Let's Get Really Small
Bridgeway Fund: Ultra Small Company Portfolio (BRUSX ) goes where few funds have dared to go before -- portfolio manager John Montgomery searches at the very bottom of the market-cap ladder to find stocks he believes can deliver high growth. "Ultra-small" companies are even smaller in size than micro-cap stocks -- the maximum market cap size for the fund is currently about $104 million.
Montgomery is strictly a quantitative investor, meaning that he uses various proprietary models to screen stocks. Reflecting how independently such tiny-cap stocks behave relative to the overall market, the fund was up 24.8% year-to-date through July 16, while most every other index was in the red. Moreover, last year the fund rose 4.7%, in a very difficult market environment. Montgomery has managed the fund since its inception in August 1994.
"Ultra-small" might also descrbe the fund itself. According to Montgomery, the fund will be closed to all investors when it reaches $55 million in net assets.
Palash Ghosh of Standard & Poor's FundAdvisor recently spoke with Montgomery about the fund's investing strategy, current top holdings, and recent portfolio moves. Edited excerpts of their conversation follow:
Q: How large is the fund currently in terms of net assets? A:
Q: How large is the fund currently in terms of net assets?
A:We are currently at about $52.5 million in net assets. The fund is presently closed to new investors, and when we reach the $55 million level, we will close it off to existing investors.
Q: How do you define "ultra-small" cap? Is it the same as micro-cap? A:
Q: How do you define "ultra-small" cap? Is it the same as micro-cap?
A:Ultra-small cap is smaller than micro-cap. We define "ultra-small cap" as the average size of the smallest 10% of companies on the New York Stock Exchange -- at the moment, that translates to a maximum market cap size of about $104 million. Thus, ultra-small stocks are in that 10th decile of the NYSE companies, while we define micro-cap as companies in the 9th decile (which currently ranges between $104 million and $264 million). Of course, these ranges can vary along with market conditions.
Q: How do ultra-small stocks compare with micro-cap stocks? A:
Q: How do ultra-small stocks compare with micro-cap stocks?
A:Ultra-small companies are as different from micro-caps as micro-caps are from the S&P 500 stocks. Historically, among the different asset classes with small-caps, ultra-small caps is "where the action is," that is, they offer the highest volatility and the higher potential average annual returns. To tolerate such volatility, an investor would be expected to demand higher returns. There are currently about 1,970 companies in the universe of ultra-small companies.
Q: How many stocks are in the fund currently? Is this a typical number? A:
Q: How many stocks are in the fund currently? Is this a typical number?
A:Typically we have about 160 stocks in the portfolio. Individually, ultra-small stocks carry a great deal of risk -- some can quadruple in value in one year; while others can go bankrupt. In order to dampen that risk we feel it's better to have a large number of equities.
Q: What are your buy criteria? Describe your investment process. A:
Q: What are your buy criteria? Describe your investment process.
A:We are a quant shop -- we look strictly at numbers. I've only made one company visit in my entire career. We run five proprietary models to screen our universe of companies; these models contain both value and growth characteristics. However, since ultra-small stocks are still so cheaply priced relative to the rest of the market, they are primarily value stocks -- although, you can find individual ultra-small stocks that possess strong high-growth characteristics. Our models will yield a wide variety of companies; we've had stocks with price-to-earnings ratios as high as 200 -- we've even had stocks with no earnings.
Q: Given that ultra-small and micro-cap stocks are little known and usually ignored by Wall Street, how do you go about researching them? A:
Q: Given that ultra-small and micro-cap stocks are little known and usually ignored by Wall Street, how do you go about researching them?
A:The vast majority of our research consists of poring over publicly available SEC filings. We examine balance sheets, financial income statements, etc.
Q: What is your benchmark? Is it the Russell 2000 Value Index? A:
Q: What is your benchmark? Is it the Russell 2000 Value Index?
A:Our primary benchmark is the CRSP Cap-Based Portfolio 10 Index -- which was created by The Center for Research in Securities Prices at The University of Chicago. This particular index matches our universe of ultra-small stocks perfectly. In calendar 2000, our fund edged up 4.7% while the CRSP Index declined 13.2%. Through the first quarter of 2001, the fund gained 11.4% while the CRSP Index rose 10.7%.
Q: What are the 10 largest holdings in the fund currently? A:
Q: What are the 10 largest holdings in the fund currently?
A:As of June 30: Christopher & Banks Corp. (CHBS ), 7.7%; FTI Consulting (FCN ), 3.4%; SCP Pool (POOL ), 3.1%; AAON Inc. (AAON ), 2.5%; Movie Gallery (MOVI ), 2.5%; Hot Topic (HOTT ), 2.5%; TTI Team Telecom (TTIL ), 2.5%; Keith Companies (TKCI ), 2.1%; Bellwether Exploration, 2.0%; and Navigant International (FLYR ), 1.7%.
The largest holdings in this fund will always be heavily weighted due to rapid price appreciation. With such a large number of stocks in this portfolio, any initial position taken will typically be under 1%.
Q: Can you discuss some of your major holdings? A:
Q: Can you discuss some of your major holdings?
A:Christopher & Banks is a retailer, and we've owned it for quite a while. Formerly called Braun's Fashions, it's a terribly consistent growth company. From 1997 on, their annual earnings increased from $0.30 per share to $0.38 to $0.72 to $1.50 -- and we're expecting this year's earnings to exceed $1.85. This is extraordinary growth. We originally acquired this stock during a turnaround situation, which is not uncommon for us.
FTI Consulting, which has almost quadrupled in value since the beginning of the year, provides consulting services in the areas of financial restructuring, litigation consulting, and engineering. We've owned it for several years.
Q: What are your sell criteria? A:
Q: What are your sell criteria?
A:We generally unload a stock when it falls in our proprietary screening models.
Q: Do you automatically dispose of a stock once its market cap size gets too large? A:
Q: Do you automatically dispose of a stock once its market cap size gets too large?
A:Not generally, we don't have a fixed cut-off level. However, we will likely not hang onto a stock for more than one year after it's reached the upper boundary of our ultra-small cap range. There are exceptions, of course. For example, our largest holding, Christopher & Banks currently has a market cap of about $478 million (we initially purchased it at one-tenth that size).
Q: What are your largest industrial sectors? A:
Q: What are your largest industrial sectors?
A:As of June 30: Consumer cyclicals, 34.5%; consumer non-cyclicals, 16.8%; energy, 15.1%; financials, 10.1%; and industrials, 8.8%.
Q: How much exposure do you have to technology? Have micro-cap tech stocks suffered as much as their large-cap counterparts have? A:
Q: How much exposure do you have to technology? Have micro-cap tech stocks suffered as much as their large-cap counterparts have?
A:Technology accounted for about 5.8% of the fund's assets as of June 30. This is the lowest exposure to tech that we've ever had. Micro-cap techs have been battered but not quite as badly as the large-caps have been.
Of those 1,970 stocks in the ultra-small universe, about 220 of them were Internet stocks at the start of the year. In 1999 and early 2000, all these dot-coms came to market, and then most of them crashed. The ones that survived lost a lot of their market-cap value and fell into our ultra-small sector.
Q: What sector has performed the best for you this year? A:
Q: What sector has performed the best for you this year?
A:The consumer cyclicals, healthcare, software, retail, and homebuilding stocks have performed extremely well for us. Currently, our best performing stocks are much more diversified than usual. For example, in 1999, when our fund gained 40.4%, performance was driven almost solely by the robust tech stocks -- as it was for the rest of the market that year. We made some good money on certain Internet stocks that year.
From Standard & Poor's FundAdvisor