“When you put your hard-earned money into investment vehicles, such as stocks, bonds, or mutual funds, you take on certain risks - credit risk, market risk, business risk, to name a few. But the primary risk of investing is not temporary price fluctuations (volatility); it is the permanent loss of your capital. Otherwise known as investment risk, permanent loss of capital is the risk that you might lose some or all of your original investment if the price falls and you sell for less than you paid to buy.”
 
                                                                                      -     Wallace Weitz 

“When you underperform for a few months, you shake it off as an anomaly. When you underperform for six months, you go back and check all your numbers and process. When you underperform for more than a year, you begin to question your abilities and your sanity. Losing isn’t easy. And it shouldn’t be. But how you respond to it separates great investors from average investors.”
 
                                                                                       -     Russell Wang 

The past six months have been tough for nearly every investment class. You name it - stocks, bonds, value, growth, small-cap, or large-cap. There is red ink for as far as the eyes can see. As of June 30, 2022, the S&P 500 was down nearly 21% year-to-date. The NASDAQ was down 30% over the same period. In June 2022, every one of the eleven sectors in the S&P 500 suffered double-digit losses. The second quarter was the most difficult, with the S&P 500 down 16%, the Russell 2000 down 17%, and the Russell Mid Cap Growth Index (the Nintai Investments Model Portfolio proxy) down a whopping 21%. Nintai Investments has not discovered a magic bullet to these market conditions. Our portfolios dropped by roughly 4% in June, significantly less than the major indexes. During the second quarter of 2022, the Nintai Investments Model Portfolio was down 14%, beating nearly every major index. 
 
Relative versus Absolute Returns in Bear Markets
 
As a professional money manager, I spend much time comparing Nintai’s results against a select group of indexes. Of course, the granddaddy of them all is the S&P 500 Index. No matter what style you use or what the average size of your holding is, it is expected that you will measure your performance against this index. After that, you try to find an index closest to your style (value or growth) and your portfolio holdings characteristics/size (small, mid, or large-cap). The goal is to outperform these indexes over the long term.  
 
All this chasing performance can sometimes lead an investor astray. At Nintai Investments, we are proud to be beating our proxy over the short and long term. But it is essential to remember that absolute returns are equally important. If the S&P 500 loses 25% over the next six months and we lose only 22% over the same period, that outperformance might only be a pyrrhic victory. Many investors look at 22% or 25% losses in the same light - losing lots of money. In this case, beating the markets isn’t what it’s cracked up to be. 
 
For instance, in 1926, Benjamin Graham set up his second fund, the Graham Joint Account. This replaced his first fund (Grahar Corporation), which he had started in 1925 with Louis Harris.  Over the first three years, 1926 to 1928, Graham’s new fund earned 25.7% annually against the Dow’s 20.2%. Not a bad performance record! He also beat the markets on the way down. From 1929 to 1932, Graham’s fund lost 70% compared to the Dow’s 80% loss. While he was pleased by the outperformance when the markets went up, his 1929 – 1932 outperformance ate at him. He often spoke about this period of his investment career as an abject failure. The bottom line was that he knew he had barely survived the worst four-year period in the stock market’s history.
 
After outperforming the S&P 500 for three out of our first four years, (2017, 2018, and 2020), we felt much like Graham did in the bubble years of the mid - 1920s. I confess we felt similarly to Graham again after a very difficult stretch between July 2021 - July 2022. “Only” losing 26% versus our proxy’s loss of nearly 30% didn’t bring much solace as an investment manager or to my investment partners. When performance is abysmal, it doesn’t matter how bad everyone else is doing. They say misery loves company, but I prefer not to be miserable, and I think most of our investment partners feel the same way.
 
Even though absolute losses like we’ve seen in the first half of 2022 can be emotionally challenging and make you want to pull in your horns, you can’t think that history necessarily represents the future. Relying on the facts and your judgment must force you to invest in the future, not the past. But it’s not easy. Deploying millions of cash assets during a rapidly developing bear market take intestinal fortitude and go against every emotional response your body may have. Graham used to say that you can’t run your investments as if a repeat of 1932 is around the corner. We will have market crashes and recessions in the future. But you can’t invest thinking about these things all the time. People who do miss out on tremendous market returns in the future. 
 
Investing When Things Are Down
 
Human beings have wonderful processes genetically built into our bodies that assisted us in staying alive for tens of thousands of years. An example is our fight or flight response (more formally known as “acute stress response”), first described in 1915[1] by Water Bradford Cannon, Chairman of the Harvard Medical School’s Physiology Department. This response was originally seen as an either/or scenario where an animal (we are, after all, animals ourselves) would either run like hell or fight like hell in times of danger[2]. These processes enable us to be aware of danger (in this case, the possibility of incurring financial losses through dropping market prices) and kick our autonomic nervous system into gear. In general, these mental shortcuts have saved time (and even our lives) over the tens of thousands of years of modern man’s existence. But they can also lead us dangerously astray. For every time our instinct to run was the best choice, there was an occasional poor choice to fight, not flee. In the instances when we chose to fight - and our adversary was a Saber-Toothed Tiger - the outcomes generally weren’t great. 
 
Here are some other cognitive biases and heuristics that play a role in our investment decisions when markets drop significantly. The challenge is identifying them, recognizing when they come into play, and mitigating the damage they do in our investment decision-making.
 
Loss Aversion: Sometimes called prospect theory, loss aversion is the tendency to want to avoid a loss of a particular value more than a gain of the same value. In other words, most people take the loss of 25% of their investment far harder than a 25% gain. Since first identifying prospect theory, we have been able to quantify the general ratio of the sensitivity of loss to gain –roughly three times stronger in a loss versus a comparable gain. This unequal response rate means that investors have a far more emotional response when stocks drop in value than when stocks increase. This can be seen in nearly every bear market by the rate of the VIX’s increase versus its decrease in bull markets. 
 
Anchoring Bias: As investors, humans tend to think the first piece of data acquired is the most important (meaning it becomes “the anchor” for future thinking). As an example, if an investor learns that a company is expected to increase its next year’s earnings estimates, then two days later reads the company has fired its CFO and COO, it is likely they will place more value on the first (and positive) piece of data versus the second. This might lead them to purchase shares because of the anchoring on the first (and sound) piece of data. Someone hearing the news in the opposite order would be far more likely not to purchase shares in the company. The challenge is to apply knowledge in a regulated process and allow it to impact our decisions regardless of timing or order. Relevant data can be timely, historical, or first or second in processing. 
 
Recency Bias: Recency bias is precisely what it sounds like. Sometimes an investor will decide that because the proposition was confirmed in the past, it should be true today (and in the future). An example is when an investor repurchases shares in a company they previously held and did well on the past investment. For instance, an individual purchased shares in Coca-Cola (KO) in the mid-1990s and did well, locking in considerable capital gains when the price exceeded intrinsic value. When the stock price drops in the future, the investor might show recency bias by purchasing shares without doing robust research because the investment did so well previously. Just like all investment advisors regularly disclose, past performance is no guarantee of future returns.  
 
Hindsight Bias: The old phrase goes, “hindsight is 20/20”. We generally think we are more intelligent than we are, assuming we could predict things when, in reality, we weren’t even close. For example, many investors will chalk up good investment returns to well-chosen stocks and stock-picking wisdom. It turns out that much of this is hindsight bias and that those golden returns have a lot more to do with luck than anything else. All too often, we shake our heads or roll our eyes when we hear a co-worker or friend say, “Oh, I knew that all along.” It’s important to remember that those very friends and co-workers are likely doing the same head-shaking and eye-rolling about us. The fight against hindsight bias begins with a small amount of humble pie with a dash of ill-tasting crow.   
 
All these processes come to the fore during bear markets. As the losses build up, our palms grow sweatier, our minds race a little faster, and our nervous system begins to near the red line. Bear markets are when we need to think clearest and allow our brain's rational components to function most efficiently. Unfortunately, we usually get the exact opposite. At Nintai Investments, we are no different. We are human beings, facing the same emotional responses, the same fears, and the same cognitive biases as any other investor. We believe we have a slight advantage over others because we’ve built processes to corral those attributes that can be so dangerous in times like today. 
 
Steps to Conquer Poor Bear Market Thinking
 
I’ve said that Nintai’s long-term outperformance is generally achieved in bear markets, not bull markets. We don’t succeed by being correct; we usually succeed by making fewer mistakes. That, of course, doesn’t mean we don’t make some real whoppers. We do. Just ask our investment partners, family, and friends. But over the past twenty years, our significant outperformance has happened in brief spurts during bear markets. For instance, during the period 2004 - 2013, the Nintai Portfolio only outperformed the S&P 500 in four of the ten calendar years. But in 2007 and 2009, we outperformed the markets by 17% and 21%, respectively. Those two years essentially made our record for an entire decade.  
 
How did we achieve those results? A few things. First, we have a process that identifies companies that can weather genuinely horrific conditions. Things like the collapse of capital markets, significant economic slowdowns, and tectonic shifts in the companies' ecosystems, including competition, technology development, and product displacement. This is building a portfolio with a clear and measurable focus on quality. Second, we have developed a process that forces us to react logically and not emotionally. This consists of basing investment decisions on price versus intrinsic value, allowing for a margin of safety in our calculations, and having a relentless focus on data. Last, we firmly believe our actions outside the investment world are critical. These are the things we can control, allowing us to stand back from the pressure cooker environment of the investment advisor world and keep our emotions in check. Until you’ve made decisions that can affect tens of millions of dollars of other people's money, it’s hard to understand the impact of six months, one year, or even five years of underperformance on your mental and physical health.  
 
It’s How You Invest, and Less What You Invest In
One of the things that will carry you through a bear market is having a firm understanding of how you invest. A well-defined process with clear criteria and methodology is vital to maintaining your sanity when your portfolio enters a bear market. For example, at Nintai Investments, the “how” we invest is a clearly defined road map consisting of the following statements.

Invest for the long term. Once we establish a position, we should exit that position under only a few conditions, including (but not limited to) share price greatly exceeding our estimated intrinsic value, the investment/business case being impaired, or there is a more compelling opportunity where capital is required. We strongly believe in letting great capital allocators do the heavy lifting over decades of partnership.

Great companies generate outstanding capital returns. The greatest investments in Nintai’s history have been companies with outstanding opportunities to deploy capital over the long term. These opportunities generate exceptional returns on capital with a low average cost of capital. Outstanding investor returns are generated by such opportunities carried out over several decades. 

Achieve patience by mastering your emotions. I find Ieyasu Tokugawa - one of the founders of modern Japan - a most remarkable individual (he was the real-life person behind the character Toranaga in James Clavell’s “Shôgun.” He was famous for his ability to restrain his emotions and outwait his opponents. He codified his life’s creeds into a document called The Tokugawa Legacy. In it, he wrote about the central requirement for leaders to be patient. 
 
"The strong ones in life are those who understand the meaning of the word patience. Patience        means restraining one's inclinations. There are seven emotions: joy, anger, anxiety, adoration, grief, fear, and hate, and if a man does not give way to these, he can be called patient. I am not as strong as I might be, but I have long known and practiced patience. And if my descendants wish to be as I am, they must study patience."
 
Notice that Tokugawa doesn’t say to eliminate the seven emotions. He simply suggests that one must restrain their inclinations. At Nintai, we’ve found that nearly all our greatest mistakes happen when we become impatient. 

Always invert and review your data: When things start to sour in our portfolios, I’ve found it helpful to return to my initial investment case and recheck our assumptions. Part of mastering your emotions and being patient can be achieved by staring at numbers and data. I’ve found it’s pretty hard to get emotionally worked up when I’m staring at a fourteen-tab spreadsheet filled with net margin and free cash flow projections. I’ve also found it’s beneficial to invert our projections and play with the numbers until I’m comfortable that things aren’t as bad as they seem. They usually aren’t. But on those occasions when you’ve cocked up well and good, running the numbers can objectively tell you where and when you got things wrong and whether there is a possibility to recover.    

