November 2012
Vol. 5 No. 11  
in this issue
Mad Max Rides Again

Shell Shock Winner!

logo - Daruma

Daruma Capital Management LLC
80 West 40th Street, 9th Floor
New York, NY 10018   

About Us

Founded in 1995, Daruma Capital Management invests in high-conviction portfolios of no more than 35 stocks.

Daruma manages $1.7 billion for public and corporate pension plans, endowments, foundations and individuals. Our annualized Small-Cap return net of fees since inception is 11.9% vs. 7.6% for the Russell 2000 (7/28/95 to 9/30/12). Our annualized SMid-Cap performance net of fees since inception is 2.5% vs. 9.1% for the Russell 2500 (4/30/10 to 9/30/12).


Notes to Performance

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

It's been a sometimes gruesome, often fierce ride here in the New York area since Sandy hit last month. Today's newsletter draws a parallel between the changes brought by the hurricane and the changes in today's investment environment.

Best wishes to you for a warm and safe Thanksgiving holiday and to our many friends and neighbors still recovering from the storm.

(To listen to this month's newsletter, click here.)

All the best,
signature - Mariko 
Mariko O. Gordon, CFA
Founder, CEO and CIO
Daruma Capital Management LLC 
articleOne Mad Max Rides Again

I always thought that it would be an exploding toilet on the floor above our LAN room that would be the reason to trigger our disaster recovery plan. After all, our fabulous office, built in 1902, has many considerable charms, but antique plumbing is not among them.

Since 2002, when we moved in, we've lived through earthquakes, blizzards, hurricanes, heat waves and a city-wide power outage that conveniently happened after 4 p.m. on a Friday. But In all that time, we never had a problem worthy of activating the plan.

Until now.

This time, our entire block, despite being surrounded by festive illumination, remained stubbornly dark for five days. A minor inconvenience in the context of the destruction in the New York City metro area, even if it was during earnings season and the market reopened on the last day of what is historically a gruesome month for the indices.

Some who were stranded in Florida drove 19 hours in order to be back and pitch in; others had no power and camped out with friends and family; still others violated building codes by taking in small armies of relatives and friends. On the upper west side we had no issues, so the team set up shop in my kitchen and living room, where we were fully functional.

Pizza and ice cream were freely available, wifi was working and we got amazing amounts of work done, and quite a few laughs in as well. I wouldn't recommend anyone choose enduring disasters as a team bonding exercise, but they certainly do double as such. Team Daruma made heroic efforts on behalf of our clients, for which I am profoundly grateful.

But the reports coming in from those living in SoPo (South of Power) or in Queens were shocking.

The line between normalcy and craziness is very thinly drawn, and while there's always been a gulf between the haves and have-nots in this vast metropolis, the chasm between those with power and gas and those without is resulting in behavior straight out of the apocalyptic movie Mad Max. Indeed, when I came back from four days of research conferences on Thursday there was a long line at the marine terminal gas station in La Guardia, one that required not one, but three cop cars with which to maintain order.

Thinking about the conferences and about the difference between the hurricane-ravaged and the hurricane-spared parts of New York made me realize how we as investors face a similar chasm.

First, you have to picture these conferences. Not only do companies make canned presentations to large crowds, management also spends a lot of time meeting with investors one-on-one or in small groups. Small, numbered cocktail tables are separated from each other by screens, and investors swap tables at twenty minute intervals.

For company managements, this must feel like speed-dating with sharks. After all, like New York City after Sandy, the investment universe is also made up of a part that lives by Mad Max rules and a part where old, civilized rules of investing apply.

It wasn't that long ago when looking at a stock's market cap, whether it was growth or value, and whether it was largely held by index funds or by momentum investors was enough. Now there are all sorts of other things to watch:
  • ETFs. One company I spoke to has 10% of its shares outstanding owned by an ETF that's a basket of stocks with exposure to water. Other companies are owned not just by index funds, but also by sector ETFs, so that a surprisingly large amount of their shares outstanding are held by ETFs, whose fund flows are way more volatile than conventional mutual index funds.

    For market timers, be they in the form of hedge funds or financial advisors/planners to the retail market, ETFs are the weapon of choice to quickly add or reduce exposure, and thus they get footballed around a lot.
  • Whisper campaigns. It's not enough anymore to know whether a stock is heavily shorted and there's a holy war going on. There are perfectly reputable businesses and managements that end up on the wrong end of whisper campaigns, especially if what's being whispered isn't easily cross-checked and analyzable (which is when innuendo is most effective, after all).

    Campaigns by the shorts go way beyond accounting issues backed up by facts and now include a wide range of rumor mongering designed to impugn the possibly innocent. As an investor, you can go mad from chasing whispers that whipsaw stock prices.
  • Data point bingo. These are businesses which have the misfortune of operating in an industry where data points are released frequently, allowing so-called investors to make frequent bets on whether the number will be better or worse than expected. There is a whole class of speculators who could care less about the prospects for a business or an industry over the long haul - they merely want to bet on whether the ball on the roulette wheel will land on black or red.

    Here the volatility exists, not because of unprovable whisper campaigns, but indeed because tangible data exists on which to bet on with more frequency than mere quarterly reports provide. There is so much emphasis on whether "the number" will be met next quarter or whether guidance is conservative enough that it feels like businesses exist merely to provide data points on which to speculate, rather than create long-term value for all stakeholders, including shareholders.
Sadly, before we buy a stock that's controversial we have to think long and hard about the management and the business model relative to these nefarious factors. In the end, it's not just the extra volatility that's tough to live with from a risk/return point of view, it's the psychological impact and additional work required from having to sift through a lot of short-term noise - lots of activity relative to pay off.

The pendulum may well swing the other way someday, but I wonder what cataclysmic event has to happen to get rid of the collective short-term mindset. Businesses should not be run with the number one priority to make their numbers for the next three months. That leads to a lot of decisions that are bad for the long-term health of the enterprise, and its stock price.

I've been around too long to know that yearning for an investing universe that is free of neighborhoods overrun by Mad Max investors made crazy by short-term speculation is a waste of time. For now, all we can do is put a bunch of cop cars at the perimeter of the portfolio and keep the hoodlums - by nature, or by necessity - under control.

articleTwo Shell Shock Winner!

shell answers

Congratulations to newsletter reader and budding shell authority, Pete G., for accepting the challenge in our last issue and correctly identifying all four mystery shells.

Pete's an institutional salesman whom we've known for longer than we care to admit and, although we considered disqualifying him due to the fact that he lives in Florida (the state in which the shells were photographed!), he was indeed first with the correct answers.

The shells are identified on the right.

Thanks again Pete, your prize is on its way!

© 2012 Daruma Capital Management LLC

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