Episode #323: John Montgomery, Bridgeway Capital Management, “A Factors-Based World View Resonated With Me”
Guest: John Montgomery founded Bridgeway Capital Management in 1993 and is the Chief Investment Officer. John is part of the investment team for all Bridgeway strategies.
Date Recorded: 6/9/2021 | Run-Time: 1:00:52
Summary: In today’s episode, we start by hearing what made our John leave a job in the Transit sector to start a quantitative investment firm. We walk through what drew him to a rules-based approach and then touch on different factors, including size, value, and low volatility. We even touch on Bridgeway’s ultra small cap strategy and how it captures the small-cap premium.
As we wind down, we hear about the firm’s unique structure, which includes donating half its profits to charity with the goal of ending genocide.
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Links from the Episode:
- 0:39 – Sponsor: Yotta – Use code “MEB” to earn 100 bonus tickets
- 1:18 – Intro
- 2:12 – Welcome to our guest, John Montgomery
- 4:09 – Early career inspiration; Silent Spring (Carson)
- 5:23 – John’s first investing classes
- 6:47 – Insights into the benefits of quantitative methods
- 9:06 – Transitioning from hobby to career
- 11:41 – Foundations of Bridgeway Capital Management
- 12:44 – John’s ultra-small company strategy
- 18:38 – Bridgeway’s evolving research approach
- 20:44 – John’s fascination with low-volatility investing
- 22:10 – Blending different factor exposures
- 25:04 – Bridgeway’s rules on leverage
- 28:22 – The Great Depression: A Diary (Roth)
- 29:22 – Preparing yourself for lean times
- 31:05 – The importance of risk management
- 32:03 – John’s asset allocation strategy
- 38:53 – Bridgeway as an enduring firm
- 43:19 – Bridgeway’s giving culture
- 45:09 – Bridgeway Foundation
- 46:18 – To Stop a Warlord: My Story of Justice, Grace, and the Fight for Peace (Davis)
- 47:47 – Helping child soldiers come home
- 54:15 – John’s most memorable investments
- 56:34 – Planning your exit
- 58:02 – Learn more at Bridgeway.com
Transcript of Episode 323:
Welcome Message: Welcome to “The Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
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Hey, hey, everybody. We have a huge episode for you today. I am thrilled to welcome our guest, the founder and chief investment officer of Bridgeway Capital Management, one of the early and independent multi-billion dollar quantitative managers. In today’s episode, we start by hearing what made our guest leave the job in the transit sector to start a quantitative investment firm. We walk through what drew him to a rules-based approach and touch on different factors, size, value, low volatility. We even touch on the firm’s ultra small-cap strategy that we used to be shareholders, and how it captures the small-cap premium. As we wind down, we hear about the firm’s unique structure, which includes donating half of its profits to charity with the goal of ending genocide. Please enjoy this episode with Bridgeway Capital Management’s John Montgomery. John, welcome to the show.
John: It’s great to be here, Meb. Thanks for inviting me.
Meb: Here is where? H town, Houston?
John: Yes. Houston, Texas where I grew up.
Meb: I’ve spent a little time there. I know you’re a fellow engineer. I was a biotech engineer once upon a time and I remember going to a tissue engineering conference at Rice University right down the road where it was like 170 degrees or something in the summer, but everyone else there, it’s all energy. You come from an energy family, right?
John: That’s right. I do. My dad was the president of an oil exploration firm right here in Texas.
Meb: So what happened? You got too much oil on your genes growing up? How come you’re not a wildcatter?
John: Well, the more interesting story is how he got into it. He grew up in west Texas around hay and horses, and he was allergic to hay and horses, which gets you to the big city in Texas. And I tell people that I left Texas during all the boom years. So I graduated from high school in 1973, which was oil at, I don’t know, $40 or $50 a barrel, maybe more. And it kept going up after that. I returned, and price of oil dropped by two-thirds after I got back home. So I missed all the boom years from 1973 to 1985 when I moved back. Man, Houston went from… My childhood Houston, the entire area was 450,000 people. Now we’re like seven and a half million. That’s what air conditioning will do.
Meb: There you go. You had a couple stops on your way to the quant world, but I mean, Swarthmore, MIT, Harvard, what was the progression? Like, had you had the intentions of being an energy guy and then got head locked or sidetracked by something else? What’s the origin story?
John: No. I read a book in high school called “Silent Spring,” which was an early environmental book, but an important one that made an impression on me. And so I was out to make a difference in the environment. And in college, urban transportation seemed like a real-world way to move the needle on that. So that was my first career out of college. So my first, I don’t know, 15 years or so was in transportation, urban transportation, but I’ve worked in academia, in government, in nonprofit, and now for-profit, worked the last 28 years at Bridgeway.
Meb: I want to hear all about it, but give me the original inspiration. If you look at the sort of arc of history on the investing quantitative side, you’re definitely been at this for a little while, seen a few cycles. What was the idea that originally called you, that popped into your head? Did you read some sort of influencing tax early? Was it you were hanging out in Omaha at the steakhouse or what?
John: No. I’ve never been to the steak house in Omaha. We’ve got good steak here in Texas, so I guess it’s never pulled me up that way. But I love service industries and I was a shareholder in two IRAs back in the ’80s. I’m an engineer by background, so I love numbers and statistics, but anytime I receive poor service, whether it’s on an airline, or a restaurant, or a hotel, at the other end of the stick on an investment and communications, I always think, “Well, that’s an invitation for competition.” So I thought there’s got to be a better way to communicate and to focus than the kinds of stuff I was getting as a shareholder. That was when I was in business school. And I thought when I was at business school I’ll take a couple of investment courses just kind of on the side and maybe earn back eventually the opportunity costs, and my grades said that I should have gone to Wall Street. But I had absolutely no interest in going to Wall Street nor intention to. I was in the transportation field.
