Deconstructing Alpha - Unscripted Interviews with Time-Tested Investment Managers

EP9: Risk Managed Small-Cap Investing with Gregory Spiegel of Neuberger Berman

October 14, 2021 Geremy van Arkel, CFA® and Shannen Carroll Season 1 Episode 9
Deconstructing Alpha - Unscripted Interviews with Time-Tested Investment Managers
EP9: Risk Managed Small-Cap Investing with Gregory Spiegel of Neuberger Berman
Show Notes Transcript

Risk managed small-cap equity investing?  How to manage a large small-cap portfolio?   Can underperforming a bull market lead to multiple market environment outperformance?  For how long can poor quality businesses outperform?  Why is the beta ripping Russell 2000 Small Cap Index chock full of non-profitable companies?  

Do these questions sound like “Jumbo Shrimp”?   

We are fortunate enough to address these perplexing topics with Gregory Spiegel, Portfolio Manager of the $10 billion AUM – 30 plus year old – Neuberger Berman Genesis fund. 

Listen up and get wise folks. Time to go sit in traffic, take the dog for a walk, or just take a nap…

Please click here for a summary of the Neuberger Berman Genesis Fund’s investment risks, current performance data, including current to the most recent month end, and other important disclosures.

Geremy: The usual standard qualification I have to add here is please stay on the on the podcast till the end. And we will wrap up this podcast and try to make sure we we got something out of it. And so my guest today is Gregory Spiegel. He is a portfolio manager for the Neuberger Berman Genesis fund. So without further ado, let's get this podcast started. Greg, welcome to the podcast. I'm so glad that you can make it here. And really appreciate you being on on this call. Where are you calling in from today?

Gregory: I'm calling in from Long Island, New York.

Geremy: All right. Are you in the office? Or are you at home?

Gregory: I am at home today.

Geremy: So what is the policy at Neuberger right now about people going back to the office?

Gregory: So the office is open. Hike is in the office right now. I've been going in, you know, two to three days a week. It's been optional at the moment. You know, I think what we'd like is, is come the fall, you know, sort of September timeframe to have folks come into the office for probably around three days a week.

Geremy: I think all businesses, I think are kind of struggling with this idea of how do we get people to come back to work I'm in Atlanta, where we have, I guess you could say kind of loose COVID rules. And we've been sort of unconstrained here for quite some time. But still, I mean, I've been laughing that Atlanta is such a great place to live in, because we don't have any traffic anymore. People are doing everything that they want to do except for going back to work. And so, but I guess we've got a little bubbling up here again, of COVID. So what is the you know, New York being, you know, sort of a center of some of this COVID stuff, obviously a huge city. What is the tone of the COVID situation right now in New York City?

Gregory: Uh, it's been fairly benign at the moment, I think the positivity rate as of last night just was touch over 1% you know, having bottomed around 50 bips. So it's still quite low, you know, the percentage of people that have been vaccinated with at least one shot so far, I think is in the low 70s. So you know, the vaccination rate is quite high. Yeah. And so, you know, the the mask mandates have been lifted, indoor dining is open. And for the moment, it seems as though it's sort of business as usual. 

Geremy: Well, good, because my wife and I, we love to escape to New York, and, you know, standardized hotel and go out for a couple of nice meals. And, we were just wondering, we just personally, you know, if we did come to New York, I'm sure maybe many listeners are wondering, you know, they might love New York, too. And if we did come to New York, I mean, can we have that sort of New York experience again?

Gregory: I think so it feels a lot better. My wife and I just went to Bruce Springsteen on Broadway last week. It was a packed house. Yeah, it was awesome. We had an early dinner beforehand. restaurant was crowded. You know, so it feels better. A lot better. It was pretty grim for a while.

Geremy: I'm sure. I mean, it was grim for everybody. But I think in particular, New York must have felt extremely sad. Yeah. It was and I do want to pay my respects to New York by trying to get up there as soon as I can. So anyway, so let's get back to business here. So what is your role at Neuberger Berman?

Gregory: I am a portfolio manager on the small cap team. We manage the Genesis fund as well as a handful of large institutional separate accounts.

Geremy: Okay. It can the Genesis fund in its like in the characteristics of the Genesis fund, can it be available as a separate account for institutional investors? Or is it really just the flare of the Genesis funds really just exists as the standalone fund?

Gregory: I'm gonna turn to my colleague Hike to feel that question. Geremy, it's a great question. The Genesis fund is available in a separate account vehicle, but it is we do manage it in a more concentrated format. Yeah, it's more of a truce mid cap portfolio 50 to 55 stocks versus the Genesis Fund, which is generally been about 100 names in the portfolio. 

Geremy: Okay, so I asked that question because it is a little bit of an odd question. But I asked that question because you know, we invest in mutual funds and mutual funds are often the largest portfolio that investment managers are managing Under their strategies, and often the separate accounts are a little bit different than the mutual fund, you know. And so sometimes I feel like the mutual fund is the sort of freest format of what the managers really want to buy, which I think is a benefit to mutual funds that people don't really mention. Now, I guess I won't go as far to say that's how you do it. But that's the origins of that question. So the Genesis fund, that's the strategy that we're pretty interested in. And we have been following for quite some time. What is the AUM in the Genesis fund?

Gregory: As of this morning, it's 11.9 billion.

Geremy: So that's a pretty large small cap fund. Right, you know, small cap investors are concerned with the size of the fund. And often when people are doing due diligence, they like to look for smaller funds. So, I know that the Genesis fund has been a bit over, you know, I think a lot of times people think about 5 or 6 billion is sort of capacity for small cap. But you guys have been above that for decades. In the strategy, right? And yes, and so there is an art and science to managing large pools of money in small cap stocks, that's probably an acquired knowledge.

