Engineered Success

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.