"Don't worry. We might be losing a penny on each sale, but we can make it up on volume."  
 
                                                                                         -       Anonymous 
 "The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine."
 
                                                                                         -      Warren Buffett 

Revisiting Weighted Average Cost of Capital
 
One of the most interesting stories in the past 18 months has been the lack of discussion about the rapid fall and rise in the US 10-year Treasury yield. It isn't my intention to discuss the reasons for the changes or their meaning for the economy, but rather its simple impact on stock valuation. Such increases and decreases mean that any borrower will see a dramatic effect on their average cost of capital. With rates peaking at roughly 3.1% in October 2018, companies saw the rate drop by approximately 80% over the next 18 months. In less than six months, the 10-year US Treasury rate rose from 0.53% in October 2020 to 1.63% in March 2021. 
 
It's hard to overstate the impact these swings should have on the valuations of publicly traded equities. For those who use a discounted cash flow model (which we do at Nintai investments), a vital component in getting to an estimated intrinsic share value is calculating a company's average cost of capital. In our models, the most significant impact on that calculation is the 10-year Treasury yield. 
 
Before I get into that, a quick overview of United States Treasury note yields, how they are calculated, and their role in our financial markets. The Treasury note yield is the current interest rate paid on the 10-year United States Government Treasury note. The government pays the yields as interest for borrowing money through debt sales at monthly auctions. When the auctions take place, the government sells a specific dollar amount of bills (duration less than one year), notes (sold in 2, 3, 5, 7, and 10-year maturities), and bonds (30 years, reintroduced in February 2006).  For the sake of this discussion, we are only interested in the 10-year note.   
 
Once the debt has been sold, bills, notes, and bonds are traded on public markets, with investors buying and selling this debt and creating a market-driven interest rate. The rates generated in these markets for the 10-year note are vital in the financial markets. For instance, it is the proxy for many financial services such as mortgage rates. It is also used in determining interest rates on credit card debt. Trillions of dollars of financial instruments are affected by changes in these rates. 
 
The 10 Year Treasury Yield and Stock Valuation
 
For value investors, the 10-year note's yield has (or should have) an enormous impact on the valuation of publicly traded equities. When an investor looks to value a business, there are two calculations that play a tremendous role in estimating its long-term intrinsic value. The first is the company's return on capital (ROC). The second is its average weighted cost of capital (WACC). One of the most critical aspects of finding quality in a potential investment opportunity is a having a high return on capital. At Nintai, we look for companies that achieve 15% or greater ROC over the past decade. ROC is an excellent tool for getting a grasp on how well management teams allocate capital. But it's only half the equation (literally and figuratively!). Equally important is the company's weighted average cost of capital. A company always wants ROC to be significantly greater than WACC. It doesn't matter if they can generate an ROIC of 15% if their cost of capital is 18%. (Hence the opening quote about losing a small amount on each transaction, but making up for it in volume)
 
The weighted average cost of capital is one of those topics that inevitably leave peoples’ eyes glazed over when you bring it up. It's like discussing the interest rate you will be paying on that brand new sports car in the driveway. Not many people insist on diligently reading the term sheet. Instead, most dream of taking those sharp turns or doing racing changes on the interstate before trying to measure how the cost of capital might impact the long-term value of that new sports car. 
 
Return on Capital versus Cost of Capital: A Simple Example  
 
Let's use an example of an investor choosing to use cash obtained from a credit card advance to invest in stocks. It sounds crazy, but I've seen things more insane in my investing career. For example, let's start with the cost of capital. A cash advance can be obtained for the average credit card owner with two main items driving calculating the cost of that capital.
 
First, the card company will charge a fee which is generally based on the percentage of the transaction. For the sake of this exercise, let's assume the cash advance is $25,000. According to CNBC, the average transaction charge usually is between 3 – 5% of the advance amount. For this case, let's cut it down the middle and call it 4%. In this example, the individual will pay $1000 for the advance (25,000 x 4%). Second, the credit card company charges an annual interest rate fee on the balance. Let's assume the individual is not planning on paying off the balance for the first year but pay any fees and interest charges. According to the website creditcard.com, the average interest rate charged by the credit card company is 16.15%. For the first year, the individual will pay $4,037.50 (25,000 x 16.15%).
 
In this instance, cost of capital would be $1,000 + $4,037.50 or a total of $5,037.50. Put in the Wall Street terms, the cost of capital would be 4% + 16.15% or 20.15%. Of course, this number means nothing until we calculate the return on capital and see how the two numbers compare. 
 
To calculate return on capital, let's assume the individual wants to invest in a hot-shot stock growth fund that she's been assured is a real winner. We'll call this the "UltraHype Growth Fund" (which goes by the ticker BLECH). Over the past ten years, the BLECH fund has returned 11.2% annually. This is the starting point on the return on capital, but sadly not the final figure. The fund charges are very high – a 1.8% management fee. This is subtracted from returns, reducing the returns to 9.4% annually. Let's be generous and assume there are no additional costs like a load fee of 5.5% or 12b-1 fees or redemption fees. 
 
The return on capital number will be 11.2% of $25,000 or a return of $2,800. From that, we subtract the 1.8% management fee or $450. This leaves the individual with a net return of $2,350. Another way to calculate it is 11.2% - 1.8%, which generates a return on capital of 9.4%. 
 
It should be pointed out here, calculating the weighted average cost of capital and return on capital can be - and usually is - far more complex. It helps to have a calculator or Excel spreadsheet handy. For instance, the actual formula looks like this.

Suffice it to say our calculation in getting a cost of capital in this example is conceptually the same, but woefully deficient in terms of completeness. This is an article for investors, not a graduate accounting class!
 
So, where does this leave our individual? Did their move of taking a cash advance on their credit card pay off by investing in their expensive, hot-shot growth fund? The answer is a clear no. Their return on capital of 9.4% was swamped by their cost of capital of 20.15%. While it may seem obvious to any investor, it's important to point out this is a terrible use of capital. 
 
Cost of Capital and Stock Valuations
 
Having your return on capital exceed your cost of capital really shouldn't be that profound of a concept for individual investors, professional money managers, or senior corporate executives. Is should also be pretty clear that rising input costs in calculating your cost of capital will lead to higher cost of capital. The dramatic movement in treasury yields cited earlier will dramatically impact a company’s cost of capital. With rising Treasury yields, many company’s suddenly began to see WACC exceeding ROC in their returns. These changes should have been seen in valuations if investors were taking these changes into account. The exact opposite has happened. Except for the sharp drop in valuation in the spring of 2020 and their subsequent - and relatively rapid - recovery, the trend in stock prices has been nearly always upward. 
 
To apply this concept and see this disconnect in real terms, I want to use a holding in many of Nintai Investments’ individual portfolios - SEI Investments (SEIC). In December 2019, we estimated the company's weighted average cost of capital was roughly 9.4%. In that calculation, we included the federal funds rate of 1.87%. At that time, we estimated the intrinsic value of the company's stock was $55.20 per share. It was trading at roughly $66.00 per share or approximately 20% above fair value. By any standards, the stock was not a compelling buy. By December 2020, we estimated the company's weighted average cost of capital at roughly 7.9%. Nearly all the decrease in the WACC was the drop in the 10-year note yield. In our calculation, not much else changed. Revenue was flat, free cash flow was down slightly, and publicly traded shares were down slightly. There wasn't much to change valuation except the drop in the funds rate. But, boy, did that change our valuation. The $66 per share in December 2019 had jumped to $73 per share in December 2020. With the stock trading at $56 per share, the company was now trading at 23% below fair value - an enormous change in roughly one year. What had been a moderately overvalue company was now trading moderately below intrinsic value. On these numbers, we purchased shares in our portfolios. What a difference a year makes. 
 
But our example doesn't end there. The exact opposite happened from October 2020 to March 2021. The 10-year note rate jumped 0.53% in October to 1.63% just six months later. The example we just showed went in the exact opposite direction. With such a massive jump in the 10-year rate, companies' valuations took a whopper of a hit. SEIC's valuation dropped from $73/share back to $61 per share. With shares trading at $60 per share, they were now at fair value instead of 23% below intrinsic value.
 
Talk about a whipsaw! In a little over 16 months, SEIC went from moderately overpriced to moderately underpriced to roughly fair value, all due mainly to changes in the 10-year Treasury note yield which then impacted the company's weighted average cost of capital.  SEI Investments wasn't the only company that saw its valuations affected by its drop in the weighted average cost of capital. Every company in the public markets was impacted – some more than SEI, some less. Throughout all of this, overall yields didn't move much. The 10 Year US Treasury note yield was 1.73% on December 3, 2019, 0.92% on December 1, 2020, and 1.45% on March 1, 2021. But there was quite a gap between highs and lows. In August 2020, rates hit their low  0.52% and hit their high in December 2019 at 1.93%.
 