Gregory: That's absolutely correct. And, you know, we have tons of data, as you know, we've sat together and gone through our, 150 page deck. But we've been running sort of 10 billion or more in the fund, basically going all the way back to 2004.

Geremy: Wow. And I think what sometimes people like I think people's rules on small cap sizes of funds, sort of were set somewhere in time like, 25 years ago, that well, a $2 billion fund is pretty big, but the market cap of the general market has risen by so much. And still, I think that maybe, we haven't held fast to some of those rules. And another reason why we haven't felt held so fast to those rules, because we do find in, in different areas of the marketplace, that some funds that are large, tend to continue to outperform. And, the aim is not a hintermann. 

Gregory: So let me share a couple thoughts with you. And, I know you're quite familiar with the strategy, what allows us to run so much capital is really the strategy, we run a low turnover portfolio. And so we're holding on to these businesses for 6-8-10 plus years, the average turnover of the fund has been around 15%, 15% for the past decade. So mathematically, you know, we're holding these businesses for a very long time. That's really what sets us apart from most of our peers, right? Most small cap managers are turning their portfolio, 90 to 150%. If we were doing that, it would make it much more difficult to run the amount of capital we're running. And so I say the other thing I would say is given our size, you know, I think it sets us apart also from a competitive advantage perspective, because it allows us to fund a very large research team, right? So we do all of our own research, there are 10 people on our team that work exclusively, on the strategies we're discussing today. And as you know, the small cap market is highly inefficient part of the US equity market, right? meaning there's not a lot of research coverage, there's an information vacuum. So to have your own research effort on the team fully dedicated to attacking this opportunity, yeah, is a huge advantage. And again, at the competitive advantage, it really sets us apart, but the only way we can do that is by running so much capital again, right? Because that allows us to fund that team

Geremy: In this in this day and age of like zero expense ETFs, where you get what you pay for, you just get a formula of stocks, the people have forgotten that part of the reason you pay management fees on a mutual fund is because it pays for the smart people to do the actual research, right? And so in your case here, the larger the pool of money you can lower your expenses to a very reasonable rate. And then you can also be able to fund quite a team of people that I'm glad you brought that point up because I think people forget that point. So in light of that, the strategy. How long is the strategy been around?

Gregory: So Judy Vail arrived in Neuberger in 1992. And really, sort of spearheaded this strategy. Bob Dalio joined her in 96, and so those two together have been co managing the strategy in its current form since 1996.

Geremy: Yeah, and that's probably one of the longer running existing small cap strategies? And I kind of know the answer to this one. But you know that one of the sub questions that we can probably just get right to here is, you know, how is it possible? I don't want to actually get into this, but I say, I'll just say it is possible for a mutual fund outperform for 30 years, which is people always say, Well, I'm paying for active management, and how long could the outperform how much how conformance can be had? And if How long can it occur. And what we've found is that a lot about performance can be had if you do it, right. And it can happen for a long time, because there could be transfer, you don't have to have just the existing manager be on place the whole time, there could be transference of knowledge from one team to another. And so I commend you on your, solid, very long track record. So in your words, what is the How would you describe the strategy? What do you all try to do over there?

Gregory: Yeah, what we're trying to do is identify the best business models we can find, which we define, you know, as businesses that generate above average profitability, which we measure, by return on assets generate sustainable and ample free cash flow, so that they can sell finance the business, they can buy back stock, they pay dividends to create m&a, tend to have very strong balance sheets, and some type of competitive advantage, or a barrier that's going to help that return and cash flow stream accrue to us, again, over the long term. So broadly defined, we're quality managers, right? And, you know, again, trying to identify these great business models, own large pieces of those businesses and allow that to compound over time, you know, again, the world's time horizons have compressed, right, everybody's looking for the next data point, the next quarter, we're looking out three to five years to try to understand what this business can produce in free cash flow, what they're gonna do with that free cash flow, how that benefits us, and how that translates ultimately, into free cash flow growth over time. Because ultimately, that's what the stock market is right? In the short term. It tends to be a voting machine, I think this is stolen from Warren Buffett right? And you're voting on Is it good is bad. In the long term, it's a weighing machine. And what it's weighing is free cash flow, right? And so that's where we live, eat breathe, is free cash flow, and the sustainability and durability of that free cash flow profile.

Geremy: So you know, anybody can access the data on your fund and everything. And I know it has a great solid, consistent track record. So I interject this here on just what you said is that you didn't say anything about all we tried outperform benchmarks, which is, you know, essentially, the snippet that the industry is looking for. Like, oh, you know, we're trying to outperform benchmarks every quarter, right? And so, I noticed you didn't say that. And then you didn't mention anything really about growth or value. Right? So those are sort of, you know, from a due diligence perspective, or an investor looking for a fund, they're typically searching on growth or value? And did you outperform your benchmark? And so I guess the implied point that you're making is, is that it doesn't, I'll let you expand on that.

Gregory: Sure. So what we're trying to achieve is very attractive, risk adjusted, long term returns cross site, right. And it's important to remind investors that there are cycles, and we've been through some periods, you know, primarily coming off the bottom of 08 09, all the way into the beginning of COVID, where there actually were no cycles, right? We're beta beta, beta beta, rise, the call of the day. And so again, what we try to do is produce very attractive risk adjusted long term returns. The way we do that is really by not losing as much in the downturns as others may lose and as the the indices may lose, and participating over time in the markets, and that historically has been the performance pattern of the fund. And this is not something that we intentionally do. It's not as if we've identified mounting risks around the world in, you know, at the rates market or real estate market or COVID. You know, this is a byproduct of our philosophy that focuses on quality businesses, free cash flow generation and balance sheet strength, which tend to be in demand, especially in times of stress or distress.

