← How I Invest with David Weisburd
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- [00:00]
A
Going back to 1926, where the database starts, just invested purely on a quantitative basis without any qualitative overlay. In small stocks with low price to book values today you would have $491,000 and that annualizes out to a 14.3% return. If you compare that to large cap growth, the exact same analysis, investing in large companies with high price to book values or growth stocks, you'd have $13,900 and about a 10.2% return. So you have over a 400 basis point spread between small cap value and large cap growth going back to 1926.
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B
Why is this strategy not more widely accepted or implemented in investment management?
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A
If you're a multi billion dollar family, office or institution, typically you'll just have James.
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B
Welcome to the 10X Capital podcast.
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A
David, thank you so much for having me here. I'm so excited for today.
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B
So you worked with Nobel laureate Eugene Fama at the University of Chicago. Tell me about that.
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A
He was a really tough guy to work for, very demanding. Essentially what I did for him is I helped him assemble a database of information on publicly traded stocks. So I would go into the depths of the Regenstein library and grab the Moody's manuals and Weisenberg manuals and manually enter stock prices, income statements, balance sheets into a database that was used to produce his three factor model that was published in 1992. Since Harry Markowitz published his CAP M study in 1959, there really hadn't been any updates to that work to describe what exactly moves prices. And the Markowitz model explained about 70% of stock price variation. And the Fama French three factor model described 90% of it. So using two different factors, the work that I did still carries forward to everything that I do today, 30 plus years later.
- [02:11]
B
Overly simplistic to say that Eugene Fama and Ken French developed a market to better explain the efficient market hypothesis.
- [02:19]
A
Essentially the Markowitz model, the kappam model, there was really two factors, one being beta and the other one being alpha, to describe, you know, the difference between the variation and stock price returns. So what Fama and French did is they added size, what the market capitalization is of a company, a publicly traded company at that point in time, and what the price to book ratio is for that business. What the data found, which had never been looked at this closely before, is that the smaller a stock is, the better it tends to perform. And the more book value a company has relative to its market capitalization, the better it performs. So combining those two factors, small stocks that are value oriented historically have provided excess returns to investors.
- [03:15]
B
Eugene Fama is an academic, Ken French is an academic. Is this a purely academic insight? How much of a difference does this actually make in returns?
- [03:23]
A
It's truly incredible. $1 going back to 1926, where the database starts, just invested purely on a quantitative basis without any qualitative overlay. In small stocks with low price to book values, today you would have $491,000 and that annualizes out to a 14.3% return. If you compare that to large cap growth, the exact same analysis, investing in large companies with high price to book values or growth stocks, you'd have $13,900. So at about a 10.2% return, so you have over a 400 basis point spread between small cap value and large cap growth going back to 1926. If you fast forward to where we are today, when you look at a declining interest rate environment, historically, small cap value has produced almost a 20% return annually when interest rates fall for six months. And that compares to the overall equity markets at about 15.5%. So you're getting once again over 400 basis points of alpha in a declining interest rate environment. So as we sit here today, it's a very good time to be looking at small cap value as an asset class.
- [04:49]
B
So going back to 1926, which is where this data was almost 100 years, you have a 400 basis outperformance for small cap value versus large cap growth. On top of that, you also have this 20% return going back to 1976 in terms of in a declining interest rate environment, small cap value doing 200%. So double the returns. Why is this strategy not more widely accepted or implemented in investment management?
- [05:19]
A
The reason why everybody's not doing it is primarily due to scale. It's very difficult for a large institutional investor with billions and billions of dollars to deploy the amount of capital necessary to take a meaningful position in the asset class. So if you're a multi billion dollar family, office or institution, typically you'll just have a couple percent allocated in the public markets into small cap stocks. And the best way to achieve that allocation typically would be through an index fund that's diversified over hundreds of companies. If you took a more concentrated position, you would end up owning very large positions in these individual companies. 2, 3, 4%. Which makes it difficult to get in and out of the position as you see fit. You know, for example, the fund that I ran at Advisory Research, we capped it at $1 billion and had that money spread across 40 stocks because that was enough money for us to have a meaningful position in individual companies, but not get to the level that we were extraordinarily affecting what the stock price did relative to our allocation.