It's important to note that the markets overall were minimally impacted by these changes. From December 2019 to March 2021, the S&P 500 gained 25.4% rising from roughly 3150 to 3850. This even includes the massive drop in the spring of 2020 when the S&P dropped nearly 30%. 
 
What This Means
 
For all this data and heavy reading, you might be asking yourself at this point what this all means. It's a good question and an important one to answer. The most important lesson to understand is that having cost of capital exceed return on capital is not a recipe for outstanding long-term stock returns. It should be common sense to any investor, but roughly one-third of all publicly traded companies currently have WACC exceed ROC. Somebody is investing in these companies, so not everybody has learned this lesson.  Here are some other learnings to think about. 
 
WACC and ROC Must Be Measured Together: I have to concede that I searched for companies with extremely high ROC at the beginning of my investing career but never screened them for WACC. There is a particular bias that a company with high ROC couldn't possibly have even higher WACC. It happens, though. And like any other company with a negative ratio, it's a company that doesn't generate value. Always remember to look at both ratios, not just one. 
 
The 10 Year Treasury Yield Has a Big Impact: I used to denigrate investors who took a lot of time looking at macroeconomic issues because I felt they play a minor role in the business. I was right about that. What I was wrong about is that it plays a massive role in the stock. Remember: sometimes, a company's stock (and its price) has little to do with the company. This type of disconnect happens all the time. A significant rise in the 10-year note rate can drive up the cost of capital, making a dollar in the future worth a lot less. While the company might remain the same, its intrinsic value might decrease significantly. Never lose sight of the role of interest rates in valuation. 
 
In the Short Term Voting Machines, In the Long Term Weighing Machines: Having said that interest rates could affect valuation, it's important to remember the longer the holding and the greater the business's success (through quality and value) the less the impact of interest rates will be. This is a convoluted way to say that time and business excellence overrides the shorter-term impact of interest rates. Being patient and allowing time to work its magic can dramatically reduce some of the risks (but not all!) associated with cost of capital. 
 
Conclusions
 
For any long-term value investor (and what other kind is there? “Short-term value investor” is undoubtedly a contradiction in terms), the ability to find a business and management team that can produce value over a decade or two is the means to creating investment gains. The underlying foundation of this value creation is the ability to have the return on capital far exceed the cost of capital.  Given time and allowing for the weighing machine of the markets to work their magic, companies can become compounding machines for their shareholders. 
 
Understanding the dynamics of what constitutes the cost of capital and its relationship to return on capital is one of the most powerful concepts to a value investor. Looking at both and understanding the drivers of each, an investor has the tools necessary for making the best investment decisions possible. Will the markets always agree with you? Absolutely not. But an investor can go to bed each night fully understanding their investment has created value that day, that week, that month, that year, and hopefully the next decade or two. 
 
I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai Investments has no positions in any stock mentioned.

Yesterday, we learned about the death of Charles de Vaulx by suicide at his offices in New York City. Before anything else, this is a human tragedy. By every measure, Charles was a diligent, hardworking, and incredibly thoughtful value manager. He leaves behind a wife and two children. Everyone at Nintai sends our condolences to his family at this very difficult time. 
 
Charles was a value investor who represented the best of the Old Guard. By that, I mean in thinking, not in age. He was only 59 and still had much to offer the investment community. I refer to his investment thesis, portfolio management theory, and investment practices. First and most important, he always insisted on a reasonable margin of safety. He was willing to go to what is considered today heretical, extraordinarily high percentages of cash, reaching 40% of total AUM sometimes. He insisted, much like his mentor Jean-Marie Eveillard, in holding actual gold in portfolios as a means to offset risk. Last, he saw his job’s role as a means to retain wealth, not just createwealth. His passion for reducing risk for his clients’ assets was legendary. 
 
All of that was, of course, profoundly out of step in today’s investment world. Nearly every core concept Charles held dearly has been tossed topsy-turvy over the last decade. Interest rates continued their downward trend that had started in the 1980s, finally turning negative (!) in many countries around the world over the past few years. His remarkably high cash position was a terrible drag over the past decade. Interestingly, even that didn’t help when the market suffered its collapse in the spring of 2020 with the onset of COVID. Even with so much cash, IVA funds saw share price drops of over 25%.  
 
The last year had been difficult for IVA and Charles. Total assets had dropped from a peak of nearly $20B to less than $1B this year. In July last year, Charles’ co-investment manager Chuck de Lardemelle left the firm. In December, another founding partner, Michael Malafronte, left the firm for health reasons. The final blow was a dreadful 2020, with both funds underperforming their index by nearly 15 percentage points. The end came on March 10, 2021, when IVA filed with the SEC that it intended to liquidate its two mutual funds – IVA Worldwide and IVA Global and shutter the firm altogether.
 
The Weight of Professional Asset Management
 
There is a vast distinction between managing your own money and doing it professionally. It’s hard to describe the pressure one feels as underperformance piles up. The markets are famously unfeeling. You wake up every morning, and you compete against a faceless index. There is no emotion or subjectivity to what a professional investment manager does. You either outperform the market, or you don’t. You can come up with many reasons why your picks have performed poorly, but there is simply no hiding from the numbers.
 
For many value managers, the past decade or more have been a grueling experience having to report -  year after year - underperformance to their investors. After the first few years, it becomes increasingly difficult not to question your methodology. After a decade, it becomes hard not to question your entire investing career. Was initial success just luck? Is it possible to add value to your clients? Is it even worth continuing?
 
When I listened to Charles on Morningstar’s “The Long View” in November 2019, it was clear IVA and the investment management team still felt their underperformance would turn around. The markets would return to some form of sanity after nearly a decade of seeming craziness. Somewhere between then and March of this year, their view fundamentally changed.   
 
I can only speak from my perspective of having an abysmal 12 month run over the past year. I find I don’t sleep as well. I spend days evaluating current holdings, re-running our investment thesis, tweaking the numbers until there isn’t much else to do. I find it takes about six months of straight underperformance before I question not only the investment thesis but whether Nintai’s strategy is flawed. In this business, I think three major themes can significantly (and negatively) impact a professional value manager these days. 
 
Some Important Themes
 
Competition is Brutal
I’m not sure you will find an industry with such widespread competition as investment management. At the strategic level, competition takes place against other active managers and against index (or passive) funds. With fellow active investors, a manager competes on her stock-picking abilities and his management fee. Against index funds, the battles rest more on price (it’s hard to compete when you give away 1.5% at the top every year) and secondarily on stock picking. At the tactical level, competition is intense as data and content have become democratized. The days of finding net/nets by reviewing individual annual reports or Value Line surveys has been replaced by utilizing a search query of GuruFocus that takes roughly 25 seconds to run. Nearly every competitive advantage a value investor brought to the table 25-30 years ago is gone in today’s investment world. 
 
Generally, Your Behavior is Your Enemy
Value investors operate in a field where nearly every genetically programmed behavior is contrary to what it takes to be successful. Everything from confirmation bias to loss aversion pushes an active manager to behave against their investors’ best interests. The ability to control your emotions and focus on what works – regardless of your native impulses – is vital to success. As almost anybody who has invested for more than a decade can tell you, that sure as hell isn’t easy. 
 
Time Should Be Your Friends, But Sometimes Isn’t
The past decade has added an enemy to many value investors that have always been one of their greatest allies. Warren Buffett said that a key to investment success is to find wet snow and a very long hill. For nearly every decade since the 1920s, it was assumed the long hill ran downwards. The past 12 years have been a long uphill climb for value investors. Nearly every investment thesis and process has been challenged or simply not worked since 2009. That’s a long uphill climb. 
 
Conclusions
 
I can’t say Charles de Vaulx was an acquaintance, let alone a friend. I met him several times, and I treasured our conversations. I first knew of him because I admired his investment record over the long term, the brilliance and clarity of his intellectual frameworks, and his ability to stick to his core convictions. (I highly recommend the aforementioned “The Long View” interview on Morningstar. It can be found here.) It’s unlikely we will ever be sure what happened over the last few months of his life. Still, we can be pretty sure he looked out over the previous decade as every value investor has and saw a challenging period that posed a risk to his very professional being. He isn’t alone. But it’s important to realize that at its most fundamental, value investing is about human beings making judgment calls on the long-term future of a possible investment. Charles was human, and he also happened to be a good human being. I’m glad I met him, and I’m even more glad I got to understand his skills better, thinking, and convictions. He will be missed.  

We are pleased to announce that Tom's book "Seeking Wisdom: Thoughts on Value Investing" is now available on Audible. A compilation of Tom's articles written for the website Gurufocus, the book has a great deal of original content as well. For those looking to listen and learn about value investing from diverse angles, "Seeking Wisdom" is sure to get you thinking differently about investing. You can find it here: https://tinyurl.com/yt7ac3uv

"When you combine ignorance and leverage, you get some pretty interesting results." 
 
