February 2009
Vol. 2 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 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 10.2% vs. 5.3% for the Russell 2000 since inception (7/28/95 through 12/31/08). (Notes to Performance

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


My trip to last month's inauguration  amid the throngs who had the same idea reminded me of the investment danger that a crowd can present.  Read on as I explain why ...
Please reply to share your comments, questions or objections.

All the best,
signature - Mariko
Mariko O. Gordon, CFA
Founder, CEO and CIO
Daruma Asset Management, Inc.
articleOneObama-nians at the Gate

I don't like to be cold, and I don't like crowds. Nevertheless, tickets to various inaugural events kept manifesting themselves, so I felt the call of destiny and decided to head down to Washington.  After all, how often does your high school classmate get sworn in as president? (I know, I know, I've mentioned this a few times and I promise to shut up about it already.) 
The shuttle on Sunday morning was packed.  But instead of the usual suits carrying nothing more than briefcases and Wall Street Journals, there were people of all ages, colors, shapes and sizes, several of whom were engaged in overhead bin suitcase wars.  This was to be a perfect introduction to the inauguration - crowds and a carnival atmosphere.

When Tuesday morning came I walked past the street vendors hawking Obama swag (and what a dizzying variety of stuff there was) and joined the throngs streaming into the Metro at Dupont Circle.  A few minutes later, I surfaced at Judiciary Square near the Purple entry point; in my hand I held one of the 240,000 purple tickets issued.

I felt I'd entered an alternate reality. No cars (the roads and highways were shut down), just masses of people streaming by, along with EMTs, firefighters, police and snipers on rooftops in every direction. The multiculti-crowd was bundled up against the cold and humming with goodwill.

Slowly, however, the mood began to change.

As I waited for the magical purple gate to open, more and more people piled up behind me.  A woman went into labor and the ambulance carting her away slowly nudged through the crowd. A police car squeezed through, causing everyone to smash against their neighbor. People were passing out up front, and the EMTs finally gave up, took the stretcher out of the ambulance and made their way on foot (I never saw them come back).

The crowd was getting restless, and the jostling elbows became a little sharper.  At times I was almost lifted off my feet.

It's well-documented that hanging out in crowds can be dangerous (see Gustave Le Bon's The Madness of Crowds), and everyone's danger meter is different. You may enjoy mosh pits and not bat an eye when the guy next to you fires up a Molotov cocktail.  Wimps like me, on the other hand, like to get out at the first sign the crowd's mood is turning sour. 

So I invoked the rarely used, "life is too short to die trampled by an inaugural crowd" rule and bailed.  (I am now a proud member of the "Survivors of the purple tunnel of doom" group on Facebook - 6,171 members at last count).

What do crowds have to do with investing? Lots.  And when a trade gets too crowded, it's your financial life that may be in danger.  Some notable, recent examples:

  • The Meltdown of 2007. The summer of 2007 saw the great quant implosion that resulted from a crowded trade. Both the number of quant funds and their assets under management had grown exponentially in the prior years, and they all had similar assumptions underpinning their models.

    When the real world intruded with out-of-normal, out-of-model behavior (was it someone getting killed in subprime who had to liquidate all their positions suddenly?), the supercomputers kicked in and unleashed a frenzy of algorithmic trading, with everyone wanting to take the same side of the trade at the exact same time.

  • The Mother of Short Squeezes. In a crowded trade of another sort last November, "the mother of all short squeezes" resulted in Volkswagen's market cap ($370 billion) briefly exceeding Exxon Mobil's ($343 billion). When Porsche announced it had stealthily accumulated 75% of Volkswagen's stock, all the short sellers who'd piled on believing that Volkswagen was overvalued and hardly immune to economic slowdowns got killed.  Another 20% of Volkswagen stock was held by the German State of Lower Saxony, leaving a very large crowd at the exit (12.8% of Volkswagen's stock was sold short, making it at the time, the most shorted stock on the DAX).

  • The Hunt Brothers Take a Bath.  As the Hunt brothers learned when they tried to corner the silver market, things can shift quickly.  One day you control a third of the world's supply and prices have gone from $11 to $48 an ounce; the next day exchange rules on leverage change and a couple of margin calls later, pfffft! you're broke.

What's it all mean?

The irony of course is that while you can make a lot of money as the trade gets crowded, if it gets too crowded, you can lose your shirt.  And gauging whether a trade is too crowded is a bit like knowing when the crowd is about to turn ugly there's no hard and fast rule. 

That said, here's what we look for in reading the crowd:

  • Who's holding the stock? Is the bulk of the stock held by index funds?  Momentum shops?  Deep value vulture shops?  

  • Is the stock heavily shorted? We track the short interest in every stock we own or are interested in buying.  Not just because shorts are nobody's fools and we need to make sure we have any controversy well parsed out, but because we need to know if the short trade is getting crowded.

  • Who's leaning long? A crowded trade on the long side is a little harder to spot, particularly if the fundamentals are also better than expected.  But eventually, marginal buyers are exhausted, the stock is expensive, and the slightest thing can trigger an avalanche of selling. So we like to know where the sell side's head is at, especially with respect to target prices and the catalysts needed to move stock ratings up or down.

  • What are the technical analysis hot buttons? Whether you believe in technical analysis or not, an awful lot of trading gets done on that basis.  It's important to know whether some major technical inflection point has been crossed, as that will cause a crowd to gather at the gate.

  • What are the insiders up to? If the insiders are leaving the party as others are arriving, you want to pay attention.  They're the ones who paid the DJ and will know when the music will stop.

A final word of caution: Sometimes, as fundamentalists, it's too easy to get hung up on the "truth" of owning a purple ticket (the valuation case).  Because while that may give you the right of entry to inaugural nirvana (a higher stock price), the madness of the crowd can trump even the best empirical evidence. 

And when that happens, watching the action unfold from a safe distance is a more than acceptable consolation prize for not risking one's life, financial or otherwise.


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articleFourDaruma Pompano Index Update

In January 1,240 (33%) of the 3,736 pompano in the pond were up, which is pretty amazing given that the Russell 2000 was down 11%.  Don't get too excited, though, because it was only the small-fry that saw a January effect. Remember, we weren't too choosy about our initial group of fish -- they only had to be listed on a for real exchange, be under $2 billion in market cap, and have sales of at least a dollar.
46% of our fish trade for under $5 (up from last month's 44%); 15% trade for under a $1, roughly unchanged. Just to put this number in context,  January 2008 saw only 20% of the fish population trading under $5.

The stocks that rallied were beyond micro-caps they were nano-caps the median market cap of the group that was up was only $57 million, a lot smaller than December's median market cap of $250 million.
Beyond that, there wasn't much change: The number of stocks trading at a free cash flow yield greater than or equal to 10% went down to 939 from 1,019. The number of stocks trading below net cash went down to 100 from 112, and those trading below net-net working capital went down to 22 from 26. These stats would also suggest a improvement underneath January's wretched market.
Health status: Small fry getting enough fish chow to grow (for now).
articleTwoDaruma's Darumas
Since so many of you enjoyed last month's field trip photos, we thought it would be fun for you to meet the newest additions to our Daruma Collection.

Follow this link for a look at nine modern darumas made by different contemporary artists.


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