Bloomberg's Inside Active Podcast - Interview with Bryan Wong

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David: Welcome to Inside Active, a podcast about active managers that goes beyond soundbites and headlines and looks deeper into their processes, challenges and philosophies and security selection. I'm David Cohne. I lead mutual fund and active research at Bloomberg Intelligence. Today, my co-host is Michael Casper, US Small Cap and Sector Strategist at Bloomberg Intelligence. Mike, thanks for joining me today.

Mike: Thank you, David.

David: So you wrote an interesting note last week on the connection between small cap stocks and M&A. So how do mergers and acquisitions affect Russell's 2000 performance?

Mike: Yeah, well first a recap of what happened in 2024, and it was the weakest year we had on record going back to about 2000 with the last quarter of 2024 being particularly bad, just two deals worth a paltry 4.4 billion in the fourth quarter. But that capped a year where there was only about 52 deals, that was worse than 2008's 61 deals and making it the worst, going back to 2000.

Now you might be wondering where did that dip come from? It was definitely in financials. They made up just 9.3% of last year's 54 deals. Typically, they average around 18.3% or so of deals annually, going back to again, 2000. So really the big departure was in financials. Only energy though saw more deals than its pre-pandemic and ex-Great Financial Crisis average.

But why does this really matter for small cap stocks? At the end of the day, small cap performance and the amount of M&A, so the amount of targets in the small cap index are pretty closely linked. So if you look at calendar year performance of the rest of 2000 and deal count-

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Mike: - value in the correlation between the two, Russell 2000 annual performance, calendar year performance, is 0.52 correlated with deal count and it's 0.4 correlated to deal value. So a pretty significant positive correlation there. Obviously as takeouts accumulate, it drives a premium for some of these small cap stocks in some of these sectors. And one of the cool things, just before I give up on this, one of the cool things we did that I want to mention, is that we tried to look for commonality across these takeout targets in the Russell 2000, going back to again 2000 or 2001. And what we found the commonality amongst them was most of them had positive EBITDA for the year prior to the deals announcement. Over 60% of all those deals going back to 2000 had positive EBITDA. 72% or so were cheaper than the index median EV to EBITDA. And about 70% had lower net debt to EBITDA, so lower leverage than the median stock in the Russell 2000. So we did a nice little takeover target screen looking at companies in the Russell 2000 today.

David: That's great. So if we are talking about small caps, I think it's a great time to welcome our guest. I'd like to welcome Bryan Wong to the podcast. Bryan is Vice President and Small Cap Growth Portfolio Manager at Osterweis and a manager for the Osterweis Opportunity Fund, ticker OSTGX. Bryan, thanks for joining us today.

Bryan: Thanks for having me, David.

David: So I'd like to begin by asking you how you got your start in the investment business.

Bryan: Sure. Well, I went to college at Yale. I was a political science major, so a great training for investments of course. And really what I was focused on studying in college was the grand strategy of countries. So I wrote my senior essay on the grand strategy of Deng Xiaoping, who's really China's sort of modern leader following Mao Zedong, really opened up the economy there, but still preserved capitalism with Chinese characteristics. And when I was graduating from college, I got a great opportunity to join a long/short hedge fund run by a Yale history major, Dan Wohl, who really saw how my skill set might translate. And so the first book he gave me was Competitive Strategy by Michael Porter. So really I went from studying the grand strategy of countries and leaders to companies. That was just a tremendous opportunity to learn the craft of investing.

The senior analyst at the firm was a fellow by the name of Sal Khan who went on to found the Khan Academy. And so I remember just sitting with Sal after work, many days seeing him watch him record these videos of him tutoring his cousin in math and really sort of grew to appreciate the power of technology, obviously leveraging a new model of distribution, YouTube, to reach a much broader audience of millions of people. And the idea of using technology as this efficiency driver, you can record something once, but obviously the content is forever.

And then additionally, I think just this idea of scaling by creating value for others. Dominant companies don't start out that way. Every entrepreneur has humble beginnings, an idea, it requires very hard work. So that was a neat experience to see very early on in my career. And so when Sal left to start Khan Academy and Dan retired, I joined the Packard Foundation, which is now run by Kim Sargent, a disciple formerly of the Yale Endowment. And there I learned the value of long-term investing. And for the past decade I've been at Osterweis applying sort of what I've learned through those three, two former stages of my career. First, the idea of strategy and competitive advantage. Second, the long-term focus, and third, this idea of how do these companies start out from something small and scale to become something very significant. So I'm very fascinated by that and that's what I've been applying for the past decade.