- [06:28]
B
Talk to me about the intuition behind why small cap value investments outperform large growth investments.
- [06:35]
A
There's several reasons that would explain that dynamic. The first one is the higher risk premium associated with small cap stocks. So historically small cap stocks have been slightly more volatile or had a standard, higher standard deviation of return pattern than large cap stocks. So in order to be fairly compensated for that, you need a higher expected return. So the risk premium would kind of be the first reason. The second reason was would be that there's very, very little analyst coverage, if any, on these stocks. And what that does is it creates inefficiencies in terms of information knowledge as well as earnings expectations and how a company is performing relative to those. So you can really find stocks that are mispriced because they're overlooked and they're under followed by other institutional investors as well as the Street. The third reason would be that typically what happens with any publicly traded company if you have underappreciated fundamentals relative to where averages should be, there's a mean reversion that takes place. So by definition, a value stock will have fundamentals that don't match where the market is at. And typically what happens is you have that reversion back to the mean and you have a higher return in the stock price. The last thing that I would mention that I think is a driver for this phenomenon is that you're operating off of a lower base. And typically in periods of economic expansion, smaller stocks tend to do better than larger stocks. And if you go back over the last hundred years, we've been in economic expansion periods many, many more times than we've been in depressed economic periods or recessionary periods. So I think once again, if you take a long term horizon on that, all of these phenomenon combined explain why small cap value tends to outperform.
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B
So when you're talking to clients or for institutional invest listening to this podcast, they should essentially sell their large growth and invest in small cap value. How do you take the theoretical strategy and turn it into practical advice?
- [08:48]
A
Sure. So you know, we certainly advocate having exposure across the capitalization spectrum. We take a very academic and mathematical and thoughtful approach to those allocations. On the larger cap side, for example, we don't think that having the S&P 500 as a market capitalization weighted index makes a tremendous amount of sense. It Actually is counterintuitive because what that implies is that the larger a company is, the better it will perform relative to other companies. So if that continues, if that phenomenon continues in the future, those large companies will keep getting larger within the index and then the concentration will be untenable. A great example would be at the beginning of this year. You had 10 stocks that represented about 35% of the S P 500. That concentration was unfathomable. And then what happens eventually is the government steps in and says, you're too large, you have too much power, we're going to break you up. And that just happened to Google two days ago. The government came out and said, we are going to challenge your status as a non monopoly and advocate some sort of breaking up of your company. So having an equally weighted approach, taking all 500 stocks that are in the S&P 500, investing the same dollar amount in those companies historically gives you 2% more annually in excess return just simply by investing in the same stocks in a different proportion.
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B
Which sounds intuitively like the wrong strategy. It sounds like you're using a blunt instrument. Where does the 2% come from? Is that the fact that you're not selecting for monopolistic companies? And talk to me about that 2%.
- [10:33]
A
It really comes from the fact that small stocks, as we've talked about, do better than large stocks. So you have the stocks that are smaller weighted in the index that are outperforming over long periods of time the larger stocks in the index.
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B
Why not take that to more extreme and do a total equally weighted stock index? Why actually invest in the top 500 biggest companies?
- [10:55]
A
That's a good idea in theory, a very difficult idea to implement in reality. So if you take the universe of, if you just take the Russell 2000 for example, you're investing in 2000 stocks. Some of them trade by appointment only. So even investing on an equally weighted fashion in those less liquid stocks becomes very difficult. There have been some people that have used kind of a sampling approach in order to get close to an equally weighted Russell 2000, but still it hasn't been widely accepted. You know, really the best way to approach it once again, because there are so many inefficiently priced stocks within the small cap universes to roll up your sleeves, to do the work that nobody else is doing on the financial statements, to drill down with management teams to find out exactly what their strategy is to unlock value and establish positions in those. So having an active strategy within the small cap universe really, really works over time. If you do your homework and that's.
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B
What you did, advisory research, investment management for that's exactly 24 years. So walk me through that. Talk to me about that strategy.
