Last year, we published an article entitled “Where We Stand Today,” which discussed the status of the Nintai portfolio after a very difficult 2021. After reviewing performance through the third quarter of this year, I thought it might be helpful to discuss two findings we’ve seen developing over the past three years. Why three years? Mainly because we have been questioning why Nintai portfolios outperformed for four straight years (2017 - 2020) and significantly underperformed for two (2021 and 2023 YTD) out of the next three years. Here’s how the data looks:

​A few things from the graphic stick out. First, performance excelled when assets in the Nintai’s AUM was at its lower asset levels, dropping off dramatically as soon as assets jumped to their current levels starting in 2021. Second, over time, the portfolio has gradually decreased its market cap, moving from a primarily large-cap focus to mid-cap with a good slug of small-cap. Why does this matter? Because of the past three years, most of the outperformance in the market has been in large to mega-cap stocks, with small and mid-caps underperforming. 
 
Looking at these returns, it wouldn’t be unreasonable to ask, “Have we lost our touch?” Is Nintai’s methodology somehow flawed? Indeed, after watching the performance of the last three years, our (and perhaps our investment partners’) confidence has been shaken. You wouldn’t be human if you weren’t. 
 
But there are some logical explanations for the underperformance. To be clear, we are not making excuses. The last three years’ returns are awful. There’s no other way to describe them. That said, two themes have driven Nintai’s returns since 2021 – return sequencing and market cap performance.
 
Return Sequences
 
Traditionally, the definition for return sequences is “the danger that the timing of withdrawals from a retirement account will hurt the overall rate of return available to the investor.” In plain English, timing matters greatly when moving from a net investor to a net withdrawer of one’s investment portfolio. For instance, if someone invests during a bull market but starts withdrawing during a bear market, the chances they will run out of money sooner than later is relatively high. Conversely, those who invest in a bear market but start withdrawing in a bull market will likely do just fine. 
 
We have seen a form of return sequencing with the Nintai portfolios. While the returns for the portfolio were excellent in the first four years, the total assets under management (AUM) were relatively small. Conversely, though the portfolio has only had two down years over the past seven years (though only invested for four months, the portfolio outperformed in 2017 as well), those two years were after the portfolio had significantly increased its AUM. In other words, we outperformed at precisely the wrong time. Over the past three years, generating outsized returns would have been far more profitable than the first four years. This is driven by the size of our assets under management at certain times—a classic example of return sequencing. 
 
What can be done to offset the effects of return sequencing? The short answer is not much. The more robust answer is allowing time with a steady amount of assets under management to reduce its impact. The reason for the outsized impact of return sequencing in the Nintai portfolios is based on both a.) a short reporting time and b.) a massive increase in funds under management in that short period. Or, as the classic adage goes, only time will tell. Our investment approach and long-term time horizon will determine the difference between the pre-growth and the post-2021 returns. 
 
Portfolio Holding Market Caps: Mid-Cap and Getting Smaller
 
As I mentioned, the Nintai portfolios have gotten smaller in market cap since their inception in 2017. In its first full year (2018), the portfolio comprised 52% large-cap, 36% mid-cap, and 12% small-cap stocks. 

​By 2023, the portfolio had gotten much smaller regarding market cap. It comprises 14% large-cap, 56% mid-cap, and 30% small-cap stocks. 

Why does this matter? Because over the past five years, large-cap stocks led by the Magnificent Seven - Apple (AAPL), Amazon (AMZN), Alphabet (GOOG, GOOGL), Meta (META), Microsoft (MSFT), Nvidi - a (NVDA), and Tesla (TSLA) - have outperformed all other cap stocks. Conversely, mid and small-cap stocks have had three double-digit corrections in the past five years: -27.2% in 2018, -41.9% in 2020, and -33.0% in 2022/23. That’s one bear market and two market crashes since the Nintai portfolios’ inception. It has not been a good time to move down the market cap ladder. Seen another way, here’s how each major market cap group has performed since 2014. It’s not a pretty picture for those with a small to mid-cap focus. 

Conclusions
 
As I mentioned at the beginning of this document, our interest lies in better understanding the dichotomy of our early returns versus our later returns. The two issues of return sequencing based on AUM size and the movement to small and mid-cap stocks explain some differences in returns versus the S&P 500 Index. I want to be clear that these are not excuses for the portfolio underperforming that proxy (but conversely outperforming its closest one - the Russell Mid-Cap Growth index). They are interesting facts to understand better why the underperformance has occurred. Indeed, our investment in New Oriental Education (EDU) had a more significant impact than the concepts discussed here. At Nintai, we think it’s vital that we explore both the winning and losing trends in our portfolio performance. I’ve pointed out many times that to outperform in the long term, it is a necessary fact you must underperform for some shorter periods. It’s unpleasant, but it's essential to learn from these down periods to minimize their breadth and depth in the future. 
 
As always, we thank you for your continued support of Nintai Investments. Please let us know if you have any questions or comments. 

“We think being a better investor relies on several core concepts. First, keep costs to a minimum. Costs are corrosive and eat at your returns like the most aggressive flesh-eating disease. Second, know what you want to invest in and know what you won’t invest in. The former should be one-tenth the size of the latter. Third, empty your emotions at the door. Getting emotional in down markets can lead to truly catastrophic decisions. Last, invest in quality and for the long term. You don’t see many (any?) billionaires who made their money on betting against things over the long term. Are they occasionally correct? Yeah. But even a broken clock is right two times a day.”
 
                                                                        Nintai Partners Annual Report
                                                                        “NP Internal Investment Fund”
                                                                        February 2004
 
I recently discussed investing with senior citizens at an investment conference. Each of these individuals was living a comfortable retirement thanks to their investments. We began defining the most important things in investing. That made me think it might be helpful to create a list of things that have made me (and people I’ve learned from) a better investor. Without further ado, here they are. 
 
It’s less what you invest in and more what you won’t invest in.
At Nintai, we have a detailed set of criteria to identify companies we would like to partner with over a decade or longer. It keeps our investment universe to around 250 US and European companies. While many people are fascinated by who these companies are and how we selected them, we think it’s more important to understand that we don’t feel comfortable investing in roughly 99.8% of all publicly traded companies. Our concise watch list doesn’t say much about the companies on it, but the names not on the list tell us how little we know about so much of the investment world and how focused we are on what we know. It’s essential to keep a list of things you want in an investment and, equally important, what you don’t. 
 
What you can control is extremely small in size and scope.
It’s incredible watching CNBC or Bloomberg how many experts there are on TV or radio predicting recessions, no recession, thoughts on rising (or falling) interest rates, predictions on stock prices, etc. None of them seem to recognize that nearly nothing that happens in the economy or stock market can be controlled or even accurately predicted. Successful investors know that the amount of control or understanding they have in their investment process is minimal. At Nintai, we focus on the areas we know we can control. These include our emotional responses, intellectual biases, and working with objective data that helps us better understand a portfolio holding’s business or estimated intrinsic value.   
 
Most of your knowledge only makes your investment process worse.
Most of the data we obtain on our computers, Bloomberg stations, or televisions adds little to our investment process. How corn futures are being impacted by poor weather in Poland or what Elon Musk is purchasing in the after-hours markets generally helps us not all in managing our investment portfolios. We have found that investment houses that build enormous models based on collecting, collating, and analyzing vast amounts of data don’t perform all that well. We recommend investors stick to data that can help them understand a portfolio holding’s business model, competitors, and ecosystem. This information can help investors better understand the value behind their investments and whether it is best to hold, add, or reduce their position. 
 
