May 2013
Vol. 6 No. 5  
in this issue
A CFA and Three CPAs Walked into a Room...

Seeking Out Criticism

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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 $2.1 billion for public and corporate pension plans, endowments, foundations and individuals. Our annualized Small-Cap return net of fees since inception is 12.7% vs. 8.2% for the Russell 2000 (7/28/95 to 3/31/13). Our annualized SMid-Cap performance net of fees since inception is 8.4% vs. 13.2% for the Russell 2500 (4/30/10 to 3/31/13).


Notes to Performance

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

It's easy (and often enjoyable) to engage in abstract discussions on any number of topics. When it comes to making investment decisions, however, it's critical that you and your team first have a shared level of understanding regarding the situation and facts.

Today's newsletter looks at the benefits of describing a process, issue or opportunity concretely, before moving on to a broader discussion.
(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 A CFA and Three CPAs Walked into a Room...

When the CPAs outnumber me - a CFA-sporting Comparative Literature major - by three to one, you can bet I'm not going down without putting up a good fight. Last week, I found myself in that very situation, huddled with our ops team, weighing the pros and cons of participating in a stock lending program.

It all began a few weeks ago when we sold a position that happened to be heavily shorted. Though in the end it all went well, the settlement process was not its usual smooth sailing, and Daruma Portfolio Accountant Jonathan Teich wanted to know why he'd had to endure a couple of miserable days.

Nosing around, he discovered that many of our clients lend out their stocks. In this case, that meant their custodian banks had to get the shares back from the borrowers, delaying things just a wee bit. This led him to wonder what this stock lending business was all about and, to his credit, whether there was gold in them thar hills for us.

That's when I stopped the meeting.

Before talking about the return we could generate from stock lending (and the risks involved - no such thing as a free lunch, remember?), we needed to start at the beginning. My team had to explain to me - exactly and in very concrete terms - how stock lending works. While I understood conceptually what stock lending was, I wanted to know how it would actually work for us in real life. And I wanted each step in the process spelled out.

Why? Because I like to know precisely what I know and what I don't know. Better to risk looking ignorant and find out what I don't know now, than assume what I know is everything I need to know - and then find out later and to my lasting regret that there was something I should have known earlier. (Got that?)

This isn't just a matter of personal taste, either. There's a method to my madness. Indeed, the very act of describing a process or an issue concretely before having an abstract discussion about it has several benefits, applicable to life as well as investing:
  1. You can tell if those who are pitching you know what they're talking about.

    ALL concepts, even the most complicated, can be explained simply. If someone says it's too complicated to do so, it can mean only one of two things: they're trying to hide something or they don't really understand it.

    In either case, why listen to them? I know of a banker who saved his company from lending millions to Enron by applying this principle. (He also has a Ph.D. in mathematics from MIT, so the "it's too complicated for you to understand" excuse served up by Enron didn't fly.)
  1. You can gauge how much you yourself know about the subject.

    It's an old study trick - if you can't explain a concept to someone else, you haven't mastered it enough to pass the test. I often do this exercise with companies I'm working on to see where my understanding is half-assed. If I can't diagram how their business works, then I don't really understand it enough to model the numbers.
  1. You can make better decisions.

    When you (or someone else) stops to explain things concretely, you can see where in the process any assumptions lie. This may reveal which things are not based in fact, where something potentially worrisome is being glossed over, or where the weak links and fail points in the process exist. Understanding the specifics helps you ask better questions.
  1. You can remain open-minded.

    According to a recent study published in Psychological Sciencethis process generates open mindedness and a de-entrenchment of opinion. Researchers surveyed people on a variety of political and social topics to measure how extreme their stances were. After asking them to map out the implementation of the policies they had strong opinions about, they found that people became less rigid in their positions.

    Why? I can only guess it's because people became aware of how little knowledge supported their opinion, or how much more complicated a solution to an issue might be, or how nuanced or ambiguous determining the right solution is.

    To me, more open-mindedness makes it more likely that all the positives - and perhaps more important, all the negatives - are considered before making a decision. That's the paradox of investing: you need to have strong conviction, but it needs to come from a flexible place that objectively weighs the sources of both upside and downside.

    It seems that abstraction creates rigidity of thought while concreteness creates flexibility. Perhaps because it takes thought from the perfect realm of "what it ought to be" to the messy realm of "what it is."
And that, my friends, is how you have a healthy debate when you are outnumbered by a ledgerbook full of accountants. I'm confident that our decision was well made, knowing that the pros and cons were fully fleshed out, that everyone's perspective came from the same level of understanding, and that everyone knew what they were talking about.

Not only that, I learned a thing or two about stock lending and my team learned a thing or two about the merits of starting with the Zen concept of a "beginner's mind." Another benefit of a cross-disciplinary approach and a multiplicity of perspectives, something being a Comp Lit major taught me well.

articleTwo Seeking Out Criticism

While we're on the topic of being open-minded, we can all take a page out of Warren Buffett's book: At last weekend's Berkshire Hathaway annual meeting, the always unconventional Mr. Buffett chose for the Q&A panel an analyst who has bet against Berkshire stock.

No scripting, no pre-approvals. Just the challenge of an opposing viewpoint.

To read the full story in the Wall Street Journal (subscription required) check out "Lesson From Buffett: Doubt Yourself."

© 2013 Daruma Capital Management LLC

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