David: So let's kind of dig into the Opportunity Fund. It sounds like you started getting into the philosophy behind the fund strategy. Can you, I guess, give us a little bit more about that philosophy that you're using, I guess, for the investment process of this?

Bryan: Yeah, I guess just to take a step back even before we talk about the philosophy, I mean why be in small caps at all? I think it has to do with this defining characteristic of capitalism, which is this what makes America exceptional, right? It's innovation and sort of this process of creative destruction whereby smaller companies and entrepreneurs come up with newer, more innovative ways of doing things, they offer superior value to customers and improve lives. So I think I very much believe in that fundamental process.

And then if we move to active management, we firmly believe there's a value of active in small cap. And you start with the idea that small cap is inefficient. You have a universe of emerging companies with limited analyst coverage. So it's certainly an area where active management can add value. I think Morgan Stanley did a great study where they found the cumulative median alpha by active managers in small cap was nearly 60% over the past 30 years. It's very different versus mid cap and large cap.

And then third, similar to private markets, the best managers, and I'm really talking about the top quartile, the top decile, can add tremendous value. And that's similar to kind of like an institutional investor looking at private equity or venture capital. You don't want to be in sort of venture capital just for the sake of being in venture capital, you really want to be in a top quartile type manager. And so those are the things we believe.

And if you then layer into kind of our strategy, we think we have a few key advantages. First, all we do is small cap, at least my team of four, we focus on this emerging company universe. We happen to be located in San Francisco, which obviously gives us a backdoor seat to a lot of the innovation, particularly in the technology and healthcare sector.

Second, our team experience, again, I mentioned the four of us as industry specific sector analysts. Third, an absolute valuation discipline, which I'm sure we'll get into later, but every name has to have at least 100% upside at the time of our purchase. Over a five-year time horizon, we use no more than a 30 times P/E multiple in our five-year model estimates. And then finally fourth, a high conviction portfolio. So on average we have about 40 names in our portfolio, so fairly concentrated. And so what that gives us is this portfolio of innovation and growth, but it's also tethered to reality and valuations. And we think that's the secret sauce to full cycle returns and the alpha we've been able to generate over time.

David: So I know quality is an aspect that you're looking for. Is there anything that you would define quality as? Any specific characteristics?

Bryan: Yeah, I think traditional managers would certainly look on wide motes, high return on invested capital, that sort of thing. And I think quality has a number of different dimensions as you said. We like high return on invested capital businesses just as much as everyone else. But I think sometimes the opportunity in this emerging company universe is to have a more forward definition of quality and sort of as Gretzky said, "Skating to where the puck is going to be." So we're much more forward-looking than sort of backward looking.

So in addition to kind of the playbook of being able to buy high return on invested capital businesses when they sell off, we want to kind of be diving into the mystery of the emerging company universe and think about these future forward-looking quality metrics. And so certainly we care about competitive advantage, but I think frequently there's an innovation component which we're looking for. There's a strong margin expansion component. So we're often focused on incremental margin as opposed to just current margin. And then we're focused a lot on management obviously, and trying to invest with these entrepreneurial management teams that set ambitious objectives but also have a clear plan and track record upon which they can execute towards those objectives.

Mike: And you mentioned P/Es as one of the metrics that you use. How do you feel about equity valuations broadly? And are there any other metrics that you like to use for valuing stocks?

Bryan: Yeah, our primary valuation metric is long-term earnings power. And so we have a process, we call it this anchor point, where we're focused on intrinsic value five years out. So we're oftentimes looking, we're trying to understand the unit economics of these companies. Everything we do is focused on fundamental bottoms up research. And so if you break down revenue of any company, there's often a volume component and a price component. A company can sell a certain amount of widgets and charge a certain price per widget, and then you layer on the incremental margins, you arrive at the earnings per share target. And so upon which we apply no more than a 30x P/E multiple to those five-year estimates, and every company to enter the portfolio has to have at least 100% upside on those metrics. So that is the primary valuation metric we use. We do look at other relative valuation metrics, EV to sales, EV to EBITDA, things like that but the primary metric is really the five-year earnings power and the intrinsic value of these companies.

David: I wanted to do a follow-up on, you were talking about management teams just a few moments ago. What are the exact qualities, I know you mentioned having ambition and having good products. Are there any other, I guess, qualities you look for in management teams?