Your Personality and Surviving Bear Markets
Having a process and following it are vital to surviving bear markets. I’ve also found that developing personal traits can also save you an awful lot of grief when things look bleak. Here are a few I practice every day. I emphasize these when the news isn’t great for the markets or our portfolios. 

Step back and hit the pause button: No matter how severe the downturn, not much will happen over the course of a day, let alone an hour. As an individual investor or small money manager, you have the luxury of stepping back and taking the time to think about what’s happening. Turn off the screaming talking heads with their “BUY! BUY! BUY!”, ignore the panicked announcers, and just sit and think. There is nothing wrong with pausing and reviewing your investment strategy, portfolio selections, and any investment case assumptions. Over the course of my investment career, I’ve seen so many instances of hasty decisions made without much thinking. In investing, nobody forces you to purchase or sell a stock. You can take as long as you want and take as many swings as you like. Use that to your advantage.   

Don’t take yourself so seriously: Making mistakes is part of the daily routine here at Nintai Investments. We’ve learned not to take ourselves too seriously. Every day we learn something new about one of our existing holdings, a potential holding, or a new tidbit about ourselves and the world we live in. It may seem that your decisions are the be-all, end-all of your investment world. We aren’t omnipotent in our knowledge or decision-making. Always remember that the markets can humble you on any given day. Never be afraid to admit your mistakes and always learn from them.   

Investing is part of your life, not your whole life: As a full-time investment manager overseeing tens of millions of dollars of other people’s money, it’s very easy to let times of underperformance change your whole life’s outlook. The past year has been awful for me personally. I find I sleep less well at night. I’m more anxious and find myself checking the markets more frequently than I have over my investing career. It’s taken me a great deal of time to realize that the markets and their returns shouldn’t define the direction of my life or how successful I feel about my career. Bear markets can tell you quite a bit about how your portfolio holdings adjust to adverse markets and how that impacts your portfolio value. Remember that they don’t tell you much about your personal value. It doesn’t define what you bring to the world as a parent, a non-for-profit volunteer, or simply the person who gets up and tries to make a difference every day. It is - after all - only investing. Make sure to keep it that way.  

Conclusions
 
Investing in bear markets is an extraordinarily difficult task for a human investor (compared to those computer/AI-driven models and algorithms). The components of such a market - falling prices, lost portfolio value, and the constant drumbeat of the financial media - trigger cognitive biases and emotional responses that push us to make bad decisions. As investors, our minds and bodies want to flee and seek what we perceive to be the safest ground. Like some diabolical plane from Dante, bear markets are when we need the greatest courage. Doing what seems to be the craziest of all things – putting capital to work – is usually the safest course in the long term. The greatest investors have processes in place to take advantage of these times by coldly looking at the numbers, devoid of all the noise accompanying them during bear markets. They also can master their emotions, overcoming the fear and flight sensations that come on so strong when the markets take their nosedive. Having a process that you know works for you and considers your intellectual and emotional weaknesses will go a long way in mitigating the risk of bear markets. 
 
What works for you during these trying times? I look forward to hearing your thoughts and comments. 
 
DISCLOSURES: None

[1] “Bodily Changes in Pain, Hunger, Fear, and Rage: An Account of Recent Researches Into the Function of Emotional Excitement,” D Appleton & Company, 1915

[2] This has been modified since by including the additional possibility of freezing or standing rigidly still (hence the more contemporary name “fight, flight or freeze response”).

“When you are captive between what is real and what should be, attempt an escape to real; should be is a mirage that does not exist.” 
                                                                          -     RJ Intindola 
“Valuation doesn’t really matter when it comes to crypto. We’ve escaped the boundaries of old thinking like that. We aren’t beholden to the old boogiemen of Wall Street anymore. I’m part of the future, and you need to accept that. Defining value through the cash flow of an asset is dead. Crypto killed it.”
 
                                                                         -     Comment on Nintai Investments website 

In the last year or two, I’ve had quite a few individuals write to me (see the above quote as an example) and tell me the reason for my underperformance is the lack of crypto in my portfolios. One writer went so far as to say to me I faced perpetual underperformance until I woke up to the reality that “crypto” (the shorthand version for describing the crypto ecosystem) was the only way to outperform the general markets. I must concede this claim exceeds my limited intellectual abilities. I have tried for several years to get my arms around blockchains, cryptocurrencies, cryptoexchanges, and stablecoins. Certainly, none of my co-workers or Board members would argue I’m a pro when it comes to this brave new crypto world. 
 
That said, I find it hard to see how anybody can value crypto assets in any traditional valuation model. Let me rephrase that: I don’t understand how anybody can come up with a valuation model for crypto assets at all. I am a traditional value investor who looks at an investment as purchasing the piece of a business or future free cash flows discounted back at a reasonable rate. Warren Buffett described it best (doesn’t he always?) when he was asked to describe investing in terms that the meanest laypeople could understand. Utilizing John Ray’s work from 1670’s “The Handbook of Proverbs”, he states:
 
"And then the question is, as an investment decision, you have to evaluate how many birds are in the bush. You may think there are two birds in the bush, or three birds in the bush, and you have to decide when they're going to come out, and when you're going to acquire them. Now, if interest rates are five percent, and you're going to get two birds from the bush in five years, we'll say, versus one now, two birds in the bush 
 
are much better than a bird in the hand now. So, you want to trade your bird in the hand and say, "I'll take two birds in the bush," because if you're going to get them in five years, that's roughly 14% compounded annually and interest rates are only five percent. But if interest rates were 20%, you would decline to take two birds in the bush five years from now. You would say that's not good enough, because at 20%, if I just keep this bird in my hand and compound it, I'll have more birds than two birds in the bush in five years. That’s all investing is.”
 
As Buffett points out, the only thing necessary to calculate one investment’s valuation is some basic arithmetic that can be done relatively quickly on the back of an envelope (in Buffett’s case) or an Excel spreadsheet (for us mere mortals). Of course, for this simple model to work, the investor must be able to define the value of the birds in the bush. At Nintai, we use a free cash flow model that uses a growth rate for the cash flow over the next decade, a terminal rate (meaning growth into infinity), the number of shares outstanding, and the discount rate (or cost of capital). That’s it. Like I said, simple enough to use a single tab on an Excel spreadsheet. But I won’t fool you. Much research goes into getting all the background research that produces those numbers. That’s for another discussion, however. 
 
Benjamin Graham said it best when he wrote, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” The key term for today’s discussion is “thorough analysis.” I want to point out that a thorough analysis should consist of identifying a valuation based on economic principles, financial data, and the business behind the stock share. In essence, research should show that the investment has an underlying economic value driven by some assets or cash flow that can be measured.  
 
Beautiful Leaves and Value
 
For example, this morning, walking into the office, I saw a lovely maple leaf showing fall colors of yellow, orange, and flaming red. Let’s say I came to you as an investor and said, “here is a tremendous investment. I’ll offer it to you for $250”. In the traditional investment model, you might try to collect some core data to help you understand the value of the leaf and whether it provides a sound investment. Here are some questions you might ask.
 

1. Is there a going rate or market for beautiful decomposing leaves?
2. Does the leaf have any underlying intrinsic value?
3. Will the leaf generate additional value (such as free cash flow) over its future?
4. What is a reasonable discount rate to calculate whether the leaf in hand is worth two in the tree?

 
I would argue (and I personally and professionally think it’s a valid argument) that with this leaf you cannot answer any of these questions qualitatively or quantitatively. Ergo, purchasing the leaf cannot be defined as an investment in any way, shape, or form. Having said that, I can hear somebody retort, “Oh, but Tom, ye have little faith or knowledge of dead and decomposing leaves. There is a market for said framed colorful leaves right now on Etsy”. Even granting this example, it is still hard to calculate the value and potential returns as an investment for such a framed dead and decomposing leaf. If anything, I would argue that purchasing such a leaf would qualify as speculation based on the greater fool theory that one man’s leaf is another person’s treasure based solely on the subjective view of the beholder (or potential investor). 
 
But enough of our lovely leaf and its potential as a future investment (or not). To tie this example into cyber, imagine I came to you and said I wanted to sell you a theoretical leaf. There is no leaf except what I have created in my mind and have assigned the same $250 value as the physical example. Does this change your view as an investor? Can you come up with any means to value such a leaf (or notion of the leaf)? If you thought valuing that beautiful physical leaf was difficult, try this example on for size. This, of course, gets us much closer to cyber and the difficulty in defining value. 
 
Valuing Cyber
 
As I discussed at the beginning of this article, quite a few investors have written in, saying my underperformance is based on a lack of cyber in my portfolios. This includes everything from decentralized digital currencies (Bitcoin) to digital collectibles residing on the Ethereum blockchain (NFTs). If we stretch our leaf example into the cyber world, I find it just as challenging to answer the four questions with Bitcoin as I did with our colorful leaf. 
 
My puzzlement rests on getting my arms around how to value these items. They certainly are not traditional companies (they generate no cash flow), nor do they have what appears to be any form of hard asset (unless you consider a Bored Ape Yacht Club NFT as one). To give an example of my confusion, I wanted to share with you a conversation that – for lack of a better phrase – nearly “blew my head off” (you’ll get the joke after reading the interview). 
 
I was listening to the most recent episode of Morningstar’s “The Long View,” where the discussion was about cryptocurrency and its role in the individual investor’s portfolio. Ric Edelman, the founder of the Digital Assets Council of Financial Professionals (DACFP), started the conversation by being asked by Jeff Ptak about coming up with an intrinsic value for bitcoin. I think the discussion is worth quoting in full. 
 
Ptak: When it comes to things like stocks and bonds, we use cash flows to try to estimate intrinsic value. But that's not possible with bitcoin as there are no future cash flows. Given that, what confers bitcoin's value, especially considering its volatility currently makes it hard to use as a medium of exchange?
 
Edelman: This is where people's heads explode. I've been managing money for 40 years. I built the largest RIA in the country managing $300 billion in assets. We serve at Edelman Financial Engines 1.4 million people around the country. And so, yeah, I've been working with individuals on managing assets for a long time. And when you try to value bitcoin and other digital assets, your head explodes. What I have found is that as I've trained thousands of financial advisors over the past six, seven years in this area of crypto, I found that the more knowledge and experience you have as an advisor, the more experience as an investor, the more training, designations, college degrees you have in managing money, the more your head explodes, because all of that traditional training and all of that knowledge from Wall Street does not have any applicability in the crypto space. They are totally separate conversations. But most in the crypto world, or those in the Wall Street world, are trying to apply their knowledge to the crypto world. This is why you get people like Jamie Dimon, very bright guy, saying crypto has no value; why Warren Buffett calls it rat poison squared. These are brilliant Wall Streeters who are trying to apply their world to the crypto world. It is a non sequitur. It simply doesn't work. And here's why.
 
When you apply, as you said, Jeff, traditional valuation models, you're looking at the company, you're looking at the employees, you're looking at the product, the revenues, and the profits. And you look at other companies in the same industry that have been sold to determine relative valuations. And all of that helps you determine what the value of your company is that you're examining to establish the price of that company. Well, that works fine when you're evaluating a stock. But it doesn't work with bitcoin for the simple reason that bitcoin is not a company. It has no employees, there's no product, there are no revenues, and there are no profits. All of those numbers are zeroes, leading Jamie Dimon and Warren Buffett to say, therefore, bitcoin's value is zero. What they don't understand, very simply, is that bitcoin's value may not be something that we can clearly understand, but it certainly has a price. And that's the real key. We have to understand that the marketplace of investors—buyers and sellers—have ascribed a price to bitcoin—as we record this, about $40,000. That's all that really matters. It's a supply/demand equation. It isn't a stock valuation equation. And until you’ve begun to accept that fact, your head will continue to explode.”
 
