Glancing Back At 2014

It’s that time of year – calendar year 2014 draws to an end. For one's trackrecord, there's particular emphasis on annual calendar year returns. Convention dictates that the annual return period fall between January 1st and December 31st, although there is no particular rhyme or reason behind this convention (e.g., why not April 1st to March 31st of the following year?).

For investors currently managing capital (especially those hoping to woo additional capital), we are subjected to the rules of the game – however arbitrary or nonsensical they may seem. Instead, let’s turn our attention to a more productive topic (something we can control) related to the calendar year convention…

2015 approaches – a new year, your oyster and blank slate – the possibilities are boundless! But before you say goodbye to 2014, will you glance back to examine, really breakdown, your 2014 returns? The exercise builds not only awareness, by forcing us to assess and admit our strengths or weaknesses and what we did well or poorly, it also reinforces a process over outcome approach to investing. How much of performance was due to luck? How much performance was due to process and skill? While not guaranteed to make us better investors, these are likely good questions to ask ourselves and perhaps even considerations to be worked into our investment processes throughout the next year.

For those needing ideas on how to evaluate your 2014 performance, below are excerpts from an article written by Mariko Gordon of Daruma Capital almost exact a year ago in December 2013:

“As the year ends, whether bull or bear market, the time of reckoning draws near. Now, mind you, scorekeeping happens all year round. But there's something about the nights getting longer and the coming winter solstice that creates an extra level of soul searching.

At Daruma, here are the things we ponder as we perform a post-mortem on the year's performance:

1. What percent of the stocks we owned over the last year and three years went up? And by how much compared to those that went down? It's easy to focus on the 'hit rate,' but if the pluses are small and the minuses are big, having a positive hit rate isn't going to do much good.
2. Did we add any value with adds and trims? Did we do a better job when we added or trimmed on the way up, or when we added or trimmed when the stock went down? Did we waste too much energy chasing squirrels when we should have focused on elephants? Activity does not always translate into returns.
3. How did the stocks that we sold do compared to the stocks we replaced them with or decided to keep? 'Out of sight, out of mind' means that we risk scoring ourselves only for what happened, and not for what could have been.
4. How did we spend our time? Since one team is responsible for two products, did we allocate our time properly between the two? And while we're at it, did we get the right balance of new ideas versus maintenance research? And did we have the right mix of tasks – calls with analysts versus field trips to companies, for example? It's easy to look at results without examining the success of the actions that led to those results.
5. How did we perform on an absolute and relative basis - in addition to the benchmark, sectors and industries - against the true investable universe? Not every stock in a small-cap benchmark in particular can be bought, as there are many teeny and illiquid banks and companies. Did we catch the best possible fish in our pond?”

Waiting For The Next Train

Following up our recent article on selectivity standards in an upward moving market, below are some comforting words (and/or coping advice) from Mariko Gordon of Daruma Capital derived from her October 2013 Newsletter. “My ruminations on regret are of the bull market variety. Whereas bear markets make me regret owning every single stock in the portfolio, bull markets make me regret every stock we flirted with but didn't buy.

Why? Because it feels like everything we looked at and passed on is up way more than what we own or bought instead. And whether we passed for stupid, the-dog-ate-my-homework reasons or because we thought the price wasn't right, this is what happens in bull markets:

...the stock gets bought out at a ridiculous premium, or ...activist shareholders announce their position the day AFTER we shut the file for good, or ...the stock simply skyrockets, just out of spite.

As the markets rise, great ideas are harder and harder to find. Everything cheap has so much "hair" on it that it makes Chewbacca look as sparse as Kojak (look him up, youngster). Sorting through the "hair" that makes the stock cheap - and therefore unattractive to other investors - is not only time-consuming, it requires the investment equivalent of a hazmat suit.

On the other hand, if a new idea has a timely and compelling investment case, it will be anything but cheap. Even if other investors haven't discovered ALL of its charms, it will be 30% higher just because of the rising tide of the market. We then hesitate to pay up - because we all know what happens when the tide goes out.

Most days, therefore, you're faced with either loading down the portfolio with broken down junk that, while cheap, doesn't represent real value and will sink further or, chasing stocks that have gone parabolic, leading to multiple compression when the inevitable market melt-down happens.

In short, bull markets make you want to grab the nearest bottle of whiskey and listen to Edith Piaf songs until the market rolls over and dies.

Here is how I keep the hounds of bull-market frustration at bay:

• I work on what look to be great businesses, regardless of valuation, figuring that one day we may get our chance.
• I look to see which insiders are buying their stocks, because most of them are now selling faster than you can say hot potato.
• I look to see where there's a management change, because maybe the force will be strong with them, and a piece-of-junk of a business will start to deliver and the stock will levitate.

And, most important of all, every day, without fail, as sacred to me as a bedtime prayer, I think of the following advice: One morning, years ago, I scrambled down the subway steps, only to find the train leaving the station, a pissed off woman cursing up a storm and a homeless guy sitting on a bench. After watching the temper tantrum unfold for a minute, the guy finally said: "Lady, relax. Trains are like men. Another one will come along."

So whenever I think of Piaf songs and of the frustration of the hot stock that got away in this bull market, I remember that patience is needed to get over those heartbreaks. Because another new idea, like trains and men, will come along soon.”