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A
Yeah. So I had an absolutely fantastic experience at advisory research, started there in my early 20s as a research analyst. Once again, I had small cap value running through my veins. And the firm was dedicated to a small cap value strategy at the time. We had individual investors, some of them might have had 10 stocks in the port their portfolio, some of them might have had 25 stocks. So we institutionalized the product. In other words, we kind of got all portfolios to be homogeneous. And at that point we were able to create a track record and start to build alpha, put it in the institutional databases. And we are very fortunate that we did our homework extraordinarily well and created a tremendous amount of alpha and grew the small cap product from $100 million or so once again up to over a little bit, over a billion dollars over about a six year period. After that, the natural progression is to go up in market capital a little bit. So we created a SMID cap value product from scratch and got that up to about $5 billion. So as one of the portfolio managers making decisions on which stocks to buy, how we're positioned from a sector allocation standpoint, and talking to management teams on.
- [13:31]
B
A daily basis, and you continue to do this strategy at Rembon, to play devil's advocate, your active management of portfolios does not, not really take away the, you know, 200 basis points of performance. That's kind of always been the criticism of active management is yes, maybe there's a little bit alpha, but isn't that. Aren't you losing that in fees?
- [13:52]
A
No. Historically, you know, we've been able to add 3 or 4% in terms of alpha to a client's portfolio, not only in the small cap side, but also in the way that we position in a more thoughtful way, the way large cap stocks are weighted and positioned. We also charge an extraordinarily reasonable fee. So, you know, net of fees are. We've been very, very lucky in our alpha generation capabilities.
- [14:24]
B
So tell me more about Redmont, your CEO. Tell me about the firm's strategy.
- [14:28]
A
So really the firm's strategy is to provide individual investors with an institutional framework for investing in. So when we build portfolios, we want to take an individual and provide them access to institutional level and quality of investment. So if we talk about the publicly traded markets typically, and obviously from this podcast, investors tend to be very underweighted in the small cap space and they're not utilizing active management to a high enough degree. So we want to make sure that we have a target allocation that's very appropriate for each one of our investors.
- [15:07]
B
Tell me what you think the ideal profile should be for a liquid institutional public book.
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A
Assuming that you have unlimited time horizon associated with your investment portfolio. You know, I would say probably 40% of your portfolio on the on the public side in small cap stocks that are actively managed, 40% in mid and large cap stocks and then 40% in non US stocks, both in developed markets as well as emerging markets.
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B
And you mean 20%?
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A
20%. Yes, 20% in non US stocks, both in the developed markets as well as the emerging markets. So that's on the public side. Seems to be the appropriate way that I would think about structuring asset allocation for once again, wealth or an endowment that has has no time horizon associated with it.
- [16:02]
B
Value tilt on the large cap.
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A
On the large cap side, not necessarily. I think you get most of your alpha from small cap stocks. So we're trying to get beta on the large cap stocks, but once again using an academic approach. So when we look at most portfolios that come into us and we do portfolio analysis on a complementary basis for prospective clients, almost every single one is overweighted to large cap growth. And certainly that has worked for the last year and a half. In 2022 it didn't work at all. You know, people have short memories. I think a lot of people forgot the NASDAQ was down around 40% during that period. You know, the entire market was down. Our small cap strategy was out about 5%. So we looked like we were super smart. In 2022, roll into 2023, it's why don't you own Nvidia? Why don't you own Microsoft? Why don't you own Tesla? And the reason is we do own those stocks, but we're not weighting them in an aggressive manner because we don't understand those businesses and we don't have a crystal ball that gives us a clear vision into what those companies are going to look like 10 years from now.
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B
Why put 20% of your liquid portfolio in developed and emerging markets?
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A
The rationale is it provides you with diversification. So there are a lot of economies, emerging economies, that are going to do extraordinary things from at a company level perspective. And having an allocation to those businesses just makes a lot of sense. There certainly are times that when the pistons are firing overseas and they're not necessarily firing over here. So having that diversification worldwide and globally just makes sense to us.
- [17:53]
B
In the 40% in small stocks, you believe in active management. On the 60% of large stocks and developed and emerging markets, do you believe in indexing? Do you believe in active management?
- [18:06]
A
Once again, we believe in indexing and large cap stocks within the US equity market in a thoughtful manner. So not using market capitalization, weighting, using quality weighting, or equally weighting or some other more sensible way of weighting the stocks. Once again, market capitalization way of weighting stocks is completely arbitrary. If you talk to any active manager, probably in the United States, and ask them, do you weight your portfolios, actively manage based on market capitalization, the answer will be no. So the largest index that is investable in the United States has that structure. So there is this, this large disconnect.