                                                                                 - Warren Buffett
 
Margin Debt: A Brief History
 
Margin debt is when an investor uses assets provided by a third party - in many cases, the investor's brokerage house - to purchase more shares than they usually could using just the cash assets available to them at the time of purchase. This means opening a margin account and utilizing the credit line on the account to make such a purchase. For instance, assume an investor has $1,000,000 in cash in their brokerage sweep account to make purchases. Also, they have a margin account with a credit limit of $500,000. The investor wants to purchase $1,000,000 worth of a particular stock. They can use the $750,000 available in their sweep account, and they borrow $250,000 on their margin account and make the purchase. This means the investor has $250,000 in cash as collateral for the $250,000 balance on their margin account. This has allowed the investor to boost their share purchase by $250,000 while still leaving cash in their sweep account.  
 
It's important to note a few things. The Federal Reserve Board's Regulation T limits the broker to lending up to 50% of the initial investment. This puts a hard cap on how much margin the investor can borrow. Second, many brokerage houses have their own regulations that may be more stringent than Regulation T. 
 
This, of course, is all fine and good if the stock goes up. Using leverage (or gearing as they call it in the UK and Australia), investors can make more profits than they could have if they only used their own cash. But what if the stock goes down? If that's the case, then the investor's losses would be much more significant than if they only used their own cash. One of the worst possible scenarios is when the stock price drops so low, the brokerage company makes a "margin call," essentially demanding the investor pay back some - or all - of the total amount of margin borrowed. Margin calls can force investors to sell other assets to raise cash at precisely the wrong time, wiping out gains or even bankrupting them. As usual, there is no free lunch, and increased returns always come with higher risk. At Nintai, we have an official policy that bans the use of leverage - or margin - in both individually managed as well as our internal fund.   
 
So why bring up margin loans/debt at this point in the market cycle? The major indexes are near all-time highs, and the economy is slowly recovering from the COVID crisis. What's to worry about?        
 
A Remarkable Twenty Year Run: 2000 - 2020
 
Below you will find a chart mapping two trends – the returns of the S&P 500 (the blue line centered on the right axis in terms of trading price) and the amount of margin debt (the red line centered on the left axis in billions of US dollars). The chart begins in 1997 because this was the year of the margin debt reporting changed dramatically. Before 1997, margin debt data was available for only the New York Stock Exchange (NYSE) members. Post-1997, the NYSE closed down its data collection and allowed the Financial Industry Regulatory Authority (FINRA) to capture data from all major exchanges such as NASDAQ and NYSE.   
 
As you can see, 1997 represents the nearly three-quarter point in the 1982 - 2000 bull market that culminated in the great technology bubble. Margin debt peaked in 2000 before reaching its nadir in 2003. It wasn't long after getting this bottom that investors forgot any lessons related to the risk of margin and market bubbles by pumping up margin debt to all-new high highs in July 2007 - just in time for the collapse of the next market bubble (the Great Credit Crash) leading to stunning losses in individual brokerage accounts accelerated by this considerable margin debt. But like Sisyphus (who really should be Wall Street's patron saint), investors started the cycle all over again (the third time in just ten years!). With the new bull market beginning sometime in 2009, margin debt has grown hand in hand with growth in the S&P 500 average, with total margin debt rising from roughly $250B in 2009 to nearly $800B in 2020. After the market correction in early 2020, margin debt fell from $600B at the beginning of 2019 to $475B after the correction. After such a reduction, any pessimistic feelings were immediately forgotten when debt rose from $475B in early 2020 to nearly $800B (!) by the end of the year – a staggering 68% increase in just nine months.  

Source: "Margin Debt and the Market: Up 2.6% in January, Continues Record Trend", Jill Mislinski, February 18, 2021

If we zoom in further and look at the tail end of the chart data, you can see the remarkable increase in margin debt. FINRA (through Investopedia) stated[1]:
 
"Margin debt has reached the highest point in two years as investors borrowed a record $722.1 billion against their investment portfolios through November, topping the previous high of $668.9 billion from May 2018, according to the Financial Industry Regulatory Authority (FINRA). This amount is a 28% increase since the same time last year and is up nearly 10% from $659.3 billion in Oct. 2020".
 
This massive increase was likely driven by the markets' assumptions that vaccines would bring an end to COVID-19 as an economic story. 

Source: FINRA, "Margin Statistics," January 2021

Why This Matters
 
Many readers may ask, "So what? The markets are going up. What's the big deal?". If markets continued to rise indefinitely, then the short answer would be there isn't much to worry about. But we all know markets don't go up indefinitely. An 11-year-old bull market will end. The question isn't if. The question is when? 
 
Margin debt is no different from corporate debt, except that margin debt would be considered short-term debt at all times. The reason why Nintai Investments is so averse to debt is that it seems to come due at the most inopportune time. Most companies borrow money when they need it but have to pay it back when they need it even more. This doesn't make for the best capital allocation decisions. 
 
Individual investors are no different than corporations when it comes to margin debt. Investors tap their margin credit lines when they want to purchase more shares and leverage their current assets. They need that credit even more, when markets crash and margin calls come flooding in. Much like the corporation, this doesn't lead to rational capital allocation decisions. 
 
A Useful Example
 
Let's assume Bob is an investor who considers his stock-picking abilities above average and is tired of just barely meeting the index's returns (which, when you think of it, makes him just average, but will let that go for the sake of our case). Bob has $600,000 of equities in his taxable brokerage account and $200,000 in cash in the brokerage account's sweep account. He has decided to leverage these assets and begin trading on margin. A quick reminder: in Bob's brokerage account (or cash account), all transactions must be made with the cash on hand in the account. A margin account allows the investor to borrow against the total value of assets in the cash account. In Bob's case, his cash account would be worth $800,000 ($600,000 in equities and $200,000 in cash). According to Regulation T, Bob's brokerage house can loan him up to 50% of the total purchase price. 
 
After considerable research, Bob has decided to purchase $250,000 of "Ted's Adventure Company" (note: this is a fictional corporation). When Bob purchases these shares on his margin account, he has one "payment period" (his brokerage account names this as five business days) to meet the Regulation T 50% margin requirement. Bob utilizes his cash and equities as collateral. He feels very comfortable knowing he has $800,000 in his cash account to post versus the $250,000 margin balance. Regulation T requires 50%, so Bob is required to cover $125,000 (which is 50% of 250,000 on margin). 
 
So far, so good. Bob is in fine shape unless one of three things happen. First, a general market decline decreases the value of both the stocks he borrowed against (Ted's) to buy (remember: the $200,000 balance remains the same). If the stock drops by 25%, then Bob now needs to have enough capital to cover the $250,000 initial loan plus the 20% decrease in the value of his shares bought with the loan ($250,000 x 20% = $50,000) In this case his margin balance increases from $250,000 to $300,000. The second action that impacts his margin status is if the value of the stocks he holds in collateral decreases. For instance should Bob’s equities also decrease by 20%, then his balance available as collateral drops from $600,000 to $480,000 ($600,000 - 20% = $480,000). If Bob is near the 50% required collateral level, he may be required to post additional assets to keep below the 50% mark. This is known as a margin call. I'll get into more detail about that shortly. The third action that would affect Bob's margin status is if he finds himself in need of cash and has to tap the $200,000 in his sweep account. Again, this might bring him below the required 50% margin coverage.
 
Unfortunately, rarely does one of these things happen alone. During a market crash, the stock price (Ted's) is likely to drop in addition to the value of the equities in Bob's brokerage account. Additionally, he may need cash from the sweep account because the market crash has accompanied an economic downturn and Bob's planned bonus never appeared. This would be known (and I hate the term) as "the perfect storm" for Bob's portfolio.      
 
The Margin Call
 
Now that we've walked through the logistics of using margin, let's look at the worst-case scenario when things go wrong – the dreaded margin call. A margin call happens when the amount of assets in the investor's margin account falls below the required amount. For instance, let's use the case of purchasing $250,000 of Ted's Adventure Co. Assuming our investor used $125,000 from their cash account and $125,000 from their margin account, they have barely met Regulation T that requires the amount of the margin purchase not to be more than 50% of the total price paid (Since the purchase was $250,000 in stock and the investor used $125,000 of their margin account, then just met Regulation T's 50% rule). Should the stock price start dropping, the brokerage house will begin the process of a margin call when the asset price falls below $125,000. For instance, should the stock drop 20%, then the stock's total value purchased on margin drops from $125,000 to $100,000. In this instance, the brokerage house would place a margin call for $25,000. This means the investor would need to place an additional $25,000 into the margin account. Since this event rarely happens in a vacuum, a margin call can put enormous strain on an investor. If the brokerage company doesn't receive its $25,000, it can liquidate other stocks - no matter the price - to meet the margin call. As I said, these events rarely happen in a vacuum, and the forced selling of additional prices likely will take place as those share prices are dropping as well. It's never good when you are forced to sell at any price. Particularly when the proceeds of any sale are needed to fill a gap caused by a margin call. When a margin call forces a sale, you can expect the prices your assets are sold will be to your disadvantage.
 