Geremy: Well, it's interesting, you mentioned that performance pattern, right? So that, you know, I kind of use the term endurance, right the ability to endure multiple market environments that are likely to happen in our future, right? So, you know, hey investors who are listening, you don't get to go back in time. Right? Everything that's already occurred, is over. And, you have to go forward, and going forward at any point in time in history, you're gonna have to consider multiple market environments. And, for us as well, if we try to lose less when the losing occurs, and make enough when markets are good. And we believe that that compounds to a more consistent experience for clients, and it's just more reliable. And so you did mention risk management there. And so we've noticed, in your track record, that it appears that normal stuff, you know, most of the time when there's sort of trauma in the small cap space, or the US stock space, that your fund performs really well, relative to other things, right. It could be benchmarks or peers or whatever you want to put there. It you, you know, case in point first quarter of last year. So you mentioned risk management, it appears to me that your fund does a very good job of mitigating risk when the risk occurs. So how is that happening?

Gregory: It happens by virtue of the businesses we own. And again, if you think about the attributes that sort of define our strategy, we want very high returning businesses that are generating sustainable and ample free cash flow. free cash flow in the time of stress or distress is priceless, right? It means you don't have to tap the capital markets, which are probably closing because they're under pressure. And you can be aggressive repurchasing your own shares at very accretive multiples, right, which will benefit long term holders. And you can take advantage of potentially stressed or distressed assets that become for sale in that marketplace, given the strong balance sheets that we also prefer. And so it's really those attributes that that helped to drive and create that risk management. So it's almost done at the security level, where when markets really come under pressure, these attributes tend to stand at the forefront. Right. To your point earlier, you know, we're managing a $12 billion small cap fund, it's not as if I can convert the portfolio to cash, because COVID is eating the world, right? Yeah, it's just impossible. It's not what we're paid to do. And it's not even, you know, if I was a market timer, and I had a crystal ball, that would be doing a different job. It really is a byproduct of the businesses we own. Right, and, you know, it's super important, you know, for me to state that we don't deviate from that strategy, when things may not be working in the market, because I promise you, there are periods where this will not work. And the attributes of those businesses are far less in demand, for instance, starting in the fourth quarter of 2020. Right when the market started to sense that there was a vaccine coming out, and that you could make the case that we were at the dawn of a new economic cycle, what that creates is the beta river, right? You want to go for the lowest quality, highest beta, most levered most economically sensitive parts of the market. And so that's what rips huge and that's why value has ripped so viciously off the bottom. Right? That's a period. It's the first bullet point on our page, what you can expect from us, we will underperform that because that's just not what we're offering. Right. And we've seen this episode many times in the past. And so yeah, yes, it stinks. I see that. Yeah, but we've seen it in the past. Yeah. tends to move in cycles. Righ, and so we don't deviate? Because that's happened.

Geremy: Well, let's break that down. Last year. Oh, so let's say the last 18 months because it really feels like an aberration or sort of an anomaly year. I've got a library of books here in my office, and not one of them explains anything remotely like what happened in the last 18 months. And, furthermore, you know, I'm still a little bit in shock and might need to just talk it out. So, the first quarter, right, so when the COVID hit, I mean, so, you don't really have to do anything going into the first quarter, right? I mean, like, we were operating under the assumption that we're in a low and slow economy, asset prices just floating up. It's very low volatility. It's all fed back. And it just looks pricing Right? And then COVID hit. And so what did you all do when the COVID quarter hit?

Gregory: So first, we all went home, right? and stayed home, basically for the next 16 months. Yeah. So that was step one, right? I'm really what the markets were moving so fast and in such large increments, that what we started to analyze, and what we really wanted to defend against was, we didn't want to be getting more defensive as the market went lower. And so positioning, portfolio position changes in two ways, it changes one by virtue of what the market does to different sectors and different securities in those sectors, right? Meaning some really go down a lot. Some stands still. The second way changes is by virtue of things that we do deliberately, right? I want to sell this thing and buy this thing. So you know, what's the Russell going down five 6% a day, we had sectors and securities that were going from 100 basis points position to 150 or 200 basis points positions overnight, right? Your whole portfolio is drifting with the mark by virtue of doing nothing. And so we made, I'm going to show you this sheet and you can describe it later. But we had to make this sheet, right, which dissects every, every single security inside the sector, between what the market had done to us and what we had done in terms of intentional traits. And so as the markets went lower, we started to harvest basis points from some of those defensive steady Eddy type areas of the portfolio, consumer durables, some of the software names that held up really well and move those into the more cyclical areas that had really been killed more, right, just in an effort to almost maintain balance. And so that, you know, that took a few months, and that was probably, you know, a couple 100 basis points. But shortly into that process, the market bounced, right. And so, you know, things start to change again. And so really, we had to analyze the portfolio positioning every day. So this was a sheet that that was run every single morning, We had a we have a zoom call at 9am every single day we went over each sector is security. And so, you know, you know, our strategy, we don't make wholesale moves. Yeah, we tried to make some moves on the margin to maintain balance. We weren't calling the bottom of the market, it was a lot of uncertainty, a lot of volatility, right? We couldn't really see that far into the future. When we spoke to the businesses we owned, it really wasn't about current trends, or, you know, the next Corallo, it's really about what's happening in your industry, is your set of assets becoming more competitive or less competitive? And why? Right, so that was the lens that we focused the team, you know, to have these discussions with, and then that helped guide the movement of some basis points, because there were clearly winners and losers emerging in that early COVID. Yeah, sort of beginning?

