On Daruma's Watch

monthly small-cap insights for investment professionals

December 2008
Vol. 1 No. 4


This month's newsletter takes a look at five "vital signs" for gauging the health of the small cap markets.

Please reply to share your comments, questions or objections.

All the best,

Mariko O. Gordon, CFA
Founder, CEO and CIO
Daruma Asset Management, Inc.

Not Dead Yet - 5 Vital Signs for the Small-Cap Market

One of my favorite books on investing is legendary money manager Marty Sosnoff's Humble on Wall Street, published in 1975. It's a hilarious romp through the late-60s gunslinger's market and the vicious 1974 bear market.

The war stories contained within remind me that precious little has changed when humans and markets collide. Among the many gems, the following unforgettable lesson is my favorite:

"In the late Sixties, a group of superspeculators met monthly over dinner. A dozen of us would sit around and tell our most promising stories. I heard thousands but the best we all agreed was the one about pompano. They were to be raised in a controlled environment - a super fish farm. There is never enough sweet pompano to go around and I think the price per pound was a dollar fifty or two bucks. The company was going to hatch the eggs, grow the fry in tanks and then raise them to a couple of pounds and ship out five to ten million pounds of fish a year and make $10 million from a standing start.

"We all tried to shoot this one down. What would happen to the price of pompano if 10 million incremental pounds came on the market? Could Ralston Purina ship enough feed to grow the fish? How would they taste? How proprietary was the process? All our questions were answered and some of us even went down to Florida to watch the eggs hatch and inspect the fry swimming around in the 2000-gallon tanks. It was all very exciting and we saw every fish house in the country featuring fresh pompano a la carte till the end of time. We couldn't wait for the next monthly meeting to find out how fast the fish were putting on weight. Then the news hit us - all the fish had sickened and died. Nobody at the company knew why. The fish had died and we all burst out laughing hysterically - laughing at ourselves for none of us had dreamed that the fish could die. This is bull market thinking - the fish never die."

Given that this grizzly of a bear market has flung a lot of dead fish around, I thought I would remix Sosnoff's story with an idea from Calculated Risk, our favorite credit market blog. Specifically, we've come up with our own list of vital signs for the small-cap market (and the fish that are still swimming).

We call it the Daruma Pompano Index (DPI). Here's how it works...

We ran an elementary screen on November 30th, deliberately casting our net wide: Stocks at or under $2 billion in market cap; listed on the NYSE, Nasdaq or the AMEX; with sales of some kind, even if only one dollar. 3,736 companies made the cut.

DPI findings regarding these companies:

  • 348 (9.3%) are up for the year, which is not too shabby in this environment. The median increase was 15%, market cap was $391 million and stock price was $16.
  • Almost half (1,669) are trading under $5 and 506 of those are actually trading under a dollar. A year ago, only 65 of this very same group of fish traded under a dollar, and a mere 680 traded under $5.
  • In 2008 there are 1,017 companies trading at a free cash flow yield of 10% or higher. A year ago, only 423 of these were so cheaply valued.
  • 108 are trading below the net cash on their books, versus 11 a year ago.
  • 21 are trading below net-net working capital (Ben Graham's favorite metric), compared to zero last year.

So there you have it: the five vital signs of small-cap life worth watching. We'll update these monthly, and for now, let's hope that Purina can ship enough chow to keep these fish growing.


DIY Daruma

Daruma (dah-ROO-mah) was a fifth-century Indian monk who reached China after a perilous three-year sea voyage and became the founder of Ch'an (Zen) Buddhism. He is said to have trained the warrior monks of the Shaolin temple in Kung Fu, crossed the Yangtze River on a reed and meditated continuously for nine years (losing his arms and legs in the process).

Many of the tenets of Zen Buddhism (separating illusion from reality, nonattachment to emotions and ideas, self-discipline and embracing impermanence) are also key to successful investing, and many of the qualities Daruma is best known for are those we seek to emulate every day.

A popular form of Daruma in Japan is the papier-maché doll, traditionally purchased at New Year's. The owner commits to fulfilling a goal through hard work and discipline and paints a pupil in the left eye. Once the goal is achieved, the right eye can be filled in, making the doll complete.

And so, not wanting to leave you out of this 1,600-year-old tradition, we're offering you your own Daruma, and the opportunity to strive for your own goals in the coming year.

Download the PDF on our website (http://www.darumanyc.com/pdfs/DIY_Daruma.pdf), print, fold and cut as indicated, and voila! All the best for a goal-reaching 2009, from all of us at Daruma.


And speaking of achieving personal goals, the city of Obama, Japan has created its own, custom Obama daruma, in celebration of you know who.

The Daruma is called "Urushi Daruma," ("urushi" means "lacquer"), Obama (the city) has sent this daruma to Obama (the man).


Is Daruma ForYou(ma)?

Our company continues to expand; we have created a new position of Quantitative Analyst/Data and Text Miner and are currently interviewing candidates.

If you (or someone you know and respect and want to pass this along to)...

... have outstanding applied math and computer science chops

... are entrepreneurial, creative and have a voracious, wide-ranging curiosity

... are excited by the prospect of driving our fast, robust, scalable, custom-developed data/text mining Ferrari

This may be for you. Follow this link for more information: (http://www.darumanyc.com/newsletter/documents/2008_12_03_job.pdf)


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 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.