November 2010
Vol. 3 No. 11
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.

Daruma manages $1 billion for public and corporate pension plans, endowments, foundations and individuals. Our annualized return since inception is 12.6% vs. 6.9%, net of fees (7/28/95 through 09/30/10). (Notes to Performance
For more information about the work we do, please visit us here


Last month, we examined the validity of using the "skin in the game" metric when evaluating a money manager. Today, thanks to a reader e-mail, we see how well it applies when used to assess corporate management. (Hint: Not so well.)

All the best,

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

articleOneSkin in The Game, Part II

I have 26 of these newsletters under my belt. Thanks to all this practice - not to mention learning how to write on deadline for the school paper - I've gotten to the point where I knock these out without too much fuss.

It used to be that I began with the "So what?" - the key point - and then scrambled backward for a hook that would set up an intriguing segue. Now I tend to go the other way, beginning with a story about what's happening in my life and looking for an investment lesson worthy of being shared.

Either way, the fun part of writing this sucker is the feedback I get, even if it's not always fan mail. It means I don't have to brood like B.B. King when he sings, "Nobody loves me but my mother, and she could be jivin' too." It's nice to know that people (you) are reading the damned thing.

In response to my last newsletter, and speaking of "not always fan mail," one reader - John - took me to task:

"I couldn't disagree with you more... do you make it a habit to invest in companies where management has very little "skin in the game"?... I don't... it's one of the major things I look at before investing... one of my first checks is the proxy to see what management and the directors own... yes, it's not perfect, like many things in life, and there are always exceptions to the rule, but this is a game of probabilities, and with this one, it pays to bet on the guy or gal with a fair amount of [skin in the game]."

To reiterate my position, I think skin in the game is important, but it's only one data point and it doesn't tell the entire story.

But what about John's observation re "management?" Last month's newsletter was focused exclusively on money managers, but how about the people on the inside, the ones running the company in question day-to-day? Does the "more skin the better" rule apply to these folks?

Alas no. Here too, there are plenty of exceptions to such a tidy correlation and it's more like "Goldilocks and the Three Bears." The trick is in telling what amount is juuuuuuuuust right - attitude can sometimes trump ownership.

At first glance, it may seem that degree of management ownership would be a pretty good predictor of what you're looking for as an investor. After all, if you had to choose between a go-go momentum guy "investing" in a stock for a week or two while badgering management to lever up and buy back stock, vs. an insider who is managing the business for the long-term, I'm willing to bet you'd go for the latter.

Me too. Ensuring healthy profits in the future by investing a little more (and tempering results) in the present can lead to better long-term stock performance than running the business for short-term results.

But there's such a thing as too much ownership and there is a dark side to a private owner's mindset, especially if they own enough to control the fate of the company. We once owned a venerable (now dead) regional department store during a time of industry consolidation. The family owned a boatload of stock and was willing to sell ... provided it maximized its after-tax proceeds. The deal, as finally structured, screwed public shareholders, most of whom were tax-exempt.

Sometimes a controlling interest is spread among many descendants, and they can be more concerned with their dividend checks than in taking cash flow and reinvesting in the health of the business or, when times are tough, shoring up the balance sheet.

Other times, a family uses its stock as collateral and when the world comes to an end, as it likes to do every so often, decisions for the business are not made independently of the consequences for the family's personal financial situation.

Even in those seemingly balanced circumstances where a founder and/or descendants own enough stock to have skin in the game but not so much as to ignore the little people, it doesn't always mean investing utopia. We used to own a lighting company whose founder still owned a nice chunk of stock. He decided to take the company private and fleeced public shareholders, paying a small premium to a depressed stock price at a market bottom. The board was stuffed with his cronies, and though there was a proxy fight, public shareholders lost. (He was the Louis XIV of corporate America: "The company, c'est moi.")

Finally, with management teams that are not to the manor born but are hired mercenaries with generous options packages, there can be difficulties of another sort. Indeed, they have a lot of skin in the game, but only if they jack up the stock price meaningfully, and short-term tactics can be detrimental to the long-term health of a company. (Can you say "Chainsaw Al?") Needless to say, incentives must be structured such that the pot of gold at the end of the rainbow does not encourage management to indulge in high-risk, high-reward, bet-the-farm tactics, even if they aren't fraudulent.

In practice, exceptions will always exist, whether due to context, conflicts of interest or other fuzzy human motives ... none of which can be reduced to a simple metric.

P.S. Many thanks to John, our muse for newsletter #27, who helped us put a finer point on the topic. Your custom, urban vinyl Daruma (image at the right) is in the mail and on its way to you, along with our appreciation.

articleTwoView from the Top

For the second year in a row, we were thrilled last week to host a number of Marquette University students of the Applied Investment Management Program. They stopped by to pick our brains about stocks, investing, life and The Big Apple.

We did our best to respond and before they left, took them on a brief office tour - including our wrap-around balcony. Clearly heights are not a problem for these students!

articleThreeThe Accidental (Daruma) Marketer

Although the World Cup and its vuvuzela craze are now just a happy, summer memory, one of our clients - Dale Kowacki - took things into his own hands recently by Daruma-fying his souvenir.

Thanks Dale! We admit to a considerable bias, but we think your custom art is worth making noise about.


Click here to watch Dale's 17 second Daruma video.

© 2010 Daruma Asset Management, Inc.

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