Summary of "E115: Is the 60/40 Portfolio Outdated? w/James Langer" on The 10X Capital Podcast

Release Date: November 26, 2024

In Episode 115 of The 10X Capital Podcast, host David Weisburd engages in a comprehensive discussion with James Langer, a seasoned investment professional with extensive experience in small cap value investing. The conversation delves into the historical performance of small cap value versus large cap growth stocks, the challenges of implementing effective investment strategies at scale, and practical advice for institutional and individual investors navigating today's dynamic market environment.

1. Historical Performance of Small Cap Value vs. Large Cap Growth

James Langer opens the discussion by highlighting the remarkable long-term performance of small cap value stocks compared to large cap growth stocks.

• Key Statistics:

  • Since 1926, a $1 investment in small cap value stocks would have grown to $491,000, annualizing a 14.3% return.
  • The same investment in large cap growth stocks would have yielded only $13,900, with a 10.2% annual return.
  • This represents a 400 basis point spread favoring small cap value over large cap growth.

• Notable Quote:

  • James Langer [00:00]:

    "If you're a multi billion dollar family, office or institution, typically you'll just have James."

• Additional Insights:

  • In declining interest rate environments, small cap value has historically delivered nearly 20% annual returns, surpassing the overall equity market's 15.5%.

2. Foundations of the Fama-French Three-Factor Model

Langer discusses his collaboration with Nobel laureate Eugene Fama at the University of Chicago, contributing to the development of the Fama-French three-factor model.

• Role and Contributions:

  • Assembling comprehensive databases on publicly traded stocks.
  • Manual entry of stock prices, income statements, and balance sheets to support the model.

• Impact of the Model:

  • Enhanced the Markowitz model by adding size and price-to-book ratio factors, explaining 90% of stock price variation compared to the Markowitz model's 70%.

• Notable Quote:

  • James Langer [01:09]:

    "Since Harry Markowitz published his CAPM study in 1959, there really hadn't been any updates to that work to describe what exactly moves prices."

3. Reasons for the Underutilization of Small Cap Value Strategies

Despite its proven performance, small cap value investing remains underrepresented in institutional portfolios.

• Challenges Highlighted:

  • Scale Limitations: Large institutional investors find it difficult to deploy substantial capital without impacting stock prices.
  • Diversification Needs: Managing meaningful positions typically requires diversifying across numerous stocks to avoid cumbersome concentration.

• Notable Quote:

  • James Langer [05:18]:

    "The reason why everybody's not doing it is primarily due to scale."

• Practical Implementation:

  • Langer’s experience at Advisory Research illustrates capping funds (e.g., $1 billion spread across 40 stocks) to maintain meaningful investments without affecting market prices adversely.

4. Intuition Behind Small Cap Value Outperformance

Langer provides a multifaceted explanation for why small cap value stocks outperform their large cap growth counterparts.

• Factors Contributing to Outperformance:

  1. Higher Risk Premium: Small cap stocks exhibit greater volatility, necessitating higher expected returns.
  2. Limited Analyst Coverage: Reduced scrutiny leads to pricing inefficiencies and opportunities for mispricing.
  3. Mean Reversion: Underappreciated fundamentals tend to revert to the mean, boosting value stock performance.
  4. Economic Expansion Alignment: Smaller companies perform better during economic expansions, which occur more frequently over long horizons.

• Notable Quote:

  • James Langer [06:35]:

    "Idiomatically, small cap stocks have been slightly more volatile or had a higher standard deviation of return patterns than large cap stocks."

5. Translating Theory into Practical Investment Strategies

When advising clients, Langer emphasizes a balanced, diversified approach rather than a wholesale shift from large cap growth to small cap value.

• Strategic Allocation:

  • Public Markets:
    • 40% in actively managed small cap stocks.
    • 40% in mid and large cap stocks.
    • 20% in non-US stocks, encompassing both developed and emerging markets.

• Notable Quote:

  • James Langer [08:47]:

    "We certainly advocate having exposure across the capitalization spectrum."

• Rationale Behind Allocation:

  • Diversification across different market capitalizations and geographies mitigates risk and capitalizes on varied growth opportunities.

6. Active vs. Passive Management in Large Cap Stocks

Langer critiques traditional market capitalization-weighted indexes like the S&P 500, advocating for more thoughtful weighting strategies.

• Critique of Market Cap Weighting:

  • Creates excessive concentration in a few large companies (e.g., 10 stocks representing 35% of the S&P 500).
  • Leads to potential governmental interventions, such as antitrust actions.

