We are looking for companies that are inexpensive and changing for the better. We seek positive change in the rate of change. This gives us a good balance between risk and reward.

Rather than screening only on numbers, we also touch every stock in our universe quarterly via conference call transcripts. We look for changes in how the company is being run that are not yet evident in the financials ─ changes in sales force compensation, for example, or the adoption of lean manufacturing techniques. Analyzing transcripts further allows us to track changing management sentiment, which can lead to companies whose fortunes are improving.

We run quantitative screens as well, looking for stocks that are:

• Pummeled (big moves down, estimates slashed)
• Unwanted (drifting down to new lows, negative analyst ratings, thinly covered)
• Cheap (by a variety of measures, but especially in terms of cash flow)
• Changing (e.g., better sales, profits, balance sheets, returns on invested capital, or new management)
• Experiencing unusual purchases by insiders

New ideas also come from meetings with management teams on-site, at research and industry conferences and in our New York City office. Our research on existing holdings often leads to new holdings in the same or a related industry. Daruma’s best-ideas strategy means that we often are long-term holders of the companies in our portfolio. Because we are the kind of shareholder that management wants, we get a lot of management time and attention.

We are agnostic as to the source of improving results as different drivers of improved results have different risks and different rewards. Our job is to make sure that the upside of being right far outweighs the downside of being wrong. For example, a sustained acceleration in sales will be rewarded more handsomely by investors than a small increase in profit margins. A business whose revenues become more predictable is also more valuable. Much of our work focuses on where investors are making a miscalculation related to the growth, predictability and sustainability of cash flow.

Every business has a point at which an incremental dollar of sales becomes much more profitable. Every business has an optimal sales mix to maximize profitability. Every business has an optimal growth rate: too slow and assets are underutilized and inefficient, too fast and key business processes may shatter under the strain. We need to understand what will drive future results, and calculate a range of probable outcomes.

Next, we define on paper why we believe that the company is a good investment. The investment thesis describes why we expect sales, profits or cash flow to improve; what we expect the company to earn; and the time frame within which we expect this to occur. In developing the investment thesis, we work hard to find information that could derail our outlook, as opposed to searching for information that validates what we already think. It's important to spell out why our opinion is different. Is it that we can be more patient in holding a stock that's cheap and in plentiful supply? Is it that, by dint of our research efforts, we feel more certain than the majority of investors? Is it that we handicap the odds or the range of outcomes differently?

We lay out the case of our upside and downside price targets. To justify a purchase, the upside potential to downside risk relationship must be 3 to 1, and we need to make a case for appreciation of at least 50% over two years. This forces us to focus on only our most compelling ideas.

We live by the dictum, “Every stock must earn its keep.” This belief guides every step of the investment process, especially the sell discipline. We sell when:

• A stock is too expensive, and thus too risky
• A stock gets taken over
• New information contradicts our thesis
• Our investment thesis was right, and we now have fundamental risk (results start to decelerate), valuation risk (the downside outweighs the upside) or both
• We find a more compelling idea
• The position gets automatically trimmed at a 6% portfolio weight

Investing is a humbling pursuit, and mistakes are an occupational hazard. We choose to learn from our mistakes, and we strive to keep them small. Crucial to our process is active decision-making. If a stock is down meaningfully, we must either buy more or sell it within 90 days. Why 90 days? That gives us time to wait, if we must, for a key data point ─ or time to do more research. Why must there be a decision? If a stock is down, it's either a buying opportunity or a mistake. We must have a strong opinion, backed up by facts, and we must act on that opinion. It's the only way to add value as active managers. We don't always make the right decision, but we do have a system in place to ensure that a decision is made, and that we're not sleepwalking through our investment process.

We also have analyzed (and continue to track) every buy and sell decision we've made. This prevents us from rewriting history or repeating the same mistakes, while allowing us to repeat our successes. As investors engaged in the imperfect art of predicting the future, we want to define through every possible means what we have done well and what we could have done better.