The Importance of Knowing Thyself

Readers know that I’m a fan of Mariko Gordon of Daruma Capital. Below is an excerpt from her recent March 2013 Letter. Although she is referring specifically to equities, I think her comments are applicable to all portfolio assets. Lao Tzu wrote that “He who knows others is wise; he who knows himself is enlightened.” This letter perfectly showcases why I’m a fan of Gordon. She is already a successful investor running a successful investment management firm. Yet she never stops searching for incremental knowledge – of herself, her results, her surrounding environment – striving for improvement. She is aware of the competitive nature of this business, and how she fits into that landscape. There are no illusions here…or at least that’s the goal. All that we are, as it pertains to investing (and sometimes even personal tendencies), is stripped bare and evaluated for the good and the unpleasant. The willingness to withstand such scrutiny, and reexamination year after year, is the mark of great investors.

Mistakes, Process Over Outcome, Psychology, When To Sell, When To Buy

“The investment case must be made in a completely detached way. A stock doesn't care whether you own it or not, or whether you had a good or bad "relationship" with it during the course of your ownership. A stock is not your friend. It doesn't give a crap about you, and you should reciprocate that indifference.

All of my investment process mistakes (as opposed to all my bad outcomes - this is an important distinction, as one can have bad outcomes despite a good process) have always come from a place of emotion. Every single one, whether it was a purchase or a sale.

By contrast, my best decisions in fraught times have been when I have accessed that place of flow and clarity by being entirely detached emotionally. It turns out that for someone who tends to be very expressive and prone to hyperbolic language, I can be quite cold blooded and calculating when I need to be, for the good of the portfolio.”

Planting Seeds of Expected Return

We have been reading (and thoroughly enjoying) the humorously insightful letters of Daruma Capital’s Mariko Gordon (who manages ~$2Bn in a small-cap concentrated strategy). In her Feb 2010 letter, Gordon muses upon the source of portfolio returns (and consequently future portfolio expected return). As we have written in the past, future portfolio returns do not magically materialize via spontaneous generation. Investing amounts roughly to opportunity farming – you reap what you sow, and any harvest of returns is the culmination of past labor.

Gordon thoughtfully considers the topic and its relationship to other aspects of the investment management process, such as time allocation:

“I was explaining our process for finding new ideas when I had this epiphany: Oil and gas companies use the drill bit to grow revenues; portfolio managers use new ideas to generate additional returns in a portfolio. Both work hard to keep a constant pressure - a steady flow - of hydrocarbons or ideas, as the case may be.

In stock picking, however, maintaining the new idea pressure on a portfolio is largely fiction - markets don't strictly follow the laws of physics (too many human beings involved). And so, while we aim for a steady, garden hose stream of new ideas, they tend to make themselves available between the two extremes of ‘fire hose’ and ‘dripping faucet.’

When markets are cheap, we have more ideas than time; triage of the best is the way we add value. When markets are expensive and ideas are scarce, we get the job done by scouring efficiently, patiently and thoroughly.

Yes, we're always on the lookout for new ideas to put pressure on our existing positions…After all, in any given portfolio, on any given day, there are positions that are working, those that are mistakes, and those that are getting long in the tooth. But steady new idea pressure a la hydrostasis? Fairy tales.

And that's the point. Because in our experience, both investors and clients find comfort in believing that there exists a steady flow of new ideas. But we shouldn't collude in that desire for comfort. The commonly asked question, ‘Where do your new ideas come from?’ is largely missing the bigger, more essential point:

Given the cycle of floods and droughts in investment idea generation, what really matters is having a sound strategy for uncovering the best when ideas are as plentiful as mushrooms after a rain, and locating the gems when the pendulum inevitably swings back the other way.”

Decluttering the Portfolio

Many thanks to Lisa Rapuano for telling me about Daruma Capital’s Mariko Gordon, and her humorously insightful letters! This article will undoubtedly be the first of many based on interesting topics extracted from Gordon’s letters. In the August 2012 letter, Gordon discusses portfolio review and its parallels to a massive home cleaning project. For those of us with hoarding tendencies, what is the impact of this psychological behavior on our portfolio management decisions? Gordon offers some wisdom:

“I have been adamant about our ‘no more than 35 stocks’ rule…Whether right or wrong, all of this pruning keeps the portfolio in the here and now, and me actively engaged in the process of evaluating whether every stock is earning its keep. And yet as with clutter, it's easier said than done… [Diversification]

If it's a big winner, it reminds you of how smart you are, and how it made your clients rich. All that warm fuzziness means that when it breaks you will crazy glue it, and never be able to let it go. That, my friends, is how you round trip stocks - the hard part is knowing the difference between an air pocket where you sit tight, and a death spiral, where you pull on the ripcord and bail. [When To Sell]

A loser in the past can likewise cause problems. Like cats, some investors prefer to bury their ‘flops’ rather than be reminded every day that they're idiots. They feel such shame that they immediately sell off a loser, unable to decouple the past enough to soberly recalculate whether the stock represents good value in the present. The fact is, if the portfolio you've been presented by your money manager doesn't include a howler or two, be very suspicious.

Too many howlers, however, may be symptomatic of another problem, this one caused by a manager who can't admit that he or she has made a mistake. These investors stubbornly insist that it's the market that's wrong (again), for disagreeing with his or her brilliant analysis. [Making Mistakes]

So let the past go…But it's not always the past that causes problems. It can also be the future.

An investor can become saddled by a position with enormous potential - potential that always lurks just over the horizon, just out of reach, despite excuse after excuse, inroads by competitors, or evidence that customers have gone on a buying strike. The future becomes a siren song of unfulfilled promise. Profits are always just another quarter away.

Whatever one's personal brand of emotional clutter - past, future, or some of both - it's all garbage. [Psychology]

No matter how elaborate the spreadsheet or how probabilistically the range of outcomes for a stock has been calculated to four decimal places, every attempt to declutter your portfolio must be accompanied by an attempt to declutter your attachment to the glorious past it represents, or the glorious future it will deliver.”