The power of doing nothing is nearly always underestimated.
Any mutual fund investor can look at their latest report and be startled to see turnover rates in the triple digits for many actively traded funds. It’s not rare to see an entire fund portfolio turn over completely in a six to twelve-month period. All of this action is generally not worth it because returns still do not outperform a simple index fund. At Nintai, we’ve found it’s best to find a well-managed quality company at a reasonable price and hold on to it for a decade or two. Why not let your holding’s management do the heavy lifting for you? Also, where does an investor locate so many companies to add to the portfolio? We are lucky if we find one or two companies each year that merit our investment partners’ hard-earned investment monies.
 
Some things require complex thinking. Investing is not one of them. 
When investors hear fund companies discuss the need for triple-leveraged synthetic MBS high-yield funds, they should lock their wallets and disconnect their computers. Some of the most egregious investor losses have been produced by very intelligent financial gurus without a lick of common sense. Successful investing does not need to be overly complex or use advanced financial models. In most cases, a portfolio consisting of a handful of index funds will outperform most actively managed money. 
 The road to financial loss is littered with overly complex systems managed by such luminaries at Long Term Capital Management (two Nobel prize winners!). Most investors do not need such expensive financial services and their associated poor returns. At Nintai, we advise personal investors to keep it simple - either a relatively focused portfolio of 15 - 20 high-quality companies or a portfolio consisting of 3 - 4 broad index funds. 
 
Your greatest ally in investing is time. Your greatest enemy is cost.
For the average personal investor, two areas enormously impact their returns. Coincidentally, both of them are areas where investors have the most control. These are the time horizon of the investment and the associated costs with that investment. The ability to lengthen your time horizon can be the greatest ally in maximizing your investment returns. It helps reduce your tax bill (going from short-term to long-term capital gains and lets your portfolio holdings compound value year after year. 
 
Emotional control beats intellectual gifts nearly every time.
You often hear about how some famous investor has such a high IQ or can do discounted free cash flow or depreciation calculations in her head. Undoubtedly, some extremely smart people manage money in the financial markets. But over time, I have come to believe that those individuals who can keep their emotions in check but aren’t MENSA members are generally better suited than those who are the opposite. We have seen repeatedly that extreme market moments can trigger terrible decision-making for nearly any investor - genius or not. The investors with the best long-term performance records are the ones who keep their heads, continue looking at the data, and purchase shares when at their lowest or sell when at the highest. 
 
Optimistic people make better long-term investors.
I can’t say I’ve seen a lot of empirical data to support this claim. Still, we think optimistic people are better investors than those chronically down on the markets, economy, or political economy. Over the long term, we believe it isn’t in the best interests of investors to bet against the United States or its market-based capitalistic system. Over time, our country’s business leaders have done a reasonable job of allocating capital and creating value for shareholders. Will there be down cycles, and will some economic areas flame out? You bet. But we think a well-tempered optimism is the best emotional attribute for a long-term investor.
 
Conclusions
 
Over thirty years in investing and business management, I’ve had tremendous learnings passed on or even beaten into my intellectual frameworks. Are these all of them? Hardly. But they are some of the more powerful. We usually go back at the end of the year and look for data that supports or contradicts these. You are never too old or experienced to learn from your actions or the people/systems you interact with as you invest. Keeping it simple, having your emotions in check, investing for the long term, and watching your costs are four great (and relatively simple) ways to be a better investor. 
 
DISCLOSURE: Mr. Macpherson and Nintai Investments have no positions in any stocks mentioned and have no plans to buy any new positions in the stocks mentioned within the next 72 hours.
 
 
 
 
 
 
 
 
 
 
 

Low quality investment opportunities are actually quite easy to stumble on. Having a company implode from over indebtedness, corporate fraud, or simple gross incompetence is remarkably common in today’s “go-go” easy money markets. Finding quality - outstanding management, pristine balance sheets, deep competitive moats, and high customer satisfaction - is actually quite difficult. 
 
At Nintai Investments, we utilize roughly 16 measures that help us create a list of “quality” companies based financial, operational, strategic, market-based, and competitive characteristics. This leaves us with 41 of 3,671 (1.12%) total United States publicly traded companies, 305 of 17,602 (0.23%) total Asian publicly traded companies, and 88 of 8300 (0.49%) total European publicly traded companies. As one can see pretty quickly, the amount of companies that identify as “quality” is less than 1% world-wide. 
 
Last month I reviewed what we defined as poor quality at Nintai Investments. One might think that high-quality companies simply feature the opposite traits of poor-quality companies, but that’s not entirely accurate. A quality company has characteristics unique to their category - in much the same way as poor-quality have their own. As Tolstoy wrote, “All happy families are alike; each unhappy family is unhappy in its own way”. 
 
The kind of qualities we look for in at Nintai Investments fall into four key buckets. These include:
 
Excellence in Management: We look for management that have a vested interest in how the company performs (by purchasing shares in the open market, not stock option grants), provide a history of outstanding management candidates (similar to GE’s top 3 candidates for CEO - when one was chosen and the other two were considered outstanding managers in their own right and are expected to leave the company as CEO of another firm), deeply understand they work for both shareholders and their respective community, and finally achieve outstanding results in both operational measures (ROE, ROA) and strategic measures (ROIC, FCF margins). Most important than all of these, we look for management with a clear moral compass. This presents itself in forbidding financial transactions that profit management (such as renting a building they own directly or through corporate ownership), not using off-balance sheet gimmicks (such as special investment vehicles - SIVs), forbidding any type of family interactions with the business (such as placing family members on the Board), and the use of stock options as a transfer of wealth from corporate coffers to management’s pocket book. We feel strongly the fish rots from the head and it won’t be long before that rot works its way downwards.   
 
Create Deep External Facing and Inward looking Moats: In both good times and bad, we look for managers who can create exceptional defensive moats that can keep competitors at bay as well as drive significant value for their customers creating a moat that keeps them from seeking out replacement products and services. Sometimes managers can spend blood and capital digging a defensive moat but they spend little time listening to their customers’ needs. This type of one-way thinking can create significant weaknesses in looking for new offensive opportunities in existing customers, markets, or adjacent markets. An inward looking moat means management has developed the means to make their products and services essential to their customers’ strategy and operations. This type of in-depth value - for lack of a better term “the tape worm approach” - demands a nearly constant improvement in quality, scope of offering, and new products/services on a daily basis. It’s hard to find management and corporate structures that have the drive to approach each work day as means to radically improve their value to their clients. A great example of this is Veeva’s constant evolution of products and services in the biotechnology industry. In the past 5 years the company has launched 116 new offerings and made over 1200 changes to existing offerings. That’s a launch or change nearly every 2 days.        
 
Creates a Rock Solid Financial Castle: At Nintai Investments, we look for investment opportunities that can survive the most violent shock to its foundations. This can include a sudden elimination of access to any capital (the type of shock that overcame the financial markets in 2007 - 2009), a rapid increase/decrease in the Federal Reserves’ prime rate, or the LTCM failure demanding government intervention to stave off financial disaster. All of these led to some form of catastrophic market failure.  We look for a company that is reliant upon no one or no institution for survival or financial bailout in a time of market crisis. This requires a balance sheet with little to no debt (or the ability to pay 100% of liabilities with 1 year of free cash flow), high free cash flow yield, and outstanding returns on capital, equity, and assets. This demands we focus on cash rather than earnings because we believe in Alfred Rappaports’s “profits are an opinion, cash is a fact”. We recognize its is very difficult to sniff out financial shenanigans if management is intent on cheating and the consequences be damned. But we think keeping a hawk eye on cash gives us the best chance to avoid partnering with an unethical management team. 
 
