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.”