Final Thoughts on Margin Trading
 
As major indexes trade and margin debt both reach near all-time highs, any investor utilizing high amounts of leverage (margin debt) should consider the potential implications of a severe market drawdown. As I've explained earlier, generally, margin calls are part of an investor's perfect storm with the potential of causing catastrophic losses in their portfolios. Here are some thoughts I offer investors employing leverage in today's markets. 
 
Leverage Goes Both Ways
For every person who uses margin to increase their profits, some investors increased their losses by utilizing leverage. After such a long period of market gains, it's easy to lose sight of the fact that markets can drop - and drop fast. Just ask anybody who was highly leveraged in the spring of 2020. With valuations as tight as they are, it shouldn't surprise anyone to see a 25 - 30% correction at any time. If you are using a model that uses a significant increase in market prices, build in such a loss. Then double it again. You might be surprised by the results. 
 
Just Because You Can Doesn't Mean You Should
The recent events with RobinHood and GameStop (GME) trading have shown that not everybody should be trading on margin or shorting stocks. Just because an investor has access to margin accounts and trading doesn't mean they should employ such a strategy. Unless an investor has given considerable thought about the potential impact (and modeled possible results) of utilizing leverage, they should stay clear of any such market operations. Just because you have access to a margin account doesn't mean you should use it. 
 
Enough Can Truly Be Enough
After a twelve-year bull market, if - as an investor - you don't feel you've squeezed out every possible profit from your investments, then margin isn't the way to go. It seems the odds (though I have no real way to predict) predict a much lower growth rate or even net negative returns over the next decade. If this proves to be accurate, then margin isn't going to help squeeze any extra returns out of the market at this point. We highly recommend investors recognize they've gotten as much as possible from this bull market and head for safer investment waters. 
 
Conclusions
 
Just a few days ago, Charlie Munger commented on special purpose acquisition companies (SPACs), 
 
"This kind of crazy speculation, in enterprises not even found or picked out yet, is a sign of an irritating bubble. The investment-banking profession will sell shit as long as shit can be sold."
 
We think the use of margin accounts and leverage are similar for individual investors. Wall Street sells margin accounts because they can. In most cases, they are inappropriate for investors and allow them to take on terrible risks while only thinking about possible rewards. There are many safer ways for investors to increase returns. These include cutting down on management fees and reducing trading costs. The actions minimize the risk while generally increasing returns. As an individual investor, at Nintai, we suggest investors look for the low-hanging fruit and safest ways to juice (no pun intended!) returns. We think this is the smartest move available to individual investors by a wide margin (pun intended).   
 
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[1] https://www.finra.org/investors/learn-to-invest/advanced-investing/margin-statistics

"A prudent mind can see room for misgiving, lest he who prospers should one day suffer a reverse."
                                           
                                                                                              -      Sophocles 

"It's amazing what you see in disclosures. People will go to all extremes to make their performance look better. Comparisons are crazy – you might see something like a  comparison of funds returns versus the amount of vanilla bean grown in Tahiti divided by metric tons of iron ore deposits in Western Australia. Voila! We outperformed that number by 3% annually. I'm kidding…..but not by much!"
                                                                        
                                                                                             -     "Sonny" Mendez 

Value Investing: "A Hell of a Beating"[1]
 
At the end of each year, the investment management world's conversation inevitably focuses on performance and how well a manager did against their respective competition (the S&P 500, MSCI International Stocks, Bloomberg Barclays Aggregate Index, etc.). This year's discussion has centered on one topic that seems to always be near the top of everybody's list - growth versus value performance. It seems an eternity since value has outperformed growth over a substantial period. Last year was no exception. 2020 was one of the worst years ever when it comes to value strategy versus growth strategy performance. Morningstar reports[2] that:
 
"Large-growth stock funds--which generally invest in companies with strong earnings growth profiles--returned an average of 34.8% in 2020. That was 32 percentage points ahead of the average large-value fund, which has portfolios of companies deemed cheap compared with their potential or are seen as turnaround stories. That exceeded the gap registered in 1999 when growth beat value by 30.7 percentage points. While the value versus growth performance gap wasn't a record for small- and mid-cap stock funds, those groups' average margins were the widest since 1999. And the woeful relative performance for value significantly widened the longer-term return gaps across the board."
 
The long-term record isn't much better. Over the past one, three, five, and ten year periods, large value, mid-cap value, and small-cap value have underperformed their growth cousins every time. That's right. Not a single time period of outperformance in any market segment in any time period. Here's the very ugly looking chart. 

I bring this data up because Nintai just released its 2020 Annual Report. I was asked several times how we decide what to disclose, how we discuss results and our methodology in comparing results against other funds or indexes. Most of the questioners were trying to ask politely - do you provide information that shows me what the hell happened this year. 
 
Discussing Failure: Avoid and Abdicate
 
With value investing performing so poorly, I've been intrigued about how investment managers have been disclosing their results and explaining the reasons for their underperformance. After reviewing about 250 annual reports, investment updates, and articles, the short answer is - most managers don't do anything of the kind. I've found many annual reports discuss everything BUT their returns – discussions that include long term energy policy, the role of climate change in fishing rights, the history of pandemics, the rise and fall of the serf-based economy, etc. Many discuss folksy wisdom like looking at investing as farming - sowing seeds, tending the weeds, and harvesting the profits. Of course, the problem with this is that it might be better to discuss the effects of a ten-year drought filled with biblical hordes of locusts.   
 
At Nintai, we always try to stick to some basic rules in our disclosure policy. First, we seek to be open and honest in our communications with our investment partners. This includes our methodology and our performance. Second, we acknowledge mistakes in a free manner. We discuss the core issues, what went wrong, what we learned, and how we will try not to make the same mistake again. It goes against nearly every business rule, but I enjoy writing about my mistakes. It helps clarify my thinking, and it tells me how my partners view my mistakes. Don't get me wrong. I hate underperformance. I'm as competitive as any manager in the investment industry. That doesn't mean that I can't be honest with myself and truthful with my investment partners.   
 
We recently released Nintai Investments' latest annual performance report. The report discusses 2020 results as well as three years and since inception returns. We compare our return against the performance of the S&P 500 TR index, the Russell 2000 index, and the MSCI ACWI ex-US index. We cite the S&P 500 for the simple reason this is the index most used by the investment world for comparison. We include the Russell 2000 because it is the closest fit to our portfolios' market cap average. Finally, we have the ACWI ex-US because our portfolios hold a considerable portion of foreign stock management assets. We encourage our investors to think of their returns as a blend of these three indexes. We also discuss what investments did best, which did the most poorly, and explain – in detail – why these companies performed the way they did. 
 
We like to think our Annual Reports - along with our Investment Cases and Valuation Spreadsheets - give our investment partners all the information they need to judge our performance and how we communicate with them. We think this type of clarity is critical to maintaining well-functioning financial markets and helps individual investors make well-reasoned decisions to allocate their hard-earned dollars. Later in this document, I will discuss what components are essential in communicating with investors. I will also explain why investment documents are vital in assisting investors in choosing, evaluating, and making decisions. 
 
Disclosure and Discussion: A Working Example
 
Before I get into those things that I think are important, I thought I'd discuss an instance of financial reports that caught my attention last month. They did so for many reasons, but several stood out. First, the returns for the investment company were abysmal. Second, the reports themselves seem to reflect nothing but good news and the seemingly endless bragging of the fund's managers' investment wisdom. Finally, the report seems to go out of its way to obfuscate and create an intellectual fog about their investment performance relative to the general markets. Before I disclose the company, I should say, in all fairness, this could be many of the funds out in the marketplace. The poor performance, the folksy talk, and the incomprehensible reporting format of performance are all too familiar. I have chosen this investment company simply because its report happened to float across my desk. I have no particular bone to pick with the managers of the investment team. 
 
In this case, the company is Muhlenkamp and Company, based out of Wexford, Pennsylvania. The company was founded in 1977 by Ron Muhlenkamp. In 1988, the company launched a no-load mutual fund (MUHLX). Ron handed the reigns to his son Jeff in 2019. 
 
First, some statistics on the fund. According to Morningstar, assets under management have dropped from $3.47B in 2005 to $181.4M in 2020 (a 94.8% decrease in AUM). Muhlenkamp reports the company's total number of accounts dropped from 289 in 2005 to 48 in 2019 (an 83.4% decrease in accounts). 
 
