On Daruma's Watch
monthly small-cap insights for investment professionals
Vol. 2 No. 10
No investor likes to see poor performance. But not all "bad returns" - even those of equal magnitude - are treated equally. Today's newsletter takes a look at two common forms of underperformance and explains why one is often viewed much less favorably than the other.
Please reply to share your comments, questions or objections (and don't forget to enter our "contest" at the end of the main article!).
All the best,
Mariko O. Gordon, CFA
Founder, CEO and CIO
Daruma Asset Management, Inc.
Guns N' Leeches
No doubt about it, it's fall. There's a chill in the air, leaves are turning and supermarket aisles are overflowing with candy. Ghouls and ghosties will soon be parading down your street.
And when it comes to trick or treating, my two kids have taken very different approaches over the years ...
The oldest, who's always hated costumes, would don his at the last possible moment and strip as soon as the last Caramello dropped into his bag. He knew the costume was the price of admission, but he would work the loopholes hard - sling on an aloha shirt and a camera and go as a tourist, for example.
My youngest, in contrast, as a toddler HAD to wear the correct gear to match whatever video he was watching at the time. If you looked in his closet you'd have thought that he was a member of the Village People. To this day, he's happy to dress up, as long as it doesn't involve a tie and jacket.
But whatever their differences over Halloween costuming, both boys were in full agreement as to what constituted "good candy" (Snickers) versus "bad candy" (Smarties). And that meant that the trick or treating post-mortem involved counting and sorting (even graphing!) the candy to gauge each Halloween's performance.
Interestingly, as the end of the year draws ever closer, investors will be going through a similarly ghoulish process of "analyzing the haul." And here, as well, there will be little disagreement over what constitutes "good" vs. "bad" performance. However, not all bad returns elicit the same client reaction.
Guns N' Leeches
Generally speaking, bad performance falls into one of two categories: "Death by Smoking Gun" or "Death by a Thousand Leeches." Both are bad news (as an old colleague was fond of saying, "Mr. Market likes to give the maximum amount of people the maximum amount of pain"); however, smoking guns, deservedly or not, tend to be preferred by clients (more about why in a minute).
The smoking gun scenario is straightforward - a stock (or two or three) blows up spectacularly. The rest of the portfolio may be fine, but performance has been killed.
Death by leeches, by contrast, means bleeding 10, 20, 30 basis points of relative performance a day, for days on end. If it goes on long enough, the portfolio (and the business) can bleed to death. There's no obvious place to apply a tourniquet, and, unlike the smoking gun outcome, no obvious place to point a finger.
Think back to 1999 and the Dot Com craziness that resulted in an entire generation of deep value managers hemorrhaging assets, many of whom, convinced that the rules of investing had permanently changed, simply retired.
The leeches typically arrive in strong up markets, or when one or two sectors in the index are on fire (sectors in which one's portfolio is underweight, naturally).
Faced with the performance doldrums, good managers do the sensible thing - make sure there's no leak in the hull, remove whatever barnacles may be slowing down the ship, and wait for the wind to start blowing again. For investing professionals who see themselves as active, heroic decision makers, it can lead to feelings of helplessness, and a potentially fatal itch to do something, anything.
But if death by leeches drives us money managers crazy, it drives our clients insane. A money manager is more likely to get fired for leeches than for smoking guns.
Why? There's a tendency to overweight bad performance when it comes slowly and to cut too much slack when it happens in one quick bang - even if the cumulative hit to performance is the same.
So why the bias against the leeches?
- Leeches can't be trusted. Leeches don't reveal a clear problem, just the absence of relative performance. The underperformance is indisputable; the cause is harder to prove.
And though the portfolio holdings may not have changed much, the underlying businesses haven't deteriorated, and there haven't been any blow ups, clients feel there MUST be a better reason for the lag ... a reason that the manager must be doing a good job hiding or is too stupid to figure out.
There's a fear that something is hidden that will later spring up, and no one wants to look foolish then, for not firing the manager when they had the chance.
- Leeches are hard to get rid of. Unlike a slow death, a smoking gun - with its one-time hit to the portfolio, rock-solid reasons for underperformance and opportunity for a quick disposal of the corpse - means that once taken care of, life and relative performance can return to normal.
The smoking gun provides what seems a simple, clear means of evaluating whether or not the investment process is broken. We can see whose fingerprints are on the gun and under what pretext it was smuggled into the portfolio.
Whether sorting treats or evaluating investment performance, a Smartie is not a Snickers. And regardless of how one or the other ends up in your candy sack, nobody likes coming up short. But beyond the losing numbers themselves, it's important to remain unbiased about the sources of bad performance.
- Leeches are icky. Pardon the chick talk, but you know what I mean. Death by a thousand leeches is slow, boring and unsatisfying. It's like sitting in a leaky boat that drops farther and farther below the water line while the crew frantically searches for the source.
Guns on the other hand, even when they go off in the wrong direction, are cool. Loud and painful perhaps, but they make for a good story.
If it's true that under the leech scenario we look too hard for obvious culprits, it's also true that in the case of the smoking guns, we don't look hard enough. To paraphrase Freud, sometimes a leech is just a leech. And sometimes a smoking gun means a killer is still loose in the house.
And speaking of Halloween, be the third person to send us an e-mail with your choice for "best" and "worst" candy, and we'll send you a goody bag filled with your favorite treats!
Daruma Pompano Index
We lost another 13 fishes, all because they were bought or merged with other companies, leaving 3,654 in the pond.
And yup, in a month where the Russell 2000 was up 5.8%, everything in the pond got more expensive.
Those trading below net-net working capital dropped to 8 from a peak of 26 in February, and those trading below net cash dropped to 36, down from a peak of 112 in December. The non-financials trading at free cash flow yield to enterprise value above 10% have bottomed out at a mere 470, down from last February's peak of 679.
Health status: Fattening up nicely. Time to sell the catch?
About UsFounded in 1995, Daruma Asset Management invests in a high-conviction portfolio of no more than 35 small-cap stocks.
Daruma manages roughly $1 billion for public and corporate pension plans, endowments, foundations and individuals. Our small-cap composite is up 33.4% vs. 22.4% for the Russell 2000, year-to-date, net of fees. Our annualized return since inception is 11.8% vs. 6.5%, net of fees (7/28/95 through 09/30/09).
(Notes to Performance: http://www.darumanyc.com/disclosures.htm)
For more information about the work we do, please visit us at www.darumanyc.com.