From what I can understand from Mr. Edelman’s comments, he appears to be claiming that the value of crypto is simply whatever the market will bear. This means there is no actual underlying asset of value but rather a perceived value between a buyer and seller. Utilizing my previous leaf example, there isn’t much difference between buying and selling exquisite rotting foliage and investing in the Bored Ape #271 non-fungible token. Utilizing Edelman’s approach, I think we can safely call any money used in acquiring crypto assets an act of speculation.
 
Conclusions
 
Through the ages, there have been crazes built upon products that - over time - skyrocket into asset bubble pricing and eventually collapse, leaving consumers holding hundreds of thousands of Chia Pets, Pet Rocks, Beanie Babies, and Garbage Pail Kids. I think it’s worth inquiring about the difference between valuing a Beanie Baby and Bitcoin. Or a parrot tulip or a stable coin? If we’ve learned anything over the past few months watching nearly $467B in notional crypto value disappear (the crypto market lost $200B on May 12, 2022 alone), it’s that the underlying value in anything crypto is as volatile and mirage-like as that fluttering leaf I found outside my office door. Our thinking at Nintai is that anybody discussing long-term investing and crypto is discussing a contradiction in terms. Value investors would be advised to steer clear of all the Wall Street jingoism accompanying its marketing campaigns. Otherwise, an investor might face a long, cold financial winter with many bare trees and very few leaves providing coverage. As Ric Edelman said, it’s enough to make your head explode.
 
As always, I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai has no holdings in any form of cryptocurrencies or assets, though he secretly admires Bored Ape #271. 
 
 
 
 

“Definition of Statistics: The science of producing unreliable facts from reliable figures.”
                                                         
                                                                                               -      Evan Esar 
“The art of valuation seems like it should be relatively simple. But nothing could be further from the truth. Investors have hundreds of ways to get to a value of a company – relative versus absolute, economic value add (EVA) versus discounted cash flow (DCF), dividend discount model (DDM) – the list goes on and on. Is one better than the other? Likely not. It’s more what facts are more important to the investor and their ultimate investment goal or strategy.”
                                                                                               -      Lester String 

“I wondered why Nintai has chosen to use a discounted cash flow model for valuation purposes versus other methods, particularly one that compares investments against each other versus just focusing on one company. Also, why do you use cash versus earnings? Thank you very much.”

                                                                                                -     A.M.
 
I have received several questions from readers (an example is quoted above) and fellow investors about why Nintai utilizes a discounted free cash flow model versus what is known as relative valuation methods. I thought I’d take a moment to answer this question as part of a series of articles on investment valuation methodology. Let me say up front that whatever I can fit into a few-page article will be woefully short of the complexity and detailed discussion the topic deserves. To any trained professional analyst, I apologize. For the rest of you, get out your green tinted shades and prepare to jump into the some of the technical aspects of investing. It will be worth it, I assure you.  

Absolute versus Relative
 
When one talks of valuation at a high level, two distinctive models are absolute versus relative. The absolute model is the estimated valuation of a specific company’s share utilizing data specific to the potential investment. This process allows the investor to measure the price versus the value of that company’s shares and that company alone. The relative model estimates how the company’s valuation compares to other industry players. This process gives the investor a very broad look at how a potential investment’s value compares to possible alternatives. Generally, comparisons are made using commonly accepted metrics like price-to-earnings or price-to-sale-ratios. 
 
In most cases, the absolute approach requires a good deal of research and considerable knowledge of the company’s business strategy, operations, competitors, market size, financial strength, etc. A great example of this is a discounted cash flow model. At the end of the exercise, an investor should be able to estimate the intrinsic value of the company and its per-share price. This is specific to the company and nothing else. The relative model will compare certain accounting ratios of the company versus other players or competitors. It’s less about the specific company’s valuation and more about whether it's cheap or expensive against similar companies. The data needed for a relative model can usually be quickly found on publicly available websites.
 
I thought I would use Abiomed (ABMD) - a current Nintai Investments holding - as an example to demonstrate both models. The company describes itself as “providing temporary mechanical circulatory support devices primarily used by interventional cardiologists and heart surgeons. The firm's products are used for patients in need of hemodynamic support before, during, or after angioplasty and heart surgery procedures. In plain English, they provide devices that keep blood flowing for patients after surgery or due to unique illnesses. For comparison, I have chosen Masimo (MASI), a maker of oximeters vital to calculating how well the patient is absorbing oxygen and getting it to their vital organs. The stock is also a holding in the Nintai Investment’s portfolio. A third company is Zimmer Biomet (ZBH), a leader in the design and manufacturing of joint replacements, including hip and knee components. All three companies are players in the medical device industry.  
 
The Absolute Model: Discounted Cash Flow (DCF)
 
Without getting into too much detail, the absolute model can tell the investor what the estimated intrinsic value of the company is at this moment, irrespective of the value of its competitors. It can give you the estimated value of the whole company or just a share. As an example of an absolute model, I will run Abiomed through Nintai’s discounted cash flow (DCF) model. I will also demonstrate a relative model to see if/how the finding varies. 
 
I won’t go into too much detail about DCF models at this point, other than to say the model is an interactive way to demonstrate that a bird in the hand today might (but not always!) be worth more in the bush of the future. The major components necessary for calculating intrinsic value are the current share price, current free cash flow amount, the estimated free cash flow growth rates over the next decade, the number of shares outstanding, the estimated discount rate, and the terminal growth rate. In this case, the major data puts look like this:
 
Abiomed Share Price (as of May 27, 2022): $266.34
Abiomed Free Cash Flow (FCF): $250,000,000
FCF Estimated Growth: 2023-2026 (14.5%), 2027-2030 (14.0%), 2031 (13%)
Abiomed Shares Outstanding: 45,900,000
Discount Rate: 8.65%
Terminal Growth Rate: 3%
 
Using Nintai’s DCF model[1], we calculate that Abiomed is worth roughly $206/share versus the current trading price of $266/share. This tells us that a share of Abiomed is trading at a 29.5% premium to Nintai’s estimated intrinsic value. Utilizing the same process, we estimated Masimo trades at a 13% discount and Zimmer Biomet trades at a 29% discount to our estimated intrinsic value. The DCF model clearly tells us that (all else being equal) Abiomed is the company we would be least likely to invest in based on valuation. 
 
This process tells us which company has the greatest variance in price to value and to focus on for additional research. The model Nintai uses allows us to focus on the most important piece that drives value - increasing free cash flow. This number is derived through the input of many variables including estimated market size, market share, company product development, competition, and technology trends (to name a few). The process also considers other measures such as the company’s competitive moat, financial strength, and management which are all part of the discount rate calculation. We believe the DCF model used allows Nintai the most comprehensive view of where value will be generated over the next decade. We don’t believe a relative valuation process is as accurate or detailed as this method. 
 
The Relative Model
 
In a relative model, an investor uses specific metrics to help estimate whether a company is trading fairly, above, or at a discount to other companies in the same industry. The most common of these metrics are price-to-earnings, price-to-sales, and price-to-book. Utilizing these, Abiomed compares to two competitors in the medical device space in the following manner.

As an investor, what strikes you right away - for all three candidates - is that they all appear equally expensive. None seem to be flashing a “buy” signal. Having said that, Masimo is the cheapest by earnings, with Zimmer Biomet cheapest by price/sales and price/book. It’s very difficult to pick a winner among the three with these results. 
 
Utilizing this process has both positives and negatives versus the DCF model. On the positive side, an investor can quickly ascertain the ranges of value within a specific competitive space. For instance, from this case, it can be quickly seen that medical device companies generally trade at higher-than-normal multiples. Finding one trading at much lower levels could give the investor insight that the company’s value is more compelling than most. On the downside, the investor doesn’t know much detail about each company, such as its financial strengths, competitive moat, or management qualities. I would argue that the relative model could be best used to quickly ascertain what company might represent a better value than others, but the DCF model would be best to evaluate if the company represents a good value in itself.  
 
Is one model better than the other for making an investment case for these three companies? At Nintai, we prefer to always base our valuations on in-depth company research combined with an intensive understanding of the markets, competition, product cycles, regulatory, and other ecosystem information. Having said that, it is the individual investor’s level of commitment, desire to learn, and focus on what’s important that will drive whether they use the absolute or relative valuation method. 
 
Cash Flow versus Earnings
 
That brings us to one of the key questions an investor must answer before deciding on whatever valuation tool they choose to use. Anybody completing a valuation of a company has the choice between earnings and free cash flow as the choice of data to use in the valuation model. Most Wall Street analysts use earnings as the basis of their calculations. 
 
Earnings represent a company's net income or the dollars they have after subtracting all their expenses, like taxes, cost of goods sold, and administrative costs, from their revenue. Earnings can be found on a company’s Income Statement. They are the most common way of reporting a company's performance on Wall Street today. Cash flow is the money, representing cash and cash equivalents, coming in and out of a business. If a company has more inflows than outflows, they have a positive cash flow. When there's more money leaving than coming in, the company experiences a negative cash flow. Cash flow (or operating cash flow) is the cash generated by business operations. Free cash flow is operating cash flow minus capital expenditures. Free cash flow can be found on the company’s Cash Flow statement. 
 
Why the distinction between earnings and free cash? Because reported earnings and free cash flow can be quite different. For instance, a company might be earnings positive but free cash flow negative or vice versa. Let’s look at how two companies might utilize different accounting to reach very different financial results to see how that might happen. Please recognize that this has been simplified for demonstration purposes. 
 
Company A had net income (earnings) of $1,000,000 and spent $500K on capital expenditures for the quarter. The company generated cash flow from operations of $1.25M. The company had no cash flow from investing or financing. The company began the quarter with $100,000 in cash on the balance sheet. There are currently 1,000 shares of company stock outstanding. 
 
In this scenario, the company reports earnings of $100 per share ($1,000,000 net income/1000 shares). The company also reports free cash flow of $750,000 ($1.25M cash flow from operations – $500,000 capital expenditures). The company reports $100,000 cash on the balance sheet (there was no cash flow from investing or financing that utilized cash). 
 
Company B (identical to Company A) has taken a different approach to its accounting by (illegally) claiming $250,000 of costs as capital expenses[1]. Let’s look at how they report. 
 
For the quarter, Company A had earnings of $1,250,000 and spent $750,000 on capital expenditures. The company generated cash flow from operations of $1.25M. The company had no cash flow from investing or financing. The company began the quarter with $100,000 in cash on the balance sheet. There are currently 1,000 shares of company stock outstanding. 
 
In this scenario, the company reports earnings of $125 per share ($1,250,000 net income/1000 shares). The company also reports free cash flow of $500,000 ($1.25M cash flow from operations – $750,000 capital expenditures). The company reports $100,000 cash on the balance sheet (there was no cash flow from investing or financing that utilized cash). 
 
So, what’s the difference we can learn from these two scenarios? Company A – reporting numbers by generally accepted accounting standards – has lower earnings for the quarter versus its evil twin Company B. From this perspective, Company B might go to Wall Street and tout it has outperformed its “weaker” twin since most analysts focus on earnings. Of course, the question is, how long is it before Company B’s financials are audited and the illegal shift of operational costs to capitalized costs is identified? However it works out, it shows the ease with which earnings can be manipulated (I should say there are much more sophisticated and perfectly legal ways to play this game. My example is for illustrative purposes only). The important point is that earnings can be manipulated rather easily, while free cash flow is extremely difficult. In the words of Alfred Rappaport, “profit is an opinion, cash is a fact”. In such instances as WorldCom or Enron, Wall Street’s focus on earnings growth blinded it to the fact that these companies were increasingly hemorrhaging cash (and reporting wholly fraudulent earnings). A savvy investor would have seen earnings increasing, but free cash flow highly negative. We choose to use free cash flow at Nintai simply because we believe it is a safer number to use.
 