Geremy: Yeah, absolutely. There was businesses it looked like they were done for, and there was businesses that looked like their business would triple or quadruple overnight. Right. So then we had, so then we had sort of this drift up, I would call it the market from say, April till November, right? November 7, I think was the day. And, it just, I don't know about you, but we just sort of when we were doing our jobs and doing all our, you know, everything we were supposed to do, but I just felt like the market was just going up every single day, and sort of like a recovery. But it all kind of felt. Yeah, I kind of get this makes sense. Right? And so yeah, it was just sort of a, you know, in hindsight, it was a very quick recovery. But there were there was that time in the middle there where it was, I think everybody was in disbelief, because we're all still at home. And there was, you know, TV, they remember that, that that thing on TV where the opera singer in Italy, and they showed all the cities of the world where there was nobody anywhere, which was very haunting to me at least. Yeah. And and then so so during that time, maybe you guys you mean you would already kind of repositioned a bit or

Gregory: Well, we you know, so we moved some basis points on the margin. And as we move through the year tierpoint markets sort of bounce they sold off again on COVID data, they bounce they sold off. It was really as we started to get more information from Pfizer, Madonna AstraZeneca around the potential for, you know, a real vaccine to roll into the market and once that once that started to take hold that sort of was the catalyst that then drove a full risk on recovery, right. But up until that point, we were sort of going through the portfolio, and trying to understand where do we have exposure to things that are benefit from reopening, and what has already benefited right from the pandemic, that likely won't continue. And so we started to move some basis points around that. And we and, started to look forward towards a potential reopening of the economy. And so that causes another marginal shift two basis points, from what I would characterize as secular winners, right, which sort of grew through COVID, that didn't get the memo that the whole world had locked down, we had now a whole portfolio of software businesses that are doubling and tripling and right didn't didn't really get that memo. Whereas the semiconductor side of the tech portfolio was left behind, right, so we started to make some of those shifts, we started to move some basis points into our regional bank holdings, right. Because with the recovery with a reopening loan demand should start to pick up even in spite of a punk yield curve. And so again, these were really on the margin. Right, nothing wholesale, just to try to maintain balance, because the macro picture was was so clouded.

Geremy: Yeah, I agree. And so I think a lot of times, like so for our listeners, I think a lot of times people think investment managers, you know, tend to make huge moves, and big bets and, things like that. And, what I've discovered that is we're always trying to work to add a little bit of value here and there. And, so investment management teams are always working. So then, you get to November, right? And then so now, I would call this next phase, I don't know what to call this next phase, right? This is November through today, right? I mean, the small caps are up 3%, or something to that, right. So November through today feels like amania. Is that sort of? I mean, how would you characterize what's going on right now?

Gregory: Yeah. So the fourth quarter of 2020 was the best quarter on record for the Russell 2000. The first quarter of 2020 was the worst quarter on record for the Russell 2000. Okay, we went into the recession, fastest on record. And the, you know, the budgeting office CBO, whatever came out yesterday. And so we actually emerged from that recession Two months later, which would have been the fastest on record also. Yeah. So, we're breaking a lot of records.

Geremy: Everything's on board.

Gregory: Right. So come November, you know, again, you get a lot of excitement around the dawn of a new economic cycle. And so, you know, I'll draw a picture and sort of, you know, this is these are economic cycles. And so, we're coming in here, this is sort of the boom phase, right. We come up this curve, and that is the beta river, right. You want to own the most cyclical, the most levered the highest beta stuff that has the most torque to a recovery, right. And then that translates them into the value river, right? Because those are the businesses that go from losing money to making money that tend to, you know, create pricing power, because there's so much demand for their stuff all of a sudden, right. And so, so that environment really started in, you know, to your point in in November, and really continued Yeah, into this year. Right, I would sort of suggest we're sort of at this point now, that is sort of,

Geremy: You know, the apex of the swing the recovery.

Gregory: Exactly. And so from that point, it really becomes a stock pickers market. And it really becomes a market, Where can the businesses, your own differentiate from all of the businesses by virtue of their fundamental performance? And so I think that that creates a great opportunity for for most active managers, and especially for us, because, you know, as you see in our performance, we lagged materially in that beta ripper. And that's consistent with history. But what we've seen over the last, you know, and in Lee are performance analyst just ran this over the last five weeks, I think the Russell has given up 700 basis points. And I think we gave up 100. So, you know, we're starting to see and not to mention that coincided with the 10 year going from 155 to like, 112, which is also incredible. So which is awesome. I mean, we can spend all day talking about, you know, the crazy stuff that's happening, It's caused a shift again, right? Because then people are like, Oh, my God, is the growth graph growth rate over Yeah. Right. And so then we've seen big sector growth rotations come back around. All the while, we're not really changing anything we do, right? We're shifting on the margin, yet the market runs away from us. It runs towards us, it runs away from us. We focus on free cash flow, high returns good balance sheets and barriers, right. We do it today, tomorrow. All the time.

