Behind Bridgeway's Coke Formula
(and Why "Ultra Small" is the Real Thing):
Interview with John Montgomery

By Richard Hefter, Editor, Small Cap Manager

When you think small caps, you can't forget the drought of the late 90s, but the Bridgeway Ultra-Small Company Fund gained 40% in 1999. It continued its strong returns in the bear market, up 4.8% in 2000, 34% in 2001, 4.2% in 2002 and 26% year-to-date through June 23. The $75 million fund is closed to new investors, but its sister fund with slightly lower but comparable returns, the Bridgeway Ultra-Small Company Tax Advantage Fund, with $263 million is assets, is open. John Montgomery, founder of Houston-based Bridgeway Funds, shares the strategy of both of these ultra-small funds and why he uses quantitative analysis in picking these tiniest of public companies.
John Montgomery
John Montgomery


What do you mean by ultra small?

We define ultra small as companies the size of the smallest 10% on the New York Stock Exchange, which is to say currently anything less than about $140 million in market capitalization. The Center for Research in Security Prices out of the University of Chicago takes the NYSE and ranks it from top to bottom by market cap and puts them in 10 equal baskets of stocks, about 160 or so stocks in each basket. That sets the size range that they call deciles. The 10th decile is what we call ultra small and the 9th decile we call micro caps.

We think that ultra-small stocks are as different in statistical characteristics to micro-cap stocks as micro-cap stocks are all the way to the S&P 500.

How so?

Part of the difference is that if you look over the last 7 1/2 decades, 10th decile, or ultra small stocks, have returned an average 13.1% annual return over that full period. The average small-cap stock has returned about 11 percentage points. So it's more than a 2 percentage point difference and most of that differential is just from the 9th decile to the 10th.

A 2% edge a year over your average small-cap fund is a lot of money in the long term. If you take a 30-year period of time and you have 2% more a year, you're looking at 80% more money after 30 years. If it's somebody's retirement money and they have 30 years to go, this asset class based on longer-term numbers historically would get you an 80% higher retirement.

How does your fund exploit this universe? What is your strategy?

Our strategy is to tap the financial characteristics of a unique asset class. There are about 2000 stocks or so that are in the universe of ultra-small stocks that we track, and we have two portfolios. One of them, our Ultra-Small Company Fund, is a very active style. We run our quantitative models to beat the market and buy the best stocks we can with that fund, which owns on average about 150-160 positions. The fund has an expense ratio of about 1 1/2 percent, which is pretty lean by industry standards of even micro cap, but is higher than our other ultra-small fund.

The strategy with our Ultra-Small Company Tax Advantage portfolio, which is the much more passively managed one, is to go out and buy a much broader spectrum of stocks. As the name implies, it's got a much stronger attention to tax management. We currently own over 500 stocks in the portfolio of these tiny stocks, and we're trying to match the industry and sector representations of the underlying index, which is that of the Center for Research in Security Prices, which publishes their index monthly. So rather than go out and just buy the very cream-of-the-crop best companies, the Tax Advantage fund takes a much more passive strategy and tries to make it up in several ways.

What ways are those?

One is on the trading cost. The bid-ask spread on stocks this small is on the order of 4-5%, so you can't just go out and tell your broker to put a market order to buy 100,000 shares or 1000 shares for that matter. If the spread's 5%, let's say, and the true market is half way in between, then every time you bought a stock you'd be giving up 2 1/2 % in transaction cost . That's about what you expect the asset class to outperform over time. So trading these stocks is very time-intensive and it's one of the reasons we think no one else offers a stock portfolio of stocks this small. We devote a lot of resources to the trading desk here at Bridgeway. Out of six people in our investment management team half of those are in the trading area. Our goal in our Tax Advantage portfolio is to buy a stock on average over time a little closer to the bid than the ask, which is a neat trick if you can pull it off. I think of it as the "frictionless wheel." To have a net no trading cost is a huge advantage over even the average small-cap fund, where you're going to pay upwards of 2% in trading costs every time you buy or sell a stock. If you have an actively managed portfolio with 100% turnover, you're paying 2% to buy a stock and 2% to sell a stock. That's a 4 percentage-point hurdle every year, and we're trying to get that down in the Tax Advantage portfolio essentially to 0. On top of that we're in an asset class that has a couple percentage point advantage, and on top of that our expense ratio, instead of being, let's say, 1 1/2 percent, is 75 basis points, so you save almost a percent there. I'm looking at a 5 percentage point advantage with Ultra-Small Company Tax Advantage over an actively managed small-cap fund before we get out and even buy any stocks.

Aren't you also trying to save on trading costs in the Ultra-Small Company Fund?