A Singular Focus on Market Domination: We look for companies that seek to wholly dominate a market so large that the runway for growth is roughly 15 - 20 years. We want to know with some assurance the company will be in the same markets (or adjacent ones) dominating them with high market share, outstanding returns, and great gross and net margins for an extended period of time. Obviously it is difficult to find a company that operates in a monopoly or duopoly environment at a discount to our estimated intrinsic value, but it is possible in the micro to small-cap markets. Examples of this include iRadimed (IRMD), Computer Modelling Group (CMDXF), and Veeva (VEEV). Finding these hidden gems - which requires an awful lot of research and industry knowledge - can successfully drive investment returns for decades. We’ve often stated that two companies - Factset Research (FDS) and Manhattan Associates (MANH) - drove nearly 80% of the Nintai Partner’s internal investment fund’s outperformance. We still believe a combination of these gems with some larger companies that meet our criteria can provide outperformance with less risk. 
 
A Final Note
 
I would be remiss to say that successful investing isn’t about just quality companies. We firmly believe your financial investment advisors core intellectual (and emotional) models matter equally. These models should include acting on facts rather than emotions (in both bull and bear markets), always being intellectually open to new ideas, new industries, and new companies, being humble about your success and even more humble about failures, and reveling in diagnosing and discussing investment screw-ups. I’ve found over the years the latter is one of the greatest Nintai and our competitors. While we have the same animal spirits as others in this field and are driven by our competition, we actually enjoy writing about our mistakes. Perhaps enjoy is too strong a word (after all we hate losing our investment partners’ hard earned capital), but we find discussing these occasional debacles helps ground our egos and forces us to better understand what happened, why it happened, and how to prevent it from happening again. So while quality investments drive returns, an investment manager should have qualities of excellence as well.

DISCLOSURES: Nintai Investments currently owns shares in Veeva, iRadimed, and Manhattan Associates.  Shares are also owned in Mr. Macpherson's personal portfolio.

During the dog days of summer, we usually move everything outside, work on the deck, and suck up the summer sun. We take the down time to evaluate roughly one-half to two-thirds of our portfolio holdings. This includes taking apart the business case, looking at the competitive markets, diving into new products and services, and completing a truly deep dive on the company financials. We do this for two reasons – one is we want be assured each and every portfolio holding can still be considered very high quality. Second, we want to look back at our projections (strategic, operational, and financial) and be assured our assumptions are valid, valuations have not decreased (hopefully increased!), and the share price has not gotten too far ahead of our estimated intrinsic value. 
 
For some of our investment partners, these revised investment cases and valuation spreadsheets are like Christmas in July and August. For others, they go the pile to read after a relaxing summer vacation. We’re fine with either. We simply want our partners to have as much knowledge as we would like if we were in their shoes. 
 
I thought I’d break this in to two separate articles. The first part is reviewing what we would consider obstacles in defining quality for a possible investment. This isn’t a complete list. It isn’t even a full description of each item on this list. But I wanted to make it as simple as possible for investors to understand why poor quality can impair your returns. The second part is describing what we consider quality at Nintai Investments. Some readers will say “Oh God. I’ve heard all this before”. If you are a long term reader of my writing then you probably have. As Aristotle said “We are what we repeatedly do. Excellence, then, is not an act, but a habit”. Nintai Investments (and its predecessor Nintai Partners) would have achieved very little as a company or an investment manager if we didn’t constantly hammer away on the concept of value. Looking through my last 100 articles, the second most common word was “quality" - coming up a total of 232 times. (“Value” was the number one word cited 431 times).  
 
Obstacles 
In some ways it’s much easier to identify what’s NOT quality than defining what IS quality. Some attributes that make up a non-quality company are the following.
 

1. Excess Goodwill: In almost any acquisition, the agreement between acquiree and acquirer involves a certain amount of negotiating that leads to overpayment. At Nintai Investments we recognize that’s part of the animal spirits that make up the capitalistic system. Having said that, I can remember a management team that completed $23.6B in acquisitions from 1998-2002. Over the period of 2003 – 2006 the company wrote off $23.2B of those acquisitions (a whopping 99%!). Management claimed this was a victimless crime - acquisitions were made nearly entirely in stock so who was harmed? Let me just say that when management can’t see the damage from the the evaporation of over 65% of total assets on the balance sheet, then they certainly don’t represent quality in our books.
2. Excessive Stock-Based Compensation: A cousin of the goodwill excess, is the gross overuse of stock-based compensation. Again, many claim this is a victimless crime until the payments are expensed under the cash flow statements. This snaps many heads around. For many companies, this type of executive compensation is simply a transfer of wealth as the company announces billions in stock buybacks while simply seeing those very stocks slide out the side door as enormous pay packages for executives. When you see a company announce a $500M stock buy back and total shares outstanding either remain flat (or worse increases) then it’s a good chance this is not an excellent company. 
3. WACC Exceeds ROIC: Don’t get hung up on the acronyms in this section. This simply means the company’s return on capital is less than its cost of capital. Let’s use a simple example to highlight this problem. Imagine you see that steak is on sale by 8% this week at the supermarket. Excited at the thought of eating steak all week, you whip out your credit card and purchase $100 worth of beautiful Delmonicos. You smile at the 8% in savings. Yet consider the other end of the transaction. The rate you pay your credit card is 24%. So while you’ve saved that 8%, the cost of that return is 24%. The formula is simple: 8% - 24% = -16%. Your return on invested capital has been far exceeded by your weighted average cost of capital. This type of disastrous financial model is sometimes explained away by the famous (or infamous) line - “don’t worry we’ll make it up on volume”. Any company that shares similarities to this example is certainly not a quality company.
4. Customer Churn/Turnover is in the Double Digits: A company that relies on constant turnover and finding new customers is highly likely to be a low-margin business with no moat. Some businesses are notorious for churn which further drives down margins. Take for example wireless phone companies. You constantly hear of dissatisfied customers, switching from Sprint, to Verizon Wireless, to US Cellular, to AT&T Wireless. It’s a never-ending movement seeking the Shangra-La of coverage with constant rebate offers, and fine print that can only be found on the seventh level of Hell.   
5. The Company’s Product Is A Nice-to-Have: The road to personal wealth is littered with the wreck of thousands of businesses that were the “new hot thing” until they weren’t. You’ve probable owned one of these in either your personal or professional lives. These are products or services you swear you can’t survive without until the next recession hits and you have to choose between keeping the lights on or having that $59/month answering service. The one that provides an $8/hour operator with the most gorgeous Scots accent and gives your company that “international” flavor. Pretty cool when you are rolling in dough, but the first to go in tough times. The company’s price falls 85% before filing for bankruptcy late Friday night when it’s impossible to save even the smallest part of your investment. 
6. Capital is Essential to Business Operations: The first trading under the buttonwood tree on Wall Street was designed to meet the needs that all capital markets provide – creating access to capital. Well run markets and companies will dip their toes (hell…even their entire lower waist) to obtain capital to increase production, complete an acquisition, or extend operations overseas. This financing can be in either debt or equity in structure. The trouble begins when debt (or issuance of equity) becomes necessary simply to keep the doors open. When a holding maxes out its credit line or raises $2B in convertible debt to “explore strategic solutions”, this certainly isn’t a quality company.    

        
Conclusions
 
There are many ways to make money on Wall Street. Since its first trades in the 18th century, the New York Stock Exchange has seen hundreds – if not thousands – of techniques used to make money in the buying and selling of equities. Since then we’ve had an explosion in the number of exchanges along with the types of things to trade ranging from corn futures to collaterized mortgage securities. At Nintai Investments, we’ve tried to keep our investment model simple and limited in its adoption of risk. We don’t trade derivatives in any way, shape or form, we don’t short, we don’t trade debt, and we avoid anything but the highest quality in companies. This article has briefly discussed what is not quality. The next article will discuss the qualities we look for in an investment - and more importantly – why its critical to our long term success as investment managers. Please feel free to send in any comments or questions and we will try to reply as soon as possible. We hope everyone finds a way to stay cool. 

