On Daruma's Watch
monthly small-cap insights for investment professionalsNovember 2008
Vol. 1 No. 3
This month's newsletter provides signs of hope in an otherwise dismal market, as well as my reminiscences about "Barry" Obama.
Please reply to share your comments, questions or objections.
All the best,
Mariko O. Gordon, CFA
Founder and CEO
Daruma Asset Management, Inc.
In Search of the PoniesWhat this dungheap of a market needs is a pony. Yes, a pony.
Maybe because it's election week, maybe because I came of age when Reagan ruled the roost. Either way, I have been thinking a lot lately about his favorite joke, as described by Reagan speechwriter Peter Robinson:
"The joke concerns twin boys of five or six. Worried that the boys had developed extreme personalities - one was a total pessimist, the other a total optimist - their parents took them to a psychiatrist.
"First the psychiatrist treated the pessimist. Trying to brighten his outlook, the psychiatrist took him to a room piled to the ceiling with brand-new toys. But instead of yelping with delight, the little boy burst into tears. 'What's the matter?' the psychiatrist asked, baffled. 'Don't you want to play with any of the toys?' 'Yes,' the little boy bawled, 'but if I did I'd only break them.'
"Next the psychiatrist treated the optimist. Trying to dampen his outlook, the psychiatrist took him to a room piled to the ceiling with horse manure. But instead of wrinkling his nose in disgust, the optimist emitted just the yelp of delight the psychiatrist had been hoping to hear from his brother, the pessimist.
"Then he clambered to the top of the pile, dropped to his knees, and began gleefully digging out scoop after scoop with his bare hands. 'What do you think you're doing?' the psychiatrist asked, just as baffled by the optimist as he had been by the pessimist. 'With all this manure,' the little boy replied, beaming, 'there must be a pony in here somewhere!'"
Whether you're a Democrat, Republican, Libertarian or Anarcho-Syndicalist, I think you'll agree that it's time to start looking for the pony in the dungheap of financial news ... if only in the interest of retaining our sanity.
If you're unwilling to soil your hands, don't despair; I have dug through the dungheap and pulled together evidence that there may be a market recovery buried here after all. The examples - all from unimpeachable sources - point convincingly to "a pony in here somewhere":
"The net consumer impact of a 3% slowing in wage growth next year would cost the consumer $198 billion but the scheduled rise in Social Security benefits would add about $106 billion. The decline in energy costs could save the consumer $137 billion, while a reduction in debt payments saves another $32 billion. It all adds up to a $77 billion positive flow for consumer savings, spending or both." [our emphasis]
As of the beginning of October, neither bank lending to nonfinancial corporations and individuals nor commercial paper issuance by nonfinancial corporations has declined sharply; rates have NOT risen to unprecedented levels; banks do NOT play a large role in channeling funds from savers to borrowers; interbank lending is alive and well.
So perhaps the credit crunch may hit Main Street just a smidgen less hard than Wall Street fears.
3-month LIBOR is now yielding 2.39%, down from a peak of 4.82% on October 10. The TED spread is down to 2.01% from a peak of 4.63% on October 10. The two-year swap spread is 108.75, down from 165 in early October. The spread on A2/P2 commercial paper has declined to 3.82% from 4.72%.
All of these measures indicate that investors are slightly more willing to take on credit risk. Fixed income colleagues confirm that the fixed income market is by no means defrosted yet, but it's beginning to thaw ever so slightly.
- Money market assets as a percentage of total U.S. market capitalization (28.3%) have now surpassed even the extreme levels seen in late 2002 and early 2003. In other words, a fat pile of cash awaits a buying spree.
- The year-over-year change in the S&P; 500 plus the year-over-year change in the 10-year treasury yield is three standard deviations below the 50-year mean, a level last hit in March of 2003. In other words, the pendulum has taken a hard swing to one side and is poised to move back towards the middle (again, more bargains to be had).
Taken together - extreme risk aversion, plus the relative attractiveness of stocks, plus anomalous market behavior - these factors bode well for a resurgence.
And finally, last month, at the market's lowest point, we ran a simple screen on our investable universe (i.e., up to $2 billion in market cap and must trade at least $1.5 million a day). We found 112 companies trading below their tangible book value.
Some have debt and some are losing money, but these are hardly fly-by-night companies. The fact is, we are starting to see loads of high-quality companies drop into our market cap range for the first time in YEARS, something which makes us very excited.
We are also starting to see stocks that had defied gravity for months - their earnings march to a different drumbeat than the economy - start to suffer from multiple compression and come down sharply.
Shovel in hand, we are now happily making our way through the muck. In our experience, when the dungheap is this big, not only are we more likely to find a thoroughbred than a mere pony, we can be sure to get him at a great price.
That's President-elect Barry to YouWow. It was surreal watching the election results Tuesday night. I still can't quite believe a high school classmate of mine is now the president-elect of the United States of America!
There were 420 of us in Punahou's class of 1979, lo those many years ago in Hawaii, and who'd have thunk any of us would turn into responsible adults? Barry was charming, affable and smart, and he kept well-hidden the adolescent angst he describes in his book.
If you want to know more about the teen-aged Barack Obama, the class of 1979 has published a collection of reminiscences, Our Friend Barry, downloadable here.
Here's a photo from our senior year. I was the editor (back row, left) of the Ka Wai Ola, the literary magazine. Tim Robinson and Tommy Krieger, good friends of Barry's and shown sitting next to him, contributed many wonderful drawings. Barry happened to be walking by when our photo was being taken for the yearbook, and because we were a pathetically small group, we asked him to join us and paper the house. This is likely my one and only presidential photo op!
Daruma Sponsors Exhibit at Japanese American National MuseumDaruma Asset Management is the proud sponsor of the Dreams to Dreams exhibit at the Japanese American National Museum in Los Angeles, December 6, 2008 through January 4, 2009.
The show features over 40 talented artists, each of whom has designed an urban vinyl Daruma figure. Urban vinyl collectables have become a global pop culture phenomenon, and it's high time Daruma, a 5th century monk, entered the 21st Century.
If you can't see the show in person, visit the JANM online store to get a closer look at a post-modern Daruma.
About UsFounded 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 roughly $1 billion for public and corporate pension plans, endowments, foundations and individuals. Our small-cap composite has an annualized return net of fees of 13.0% vs. 7.8% for the Russell 2000 since inception (7/28/95 through 9/30/08). (Notes to Performance)
For more information about the work we do, please visit us here.
© 2008 Daruma Asset Management, Inc.