October 2008
Vol. 1 No. 2
in this issue

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Daruma Asset Management, Inc.
80 West 40th Street, 9th Floor
New York, NY 10018

About Us
Founded in 1995, Daruma Asset Management invests in a high-conviction portfolio of no more than 35 small-cap stocks.
Our firm is 100% employee-owned, and manages $1 billion for public and corporate pension plans, endowments, foundations and individuals. Our small-cap composite has an annualized return net of fees of 13.5% vs. 8.1% for the Russell 2000 since inception (7/28/95 through 6/30/08). (Notes to Performance

For more information about the work we do, please visit us here


This month's edition of our newsletter takes a look at The Reserve Fund and how to tell if your manager is "walking the talk."

Please reply to share your comments, questions or objections.

All the best,
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Mariko O. Gordon, CFA
Founder and CEO
Daruma Asset Management, Inc.
Reserve Fund Woes... Talking Talk Easier Than Walking Walk

"The lady doth protest too much, methinks."
- Shakespeare, Hamlet, Act III, Scene II

When I studied for the CFA I exam back in the day (that would be the late 80s), the book I most resented lugging around was Marcia Stigum's The Money Market. Nothing against Ms. Stigum, but at a whopping 689 pages, her encyclopedia of short-term money instruments was a space hog.

And as my staff and I went through our periodic purge of the library shelves a few months ago, I held the book in my hands and considered tossing it.

Now I'm glad I didn't. As we collectively try to navigate the financial chaos around us, the book has been a useful resource in sorting out the current battle between free marketers and regulators - a thirty-year brawl dating back to the creation of money market funds that makes the struggle between good and evil itself seem like small potatoes.

When the news broke last month that money market pioneer, The Reserve Primary Fund, "broke the buck," a giant sucking sound was heard throughout the banking system and an epidemic of bad backs caused by lumpy, overstuffed mattresses afflicted the nation overnight. This chiropractic bonanza was set off by the spontaneous combustion of the very first money market fund ever created... if not at the actual Dawning of the Age of Aquarius, at the time the song hit the charts, anyway.

It was sad to see Bruce Bent, who'd skippered The Reserve Fund since inception, hoisted with his own petard: For years, he'd been widely quoted denouncing his peers for chasing yield with ever riskier investments.

However, a bit more nosing around suggested that this comeuppance should not have been so surprising: [Note: Boldface within quotes below added for emphasis.]
  • As early as 1974, in a New York Times article dated June 20th, industry participants revealed dangerous temptations: Harold Kurtz, a dealer in money market instruments, said that a fund was "only as safe as its management" and warned investors against funds that put an excessive amount of capital into illiquid assets.
"Mr. Kurtz feels strongly that bank letters of credit - which make up 90 per cent of the Reserve Fund's portfolio and have a strong bearing on its present strong performance - can be difficult to market." Bruce Bent disagreed with this assessment, of course, however William Berkowitz, a portfolio manager at Dreyfus, presciently observed: "If everybody's going to try to outdo each other on the rate as more funds come along, it will become a game of 'who's paying the highest rate today.' If that happens the only way to improve the rate will be to lower the quality."

  • By 2001 the temptation to chase yield was as strong as ever. Bent again sounds the alarm in the NYT:
"Investors tend to overlook the potential for risk in money market funds. But this is a pattern. Companies are buying garbage in their money market funds, and the public should be made aware of it." In a follow-up letter to the editor, Bent writes: "To this day, none of Reserve's money funds have ever invested in commercial paper. My hope is that money funds that are reaching for yield and buying commercial paper are doing their own credit analysis, because the commercial rating agencies didn't give much warning about the problems with the two California utilities that defaulted earlier this year."

Yeah, well, the rating agencies didn't see Lehman coming, and neither did the fund's credit analysts.

  • By 2008, the Reserve Fund was laden with commercial paper, presumably because as an independent, privately owned firm in a cutthroat market, they felt they had no choice.
Bent, in a January 25th, 2008 letter, sought to reassure investors:

"When we created the world's first money fund in 1970, we clearly stipulated the tenets that define a money fund: sanctity of principal, immediate liquidity, a reasonable rate of return - all while living under the overarching rubric of boring investors into a sound sleep ... We have been "accused" by some of asserting these tenets as if they were dogma, to which The Reserve pleads: Guilty as charged. ... Let us hope that this dance on the precipice will re-instill the objectivity that is crucial to cash management in both the money managers and the investors who have exhorted them to take a flyer."

A cursory glance at The Reserve Fund's semi-annual statement suggests frequent bouts of insomnia were more likely.

Taken together, it is thus not too surprising that broker-dealer Ameriprise is suing The Reserve Fund, claiming that large investors were tipped off about the gaping hole in the portfolio, leaving their clients to eat the losses caused by Lehman going toes up.
While it's ironic that the founder and (for the last 40+ years) most vocal critic of the industry's greed should be the one choking the hardest on worthless Lehman paper, the story of The Reserve Fund has become a modern day Aesop's Fable.

The moral in all this? Simple. Double-check that your fund managers are walking the walk. In addition to the battle between the free markets and the regulated markets, remember the inevitable conflict between the business of managing money (generating fees) and the profession of managing money (investment decisions).

Weekly chart of Russell 2000 stocks making new 52-week lows
As we pick through the rubble looking for new stock ideas, we've made an interesting discovery: Despite current headlines heralding Armageddon, most of the damage to the Russell was done earlier this year. January was a far worse month in terms of new lows, followed by July, when the bottom in small-cap financials appears to have been made.

Famous Last - and First - Words
As small-cap stock pickers we spend loads of time parsing out corporate verbiage, painstakingly looking for hints of change that will make their way into reported numbers.

It's no surprise, therefore, that we're also fascinated by Wordle.net, a free online service that generates "word clouds" from provided text. Using word frequency to determine font size within each picture, Wordle offers a visual glimpse into any written document.

Here, for example, is a calligraphic rumination on death and rebirth: Portraits made from JP Morgan's first published words announcing the purchase of Bear Stearns and Washington Mutual.

Bear's portrait is all about the transaction in a terse 492 words...

While Washington Mutual's announcement is, by contrast, a jaunty meditation on the banking business in a more generous 783 words...

In both cases, the words "Bear Stearns", "Washington Mutual" and "JP Morgan Chase" were removed, for aesthetics. Graphics were created at http://wordle.net using JP Morgan press releases dated March 16, 2008 and September 25, 2008.

© 2008 Daruma Asset Management, Inc.

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