These decreases have likely been driven by performance, which has been pretty hard to read about from 2005 through 2019. When measured against the S&P 500 TR, the fund's record is the following:

According to Gurufocus.com, the Muhlenkamp fund has underperformed the S&P 500 by -7.31% annually over the past three years, -8.13% annually over the past five, -6.13% annually over the past ten, and -4.97% annually over the past fifteen. The fund has a one-star Morningstar rating for its 3, 5, and 10-year record. Its qualitative rating is negative, People rating below average, Process rating low, and Parent rating low. Overall, the statistics paint a pretty grim picture. 
 
With these numbers in mind, I thought it might help look at what and how Muhlenkamp reports this information to its investors. On its website, there are 8 page tabs including Home, Individuals, Business, Fund, Separately Managed Accounts, Blog, About Us, and Contact.  Performance information can be found both in the Fund tab underperformance and can also be found at the end of each "Muhlenkamp Memorandum." A few things jump after reading nearly ten years of reports and memorandums.  

1. I couldn't find any explanation in any document why returns were so poor. Memorandums were filled with information on the economy, politics, and broader societal issues (like COVID). Yet nowhere could I find an explanation for such overall underperformance (was it due to poor stock selection, lousy market timing, value as a class underperforming growth?). If my fund underperformed (by a lot) on a 3, 5,10, and 15-year basis, I'd feel a deep obligation to explain to my investors how and why performance was so poor. 
2. Some of the performance data seemed (and this my impression – I have no facts to back this up) to be in the charts to make the funds returns better. For instance, what in the world does the consumer price index have to do in comparing the fund return versus the S&P 500? – other than the CPI number looks a lot smaller than the fund returns.[3] Second, there were columns in the return analysis that I had no idea what they meant or why they were important. For instance, one column was the Composite Dispersion, which is "a measure of the similarity of returns among accounts of the Composite.  It is the standard deviation of the annual returns for all accounts which were in the Composite for the entire year." Would an average retiree understand the meaning of any of that and how it impacts their retirement portfolio?
3. There is the usual discussion in one of their reports of the sowing and reaping and having a farmer's fortitude and patience. If I had a nickel for every time an investment manager talked about farming, I wouldn't need to be an investment manager. With active value management's performance as it is over the past decade and a half, I'm not sure discussing sowing and reaping is the best approach. 

 
Muhlenkamp's slogan is "Goal-setting, dream-building, future-conquering, financial freedom starts here." They go on to say, "WE'RE NOT YOUR AVERAGE MONEY MANAGERS. We're a scrappy pack of financial nerds and outliers, passionate folks who believe in redefining the industry with data-driven, intelligent investing. We love to smash through the smoke and mirrors that so often mystifies wealth building as we eagerly share our knowledge and decades of expertise with people just like you. We're Your Hometown Team, Forging A Better Way."
 
Looking at Muhlenkamp's performance over the past fifteen years would suggest they look an awful lot like your average money manager. More importantly, it is unclear what gains have been obtained - from all this smoke and mirror smashing - in both returns and investor knowledge. 
 
As I said previously, I don't have any particular bone to pick with Muhlenkamp and Company. They are pretty standard for a Wall Street investment house (though based in PA). Whether it is caused by the long-term underperformance of value investments in general or something specific to the Muhlenkamp strategy or team, what is evident is that performance is lagging, and disclosure does very little to explain why. It's bad enough their investors have taken their lumps when it comes to a truly horrific case of returns. It seems far worse when these investors are seemingly left in the dark. 
 
So What Can Be Done?
 
If this type of situation is typical (and value underperformance combined with poor communication is pretty consistent across the investing world spectrum), what can investors do to avoid it? Are there specific items that managers can include in their reports which better educate investors? I suggest there are five particular areas where individuals can look for receiving more pertinent and relevant data.
 
Does Fund Management Use Fair Comparisons?
One of the first things an investor should look for is fair comparisons when measuring performance. For instance, if a fund invests in small or micro-cap stocks, it's probably not a great idea to measure itself against the S&P 500 index (representing the largest 500 companies). When you see comparisons against indexes with very little in common with the fund, management would seemingly have very little knowledge of market indexes or a willful denial in seeing relevant comparisons. You see this a lot when fund managers are desperately looking for a way to make their returns look better than they really are. 
 
Does Management Openly Disclose and Discuss Mistakes?
Nearly every manager I've ever worked or consulted with has told me discussing mistakes is a form of weakness. I couldn't disagree more strongly. That statement is one of the more egregious I've heard over my years in business. If someone can't confess to errors to themselves and their clients, to whom can they confess? Once an investment manager deceives himself, it isn't long before they start deceiving their clients. Granted, I don't want someone writing me a mea culpa once a month, but the occasional explanation of an error – and description of what they learned – is quite refreshing and assuring.  
 
Does Management Clearly Show Impact of Fees?
This is an area where Nintai Investments needs to do a better job. We charge a rate slightly lower than most actively managed investment services (0.75% annually) but don't describe how much this rate eats into long-term results. I think it would be beneficial to show the difference between an active fund's returns versus their respective index and show the impact on returns by management fee, trading costs, etc. It is certainly possible to show cumulative annual trading costs in an annual report. This is information that could be very helpful to individual investors. It is a goal at Nintai Investments to include this data in 2021 and going forward.  
 
Does Management Discuss Individual Portfolio Holdings?
We think it's constructive for investors to see the investment cases for individual portfolio holdings and an estimated intrinsic value when the stock is purchased/sold in or out of the portfolio. At Nintai, we do this for every stock in every investment partner portfolio. Some have told us they find the information quite helpful and interesting, while others have asked us to stop sending it. Either way, we want to give partners a choice in how much knowledge they have of their investments. After all, it is their hard-earned dollars. We are just fiduciary custodians. 
 
Does Management Clearly Articulate Their Investment Process?
Whenever an investor receives a document from an investment manager, it should assist (in some way) in better understanding that manager's style, approach, and process. We often read reports (much like the infamous "farming sowing and reaping") that tell us nothing about the manager's thinking. This type of writing can help investors better see why a manager made individual decisions and how they feel about their outcomes.   
 
Conclusions
 
As we head into the twelfth year of value investing underperformance against growth, managers must be able to articulate why their value investment process is still relevant. More importantly, investors want to hear why they should hold tight with managers who have performed poorly over both the short and long term. I've written several times before that underperformance is necessary sometimes to achieve overperformance in the future. If value investing is to avoid the dodo's life path, managers better start explaining how such a theory works and how they expect it to 
 
improve performance going forward. Underperforming on a one, three, five, ten, and even fifteen year time period ask an awful lot of investors' patience. Managers have two choices - increase performance or sharpen their explanations on their investment process and outcomes. Otherwise, as Sophocles pointed out, prudent minds will have had enough of suffering reverses and simply walk away. With losses in AUM like we've seen over the past fifteen years, that might simply be the final straw for many value investment managers.  
 
As always, I look forward to your thoughts and comments. 
 
Disclosures: None

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[1] The quote comes from General “Vinegar” Joe Stillwell of US forces in Burma in World War II. When asked what happened to the allies after the long retreat from Burma he was quoted as saying “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.” 
[2] “Value vs. Growth: Widest Performance Gap on Record”, Katherine Lynch, January 11, 2021 https://www.morningstar.com/articles/1017342/value-vs-growth-widest-performance-gap-on-record
[3] Granted, the CPI impacts the purchasing power of the consumer and cuts into returns. However, utilizing this number is similar to comparing the amount of 8 inch turkey subs versus 12 inch turkey subs sold because it reflects the overall strength of consumer spending.

We spend a vast amount of time at Nintai thinking about quality and value. It’s the two measures that we believe give us our leg up on Wall Street. If we can find a hidden gem of a company - built on a solid foundation of quality measures in an industry we understand and priced with value in mind - we will likely back up the truck and happily put anywhere from 5 - 10% of our assets into the company. Because of that focus and such a large percentage of our assets, it’s vital we spend time understanding the characteristics of the company’s quality. It’s equally vital we spend time on what could impair its quality and create tools and processes to help us avoid such mistakes.   
 
At the highest level, at Nintai we think the following characteristics make up quality. 

• Run by management who allocate capital like it is their own money. Nothing turns us off as much as individuals who think of the company purse as their own personal piggy bank. We also want individuals who see themselves as stewards of their shareholders. Every action should be about building value for them. Building empires or funding pet projects simply don’t wash. 
• The company generates extremely high return on capital, return on equity, and return on assets. What we mean by this is when the company spends money it achieves good profits from the effort. If management spends a dollar to build a new product, we like to see five dollars in return. Much like a person who doesn’t want to spend good money for a dishwasher only to have to spend hundreds more in repairs, we like to see good money spent on even better returns. 
• The company has a competitive moat generated by internal competencies (very high quality control, streamlined/efficient manufacturing, great personnel policies, etc.) and external advantages (product/services deeply embedded in client strategy or operations, product hard to replicate due to intellectual property rights or patents, etc.) Both of these show up in the company’s returns on capital and equity.
• A fortress-like balance sheet and cash flows. Nintai looks for companies with no or very little debt. If the company holds debt, we look for the ability to pay off such debt within 12 months through ether cash on the balance sheet or free cash flow. We look for free cash flow (meaning all cash remaining after paying all its bills) to be at least 25% of total revenue. As we’ve said many times before, it’s very rare for a company with no debt to go bankrupt.   
• We like to purchase a company’s shares for a substantial discount to our estimated intrinsic value. As much as shoppers don’t want to overpay for the groceries, their car, or their home, we like to have what Ben Graham called a “margin of safety” in case we get our estimates wrong. 