Bryan: Yeah, management, I mean, there's kind of the science of investing and I guess there's the art, right? And I think management is much more of an art than a science. To say there's one way of managing a company, obviously every company can be very different, but I think the best entrepreneurs do, if you look at just the Magnificent 7 for instance, I mean the most successful companies were all sort of founder-led, these folks who are driven to change the world and have been able to scale the companies in remarkable ways. I don't think every founder has the capability to scale to those levels, obviously, but those are the most successful outcomes.

But we do analyze culture of companies, even Glassdoor reviews, things like that. We certainly like to take advantage of our location again, being in the Bay area, being able to access private companies, venture capitalists, competitors, suppliers, kind of the traditional Phil Fisher scuttlebutt work. And then ultimately, I think somebody once told me the best managers do set low expectations and constantly surpass them. Not to say that they're unambitious expectations, but if you can consistently outperform relative to the expectations you set, that's a very good thing.

Mike: Are there any sectors you currently find particularly compelling? And one of the things I'm focused on in 2025 is the sector rotation that moved away from tech, especially in large caps, do you think that could last in 2025?

Bryan: I am hopeful. I personally spend a lot of time in the Technology sector, but you're absolutely correct that when you look at the drivers of the S&P 500, obviously they're very much concentrated in the Magnificent 7 or 8. One of the interesting things about the small cap universe is to some extent we've seen that broadening. So if you look at the drivers of the returns in the small cap space, it is not solely technology. And certainly for our strategy, we've seen great performance in Consumer, in Health Care and in Industrials and other sectors. So I think we're already starting to see some of that broadening. We haven't seen it to the extent in the S&P 500, but I think some of that will depend on obviously whether Technology can maintain its leadership, particularly in AI and whether some of these other sectors can broaden out, certainly with the new administration that there is some reason to be supportive of the overall economy.

Mike: Yep. And it's good that you bring up the new administration. Do you think that any of the election results changed any of your investment theses?

Bryan: Yes and no. I mean, I think we are much more focused on the secular growth themes of Technology, Health Care, just more innovation throughout the economy. Consumer businesses are always offering better value to customers, companies like Sweetgreen and restaurants along healthier living trends or e.l.f in beauty and cosmetics offering sort of value at a good price point. And so those don't tend to be correlated as much with sort of administration changes, where you might have more cyclical factors of Industrials being more in or out of favor.

But I do think on the margin, obviously we're paying attention to tariffs, we're paying attention to the drive towards government efficiency. But I think the most positive factor with the administration is there does seem to be a renewed focus on innovation and technology in general. So obviously you have JD Vance who is formerly a venture capitalist, there's reasons to think he might be better for little tech as opposed to just big tech, which would benefit the small cap space as well as venture capital. And you have Elon and other folks who are driving efficiency and innovation, which I think is good for America and good for small cap.

Mike: And I've been really focused on rates, and obviously the rate picture's increasingly more up in the air as we get into 2025, but I've been really focused on rates as a catalyst for small cap stocks to kind of narrow the gap with the S&P 500. What do you think the catalysts are for maybe a small cap resurgence this year?

Bryan: Yeah, I think a stabilization in rates is really the key. We've never wanted to make explicit bets on rate cuts and things like that, although we understand the market does that for us and may have gotten a little bit ahead of itself maybe let's say six months ago. But now I think the general consensus, we'll see maybe one or zero rate cuts. Again, I think putting the past five years in context, rates on the 10-year went from close to zero, maybe 50 basis points to 4.5%. And so that was a big headwind for small caps. And now I think there's a debate of do rates tick down a bit or tick up a bit. Again, putting this all in the context of the past five years, I think the most important takeaway is nobody's expecting a four or 500 basis points increase in rates, right? We seem to be entering a more stabilized period of interest rates broadly, and I think along, combined with a strong economy, that's going to be a very positive thing for small caps.

Mike: And since I talked about it at the beginning of the segment, what do you see as the outlook for IPO and M&A? Do you see a comeback after this really weak two-year stretch that we've had?

Bryan: Certainly. So I think we're already starting to see it. We've seen a trickle of technology IPOs, but you're correct that following a rowless 2020 and 2021, '22, '23 and '24 were fairly meager. That window is beginning to lift. I follow the private technology ecosystem very closely. Supposedly there are 1,500 private unicorns with valuations of a billion or higher, and I think there's been a strike by the private markets to really underwrite the lower valuations that are necessary in some cases to take those companies public.