Conclusions
 
In this - the first in a multi-part series on investment valuation models - we’ve discussed a couple of issues an investor faces when choosing a valuation method. In Part 2 of this analysis, I will look at the distinction between possible valuation means – our old friend, the DCF model, and Economic Value Add (EVA). EVA is an approach developed a couple of decades ago that – in its simplest form – should end up with the same valuation as your DCF model. I will discuss the pros and cons of these and why I feel they are complementary but not the same. Until then, I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai Investments currently holds shares of Abiomed and Masimo in client portfolios. 


[1] In explanation, there are two types of expenses - operational and capital. Operational keep the company running and include such thing as salaries, office supplies, administration, etc. Capital expenditures are those that extend out over years and are long-term in nature. By generally accepting accounting standards, it is unacceptable to try to put operational costs under the capital expense category. Why? Because it inflates earnings and depresses the free cash flow number.
[2] ​In explanation, there are two types of expenses – operational and capital. Operational keep the company running and include such thing as salaries, office supplies, administration, etc. Capital expenditures are those that extend out over years and are long-term in nature. By generally accepting accounting standards, it is unacceptable to try to put operational costs under the capital expense category. Why? Because it inflates earnings and depresses the free cash flow number.

Tom was recently interviewed as part of the Brown University Virtual Value Investing Q&A Speaker Series. Check out the full interview below.

​“Moats are terribly important to the long-term investor. Any company that can maintain a wide moat over twenty or thirty years can smooth out an awful lot of poor investment decisions. Conversely, getting a moat wrong (through either not understanding its durability or its existence at all) can crush your investment returns. If I have one piece of advice for new investors, it’s to look to your holding’s moat – understand its components, understand its durability, and understand its role in your estimated intrinsic value”.   
 
This quote is from a speech I gave in 2011 to a collection of healthcare analysts who were grappling with understanding a company’s moat and its importance in a company’s valuation. Re-reading it eleven years later, I’m not sure I’d change a single word. The only addition I might make is to be “very” conservative in your estimates (not just conservative) when valuing a possible investment’s moat. 
 
Generally, when we get moats wrong at Nintai, it’s because of two things. The first is that business conditions change enough to impair the company’s ability to maintain the characteristics of a wide-moat business. Secondly, as investors, we convince ourselves the company has achieved a wide moat when one has never existed. In the final analysis, the damage is the same in both, though it generally goes much quicker in the latter than in the former. 
 
I’m going to discuss both cases in much greater detail. Both can be deadly when it comes to long-term performance. I recently wrote an article about New Oriental Education and Technology (EDU), a holding in some Nintai investment partner portfolios that lost 75% of its value in two days in 2021. That poor choice was a combination of Option # 1 (the company lost its ability to maintain a moat due to changes in governmental policy) and Option #2 (the moat we thought the company had was much weaker in reality). 
 
In today’s article, I wanted to discuss Option #1 (why a company's moat might fail) in much greater detail. Before I get started, it might be helpful to quickly review what Nintai thinks are the primary sources for sustainable moats. 
 
A Brief Review of Moat Characteristics
 
A competitive moat is a term first used by Warren Buffett to describe a company's competitive advantage over time. This competitive advantage creates an “organizational moat” that makes it more difficult for competitors to capture market share, increase prices, or build a better mousetrap. The broader and deeper the moat, the better the protection and the greater the likelihood the moat is sustainable over the long term. No company has better articulated Buffett’s concept of moats than Morningstar. Their “Economic Moat Ratings” are essential in understanding how a company derives its moat, sources, durability, and trend. The company’s “Why Moats Matter: The Morningstar Approach to Investing” by Heather Brilliant and Elizabeth Collins remains a true classic. 
 
Morningstar’s Types of Moats: We agree with Morningstar that there are certain forms of moats.[1] These include Network Effect (whereas more users join a network, the more powerful it becomes as dictated by Metcalfe’s Law), Intangible Assets (where patents, brands, or regulatory approvals can create legally-derived moats around a business), Cost Advantage (where a company can keep costs down, but profits up regularly), Switching Costs (where it becomes cost and skills prohibitive to remove a product from the customer’s business processes), and Efficient Scale (where several players dominate a market that lends itself as too expensive to build out a competitive offering – like pipelines). We use some specific measures at Nintai that we think are critical components to any company with a moat. 
 
High Returns on Invested Capital:  Companies with wide moats can use capital to produce high returns on said capital. In plain English, this means a company can utilize capital (such as cash, debt, or money raised through stock sales) by deploying it into either existing operations (such as building a new plant) or new operations (such as an acquisition or creating a new product) that generates high returns on the invested capital. Great companies find ways to use the money to increase their moat, while poor companies generate inadequate capital returns by squandering it on bad business deals or product development.
 
High Free Cash Flow Conversion: At Nintai, we look for companies that convert 25% or greater revenue into free cash flow for at least the past ten years. After paying all the bills to keep the business running (labor, SG&A, leases, capital expenditures, etc.), the company clears over one-quarter of all revenue as wholly theirs. This demonstrates that the company can achieve extremely high profitability and has enough cash to little to no need to go to the capital markets or raise debt. 
 
Competitive Strength: We also look for companies with obvious competitive strengths. Easily identified strengths are monopoly or duopoly (when there are only one or two companies in that line of business, an investor should expect to see higher growth rates and increased profitability. Another example is dominance achieved through regulatory or patent protection. When a pharmaceutical receives a patent for a particular molecule or product, this guarantees exclusivity for anywhere between 7 - 15 years. Not bad if you’re the only company treating a specific disease. 
 
Excellent Capital Allocators as Managers: Just because a company can achieve high returns on invested capital and find ample opportunity to invest in the current business doesn’t mean they will. An equally important component has a management team with the discipline to stay with projects that aim for high returns on invested capital, as well as the discipline to reject those that don’t have those characteristics. 
 
Why Moats Fail or Get Filled In
 
Of course, nothing is better for an investor than bringing a company into the portfolio and watching it broaden its moat, grow revenue, increase profitability, and successfully allocate capital to grow the company over a ten to twenty-year period. At Nintai, we’ve been lucky to have a couple of these, including Manhattan Research (MANH), Intuitive Surgical (IRSG), and FactSet Research (FDS). Unfortunately, we’ve also had more than our share of portfolio holdings where the moat disappeared, along with our investment case and investment returns. Several great (perhaps that’s not the word) examples from Nintai’s past include Corporate Executive Board (merged) and New Oriental Education (EDU), and Computer Programs and Systems (CPSI).  
 
Each of the latter cases involved companies that faced a rapid decline or collapse in their competitive moat. This further led to a near-complete collapse in stock price and competitive position. In each of these cases, one of three reasons led to such rapid changes. 
 
Government Regulations Change: The old phrase goes that the good Lord giveth, and the good Lord taketh away. Indeed, nothing could be more accurate than the case of New Oriental Education and Technology. For nearly two decades, the ruling Chinese Communist Party (CCP) encouraged families to invest in learning English as a second language, getting tutoring services to improve those skills, and leveraging EDU’s country-wide infrastructure to increase their skill sets. In 2021, the CCP pulled the rug out from tutoring companies complaining they were forcing families to spend too much on education as a percent of their total family income. In one week, the government completely obliterated the business and investment case in the mainland China for-profit education market. 
 
New Technology/Product/Process is Developed: Sometimes, it’s as simple as competitors exploding on the scene with a new product or offering that instantly makes a business or product obsolete. For instance, in most major cities, there are a limited number of hackney medallions that allow you to drive a taxi. In Boston, there are 1,825. At its height, cabs picked up 14.6M fares in 2012. That number dropped to 5.9M in 2018. In 2021 it was estimated to be roughly 2.3M. The cost of a medallion has fallen from $900,000 in 2013 to $34,000 in 2021. The reason for this collapse? The democratization of ride-sharing through Uber and Lyft. In the blink of an eye, the entire business model of the taxicab in major cities was blown apart. 
 
Management Takes Their Eye Off the Ball: Occasionally, great companies will have management takeover that aren’t as good capital allocators as their predecessors. A former holding in the Nintai Charitable Trust portfolio - Computer Programs and Systems (CPSI) - saw return on equity drop from 43.3 in 2014 to -11.6 in 2017 under new management. This type of collapse in return on equity reflected a broader breakdown in the company’s moat, leading to the permanent impairment of Nintai’s capital. In this instance, management took its eye off the ball of the electronic health/medical record (EHR/EMR) space and lost its competitive advantage over the next few years. The stock price shared an equally severe drop, and Nintai’s investment was permanently impaired.
 
Signs of a Deteriorating Moat
 
What should an investor look for when identifying if a portfolio holding’s moat is deteriorating in size or scope? Here are some things we look for at Nintai Investments. 
 
Revenue Decrease: a slight and consistent decrease in revenue tells you more about an eroding moat than one awful year. When a company sees revenue decrease year-over-year for an extended time, it can mean the company’s product is losing the loyalty of customers, loss of pricing power, or that the company simply isn’t executing its strategy very well. Whatever the reason, decreasing revenue is not what an investor is looking for in a company with a narrow or wide competitive moat. 
Profit Decrease: Another sign of a deteriorating moat is squeezed gross and net margins, or most importantly, a decrease in free cash flow or free cash flow as a percent of revenue. Any of these three might suggest the company no longer can keep costs contained (raw supplies costs have increased or the labor market is too tight) or worse; it is losing the battle of maintaining control over pricing versus customers who don’t see the value anymore.
Decreasing Market Share: A clear sign of an eroding moat is when a portfolio holding sees a marked deterioration in market share. Numbers like this reflect something either very wrong at the portfolio company or something very right at a competitor. As an investor, we prefer to see it the former, not the latter. Why? Because this is something in the company’s control that with the right management team, strategy, operational team, and adequate capital, can be solved. That said, any solution must thread the needle of all these listed issues as well as complete them in a reasonable period. Many customers won’t have the patience to see a vendor go through a series of missteps.  
Specific Government Action: In some instances, a government may change its policies and have an enormous impact on a company’s moat. For instance. Mexico’s government provides supportive policy to three Mexican publicly traded airport operators – Grupo Aeroportuario del Pacifico (PAC) holds the most significant passenger market share at 26%, compared with 23% for Grupo Aeroportuario del Sureste (ASR) and 15% for  Grupo Aeroportuario del Centro Norte (OMAB). Any change in government policy - such as moving to a more free-market model or a change in licensing – could dramatically impact each of these companies’ competitive moats. 
 
A Note on Speed
 
Some of the previously mentioned events can lead to much quicker moat deterioration than others. For instance, a change in government policy - created by a change in administration or simply an unplanned policy change - can destroy a moat in days. For example, Nintai’s investment in New Oriental Educational (EDU) lost its entire moat and most of its valuation in just 72 hours in the summer of 2021. Others, such as decreasing market share, can take years of erosion to eat away at a company’s moat. In Computer Programs and Systems case, it took several years before the extent of damage to the company’s moat was identified.
 
Questions to Ask Going Forward
 
Inevitably, an investor will own a portfolio holding that shows the signs of a weakening moat, as described in the previous section. When this happens, there are several questions the investor should ask relative to the future of the moat, can/will it return, or is there an opportunity to create an entirely new moat.  
 
Is the Moat Permanently Impaired?: The first question an investor should ask is whether the moat has been permanently impaired. Events such as the loss of a patent, a radical change in government policy, or the launch of a truly ground-breaking new product by a competitor can usually mean the damage can be ascertained quickly. But most cases aren’t so clear-cut. Sometimes it can take several quarters or even years before the erosion, and its certainty becomes clear. We’ve found the best way to mitigate the risks associated with this long-drawn-out process is to know your portfolio holding, market, and competitors exceptionally well. If the investor isn’t willing to do some real, in-depth leg work, then find a quality index fund.  
 