We try, but that's a more actively managed version, where we go out and buy those stocks faster. We're only going after the cream of the crop in that portfolio, and those stocks tend to move faster, so we're going to ante up a little more to get those companies right away.

500 stocks, or even 150, is quite a large number. Why so many?

It's enough to reasonably diversity away the company risk, and it does take a lot more diversification when investing in companies this size. One way to think of it is that in any one year there are going to be a lot more ultra-small stocks that can double and quadruple. If you're a tiny company that owns .01% of the market for a given product, let's say a soft drink company and we've owned one, and you wake up next year and you own .05% of the market, your revenues are up five-fold and Coca Cola still doesn't know you exist. Microsoft and GE aren't doubling revenues next year, but a reasonable percentage of ultra-small socks can go up strongly. The downside, or reverse, of that is that a much higher percentage of ultra-small stocks go completely out of business every year.

Don't you have to do far more research on these companies and their management given these risks?

That observation is the reason no one else offers a stock portfolio of ultra-small companies. In fact, we're a pure "quant" shop. All of our modeling and understanding of these companies is based on numbers and statistics, mostly fundamental information that gets filed on Edgar: financial statements, income statements, balance sheets, cash flow statements, and then there's some technical data that goes into some of our models.

So the good thing is we don't have to go out and interview management. We don't do any market timing across the board at Bridgeway. We don't do any forecasting of the economy. It's all a bottom-up, stock-picking, fully invested methodology, and that's true for all of our funds.

Can you be more specific on your quantitative screens?

We don't talk about the specific inputs to the models at Bridgeway, so I can't talk to you more specifically.

It sounds like you're protecting the Coke formula.

(Laughter.) That's exactly how my brother describes it.

What style area do your ultra-small funds fall into?

We use models that span the style box, so it's much harder to peg. Both ultra-small company portfolios tend to show up on the more value-y end of the spectrum because the whole asset class tends to have lower P/E's, price to book, and things like that, but they've done so well in the last few years that I think we've slipped over into the blend category, according to Morningstar. It's not that we're doing anything different or we think all of a sudden growth is a good thing. It's just where those 2,000 companies show up.

1999 was your best year with 40+ percent returns, which seems odd for a value- oriented fund.

There are some ultra-small stocks in technology, and we did have some of that, and in fact we made a pile of money off a few Internet names back in the heyday of the Internet boom.

What industries come up currently in your screens?

Banks have been pretty strong in our ultra-small portfolio. Some of the home building stocks have been there, and related ones like furniture are interesting. The one that's probably strongest out of proportion with normal is telecom. What we've seen there is that telecom stocks both large and ultra-small were just trounced in the 2000-2001 period and there was a fair amount of red ink around. The valuations got very cheap over the last couple years, and the fundamentals started coming back in the last half year to year. Our model completely takes the emotion out of the process, and in a turnaround situation Wall Street tends to have a wait-and-see, prove-to-me-if-this-is-real attitude, and our models don't have that, so we've been more strongly invested in telecom.

Sometimes the models bring up companies that I think are great, and other times it brings up ones I think I would never invest in if I were doing this the classical way of thinking about the economy and good companies and what's likely to happen. For example, Ask Jeeves (ASKJ) is one our best performing in our Tax Advantage portfolio. It's a little dot-com, and after all the carnage the Internet business took people through in 2001 and 2002, that's probably the last place I would have thought to invest in stocks again. I don't think I would have picked up on that one myself, but we own a number of Internet stocks, and, quite frankly, a large number of them have become ultra small.

Any stocks in particular come up highly rated?

One company we've owned and that has done extremely well for us is Clayton Williams (CWEI), an oil and gas firm in Louisiana and Texas and some other states. Sometimes it's hard to see why we hold the stock because they're all multi-factor models. You put two companies side by side that have similar growth rates and valuations and the technicals look similar, and it's just a confluence of factors in the model that make one a buy and one not. On this particular one, they had a blow-out quarter in March. That's one of the things. They had earnings of $1.71 in the March quarter and estimate 19 cents here in the next quarter after a bunch of red ink last year, so this is a company where the stock price was pretty cheap. It's taken off like a rocket and interestingly the valuations aren't necessarily way out of bounds. Cash flow on this company looks good. Our models look at fundamental data, and this particular one is a kind of "growth at a reasonable price" model.

10 Micro-Caps Worth Watching

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Teton Raised To Strong Buy Rating In Quarterly Update
June 23, 2003. Though small in terms of revenue, Teton is the only publicly traded "pure play" on Russian oil. Virtually 100% of its 33 million barrels of proved and probable oil reserves are located in Russia. We think Teton Petroleum is on the precipice of a growth explosion. Frequently a major Russian announcement is made in one form or another; whether it is a merger or plans for a new pipeline across Siberia. Teton is uniquely positioned to benefit from the resurgence in Russian oil. Based on higher production, cash flow, and earnings, we think its share price could double over the next 12-24 months, as revenues have begun what we believe is an acceleration to $40 million in the 2004 to 2005 timeframe. We are raising our rating to Strong Buy for the Company.