Obviously many of these companies were funded during a period of very low interest rates, and so there's been a disparity in terms of private versus public market valuations. I think certainly the lower regulatory environment going forward, the certainty of the new administration will be positive catalysts for that, and I think that's necessary. I think there's been this trend of companies staying private for longer. I'm not sure that's such a good thing, and I think we'll want to see smaller companies come public sooner.

David: You had mentioned the portfolio is pretty concentrated. Do you have any, I guess, things in place to manage portfolio risk?

Bryan: Yes. I think when we look at portfolio risk, first and foremost, we are looking at the risk of losing capital as opposed to solely volatility, although you can screen our portfolio on Sharpe ratios and downside capture ratios, and we happen to look pretty attractive on those metrics. I think part of that is due to our absolute valuation discipline and our general, each company has to have at least 100% upside again at the time of purchase, we use no more than a 30x P/E on those price earnings estimates. And then we're generally trimming when the upside falls to 50% or lower as opposed to a pure buy and hold manager. We're not willing to hold an exceptional company at an infinite price. And so we're quite disciplined about that.

The best companies that stay in the portfolio over multiple years have to continuously prove themselves in terms of the upside, otherwise we'll trim and sell the lesser companies as they become more fully valued. So our best defense is really our knowledge, I think of the individual portfolio companies. We certainly want to know the key drivers of these companies as well or better than anyone else. To mitigate the concentration though again, we have a 5% max position limit, so we're not going to hold companies above a 5% weight because we recognize there can be additional volatility and risk associated with that. But really it is our knowledge of these companies and our absolute valuation discipline.

David: I had one follow up question to that. You mentioned trimming companies, and so I'm curious, are there any other things you look at, I guess, would trigger a sell in the portfolio, not just trimming if a company gets too big?

Bryan: Yeah, we sell for one of three reasons typically. One, the position becomes fully valued, two, to upgrade to better opportunities, or three, I mentioned this anchor point concept we have whereby we're really looking out five years into the future and trying to anchor to these estimates of intrinsic value. If those companies are failing to meet those objectives over time, which does happen, that's a third reason we sell.

Mike: So I've been following fundamentals for small caps for some time, and it looks like consensus is very weak for the fourth quarter earnings season. Are there any macro factors you're watching that might help turn the tide on fundamentals?

Bryan: I think interest rates and valuations would be the main thing we're focused on. In addition to just company earnings. I think the biggest debate in the market right now is technology and AI. I was just at a conference the other week, and so I think the biggest question in the market right now is perhaps AI probably has the most promise of any technology we've seen, right? Because it's TAM unconstrained in terms of being able to address labor and services, not just tools and software spend, but because of that it can be prone to over hype. And so I think a lot of Fortune 1000-type companies want to bet on a technology that's well understood and minimize risk. I think with Cloud there was much more consensus over the value of Cloud, and even then I think you saw some companies be resistant for some time. So with the risks of hallucinating, I think it's hard to see widespread enterprise adoption right now. Certainly from a consumer standpoint, it's easier to see adoption there.

I think another area that folks are wondering about is the scaling laws. We're quickly exhausting all the data upon which we're training these models and we're using increasingly synthetic data and reasoning and trying to see how that progresses as well, as well as the return on invested capital versus the CapEx. So these hyperscalers are all extremely well-funded, the Microsoft, Amazon schools of the world, and they can support this CapEx I think for some time, but at a certain point it starts diminishing your free cash flow. And so it's striking to me that a company like Microsoft is reporting a decline in its free cash flow per share this year. I think investors might overlook that for a period, but over time you obviously want to see the growth and the free cash flow.

And so Sequoia put out a good paper, I think last year on AI's 600 billion dollar question asking whether the return on this 200 billion of NVIDIA data center spend is supported by the 600 billion in revenue, software and application revenue, which we've yet to see. So I think that's the biggest debate in the market right now. I know that's less of a macro factor, but in terms of thinking about something I'm watching in terms of secular growth trends.

Mike: Yeah, that's definitely interesting. And did you have any major takeaways from the third quarter earnings season? And is there anything you're watching as fourth quarter results start to roll in for small cap companies?

