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Quarterly Report for the Period ending 9/30/2000
October 25, 2000
Dear Fellow Micro-Cap Limited Shareholder,
We churned out a stellar 11.3% return in the September quarter. I am quite
pleased.
Our quarterly return roughly matched the average annual return of the broader
stock market over the last seven decades. We beat our primary market benchmark
(the CRSP Index of similar size companies) by seven percent and the Russell 2000
Index of small companies by more than ten percent. Our Portfolio ranked 10th of
63 micro-cap funds in the quarter and 29th of 63 funds over the last year based
on data from Morningstar. Relative to all small-cap funds, we ranked 32nd of 753
(quarter) and 217th of 723 (one year). Our long term "game plan" is not to shoot
the lights out in any one quarter or year, but to beat the market fairly
consistently over longer time periods. If we are successful, we should "work our
way up the longer term charts" over time. So far, we have made a good start.
On October 22, Bridgeway closed Micro-Cap Limited to new investors at $27.5
million in net assets, as promised in our prospectus. This is half the closing
level of any non-Bridgeway fund. It helps ensure that we remain very "nimble" in
the marketplace, thus gaining better prices than would otherwise be possible
when we buy or sell our stocks.
Performance Summary
TRANSLATION: We outperformed each of our market and peer benchmarks over the
last quarter, one-year, and life-to-date periods. I'm quite pleased. Our
financial results according to the formula required by the SEC are listed below.
<TABLE>
<CAPTION>
September Qtr. 1 Year Life-to-Date
7/1/00 10/1/99 7/1/98
to 9/30/00(4) to 9/30/00 to 9/30/00(5)
-------------- ---------- -------------
<S> <C> <C> <C>
Micro-Cap Limited Portfolio 11.3% 48.4% 30.7%
Lipper Small-Cap Stock Funds(1) 3.4% 43.0% 17.0%
Russell 2000 (small growth stocks)(2) 1.1% 23.4% 7.4%
CRSP Cap-Based Portfolio 9 Index(3) 4.1% 30.2% 12.5%
</TABLE>
(1) The Lipper Small Cap Stock Funds is an index of small-cap funds
compiled by Lipper Analytical Services, Inc. (2) The Russell 2000 is
an unmanaged index of small stocks, with dividends reinvested. (3) The
CRSP Cap-Based Portfolio 9 Index is an unmanaged index of 853 micro-cap
companies compiled by the Center for Research in Security Prices, with
dividends reinvested. (4) Periods less than one year are not
annualized. (5) Periods longer than one year are annualized. Past
performance does not guarantee future returns.
Detailed Explanation of Quarterly Performance
TRANSLATION: Our top performing stocks spanned a number of industries and most
sectors of the economy. This was a "stock picker's" quarter, and our models
passed the test.
Twelve of our companies appreciated more than 50% in the September quarter. What
is most remarkable is that these companies represent nine different and
disparate industries. It is unusual, for example, to see both an energy company
and a transportation company on this list, since what is good for one of these
industries is often bad for the other. Rising oil prices helped Carrizo Oil &
Gas. Even though rising oil prices hurt
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Arkansas Best, a trucking firm, the company seems to be doing just about
everything right in managing their costs and their growth in a competitive
environment.
While Magellan Health Services more than tripled in price in the September
quarter, the company that added the most to our absolute returns was
1-800-Contacts, which sells most major brands of replacement contact lenses
through a toll free number and on the Internet. This small firm had been growing
revenues at a fast rate for several years, but just recently reached "critical
mass" so that earnings really started to take off. After a year of losses in
1998, the firm is poised to perhaps as much as double earnings from $0.48 in
1999 to a dollar this year. Representing 6.6% of net assets at the beginning of
the quarter, it was our single largest position. To double our top position in a
three-month period really shows up in the bottom line.