Geremy: Yeah, you do what you do every day, the market just does what it wants to do every day. And day to day, it doesn't have to make sense, right. It's just over time that accumulates the track record and the experience for the investors. And so, you know, the way I've heard, you know, heard it explained is that, we're just my characterization of this sort of what you're calling a beta ripper is cyclical recovery, the value stocks, you know, you know, I typically think that most quality businesses are, you know, a little bit more premium price, because most people know their quality businesses. And so they tend to be a little more on the growth spectrum. And that a lot of times the value companies are the ones that are struggling. And, what you know, when you take the economy to zero, there were a lot of businesses that look like they would just go flat out of business. And so those things were priced, like, you know, just rock bottom. And so to really have had the experience of, say, the indexes, you would have had to have dove into those, which sounds like sounded like a big bet at the time. Right. And, so these value businesses, then, because the way indexes are constructed for our listeners, and market cap weighted, they creep up the index as they as they run, and then the index sort of runs away from people. Because a lot of times, investors may be like yourself are not willing to buy those companies. In those percentages. And so there's sort of like an on the tail end of these booms. A lot of really, you know, quality type managers tend to trail because they're not willing to hold what the index is ended up holding, just through market cap weighting. Case in point I don't want to get to this too much, but GameStop, right, is the number one stock in the s&p 600 index, right. And so, and so you know, what investment manager is going to go out and buy. What is it 3% of their portfolio in GameStop? Right. And so, so really, it's been, I guess, a fun experience. So what is there a time period in history that you can point to That looks sort of like today?

Gregory: I'm not sure there is. You know, I think we are, if you would have told me that we were going to have a GDP print with a six handle. And, you know, the 10 year was going to be you know, 110.

Geremy: And it's going to be and inflation is gonna be five.

Gregory: And inflation is gonna be five, I would have, you know, sort of questioned your, you know, financial acumen. Yeah. You're familiar with, with the way markets work? Yeah. Now, I questioned my own because I look at some of these relationships. Yeah. And I'm amazed, and I look at the labor market with, I think, seven and a half million job openings. But the economy, again, we just had a GDP print with a six handle. So, you know, a lot of these relationships are, are quite bizarre look at the government has backstops the capital structure, basically, of the US economy all the way since 2008. 

you think about it, it's a whole different economy, how it works.

Gregory: It's a hold if you and if you think about the amount of stimulus, the amount of leverage that is put on the government's balance sheet, all going all the way back to 08 I mean, it's not as if we ever came off the IV. That's right. So I think that that creates a lot of structural risk longer term. Yeah, right in the way markets function in the signaling value of markets. So that's that's probably a debate for you know, yeah another day.

Geremy: I just did a you know, I do a quarterly call and I have a quarterly strategist deck and normally it could be say 12 slides. And this quarter It was like 42. Right. It was just like I just too much to deal with right. And so there is so many different concepts I'm sure we could dive into so let's so I've kind of equated this marketplace. At least that's what's kind of what's happening post November to 1999 I and I'm not, you know, I guess there's some metrics that are way out of whack compared to 1999. But it does feel like we are experiencing manic speculation. Right. Like, we've got the Bitcoin thing, we've got the meme stocks, we've got the spax. And we've got all this sort of speculation and trying to keep up, you know, and abandoning of, of strategies that are logical in the face of just chasing returns, does it feel a bit like that to you?

Gregory: I would agree in terms of the level of speculation, right? There are, you know, to your point earlier, GameStop is now the poster child for, you know, almost an investor revolution, right. Where, where financial analysis and valuation really doesn't matter. Right. And, that's what we experienced going into the.com bubble, right. It was a new paradigm. Yeah, I understand it, it's clicks and bricks and eyes, and whatever. And, you know, and so, yes, there there's definitely are pockets of speculation, you know, it doesn't feel to me, like the universe of speculation is as rampant as it was back then. Right. Because you do have a lot of these tech bellwethers, that are producing significant amounts of free cash flow, and maybe valuations a little bit high. But there are real businesses now. And some of these have been sort of winner take all kind of markets. And, you know, but there definitely are pockets of speculation, which in my view, is a byproduct of just the amount of liquidity that's sloshing around in the system, again, by virtue of the backstop that's been provided for so long, whether it's in the form of rates being compressed to zero, or buying mortgages, buying bonds buying, you know, all of these. So, again, you know, it's, it's not surprising, because, again, there's so much liquidity. But it does feel, at least to me, like the universe of that speculation isn't as rampant as perhaps it was, yeah. In 99. That's our index, the Russell 2000 index. Yeah, is hugely speculative and has gotten riskier. Over time. You know, since the bottom in 09, the percentage of money losers in the index has gone straight up. Right. I think it's like 44% of the companies now just lose money straight up every day, like just get gap losses. The amount of leverage on the on the balance sheets of those businesses has gone up. So there is there is a fair amount of risk growing under the hood?

Geremy: Well, I think in the sport, small cap space, in particular, is subject to this sort of speculation, or I don't know, maybe what is the market can stay irrational longer than I can stay solvent, but maybe, who knows? Right, but it seems like the, you know, it seems like the small cap space is experiencing a lot of imbalances. You know, and speculation. And so I think it's, you know, we feel very comfortable with active managers in this space, because of, you know, A. the index constituents, you know, the meme stocks are in there. And they're growing as parts of the index all the time. It looks, it does look like the volatility in the last five or six weeks of the Russell 2000 has gone up considerably. And, then there is this zombie company problem, right. So you just jumped right to that. And that was something I wanted to talk about. So how is it that 40% of the companies in the Russell 2000 can not earn money, yet their stock prices are still going up? That's an interesting question. Right?