Deckers Buy Rating And Higher Target Price In Update
June 20, 2003. The Company's acquisition of the Teva brand and the strong earnings performance in Q4 2002 and Q1 2003 resulted in the market's upward revaluation of the DECK pricing ratios. In spite of the stellar market performance over the past six months, we believe the stock should continue to outperform its peer group. Our revised 12-month target is $8.50, a 30% increase above the current level. The Company's three brands have undergone an expansion of lines, styles, and models that provide growth opportunities in new product categories and in new geographical markets. With the future of the Teva brand clarified, the Company can establish new brands either by acquisition or by internal development. The Company is now also an attractive target for larger acquisitive footwear and/or consumer goods companies.

First Cash Financial Strong Buy Rating Maintained
June 20, 2003. Even though the stock has outperformed the general market, we believe the current market valuation of First Cash does not reflect its excellent financial history, its experienced management in the short term loan market, or its potential revenue growth in the coming years from continued expansion of pawn shops and free standing payday advance stores, both domestically and in Mexico. First Cash reported record revenue and earnings for Q1 ended March 2003. Revenues increased 20% to approximately $34.2 million while net income increased 25% to approximately $3.5 million. First Cash's annual yield from average pawn balances was 143% at year-end 2002, up from 127% two years before. Based on our projected diluted earnings per share of $1.36 for FY2003, the price/earnings ratio is only 10.4.

Panhandle Royalty Strong Buy Rating Maintained
June 18, 2003. Because natural gas prices will likely continue to track higher from current levels, we remain bullish on the industry and Panhandle Royalty. As a royalty company, Panhandle is in a unique position to enjoy the price advances for oil and gas without incurring drilling risk. With oil and gas prices poised for further escalation, PANRA revenue could accelerate significantly during this and the next quarter. We have dramatically revised our revenue and earnings estimates for the next two quarters and for the full fiscal year to range from $23.0-$25.0 million this year, up $5 million from our previous estimate. Given our second half outlook, we believe Panhandle could post full-year earnings of $3.00 per share in the current 9/30 fiscal year. We maintain our Strong Buy rating and raised our target price to $26.

Pharmos Corporation Speculative Buy Rating Maintained
June 18, 2003. Pharmos (PARS) has begun dosing patients in its Phase IIa feasibility study for the reduction of post cardiac surgery cognitive impairment. The patient accrual in the Company's international Phase III dexanabinol trial for TBI is proceeding on track. Additionally, Pharmos began dosing patients for its cardiac surgery-induced cognitive impairment study in April 2003. This Phase IIa trial is currently underway at three centers in Israel and will enroll up to 200 patients undergoing CABG or CPB surgery. On June 2, 2003, Pharmos announced it had raised $8 million in gross proceeds in a private placement of common stock and warrants with a group of 10 institutional investors. Pharmos has received its largest single grant ($4.4 million) in the Company's history from Israel's Office of the Chief Scientist.

BioSante Pharmaceuticals Rated Speculative Buy In Initial Report
June 16, 2003. BioSante is an emerging biopharmaceutical company developing hormone therapy gel products to treat women as well as men. These products are topical gels, four advancing to Phase II, Phase II/III, or Phase III clinical trials. BISP is developing a proprietary nanoparticulate-based platform technology (CAP) using extremely small, solid, uniform particles called nanoparticles. Management has an enviable track record of developing and subsequently selling small pharmaceutical companies, and is likely to replicate this pattern at BioSante. Important milestones have been achieved, and several more are anticipated over the next 18 months. We judge that BioSante's current $26 million equity valuation represents less than what any one of several prospective products could ultimately be worth, so that the stock in effect offers the patient investor a bargain price for the Company's promising portfolio.

AdStar Speculative Buy Rating Issued
June 10, 2003. AdStar provides application software services to the $15.9 billion classified advertising industry with proprietary software that electronically connects publishers with the source of their advertising revenue. AdStar allows newspapers the ability to electronically receive classified advertising insertions directly from advertisers into their sophisticated publishing systems. AdStar contracts with publishers to design, implement, host, and manage the on-line ad-taking capabilities of their Web sites. Approximately $400 and $450 million of classified ads were placed in newspapers using AdStar's remote entry system in 2001 and 2002, respectively. There appear to be enough early signs of success that we are encouraged by the opportunities. In 2002, AdStar entered into a strategic relationship with the Tribune Company, who currently owns 29.4% of ADST shares. We are commencing coverage of AdStar with a Speculative Buy rating.

