On Daruma’s Watch

monthly small-cap insights for investment professionals

January 2014
Volume 7, Issue 1

Happy New Year!

And don't worry, it's still us - just a new design for our newsletter as we leap into 2014.

This month we take a look at economic forecasting and, in particular, why our desire to have "the forecast" is dangerous for a number of reasons.

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

All the best to you for a successful year,

Mariko O. Gordon, CFA

Founder, CEO and CIO

Daruma Capital Management LLC

Foodies, Fortunes and the Folly of Economic Forecasting

My 20-year-old son Haden, whose foodie tribal name is "He-Who-Will-Bankrupt-You-If-You-Treat-Him-To-Sushi," interrupted my New Year's Day Person of Interest Netflix binge. He wanted me to watch a TED Talk on General Tso's Chicken with him. I couldn't refuse - this was so much better than when he was five and I was force-fed Thomas the Tank Engine episodes to the point of wanting to boycott train travel for life.

To my great delight, the TED talk was given by my friend Jennifer 8. Lee, former NY Times reporter, entrepreneur and author of The Fortune Cookie Chronicles: Adventures in the World of Chinese Food.

You'll learn many fascinating things if you watch the talk, among them the fact that the chef who created General Tso's Chicken finds the American version horrifying, and that because fortune cookies are a Japanese invention, people in China will choke on the paper inside if offered one.

Being Japanese American I already knew that fortune cookies belonged to my people. But what I didn't know was that fortune cookies can literally make you rich. According to Jenny's TED talk, a 2005 Powerball lottery had so many more winners than statistically likely, lottery officials initially suspected fraud. As it turned out, 104 of the 110 winners had chosen their picks from the lucky numbers found on a fortune stuffed into a cookie and shipped all over the country.

During New Year's, when the airwaves, press and blogosphere were filled with forecasts about what the coming year will bring, I got to thinking about this idea of picking winners via baked goods. As investors, given our interest in predicting and discounting the future for our clients, it's no surprise that we create a big demand for financial oracles. As a practical matter, however, it's not much more reliable than what you find in a typical fortune cookie.

In other words, beware of experts bearing forecasts.

And so as the year begins, and as I read countless strategy pieces, macro overviews, and "our favorite picks for 2014" propaganda, I remind myself that our desire to have "the forecast" is dangerous for a number of reasons:

Attempting point estimates on something as complex as our economy is nothing short of hubris (this also holds true for predicting sports, politics and the weather). After all, if the beating of a butterfly's wings can determine the formation of a hurricane, how precisely forecastable is the U.S. economy, truly?

Forecasters are human. You'd think it would be simple enough to extrapolate a trend. And yet according to a recent Goldman Sachs study and others, forecasters consistently over- or underestimate an economic data point over several months.

They feel "close to right" and so continue to over- or underestimate until they have to change their minds, at which point they tend to overcompensate in the other direction. Why is this? Because to be human is to really, really hate being wrong.

We have a natural inability to visualize failure. Whether due to culture or hardwiring, and as the book Never Saw It Coming: Cultural Challenges to Envisioning the Worst devotes itself to describing, we find it easy to come up with vivid, detailed scenarios about what success looks like ... but we become vague when attempting to describe failure. As a result, we can underweight the bad in our forecasts.

We hate looking for and have trouble predicting the unexpected, that proverbial black swan event. We like to extrapolate from the recent past (even when we do it badly), and lack imagination about how things could change.

Trend extrapolation is linear and easy to calculate, but it will lead you to conclude things like one third of the world's population will be an Elvis impersonator by 2019. With the possible exception of death, taxes and the sun going supernova, trends are rarely self-sustaining forever.

Experts are overrated. If you read Philip Tetlock's book, Expert Political Judgment, or watch Noreena Hertz's TED talk, How to Use Experts and When Not To, you'll probably never again trust anything a so-called expert says. As Tetlock observes, "When we pit experts against minimalist performance benchmarks - dilettantes, dart-throwing chimps, and assorted extrapolation algorithms - we find few signs that expertise translates into greater ability to make either 'well-calibrated' or 'discriminating' forecasts."

And so as we launch headfirst into another year of forecasts, predictions and financial prophecy, beware of those who would claim to divine the future. Though should you stumble across a dart-throwing chimp wolfing down fortune cookies, you may want to let him pick your Powerball numbers.

The Year of The Horse Do-It-Yourself Daruma

In China, a Horse Year is full of energy and unexpected adventure, and is excellent for travel. Action brings victory and production is rewarded. Act fast and do not procrastinate if you want a successful 2014!

In Japan, folks greet the New Year by committing to a goal and filling in one of Daruma's eyes. Watchful Daruma is kept nearby as inspiration; a visible reminder and cheerleader until your goal is reached and you can fill in the other eye to signal completion.

You don't have to travel far to act fast and download your very own Do-It-Yourself Daruma, and to get 2014 started on the right hoof.

Hate horses? Email us and we'll snail-mail you a classic, horse-free, cardboard Daruma instead.

About Us

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

Our annualized Small-Cap return net of fees is 13.6% vs. 9.1% for the Russell 2000 since inception (7/28/95 to 12/31/13).

Our annualized SMid-Cap performance net of fees is 12.9% vs. 16.3% for the Russell 2500 since inception (4/30/2010 to 12/31/13).

For information about our Long/Short strategy, click here.