Can the Company Rebuild the Moat?: This is one of the more difficult questions an investor will have to answer about moats. The company and its team have already built a moat, so we have a cognitive bias in our thinking that says they should be able to do it again. But you have to let all that information go and dwell on the facts of why and how they lost the moat. It would seem unlikely they can rebuild the exact same moat because that one blew up. So, what would need to change? Strategically? Operationally? Does the company have a management team capable of identifying the required changes? Does the company have the capital required to make the changes? Again, an investor needs an in-depth knowledge of what made up the previous moat, what a new one might look like, and all the necessary information on competitors, markets, strategy, operations, financials, etc.
 
Can the Company Build a Different Moat?: This question can usually be answered the quickest of the post-impaired questions. We have found over time that it is challenging to not only rebuild a competitive advantage but to build a moat in an entirely different field. You certainly want to believe in management. After all, they’ve shown remarkable skill and drive in creating a solid business already. Who says they can’t do it again? But building a moat in an entirely new field or industry is another whole ball of wax. Having confidence in your management to rebuild an existing moat is one thing, having it in them to build a moat in an entirely new industry or vertical? That’s more likely to be a pipe dream. 
 
Conclusions
 
Building a business surrounded by a deep competitive moat is quite a task. Identifying a market, creating a product, fending off competitors, and achieving long-term growth are all marks of a great management team.  Inevitably, the hallmarks of such success tend to get weathered and fade away. For a host of reasons (listed previously), a portfolio company’s moat can (or will) deteriorate with time. The challenge for the investor is to purchase shares when the moat is in the ascendancy and not overpay in those circumstances. The second key is recognizing when a moat is weakening, identifying the causes, and ascertaining whether management can turn the situation around. A wise investor can sometimes avoid conditions that lead to crack-ups in a business’s competitive moat. But we all make mistakes. This article can’t guarantee you won’t make such a mistake in the future. But it hopefully outlines some of the issues an investor can keep in their desk drawer and pull out now and then to refresh their memory. 
 
As always, I look forward to your thoughts and comments.
 
DISCLOSURE: Nintai currently owns New Oriental Education and Technology (EDU) and Manhattan Associates (MANH) in both client and my personal investment account. 

[1] These examples are components of Morningstar’s “Economic Moat Rating” and “Moat Sources”. More information can be found here. 

“I claim we got a hell of a beating. We got run out of Burma, and it is as humiliating as hell. I think we ought to find out what caused it, go back and retake it.”
 
                                                               -      Joseph “Vinegar Joe” Stillwell 

“I like people admitting they were complete stupid horses' asses. I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.”
 
                                                               -     Charlie Munger 
 
Looking back, 2021 was when Nintai suffered from several organizational failures that led to poor investment decisions. This was most evident in our purchase of New Oriental Education and Technology (EDU). The stock has been the worst investment in our near twenty years in investment management. Following the collapse of the stock price in the summer of 2021, we focused on three areas. First, can an investment case still be made for New Oriental, or is the stock so impaired that we should write off the losses and move on? As a quick summary, we think there is a case to be made for holding the stock because our estimated intrinsic value exceeds its current stock price. Should the stock reach anywhere near that, we will exit the position entirely. Second, where exactly did we get the investment so wrong? What steps within our process failed? We’ve spent much time breaking down the process and have identified several significant problems. These include multiple instances of cognitive bias. In plain English, we found various ways in which our own brain developed muddled thinking habits over the years that blinded us to the warnings about the company. It also included a failure in our investment process. Specific cautionary steps we have created over the years failed regarding the New Oriental investment. Simply put, our process took on too much risk without fully understanding the perils of the investment environment. In part two of this section, I will detail the specific procedures that proved to be inadequate. Our last area of focus has been developing a way to prevent such a mistake again. We recognize that not every investment will turn out to be a winner (at least we learned that over the years!). We have developed a revised process that slows our thinking down, puts more checks and balances in place, and forces us to delve deeper, ask more questions, and rely on more disparate data than previously. We think these steps can help prevent another such decision like the one which led to the outsized losses of New Oriental Education investment.    
 
The Dangers of Cognitive Bias
 
Cognitive biases develop when our brains simplify our thinking about complex problems. A good percentage of these biases have to do with memory – both our cognitive memory (the fear we had when we first had a stock significantly drop or feeling of satisfaction when we sold a position at a profit) and our genetically programmed “memory.” The latter can be seen when we mistakenly see a pattern where one doesn’t exist. In investing, seeing ten profitable earnings releases in a row might have you predict an eleventh without sufficient evidence to back up that prediction. This type of bias was formed tens of thousands of years ago. Our ancient hunter-gatherers recognized that a pattern of prints could be followed successfully for that night’s dinner. Our genetic memory doesn’t remember that 1 out of 100 of these trails led to a saber-toothed tiger, not a roebuck. In that one instance, the hunter-gatherer was the dinner. Other biases have to do with simplification created by lack of attention. We can’t remember everything all the time, so we make hierarchies of what’s important to notice, thereby making a shortcut in our decision-making process. There are dozens of identified cognitive biases, each capable of creating terrible damage in our decision-making process. 
 
Here at Nintai Investments, we are as susceptible to these biases as any other human. We tried to build strategies that take these into account, and over the years, we’ve felt we did a pretty good job. And then 2021 came along. Our failings during the year were broad and diverse. Over the last sixty days, we’ve worked hard to identify what went wrong to improve our processes to prevent these mistakes from happening again. Here are some of the cognitive biases we identified that tripped us up in our investment with New Oriental Education.     
 
Anchoring Bias: When you rely too much on an initial piece of information that keeps focused on old data. This “anchoring” means you don’t consider more recent data. In this case, Nintai had invested in New Oriental previously and made a considerable return on our investment. By anchoring our thinking on the previous investment, we lost sight of the risks associated with the current investment. 
 
Blind Spot Bias: This is when you reject information because you think the source is biased (and it disagrees with your opinion or finding). For several years, we have heard that the Chinese Communist Party (CCP) felt the economy had moved too close to capitalistic practices. We chose to ignore this thinking. We chalked it up to the usual anti-Communist croaking by certain western writers when we should have talked to Jack Ma or people familiar with Jack’s experience with the CCP.
 
Confirmation Bias: Somewhat an inversion of the Blind Spot Bias, this one is where you lock on information that confirms your theory or decision to the detriment of information that contradicts it. For instance, looking back at our research of EDU, I found that we read pro-investment studies at nearly four times the rate of dissenting views. We fell prey to the same mistake many older value investors made in 2006-2007 with financials. Everyone had seen this before, so everyone did the same thing, regardless of the data that showed this time it was different. Our work with New Oriental mimicked this only too well.
 
Hyperbolic Discounting: This bias is when you look for a short-term gain (at much higher risk) over the more tedious and less heroic long-term gains achieved through patience and longer workout times. At Nintai, we’ve traditionally looked for companies that we can partner with for decades that hopefully achieve slow and steady growth in free cash flow. We’ve never been much to finding fallen angels and hope to see relatively quick profits. That is until New Oriental. Looking through our analysis, it’s clear that the idea of a relative short gain could help offset our underperformance through the year up to that point. We haven’t done that in our career previously, and we learned why we wouldn’t be doing it in the future. 
 
These are four (and there were more!) cognitive biases that played a role in our poor decision to invest (and then double down) in New Oriental Education stock. I hope this helps illustrate some mistakes that Nintai was guilty of and hopefully learn from going forward.
 
How Did Nintai’s Process Come Up Short?
 
We’ve spent a great deal of time looking at what went wrong over the past year, with a particular emphasis on our decision-making surrounding New Oriental Education. I previously discussed the cognitive biases I was guilty of over the year. These I group as individual faults made through human miscalculations. The second large category of mistakes reflected a breakdown of an organizational nature. In these instances, business processes focused on factors that simply didn’t matter and missed things that mattered very much. These failures are easier to identify and remedy because they are process problems, not human problems. The breakdown in our organizational processes falls into four significant findings. Each of these on its own could have created the opportunity for poor decision-making. The presence of all four nearly assured it. 
 
Breaking the case was inadequate: I have written previously about our process of “breaking the case,” or where we invert our assumptions to the point that the investment case is broken. We do this in many ways – decreasing free cash, decreasing market share, increasing sales and administration costs, creating litigation costs, etc. One of the things we’ve never really built into our models is the state government actively seeking to destroy an entire industry in one fell swoop. Our problem, in this case, was believing the Chinese government would want as many of its citizens educated and trained as possible. Overall, our breaking the case model had gaping holes in its methodology and scope.  
 
New Oriental was out of our wheelhouse: Looking back over our investment career, most of our successful investments have been in two industry verticals – healthcare and technology. More particularly, many of these companies have been in either healthcare informatics or technology-based platforms. Some of our least successful – such as Computer Modelling Group (CMDXF) – have been industries where we have no distinct edge in knowledge (in CMDXF’s case, the energy industry). It should come as no surprise that New Oriental Education was not in any of our circles of competence. We had no edge in China as an investment environment or education as an industry vertical in this instance. Looking back, I would say both were almost anti-circles of competence. 
 
We underestimated non-corporate risk: As I mentioned previously, it’s clear we have focused far too much on business risks to the detriment of regulatory or government risk. Interestingly, when we look at any possible healthcare investment, we spend an enormous amount of time understanding the risks related to FDA regulation, regulatory approvals, etc. In this case (again, because of our lack of industry and geographic knowledge), we spent far too little time understanding the CCP’s role in government regulations, setting industry priorities, or capitalistic models in the Chinese economy. While we did a decent job understanding the industry, competitors, and the company’s financials, we dropped the ball investigating outside the walls of New Oriental.  
 
“Never Invest” wasn’t broad enough: W.C. Fields’ adage was that actors should never work with kids or animals. Over time, at Nintai, we’ve developed similar “Never Invest” conditions. These include significant debt, no moat, and low-margin businesses. For instance, we’ve never invested in the consumer retail space because they almost always have all those conditions, not just one. We overlooked when it comes to New Oriental that we should never invest in a country where the ruling government has the power/capabilities of disrupting or eliminating a company’s business model or industry. Though they may look like they are invested in a capitalistic model (like Russia or China), certain countries do not have the political or economic infrastructure to guarantee investor or corporate rights. 
 
How to Prevent This Again
 
“We do not learn from experience; we learn from reflecting on experience.”
 
                                                              -        John Dewey 
 
Now that you (and we) know what went wrong in the New Oriental investment, I wanted to take the time to discuss what steps we’ve taken to make sure this doesn’t happen again. 
 
Non-business risk is just as important as business risk: I’ve spent tens of thousands of hours learning what makes businesses tick for over two decades. I’ve learned what role strategy and operations can play in creating a moat, how the lack of access to capital can bring a company to its knees, and how unethical management can start rotting a company from the head down. One thing I haven’t focused on enough is that risks outside the company – governmental, socio-economic, or political – can be as severe in size (or even more severe) than those within the company I mentioned previously. It’s easy to make assumptions or have cognitive biases in such issues as the political structure of a country. For instance, in China, I made a mistake to assume that the ruling CCP would do what’s best for its people as seen through the eyes of a quasi-capitalistic system. I didn’t take into account two risks. First, the government would unilaterally act seemingly detrimental to its people (meaning millions will no longer have access to top-quality tutoring). Second, the government would act in such a manner as to call into question (from the West’s standpoint) an entire generation of capitalistic moves that created an opportunity for millions of its citizens. 
 
Going forward, we have broadened our risk assessment tools adding new sections on government and politics. This will include new sections specifically discussing the nature of these risks and any mitigation steps Nintai can take before investing. This might range from requiring a more significant margin of safety to adding the company to the “Never Invest” category. In addition, we have built new steps in our modeling (such as “Breaking the Case”) where non-business risks impact valuations to a greater degree. This includes government intervention in customer markets, unilateral powers vested in the government, or actions are taken to retain control that impacts the company or its business model. 
 