But I did have a knack for investments and I had a case study, this was at Harvard Business School, of a quant shop, and I thought, “Wow. You can use numbers and statistics to do all this stuff.” Instead of the classic CFA fundamental bottom-up interview management, think about the economy and figure out what industries will do well and then figure out what companies will do well in that industry. It’s like there’s a different way to go about this. And so I was in one class in particular, and I had a behavioral finance insight. So this was before I knew anything about behavioral finance. But the insight was at the end of this class with the quantitative methods, and I was completely turned on, the professor steps back from the bulletin board, tugs on his beard, and says, “So how many people in here think like when you get out of business school, you can beat this track record?” And 80% of the hands in the class go up. Now, that’s not different from any other place. And I immediately recognize the 80/20 rule, it’s like 20% of people can actually outperform and 80% of the people think they can.
Meb: I was going to say today that’s 99%. Why is 80% so low? Now, today on Robin Hood and everywhere else?
John: I don’t know.
Meb: The optimism’s closer to 99.
John: Maybe the database I was looking in had survivorship bias, Meb. That could be the reason for that. But I thought, “If this is true of Wall Street people five years from now, then it should give a leg up for people that are using quantitative methods in investing.” So I started doing that as a hobby for the next six years.
Meb: There are two funny takeaways I have from this. The first is the Lake Woebegone analogy where we all can’t be better than average, but the reality is you then built a incredibly successful quantitative shop. So you were in the right cohort, but second is, who is the case study focused on? Do you recall by any chance?
John: I’ve got a name, but I don’t know for sure. So I’m not going to give it. I do know the professor’s name. It was Professor Perold.
Meb: That’s awesome. As an aside, listeners, will be stunned, but there’s some unbelievable number, if you look at the Harvard publishing yearly revenue is like $300 million or something. It’s some incredible business, by the way.
John: Is that right?
Meb: Oh, no. Sorry. And the business school, in general, generates almost a billion in revenue, but the publishing arm alone is a couple of 100 million, so great business, by the way. All right. So you said, “Okay, there’s numbers, this is interesting.” And at that point, it was just hobby or, like, what was the next step?
John: I started doing research on quantitative methods and kind of came up with some thoughts about how we’d go about it and started investing my own money that way as a hobby. That was what I did for the next six years. At the end of six years, I had the thought, “I think I might like to do this for my day job.” So it was a pivot point in my career. I was 36, 37 at the time and had some entrepreneurial bent. By the way, I did not take a single course in entrepreneur-ism and business school, which is probably a good thing because I didn’t know the statistics on the percentages of companies that don’t make it to year 5 and year 10. They’re not very good. Might’ve been discouraging to actually starting, but pitched in. It did take us three years to get to the breakeven point as an advisory firm. And my business plan had us breaking even in less than half that time. So good lessons and humility in the early stages. And I’m a big believer in the power of humility in business.
Meb: Yeah. That’s one of my favorite phrases, is, like, the biggest compliment you can give anyone in the entrepreneurial startup world in asset management is just survival, just existing. So many entrepreneurs go into this. You talk to every entrepreneur at every startup class or discussion and everyone says most startups fail, but zero startup founders expect it to be them. And it’s interesting to watch like so many companies, and not even startups, incumbents too, it’s like you look back at the old…I think Buffet actually posted it in his annual talk this year, that it was like the largest market cap companies by decade. Back when you were starting out in the ’80s, it was a lot of Japanese companies and even in like the late ’90s, it was a lot of the big tech in the U.S. and now it’s totally different lists. So it’s hard just to stay relevant and exist. But I was laughing as you were saying breakeven because I was like, “What does that even mean? We’ve been doing this 10 years. I’m still trying to find that.” The promised land. All right. So what was the original framework? Was it similar to what you’re doing now? I mean, were you able to craft together some quantitative insights on a, I don’t know, Commodore 64, Apple IIe? What was it back then?
John: The only computer programming course I ever took was in Fortran 4, which definitely dates one. But they had…spreadsheets were a deal and there were some good statistical programs even back then. But one thing in terms of the founding of Bridgeway was right about the same years, the seminal work on value by Eugene Fama and the size and the value factors just resonated with me. The whole concept of risk and return made sense in my world. Smaller companies are more risky any way you want to make sure it, and it seems to me like investors should be compensated for that. One of the things that some people will tell you about me is I’m just cheap. I like a good deal, whether I’m buying a car, or a refrigerator, or a stock, that’s my most favorite, comfortable place to be. So I’m a contrarian for the same reason. I’m most happy when other people are bringing their hands and I’m bringing my hands when most other people think that they own the world and things will go up forever. So back to kind of behavioral finance aspects of that.
But continued to develop reading about momentum and studying other factors over the years. But one of our first three strategies was one I’ll call teeny tiny. We call ultra-small size company, and it came from waking up in the middle of the night, thinking about, “What can a small startup firm do that the big guys can’t do?” And it’s like I’ve seen those graphs of small size, like in stocks, bonds, bills, and inflation, and there’s more action on the really small end of the spectrum long-term, and I bet those stocks are not liquid enough for the big guys to play in. And that turned out to be true in spades. So we’ve made a name for ourselves in very small stocks, and they lean value and that makes me happy. And anyway,
a factors-based worldview resonated with me.
