The Wisdom of James Langer, CIO of Redmont Wealth Advisors

• A quantitative analysis of small stocks with low price-to-book values from 1926 to the present day would have yielded approximately $491,000 and an annualized return of 14.33% 00:10.

• In contrast, investing in large-cap growth stocks with high price-to-book values over the same period would have resulted in around $13,900 and a 10.2% annualized return 00:29.

• This represents a significant 400 basis point spread between small-cap value and large-cap growth strategies since 1926 00:35.

• Despite this, the small-cap value strategy is not more widely accepted or implemented in investment management 00:45.

• The discussion will explore this topic further with guests James and David on the 10x Capital podcast 00:59.

• Eugene Fama, a Nobel laureate, worked at the University of Chicago, where he was known for being a tough and demanding individual to work for 01:04.

• The work involved assembling a database of information on publicly traded stocks, including manually entering stock prices, income statements, and balance sheets from sources like Moody’s manuals and Weisenberg manuals into a database 01:19.

• This database was used to produce Fama’s three-factor model, which was published in 1992 and described 90% of stock price variation, a significant improvement over the 70% explained by Harry Markowitz’s CAPM study in 1959 01:38.

• The Markowitz model used two factors, beta and alpha, to describe stock price variation, while Fama and French added two more factors: size (market capitalization) and price-to-book ratio 02:21.

• The data found that smaller stocks tend to perform better, and companies with more book value relative to their market capitalization also perform better 02:49.

• Combining these factors, small, value-oriented stocks have historically provided excess returns to investors 03:09.

• The work done on the Fama-French three-factor model still carries forward to this day, over 30 years later, and has been influential in understanding the efficient market hypothesis 02:06.

• The Fama-French model demonstrates that investing in small stocks with low price-to-book values can generate significantly higher returns compared to large cap growth stocks, with a $1 investment in 1926 growing to $491,000 by today, representing a 14.3% annualized return 03:23.

• In contrast, investing in large companies with high price-to-book values would have resulted in a $1 investment growing to $13,900 by today, representing a 10.2% annualized return 03:48.

• Historically, small cap value has outperformed large cap growth by over 400 basis points, with a significant performance gap observed in declining interest rate environments 04:03.

• In a declining interest rate environment, small cap value has produced almost a 20% return annually, compared to the overall equity market’s 15.5% return, resulting in over 400 basis points of alpha 04:19.

• The strategy of investing in small cap value is not more widely accepted or implemented in investment management due to scalability issues, making it challenging for large institutional investors to deploy sufficient capital to take a meaningful position in the asset class 05:19.

• Large institutional investors often allocate only a couple of percent to small cap stocks in the public markets, typically through a diversified index fund, as taking a more concentrated position would result in owning large positions in individual companies, making it difficult to enter and exit positions 05:38.

• A more concentrated position in small cap value stocks requires careful management to avoid affecting stock prices, as seen in the example of a fund that capped its allocation at $1 billion and spread it across 40 stocks to maintain a meaningful position without excessively influencing stock prices 06:09.

• There are several reasons that explain why small cap value investments outperform large growth investments, including a higher risk premium associated with small cap stocks, which have historically been slightly more volatile or have a higher standard deviation of return patterns than large cap stocks 06:38.

• Small cap stocks often have very little analyst coverage, creating inefficiencies in terms of information, knowledge, and earnings expectations, allowing for the discovery of mispriced stocks that are overlooked and underfollowed by institutional investors 07:01.

• Typically, publicly traded companies with underappreciated fundamentals relative to averages experience mean reversion, resulting in a higher return in the stock price, which is a characteristic of value stocks 07:29.

• Operating off a lower base, smaller stocks tend to do better than larger stocks in periods of economic expansion, which have been more common than depressed economic periods or recessionary periods over the last hundred years 08:03.

• The combination of these factors explains why small cap value tends to outperform, suggesting that investors should consider selling their large growth investments and investing in small cap value 08:28.

• Exposure across the capitalization spectrum is advocated, with a thoughtful approach to allocations on the larger cap side 08:49.

• Having the S&P 500 as a market capitalization-weighted index is considered counterintuitive, as it implies larger companies will perform better and continue to grow within the index, leading to concentration issues 09:03.

• A market capitalization-weighted index can result in concentration, as seen at the beginning of the year when 10 stocks represented about 35% of the S&P 500 09:31.

• Government intervention can occur when companies become too large and powerful, as seen in the recent challenge to Google’s status as a non-monopoly 09:50.

• An equally weighted approach to investing in the S&P 500, where the same dollar amount is invested in each of the 500 stocks, has historically provided 2% more in excess return annually compared to a market capitalization-weighted approach 10:00.

• The 2% excess return from an equally weighted approach may be due to not selecting for monopolistic companies, which can be broken up by the government, leading to potential losses 10:28.

• Small stocks tend to outperform large stocks over long periods, which is why some consider using a total equally weighted stock index instead of investing in the top 500 biggest companies 10:33.

• Implementing an equally weighted stock index in reality is difficult, especially when dealing with less liquid stocks that may trade by appointment only, such as those in the Russell 2000 universe 10:58.

• Some people have used a sampling approach to get close to an equally weighted Russell 2000, but this method has not been widely accepted 11:17.

• The small cap universe contains many inefficiently priced stocks, making it beneficial to have an active strategy that involves researching financial statements, meeting with management teams, and finding ways to unlock value 11:31.

• Having an active strategy within the small cap universe can be effective over time if done correctly, as demonstrated by the success of Advisory Research Investment Management over 24 years 11:53.

