On Daruma’s Watch

monthly small-cap insights for investment professionals

October 2014
Volume 7, Issue 10

Welcome!

Being a good investor requires, among other things, knowing how not to lose money.

Which is why this month we spoke with Daruma Senior Analyst, Mark Miller (the person around here who does the best job playing defense), and asked him to share three of his favorite techniques for avoiding losses.

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

Mariko O. Gordon, CFA

Founder, CEO and CIO

Daruma Capital Management LLC

New Seasons and Old Letters... Three Rules for Managing the Downside

I grew up in a tropical climate, one with just two seasons: rainy and dry. And so I've come to appreciate living in New York, where all four seasons fully express themselves.

There's something about the cycles - knowing that the ginkgo trees will soon turn butter yellow; that the pretzel carts will soon begin selling chestnuts; that the ice rink in Bryant Park will soon open to skaters - that both propels us forward through time and brings us home again. If we miss apple-picking season this year, it will make our anticipation of next year's that much more acute.

It all hit home recently when I came across this gem of a post from my favorite astronomy blog on the same day that an old friend sent me a batch of letters I'd written to him in my twenties:

"In the Chinese tradition, the autumn season is associated with the color white, the sound of weeping, the emotions of both courage and sadness, the lung organ, the metal element, and a white tiger. Autumn is also connected in Chinese thought with the direction west, considered to be the direction of dreams and visions. ... Consider your dreams and visions, and the path on which you're moving forward through your life." (EarthSky.org)

As for the letters, 26 years ago in 1988 (back when I myself was 26 years old), I sent one to my pal Malcolm, a school teacher, in which I considered The Path of my life. Today, in celebration of the equinox and its implications for us stock pickers, I share an excerpt of that letter:

"What, you asked, is a financial analyst? Well, I read annual reports and the numbers have only just begun to sing to me. Songs of fraud, of betrayal, or bliss (financial bliss that is). Once you do research on what looks like to be a decent company then you figure out what the odds are of making money in the stock if you buy it. That is, is it CHEAP? It's a bit like handicapping race horses, but it IS completely unlike sky-diving.

"An unlikely profession to have turned out to be my calling, you say. The problem with the world outside school (let's call it 'real') is quite dull, and jobs are often boring. This is a job that's never mastered. The world is always changing and one's always having to adjust. Companies are like people too - they screw up, or they rebel against their parents, or they overcome heroic odds.

"The learning curve for this business if you're any good is forever steep, so you can't afford to be bored. There's also the crucial element adding spice to the equation: the gamble. If you bet wrong (and by definition you'll always be wrong some of the time - think baseball batting averages), you lose money - yours or other people's - neither of which is a happy event. You can't afford to get too cocky in this business or you'll get your head handed to you on a platter."

So there you are - that's what I do.

And yes, it's true that being a good investor is knowing how not to lose money. Which is why I asked Daruma Senior Analyst, Mark Miller (the person around here who does the best job playing defense) to share three of his favorite techniques for avoiding losses:

Rule #1: Two Downgrades. Sometimes very bad news hits a company and its stock plummets faster than projectile vomit. Other times, the stock drifts down. Why, in the latter cases, is the Street slow to react?

When a stock has not responded as poorly as we expect, we apply the "two downgrade rule." If only one sell side analyst has downgraded a stock on bad news, maybe the news and impact just hasn't been as widely received or read. But after the second downgrade comes, we think most investors know the issue and have made their bets, which means that most of the weaker holders have flushed the stock from their portfolios. As a result, the strong downward pressure will subside.

Rule #2: Buy stocks at trough multiples of trough earnings. This rule (sometimes applied after the two downgrade rule) relates to uncertainty about a company's earnings; we do a scorched earth scenario analysis to estimate the company's worst case.

Then we look at how the stock and its peers are valued, using various current and historical metrics, to estimate what we believe would be the lowest multiple the market would put on the company's earnings. If a stock is trading at a price close to the scorched earth price (i.e., trough multiple applied to the worst case earnings estimate), then we believe there is little downside in the stock.

Rule #3: Find stocks trading near what we could call their asset value. Here we consider what the company would be worth if it wound down operations or changed its structure. It doesn't happen often, but sometimes the Street gets so pessimistic about a company's fundamental outlook that investors overlook key assets the company owns.

Health insurance companies, for example, are required to hold a substantial amount of cash in reserves to make sure they are able to pay all claims. But what if investors became so pessimistic about the outlook for a health insurer that the stock traded at only a 20% premium to the cash that would remain if the company shut down its operations, paid off its claims, and then recouped all the cash held in reserves?

A similar analysis can be applied to companies with hard assets. What if the value of a company's helicopter fleet was worth almost as much as the entire company? These stocks would be said to trade near their asset value, and therefore would have some measure of downside protection.

There you have it - some advice for a stock market season that calls for courage and evokes sadness. And while investing can certainly lead to a lot of weeping if one isn't careful about managing the downside, it remains the most beguiling, maddening and satisfying profession I can imagine. After almost 30 years in the game, I wouldn't change a thing.

Our Affection for Ginkgos

Ginkgos are among my favorite trees - so much so that we've named our small-cap fund after them.

They have distinctive, fan-shaped leaves, lived during the time of the dinosaurs, and yet thrive in urban environments. In short, a beautiful tree with a long lineage of survival and the ability to be adaptive and flexible - the
perfect mascot for a long-term investment strategy.

In the autumn, Ginkgos are known for turning a pure, crisp yellow, for producing odiferous fruits that encapsulate delicious nuts, and for dropping all their leaves at once. This is a tree that when change is necessary, COMMITS. I once photographed a ginkgo tree as it shed all of its leaves in a matter of hours. The leaves fall in a steady rain, blanketing the sidewalk. Each tree seems to hear a different signal, so if I pay attention I get to see the miracle of the seasonal ginkgo leaf rain more than once, as they take turns.

About Us

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