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 “When you look at the data, they show that funds that trade less, charge less, and keep things the simplest, nearly always outperform those with more trading, higher costs, and increased complexity. This isn’t rocket science.” 
 
                                                           - Nintai Partners, "Investing in the KISS Method”
 
Over the years, I’ve written several times about how complexity plays a role in investor performance, generally in a negative way. This is for two reasons. First, complexity typically means higher costs because of increased trading or transactional costs. Second, complex investment strategies generally need more things to go right, which inverted means many things can go wrong. In most cases, the latter is more accurate than the former. 
 
Even with such a poor record, complexity continues to drive growth on Wall Street. A classic example has been the growth of thematic funds, where a mutual fund company creates a fund based on any industry or societal trend where investors think above-average growth and profits will take place over the next few years. These trends or themes include everything from an obesity-focused fund to an ADHD-centered fund or model train focus (I’m not kidding. These are real thematic funds). Unfortunately, these funds have two things going against them - one I’m focused on today (complexity) and the other which haunts all trendy sales - they are great until they aren’t.  
 
Complexity: This Ain’t Your Father’s Fund Marketplace
 
Before I get into the results of Morningstar’s review of thematic funds, I want to touch on the more general idea of complexity in mutual funds. The industry has created a huge range of products that boggle the mind. Funds have been created in almost any shape or form, ranging from index-based to actively managed, single-leveraged to triple-leveraged, from a passive ultra-short S&P 500 index to an actively managed Genetic Biotech High Growth fund. Morningstar reports[1] that just in the US-based fund database, there are more than 28,000 share classes from more than 800 fund companies and 128 unique fund types. And that’s just the United States markets! 
 
On top of that, fund complexity continues to grow more diverse and far richer in its scope. From the same Morningstar report, they report that fund companies rolled out at least 139 funds focusing on options trading, 53 leveraged equity, 39 digital assets (aka cryptocurrency), 26 trading—inverse equity, 274 sector, and 205 thematic funds.
 
Thematic Funds: Chicken, Egg, or Cooked Goose?
 
As we can see from the numbers, Wall Street has continued its normal pattern of creating and marketing funds that are good for fund companies rather than for investors. The growth of thematic funds remains remarkable. Again, according to Morningstar, as of the end of December 2022, there were 2,072 surviving funds in Morningstar’s global database that fit their thematic definition. From 2019 through 2021, assets in these funds grew nearly threefold to $806 billion from $255 billion worldwide. The good news  (unless you are a fund company selling such funds) is that, much like the overall markets, assets under management in thematic funds crashed in early 2022. Assets went from $241B in April 2021 to $59B by April 2022, a decline of 76%.
 
The question is, how has performance been over the long term? As with any financial instrument that combines esoteric strategy with a high turnover model, the short answer is not good. Over ten years from 2011 through 2021, annualized total returns for thematic funds was 9.75% versus a 13.86% return for the Morningstar US Market Index. Fees cause part of this disparity. The average thematic fund charges a 1.04% management fee versus the stock index funds of 0.09%. The other is the simple inability of fund managers to predict the direction of market themes accurately. Just ask anybody who has bet on the theme of crypto-currency, and you will likely see very similar results.    
 
Another Poor Example of Complexity: Tactical Allocation
 
It isn‘t just thematic funds that have taken a complex model, put increased management fees in place, and allowed investors to underperform for years. Another example of this is tactical allocation funds. In another Morningstar article[2], Jeffrey Ptak discusses the absolutely dreadful returns of tactical allocation funds. He goes on to show that these fund managers never traded again after their initial “tactical” 
allocation, they would have doubled their returns. Let me repeat that: they would have doubled their returns by simply setting their allocation and then gone on vacation for the next decade. The cause for this? Two things: high costs and bad “tactical” allocations. 
 
Conclusions
 
No matter how hard Wall Street flogs their increasingly complex (and expensive) fund products, they have an extremely difficult time beating the cheaper, and far simpler, passive index funds offered by Vanguard and other investment houses. The recommendations for the average individual investor remain the same – find an all-stock or all-bond index fund and add to it every month for your entire working life. In general, adding complexity isn’t going to add additional returns over the long term. In fact, the opposite is far more likely to be the case. Finding an investment house that talks about “innovative synergistic strategies,” “not for the complacent investor,” or, worst of all, “cutting-edge thematics,” generally is warning enough to close your wallet and walk away as quickly as possible. Complexity means more expensive, and more expensive means more money for the house and less for the player. 
 
In next month’s article, I will address the last of the three themes discussed in “Thoughts in Investor Performance” in March 2023. Until then, keep your eyes on costs and invest in opportunities where assets can be purchased at a significant discount to intrinsic value. As always, I look forward to your thoughts and comments. 
 
DISCLOSURE: I/Nintai Investments have no positions in any stocks or funds mentioned, and have no plans to buy any new positions in the stocks  or funds mentioned within the next 72 hours. 
 
 
[1] “The Dark Side of Thematic Funds,”, Amy Arnott, Morningstar, https://www.morningstar.com/markets/dark-side-thematic-funds  

[2] “They Came. They Saw. They Incinerated Half Their Funds’ Potential Returns.” Jeffrey Ptak, Morningstar, May 30, 2023. https://www.morningstar.com/portfolios/they-came-they-saw-they-incinerated-half-their-funds-potential-returns.

“Normally, when you buy something, the more you pay, the better the product or service is. But with investing, it works the other way around. Generally speaking, the less you pay to invest, the higher the net returns you can expect to receive.” 
                                                                                    -       Robin Powell 
​
In my article last month, I discussed how three things greatly impacted long-term investor returns. These were high versus low fees, active versus passive investing models, and complicated versus simple strategies. The next few articles are going to discuss each of these in greater detail and discuss why and how they impact returns to such a significant degree.  
 
In today’s article, I will discuss the impact of high fees on investment returns (and inverting to show the positives of low-fee options). The good news is that fees have decreased dramatically over the last 30 years. According to the Investment Company Institute, over the past 26 years, average expense ratios of equity and bond mutual funds have declined substantially. The average expense ratio for equity mutual funds declined 58 percent from 1996 to 2022, and the average bond mutual fund expense ratio decreased 56 percent over the same period. The downside is that far too many investors still invest in products with far too high rates driven by high management fees and costs of extraordinary turnover rates. For instance, 9% of total US fund investors still invest in funds that charge a 12-b1 fee. These are fees paid out of the mutual fund or ETF assets to cover the costs of distribution – marketing and selling mutual fund shares – and sometimes to cover the costs of providing shareholder services. 12b-1 fees get their name from the SEC rule that authorizes a fund to charge them. They are considered noxious because they go toward costs, like marketing and distribution, that ultimately benefit the fund's managers, not its investors.  
 
What Constitutes High versus Low Fees?
 
Investing in mutual funds can provide an extremely wide range of management fees. It’s hard to sometimes ascertain why some fund companies charge 0.74% for investment grade bond funds while another might charge 1.52%. It’s harder to understand with the amount of outstanding funds charging very little, why many investors will remain with a fund that both underperforms and overcharges. But I will get into that later. 
 
Generally, fund fees are divided into deciles (mean 1/10th or 10%) with the top 10% representing the lowest-charging funds and the 90th decile representing those charging the highest rates. A breakdown of major fund categories shows the difference between the highest and lowest fees charged.

Source: Investment Company Institute and Morningstar

A few things jump out at once. First, the difference between the 10th and 90th percentiles is dramatic. In particular, the difference in the index fund class is stunning. How an investment house can get away with charging a high actively-managed-like rate for following an index is hard to understand. The fact that an investor would put money into such a fund is even harder (if not near impossible) to understand. Second, it’s difficult to understand why bond funds should charge such rates (particularly in the 90th percentile) for managing bonds. The fees have a far greater impact on bond funds than equity funds due to the nature of each’s returns (meaning bond funds generally return less than equity funds over time). 
 