Clearly define your circles of competence: At Nintai, we’ve never explicitly stated what lies within our circles of competence. Our corporate structure and management agreements do not prohibit me from investing in any type of industry or specific company as Chief Investment Officer. Over time, we have recognized that our expertise lies in the areas where Nintai Partners conducted business. This included healthcare, healthcare informatics (the use of information and data in strategy and operations), and technology platform companies (where the company provides a platform that integrates a client’s information systems). Secondary (but equally important) are companies that meet specific characteristics in the structure and operations. These include high returns on capital/equity/assets, high free cash as a percent of revenue, little or no debt, a competitive moat, excellent capital allocation skills by management, and trading a discount to our estimated intrinsic value. Unfortunately, New Oriental was far outside our circles of competence regarding knowledge about the investment country or the industry. If we were asked today to check off the significant characteristics cited, it would go something like “little to no knowledge of Chinese economic policy?” Check. “Little to no understanding of the Chinese educational system?” Check. “Little to no understanding of the ESL/tutoring/certification studies market?” Check. It is not a great performance from our risk management process.
 
Going forward, we have created a system that makes a structured view of our circles of competence, including industries, geographies, markets, regulations, etc. This new system requires that any potential investment be vetted through these circles’ characteristics. Any company that meets less than an 80% overlap is immediately rejected. We will also be adding this to Nintai’s annual review of current holding to make sure the holding hasn’t drifted outside our circles of competence.  
 
New categories of “Never Invest”: As I’ve mentioned previously, over time, we’ve developed a list of “Never Invest” companies or industries that don’t meet our investment standards are we don’t understand. Until this year, we’ve eliminated companies or industries because we couldn’t quantify the risk. For instance, in many biotechnology companies, we simply cannot tell the odds of a company getting FDA approval for a new product. We know it’s low, just not exactly how low. With our investment in New Oriental Education, we realize that there are opportunities where the level of risk can be quantified, and it’s simply far too much. In this instance, the risk is that the CCP can eliminate the company’s entire business model in one brief announcement. While it might seem unlikely they would do this, the consequence could be (and have been) catastrophic.
 
Going forward, we have added a new bucket of “Never Invest” companies and industries driven by the fact that outside risks are simply far too impactful, no matter what the chance. This might include companies that are beholden to one or two products for most of their revenue or similarly might count on a single client for much of their revenue (Skyworks Solutions came close to this with their Apple relationship). It will also include risks outside of the business (such as New Oriental) where a single event such as an earthquake or governmental edict can impair our investment case. Hopefully, this new addition to our risk assessment process will prevent another poor investment outcome, such as New Oriental Education. 
 
Final Thoughts
 
2021 was another year dominated by COVID, though there was some heartening news when several effective vaccines became available. We found out exactly how resilient the economy was as we had several new waves of variants without a dramatic impact. Unfortunately, we saw an increasing polarization within our political system, starting with the January 6 insurrection and attack on the Capitol. The markets had another banner year, with the S&P 500 gaining nearly 27%, the Dow Jones roughly 19%, and the NASDAQ 21%. It was the twelfth year of a bull market that started at the end of the Great Recession. 
 
2021 was undoubtedly a disappointment to Nintai Investments and most of our investment partner portfolios. No investment manager will ever get every pick correct unless your first name is BERNIE and your last name starts with M_A_D_O_F. Confessing poor judgment and owning up to your mistakes is never easy, even if you are Charlie Munger. But as an investment manager, I feel it is my responsibility to take credit (not sure that’s the word I’m looking for) for the wins and the losses. More importantly, I believe each of our investment partners is due to an explanation as to how we will prevent such a mistake going forward. I hope this report has provided that to our investment partners.

"The strategy of buying what's in favor is a fool's errand, ensuring long-term underperformance. Only by standing against the prevailing winds - selectively, but resolutely - can an investor prosper over time. But for a while, a value investor typically underperforms."
 
                                                                                              -     Seth Klarman 

I recently read an article ("Investing When Everything is Expensive") by John Rekenthaler, Vice President of Research at Morningstar[1]. He discusses why it might be necessary to rethink the concept of "core" and "explore." The former is plain old generic stuff such as blue-chip US/foreign equities and high-quality debt. The latter are investments that might seem more risky but likely to outperform over the investor's lifetime. For me, the article resonated because Nintai has found itself looking like one of those dogs trying to find just the right spot for their morning business. We all know the look - nose to the ground, running in circles, revisiting spots they just investigated a minute before. When every asset class is inflated in price - core or explore, bond or stocks, domestic or foreign, wide moat or no moat - we find ourselves trotting around, looking at every class for some obscure gem of an investment. We got into investing in 2003-2004, so Nintai missed that period in 1999-2000 when many stocks were egregiously overpriced. But even then, many bargains were to be had in non-"e” or technology such as manufacturing or utilities. In today's market, every asset class we play in is overvalued. We don't see any screaming bargains in our investment horizon. 
 
What makes this particularly painful is that our investment partner portfolios have underperformed over the past twelve to eighteen months as we hold significant cash positions, and our portfolio stocks have been hit hard after nearly a decade of outperformance. Nothing is more frustrating and stomach-churning than underperforming and knowing there is little you can do about it. "These are the times that try men's souls," said Thomas Paine. Mr. Paine had the heart of a value investor experiencing a sustained bull market. 
 
A Quick Review on Strategy 
 
Before I get into why it is so challenging to be a value investor in expensive markets, I thought I'd quickly review our investment methodology here at Nintai and how it relates to our actions in these overpriced times.
 
Focused Portfolios: At Nintai, we operate in a relatively simple format of being invested or not. We run a focused portfolio (anywhere between 15 - 25 positions dependent on size or investment need. As I've discussed previously, we focus on companies with high returns on assets/capital/earnings, fortress-like balance sheets, deep competitive moats, and managed by great capital allocators. After running a search with such criteria, there are generally only 150-175 companies worldwide the meet our demands. By its very nature, our investment strategy forces us to focus on just a few holdings and to hold them for the long term. 
 
We Hedge with Cash: We use a simple model when it comes to investing. We are invested in our focused portfolio holdings, or we hold cash. We aren't limited to any particular model in our investment management agreements. We could use actively managed funds, ETFs, or even individual debt instruments as hedging tools. I don't do this for the simple reason our partners invest with us to use Nintai's strategy – not for me to use a competitor's model. Consequently, when no opportunities arise with Nintai's strategy, I will hold cash. This can sometimes drive cash to 30-35% of total assets under management. 
 
Valuation Drives Portfolio Holding Make-Up: How much we hold in equities or cash is driven solely by valuation. By this, I mean that we use two distinct valuation measures – one individual and one broad. The first is the valuation of each holding. If we think the valuation of a specific stock is compelling, we will likely add to the position, thereby necessarily driving down the portfolio's cash position. The second (and somewhat in congruence with the first point) is that I will likely hold more cash if I feel the markets – as an aggregate - are overpriced. Conversely, if I think markets have gotten far ahead of themselves (an example might be our aggregate portfolio is 125% above our estimated intrinsic value), I will sometimes shave 5% off every individual portfolio position.

Where We Stand Today
 
As of November 29, 2021, the S&P 500 stands at 4668, up roughly 22% year-to-date and roughly doubled over the past five years. Morningstar currently has its total rated stock universe approximately 4% above fair value. It calculates that the healthcare and financial sectors (by far Nintai's majority of holdings are in these two sectors) are 6% and 10% above intrinsic value, respectively. Other indicators reflect a much higher valuation versus historical data. For instance, the Schiller PE ratio has only been higher once before in the late-1990s before the technology bubble and crash. From the old-fashioned PE ratio to the newer PEG ratio, nearly every historical measure is at all-time highs. Fighting this trend, the current Nintai holdings are trading – in aggregate – roughly 11% below our estimated intrinsic value. The aggregate PE ratio of most portfolios is less than half the S&P 500s. At the same time, returns on equity, capital, and assets are substantially higher than the market averages. 
 
Nintai has been down this path before when we thought markets were wildly expensive. Our last experience was during 2006 – 2007, just before the real estate crash and the ensuing global credit crisis. For almost the entire year of 2006, the Nintai Partners fund held nearly 45% of total assets in cash. We avoided corporate and government debt as fervently as equities. As a result, we could find little value in domestic or foreign markets, debt, or equities. In the ensuing market crash, we significantly outperformed the markets after trailing for several years of slight underperformance. Indeed, much of our long-term outperformance was generated in the single year of 2007 when we beat the S&P 500 by nearly 30%. 
  
We are currently looking for ways to batten down the hatches but not get left behind by the S&P 500's double-digit annual returns. This is the rub, of course. You must attempt to prevent a permanent loss of capital in a sudden market crash but at the same time stay as invested as possible to allow compounding to work its magic. As we take the necessary steps to obtain that balance, we try to focus on several core tenets.  
 
To thine own self be true (your process is your guide)
Generally, value investors underperform in prolonged bull markets. It can seem that every decision you make has the markets go against them. Stocks that you purchase drop by another 30% over the first few weeks. Even companies that present shining earnings quarter after quarter can stagnate and underperform for years at a time. No matter how much you hear about the latest nanotechnology, day trading with options, or how value investing is dead, your process must always be the anchor in your decision-making. Your process must be your guide. As a value investor, your methodology rests on the simple premise that a company's share price will inevitably be matched by its intrinsic value. It can take years for the markets to reach these same conclusions, and to date, they usually do so. Hold on to that fact dearly. 
 
This ain't no fantasy football (valuations are only reasonable when based in reality)
One of the problems with expensive markets is the growing ability of Wall Street, investment advisors, and personal investors to convince themselves that prices really aren't that bad. That 55% projected growth rate over the next decade might just be reasonable if you hold your nose and believe in management's claims. Never, ever do this. Your job as a value investor is to question everything in your investment case - including claims by management and your assumptions for valuation. Every investment debacle I've had (and there have been quite a few) has been caused by my inability to force some form of brutal reality into my assumptions.    
 
Just because the market is crazy doesn't mean you should be too 
A corollary to the previous point can be summed up by that phrase so many of us heard from our parents. "You wouldn't jump off the bridge because everyone else is doing it, would you?". We would frequently answer that; of course, we wouldn't do something so ridiculous. If you wouldn't do it as an eighteen-year-old, why do it as a seasoned value investor? Of course, the pressure is intense when talking heads slam buttons that scream "Buy! Buy! Buy!" or you read how some new prodigy achieved 94% returns on only ONE stock that he's more than happy to share with you for only just $499 right now!  Just because networks allow this type of behavior on their shows doesn't mean you need to listen. Base your decisions on a well-reasoned and well-researched process that meets your goals. Anything else looks like a lemming running at top speed with all its friends and relatives, and we know how that ends.   
 
Conclusions
 
Investing in expensive markets can be costly in more than one way. Elevated prices supported by nearly a decade of steady gains can make you want to overpay for a stock that looks so good on quick review. It looks even better when you hear about it at the staff Christmas party or your New Year's party with your neighbors. You can frequently hear them talking about how 
 
their outstanding stock-picking abilities paid for that BMW or pool. Don't believe it for a moment. Most gains in the market are made by purchasing shares at a reasonable price and selling them when overvalued. That's value investing. Buying expensive stocks and selling them after they become more expensive (hopefully) is a process dependent on the greater fool. When stocks are trading at such all-time highs and nosebleed valuations, it's hard to know who's the real fool. Be careful. It might just be you.
 
As always, I look forward to your thoughts and comments. 
 
DISCLOSURE: I have no positions in any stocks mentioned in this article.


[1] John is a brilliant writer with the rare attribute of being able to see the investment process from many different angles and disciplines. I highly encourage my readers to go to Morningstar and become regular readers of John’s “Rekenthaler Report”. You can find his writing here.  