• James Langer had a fantastic experience at Advisory Research, where he started as a research analyst in his early 20s and worked with a small cap value strategy 12:07.

• The firm institutionalized its product, making all portfolios homogeneous, which allowed them to create a track record, build Alpha, and grow the small cap product from around $100 million to over $1 billion in six years 12:20.

• Langer was one of the portfolio managers making decisions on stock purchases, sector allocation, and talking to management teams daily, and he continues to use this strategy at Redmond 13:19.

• Redmond’s strategy is to provide individual investors with an institutional framework for investing, aiming to give them access to institutional-level and quality investments 14:29.

• The firm’s approach is to create a target allocation for each investor, taking into account their individual needs, and typically, investors are underweighted in the small cap space and do not utilize active management enough 14:51.

• Langer believes the ideal profile for a liquid institutional public book, assuming an unlimited time horizon, would be 40% in small cap stocks, 40% in mid and large cap stocks, and 20% in non-US stocks, both in developed and emerging markets 15:18.

• The firm aims to get beta on large cap stocks using an academic approach, and most portfolios they analyze are overweighted to large cap growth 16:18.
  

• The performance of a small cap strategy was out about 5% in 2022, making it look successful, but this success may not be sustainable in the long term 16:48.

• The rationale for allocating 20% of a liquid portfolio to developed and emerging markets is to provide diversification, as there are many emerging economies that will perform exceptionally well from a company-level perspective 17:20.

• Having a global diversification makes sense, as it allows for investments in economies that are performing well even when the domestic economy is not 17:46.

• The 40% allocation to small stocks is managed actively, while the 60% allocation to large stocks and developed and emerging markets is managed through indexing in a thoughtful manner, using quality weighting or equal weighting instead of market capitalization weighting 17:59.

• Market capitalization weighting is considered arbitrary and not fundamentally sound, as it is equivalent to a momentum trade that favors companies that are growing faster 18:27.

• Historically, value has outperformed growth since 1926, but in the last 10 years, large growth has outperformed, which can be painful for a portfolio that is diversified across the entire market capitalization spectrum 19:21.

• A diversified portfolio will not be hurt badly in situations where there is a different trend in the market, and clients who are focused on capital preservation and participating in upward movements of the market will not be disappointed with a 20% return in a diversified manner 20:30.

• When the markets go down, they can fall very quickly, and a diversified portfolio will tend to do extraordinarily well in down markets, sideways markets, and slightly up markets, but may trail in environments that are very concentrated in a handful of stocks or a particular sector 21:49.

• The RSP, an equally weighted S&P 500 index, is a preferred indexing tool due to its extraordinary liquidity and ease of purchase, making it a suitable complement to the S&P 500 for most investors 22:17.

• DFA is a good option for small-cap index investing, as it uses a quantitative approach based on quality or other factors that have historically driven alpha in the marketplace 22:30.

• An active strategy in the stock market involves taking a position in a company and communicating with management to align visions on unlocking value, with the goal of being a “quiet activist” 23:01.

• The difference between a quiet activist and a true activist investor is that the latter often has a large disconnect with the management team and agitates for change, which can be a successful but messy strategy 23:27.

• Governance is considered a key lever in investing, and having the same board can limit the potential for different actions, but sometimes boards need an outside perspective to open their eyes to new ways of thinking 24:04.

• Activist investors, like Bill Ackman, can introduce a different way of thinking for board members and sometimes achieve success through aggressive means 24:51.

• The most successful investments have been assets bought at a significant discount, where the management team realizes the stock does not reflect the net asset value of the business and has a specific plan to unlock that value 25:08.

• This plan can include buying back stock, selling a division, or putting the whole company up for sale, and having a management team aligned with this goal is crucial for effective investment 25:21.

• It is more difficult to approach small cap value investing without a management team that acknowledges the stock’s undervaluation and has a plan to address it, as this can create a contentious relationship and hinder information flow 25:42.

• Key factors for effective investment include being mindful of fees, having an appropriate asset allocation, accessing unique investments, and using an academic approach to the public markets 26:18.

• Redmont Wealth Advisors offers a free portfolio review service, which includes breaking down allocation by sector, market cap, and biases on the growth and value sides, to provide a holistic view of one’s investment strategy 26:50.

• This service is available to anyone, regardless of whether they work with Redmont Wealth Advisors, and is intended to be helpful to the greater community 27:42.

• Redmont Wealth Advisors uses proprietary tools to analyze portfolios and provide a comprehensive view of one’s investments 28:00.

• J Langer, a representative of Redmont Wealth Advisors, can be contacted at j.langer@redmontwealth.com for more information or to request a portfolio review 27:00.

• A proprietary tool has been developed to analyze portfolios by loading tickers and the number of shares, providing a comprehensive breakdown of market capitalization, sector and industry exposures, biases, and fee analysis 28:05.

• The tool’s analysis is combined with practical investment experience to provide meaningful advice to clients, with no client having reported that the analysis was unhelpful 28:34.

• The episode is dedicated to Ken French, a business school professor who had a significant influence on the way public markets are viewed, and who worked with Eugene Fama, the 2013 Nobel Prize winner 28:45.

• Ken French’s contributions to the field are considered significant, with many believing he deserved to share the Nobel Prize with Eugene Fama 28:59.

• The individuals involved in the discussion have a personal connection to Ken French, having worked with him and remembering his importance in their analysis and work 29:13.

It is acknowledged that Eugene Fama would likely agree that Ken French’s work warranted a shared prize 29:32.