The Impact of High Fees Over Low Fees
 
Funds with higher fees have several major consequences for an investor. The first, and most immediate and profound, is the reduction in total return. Every penny that is charged as part of a management fee or 12-b1 fee, comes directly from the investor’s returns. Fred Schwed once asked where all the customers’ yachts were, and if one had to take a stab at the question, it’s likely they went the way of management fees. 
 
For a concrete example, let’s imagine Bill and Meghan Smith investing $100,000 in a low-cost index fund with a super-low management fee of 0.04%. Over twenty years, they earn a 6% return. After expenses, they are left with $318,301. They’ve paid a total of $2,413 to their investment company. That means they’ve kept the vast amount of their returns (here, the customer can buy a big yacht!). On the other hand, Bill and Meghan’s neighbors Rob and Cindy Owens, invested the same $100,000 in a high-fee active fund that charges 2.0% annually. After earning the exact same 6% in returns over the same twenty years, they find that after expenses, they only have $219,112, or nearly $100,000 less, than their dear friends. Here’s how it looks graphically. 

In Rob and Cindy’s case, the question of where the customers’ yachts are is quite revealing. Their yacht is likely being sailed by the managers of their high-cost mutual fund. 
 
This underperformance caused by high fees impacts nearly every aspect of the investment universe. Morningstar frequently evaluates the impact of fees on investor returns and shows that the vast majority of investors see a significant portion of their returns eaten up by expenses. The underperformance becomes even more glaring when divided into quintiles of least expensive to most expensive. Here’s a graphic from Morningstar’s “Mind the Gap” annual review of investor returns versus fund returns. You can see from the data that the most expensive funds create enormous gaps in performance in nearly every major category, whether in equities, fixed income or allocation strategies.

Several other factors come into play when an investor chooses to invest with a fund or investment manager who charges high fees. 
 
Research has proven that higher fees generate two very specific results. First, higher fees generally don’t produce higher returns. In fact, the exact opposite is true. The same research has shown that the number one predictor of investment returns is the level of fees charged by management. The higher the fees, the greater the prediction of underperformance. Once again, Morningstar's research has proven this to be the case. Research in 2016 (and confirmed over the years) showed that funds with the highest fees generally produced the worst results. Here’s the data.

​Conclusions
 
It’s hard to overstate the impact of high fees on investor returns. What seems like a small difference of half a percentage point can make the difference of a quarter of a million dollars over a twenty-year investment horizon. With so many outstanding options available to investors, such as low-cost index funds or even lower-cost actively managed funds, there aren’t many compelling reasons to overpay for investment services. If that doesn’t make for a compelling case, it should be pointed out that nearly all evidence points toward the fact that the higher the fee, the lower the performance. Next month’s article will examine the difference between active and passive investing and why the former is nearly always a losing bet.    
 
As always, I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai Investments has no positions in any stocks mentioned and has no plans to buy any new positions in the stocks mentioned within the next 72 hours. 
 

“Managers should start out with the belief that if they are trying to actively manage money and outperform the market, the odds are against them.”
                                                                                      -      Bill Miller 

“I like the idea of having a little action. That may not be good from a logical point of view, but it's good from an emotional point of view.”
                                                                                     -       Walter Schloss 

“Don't think for a moment that small investors are the only ones guilty of too much attention to the rear-view mirror.”
                                                                                    -        Warren Buffett 

No matter how much the data show, it is very difficult for investors to grasp that indexing generally beats active management, low-cost funds usually beat high-cost funds, and most investors' behaviors create a substantial gap between investor and fund returns. And an enormous amount of outstanding research is out there that discusses just these issues. I wrote about much of this in 2015 - 2016 when I was a regular contributor to GuruFocus and an investment manager of the Nintai Charitable Trust. So, after roughly six years of being a professional asset manager with a public performance record, I thought it might be a good time to revisit these themes and see if there have been any changes in the investment world. 
 
Active versus Passive Investing
 
The news over the past decade has been both good and bad. The good news is that there has been a seismic shift from actively managed funds to index-based investing. According to the Financial Times[1], US stock market ownership has gone from 20% active and 8% passive in 2011 to 16% passive and 14% active in 2021. The ten largest fund houses manage the bulk of passive assets. Actively managed domestic equity mutual funds have suffered net outflows since 2005, even as their passive peers have inflows nearly yearly over the past decade. Index-tracking ETFs have proved more popular still. US-listed ETFs, overwhelmingly passive, have seen their assets rise fivefold to $7.2bn since 2012. 
 
Fund Costs Decrease
 
Another piece of good news has been that the costs of both mutual funds and exchange-traded funds (ETFs) have decreased significantly over the past decade. According to the Investment Company Institute (ICI)[2], in 2021, the average expense ratio of actively managed equity mutual funds fell to 0.68 percent, down from 1.08 percent in 1996. Likewise, index equity mutual fund expense ratios fell from 0.27 percent in 1996 to 0.06 percent in 2021. Investor interest in lower-cost equity mutual funds, both actively managed and indexed, has fueled this trend, as has asset growth and the resulting economies of scale. In 2021, the expense ratios of index equity ETFs were 0.16 percent (down from 0.34 percent in 2009). Likewise, expense ratios of index bond ETFs, down from a peak of 0.26 percent in 2013, fell to 0.12 percent in 2021.
 
Investor Returns versus Fund Returns
 
So, what’s the bad news? Investor returns continue to leg fund returns. According to Morningstar[3], the 2022 “Mind The Gap” study of dollar-weighted returns (also known as investor returns) finds investors earned about 9.3% per year on the average dollar they invested in mutual funds and ETFs over the ten years that ended December 31, 2021. This is about 1.7 percentage points less than the total returns their fund investments generated over the same period. This shortfall, or gap, stems from poorly timed purchases and sales of fund shares, which cost investors nearly one-sixth the return they would have earned if they had bought and held. This 1.7-percentage-point gap between investor returns and total returns is in line with the gaps found for the four previous rolling 10-year periods. While funds can decrease costs and investors can focus on passive investments, the sad fact is that human behaviors, such as recency bias, are challenging to overcome or reform.   
 
Themes for Further Discussion 
 
With the context of these three broad themes, I'd like to spend time over the following few articles to discuss some issues that profoundly affect investor returns over the long term. These will include the following:
 
Low versus High Fees: Evidence suggests that funds with the highest overall fees grossly underperform those with the lowest total costs. I will discuss what causes such a disparity, what fees are not reported, and why investors continue investing their money in such funds and their management. Issues include why “mutual funds” aren’t mutual at all, why some funds are immune to economies of scale, and why turnover is a substantial marker for poor performance. In the words of Jack Bogle, you generally get what you don’t pay for. 
 
Active versus Passive: While it’s great to see such a move from active to passive, a considerable amount of money remains in actively managed funds that underachieve their proxies over the short and long term. David Swensen once said, "the mutual fund industry is not an investment management industry. It's a marketing industry.” Part of why so much money remains in active management is that many fund companies have convinced investors they outperform when they don’t. I’ll look at a couple of these “guru” managers and their investment companies and discuss why active management is sometimes worse than it seems. 
 