And that was all great, and fine, and dandy until I first read research on the low vol effect, and I went like, “Wait… Hold the horses here. You’re saying that lower volatility, less risk?” And, by the way, this is like the metric that academicians measure risks by. It’s not like we’re picking a different one and translating some. I was like, “Take the exact same thing that we all measure risk by.” And lower risk companies do better in the long-term like that. Like how can that be? That rocked my world. That’s where behavioral finance got to be a bigger piece of the pie for me, and that there are non-risk reasons why stocks do what they do and people do what they do.
Meb: Your ideas and concepts definitely resonate. I jokingly…when you were talking about value, I love to refer to myself and the podcast listeners as cheap bastards, and I say that as a compliment as it applies to all walks of life, but the value approach certainly makes a lot of sense, and value in my mind is also being not just investing the cheap stuff, but avoiding the really expensive. But your fund, you guys may have to check the roles at some point, but my mom was definitely a shareholder at some point. You guys have closed this thing and reopened it over the years, the ultra small-company fund. So I don’t know if mom favor is still in there. I’d have to ask her, but she was a long time happy shareholder, for sure. Is that even still open to investors or is that closed currently?
John: It is open. The ultra-small company market fund is open. That’s probably the one that she was in because we closed the smaller version with a fewer stocks back in, I don’t know, 1997 or so.
Meb: I don’t know. She might’ve snuck in before the gates came down.
John: She snuck in. She’s a long-term… We don’t lose many people in that strategy. And if she still is, small stocks have done really well over the last year, admittedly, of a low base and just a headwind painful one for small stocks decade before that. But the last year has been good.
Meb: So just for anchoring, when you say small stocks, like what does that mean to the average person listening to this? Like what’s the market cap ballpark when you’re saying small?
John: We talk about large caps, mid-caps, small caps, and micro caps, and ultra-small. So we slice and dice it a bit more thinly than most people do. And to give you a rough idea, ultra-small is breathtakingly small. These are companies…I don’t have the most recent data, but on the order of 280 million at the top end, so our average market cap is significantly below that. The Russell 2000 Microcap Index only has 17% represented in ultra-small stocks the way we measure it. And we say ultra-small stocks or stocks the size of the smallest 10% on the New York Stock Exchange. So it’s not all stock exchange-related companies. They trade on different exchanges, but you take all the companies on the nice and rank them by market cap, and the bottom 10% in number is what we set. They represent currently about one-third of 1% of all the dollars on the U.S. exchanges.
John: We’re talking really small. They are very small. And they’re so cool. I just love them. You read about what they do, like you can read a financial statement and you can understand it. You think about the product, you’d understand that. I mean, it’s just more accessible.
Meb: It’s always astonishing to me, you find these businesses versus the large competitors that have, I don’t know, 30 Wall Street analysts following them and everyone that’s covered them to the decimal point on their annual statements, and it goes to this topic of just old Munger quote of if you’re a fisherman, like go where the fish are and there’s no competition, it just seems to make a lot more common sense to not be competing for who has the best Apple cash flow model versus this tiny company in Louisiana or Oregon that sells steel widgets. I don’t know. But it’s fun. And the quantity approach, at least, you don’t have to cover 10,000 companies. You can help use the computer. Okay. So the framework was value in small. You guys have since expanded into a number of different things. You’ve got maybe, what, like a dozen funds now, is that about? Somewhere in the ballpark?
John: Yes. We manage just shy that.
Meb: Walk me through how the philosophy and research process has changed over the years. You’ve seen, like I said, quite a few cool and some painful market events during this time. We got the ’87 crash, the Japanese Bubble, Tequila Crisis, on and on, and even more recently, you know, the last two years have been pretty weird. How have things evolved for you guys as far as the research side? I want to get to the actual company in a little bit.
John: In some ways, they haven’t changed much at all. So having a factors-based worldview, I still think, is a big advantage. And so our four core pillars of our investment philosophy haven’t changed, and some structure of how we do has and hasn’t changed. So I didn’t grow up in the industry. This is a little unusual, that I started a company in a industry that I had never worked before. People don’t usually do that. And it has all the disadvantages you would think of not having experience in certain areas and some other advantages where you don’t think things have to be a certain way. So especially on the culture side, Bridgeway is a very unusual place to work. But sticking to the research side, I guess the big thing that’s changed is access to quality data, longer-term data, and these amazing people that I get to work with, the systems and the automation.
We’ve got PhDs on the investment team now. They’re easily three or four people that can dance circles around me on statistics. And so I get to be in the room with them. It’s awesome. We really have a great team. So I didn’t have any of those resources in the beginning. I remember one of our first paying for data was a company called Teluscan and they eventually got taken over by somebody. I don’t know who. But just to say the data quality has improved over the time. Bridgeway has branched out into some emerging markets, not on the mutual fund side at this point, but that reminds me a little bit more of the earlier years. Some of the data quality is not as good internationally as we have here in the U.S.
Meb: You mentioned low vol. Feel free to talk about that for a little because it is a little odd, and any other kind of factors or ideas over the past 20 years that have either been head-scratchers, or confusing, or amazing that you’re willing to discuss and not keeping the komono as far as things you’ve looked at or studied that you think are particularly interesting.
John: It’s interesting to focus on where we do things differently and the same. So low vol is fascinating to me because you just can’t come up with a risk argument. Now, I’ve heard people do so, even Annie Scott, like some ways to look underneath, but it just seems like a stretch to me. It’s like we’re talking about low standard deviation, the price doesn’t move so much, versus the ones that do a lot. I was at a conference where they said, “This is not really the low vol effect, it’s the not high vol effect,” which is to say the real value add is on the short side, staying away from the very volatile companies. And that has been our experience, except some of the quantitative models that we’ve got feed off of that volatility to separate out good companies from bad companies according to some other metric. A related quote that I’ll mention is from Elena on our team who once said… She’d done some research on fixed income for some reason. And she came back and reported in our weekly meeting and said, “I just like stocks so much better. They move.” And with respect to high volatility, in some ways, it’s easier to see what’s going on when there’s more movement there. But as a generalization, we all know now low vol is better. So that’s what I’d say about that.