 
In the final analysis, we want to purchase a company that will provide Nintai with the ability to compound its capital at a rate greater than its competitive index. More importantly, we want to purchase companies at a value and a quality that will minimize our chances of permanently impairing our investors’ capital. That’s a fancy way of saying we hate losing our investors’ money. 
 
Because of this, most days you will find us hard at work taking apart business cases, looking at the competitive markets, diving into new products and services, and completing a very 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 they’ve increased), and the share price has not gotten too far ahead of our estimated intrinsic value. When these reviews are complete, we share our findings and recommendations with our investment partners in the form of investment cases and valuation spreadsheets.
 
When we begin the evaluation process of a potential investment, I think it’s critical that at completion you have a clear understanding of what parts of the company demonstrate outstanding quality characteristics, what do not, and what actions could lead to the degradation of such quality. We feel it’s equally important to understand the same characteristics about the company’s value. Whether you are a sophisticated, professional asset manager or an individual investor just starting in investing, the ability to identify quality and value, understand their resilience, and how those characteristics convert to competitive and financial strength is the most essential arrow in your investment quiver. If you don’t understand what makes up quality, then you don’t understand what creates value. 
 
As we begin the process of thinking about what makes up quality, I thought it might be helpful to discuss not only what it is and what it is not. It’s important to get these two lists firmly in your head. Nearly every decision you make in your investment career, will center on what is and what is not to be considered quality. One mistake - and rest assured you will make more than one mistake in your investment lifetime - can cause considerable havoc in your long term results and in meeting your investment goals. At my mentioning of the word quality, some of my readers will say “Oh God. I’ve heard all this before”. And 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 quality and its relationship to value. Looking through my writings since June 2018, the second most common word was “quality” – coming up a total of 232 times. (“Value” was the number one word cited 431 times).  
 
So Just What Does Quality Mean?
 
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. These criteria generally leave us with about 40 of 3,671 (1.1%) total United States publicly traded companies, 300 of 17,602 (0.23%) total Asian publicly traded companies, and 90 of 8300 (0.50%) total European publicly traded companies. This leaves us with roughly 400 - 450 companies globally that meet our statistical measures of quality. If you add the criteria of value (meaning trading at a discount to our estimated intrinsic value) the number drops to less than roughly 10 - 15 at any one time. That’s a pretty small investment universe! 
 
Earlier I outlined some the characteristics we look for when it comes to identifying a quality company. 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”. To supplement the list I cited a few pages back, here are some the very high level components that Nintai thinks makes up a truly quality company. 
 
Excellence in Management: We look for management that have a vested interest in how the company performs (such as by purchasing shares in the open market, not stock option grants), has a history of outstanding management candidates usually found within the company’s ranks, deeply understands they work for both shareholders and their respective greater corporate community, and finally achieve outstanding results in both operational measures (return on equity, return on assets, etc.) and strategic measures (market share percentages, industry respect, product innovation, etc.). Most important than all of these, we look for management with a clear moral compass. This presents itself in such ways as forbidding financial transactions that profit management (such as renting a building they own directly or through corporate ownership), banning use of 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.  
 
An example of a management team that drives quality O’Reilly Automotive (ORLY). First, management compensation scheme keeps executives’ thoughts and actions on creating long term value for shareholders. Roughly one-third of compensation is calculated on a base salary. The remaining two-thirds is a combination of cash awards and stock grants based on return on invested capital, growth in free cash flow (not earnings), increase in operating income, and growth on store sales. Second, management has done an outstanding job at allocating capital. As I mentioned earlier, as an investor you always want to see management obtain a better return on capital than its cost of capital (meaning they make more money on the capital than it does to borrow it). In O’Reilly’s case, the company has averaged a 19% return on invested capital against Morningstar’s estimated weighted average cost of capital of 8% over the past ten years. While achieving such results, management has greatly expanded O’Reilly’s footprint though small “tuck-in” (meaning smaller, adjacent opportunities) acquisitions, never overpaying for new investment opportunities. Finally, the company has a long history of focusing on corporate governance including diversity, health & safety, training/promotion within, and corporate giving. Morningstar rates corporate governance as Excellent.   
 
Create Deep Externally Facing and Inwardly Looking Moats: In both good times and bad, we look for managers who can create exceptional defensively and offensively balanced moats. By defensive moat, we mean management keeps competitors, the general business environment, and time from attacking its position of strength. Defensive moats consist of maintaining market share, achieving steady and high pricing power. Defensive moats prove their worth as competitors seek ways to chip away at high gross or net margins or high return on capital. However, managers can sometimes excessive spend blood and capital digging a defensive moat and trying too hard at maintaining the status quo. 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 or offensive 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, increased scope of offerings, better quality, and new products/services on a remarkably frequent basis. An offensive moat is designed to find ever increasing opportunities (both in depth and breadth) with existing customers. 
 
An example of a company working diligently at both defensive and offensive moats is Veeva (VEEV), a Nintai Investments holding as of January 2021. Starting out as a customer relationship manager spinoff from Salesforce.com, the company has initially focused on achieving market dominance in the pharmaceutical/biotechnology industry. As of 2020, the company contracts with 19 of the 20 largest industry companies. Its numbers tell the story of an incredibly strong defensive moat – 21% return on equity, return on invested capital of 49%, free cash flow margins of 38%. The company has grown revenue at 26% for the past five years and free cash flow by an astounding 60% over the same time frame.  
 
But the company doesn’t just create a defensive moat. It has worked incredibly hard to keep expanding its moat within its customers. Average contract value per customer has increased by 167 times since 2006. Average product per client has increased from 31 in 2008 to 431 in 2020. Talk about embedding yourself with your clients. Veeva is a moat building domino.  
 
Create 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 it’s 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. 
 
An example of such a company is SEI Investments (SEIC), a Nintai Investments holding as of 2020. SEI  provides investment processing, management, and operations services (what often referred to as “back office” operations to financial institutions, asset managers, asset owners, and financial advisors in four material segments: private banks, investment advisors, institutional investors, and investment managers. 
 
As a company reliant upon the financial markets for 100% of its revenue, an investor can imagine the impact of the credit crisis of 2007 - 2009 and the ensuing market crash would have a powerful impact on the company’s operations and finances. It most certainly did. Revenue dropped from $1.37B in 2007 to $901M in 2010 - an extraordinary 34% drop. Free cash flow dropped from $282M to $177M in the same time - a 37% drop. For many companies a drop like this could cause management to hit the panic button. Such a huge decrease in free cash could put pressure on capital spending and debt servicing. Any hint of this - such the rumors swirling around Bear Stearns or Lehman Brothers could put the stock price into a death spiral. 
 
SEI stock did drop horrifically like the rest of the markets but in time recovered. Most importantly there was no rumors of insolvency or inability to meet its obligations. Why was that? Certain part of that was the company had zero debt. No short term and no long term debt. It had roughly $400M in cash on the balance sheet and the previously mentioned $177M in free cash flow. For a company in the hardest hit industry in one of the worst crisis in Wall Street history, the company’s fortress-like balance sheet held the walls against all issues. This was a castle we were happy to hold.     
 
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. Amazingly, companies with these attributes can be frequently found in the course of the markets’ daily trading. Generally monopolies and duopolies have intense competition as other companies’ leadership see the opportunity to get in on a profitable business segment. 
 
But many duopolies and monopolies are founded by legal or regulatory rulings that are difficult to break through. Others are created through the ability of a company or a couple of companies to capture such a significant market share there simply isn’t room for any new competitors. A classic case of a duopoly is Visa (V) and Mastercard (MA). The latter is a Nintai Investments portfolio holding. While there are other companies - such as Discover (DFS) or American Express (AXP) - that offer card services, these two behemoths have essentially split the market between themselves. 
 
What we look for the most at Nintai are companies with domination provided by legal means such as patents, regulatory approvals, etc. An example of this is iRadimed (IRMD) a Nintai investments portfolio holding. The company is the maker of non-magnetic MRI pumps and oximeters. This allows patients to have their IV pumps be brought directly into the MRI (magnetic resonance imaging) room without having to run long extension tubing outside vastly increasing the chances of a medical adverse event. This monopoly was created by FDA when IRMD received its FDA approval thereby winning a more-than-decade long prohibition of patent infringement. This type of monopoly will allow iRadimed to expand its markets, develop new products, and embed its in every ambulatory or hospital-based MRI imaging centers in the US. Now that’s what we like to own.   
 
