Mariko Gordon (Trades, Portfolio) founded her own investment advisory firm some 22 years ago and went on to become an investment guru through small and midcap stock picks.
Since inception, her cumulative returns have beaten the Standard & Poor's 500 by nearly 4 points, using concentrated portfolios of 35 or fewer stocks. She’s also stayed ahead of their internal benchmarks, the Russell 2000 and Russell 2500, on the basis of cumulative returns.
However, returns in recent years were off; she admits her results suffered when the firm began growing, and she became an administrator as well as a stock picker. As a result, Gordon made dramatic changes, changes that have started to have an effect on performance.
This article is one in a semiseries examining the top stock-picking gurus (sometimes individuals and sometimes teams). The others are: David Tepper, Prem Watsa, Bill Ackman, Seth Klarman (by Rupert Hargeaves), Chuck Akre, Vanguard Health Care Fund, Yacktman Focused Fund, Jerome Dodson, Frank Sands, the Eaton Vance Worldwide Health Sciences Fund, PRIMECAP Management, Daniel Loeb and Bill Nygren.
Who is Gordon?
Gordon says she became a money manager because it was in her genes. On her mother's side, her grandparents left Okinawa to work on a Hawaiian plantation; they later bought their way out of indentured servitude and built their own farm. On her father's side, her grandfather started as a messenger boy in a brokerage firm, then went on to earn a law degree and buy a seat on the New York Stock Exchange. Her parents, she says, were serial entrepreneurs.
As for Gordon herself, after graduating with a humanities degree, she started as an apprentice portfolio manager at Manning & Napier in New York. Soon afterward, she joined Chuck Royce (Trades, Portfolio) at Royce & Associates, which allowed her to manage a portfolio. And, then it was on to Valenzuela Capital Management, where she became a partner and research director. Finally, in 1995, she started her own firm, Daruma Capital (bio based on information at the Daruma Web site).
In a quotation (as curated at Quoteswise.com) she said, “Given my family history, combining entrepreneurship and portfolio management, my founding Daruma in 1995 wasn’t as far-fetched as it might seem for a Princeton '83 comparative literature major.”
What is Daruma?
Founded in New York City, Daruma Capital Management is a small investment advisory firm of fewer than two dozen people. It operates two portfolios, each containing 25 to 35 stocks:
- Daruma Small-Cap composite, which benchmarks against the Russell 2000.
- Daruma SMid-Cap composite, which benchmarks against the Russell 2500.
It is an active management shop and only buys stocks that have the potential to increase in price by at least 50% or more over the next two years while maintaining a reward-to-risk ratio of 3 to 1. Employee owned, the firm manages $1.78 billion on behalf of public and corporate pension plans, endowments, foundations, and individuals.
The firm struggled in 2014 and 2015, posting losses in both years and underperforming its benchmarks. In an interview with Barron’s, published in March 2017, Gordon conceded the firm’s lacklustre performance, citing a lack of REITs and utilities, but more importantly, the firm’s loss of focus. She says that the firm was small, nimble, and tightly knit for 15 years, but then expanded, and in her words, “we doubled head count and got more hierarchical. The process slowed, you had death by meetings, a little bit at a time. You could really see the new idea count going down.”
Gordon is big on what she calls "idea counts," which refers to the number of potential stock buys in the pipeline. She notes that after downsizing back to the previous size, they’ve become creative again and had developed 14 new ideas in the previous 12 months.
Gordon’s philosophy and investing process
The philosophical side gets lots of attention at Daruma, and in the section of the Web site titled Culture, Gordon articulates nine defining attributes of the company:
- Performance is more important than asset growth; she states the firm will limit assets under management to meet performance goals.
- They are and will continue to be stock pickers and active managers. No following the index, since clients pay them for active management.
- Ongoing improvements in their investment and business practices are emphasized. They want to be faster, better and smarter.
- Downside risk is to be limited by sticking to strict rules for selecting stocks and constructing portfolios.
- They monitor all holdings against a written document, a document that explains the investment thesis and lays out the fundamental milestones. This allows them to learn from failure and replicate success.
- Stick to the plan as long as the facts remain essentially the same, but be prepared to change course if the key facts change. Be prepared to concede you were wrong when the facts contradict your opinion.
- Steadfastly pursue excess returns over time.
- Share profits and equity with colleagues to ensure the firm delivers stable results in the long term.
- Be available to explain investment performance to clients. “We consider time with clients time well spent.”
Turning to process, the firm has an established six-step plan:
- Screen all smid-cap and small cap stocks to find those that are undervalued and improving.
- Quantitative analysis: What are the drivers of past growth?
- Qualitative analysis: What will drive future growth?
- Investment thesis: Synthesize the qualitative analysis to generate fundamental milestones.
- Valuation: What are the high and low price targets?
- Weekly review: Maintain discipline by selling when (1) milestone or price targets are reached, (2) if new opportunities present themselves or (3) the aggregate portfolio risk needs adjustment.