One of our pillars of our investment philosophy is focus. So we believe in strong factor exposures. And then we have strategies in two camps, one called Omni and one called Select. And think of Omni as we’re trying to give exposure to what we think of as an entire asset class or a large niche. And it tends to mean you’ve got more companies. So we might have, like our Omni small value strategy has hundreds of stocks in it, and it gives you very wide exposure to something, in particular, you’re looking at, or your mom’s ultra-small company market strategy, it’s similar.
We’ve got hundreds of stocks, like 500 teeny tiny stocks in that. Our Select strategies tend to have fewer numbers because we’re focused on what we call the tip of the spear. So if you think of you’re buying value companies, and to simplify it, let’s say you’re ranking stocks by price to earnings. And what I can tell you is that we’ll say you’re ranking the Russell 2000 stocks by that. The 200 cheapest stocks, which would comprise what we call a decile, 200 out of 2,000, so 10%, don’t give you a strong factor exposure as the cheapest 500, from 200 to 50 stocks and from 50 to 10. Now, at some point you’ve got instability, so you don’t want to just invest in 10 stocks and all the rules of diversification apply. But with respect to strong factor exposure, fewer is better and so our Select strategies tend to blend different factor exposures, but with very serious exposure to the individual factors that you can.
So there’s cool research around that to know how low do you go. Everybody who’s like factors-based believes this is true to some degree because typically they’re not buying the top half and not the bottom half. It’s more focused than that. And so the question is, where do you stop? And part of the answer to that is liquidity again. The big companies are going to have more companies because they need to push through a lot more dollars in order to make money. But that’s one of our advantages. We don’t have to do that. So I like the less liquid market, ultra-small, emerging. As Elena says, they’re kind of more fun because they move, and it plays to our strength. Experience, first of all, we got 28 years experience doing this now. Trading is the other huge piece of that. Transaction costs get to be a much bigger piece of the pie when you’re talking about less liquid companies, obviously, and Bridgeway has a lot of experience with that.
Meb: I was thinking, as you’re talking about the bonds don’t move that much and say, “Well, just ask the long-term capital guys.” You put enough leverage on these suckers and they can move too. All you need is 500 to 1 leverage, John, then they’ll be volatile.
John: That is so true. Before I started Bridgeway, I did something that I saw another businessman in Houston do. He was the mayor and he had had five different careers over his lifetime. And each time he started a new venture, he took a year off to study the heck out of the next thing. So I actually did that when I went from transportation to investments. And as part of that, I was studying my own methods, which had been even more successful than I had thought that they would be. So I was trying to understand why that was and drilled down and studying historical data. Well, part of the data that I studied was downside data. If you’re a value player or you’re a contrarian, for anybody that’s going to use leverage, you want to know how it looks when it looks really, really bad. So I went back and studied the great depression, ’29 through the ’30s.
Like, if you want to steep yourself, 2020 pandemic was a yawn compared to what they experienced in the great depression. Now, it was much faster, the more recent downturns are pretty steep and much faster, but this was decade-long. It took to 1938 to get back to the high point of 1929. But one of the things I learned about that is the Dow Jones industrial average, which they got pretty good data on back then, and those data goes back that far as well, dropped 86% from the peak to the base, 86%. And to me, I’m a big believer in stocks for the long-term, like just buy them and then hold them forever is a great timeframe. I mean, it is cash, it’s money. If you don’t spend it someday, you got to ask, “What is it for?” Well, maybe it’s for the, I don’t know, next generation.” Or we’ve got interesting things there, but an 80% drop will pretty much wash out anybody that’s using leverage. You’ll get a margin call a long way before that. So I made a decision before starting Bridgeway, never use leverage in a straightforward way. We use some derivatives in one strategy to dampen the market risk of the fund, but we never ever leverage using borrowed money. So that’s one of the things that I learned in the beginning and has not changed.
Meb: It’s obviously essential to be a student of history when it comes to markets. Going through what we’ve been through in the past 20 years, we’ve had 2…about 50 percenters in the U.S. and last year, really fast and back up, a little jiggle, but compared, again, to an 80%-plus, it’s hard for people to fathom just how bad that is. And you’ve had that in some other countries since then outside the U.S., but not as much in the U.S., and that creates such a mass… I mean, if you think of the behavioral issues the last 20 years are problematic when your stocks go down 20% or 50%, 80% is a whole another ball game. I think it’s like a Richter scale for earthquakes. It’s like every 10% gets 10X worse. So down 10 people started complaining, down 20 are getting like clients, closing accounts, or angry at you. This applies to under-performance too.
And then everything after that, it’s just people stop opening an account, yada, yada. There’s a good book on this time called, I think, “The Great Depression,” a diary that walks through…I think it was a lawyer, but he was talking…from an investing angle, listeners, that I think is really thoughtful way to go about it. Because so many people, I think, assume they’ll be able to buy hand-over-fist rationally when things are down 50, 60, 70, 80. But the problem, and this was a conversation I had in some countries over the past 5, 6, 7 years, nobody has any money. It’s like if you were the rare exception that has some money to put work when something is down 80, great, but usually, it cleans house for almost everyone.