Gregory: Yeah. So capital markets are wide open. As we've seen, right. As you mentioned earlier, spax are raising capital and our fiscal problem. So there's been seemingly an infinite amount of demands to buy very low quality paper effectively, and, again, in my view of a sort of outgrowth of the rate picture and the amount of liquidity  that's really sloshing around. Right. Now, as you know, the Russell 2000 is pretty homogeneous in its construction. And so what I mean by that is the largest position to the smallest position, the delta is only about 20 pips in terms of the weighting in the index. So when you get a passive flow of $1 into the index is basically buying all of those businesses, right, all of those companies, so when you get so we if we sort of rewind the tape back to November, You have the dawn of a new economic cycle? Yeah. Right. The best way to get exposure to that is to own small caps historically. Yeah. But what we saw was we saw $10 billion of passive flows into small in January, that's versus a 10 year historical monthly average of about 900 million.

Geremy: Yeah. So there's been, I just saw that data that is staggering to me, that the amount of money that's gone into the markets this year, if you annualize it exceeds the amount of money total net for the last 20 years.

Gregory: Okay. So, so that's what explains, and these very low quality companies go up and just supply demand of those shares.

Geremy: And I think that the majority of the money now is indexed. So the investors are they're pouring those pushing those buttons give me some of that. They're, they don't care what they're buying. And they don't realize that as long as the index goes up, they don't care. They don't realize that a large percentage of the companies are not quality businesses, and they're just as important.

Gregory: It tends to get very leaky over time, right? I mean, the flows start to moderate people start to realize, okay, you know, the Russell 2000, best quarter on record for the border ripped huge into 2021, you start to see the flow start to moderate. And then on the other side, there's no bid for any of those businesses.

Geremy: Right. So all right, so on the one hand, a lot of small cap businesses are not performing and not performing well as businesses. But their stock prices. Nobody seems to care. On the other side, there are great businesses in the small cap index, right. I mean, obviously, that's where you go. And so I'm the kind of having a pause here. Okay, so for the businesses that you own, how are the fundamentals doing? Right. Because, you know, as a strategist, we follow, you know, earnings yield, and we try to compute expected returns and, and understand valuation. And there's, you know, it feels like historically, in historical perspective, it feels like we're in sort of uncharted territory, for valuations of indexes overall, right. They all feel extremely pricey. And it doesn't feel like the earnings are keeping up. So let's, so what about your the portfolio, you own the businesses in your portfolio, Are they performing well, not stock price, but business wise?

Gregory: Yeah. So the short answer is yes. We are very happy with the fundamentals of the businesses we own. And the business models have proven to be extremely durable. Last year, so in 2020, if you looked at our portfolio as a company, I think on a reported basis, we would have reported flat revenue and earnings up low single digits, right. And this was set against Russell estimates at that point for revenue and earnings per share to be down 15 and 30, respectively right. So the business, the fundamentals of the businesses are quite good, and have proven to be extremely durable in the hardest of times. We're now entering into second quarter reporting season and so we'll get a fresh look at you know, both results for the quarter as well as guidance for the rest of the year. Yeah, we heard in the first quarter, sort of across the board was supply chain disruptions causing, you know, elevated expenses. Some input cost inflation, also eating into some margin, as well as labor, right. labor rates across the board, have been up. And so these are things we're monitoring quite closely, unless concerned about bucket one and two, bucket three, the wage inflation piece, I think is going to prove to be quite sticky, and will stay with us for quite some time. The fact that there are so many job openings that aren't getting filled to me implies wages will likely go higher. We've seen a lot of fast food restaurants, a lot of retailers have to offer signing bonuses to folks to come in to interview to ultimately get higher. And so, you know, this is an area you know, we're paying particularly close attention to

Geremy: Well, yeah, so the inflation's in move. thing. And if you're if your companies are mentioning problems with supply chain and or problems with getting workers, then that's both sides of that inflation debate that's going on right now. So so one side of the one side of the equation is demand and demand would be increased if people got paid more, and the other side would be supply which has been restricted because of all these lumpy COVID startups and restarts. And so it's interesting that you say that, because we try we try to get an understanding, you know, I think the people that know the most about what's about to happen are the people that are running businesses right. And, so but that's the big debate on inflation. So, inflation does seem high, and it's all just a matter now, is this base effects. Is this temporary supply chain shortages? Or is this something more meaningful? And I think the common you know, the common brush everybody's just painting it with is, well, if wages go up, it'll be meaningful, you know, and inflation will stay here.

Gregory: Yeah. And, we started debating this midway through last year, right. Because we saw, you know, whether it was a lumber mill or a steel mill, you know, copper mine just get shut down. You can't go from running, you know, 80-90%, utilization to 0. And then back to 80-90%, without a bunch of air pockets. And so. So the discussion then turned to, to our businesses and pricing power, right, when they offset the simple costs, right. And again, if you think about the attributes we're looking for, most tend to have pricing power, because if you have the combination of very high returns generate sustainable and ample free cash flow with a barrier to protect that, that means you have something that's sort of special, you should be able to price for it. We'll see.

Geremy: Yeah, yeah. Well, it feels like we're sitting here at a point in time where valuations are high. So I mean, I don't know exactly for your portfolio, but it seems like prices are pretty high relative to the earnings, the businesses are achieving. And, and then you have this inflation thing. And so I think that, again, no rest for the, you know, you don't get a rest here, you gotta go now figure out that. 

Gregory: That's what makes it fun. I mean, the truth is, we debate this stuff all the time, right. Every morning, we're talking about all this stuff. At the end of the day, it's not really investable. Right, what we're looking for is what I've described, and that's really, you know, what I tell what I tell investors I meet with is basically, my macro views are worth zero basis points, in fact, in fees, literally zero, okay. And so, you know, we have to have a view, and we understand it, and we got to, you know, sort of think about it, but again, what drives our performance and what drives ultimately, our return stream is to find these awesome businesses that are unique and differentiated, and there's no research coverage, and there's an information vacuum and we have a, our team can go attack it, and we can own big pieces of it and let it compound that's really, that's the bread and butter.