Bryan: No, I mean I think it's mostly a function of what I just described. I think we're trying to think about the broadening, I guess, first and foremost what's happening in the Technology sector, but second, also the broadening of the economy, certainly with industrial economy ISM, data like that as well. But again, our focus is more on secular growth and whether these companies are tracking towards these long-term anchor points. I think during the Dot-com bubble, Jeff Bezos said it best. I think his stock, Amazon, was down something like 80, 90% at one point. But he was talking about how by any measure, Amazon was stronger than a year ago. Its customer account had increased from 14 million to 20 million. Its sales had climbed over 68%. Its operating loss had narrowed. And so we're trying to think about these fundamental metrics in terms of the drivers of unit expansion and incremental margins that are creating heavier and heavier businesses over time because in the short term, the market is a voting machine, but in the long term it's a weighing machine and we're trying to invest in these heavier companies over time.

Mike: And you mentioned the AI investment maybe not justified by the payoff as a risk. Are there any other big risks you see the stocks this year?

Bryan: Well, certainly as we've touched on, I think interest rates and valuation metrics would be the concern. So those are factors we will be following. I think the market is relatively expensive by traditional metrics. One of the encouraging factors on small cap is, relative to large cap, we are undervalued on a relative basis. And certainly small caps have underperformed large caps over the past decade. I think it's the longest stretch in history.

Traditionally, obviously there's been this small cap premium. I think over the past 97 years, if you invested a dollar in small cap versus large cap, you would've ended up with over four times your money in small cap. So that hasn't been the case for the past decade. There's good reasons why that is the case with the rise of these Magnificent 7 companies and so forth. But market's trends don't tend to last in one direction forever and we think there's a real opportunity for mean reversion here. As a small cap has underperformed and the valuations are relatively cheaper, that should bode well as the economy broadens. And we could see some momentum in small cap. And then again, additionally, an active manager doesn't have to invest in the whole asset class but can really invest in the most exceptionally well-positioned companies within the asset class.

David: Well, it'll be something to definitely look forward to, but before we let you go, we'd love to hear what some of your favorite reads are. Any favorite financial books you like?

Bryan: Yeah, I began talking a little bit about the Phil Fisher scuttlebutt type work, attending conferences, industry events, expert networks. We mentioned kind of our location here in the Bay Area. I remember one investment we made in a software company called Avalara for sales tax collection. Obviously there's only two certainties in life, death and taxes. And so I remember going to some of these tax conferences and hearing from the California Department of Tax and Fees that they're expecting additional 1.5 to 2 billion revenue back in, I think the 2018 or 2019 timeframe because there was a Supreme Court decision called South Dakota versus Wayfair, which ruled that it overturned the physical presence requirement where if you bought something on Amazon, let's say from California, but it shipped from Texas, Texas couldn't collect state tax on that unless the seller had a presence in Texas. And so when the Supreme Court overturned that ruling, there was a huge rush to tax a broader jurisdiction so Avalara was well-positioned for that trend.

And so the scuttlebutt, I mentioned in terms of that primary due diligence, really is the craft of small cap investing. And Phil Fisher very much pioneered that with his book Common Stocks and Uncommon Profits. I think one of the questions he always asks management teams is, "What are you doing that your competitors aren't doing?" Because you really have to sustain innovation to drive future appreciation in your business.

And then the second book, I think, is a book called 7 Powers by Hamilton Helmer, and it's a little bit an extension of Clay Christensen's work on the Innovator's Dilemma, but he has a concept called "counter positioning," which is very, very powerful in small cap. And a classic example I think is Netflix versus Blockbuster. So when you looked at Blockbuster's business, they were challenged in a couple different ways, not only with sort of the Internet distribution model, changing that from brick and mortar, but also if you looked back at their business, I think a substantial chunk of their income was derived from late fees. And so when you had a newer incumbent like Netflix rise, they were able to compete in a way that Blockbuster was really powerless to sort of respond to because to compete, they had to not only change their business model in terms of the generation from late fees, but also the brick and mortar model to Internet. And so we like this idea, but whereby new companies can counter position against legacy incumbents.

David: That's an interesting point. I guess I never really thought about all those nights going to Blockbuster years ago, the late fees drove so much of their revenue, but definitely makes sense. This was great, Bryan. Thank you so much for joining us today.

Bryan: Thank you.

David: Mike, thanks again for being my co-host today.

Mike: Yeah, thank you both.

David: Until our next episode, this is David Cohne with Inside Active.