John: It happens typically at the worst possible time or at least when you’re worried about that. So take 2008 or 2020. One of the things on your mind is, “Oh, shoot, I could lose my job.” And a lot of people did in both cases, 15% unemployment is steep, but it’s not everybody. I tell people, again, being a believer in stocks for the long-term, you shouldn’t have money in the stock market that you might need in a few-year period. That’s an improper use of a financial instrument. So match your investment horizon to an appropriate security in stocks or for the long term. Also have an emergency fund. So know what you’re going to do. I like to say you need enough money in the bank that if the engineer car falls out on the road, you have the money to replace it and you don’t have to sell stocks at what might be the worst time to do it. And then you need an ultimate plan. You know what my ultimate plan is?
Meb: Go to space with Elon or Jeff, I should say, Bezos?
John: No. It’s move in with mom. Come on. It’s move in with mom. They’re all these 30-somethings and like, “I never move in with my parent. I will never do that.” You know, it’s like, “I’m an adult now.” It’s like, guys, just get a life. Get over it. You move in with them, they move in with you, you can handle it. Life gets more difficult than having to deal with that. Well, my mom is 98 now and she’s amazing. She’s the force in my and other people’s lives. And I’ve been giving speeches saying like, “You should have a backup plan.” And it’s like, if things like stocks don’t exist anymore and nobody will hire me anymore, it’s like I’d have to sell my house and I’ve got a place to move, and then be like, “I’ve never actually asked my mom.” So I called her up on the phone and said, “Mom, people think that you’re moving in with me.” And she’s like, “Well, that’s never going to happen.” “But I’ve never asked you.” And she said, “Yeah. Sure. You can come over here. We’ll have a good time together.” So that’s my backup plan.
Meb: Got your old bedroom. I even got your old high school photos still up.
John: Have an emergency fund and have a backup plan for if the 1930s hits again. And then hopefully it’s not going to hit again. We know more about the economy than we did back in the 1930s. On the other hand, we didn’t have nuclear war risk in the 1930s like we do today. So risk, that’s another thing I’ve learned, is, like, there are different kinds of risks, but thinking about risk is key and important and do identify it, do manage it, but don’t run from it because you’ll be running from some of the wrong things. Some of our biggest opportunities in life, frankly, have risk attached to them.
Meb: Because you’re talking about that, my mom, every time she comes to visit me in Los Angeles, because I don’t own a house and we tend to be transient, she, like, brings a suitcase of my stuff. She’s like, “I’m tired of storing this.” She’s like, “This is a one-way street. You can do with it whatever you want, but I’ve been saving this pottery or this whatever of mine.” She’s like, “It’s long enough.” I love your mom. Having this long-term perspective is so essential. It doesn’t make any easier. You’ve probably dealt with, I don’t know, hundreds of thousands of clients over the past 20-plus years. Do you have any general perspective or comments on just kind of how to think about these different markets and regimes? I think a lot of people looking at where we are now with, whether you talk about sentiment, or evaluations, or specs, or everything, rinse, repeat over every cycle, but thinking about some of the best practices on how to think about sitting through the lean times, and that can mean either drawdown in an asset class but also drawdowns in strategies, of any strategy. It could be commodities, it could be value, it could be U.S. bonds, stocks, whatever.
John: Well, my thoughts overall on asset allocation, I know you have a more sophisticated view on this than I do, Meb, but my overall thing is have an appropriate asset allocation, write it down, implement it, stick with it through thick and thin, and especially when it feels least comfortable to do so. So I’ve got a static target of how much of each of our Bridgeway strategies I invest in, and so what does that mean? What am I investing new money in? And it’s always in whatever’s gone down the most. Having that and the discipline of that, I think, is great. And one thing that I would highlight, you know, are there things out of favor? Yeah. Small size was out of favor. And I just love the articles that come out when something is out of favor. It’s like, oh, the small firm effect is dead or probably was never there. And there are some actually quite good academic papers on this from which you can conclude from a factors-based worldview that other factors can explain away the size effect. So you put the right combination together and size becomes statistically insignificant. And there’s nothing flawed in the research. The research is solid. It’s just that when you step back, you go, so, however, these factors work better, the smaller size you go. So it sounds to me like semantics. You can say factors work better in smaller, less liquid companies, or you can say there’s a small firm effect, and to me, it doesn’t change your action and having a percentage exposure to that as an asset class.
There’s one other thing before we get away from it that I wanted to mention in terms of advice for people, and that wouldn’t be on the specific market niche side, it would be on the more general, and that is the single biggest thing you can do over a lifetime that makes a difference is adjusting your spending relative to your revenues, which means save and invest. It doesn’t matter how good or… Well, if you’re a really poor investor, that’s pretty bad, that you can do damage if you’re…at any rate. You have to have a nest egg to do so. And the power of compounding is huge. I love to preach to teenagers. So get a job, save. And if you start early, it will be so, so much easier. People make the mistake of thinking like, “If I wait another decade, I’ll be making more and it’ll be easier to save.” No, no, no, no, no. That’s wrong. Save 10%, save 20%.
I’ve got a friend who got married in his 20s, and he and his wife agreed that they would save one of their salaries. Brilliant. Brilliant. And it worked. I promise you like it worked. These days, you don’t have to be rich to take part in that. You can get a low-cost index fund and open an account for zero commission and, like, four basis points of cost. I mean, how great is that for the small investor? That’s awesome. But you got to save and invest. And if you run the numbers, saving 10%, 20%, it’s not that hard. People tell me is like, “Well, you don’t understand, John. I got a mortgage, I’ve got kids, and I’ve got this and that.” It’s like, it’s not that hard. All you have to do is find somebody that makes 20% less than you do, their income’s 20% less, and study the heck out of their lifestyle. That’s the lifestyle you need. I’ll get off my soapbox now. I love to have younger folks in them. And it works reasonably later in life too, but the power of compounding is a big deal.
