”
Montgomery admits that while the fund’s performance has been impressive, ultra-small companies run a higher risk of takeover and foreclosure. “But they also have the potential to increase revenues tenfold,” he offers. “One of the things I love to do is to find something that is really bad and turn it into something that is really good.”
We recently spoke to Montgomery about the investment philosophy behind BRSIX and his attention to tax implications.
What is the process your investment method follows? What makes it work? In school we learned about the 80/20 rule–20% of your customers account for 80% of your revenues. During week one in [business] school, the professor asked us how many people would be graduating with honors from Harvard, and 80% of the class raised their hands. I knew that wasn’t going to happen. A year and a half later, I was going through this quantitative stuff I thought was pretty cool and I made the connection that 80% of the people who think they are going to graduate with honors, or 80% of fund managers who thought they would outperform their peers, created a market opportunity.
If there are all these people out there who one day will be in investment management, they are then driving the market. That opens the opportunity for someone to get in in a very disciplined way by incorporating quantitative methods. I started thinking that investing was a natural application of quantitative theory. Over the next six years, my methodology was significantly more successful than I expected. I left the transportation industry in 1991 and spent a year and a half doing research on the models that I created, and researched the feasibility of starting a mutual fund company. I incorporated Bridgeway in July 1993. [The funds were made available to the public in 1994.]
Tell me about your screening process. Our definition of ultra-small company is the size of the smallest 10% of the companies listed on the New York Stock Exchange.
Currently that number is about $115 to $125 million in market cap. Having done that [calculation], we include all companies in the NYSE in the bottom 10%, but also add in American Stock Exchange companies, and NASDAQ companies that meet the same market cap. Not surprisingly, there are about 2,000 companies among those three exchanges that meet that criterion. So it is not an index like the S&P 500, but of 2,000 companies. These are very small but publicly traded companies. Some people think these companies are like IPOs. It includes some of those, but actually the majority have been around for a number of years and have good businesses.
You currently maintain 394 holdings in this fund, according to S&P. Why so many? One way to look at it is to ask why so few? If we are trying to replicate the performance of all 2,000 companies in the CRSP Cap-Based Portfolio 10 Index, we could argue that we should buy every company in the index. Instead, we created a sampling method that picks companies to roughly match the composition of the index.
How do you determine the mix of the fund? What is your criterion for dropping a holding? We do have some constraints. For example, when we purchase the stock, we can’t get more than 1.5% out of line with the sector representation of the underlying index. So we can’t just go out and pick any ultra-small-cap company. When everything is said and done, we hope to have a basket of 400 stocks that looks something like the makeup of the 2,000 stocks in the index.
Do you maintain the same number of stocks every year? It has gone up some over time, but it has remained fairly constant over the last year. It’ll probably continue to rise if assets in the fund grow. With 400 holdings, your average holding [accounts for] 0.25% [of the portfolio], and that is great diversification, which is a huge issue in this portfolio.
If you take the companies in the Dow Jones industrials, the probability is extremely low that any one of them will go out of business. But none of them is going to quadruple sales this year, either. With ultra-smalls, a much higher percentage go out of business every year, and a much higher percentage of them will quadruple their sales. So when a bad thing happens to an ultra-small company, it can be history. On the other hand, if you own 0.1% market share of some medical equipment manufacturer that comes out with a great product and you own 1% of the market, you have gone up tenfold in revenues. That is part of the characteristics of ultra-small stocks. They are similar to warrants or call options. They can go completely out of business and you can lose all your money, or you can make a killing in one company.
BRSIX is just an index fund, and quite frankly, anyone can operate an index fund. You can go out and figure out how to sample companies to somewhat replicate an index yourself; you don’t ever have to analyze the companies.
But there are some other things we do to create value. One is on the trading side. The average spread on a stock is about 5%. You take the difference between the bid and the ask and divide that by the last price; you’ll come up with a number on average of about 4.5% to 5%. So if you call your broker and say buy 100 shares of XYZ ultra-small company tomorrow on the open market, you have just given up 2.5% of the value of that stock. You are going to pay the ask.
When you think, theoretically, that the value of the stock is halfway between the bid and the ask, then every time you buy and sell a stock you have lost 5% on the return of that portfolio. That is a huge problem in an actively managed fund that turns over 100% a year. You would literally give up 5% of the return in the portfolio.
The cool part of this asset class is you’ve got a couple extra percentage points of return relative to small-cap or even the S&P 500 large-cap equity portfolio. You are taking on some additional short-term risk, but if you are a long-term investor, you should care about long-term volatility.
If you are going to let it sit there, then why not let it sit in a volatile asset class that gives you a couple of percent more on average year in and year out, and let it ride? Ten percent a year over 20 years is 50% more money, and that is a lot of money.
What makes your fund a tax-advantaged portfolio? We haven’t distributed a capital gain in 5 1/2 years. That is the proof that we are a tax-advantaged portfolio. One of the neat things about having companies this small, or the structure of having only 400 out of 2,000 companies, is that at any one time I don’t have to own any one of those companies. There is always a roughly equivalent company I can buy, and sell the one we have. This means we can go through periodically and harvest tax losses; we track individual tax lots and periodically harvest some of those tax losses. We will sell that company or those lots of companies that we own, and then get to report that realized capital loss for those positions. This offsets future gains.
There are two major sources of gains; the first is a takeover. A much higher percentage of ultra-smalls are taken over during a year and typically at a much higher price, so that means you are getting a short-term or long-term capital gain. As a result, we are always trying to stay ahead of that curve by harvesting enough losses to offset those gains.
The second happens when a company goes up tenfold in market cap; then it is no longer ultra-small. Eventually you are going to have to sell it. Normally, larger firms can’t do this very well because you get eaten up in transaction costs. But with ultra-smalls, we have figured out how to buy close to the bid and sell close to the ask, and we actually create a little value on average every time we make a trade, even though the tax management of the portfolio increases our turnover. Most people think that is a bad thing. But in our case, this is like the frictionless gear. As an engineer, I think this is really cool. So the implication on the trading is that it allows us to do tax-loss harvesting.
How has the bear market affected your fund’s performance? And if we are in fact heading into a new bull market, how would that affect your performance and your tax efficiency? In the bear market of 2001, our return was up 24%. Return in 2000 was 0.7%, so this is not an antigravity fund. Year-to-date [as of December 12, 2002] we are up 4.5%, and that is the unusual part of it. We are outperforming our own index [the CRSP Cap-Based Portfolio 10 Index] by a measurable amount, and have been since inception.
Small companies got left behind for five years in a row, and when something gets trounced, it is going to come back at some point. So, even though we entered a bear market period over all, and large caps had such an incredible run, we have unwound the previous five years of large-cap dominance. And we aren’t through.
This fund is a great diversifier. In the bear market we have had continued positive returns. But it doesn’t always go in the opposite direction of large-cap stocks. The last three years look great, but people should not buy BRSIX if they think that if the overall market goes down we will be positive. That is not our nature, although it happens to have been true.