Complicated versus Simple: When the idea of mutual funds became a reality in the 1920s (think MFS’ Massachusetts Investment Trust) and again when Jack Bogle created the (nearly) first index fund in the 1970s, the model was relatively simple. Allow investors to own a broad selection (or the entire selection in Vanguard’s case) of stocks with minimal trading and associated cost and tax burdens. But Wall Street has always succeeded in creating financial tools that make investment managers profit first and then investors second. The primary method in achieving such financial success was to make investment tools increasingly complex, customized, and (surprise!) expensive. This constant pressure to innovate (and drive Wall Street profitability) has led to a $20 trillion market filled with hard-to-understand and even harder-to-employ specialty investment options. In a recent article (“Why Investment Complexity Is Not Your Friend”), Morningstar’s Amy Arnott writes that “during the past three years, for example, fund companies rolled out at least 139 funds focusing on options trading, 53 leveraged equity, 39 digital assets (aka cryptocurrency), 26 trading—inverse equity, 274 sector, and 205 thematic funds.” She reports that roughly 14% of the total funds covered by Morningstar provide core investment coverage. Complexity offers little opportunity for the average investor but significant profits for the fund companies.
 
Conclusions
 
Over the next several months, I will cover these themes in more detail. My goal isn’t to poke fun at Wall Street in general or individual investment shops in particular. Rather, I want to focus on the fact that investors can do best by keeping things simple, watching their costs, and understanding that action in any form creates frictional costs that come directly out of their pockets. I want to be upfront with my readers. I’m a professional investment manager who charges customers a percentage fee of total assets under management. Our goal at Nintai is not to be part of the problem but part of the solution. To achieve that, the answer is quite simple. Nintai must outperform the markets over and above our fees to add value to our investment partners. It’s that simple. We can do this by keeping costs at a minimum, trading infrequently, and utilizing an investment process that chooses quality companies generating significantly higher returns on capital versus their weighted average cost of capital. We believe, and the records show, that we have provided real value to our clients over our investment career[4]. 
 
As always, we look forward to your thoughts and comments.  
 
DISCLOSURE: Nintai Investments nor Mr. Macpherson has no positions in any stocks mentioned and has no plans to buy any new positions in the stocks mentioned within the next 72 hours.
 
 
 
 
 


[1] “Passive fund ownership of US stocks overtakes active for first time,” Financial Times, June 6, 2022. https://www.ft.com/content/27b5e047-5080-4ebb-b02a-0bf4a3b9bc08

[2] “Trends in the Expenses and Fees of Funds, 2021”, ICI Research Perspective, March 2022, Volume 28, No. 2 

[3] “Mind the Gap – 2022”, Morningstar Portfolio and Planning Research, July 2022

[4] Of course, past performance is absolutely no guarantee of future returns. 

“A huge mistake for people making decisions is not distinguishing between complicated and complex problems. A complicated problem can have many moving parts. These parts can be measured, and solutions found to solve them. Complicated problems are ones where pure hard thinking can solve most of them. Complex problems need intelligence, good judgment, and luck, and we all know that luck can be a very fickle master.”
                                                                                -       Michael Arbuthnot 

“Three properties determine the complexity of an environment. The first, multiplicity, refers to the number of potentially interacting elements. The second, interdependence, relates to how connected those elements are. The third, diversity, has to do with the degree of their heterogeneity. The greater the multiplicity, interdependence, and diversity, the greater the complexity.”
​
                                                                               -        Gokce Sargut & Rita McGrath[1] 

In my book “Seeking Wisdom: Thoughts on Value Investing”, I wrote quite a bit about the concept of risk versus uncertainty. I defined risk as something that can be defined and measured while uncertainty cannot. For instance, risk might be seen as the chance of drawing a particular card from a full deck. We know the percent chance of the event happening. An example of uncertainty is calculating the number of hurricanes in next year’s autumn storm cycle. In this case, we can figure out how risky a hurricane might be (starting by estimating its strength with the Saffir Simpson scale), but not the number of hurricanes, simply because of the complexity of atmospheric change and storm development. In any situation, a participant must be able to ascertain what can be defined as risk and what is defined as uncertainty. One you can mitigate against is a rather specific way. The other you cannot.
 
Wall Street has always had a difficult time making the distinction between risk and uncertainty. Many times, analysts will use them interchangeably. This does investors a considerable disservice. Whether it be in the creation of credit derivatives or crypto blockchain, investors must be able to accurately discern between what is a risk to their assets and what is an uncertainty in their investment model. Another tool to employ is distinguishing between complicated models or operating systems and those that are complex.  
 
Complicated versus Complex
 
Making the distinction between complicated versus complex isn’t helped by the fact that Roget’s Thesaurus shows them as synonymous. This most certainly is not the case when comparing complicated versus complex systems. So, before I get into why it’s essential to make the distinction, it might be helpful to define the meaning of each.   
 
Complicated Systems
 
Complicated systems can have many moving parts - the more parts, the greater the complication. What’s critical to these systems is that each component reacts not only to the other but also in a deterministic manner. This means the reactions are in reliably predictive ways. Complicated systems generally operate under major laws such as chemistry, physics, etc. The responses are definable and generally consistent. These systems and their reactions/outcomes can be measured quite precisely. In this way, they are similar to our definition of risk. Much like knowing the odds of pulling an ace of hearts from a deck of cards, we can assign probabilities and percentages to reactions in complicated systems. Another essential part of complicated systems is that they aren’t impacted by unmeasurable components such as human emotions. Complicated systems don’t have a mind of their own, like financial markets or hurricane seasons. 
 
An example of a complicated system is a discounted cash flow model. While very complicated with an impressive amount of data inputs, we can nearly always measure the reaction of some components against the actions of others. For instance, the company's valuation will drop with an increase in the ten-year treasury rate. This is due to the scientific nature of the time cost of money. The valuation drop can be calculated by the rise in the ten-year interest and the impact on the discount rate. There is nothing left to subjective or unmeasurable events. From this, we can declare the risk of investing in such an asset.    
 
Complex Systems
 
Complex systems are very different from complicated systems. Whereas a complicated system can be overcome by understanding relationships and deterministic patterns, complex systems develop their own self-interest. Complex systems don’t change on relatively set designs but evolve based on random actions. The operative word here is “evolve” rather than develop. Because of this, complex systems generally have no central control points. It’s impossible to say if I make point A zig, then I know point B will zag. This difference makes the relationship between complex and complicated systems very similar to risk and uncertainty. One is more defined, measurable, and quantifiable. The other is not. 
 
An example of a complex system is the ecosystem in which a portfolio holding operates. It comprises companies, management teams, customers, and thought leaders, all driven by self-interest. It is nearly impossible to calculate the exact response of how a customer might react to a company’s new product or how a portfolio-holding management team responds to a competitive acquisition. Based on the player's self-interest, these responses can vary in so many ways to make a prediction a very shaky proposition. Moreover, the ecosystem in which your portfolio holding operates will evolve over time, with little central control or deterministic approach.      
 
Why This Matters
 
As an investor, it is vital that you make the distinction between complex and complicated. You can spend much time and brainpower trying to solve problems or predict futures when it can’t be done well or repeatedly. In David Halberstam’s classic “The Best and the Brightest,” he details how the leaders in the Kennedy/Johnson administrations, deemed to be the smartest group of individuals since Jefferson’s time (hence the title), utterly failed to see what was happening in the war to save South Vietnam. They mistook a highly complex problem for a mildly complicated one, where grinding out the numbers could solve almost any issue. History has shown that some of the worst quagmires have been where leaders mistake complex for complicated. Value investing is no different. Several things to bear in mind when deciding whether you are faced with one or the other can be summed up as follows.  
 
Draw a Bright Line Around Your Circle of Competence
Investors can avoid much trouble if they realize their circle of competence is smaller than they think. A circle of competence isn’t simply built around a particular industry or market cap. It also must define the limits of what you – as an investor and business analyst – can gainfully measure and use in your valuation process. Utilizing data from a complex system - thinking it is as valuable as a complicated system - can draw an investor far from any circle of competence. Knowing the distinction between the two can make all the difference between success and failure in your long-term investment performance. 
 