Meb: You’ve nailed it. I mean, you and I could probably spend hours and hours just discussing the intricacies of factor models and, like, the most in-depth academic papers. And in reality, all of this is trumped by when you decide to start investing, how much you save, and that’s it. The best day is yesterday, but the second best day is today. It’s such simple advice that it’s more important than everything else combined, in my opinion. And so…
John: I’m with you, Meb. I agree.
Meb: I’m only going to add one caveat to what you said, which is after you have that plan and write it down, you got to share it with someone so they keep you honest. It’s like a diet. If you’re like, “I’m cutting out pizza,” but you don’t tell anyone… If you tell your significant other and they see you sneaking a slice of DiGiorno, then they can slap your hand or something. So that’s mine. I say you got to share it with someone. Or even better is put it on some sort of automation too, all the behavioral nudges that…they’re just words in the background, I think, is such a wonderful approach. That 20% you’re talking about, it’s a lot easier when you don’t even see it. It gets skimmed off the top and tossed in a savings account, and that’s that. Altogether, good advice. Too sensible. I’d like to talk a little bit about, you guys, going back to the earlier part of the conversation, have survived. Not only survived, but thrived, built a great organization that’s lasted through the various markets. And there’s a statistic that over 10 years, roughly half of all public funds close. So to at least continue to be around is a huge compliment, but you’ve also built this organization in your image, which is different than most, and we’d love to hear a little bit about kind of that philosophy and progression over the years because it actually, I think, it has a big impact on the funds and probably the clients you end up with too.
John: Well, first, I hope it’s not in my image. It’s not Montgomery Asset Management. I love one of the people that I work with. We call everyone with a long-term commitment here, partners. And one of my partners gave me a lesson on, “John, our job is to be here and set a foundation. The next generation’s going to stand on our shoulders and do much bigger things.” I think that’s a wonderful image for the future, but the staying power, our president, Tammira Philippe, likes to talk about Bridgeway as an enduring firm. And we actually have a plan to be around in 50 and 100 years. So I was in a room full of entrepreneurs one time and they said, “Who here expects your company to still be in business in any recognizable form in 20 years?” Out of 17 people, I was the only hand that went up in the room, the only one. People ask, like, “What’s your exit strategy? Like are you going public? Are you going to be bought out by private equities? Some big competitors are going to swallow you up?” And if you don’t make plans, that’s the natural tendency.
So we did two things at Bridgeway for that. One is we set up a structure inside of which the ownership of the firm moves into what’s called a special purpose trust that can hold those shares in perpetuity. And that creates a lot of stability in ownership. You don’t have to worry like what happens if John dies? So it was like, frankly, not that much as far as the team behind me is deep and broad, the ownership structure. The second thing that gets people is inheritance taxes. So either founders want to cash out to go retire, and I’ve saved up my money just like anybody else at Bridgeway in a 401k and maxed out my IRAs every year and saved aggressively and invested stocks for the long-term with our own strategies. So done all that.
So that’s my retirement money. My retirement money is outside. I don’t need to tap the firm to do that. And we’ve got a structure now where Uncle Sam, it perpetuates from generation to generation. We’ve got what we call a partner stock ownership plan that helps feed that. There are a number of ways where we don’t have to sell the firm to raise money for taxes in an estate situation and where I don’t… I told my children and I told our fellow partners, I’ll never use my ownership in the firm for spending personal things. Now, giving is a different story, which maybe we’ll come to, but the pattern from the beginning was that we’re a long-term, really long-term multi-generational player. So it’s not about me, it’s about… Think about if you knew you were going to be around, Meb, in 50 years, not you personally, but your firm, what would you be doing differently today so that those people have the advantage of how you’ve invested in them today?
I know very few people who think about that. And it’s so powerful. I mean, just like if you think… We’re still a relatively… We have 5 billion under management. That sounds like a pretty big number to me, but we’re still a very small fish in the big pie. But a generation and two from now, I think we’re going to be a bigger force to deal with. And it’s not just about the money, it’s not just about what we do. It’s also the power of being a generous giving company. So I like being an enduring firm. I like the generosity aspect of what we do, I like that we made a commitment when we founded Bridgeway 28 years ago, that we give half of our profits away and we save and invest the other half for what we call our rainy day fund. So in a downturn, rather than laying everybody off or closing up shop, like sadly some of our closest competitors had to do last year, that’s when we selectively hire because that’s when great people are available, and then when you come out the other side, like you got to be strong, you got to continue to grow and expand. So that’s the formula that we’ve been working on for a generation now, 28 years, and got more to go.
Meb: I wouldn’t sell yourself short. You got the jeans to last the triple digits in modern medicine. You may be like Ted Williams style head in a tube somewhere, living to 300, 400 years from now. So we may be doing this by hologram in 2220. You mentioned this concept of giving, and I’d like to hear you talk a little bit about it because it’s certainly not universal. It’s not even necessarily traditional. Talk to us a little bit about y’all’s philosophy and how you go about it.
