August 2014
Volume 7, Issue 8

In This Issue
Do You See What I See? Three ideas for changing your investment perspective.

Proof of Concept

 
About Us

Founded in 1995, Daruma Capital Management invests in high-conviction portfolios of no more than 35 stocks.

Our annualized Small-Cap return net of fees is 13.21% vs. 9.02% for the Russell 2000 since inception (7/28/95 to 6/30/14).

Our annualized SMid-Cap performance net of fees is 12.59% vs. 15.83% for the Russell 2500 since inception (4/30/10 to 6/30/14).

Please read the above performance in conjunction with our Small-Cap Equity and SMid-Cap Equity Composite Presentations. Past performance does not guarantee future results.

 
Welcome!  

Drawing, as with most skills, is something that can be learned. In today's newsletter I share how a simple drawing trick unleashed my inner artist and how tricks, similarly applied, can improve your investment skills as well.

(To listen to this month's newsletter, click
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signature - Mariko 
Mariko O. Gordon, CFA
Founder, CEO and CIO
Daruma Capital Management LLC 
 
articleOne Do You See What I See? Three ideas for changing your investment perspective.

For reasons I have long since forgotten, sometime around the age of ten I became obsessed with learning how to draw properly. I wanted my drawings to accurately reflect what I saw - and not look like something sketched by a kid.

This proved to be mission impossible.

And yet, every few years, I would heed the call of my art muse and enroll in a drawing class, hoping that maybe this time someone would teach me HOW. Instead, I was always told to "just go ahead and draw what you see," an instruction that always left me completely paralyzed. (If I knew how to draw, I wouldn't be taking a CLASS, now would I?!)

Happily, that all changed 30 years later, when I signed up for a workshop designed for adult, stick-figure artists like myself. The workshop, a weekend-long event, used techniques developed by Betty Edwards, author of the best-selling book, Drawing From the Right Side of the Brain.

That workshop changed my life. Mostly, because it proved to me that learning anything - at any age - is possible, provided you're willing to break yourself in two.


Upside down drawing

As it turns out, the trick to learning how to draw is in relearning how to see.

Why? Because somewhere along the way, as our brain matures, we start to draw what we THINK we see rather than what we're actually looking at. And while this evolutionary shortcutting serves us well in most instances (it's the reason we don't look at a person standing in profile next to us and wonder where their second arm and leg went), it hampers our ability to really observe things. And to draw well, that's exactly what you need to do.

One of the tricks used by Betty Edwards to rewire her students' brains was to have you copy a simple drawing of a chair. Except ... you copy it UPSIDE DOWN. Somehow, and because a chair in this position is unfamiliar, it turns off the know-it-all part of your brain and appears as just a bunch of lines and angles. Copying it this way leads to a much more accurate drawing.

It's sheer genius, and it literally changed the way I see the world. I was no longer afraid to pick up a pencil, or to learn impossible things, once I realized that my brain is a completely plastic thing.


Upside down investing

My drawing insight made such an impression on me that just this week I shared the story with a colleague. Together, we got to cataloging similar tricks to use when investing - tricks that would allow us to "see better" by shutting off the mind shortcuts we've picked up along the way.

We uncovered three, which I share with you here:
  1. Working the Matrix.

    Kara Lilly, the strategist of Mawer Investment Management and author of the brilliant white paper, "Language Matters," details a technique that her firm dubs "The Matrix."

    The Matrix 

    "At its core, the matrix is a simple tool that allows our team to discuss the relative attractiveness of new and existing stock holdings without falling victim to the weighting problem of language. The horizontal axis grades the company on its return potential, while the vertical axis grades the company on its quality. As a result, every company that we look at gets plotted somewhere on the chart. This allows our team to debate an investment with greater understanding of each other's viewpoints and compare it to other investments."

    I love that the Matrix separates out the qualitative assessments of a company from the quantitative while making it easy to see where disagreements lie, visually. Are people fighting over valuation, or over the quality of management? And, depending on the answer, how best to settle the dispute?
  1. Tapping the subconscious.

    Clearly, decision making that is 100% devoid of emotion is 100% disastrous. But it's more than just that. If you are NOT paying attention to your emotional state when you make a decision, you may also be making a big mistake, something I learned from Denise Shull's fascinating book, "Market Mind Games- A Radical Psychology of Investing, Trading and Risk."

    And so one thing that I've added to our research notes is an emotional scale - a measure that implores us to check in as to how we're feeling about a position. This is particularly useful when there's nothing unusual about the objective information, and yet there's a quiet shift in one's sentiment. It could be the small fizz of champagne in the belly or an oily wave of disquiet in the gut.

    Whatever the case, there are many things that our subconscious picks up through experience and yet reveals to us very, very quietly. Making explicit room for a gut check on a research note might cause us to catch something early or that we might otherwise miss.
  1. Uncovering the plotline.

    This perspective-shifting trick is no doubt the result of my being a comp lit major: Every investment in the portfolio can be tagged with a plotline, something which allows for classification beyond upside/downside scenarios, industry and sectors, or business models. Plotlines include things like "a stranger came to town" (new management); "Lazarus, come from the dead" (turnaround story); and "roll tide roll" (improving demand for a company's products).

    This is fun, and may even seem a little silly. But all investment cases have a narrative arc; this simply puts our case into a verbal shorthand. It's another way to remind ourselves of why we bought a stock, so that, for example, if demand fails to materialize, we can't simply hide in the numbers. This also allows us to measure, for example, if we have a better hit rate with turnarounds or with "bright shiny objects" (new product cycle stories).
In the end, and whether you find these specific exercises useful or not, playing with perspective and assuming that what you see is not really what you're looking at is always a useful investment mind hack - and one that might just be what allows you to see your way to profits. At the very least, your skills as an artist are bound to improve.


 
articleTwo Proof of Concept

And speaking of drawing, I share with you here, two of my own. I'm no threat to the pros, but I'm happy to say that I can finally do what I set out to do all those years ago!


© 2014 Daruma Capital Management LLC


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