Feast your eyes on this pretty list:
<TABLE>
<CAPTION>
Rank Description Industry % Gain
---- ----------- -------- ------
<S> <C> <C> <C>
1 Magellan Health Services Healthcare-Services 210.0%
2 Carreker Corporation Computers 116.7%
3 1-800 Contacts Inc. Internet 104.3%
4 Carrizo Oil & Gas Inc. Oil & Gas Producers 95.8%
5 Radiologix Inc. Healthcare-Services 70.2%
6 Chico's FAS Inc. Retail 70.0%
7 Engle Homes Inc. Home Builders 62.7%
8 Pitt-Des Moines Inc. Engineering & Construction 59.9%
9 Christopher & Banks Corporation Retail 59.0%
10 Arkansas Best Corp. Transportation 54.7%
11 Gadzooks Inc. Retail 54.0%
12 Taro Pharmaceuticals Industries Pharmaceuticals 52.1%
</TABLE>
Obviously, not everything went up in our Portfolio. Four stocks declined by as
at least 50%:
<TABLE>
<CAPTION>
Rank Description Industry % Loss
---- ----------- -------- -------
<S> <C> <C> <C>
1 Corsair Communications Inc. Telecommunications -72.8%
2 Unify Corp. Software -72.4%
3 Titan Corp. Aerospace/Defense -63.1%
4 Railworks Corp Transportation -57.7%
</TABLE>
Corsair was our second best performing stock last quarter, so it was unfortunate
to see it plunge by so much. Corsair's primary product is being phased out in
favor of a new one. This transition period has Wall Street nervous. The
telecommunications industry also had a very poor quarter overall, contributing
to the decline. Nevertheless, we still like the company.
Top Ten Holdings
TRANSLATION: While our Portfolio is more concentrated or "focused" on a handful
of companies (which can add to the Portfolio volatility, a measure of short-term
risk), we think our overall diversification is very strong. The advantage of
focusing assets on a smaller number of names is that the stocks our models like
best can have a bigger impact on the bottom line, as demonstrated by
1-800-Contacts.
Even after trimming back 1-800-Contacts during the quarter, it still represented
an unusually large 10% of the Portfolio at quarter end. We will be looking for
more opportunities to trim, but our model still really likes the stock.
With 46.5% of net assets in the top ten holdings, the list below demonstrates
one of the characteristics of our Portfolio: at times it can become more
"focused" on a handful of names. I like this characteristic since it
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means that the stocks our models like most can have a bigger impact on our
overall performance. Given our active management style, this would not be
possible if we didn't severely limit the assets under management.
Although more focused on a smaller number of stocks, our holdings are still
quite diversified across industries. The ten stocks represent eight different
industries. Here are the top ten holdings at the end of September:
<TABLE>
<CAPTION>
Percent of
Rank Description Industry Net Assets
---- ----------- -------- ----------
<S> <C> <C> <C>
1 1-800 Contacts Inc. Internet 10.4%
2 Chico's FAS Inc. Retail 7.1%
3 Petco Animal Supplies Inc. Retail 5.2%
4 Patina Oil & Gas Corp. Oil & Gas Producers 4.6%
5 Applied Films Corp. Miscellaneous Manufacturer 3.8%
6 Arkansas Best Corp. Transportation 3.7%
7 Corsair Communications Inc. Telecommunications 3.3%
8 ICU Medical Inc. Healthcare-Products 3.1%
9 Candela Corp. Healthcare-Products 2.7%
10 Sunquest Information Systems Software 2.6%
-----
46.5%
</TABLE>
Disclaimer
The following is a reminder from the friendly folks at your fund who worry about
liability. The views expressed here are exclusively those of Fund management.
They are not meant as investment advice. Any favorable (or unfavorable)
description of a holding applies only as of the quarter end, September 30, 2000;
security positions can and do change thereafter.
Investment Philosophy: "Don't Look"
TRANSLATION: When thinking about the stock market, one of my long-held rules of
thumb is "if it doesn't affect a decision I will make, I don't look." This saves
me a lot of time and helps me focus on the important aspects of my job, like
seeking to discover the next great company.
The industry rule of thumb: track your investments and the stock market closely
so you will know when to bail out or add more. Unless you are a new shareholder,
you probably know that Bridgeway doesn't believe in market timing. Most of the
TV programming and evening news reports about the market are just so much
entertainment. It's probably the worst place to go to gather information you
might use in making an investment decision. When people ask me what the market
is going to do (in the next week, month, or year), I usually ask, "Why do you
care?"