John: There are a number of giving philosophies now and companies that are doing some great things here. So Bridgeway is certainly not the only one. At the time that I started Bridgeway 28 years ago, I didn’t have a single model of doing this. I just had a thought that, A, your revenues don’t have to drive your expenses and we had a certain standard of living. My wife and I were already there. We didn’t need more stuff. And I actually was worried about that with respect to raising small kids, which we had three of at the time. And we thought, “Well, if Bridgeway is successful as I’ve been personally investing over the prior six years with the low-cost strategy, it should be a cash cow. And what would you do with that money?” And so that’s where it was born, the idea of, well, let’s give half of it away and it’ll be a lot more fun to do that along the way than like back then, mostly people just did at the end of life. And, by the way, there’s nothing wrong with that either. But I just thought it’d be more fun. And then I had the thought, and this was…when I founded Bridgeway, I thought I had a dozen good ideas. Meb, I would say maybe three of them were marketable. Not nine of them. I still think one or two other ones that were a good idea, but not marketable.
Meb: I’ve got way more unmarketable ideas. You should see our prospectuses of unlaunched funds. It’s like a free graveyard of ideas that no one will ever like.
John: The one idea that was 10 times more powerful than I had any idea was this generous giving, giving half back. And we folded it into the culture of the firm, we use it to attract like-minded people. If you’re in investments, you can make a lot of money. That can attract greedy people, so we have a stewardship pay plan where we try and get off of the more is better forever, and talk more about quality of life and what we’re here for, purpose. But the generosity side, it’s easier to attract people. It’s amazing what you can do in the world as in our case, a pretty small firm. So we have an affiliated Bridgeway foundation. If you want to get a view into that part, which has to do with advancing peace, reconciliation, and ending genocide, we have other things that we support each other in terms of partners’ interests at the firm, but that’s mine and a significant one of the foundation. If you want to get a view into that, Shannon Davis, who’s the head of our foundation, wrote a book, came out a year and a half or so ago, and it’s called “To Stop a Warlord.” So it has to do with peacemaking efforts in Sub-Sahara Africa, which is our focus area. And I have to say, I thought it would take a lot longer to get to the point that we are in making a significant difference for peace somewhere in the world. And the people that we work with are some of my biggest heroes. It’s just unbelievable.
Meb: I’m sure the listeners are, like, if you were to ask most people that, like, “What’s your number one?” They’re, like, “World peace.” But like stopping genocide is a pretty ambitious goal up there too. With that, give us like the kind of back flap of the book. I’ll definitely pick up a copy, but how does one even go about thinking about that?
John: I didn’t think it was going to be possible to ever write a book because we work with people on the ground whose identity would put them at risk. They’re true heroes. I’ll just mention, there was a, in the last couple of months, a true hero that we worked with anew, who was a Muslim preaching peace and good things, and he got assassinated. He got taken out. So sad. And like he was willing to stand up to say the right thing and it put a target on his back and somebody took him out. So, like, it can happen, but it just reminds you of the seriousness of that. So I thought we were never going to be able to write a book. Shannon figured out a way to do it, and it’s Shannon and her role in the foundation. It’s Shannon as a mother and it’s David Ocitti who was a child soldier in the conflict that we were working on at the time, and it’s the subject of this book. And he escaped after six months in the bush as a child soldier. And there’s nothing more horrific than what happens to kids as soldiers. But now he helps other people who have escaped re-enter society again, which is a really big deal. So it’s that story, and it focuses on the people we work with and some of the heroes that are there in the area that we’re working on.
I’ll tell you one very brief story. Sometimes people are like…there’s the bumper sticker that says world peace. “Oh, yeah. Right, peace. Great, dude. Good luck.” How do you actually accomplish anything? So in this book and in this period with the LRA, they did a bunch of work with governments, other civil society people, some just individual heroes, people making the right choices for the right reasons and you think, “Gosh, we need more people like that in the world.” One of the things that they did was trying to get these child soldiers, and then some of them were like 25 years old. They were out there long enough to defect and to re-integrate back in their home. They’ve all been told they can never come back home. So it meant taking an aeroplane, flying over places where these soldiers are, dropping leaflets saying, “If you meet us at these safe zones, we’ll get you out, and there’s an amnesty program back in your home country.” Well, that’s cool. And people have been using planes to drop leaflets forever. As long as there’ve been planes, they’ve been used in wartime in good, and unfortunately, mostly for destructive reasons. But we were doing it trying to get people out to reduce the number of combatants and bring peace.
So one of our partners we were working with came up with the idea, it was like… We actually got a few out, the very first ones that come out, you go like, “That’s awesome. It works.” And then, “Who among your fellow soldiers is susceptible to being called out?” And you get names, and you get villages where, like, they grew up. You go to the villages and you interview, say, their mom, and their mom’s voice, you recorded on tape, calling them back home, saying, there’s a place for them back home. Then you go out in a flight and you play this recording over a loudspeaker, “Hey, Joe Smith…” Well, obviously not Joe Smith, but the person’s actual name with the voice of the mother. It turns out that the voice of the mother is incredibly powerful to call soldiers back home. And I think that’s brilliant. It was effective and we didn’t fire a single bullet to do it.
Meb: Man, that’s powerful. That’s tough to hear. Mom’s voice definitely brings peace to the world, bring anybody home.
Meb: John, this has been a whirlwind. Let’s do a few quick questions to kind of start to wind down. First, what do you think that you believe that the vast majority of your contemporary financial professionals don’t? So meaning like it’s somewhat of a contrarian view, but it’s something that you believe pretty strongly at your core. Anything come to mind? There’s probably a lot.
John: From March of last year as the peak point that the small firm effect is dead, we liked to look at very long periods of time. And so I don’t think that we’ve got ways of measuring how far out of favor something is. It’s always good to keep in mind, no matter how cheap something is, it can always get cheaper. There’s always one more standard deviation of how far out of favor it can get. So lessons in that, one, humility, and two, staying in for the long haul. We got the equivalent of a decade of returns all in one year in the last year, but that’s not going to be repeated next year. You kind of average that over the whole period of time and suffering through that part. So I would say that the small firm effect is dead with the caveat of what I mentioned previously. So that was getting to be a minority view.