- [18:50]
B
And that's almost a marketing thing. It's, it sounds intuitive, but it's not actually fundamentally sound.
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A
That's true, that's true. I mean, I don't think there would be a big difference between saying an index should be alphabetically weighted. You know, it's an arbitrary method, once again, of waiting the momentum trade.
- [19:08]
B
It's saying that the faster companies grow, the more you should wait to them.
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A
Exactly. And that momentum once again mathematically cannot continue or else you'll have a situation another way.
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B
Since 1926, value has actually outperformed growth, which is a momentum trade of sorts.
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A
Right, right. And a very interesting exercise that I didn't do for this podcast, but it's very googleable, is looking at the top 10 stocks in the S&P 500 kind of by decade and it changes dramatically by decade. There are very, very few companies that stay in the top 10 market capitalization of stocks for 10 years in a row. I can remember when, when Exxon, you know, was the largest capitalization company for, you know, 15 years in the United States and Apple was a mid cap.
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B
Stock, which is pretty obvious if you zoom out. But everybody, to your point, have such a short memory that they're only focused on the last six months in terms of market cap.
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A
Exactly.
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B
So going back to 1926, small value has outperformed, but last 10 years there's been large growth outperformance. Tell me how painful that is to a portfolio and walk me through the numbers of what happens when there's a different trend in the market.
- [20:25]
A
If you're diversified once again across the entire market capitalization spectrum, you're not going to be hurt badly in those types of situations. So most of our clients are focused on capital preservation and participating in upward movements of the market and really once again, preserving the capital that they've worked so hard to earn. So if the market is up 35% in a very concentrated fashion, and you have 15 stocks or so that are responsible for half of that return, our clients typically aren't going to be disappointed with a 20% return that we can provide them with in a diversified manner, once again, in a thoughtful manner, and not chasing trends and not chasing stocks that look like they could be inappropriately valued based on history. The other side of the equation is when the markets go down, they can fall very, very quickly. When the NASDAQ bubble burst in 1999, it took 20 years for it to get back to the levels it was. Before the bubble burst, the NASDAQ was down over 80%. I think a lot of people forgot about that too. When you look at returns now, periods like that, we look pretty smart at what we do. So in kind of down markets, sideways markets, slightly up markets, we tend to do extraordinarily well. But those markets that are very, very concentrated in a handful of stocks or a particular sector, we tend to trail in those environments.
- [22:07]
B
And for those who might not hit your minimums, what's your favorite indexing tool for. For the large. For large stocks, do you like DFA over Vanguard or Fidelity? Talk to me about the differentiation in the market.
- [22:19]
A
I like the RSP, which is the equally weighted S&P 500. It's extraordinarily liquid. It's very easy to buy. So having that at least as a compliment to the S&P 500, makes sense for most investors. DFA is a very good place to look at for small cap index investing. It's passive investing, but they're more mindful about the way that they construct their indexes that they're investing in. So it's purely quantitative, but it's based on quality or other factors that have historically proven to be the things that tend to drive alpha in the marketplace.
- [22:57]
B
So you take an active approach for your clients. Talk to me about what it means to be an active investor in the stock market.
- [23:04]
A
An activist strategy in the market today is something that we've looked at. It's something to consider. I kind of consider ourselves buy IT activists. So when we take a position in a company, we certainly want to communicate with management in terms of the strategy that they should be looking at, the strategy that we're looking at, and hopefully we're aligned in our vision about how to unlock value in a company. The differences between that And a true activist investor is typically there is a large disconnect between the management team of a company and the activist investor in terms of the direction of the business. So the activist investor agitates change. They try to get individuals on the board, they try to force sales of the company or divisions of the company. And this can be a very successful strategy, but it tends to be messy. It can be very litigious at times.
- [24:02]
B
Friend of the pod Bill Ackman would say that governance is the only true leverage on investing and that if you have the same board, they're unlikely to take different actions. Why is he wrong?