Geremy: The common theme I get, I mean, so in my position, we get to assemble portfolios of who we think are amazing investment managers, and I talk to them all the time. And it's a common theme that I think that listeners often don't get this, but it's a common theme that portfolios are built from the ground up, it's there, you know, the portfolio managers that are providing and at least in my experience, the consistent alpha, the added value, the the better risk management, those investment managers are building their portfolios, stock by stock bottom up, and understanding those businesses. And that the macro view is often just a just making sure we've checked all the boxes. And, so I'm glad that you mentioned that I was going to get to that. So alright, so speaking of that, so you know, so again, I'm gonna get back to performance, right. Just a little bit on the on the on this sort of, like we went through this last year, or 18 months, and it seemed extremely weird. And now it feels like investors have this urge or impulse to do something based on the last 18 months because it feels like this is a whole new world. You know, we've we've left the 08 to 2019 world, which was what I call low and slow low, right. slow growth, low inflation, low interest rates. We've left that world and now our high growth, high inflation, and it's a high amplitude, trading type world or something, right. What does it mean if a manager performed well last year on Is there any information in that? Or is it really just like this year was just so different? That it's really not indicative of any other years we're likely to have. Do you want to comment on that? 

Gregory: Yeah, so. So we divided last year, basically into 12 discrete markets Right. And so it's its ups and downs. And, so, you know, if somebody just looked at our performance at the end of last year, and said, Wow, you guys outperformed by 500 basis points in a market, That's weird. You say, Well, that's not really the story, right. We picked up a ton of ground when the market got killed, we kept it, we participated in the up markets, but then we gave up a lot, as the market really ripped in the fourth quarter, right. So, you know, I think, I think you've got to sort of dive in under the hood, and try and understand, right, if you have a manager, you know, that should have outperformed. You want to sort of look at the periods where they did, right, like, we took a lot of comfort in the fact that our portfolio performed as you would have expected it to, and as we would expect it to, meaning when the markets went down, we exhibited defensive characteristics. When the market bounced, we participated, but most times, you know, lagged slightly behind, right up until that fourth quarter period where everything sort of took off. So it's a it's kind of a hard, you know, it's a hard question.

Geremy: Yeah, it is. I, the way I look at it, you know, I just say, I just say, look, a manager gonna have 30 years of history, or 20, or however long and can can be doing their proven process and, have all the intellect that they bring to the table. And, you know, then you have a year, like last year, and has like, for me, you're making a decision based on just last year's performance, which a lot of people are doing, because the one year is in the three year it's in the five year. Right. And, and so making a decision based on last year's performance is not really going to be indicative of any other, well, I don't know for sure. But likely not indicative of any other time period, you know, and so I think investors impulse to do something here might not serve him so well.

Gregory: But I wouldn't say to agree with you. I mean, it's very hard to extrapolate from such an anomaly. Dangerous, that's a dangerous, you know, sort of trajectory to try to build in.

Geremy: Alright. So, um, we're running up against about an hour here. So this has been really helpful for me, it's been really fun. I appreciate you talking to me, and sharing and just being honest, and a real person. And so that's, that's always good. And, so before we leave, though, right. Is there anything that you want? You know, I've, I've, as usual, dominated all the questions. So if there's any, is there anything you want to leave us with anything you want to just mention before we drop off here? 

Gregory: Look, think we've touched on a lot of the most important areas, what we have built, and what we continue to build is a repeatable, scalable process that's bigger than sort of any one person. Right. This is, this is a strategy and a process that has been refined and systematized and, sort of really well honed over time, and we stick to it. Yeah, right. And so if I can leave you with something, it's, you know, we're not always going to outperform their periods where will underperform, but I can assure you, we are not going to deviate from the way we invest. Right.

Geremy: Right. And I think that's another thing that rings true with a lot of tried and true managers is that we do what we believe works. And I wouldn't be talking to you if it hadn't worked. And we do what we believe worked, and then the world will just do what he wants to do. Right. Because if we learned anything from last year, nobody predicted that. No, I mean, like I said, there's 300 books in here in my office, not one of them 2020 in it. So, well Greg, this has been a ton of fun for me. I really appreciate you doing this podcast. I hope you enjoyed it. And again, I thank you.

Gregory: I did that was great. Great fun. How happy to chat whenever, you know whenever you guys want. This was super interesting and really enjoyed it.

Geremy: Yeah, well you said it. I'll just I'll just bring you back one day.

I'm about to do it. Alright. Thanks a lot. All right. Well, by

Shannen: Well, Geremy, I think that interview was a little bit above my head.

Geremy: Did you feel a little bit like there was some fast talk in there over some pretty complex subjects.

Shannen: There was I have a lot of questions for today. 

Geremy: Before we get started on that, do we want to touch on Scott Iverson again? here every time. It's just so catchy. Yeah. So Scott Iverson is the singer of the intro to this segment. And he works at frontier asset management. And so he has the unique confluence of talents of being able to write and play folk songs about investing. And they're always so good. And he was a college football star. Yes. And he's a great all around person. And at the end of it all, he kind of works for frontier. Yeah, some great work for us. 

Shannen: We are pretty lucky. All right. So let's get started with the beta ripper. You are right. I have no idea what that means. Yeah.