• Alternative Approaches:

  • Equally Weighted Indexes (e.g., RSP): Historically provided 2% more annual excess returns by avoiding overconcentration in mega-cap stocks.
  • Quality Weighting or Other Factor-Based Weighting: Aligns investments with proven alpha drivers without arbitrary size-based biases.

• Notable Quote:

  • James Langer [10:32]:

    "It really comes from the fact that small stocks, as we've talked about, do better than large stocks."

7. Redmont Wealth Advisors: Strategy and Implementation

Langer elaborates on the investment strategies employed at Redmont Wealth Advisors, emphasizing institutional-quality frameworks for individual investors.

• Firm’s Strategy:

  • Provide access to institutional-level investments tailored for individual needs.
  • Focus on minimizing fees, optimizing asset allocation, and leveraging unique investment opportunities.

• Notable Quote:

  • James Langer [14:27]:

    "The firm's strategy is to provide individual investors with an institutional framework for investing in."

• Asset Allocation Recommendations:

  • Public Side:
    • 40% in actively managed small cap stocks.
    • 40% in mid and large cap stocks.
    • 20% in non-US stocks (developed and emerging markets).

8. Active Investment Approach and Alpha Generation

Langer defends the efficacy of active management, countering criticisms that fees erode potential benefits.

• Alpha Generation:

  • Historically achieved 3-4% alpha by not only focusing on small cap stocks but also optimizing large cap exposures.
  • Utilizes proprietary tools for detailed portfolio analysis, ensuring strategic allocations that enhance returns without excessive fees.

• Notable Quote:

  • James Langer [13:52]:

    "Historically, you know, we've been able to add 3 or 4% in terms of alpha to a client's portfolio."

9. Active Participation vs. Traditional Activism

While adopting an active investment stance, Langer distinguishes his approach from traditional activist investing.

• Proactive Engagement:

  • Collaborate with management teams to unlock value through strategic initiatives like stock buybacks or divestitures.

• Contrast with Traditional Activism:

  • Avoids confrontational tactics and litigation associated with activist investors like Bill Ackman.

• Notable Quote:

  • James Langer [23:03]:

    "An activist strategy in the market today is something that we've looked at... we want to communicate with management in terms of the strategy that they should be looking at."

10. Tools and Resources for Portfolio Analysis

Redmont Wealth Advisors utilizes proprietary tools to conduct in-depth portfolio analyses, providing clients with actionable insights.

• Proprietary Tools:

  • Analyze allocations by sector, market cap, growth vs. value biases, and fee structures.
  • Facilitate informed investment decisions based on comprehensive data and strategic overlays.

• Notable Quote:

  • James Langer [28:03]:

    "We actually have a proprietary tool that, that we have built out that we load tickers up, load number of shares in and it will spit out an analysis."

11. Tribute to Ken French

In a heartfelt moment, Weisburd dedicates the episode to Ken French, a pivotal figure in his academic and professional development, acknowledging French's significant contributions to investment theory alongside Eugene Fama.

• Notable Quote:

  • David Weisburd [28:45]:

    "I also wanted to dedicate this episode to Ken French, who is my business school professor and was very formative in the way that I look at the public markets."

• Langer’s Acknowledgment:

  • James Langer [29:12]:

    "Gene Fama would certainly agree that there should have been a shared prize to honor the work that he did as well."

12. Final Thoughts and Contact Information

As the episode concludes, Langer emphasizes the importance of mindful fee structures, strategic asset allocation, and access to unique investment opportunities. He invites listeners to engage with Redmont Wealth Advisors for personalized portfolio analyses.

• Contact Information:

  • James Langer's Email: J.Langer@redmontwealth.com

• Notable Quote:

  • James Langer [26:20]:

    "Being mindful of fees is one thing that's exceptionally important... that's why we founded the firm in order to achieve all of those different things as an independent firm."

Conclusion

This episode of The 10X Capital Podcast presents a compelling argument for the enduring relevance of small cap value investing, supported by historical data and strategic insights. James Langer effectively communicates the nuances of implementing such strategies within the constraints of large institutional portfolios while advocating for thoughtful, diversified asset allocation. The discussion underscores the importance of active management, strategic diversification, and the utilization of proprietary analytical tools to generate alpha and navigate complex market dynamics.

For more insights and episodes, visit The 10X Capital Podcast.