Trinity Biotech Strong Buy Rating Maintained; Price Target Raised to $3.25
June 05, 2003. Trinity (TRIB) develops, acquires, manufactures, and markets diagnostic products for the point-of-care and clinical laboratory segments of the diagnostic market. Its broad line of test kits are mostly used to detect infectious diseases, sexually transmitted diseases, blood coagulation disorders, and autoimmune diseases. Its UniGold(TM) HIV test has the potential to become Trinity's single most important product. Trinity completed its submission to the FDA in late March, and is hopeful of receiving marketing clearance for UniGold by quarter end. The Company's near-term outlook is very favorable, as indicated by our projected 2003 sales of $69 million and EPS of $.175, representing gains of 32.7% and 46.0% respectively. The stock remains undervalued, in our opinion, and we have raised our 12-month price target to $3.25.

HPSC Strong Buy Rating Issued
June 03, 2003. We reiterate and emphasize our Strong Buy rating for HPSC, Inc. This specialty financing company is well financed, having announced in Q1 additional financing of $323 million that insures its capacity to grow earnings in the coming quarters. HPSC earnings per share have increased at an average annual growth rate of approximately 45% in the periods of FY1995 to FY2002. In Q1 of 2003, revenues increased 19% to $14.9 million while EPS increased 57.8% to $0.30. We are estimating a 12% increase in revenues to $62 million and a 43% gain in fully diluted EPS of $1.32 for 2003. HPSC is a unique specialty/niche finance company whose core business is providing financing to licensed healthcare practitioners in the US, a market of over $5.8 billion.

Wireless Facilities Buy Rating Issued
May 27, 2003. Wireless Facilities (WFII) designs and deploys wireless networks for wireless operators. It is also well positioned to capitalize on the growing trend toward outsourcing of network management and optimization. Operators are increasingly focused on cost containment, identifying and embracing the benefits of outsourcing network management, billing, and customer care. WFII is applying its wireless network integration skills to new growth areas, including the exploding wireless local area networks (LANs, including Wi-Fi/802.11), commercial building tele-media services, and security. Recently, shopping mall owner/operator Westfield America retained WFII to provide turnkey wireless LAN integrated services including supplying backhaul, network equipment, wireless LAN design and installation, network maintenance, electronic security as well as ongoing network monitoring. We estimate WFII 2003 revenues of $284.7 million with EPS of $.31, growing to 2004 revenues of $432.5 million with EPS of $.46 respectively.

We invite you to read all of our reports at www.jmdutton.com

Ultra Small Company Top 10 Holdings as of March 31, 2003:

1. FTI Consulting
2. Central European Distribution Corp.
3. JOS A Bank Clothiers
4. Bradley Pharmaceuticals
5. FindWhat.com
6. Hi-Tech Pharmaceutical Co
7. Bay State Bancorp
8. Brightpoint Inc.
9. Bank of the Ozarks, Inc.
10. Synovis Life Technologies Inc.

How did you come to use quantitative modeling?

I worked with computer modeling and quantitative methods as a research engineer at MIT in the late 1970s. I took two years off and went to Harvard Business School, and in one of the courses we had a case study on a quantitative firm. It was a firm with a very attractive track record, and at the end the professor says, "Now how many people think you can get out of business school and beat this record?"

Quantitative analysis is just numbers and statistics and not very glamorous, and a lot of people want to think they're the next Peter Lynch - that is, hold the product in your hand and scratch your bead and ask the company executive some probing question, and quantitative modeling is not that way. I like numbers, but quite frankly most people in life find this stuff quite boring.

So we were in this class of bright young men and women, and 80% raised their hands. Now at least 80% -- and I think it's upwards of 90% -- of money managers under-perform the market benchmarks over long periods of time. So you've got 80% of the people raising their hands saying they're going to beat it when you know in fact it's probably less than 20% and probably substantially less than that.

So you saw an opportunity?

That's right. Clearly, there's a strong emotional tie and optimism to thinking you can beat the market that just perpetuates itself. If people believed the numbers on active management, nobody would hire an active manger, including me. What I really got out of that class is there's an opportunity when the people that are in the positions to make the decision think they can beat it when in fact you know in aggregate that can't be true. That was my insight from business school, and I thought there should be an application for quantitative modeling. I thought essentially what quantitative modeling would do is take emotion out of the process, and that's the biggest destroyer of value in our industry.

That's what I like about ultra-small stocks, too. You don't want to go fishing in pools where the numbers are radically up against you. I've got that 2 percentage-point lead right out of the box with ultra-small stocks. It doesn't happen every year or even every decade, but as we talked about there are lot of other good things that, when put together, give you a strong advantage over the competition.