Geremy: So that is the I've heard that term, maybe once before years ago, and I perked up when he said beta ripper, because it is such a funny term for a stock, right. And so I think one of the things that happened last year, and specifically post November when the market really took off, and when we realized we weren't going to be locked down forever. And there'll be vaccines is that a lot of the cyclical businesses of the businesses that require a good economy just took off, like instantly. And, so a lot of those businesses and stocks that took off and had the most return in the recovery, were actually the ones that were greatest, had the greatest negative impact from COVID. So for example, like a cruise ship, so if you if you had COVID, you wouldn't have any cruise ships. And if you didn't use your cruise ships, I don't know, you know, how do you make money. Yeah, I didn't make money. And I don't know if you know this, but if you have a boat, and you don't use it, it's it somehow miraculously starts to turn to dust. I mean, everything on it starts breaking. And so there was, you know, a bad situation for cruise ships. And, of course, when we looked like a glimmer of hope that something a business like that would come back, their stocks just took off. I mean, you know, because they were priced for bankruptcy. So the beta rippers, were really the things that you couldn't even grab onto, they just so quickly took off exploded. And, to, and to invest in them, you really would have had to make a binary bet that the world was actually gonna get better. And that though, they would actually survive, which is, typically, when you have those stocks, they typically are in a situation where they either survive or go bankrupt, right. It's not like they're going to muddle along.

Shannen: Yep. Awesome. Well, Gregory spoke about 44% of companies lose money every day. Why is that happening? And how are they still open?

Geremy: Yeah, this is the idea of the zombie companies. And so say, you know, I don't know the exact percentage, he said, 44%, I've seen 40 I think it probably changes each year. But the Russell 2000 is the index of small cap stocks, and there's 2000 stocks in that index. And 40% of those companies in any given year, don't make any money. Right. And then and, but if you just if you just were sort of, you know, dogmatically just went out and buy on small stocks, I'm going to buy the index, which a lot of people invest that way, they're like, I think small stocks are gonna go up, I'm gonna go out and buy the index. Well, when they do that 40% of the stocks that are in that index don't make any money, so they're not being selective at all. So those stocks can be supported by just general optimism around small stock investing. And they survive basically because they have enough cash flow to just pay off their interest. And they have enough clout, I guess you could say or their stock prices remain high enough to be able to borrow against it. And so they call it those are called zombie businesses and specifically the, definition I've seen is that you can stay in business by paying off your interest payments on your debt. revolving your debt, but you're never paying off your debt. So, yeah, so in the long, we talked a lot about long term investing here in multiple market environments. And in the long run, those companies don't sound like they're gonna survive. And specifically, if things are not good in the market, then I guess you would have the, the opposite of the beta ripper.

Shannen: Well, that kind of leads me into the next thing. So they talked about how they can run so much capital and they, you know, invest in companies for so much longer than their peers.

Geremy: Yeah, it was really, I think, Warren Buffett had this great quote that really stuck with me. And he said, "one of the best things you can do when you're picking stocks is to is to think about the stock that you're going to buy as investing in a business that you're never able to sell." So if you had to pick a stock and say, I'm, never going to sell it, you would analyze that business differently than if you said, I'm gonna buy the stock. And I think if it goes to 20, I'll just sell it. Right. So that's short term versus long term. And, and so they view their stocks as businesses that need to survive multi market environments, and specifically bad ones. And so that did lends themselves to picking stocks that they that are much higher quality that they can hold much longer. And I think that's one of the keys to managing a portfolio in small stocks of billions of dollars. Right. You know, a lot of these small stock funds close and, the Neuberger Berman Genesis fund has been managing, you know, you know, close to 10 billion for probably over a decade. There's an another skill in there. It's not just stock picking, right.

Shannen: So let's talk about the GDP print with a handle of six. What in the world does that mean? 

Geremy: The six handle right, so everything in investing is is usually quoted in with one decimal. Like, unemployment, it's 4.5. GDP growth is 6.2. Right. So the handle is the first number. So a six handle means it's 6% and change in some.

Shannen: Interesting. Well, is there anything that you would like to touch on that we haven't talked about yet.

Geremy: I just really enjoyed this podcast, because there's, you know, often, when you think about investing in stocks, you know, you think about individual companies and your trading, and, you know, they're gonna go up, and we're gonna sell them. And then all this, you think about, like, sort of the 1980s style investment room where people are yelling, and trading and all that. And, I like this, because, you know, I've visited a lot of investment companies before, and it really is the, you know, a solid foundation for quality businesses for multi market environments is actually relatively sleepy approach. I mean, there's a lot going on, but, you know, it's a relatively sleepy approach. And, so I think that's really interesting in the small cap space. And then secondly, that you can actually risk manage an equity portfolio. Right. So you, you know, you could be 100% invested in equities, but actually have less risk than the overall market, which a lot of people don't think about. 

Shannen: Anyway, awesome. was always a pleasure recording with you and Sheridan.

Geremy: Yeah, I know. Well, I will be here in another couple of weeks for our annual dude ranch experience. And that's going to be fantastic. I'm just so glad we got to do it. I guess in the age of COVID, there's probably no better place than to be outside and outside with no cell phones, no service,

Geremy: No service. Do you think we'll have the cars driving up the mountain to try to get serviced so they can make their calls? The first every year? Yeah, every year, the first day of the dude ranch. There's a line of cars sitting on top of that little hilltop, yes, where people are talking in the cell phones. And but on the second and third day, there's no cell phones. So most people are enjoying themselves. So anyway, thank you very much, Shannen, see you soon.

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