"The first thing [in credit] is character, before money or anything else. Money cannot buy it. A man I do not trust could not get money from me on all the bonds in Christendom. I think that is the fundamental basis of business".
                                                                -   J.P. Morgan in testimony to the Pujo Committee, 1912
 
"Nobody who has run a business thinks 'Geez, I'd like to run this thing right into the ground, make the business so worthless that some could buy it pennies on the dollar.' No, most managers want to make the most prudent decisions to maximize the value of the company. Being a good manager isn't the best training at being a value manager". 
                                                                -  Joel Alscot   

When I first began investing (and this takes me back nearly 40 years ago) in an economics class, I saw stocks simply as a symbol in the financial section of our local newspaper. How quaint. An actual physical newspaper. My understanding of management was absolutely nil. That changed after I graduated from college, and several friends and I started a company together. I knew nothing about running a business or my relationship with shareholders (shareholders?) vis a vis being a senior executive. I got an education very quickly, starting with my first Board meeting. I quickly learned several lessons that were pounded into me by several members. 
 
It's all about allocation of capital: My job - I quickly learned - was to make decisions on allocating capital and achieving the best return I could for the company, and therefore, for our shareholders. Nothing was more essential, and nearly every major decision we made was part of this allocation process – human resources, deal structures, infrastructure spending, etc. By the end of the first year, I was thinking like a capital allocation machine. 
 
Honesty is still the best policy: My Board expected me to report the good and the bad clearly and succinctly without any gobbly-gook or hiding the facts. If we made a mistake, it was best to describe what happened and how we expected to prevent it from happening again. Our Board made it very clear: the worst thing we could do was make a mistake and hide it. When we did this we prevented them from assisting us in finding a solution. 
 
First principles thinking is the best thinking: The Chairman of our Board was a huge proponent of reasoning by first principles. This is a form of reverse-engineering a problem by removing the fuzziness and vagueness of assumptions and focusing on the essentials. Rather than assuming something works because others (our ourselves) have always done it in a particular way, you can go to the most basic level and assemble the building blocks based on facts. Many times you find assumptions can lead you far astray. 
 
After our fourth year in business, our company began an internal fund to invest our retained earnings and increase the book value of our shares. I quickly realized the views I had learned and adopted as an executive were the same values I wanted to see in companies that became our investments. I still think they are the best core values to find companies that will outperform over the long term. Here are a few examples of how I applied my learning in portfolio selection.
 
Allocation of Capital
 
When I first had a conversation with the senior management team of FactSet Research (FDS) in the 2000s, I was struck immediately by their focus on capital allocation. One executive said to me:
 
"We have a lot of choices in what we can do with our capital. We are an asset-light business, meaning it doesn't require a lot of assets to run our business, we are a relatively non-capital intensive business model. It could be easy for us to go out and do a zillion smaller acquisitions or one huge acquisition or buy a new technology for our operating platform. But you know what? We've run the numbers over and over. Frankly, we can achieve the best returns on capital by incrementally spending the money on our business and retaining capital on the balance sheet. Would it be sexy to do a huge deal? Sure! But it wouldn't be our shareholders who win. It would be investment bankers, accountants, and those of us in senior management. We try to remember every day we work for our shareholders. Return on capital means return to shareholders."  
 
From 2006 - 2020, FactSet achieved an average Return in Invested Capital (ROIC) of 34.6% versus an Average Weighted Cost of Capital (WACC) of 8.3% (source: Gurufocus). Over that fifteen-year time frame, WACC never exceeds ROIC in a single year. Now that's discipline in capital allocation.
 
Honesty and Integrity 
 
You get the feeling watching the news today that not many managers are a paragon of virtue. Stories of embezzlement, failure to pay vendors, gaming the numbers to meet earnings - the list goes on and on. At Nintai, the older we get, the more critical management becomes in the outperformance of our portfolio holdings. Negative things generally happen when good companies are taken over by bad managers (to paraphrase Warren Buffett). Some of the worst things happen when managers turn out to be untruthful or lack integrity. We haven't seen many companies implode when competent and ethical managers run them. Conversely, the investment journey is littered with companies led down the garden path by unscrupulous management. 
 
In 2019, we sold a biotechnology company out of our investment partner portfolios, the Nintai Trust portfolio, and my personal portfolio. The company was accused of overcharging the Center for Medicare/Medicaid Services (CMS) for its products. It's an all too common technique in the industry that provides a quick, highly profitable, (and illegal) manner for juicing revenue at no additional costs. The problem I've always had with this is two-fold. First, these types of issues always start at the top. You simply can't create an entirely 
 
fictional billing process along with a new revenue stream that impacts corporate revenue without senior executives' knowledge. Second, managers who believe these types of lies begin to push the envelope in other ways, such as off-label marketing and even fabricated research results. Executives willing to put patient lives at risk and overcharge those least capable of paying are some of the worst individuals I've been involved with and have happily cut all ties. 
 
First Principle Thinking
 
Applying first principle thinking isn't always a natural approach to problem-solving. In my case, it took years of note-taking and reminders to make the process a fundamental step in making decisions.  
 
A Lesson in Debt: While running my business (which I still do at Nintai Investments with only three shareholders), I quickly learned that debt could be a double-edged sword for the business. While it can provide opportunities to invest in growth, all too often, debt can be an albatross around the neck when times get hard. We've all heard the phrase "you can't go bankrupt without debt." First principle thinking allows us to break this down into different pieces. First, without debt, you can't go bankrupt. Second, debt can’t be serviced at the worst time. Third, companies often generate low returns on debt financing. Ergo, it's hard to get in trouble without debt. Consequently, in my history as a money manager, roughly 75-80% of my portfolio holdings have (or had) zero short- or long-term debt. 
 
A Lesson in Costs: When I talked to the former CEO of Fastenal (FAST) – a past holding in the Nintai portfolios – he frequently would tell me about how excited he was to obtain low costs, not just in his business, but even his personal life. Low costs were a passion for him and a sign of personal integrity. For example, he said to me once:
 
"What most people fail to understand is that to have low prices, you have to have low costs. I know that sounds crazy, but you'd be amazed by the examples I've seen where management thinks the company should have low costs, but management shouldn’t. Take a look at their corporate offices, their expense accounts, the flashy clothes. Rot starts at the head of the fish. If you want low prices, then low costs start at the very top – with the Board and the executives." 
 
His application of first principles came intuitively to him. Query: how do you achieve low costs and high returns to shareholders and customers? Answer: Have the lowest costs. It might not seem like rocket science, but frankly, I haven't found many other executives like him nor holdings as successful as Fastenal. 
 
What This All Means
 
So what does all this mean? Focusing on the lessons I learned from running my own business (both in the past and present) helped me to understand the type of company I'm looking to create and run is the type of company I would like to add to my portfolio. Several themes emerge from that.  
 
They're human beings, not robots
 
We often hear the comment that when you invest, you buy a piece of a business, not a stock share. That rule is equally valid when it comes to an investment's management. You are purchasing the qualities of a set of human beings, not a computer named Hal that runs the ship. First and foremost, managers are people just like you and me, filled with emotions like fear and joy or uncertainty and egoism. They have good days and bad days. What is necessary before anything else is that we are aware we are purchasing the rights to a human management team that reflects their emotions, skills, and values. These values will hopefully provide shareholders with adequate returns over the long term. Of course, as an investor, we expect management will make mistakes. That's part of being human. We just need to be made aware of them – quickly and openly – and plan accordingly. 
 
Values still matter
 
No matter what you may hear on the TV or read on the internet, at Nintai, we like to think that values still matter and good guys (and women) still finish first most of the time. Those that cut corners, fudge numbers to meet aggressive quarterly earnings, or create neat little off-balance sheet SIVs will eventually be hung up by their own petard. None of those scenarios are good for shareholders. Equally important is the way management communicates with shareholders. At Nintai, we like to invest in management who see us as business partners. Therefore, we want management to communicate with us in an honest and open approach helping to make the best investment decisions. When mistakes are made (see the previous point), we like our portfolio holdings' management to own up to them, explain what went wrong, and hear how they intend to prevent a repeat in the future. Bottom line: integrity still matters a lot. 
 
It's easy to forget what matters
 
I've noticed over the years our willingness to let unacceptable cases slide in some cases and not in others. It's important to realize that "it's OK because everybody does it" is just as dangerous as a case of apparent specific personal misconduct. Let me give you an example of what I mean.
 
Case 1: You read an article about a Wall Street financier who knowingly bundled together bad debt (voila! Let there be good debt) and created fictional debt instruments to be sold to unknowing investors. These instruments lead to the creation of a financial bubble that costs thousands of jobs and billions in dollars of losses. 
 
Case 2: A co-worker comes to you and asks for money to help fund a family member fighting cancer. After writing a check for $500, you find out the story was a lie, and there was no family member and no cancer. Instead, they used that money to finance a vacation to Bali. 
 
Now answer these questions as quickly and honestly as possible. 
 

1. Which case made you angrier at a purely emotional level?
2. Which individual would you least likely do business with in the future?

 
If we are being honest, just about everybody has a far more visceral reaction to the second case versus the first case. But as an investor, it's vitally important to see both as clear-cut cases to reject both individuals in a potential investment. Just because everybody is doing it (think about how widespread the problem was in the first case) doesn't make it right. On the other hand, the lack of individualized anger (such as case 2) also doesn't mean it's OK to ignore it. Have your standards and stick by them no matter the scope or size.
 
Conclusions
 
Another J.P. Morgan story relates that he thought someone failing to pay back five dollars told him more about somebody than not paying back five million dollars. Over time I've realized that genuinely great managers who produce outstanding long-term results have ethics that consider the small ($5) or very personal (the cancer scam) value just as much as driving overall corporate values. They all matter equally. Look for managers who, through their values, create value in your investments. It isn't easy. Doing the right thing isn't always the easiest path. But it is one we admire greatly at Nintai.  
 
As always, I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai has no positions in the companies mentioned within this article. 

“Ambiguity is central to Boyd’s vision. It is not something to be feared but something that is a given . . . We never have complete and perfect information. The best way to succeed is to revel in ambiguity.” 
 
                                                                              -      Grant Hammond[1] 

In 1961, Colonel John Boyd – working with Thomas Christie – wrote an article named “Aerial Attack Study.” Boyd trained as a fighter pilot, but his mind quickly developed beyond the cockpit. Aerial Attack Study introduced the military to the concept of “Energy-Maneuverability Theory” (E-MT). Boyd’s and Christie’s work was vital in understanding the various tradeoffs when working on aircraft design. E-MT was a breakthrough of immense value because it gave engineers a process to calculate how any design can be superior or inferior when measured against another. E-MT analyzed how swiftly and efficiently an aircraft could change its energy use, speed, and acceleration or potential versus kinetic energy. This analysis could then be converted to a numerical value of how well a plane maneuvers under various conditions. This process enabled fighter pilots to “converse” with engineers in their language by describing dogfighting jargon in mathematical terms. E-MT had a significant impact in creating the leading fighter aircraft over the next generation, including the F-15 Eagle and F-16 Fighting Falcon.  
 
Boyd’s next project brought him even greater fame – in terms of both name recognition and scope of impact. It also is where his thinking can best be applied to value investing theory and practice. Thinking at a higher level than his E-MT work, Boyd began analyzing what systems could be put in place to improve a fighter pilot’s speed/effectiveness in thinking processes and decision-making skills. From this, he developed the OODA  (Observation, Orientation, Decision, and Act) Loop. 
 
The OODA Loop begins by making two assumptions. First, Boyd contends that all intelligent life and human-developed organizations continuously interact with their respective operating environment. Second, all of these interactions can be broken into four major groups or functions. 