The Share Price Doesn’t Reflect its Value: One vital piece remains in finding a quality company. I will discuss it in much greater detail in “Chapter 2: Defining Value”, but let me summarize by saying quality must be linked to value to make it a compelling investment opportunity. There have been many examples in Nintai’s research where we have found a stock with every possible quality measure – except this one. For instance, in 2020 we continued to look longingly as Factset Research (FDS) a former Nintai holding which we sold out of because of price appreciation. It hasn’t come down since we sold it. To the contrary, the price has continued to reach new highs, sometimes trading at nearly double our estimated intrinsic value. No matter how impressed we were with the financials, management’s focus on profitable growth, and its near duopoly with Bloomberg (privately-held), we simply couldn’t justify paying such a price for quality. 
 
This happens a lot. It is perhaps the hardest part of being a successful quality value investor. The desire is so strong to pull the trigger and become the proud owner of such a business. But there is perhaps no easier way to permanently impair your - or your investors’ hard earned investment dollars - than overpaying for a stock. Never forget that price and value change every day. It might be that you can purchase the stock next week, next month, or next year. Or you may never be able justify purchasing it. Either way, always keep the connection between quality and value.

Hi every one. We've received the first Audible test portion of "Seeking Wisdom: Thoughts on Value Investing". We can't thank Jonathan Drake-Summers enough for his incredible skill in making the book come alive. Feel free to tell us what you think. We wish everyone a very happy New Year! 

“It’s very hard to understand that value investors need to underperform sometimes to outperform later. When we reach highs like we’ve seen over the past half-decade, value investors are likely to underperform. One question that nags at me though is that many, many value gurus have underperformed over the last 10 or even 15 years. Is that the new normal? How do we explain that?”   
             
​                                                                                  -     Peter Kinkaide 

The Horns of a Dilemma
 
As an investment advisor, long bull markets can both exciting and fulfilling as well as nerve racking and terrifying. It’s the final stages of  bull market that can really wear a traditional value investor down. This is mostly due to the fact that by the time markets reach those dizzying heights seen at such a bull’s latter stages, value is almost nowhere to be found. For those who practice dyed-in-the-wool value strategies, these final years can be agonizing for their returns, for their funds’ confidence, and their managers’ psychology.  
 
The bull market which started sometime in 2009 after the Great Credit Crisis has now run nearly 11 years with a few corrections. At Nintai Investments, our average investment partner portfolio has jumped from roughly 25% below fair value to 11% above fair value since 2018. We simply don’t find very much value out there. As an investment advisor, we face several choices when it comes to the allocation of capital – establish a new position, add to an existing position, stand pat/build cash, take profits, or exit a position entirely. The greatest impact on which course to take is that of valuation. With rising valuations over the past decade, nearly every decision has led to either standing pat and building cash (on average near 20 - 25% in our investment partner portfolios) by taking profits. These actions have placed us in an awkward position. Holding a large percentage of portfolio funds in cash is no way to outperform in bull markets. Yet, as a true value investor, I refuse to overpay and potentially open up our partners to permanently impaired capital. 
 
For the past several years we’ve been in a rather inopportune position of having our feet stuck in the mud as other investors have raced by achieving outstanding returns. What makes this so painful is that our long term record - achieved through bull and bear markets - of significant outperformance has been cut dramatically. As an example, on June 30 2020 our average investment partner portfolio had achieved a three year cumulative return of 87% versus the S&P 500’s 31% return - a 56% difference. At Nintai, we were sitting up a little straighter and walking with a little extra swagger after we reported that quarter. But - like all those who suffer from hubris (small or large) - it only took 3 months to teach us that inviolable law of reversion to the mean. By September 30 2020 that 56% outperformance had dropped to a 26% differential. Of all of that hard work and gains achieved over three years, we lost over one-half in just over 90 days. Ouch! 
 
Don’t get me wrong - we aren’t crying in our New England clam chowder here at Nintai Investments. We are doing what we’ve done for nearly 20 years - maintaining open and honest communication with our investment partners, redoubling research on our portfolio holdings, and being cognizant of our emotions during this dreadful period. Our long term performance continues to give us confidence in our process. In addition, we are blessed with partners who understand the power of patience and have faith in our methodology. 
 
Value Investing: A Wide Range of Underperformance
 
Of course, Nintai isn’t the only investment house in this position. While we had a very rocky 2020, some famous value investors have underperformed dramatically over the length of the bull market. For instance, what would your initial thoughts be of an investment manager that had the following summary description? Would you feel comfortable giving your entire retirement assets to such a fund?
 
“On a three-year basis, the fund currently sits 1,514 out of 1,516 fund managers in the Equity - Global sector. He lost 53.2% over the period to the end of March 2020 (3 Years), while the average manager in the sector lost 1.3%.”
 
Yikes. That performance was chalked up by Francisco Paramés’ Cobas Asset Management. Many people will remember Francisco from his prior investment venture - Bestinver - where he was employed for 25 years (leaving in 2014) and posted a 16% annual return over that time. For longer term underperformance, one doesn’t have to rummage around very long in the value investor hall of fame. For instance, Bruce Berkowitz’s Fairholme Fund (FAIRX) - Morningstar’s Fund Manager of the Decade in 2009 – has underperformed the S&P 500 by -16.8% over the last three years, -10.3% over the last 5 years, and -8.5%over the last 10 years. During the decade assets under management decreased from $11B to $650M. David Winters - former guru manager at Franklin Mutual before founding the Wintergreen Fund - underperformed the S&P 500 by -10% over 3 years, -10.6% over 5 years, and -6.9% over 10 years before closing the fund in 2018 after seeing AUM drop from $950M in 2013 to $10M in 2018.  Third Avenue Value Fund - Marty Whitman’s died-in-the-wool value vehicle - has really taken a beating. It has underperformed the S&P 500 by -14.2% over the last 3 years,   -10.3% over the past 5 years, and -9.1% over the past 10 years. Assets under management have decreased from roughly $5B to $390M. 
 
I didn’t write this to ridicule my fellow investor managers or hold them up as individuals who’ve lost their touch. Far from it. I give them credit for sticking to their process and moral compass. Rather, I wanted to point out that nearly every value investor has been pretty badly damaged by the last decade-long bull market. These three represent a cross section of styles, methodologies, and asset portfolio that differ dramatically. The one common theme is they all derived from the classic school of value investing. The second theme is they have all underperformed (some less than others). 
 
Is Value Investing Obsolete? 
 
As investors peruse the wreckage over the last decade within the value investment landscape, many people have begun to ask whether value investing has seen its day. It’s easy to see why that is being asked. As you look out  across the investment universe, you can find a considerable amount of classic value investors with truly appalling 3, 5, 10, and even 15 year records. This underperformance has cut across nearly every category (small, mid-cap, large, and jumbo). For instance, the Russell 1000 GROWTH Index through June 30 2020 has achieved a 1 Year return of 23.3%, a 3 Year return of 19.0%, a 5 Year return of 15.9%, and a 10 Year return of 17.2%. (return data provided Vanguard). Compare this to the Russell 1000 VALUE Index 1 Year return of -8.8%, 3 Year return of 1.8%, 5 Year return of 4.6%, and a 10 Year return of 10.4%. 
 
As value investors (and I include myself as one), one has to look real hard to see any positive message in returns like that. Over a decade, it becomes increasingly difficult to convince investors that value is simply “out of style” or “we’ve all seen this type of cycle before”. One only has to look at the bull market of the mid to late-1990s to see that growth outperformed for only roughly 5 to 6 years. As of 2020, we are looking at growth outperforming vale by roughly 12 years - nearly double the tech bubble cycle. 
 
These types of returns have begun to really bite into traditional the value investor business model. For instance, data from Lipper showed U.S.-growth funds attracted $17.6 billion in April and May of this year, while value funds witnessed outflows worth -$16.9 billion. Numbers like that are nothing to sneeze at. Assets under management have dropped dramatically for many value gurus. Vanguard reports the average actively managed Value Large-Cap fund has lost 38%, the average value Mid-Cap fund has lost 42%, and the average value Small-Cap fund has lost a whopping 62%.   
 
So is value investing obsolete? At Nintai, we feel very strongly the answer is no. As silly as it sounds to say consumers will no longer look to find groceries on sale, we think there will always be a role for value investors to sniff out value and make their investment partners handsome returns arbitraging the difference between price and value. That said, we think some things will need to change if value investment theory is to thrive in the future. Some traditional methodologies need to be discarded while existing/future trends need to be embraced. 
 