That may seem like an unusual non-answer to a question that affects the account
value of each shareholder and the revenues of our firm. But as a contrarian, if
I had to make an investment decision based on a news story, I'd do the opposite
of whatever is being suggested. Better yet, I'd simply get a long-term plan, put
it in place, and ignore the "noise." The people who have made the most money
with our portfolios are the ones who made an early investment and just let it
ride. A friend of mine, who is not a wealthy man, was the first shareholders on
the date of inception. Each $1,000 invested by June 30, 1998 was worth $1,829 at
the end of September. That's nice appreciation for just 2 1/4 years, but it
still doesn't answer the relevant question, which is, "How much will it be worth
on the day he retires and needs to start spending it?" That's the only really
relevant question, because the account values in between are "just so much
noise."
Since Bridgeway's position is that predicting the market is a fruitless
exercise, my rule of thumb: if it doesn't affect a decision you make, don't
look. Most investors waste a lot of time tracking historical events that cannot
be used to make good current decisions. I frequently go home without knowing if
the market
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was up or down that day. There are three computer screens in my office and none
of them carry the market indexes. I seek market information at three times: 1)
when I am helping work a trade, 2) when I review fund accounting statements, and
3) when I review fund performance, for example, for this letter. In a more ideal
world, I would only look quarterly or annually.
So if you find yourself looking up our net asset value in the paper every day
and getting nervous, think about whether our rule of thumb would work for you.
It would thrill me to think that one shareholder read this, put the newspaper
(or this letter!) down, and spent the extra time with their child, parent, or
friend.
How does a Growth Fund Become a Value Fund?
Please note: This section doesn't have to do with the Micro-Cap Limited
Portfolio directly. The purpose of this section is simply to indicate one reason
I think the outlook for this "value slanted" Portfolio is strong. In addition,
it highlights some interesting "shifting ground" within the mutual fund and
investment industries.
TRANSLATION: Answer to the question above: When everyone else dumps value stocks
to buy even faster growing growth stocks. The market has been so enamored with
growth stocks over the last three years that my intuition (and in this case,
also my models) say it is a good time to make sure you have some exposure to
cheaper "value" stocks.
After more than five years (1994 through mid 1999) of the most dramatic
appreciation of large company stocks relative to small ones in the last seven
decades, large company stocks as a group are very pricey. Very small company
stocks, on the other hand, still appear quite cheap by most benchmarks of value.
For example, the average PE (price to earnings ratio) of the S&P 500 Index of
large companies is 35, three times that of Bridgeway's Micro-Cap Limited
Portfolio.
Not long ago, we got a call from a prospective shareholder about our Ultra-Large
35 Index Portfolio. The caller wanted to know why Morningstar listed the fund as
a value fund. With a PE of 36 and a three-year earnings growth rate of 18.5% on
June 30, I considered this portfolio to be much more of a growth fund than value
fund on an absolute basis. I was puzzled. Morningstar had previously listed it
as a "blend" fund, which I thought was accurate since it does own both growth
and value companies. It looked plenty expensive to me. After looking into it, I
discovered that while the Ultra-Large 35 Index Portfolio had "stayed still,"
that is, held the same stocks as previously, more and more portfolio managers
had "thrown in the towel" on value stocks and joined the growth bandwagon, which
had dominated for several years. Since Morningstar's designation is relative to
other funds, the Ultra-Large 35 Index Portfolio actually showed up in their
rankings as a value fund. This caused me to ask the question, "When is a value
fund (according to Morningstar) really a growth fund (based on classical
benchmarks)?"
As a contrarian, this just looks like one more shred of evidence supporting the
view that now might be a good time to own some cheaper value stocks. Does that
mean I am "macro-managing our portfolio" or overriding our models? No. I'm still
just buying one stock at a time. But our models aren't picking up on as many
"expensive" growth stocks right now.
Conclusion
As always, we appreciate your feedback. We take it seriously and discuss it at
our weekly staff meetings. As a result of a recent shareholder suggestion, we
are adding a line at the top of page one to let you know if this is an annual,
semi-annual, or quarterly report and for what time period. Please keep your
ideas coming.
Sincerely,
/s/ John Montgomery
John Montgomery
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