1. Observe: The utilization of all major senses in the collection of data. Boyd made it clear that data was a snapshot of what was happening within a complex environment at any one time. Observation information becomes obsolete relatively quickly. Therefore, observation requires constantly updating your data. 
2. Orient: After collecting data through observation, comes the synthesis and analysis of the data. The orientation phase is about reflecting on the critical data captured during observation and considering the next steps. Above-average orientation skills require great situational awareness and a process that uses multiple mental models. Boyd saw this as the most essential function.
3. Decide: The decision phase develops a series of suggestions taking into account all potential outcomes. A key component in the decision process is creating a strategy that screens out extraneous inputs and allows management or the individual to focus on the best possible choices, not all choices. 
4. Act: The steps and actions necessary to carry out the decision. In Boyd’s final presentation on the OODA Loop, he placed “Test” directly next to “Act” (this was changed to “Unfolding Interaction with Environment” and “Feedback” in his later presentations). In doing so, he clarified that he saw the Loop not just as a decision-making process but as an individual or organization-learning process. Thus, not only should we be constantly updating inputs, but we should constantly test our mental models throughout the Loop. 

Source:    “Science, Strategy and War,” Frans P.B. Osinga, Routledge Press, December 2006 
                  “The Tao of Boyd: How to Master the OODA Loop,” AoM, November 2020
 
After developing the OODA Loop, Boyd developed several thoughts about its effectiveness and some caveats in its usage.

1. The OODA Loop is a means to operating in a complex environment. Multiple inputs are constantly changing. The faster someone can obtain inputs, the quicker someone can produce decisions.
2. The OODA loop is only as effective as the time it takes to execute a result.
3. The person or organization that completes multiple OODA loops first derives the most value. 
4. The person or organization that adapts/updates their observation and mental models quickest, thereby evolving their OODA Loop, derives the most value. 
5. Limiting extraneous factors that can needlessly slow down getting to decision and action phases can significantly impact. 

 
The OODA Loop and Value Investing
 
So what does all of this have to do with value investing? At their highest level, the description of the OODA Loop and value investing share many common attributes. For instance, the OODA Loop has been described as “a learning system, a method for dealing with uncertainty, and a strategy for winning head-to-head contests and competitions. Another description is “the OODA Loop is a means to a.) observing complex organisms, whether they be an enemy pilot or a competitive corporate threat, b.) developing possible counter-measures through situation awareness and mental models, and c.) acting on such chosen measures.” 
 
Compare that with the following description of value investing as “a trading process based on uncertainty and risk in which a.) an investor looks to identify a discrepancy between price and value identified by b.) observation of corporate data and ecosystem characteristics and c.) observable investor behavior that leads to d.) a decision to allocate capital in the security.” At Nintai, we believe the major steps in value investing consist of these steps. 

• The investor sets specific criteria by which they search for possible investments. This can be by financial, capital return, industry, or country/region. As value investors, we are constantly updating both corporate and market information. Therefore, what may not meet our criteria one week might be ringing alarm bells just one week later. Similar to OODA Loop, “Observe.”
• Research is conducted through which estimated growth, profitability, market size, regulatory issues are identified and quantified. Information can be specific to a certain date (such as the balance sheet), a defined period (one-quarter, one calendar year, year-to-date, five-year average). A series of mental models will develop cross-functional ways to observe historical, current, and future value trends. Similar to OODA Loop “Orient.”
• Research ascertains the estimated intrinsic value of the company shares and matches it against its current trading price, and develops a series of possible recommendations. These might be to purchase at a specific strike price, buy increasing shares at share prices further decrease in price, sell a position when certain conditions are met (such as the holding taking on debt), or sell on specific market conditions (a competitor successfully launches a new FDA-approved drug). Similar to OODA Loop, “Decide.”
• When certain conditions are met (% discount from estimated intrinsic value) and reasonable suggested actions are offered (purchasing X number of shares representing only 30% of one day’s total trading volume), then action should place. Following up on these actions, we will spend a considerable amount of time evaluating the success or failure of the process. Similar to OODA Loop “Act.”

 
If this sounds similar to the OODA Loop, it should. Long-term successful value investors are constantly reevaluating not just their holdings (including management performance, product development, competition, market factors, etc.) but their very selection process (what factors are most important? How do we gather and collect data? How do we evaluate trends in the data, etc.?). At Nintai, we see the investment process must be continually reviewed and adapted to the ever-changing investment universe.
 
The Importance of Orientation
 
John Boyd felt the most important of the four steps in the OODA Loop was orientation. In one of his presentations, he stated: 
 
“Orientation isn’t just a state you’re in; it’s a process. You’re always orienting.”
 
As I pointed out in the last section, Nintai sees the process of orienting our thinking as a never-ending process. This is perhaps the greatest symmetry between Boyd’s work and value investing. One of the failings in nearly every value investor (this author included) is constantly failing to update our orientation. Too often, we get stuck in a pattern of thinking which locks us into a particular model or pattern of assumptions. For value investors, this can be costly. For fighter pilots, it can be fatal.
 
One method that Boyd suggests using is applying a set of mental models regularly until they become second nature in your thinking process. Boyd lists seven disciplines that are a must for any strategist. These include:

1. Mathematical Logic
2. Physics
3. Thermodynamics
4. Biology
5. Psychology
6. Anthropology
7. Conflict Resolution (Game Theory)

 
These models are essential for any person or organization to orient themselves in their environment. Understanding these disciplines allows an individual to see their position from many disparate and unique viewpoints. In addition, constant orientation leads to the ability to act quickly and – most importantly – with the best chance of obtaining outstanding results from your decision-making. 
 
Again, this sounds remarkably similar to Charlie Munger’s concept of a “Latticework of Mental Models,” which he believes creates a powerful method of objective – and evolving – thinking. Thus, while Charlie’s disciplines[1] may differ somewhat from Boyd’s, the concepts meld pretty easily. 
 
Conclusions
 
One thing that has always interested me in value investing is the constant need to acquire knowledge. Whether improving or altering my thought processes to the knowledge of a specific industry or market verticals, roughly 80-85% of my day is spent thinking and researching. Does this mean we get everything right? Absolutely not. But it does mean that Nintai can hopefully gain the ever-so-slight edge over the marketplace, which allows for long-term outperformance. Investors can continually adapt their thinking and investment processes by studying such works as Boyd’s. The history of business – and nations – are replete with organizations that got caught in a cycle of actions that never considered changes in their operating environment. As a value investor, the OODA Loop can be a helpful tool to evolve your thinking from valuing a business to understanding changes in specific industry verticals. Next month I will use a specific case study that discusses how Nintai uses Boyd’s work in understanding changes within a specific portfolio holding.   
 
Until then, I look forward to your thoughts or comments.
 

[1] Math and Inversion, Probability, Chemistry, Statistics, Economics, Evolutionary Biology, Psychology, and Engineering 

I recently discussed Nintai's performance numbers with a group of analysts who wanted to know the secret sauce that generates long-term outperformance. Many of the questions centered on our stock-picking ability, market timing, and ability to identify business trends leading to outstanding growth. I made it pretty clear the evidence suggests there aren't many individuals who can repeatedly pick stocks that outperform (certainly we can't!), there are even fewer who can choose the highs and lows of markets (definitely not Nintai!), nor do we have a business divining rod that identifies the next hot "it" thing in the markets (we are so far from what's hot in business, I'm not sure we would know "hot" if it hit us in the nose). At Nintai, we think the more active we are, the less effective we will be in the long term. Unfortunately, our circles of competence are limited, and our crystal balls are pretty fuzzy. So instead, I told this group of analysts that our success had been driven by finding several compounding machines throughout my investing career and riding them for as long as possible.
 
What exactly is a "Compounding Machine"?
 
Compounding machines are simply companies that consistently grow free cash flow at substantial rates over a decade or two creating long-term value. This can be achieved through competitive advantages gained through internal and externally-facing moats. Additionally, these companies often generate high returns on capital and maintain fortress-like balance sheets. These attributes drive steady growth in the intrinsic value of the business. When I describe it like that, it seems like a pretty straightforward process. You simply have to find these types of companies, back up the truck, purchase a significant number of shares, and merely wait ten to twenty years as management and the company work their magic. What an easy world value investing would be if it was so simple. But, of course, we all know it doesn't work quite like that.  
 
Finding compounding machines requires several major buckets of data. Some are easier to find, while others are more difficult. Overall, it requires a significant effort to create a process, identify opportunities, research candidates, and track holdings. The primary information and process requirements can include the following. 
 
Quantifiable Data
 
In some ways, this is the easiest part of the process. A single search query can identify some (but certainly not all!) compounding machines on a search platform such as Gurufocus' All-in-One Screener. Search criteria might include the following.
 
Return on Equity (10 Year Average) > 15%
Return on Assets (10 Year Average) > 15%
Return on Capital (10 Year Average) > 15%
Free Cash Flow Margins (10 Year Average) > 25%
Free Cash Flow Growth (10 Year Average) > 10%
Debt/Equity Ratio (1, 3, 5, and 10 Year) < or = 0
 
This search on Gurufocus will likely generate less than 100 companies, and we haven't even begun to screen on valuation. An investor could probably do fine simply by investing in a broad bucket of such companies trading near their 52-week lows.
 
Non-Quantifiable Data
 
A simple query in a database can't discover some characteristics. While such searches can sometimes be good starting places, many compounding machines can only be found through the hard work achieved by rolling up the sleeves and better understanding specific industries or verticals. This includes a lot of time researching individual companies, their operations, competitors, product development, regulatory challenges, etc. In the course of this research, an investor should be looking for four broad themes.

Outstanding Capital Allocation
This is a multi-faceted attribute. It includes management that can identify great capital investment opportunities. It also requires management to say no to opportunities that might not reflect their core competence or provide adequate margins. Finally, it includes creating a business that operates in an environment where opportunities exist for allocating capital in existing business lines that can generate long-term runways for growth. 

Deep and Wide Inward/Outward-Looking Moats
In last month's presentation to the Gurufocus's "Value Investing Live" series, I discussed in depth the idea of inward and outward-looking moats. In summary, outward-facing moats keep competitors at bay through a series of strategic and operational advantages.  Inward-facing moats keep customers locked in by having products or services essential to their customer's business model, strategy, and operations. Capital compounders must have strengths in both of these, not just one.  

Expanding Market Opportunities   
This, too, is multi-faceted in that opportunities must be both in existing customers (by selling deeper into the organization) and new customers in either existing markets or new markets (this can be demographically and functionally). Compounding machines are generally strong in both of these but lean towards the former (broadening existing bases) and aim for the latter. Most avoid costly acquisitions as a means to growing market share or revenue. 

Self-Fund Growth with Existing Internal Capital
​Compounding machines tend to require very little capital to achieve growth. Because of this, nearly all new opportunities can be funded with either free cash flow or cash on the balance sheet. Most of these companies have extremely strong balance sheets with little or no debt and very high free cash flow margins (meaning the percentage of revenue converted into free cash). With extremely low weighted average cost of capital (WACC), compounding machines can achieve high returns on even lower margin growth. 
 
An Example: Veeva (VEEV)
I have written about Veeva extensively over the last two years (including a recent presentation on Gurufocus' Value Investing Live), so I won't spend a lot of time rehashing previous content. Instead, I wanted to show a graphic that demonstrates the compounding nature of the company. Seen below is a quick overview of the growth in the company's free cash flow, earnings, returns, and valuation. The reader can see strong growth combined with consistent profitability and high returns. In combination, these drive an ever-increasing estimated intrinsic value. 

Nintai estimates growth and returns will be very similar over the next decade or two (with slowing growth rates due to size). Veeva is the very image of a compounding machine. 
 
Conclusions
 
The goal of every value investor - indeed every investor - is to create value over the long term that outperforms the general markets. Compounding machines can play a huge role in achieving those results. Finding companies with wide moats run by great capital allocators in growing markets is the holy grail at Nintai Investments. When we can find a company with these attributes (and the price is right), we will generally invest a substantial portion of our capital in the stock. We will then try to sit quietly and let management do the heavy lifting and perform their wonders. A successful investor once said that it isn't the investment manager that produces excellent returns but rather the management and companies in the portfolio. That individual understood the concept of compounding machines. It would behoove all investors to follow her lead.