Even a Stopped Clock is Correct Twice a Day
As I discussed earlier, a complicated system can regularly produce deterministic results. A complex system can seemingly produce the same results. But this is where an intelligent investor must distinguish between the signal and the noise. Just because you obtain the results you would expect doesn’t mean you can repeatedly predict an outcome with real success over the long term. Very smart people can be smug until they run into complex systems. It’s incredible how fast they (meaning the intelligent person, not the complex system!) can be humbled. Remember, a broken clock is correct twice a day, and no more. A repaired clock is accurate nearly all the time. Knowing how and why the clock is correct is just as important as knowing the correct time.  
 
It’s Easy to Overthink Things
One of the things you learn with experience as a value investor is that it becomes easy to start overthinking things. It’s always great to be learning but not always to be overthinking. One of Charlie Munger’s great teachings is the idea of intellectual lattice works – the concept of multiple fields of knowledge, such as biology, statistics, psychology, and astronomy, layering and weaving together findings from each field. This latticework creates an increasingly complex ability to work on problems and see them from different perspectives. This idea of latticework can significantly improve an investor’s ability to identify opportunities and issues with potential investments. That said, it’s easy to get carried away and see trends or traits that have nothing to do with a company or market segment. Latticework is a great tool when utilized in a complicated model, but much less so when working in a complex environment. It’s easy to get overwhelmed by too much data that adds little understanding to the problem. Knowing whether you are dealing with a complicated or complex problem can reduce the risks of that happening. 
 
Conclusions
 
Over my investment career, I’ve learned that ascertaining the difference between risk and uncertainty, along with complicated versus complex, is vital to avoiding permanent capital loss. Nearly every poor investment decision I’ve made over the years has been caused by incorrectly understanding each. When I thought I could calculate the level of risk to a certain degree, I found a level of uncertainty that could not be defined. Equally, I’ve thought a tremendous amount of data and elbow grease could help solve a complicated problem when dealing with a complex system. All of these situations have been defined by several characteristics. First, I was convinced I (and my team) were far smarter and more intelligent than we really were. This led me to think this was a brain power problem with an evidentiary solution. It was a complex systems problem with no clearly defined answer. Second, I placed too much capital at risk, where the odds could not be calculated reasonably. Last, when the investment case went wrong, I didn’t have the knowledge or system to identify what went wrong and the solution. In nearly every case, the answer was to exit the position and use the experience to understand better the opposite sides of very similar coins – risk/uncertainty and complicated/complex. 
 
At Nintai, we are constantly looking to improve our decision-making processes. This includes making sure we know what we can measure, what we can control, and where we can make an impact. Understanding complicated and complex systems' role in our investment model is critical to that process.  
 
As always, I look forward to your thoughts and comments. 

[1] “Learning to Live with Complexity,” Gokce Sargut and Rita McGrath, Harvard Business Review, September 2011

​                                                                                                                                          January 2023
 
To Our Readers:
 
Enclosed is our 2022 Annual Report and Performance Review for the Nintai Investments LLC Model Portfolio. The Model Portfolio is the composite aggregate returns of all Nintai Investments investment partner portfolios. Each partner's portfolio is unique to their individual needs. The portfolios comprise holdings from the current twenty-one stocks on our investment list. The amount held in cash, the number of positions, and the percentage make-up of each portfolio differ by partner investment goals and tax situation. We do not invest in any ETFs, mutual funds, or individual bonds. Returns discussed are for performance beginning in the autumn of 2018 when Nintai Investments began operations. Please note that returns for my previous company, Nintai Partners, are not included in any way in the returns discussed within this report. 
 
2022 Annual Returns
 
Last year we opened our annual report with a 1942 quote from “Vinegar” Joe Stillwell discussing how the Allied armed forces had taken “a helluva beating” after being driven from Burma by forces of the Empire of Japan. At the end of the quote, Stillwell talked about finding out what went wrong and going back to retake Burma. In a similar vein, in last year’s annual report, we wrote about the mistakes we made in 2021 and what steps we took to avoid making them again. We will discuss this in greater detail further on in this report. But, for now, I’m very proud that the Nintai Investments Model Portfolio came back and outperformed each of its proxies in 2022.   
 
For 2022, the Nintai Investments Model Portfolio generated a -15.23% (inclusive of fees) return versus a -18.11%return for the S&P 500 Index, a -20.44% return for the Russell 2000 Index, and a -26.72% for the Russell Mid-Cap Growth Index. For the past three years, the Nintai Investments Model Portfolio generated a +5.80% annualized return versus a +7.66% return for the S&P 500 Index, an +3.10% return for the Russell 2000, and a +3.85% return for the Russell Mid-Cap Growth Index. Since September 1, 2018, the Nintai Investments Model Portfolio has generated a +8.89% annualized return versus a +7.29% return for the S&P 500 Index, a +1.60% return for the Russell 2000 Index, and a +5.66% return for the Russell Mid-Cap Growth Index.   
 
Over the five years Nintai Investments has managed the portfolio, we have been able to outperform the broader markets in three years (2018, 2020, 2022), roughly match them in one year (2019), and dreadfully underperformed in one (2021). As I’ve frequently written, investing is rarely about “how many times” but by “how much.” Our performance was so bad in 2021 that it took a history of significant outperformance and adjusted it to one of moderate outperformance over the long term. We are optimistic (but we must remember that past performance is no guarantee of future returns!) the portfolio is well-positioned from a valuation standpoint. Additionally, we are comfortable that each holding is remarkably strong financially, with deep competitive moats and outstanding capital allocators at the helm. Only time will tell if we are correct, but we like the prospects of each holding over the next decade or two. 

Portfolio Changes
 
In 2022, we added two new companies to the portfolio – Monolithic Power Systems (MWPR) and Tyler Technologies (TYL). MWPR has been on our watch list for over four years. With the onset of the bear market and collapse in semiconductor (and, more generally, technology) stocks, we were able to pick up shares at a nearly 40% discount to our estimated intrinsic value. Monolithic has all the characteristics we look for in a holding - no debt, high free cash flow margins, high returns on invested capital, and outstanding capital allocators at the helm. We look forward to partnering with the company for an extended period of time. TYL was nearly a holding in the portfolio a couple of years ago, when the company acquired one of Nintai’s portfolio companies - NIC (de-listed). At the time, we believed Tyler Technologies was overvalued, and we consequently sold our NIC shares and used the cash for new investments. With the COVID market crash, shares of TYL took a severe tumble and we thought the value and quality compelling.  
 
During the bear market in 2022, we used nearly every dollar of our cash reserves to add to existing holdings. Many of these were trading at compelling prices. Positions we added to include Genmab (GMAB), Veeva Systems (VEEV), Masimo (MASI), Skyworks Solutions (SWKS), T. Rowe Price (TROW), and Guidewire Software (GWRE). 
 
We completely exited two positions during 2022. We invested in Citrix as we thought the business's long-term prospects were outstanding and that the management team in place would take the necessary steps to turn the company around. We were indeed wrong about the latter. That management team was replaced by a new one in 2021 (the fifth in six years) which promptly agreed to let the company be acquired for a discount to our estimated intrinsic value and a slight loss in our investment. There is no way this investment can be categorized as a success.  Second, we exited Biosyent (BIOYF). We sold this company based solely on the fact that we needed cash to purchase (what turned out to be) Monolithic Power Systems. MPWR has a wider moat, stronger financials, and a higher future projected growth rate. It also traded at a significantly higher discount to our estimated intrinsic value versus Biosyent. 
 
Winners and Losers
 
2022 turned out to be a year where losing less was a valuable tool in portfolio management (though we think that applies every year!). We had two stocks in healthcare that saw double-digit gains in a year where nearly every major index had double-digit drawdowns.
 