- [24:13]
A
I would hate to say that Bill Ackman is wrong because he's. He's right a lot more than he's wrong. But I think from a governance perspective, sometimes a board needs to see things from an investor's perspective in order to open their eyes. Sometimes boards can be very insular in terms of the paths that they're looking at once again to create value or governance issues or of the like. But activists and investors coming in and saying, have you thought about this? You know, you might be better off doing this. This is better for shareholders. Sometimes open up opens board members eyes up to a different way of thinking. So I think Ackman certainly introduces a different way of thinking for board members and sometimes an aggressive fashion. And it tends to work.
- [25:00]
B
Sometimes internal party just wants an outside champion, wants a friendly investor.
- [25:05]
A
Exactly. Using our history as a guide, the most successful investments that we've had have been assets that we bought at a significant discount. The management team realizes the stock does not reflect the net asset value of the business and they have a specific plan to unlock that value. It can be buying stock back, it could be selling a division, it can be putting the whole company up for sale. So when we're aligned with the easiest way of approaching small cap value investing in terms of the way that we do it, is having a management team that says, yes, my stock is undervalued and here is what I'm going to do about it. It's more difficult to say, well, why don't you do this instead? Because you're going to get pushback from management saying, we've thought about this and this is the reason why we don't think that this is the best idea. So once again, you create that contentious relationship and then it's harder to work with management directly.
- [26:08]
B
And then the information flow and other side effects of going activist on a company.
- [26:14]
A
Exactly. That's right. That's right.
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B
What would you like our listeners to know about you, Redmont Wealth Advisors or anything else you like to shine a light on.
- [26:20]
A
Being Mindful of fees is one thing that's exceptionally important. Having an appropriate asset allocation is something that's exceptionally important. Having access to unique investments is exceptionally important. Using an academic approach to the public markets, also very important. And that's why we founded the firm in order to achieve all of those different things as an independent firm. Yeah. And if anybody that's listening would like to learn more about what they do or have us take a look at your portfolio, we do that for free. Kind of a doctor's a physical on what your investment strategy is, you know, reach out to us. My personal email is J Langer J L A N g e r@redmont wealth.com.
- [27:08]
B
I might actually have to take you up on it. I have an embarrassingly non reflective public portfolio. My whole personal narrative has been spend 99% of your time on alternatives, on alpha, et cetera. But I've embarrassingly not really been introspective at my public portfolio. So I might actually take you up.
- [27:26]
A
Very, very happy to do it. We break down how you're allocated by sector, by market cap, by biases on the growth side, the value side. And it's a really interesting way once again to be introspective about the way that you're currently positioned. Whether or not you work with us, we provide that service to be helpful to the greater community.
- [27:49]
B
And essentially you're buying an index. You just see the ticker, but the ticker is underlying companies and then you have to take that pooled underlying against your other indexes and actually have a holistic view on it.
- [28:00]
A
That's exactly right.
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B
What tools do you use for that?
- [28:03]
A
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 providing us once again with everything that we've talked about. Breakdowns on market capitalization, exposures, sectors, industries, biases. Fee analysis also comes into play. And then we overlay that with our practical investment experience and provide meaningful advice. We've never had a client come to us and say can you take a look at my portfolio? And say that didn't help us at all. It's like going to the doctor. You're going to hear something you might not like, but it's going to be helpful in the long run.
- [28:46]
B
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. Although he would be embarrassed by my, my lack of sophistication. But, you know, when Eugene Fama won the Nobel Prize in 2013, a lot of people believe that Ken French also deserved that due to them working together. Um, so it's, it's a bit of a shame, but I just wanted to dedicate this to Ken French.
- [29:12]
A
Yeah, that's amazing. And, you know, certainly I worked with Ken French and remember when I was 21 years old putting floppy disks in envelopes and, and sending them off to, to Dartmouth. So, you know, a really special individual and he was very important in the analysis and the work. And I think Gene Fama would certainly agree that there should have been a shared prize to honor the work that he did as well.
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B
Well, James, I've enjoyed really learning about the public markets. Thank you for jumping on the podcast.
- [29:46]
A
Yeah, thank you very much, David. I really appreciate the opportunity.
- [29:49]
B
Thank you. Thank you for listening. The 10X Capital podcast now receives more than 170,000 downloads per month. If you are interested in sponsoring, please email me atdavidxcapital.com.