Another one is that stocks are risky and bonds and money markets are safe. And to me, the answer to that is it’s a little complicated, but the answer is it depends. So if you need money two years from now, stocks are risky and money markets are safe. That would be a true… However, if you’ve got a 10-year timeframe, it’s much messier because we all spend after-inflation dollars. And if you inflation-adjust, if you go back over the last 100 years and look at T-bills, which are supposed to be the risk-free rate, that’s in finance, they call it the risk-free rate, which I always smile at because they’re not even AAA-rated any more by one agency, at least. But apart from that, let’s say the U.S. is always going to be here and they really are safe, inflation can decimate the purchase power of T-bills. Note, the 1940s in the U.S., the purchase power of a dollar invested in T-bills with interest reinvested through the entire decade of the 1940s, so 1940 to 1950, declined 41%. Now, the stock market goes down 41% and you think, “Oh, my gosh, a bear market, this is huge. This is so awful and it’s so painful. And what happened? Where did my money go?”
With T-bills, which are the risk-free rate, you still got it adjusted for inflation, and on that basis, stocks are safer than T-bills because what happens in inflation? If inflation kicks in, businesses raise their prices and recalibrate, but fixed income is, by definition, fixed. You’re just stuck with less. And I know people in Houston that had laddered CDs as a way to retire because they were in banking. And in ’79, ’80, they got decimated by inflation. Well, it’s been a long time, but we haven’t seen probably, in my lifetime, and for sure, in yours, Meb, the last bout of inflation in the U.S., and people are just completely asleep on that. Some people are talking about it, but nobody’s doing squat about it.
Meb: You mentioned a couple of things. I mean, we do a lot of Twitter polls and we did a Twitter poll, basically, touching on what you talked about, which was, says, like, when you invest in safe T-bills, what do you think your biggest loss was after inflation? And everyone said 0 to 10 or 0 to 5. And almost no one said the reality, which was cut in half at one point. It tends to be more of a slow bleed unless it’s like a ’70s gusher, but this concept of time horizon, certainly, I think, is really important on the volatility and holding periods and all that good stuff. What do you think has been your most memorable investment? Anything come to mind? Of all the thousands of probably tens of thousands of stocks you guys have owned over the years, any stick out as being particularly memorable, good, bad, in between? It doesn’t have to be stocks, sorry, just investment. Sorry.
John: The disposition effect says the painful ones stick in your memory more but I’m contrarian, so the reverse is true. We owned a value stock. Like we bought it because it was a value stock. And this was like a year, year and a half ago. I don’t remember the exact date, but it was cheap. That’s why we bought it. And in January of this year, it went zonkers. And we have a whole process, a very disciplined process about what we do when something gets to be too big a piece of the pie. And I’ll have to say the top four times I can remember a stock that’s gone zonkers, a risk management around the discipline of that has paid off every single time. It’s shocking, the percentage of time that it’s paid off. It shouldn’t even be that much. Christine, on our team, went back. She had the ideas like, “I wonder where this compares to other individual stocks in an individual month.” So she went back through the CRSP database, which was coming up on 100 years of. And do you know this stock ranked number three of single-month returns through the entire history?
Meb: What was the other two, I wonder? That’s great. The same stock the next month?
John: I can’t tell you, but none of them were real recent. Some of them went back quite a number of years. And there was one other stock. I’m going to tell the story on the earlier one and then I’ll just give you the name on the second one. The other time in my career, I remember one that went zonkers just like that was an ultra-small stock. It was a State of Maine fish oil company. They actually fish, they get fish, they make in fish oil, sell the fish oil. That’s what the company did. This was in 1998, ’99. Well, in 1999, when the internet’s going zonkers, this company has all this cash around on their balance sheet. They don’t know what to do with it. Couldn’t return it to shareholders, but they announced that they were going to be buying up internet companies. That’s what they did. They didn’t actually buy any. They just said they were going to buy some.
The stock price started from like 7 and peaked out at about 23. And we sold most of ours in the top…in the high teens. And I did it… This was back when I was trading myself. I did it the day after Thanksgiving in 1999 in the middle of this. And I’ll never forget. I was like, “I’m selling to somebody and maybe it’ll go to 50 before it stops.” But we bought a value company. It’s no longer a value company. The reason we bought it is no longer true. And there’s all this poop law around it. That’s a time to manage your risk to diversify, and that’s what we did. So that’s the story. The more recent name was GameStop.
Meb: There are so many interesting lessons on this. The biggest one, which goes back to what we were talking about earlier, is everyone…and I think it’s important, has a process to talk about what happens when things go wrong. But you also have to have a process to think about when things go right, the right tail on how do you approach it, or how do you position size? How do you think about selling without losing your mind? And do you have a disciplined set of criteria? Now, the joke’s going to be on both of us when it goes to 1,000 next month. And we were the pikers that don’t own it anymore, but that’s fascinating to hear.
John: That’s true, that it won’t be small and it won’t be value, so it doesn’t have a place in our small value fund, which is where we had it back then.
Meb: I like watching on the sidelines. I rarely get emotional about investments, but it was astonishing to watch, that’s for certain. John, this has been so much fun. I could ask you about stocks and business ideas all day long, and we may have to have you back on to keep the conversation going. Where do people go? If they want to check out what y’all are up to, read your insights, follow along with the crew, what’s the best place?
John: Bridgeway.com is a good place to go.
Meb: Beauty. Thanks so much for joining us today.
John: Great. Thanks, Meb. Really enjoyed talking with you.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at email@example.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.