Novo Nordisk (NVO): Up  20.84%
In 2022, Novo Nordisk accounted for 30% of the global diabetes market and roughly half of the $20 billion insulin therapy market. Growth is mainly coming from GLP-1 therapies, which include daily Victoza, weekly Ozempic, and innovative daily oral Rybelsus; strong efficacy and cardiovascular benefits to treatment should lead the $16 billion GLP-1 market to more than double over the next five years. In addition, we were pleasantly surprised at the success of the new obesity therapeutic sales with Wagovy (tempered by the supply chain issues resolved only in late 2022). We think the overall effect of the Inflation Reduction Act of 2022 will be relatively muted. Between the Medicare price caps and negotiation efforts, we see only a 3-4% impact on overall revenue and minimal impact on gross and net margins.   
 
Biogen (BIIB):  15.42%
The rapid rise and equally rapid swoon in Biogen’s stock price (the effect of the approval and then the disastrous launch of Alzheimer's drug Aduhelm) has been offset by the highly unexpected results of Alzheimer's drug lecanemab's positive phase 3 data. Shares of Biogen rose from roughly $195 to $306 on the news. Biogen has gone from being a very successful investment to a very unsuccessful investment and back to a modestly successful investment, all in less than one year. Behind all this is a company with a wide moat, a tremendously successful neurology portfolio, and a deep research bench. 
 
Guidewire (GWRE):  -44.90%
Guidewire suffered from a market that lost faith in businesses that have significantly sacrificed profitability in the short term to help fund long-term (profitable) growth. Guidewire is well on its way to being the clear market leader in the Property & Casualty (PC) technology platform leader. The company continues to take market share, setting itself up for sustainable growth through its software suite of solutions. While never happy with underperformance, we used lows during the year to add to our position.
 
Masimo (MASI):  -49.47%  
We won’t beat a dead horse, but 2022 saw Masimo management engage in an acquisition that had us scratching our head for the entire year and forced us to sell the company out of the portfolio when the stock recovered most of its losses at the end of the year. We aren’t sure if the Sound United deal will work out, but it completely negated our investment case and made us question the company’s management team. We exited the entire position at the beginning of 2023.
 
T. Rowe Price (TROW):  -44.54%  
Many investors think that when a bear market sets in, almost any asset manager will pay a heavy price as AUM slips. Combined with the continuing migration from active investing to passive/index, share prices took a beating in 2022. However, we think concerns are overblown. TROW continues to achieve outstanding returns for its investors. Combined with the amount of AUM in retirement accounts (and consequently far stickier), the company will see small single-digit losses in AUM over the next 2-3 years before achieving positive growth afterward. 
 
Portfolio Characteristics
 
As of December 31, 2022, the Abacus view shows that the Nintai Investments Model Portfolio holdings are roughly 8% cheaper than the S&P 500 and are projected to grow earnings at a 31% greater rate than the S&P 500 over the next five years. Combining these two gives us an Abacus Comparative Value (ACV) of +39. The ACV is a simple tool that tells us how the portfolio stacks up against the S&P 500 from a valuation and an estimated earnings growth standpoint. The numbers - as of January 2023 - are where we would like to see them. They represent a mildly cheaper portfolio with greater profitability and higher projected growth. 
 
A higher ACV number doesn’t guarantee the portfolio will outperform the S&P 500 in either the short or long term. That said, we thing a broad basket of extremely high quality companies (as seen by higher return on assets, return on equity, and return on capital) that trade at a discount to the greater markets with higher estimated earnings growth, should increase the odds of outperformance over the long term.   

​If opportunities arise, I will add or reduce an individual position size. I might also swap out an entire position for a chance to invest in a situation with a better risk/reward profile (as we did with Biosyent). I will actively seek to take profits or find cheaper prospects over the next 12 - 24 months. 
 
Portfolio Sectors
 
Traditionally, Nintai focuses on two sectors where we have significant experience – healthcare and technology informatics/platforms. This reflected in that technology and healthcare make up over 80% of total assets. Even with two holdings giving us (very) small holdings in consumer cyclicals and industrials, we still only have holdings in five of the S&P500’s eleven categories. These include consumer cyclical, financial services, technology, industrials, and healthcare. 
 
The other remaining six sectors generally don’t operate business models which we seek in our holdings – low/no debt, high returns on invested capital, opportunities to reinvest capital, and create opportunities for sustainably wide competitive moats. 

​Lessons from 2022
 
I’ve written extensively about what we learned from our mistakes in 2021 and how we worked diligently to apply those lessons in 2022. This process made us better investors and helped us outperform our proxies during the year. Here’s a quick summary of my thoughts on improving Nintai’s investment processes.
 
Stick within our circle of competence
Our most significant loss in 2021 occurred with our investment in New Oriental Education (EDU). We were in over our heads in every way with this purchase - no background in Chinese stocks, the Chinese markets, or Chinese education. We were blinded by the fact that our previous investment in the stock had (luckily) turned out well. A key learning from this investment was understanding that our circle of competence is much smaller than we’d like to think. 
 
Improve our understanding of the risks for each holding
We’ve written frequently about our process of “getting to zero,” in which we try to find a way to get the valuation of a potential investment to zero. We do this in several ways – decreasing free cash flow, decreasing margins, and increasing the weighted average cost of capital (WACC). However, one thing we didn’t do was create a model where the government regulatory body consciously decides to destroy the market of an investment holding (the case of New Oriental Education & Technology: EDU). The failure to develop such a case showed how little we understood the Chinese investment world and the role of the CCP in its capital markets.   
 
Have faith in our valuation concerns
During 2021 and 2022, we often felt valuations were higher than we would like for initial investment in some of our holdings. The pressure we felt holding 30-40% of all assets in cash made us purchase several holdings earlier than we should have if we believed in our valuation tools. There was absolutely no pressure from our investment partners to hold so much cash. While not nearly as debilitating as our sin of commission for investing in New Oriental (EDU), we should have had more faith in our models (and our investment partners' patience) and waited for better opportunities to purchase several holdings. 

Seen above is the investment model we have utilized since we began managing monies all those years ago at Nintai Partners. We have incorporated the previous three findings into this model. The most significant change we’ve made in the Nintai model is to try to reduce the risk of the permanent loss of capital. Drawdowns of 25-50% on an individual holding don’t concern us too much. All things being equal, we will likely purchase more if cash is available. What does concern us is the permanent impairment of capital like we saw in the New Oriental investment case. Our improved investment process focuses on aggressively reducing that risk.  
 
We assume these will improve our returns in the future. Of course, nothing is perfect, and we certainly cannot assure our investment partners of outperformance every year. Overall, though, our investment process held up decently through the 2022 market crash and its significant drawdown. These process improvements helped our outperformance in 2022, and we hope to see more of it over the long term. 
 
Final Thoughts
 
2022 will be considered the first post-COVID year. We aren’t entirely sure about that, but we began to see businesses open, commercial and holiday travel get back to pre-COVID levels, and the first signs of letup in the global supply chain breakdown. We will remember it as the year when sticking to our convictions and the investment process paid off. It wasn’t easy. In such a year as 2021, large drawdowns can impact your confidence as much as your returns. However, 2022 demonstrated that our focus on quality companies with financial strength and outstanding management still works. In 2023 we will continue doing what we know best – being patient value investors partnering with great capital allocators leading the highest quality companies. We believe this will lead to long-term outperformance of the greater markets over time. 
 
To take such action, an investment manager needs partners who are willing to be equally patient and ride out the inevitable bear markets and times of underperformance. I can’t thank all our investment partners enough for allowing Nintai Investments the time and strategic freedom to implement its investment process. All of us at the firm thank you for your continued trust and support. I hope everyone has a safe, happy, and healthy 2023. 
 
Tom
 
Thomas Macpherson
tom@nintaiinvestments.net
603.512.5358