Within the context of her philosophy/culture and process, the following thoughts help illustrate Gordon's approach to investing; these come from an interview with Barron's:
- She says she and her people look for a positive rate of change in a company's fundamentals. That might include top line, margins or other metrics.
- They find opportunities in companies making difficult product transitions, digesting acquisitions or acquisition opportunities.
- Smaller opportunities are just a couple of quarters away, whereas bigger, cheaper opportunities are farther out and less certain.
- She wants companies that take care of not only shareholders but also customers, employees and vendors. Focusing on short-term shareholder value jeopardizes long-term shareholder value.
In the Fourth Quarter 2016 Small-Cap Portfolio Commentary, she articulates what went right and what went wrong with their best and worst picks:
- Mastec (MTZ, Financial), a specialty construction and engineering company, was up 121%. She says the Street "misread" a decision by the company not to lay off its employees.
- DigitalGlobe (DGI, Financial), up 83%; Gordon and associates believed the company would not be adversely affected by contract renewals and competition from "microsatellite" operators, and they had faith in a new chief financial officer.
- Rogers Corp. (ROG, Financial), up 49%; as a specialty materials provider, there is not much awareness of the demand for its products. For example, its foam business benefits from a trend to OLED screens in handhelds.
- Pacira Pharmaceuticals (PCRX, Financial), a specialty pharma company, was down 58% on the year after it reported slower than expected sales growth recovery. At year-end 2016 prices, though, Gordon saw it as a compelling acquisition name.
- Scorpio Tankers (STNG, Financial) fell by 39%, because of rate declines and deterioration in the shipping sector. Daruma exited the position, concerned about "paper" fleet devaluation.
- SunOpta (STKL, Financial), an organic foods manufacturer (valuation change not listed). The position was sold after the company estimates on both the top and bottom lines, due to execution shortcomings.
Much to consider in Gordon’s philosophy, strategy and tactics. That includes a rationale for remaining a small firm; a commitment to active management; risk management; both fundamental and qualitative research; an articulated process and the discipline to stick with it; and finding ideas that encompass positive changes in candidate companies. Some of these principles have been learned the hard way.
Daruma’s current holdings
As noted, the firm holds 25 to 35 stocks in each of its two portfolios at all times, making them concentrated portfolios. As this GuruFocus chart shows, she favors Technology, Industrials and Consumer Cyclicals:
Note that information in the left column refers to both funds combined (Small-Cap and SMid-Cap).
These are the top 10 holdings in the Small Cap fund, as of March 31, with their proportion as a percentage of the full fund:
- Acxiom Corp. (ACXM, Financial) 3.72%.
- Entegris Inc. (ENTG, Financial) 3.7%.
- Omnicell Inc. (OMCL, Financial)3.64%.
- FCB Financial Holdings Inc. (FCB, Financial) 3.58%.
- Comfort Systems USA Inc. (FIX, Financial) 3.52%.
- Healthsouth Corp. (HLS) 3.43%.
- Evercore Partners Inc. (EVR) 3.32%.
- Veeco Instruments Inc. (VECO) 3.31%.
- Innophos Holdings Inc. (IPHS) 3.22%.
Although Gordon operates a small-cap fund, she, like many other gurus, has a strong position in technology stocks. Unlike the other gurus, though, she does not have access to the big names that have driven much growth in recent years, names such as Amazon (AMZN), Apple (AAPL), Alphabet (GOOG)(GOOGL) and Netflix (NFLX). Their market caps are too big for small and midcap funds.
Daruma’s performance
Although performance in the past few years has been bumpy, Gordon has posted good numbers for cumulative returns over 10 years and more:
For five-year cumulatives beyond 10 years, she also posts good results when compared with the S&P 500:
- 15 years: 9.2% (2.5% better than the S&P 500).
- 20 years: 11.6% (3.9% better than the S&P 500).
Internally, and presumably for clients, Gordon and Daruma benchmark against the Russell 2000 for their Small-Cap fund, and against the Russell 2500 for the SMid-Cap fund.
Gordon has earned her guru status by outperforming a major benchmark with small and midcap funds. Over the past 22 years, she’s posted returns of more than 40% three times, or roughly one every seven years, and these contribute meaningfully to her strong cumulative returns.
Conclusion
Gordon shows it is possible to bring in above-average returns with small and midcap stocks.
That achievement was made possible by discipline and rigorous fundamental research (that is also exhibited by other investing gurus). Gordon’s candid remarks about the slippage her firm experienced when she tried to be both an administrator and stock picker illustrate the focus required of top-performing fund managers.
She obviously takes active management seriously and literally, and her criteria include buying only stocks with the potential to increase in price by at least 50% and maintain a 3-to-1 reward-to-risk ratio.
Nonprofessional investors looking for small and midcap stocks will find it helpful to study Gordon’s picks, process and principles.
Disclosure: I do not own shares in any of the stocks listed in this article, nor do I expect to buy any in the next 72 hours.