Potential Changes in Value Investment Strategy
At Nintai, we think the 21st century will be a golden age for value investing. Having said that, we think the golden age will be powered by the adoption of new technologies and trends and the phasing out of certain methodologies or measures that may not be as effective as they were in the past. 
 
Information is a commodity now
Back in the days (and I date myself here), value investors used to take the latest Value Line report and read about hundreds of companies analyzing essential data derived from the companies’ balance sheet, cash flows, and income statement. You paid good money, but there simply was no better source of data in one place. This was further enhanced by the adoption of Morningstar’s fund data (later increased to stock and individual bond data) and the Bloomberg terminal. Unfortunately, all of this data has been digitized and is now available on a single platform with the ability to utilize your own proprietary algorithm to search for investment opportunities - all at the push of a button.[1] What once took considerable dollars and even more time can now be done in seconds. Hidden gems - even including Ben Grahams net-net opportunities are now as simple to find for your next door neighbor as they are for a senior analyst at JP Morgan. 
 
Company disclosure is available at the touch of a button
Learning about a company - everything from management compensation to chief competitive offerings –- is possible right on the company’s website. An enormous amount of content such as investor presentations and conference slide shows - not to mention 10-Qs, 10-Ks along with other SEC filings - is at the fingertips of any potential investor. The days of finding inside information or having an inside source really isn’t even an issue anymore. 
 
Investment strategy and theory is just as easy to find
Many older value investors first became cognizant of value investment theory and methodology by picking up the 8 pound hardcover version of Ben Graham/David Dodd’s classic “Security Analysis” and settling down to take copious notes and trying to match the authors’ thinking with Marty Whitman’s thoughts on calculating intrinsic value. That certainly isn’t necessary anymore. Today one can search Amazon’s business section to finds thousands of books discussing everything from modern investment theory to detailed arbitrage strategies. The ability to learn about investing - from the highest theory to the meanest methods - simply cannot compare to what it was like in the 1980s. 
 
These trends have leveled the playing field for all investors – whether they be growth or value focused, individual or institutional in size - limiting the ability to have an inside track because of corporate, competitive, or marketplace information. This has had a tremendous impact on value investors where accurately calculating the difference between value and price is the essential tool in achieving outperformance.    
 
But sometimes these trends aren’t just a detriment for value investors. For instance, while the digitization of data has leveled the field in terms of knowledge, it has also fed on the impatience of today’s investors. Rather than let all this new knowledge work for them, many investors use it to do short-term or - god help us - day trading in the markets. Here’s a few instances where new trends can be inverted to the advantage of the value investor.
 
Research can be far more robust
While digitization of data has made research available to anyone with an internet connection, most individual investors have a difficult time utilizing this new asset. Indeed, many investors have been lulled into simple algorithms/search tools like “Warren Buffet’s Stock Buys” and think they can buy stocks within the search results and voila(!) they are seemingly a partner at Berkshire Hathaway. To obtain value from this influx of data, individual investors need to roll up their sleeves, develop a set of investment goals/investment criteria, and then utilize search features to identify possible investment targets. While many think this is the end of the research, true value investors know this is just the beginning. Being able to screen useless data, applying good data to answer critical questions (such as “what are the three major components of the company’s moat and how are they supported by returns on capital?”) takes enormous effort. 
 
Digitization means more actions at faster speeds
We are beginning to see that the explosion in the amount of data is also increasing the velocity in which the data is used. According to Vanguard the average ownership time of a portfolio holding has decreased from 5 years 3 months in 1965 to less than 3 days in 2019. In some cases (such as Nasdaq or commodities trading) the holding period is measured in hours or - heavens forbid - seconds. Value investors can use this form of hyperactive disorder to purchase shares of outstanding companies at fair prices and then let time (meaning years) do its compounding wonders. Since beginning Nintai Investments LLC, our average turnover has been less than 5% annually with 75% of our holdings in the portfolios since inception. If you find an outstanding company headed by outstanding capital allocators, why not let them do the heavy lifting?
 
Great businesses are lasting longer. Poor companies are not. 
In the good old days of value investing, the idea was finding companies selling below their total net assets or operating under some impairment such as a bad business deal or bad news. One simply had to scoop up the shares at a discount, wait for the market to recognize its mistake, and sell the shares when they reached fair value. It’s not so easy anymore. At Nintai we find companies that take a hit - for whatever reason - have a tendency to stay down for quite a long time. A recent example of such an extended price depression (or as it is called - a “value trap”) is AK Steel Holding (AKS). After peaking at roughly $17.50 per share in January 2011, the stock has slowly and steadily dropped to $2.25 per share at the end of 2020. Every event which has toted to be “turning point” has not panned out - selling assets, rebound of oil prices, etc. - and simply provided patient investors with a 90% loss of their investment. With the amount of data publicly available these days, simply betting on a company selling at a discount to its assets and waiting for the markets to price in a market catalyst is a disaster. At Nintai we think one of the reasons why a company like AK Steel can be a value trap is that it is much harder to find mispricing through hidden or misunderstood assets. In the past, many capital intensive companies (like AK) could prove to be a profitable investment when a security analyst found mis-priced assets hidden on the balance sheet that eventually reached full valuation through an asset sale or divestiture. Such extensive information and data available these days makes it much harder to find such mis-pricing and simply find a value trap instead. 
 
Conclusions
 
At Nintai, we don’t believe value investing is dead. We would argue it has evolved as changes in informatics, corporate disclosures, and business velocity have altered the investment landscape. We think investors with the emotional ability to be patient and not overpay, combined with the ability to utilize all the data and information available, will be rewarded in the long term. The ability to find stocks with low PE or PS ratios or trading at 40% of its net assets simply isn’t enough these days. Neither is using some algorithm based on a formula to find “cheap” stocks enough. The playing field has flattened which has created both an opportunity and a risk. The truly successful value investors in the future will understand this and utilize the changes over the past 25 years and use them to their advantage in the next 25 years. 
 
As always, I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai Investments – nor its investment partners – own any stocks mentioned in this article. 
 
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[1] I can remember sitting at Well Beach spending a week in the sun, watching the surf and reading 8 different Value Line reports all week. I could slice and dice all this data today in a matter of minutes – not weeks. 

I recently had the pleasure speaking to an Ivy League school’s endowment board of directors about the future of value investing. The Board has been struggling with roughly a decade of relatively poor performance compared to the S&P 500. A couple of particular sticking points have been high turnover in the portfolio along with fees charged by the endowment’s fund managers. (I should note the directors have no one to blame but themselves since they sign the contracts). About mid-way through our time together, it became clear the investment structure, management organization, and decision processes had no alignment with their goals for the endowment’s assets. At this point I discussed Nintai’s use of an intellectual framework and process that provides it with the means to actualize the company’s investment tenets and rules. ​
 
At Nintai, we practice our own unique version of value investing that focuses on price, value, and quality. These three legs of our investment triangle are sometimes disputed to be growth-at-a-reasonable (GARP) and not true value investing. We discussed this all the way back in 2015 in an article entitled “Am I a Value Investor?”. Since we focus on not overpaying and look for a substantial discount to fair value when we purchase, we consider ourselves value investors. We break from more traditionalists by worrying less about certain ratios such as price to earnings or price to book, but this certainly doesn’t mean we think value has no role in investment selection.    
 
As value investors (now that we’ve settled that!), we focus on three core tenets that drive our overall investment philosophy and strategy. These are the impact of quality on value investing, making a clear distinction between a quality company and a quality investment, and creating an investment process that works for you. These tenets overlay four rules that make value investing work over the long term. These include cutting down on turnover/reducing trading and fees, mastering human emotions during good and bad times, creating a work ethic that makes you a learning machine, and understanding the relationship between value and price is the basis for outperforming the general markets.   
 
At Nintai, we think these seven tenets and rules have created an intellectual process that gives us an advantage over most of Wall Street. None of it is rocket science. None of it requires advanced mathematics. None of it even requires a master’s degree in business administration. In fact, we’ve found much advanced educational and professional training is detrimental to being a successful value investor and more suited to speculation and market timing. I recommended to the University Endowment’s Board they get back to basics and follow these time-tested philosophy’s and perhaps (of course past performance is no guarantee of future returns) they might see a reduction in fees, costs and turnover all while increasing long term performance. 
  
Value Investing and Quality
Ever since Warren Buffett partnered with Charlie Munger, there has been a robust debate about the definition of value investing. One school comes from the more traditional models of Benjamin Graham – sometimes referred to as “cigar butt”[1] investing - in which the investor looks to purchase a company where the current assets (cash, cash equivalents, inventory, etc.) exceed the total liabilities of the company. That’s a complex way to say the company has got more than it owes. This type of investment (called a “net/net” by Ben Graham) would be part of a basket of such stocks where one might make a handsome profit when the markets realized such pricing discrepancy. The other school of thought looks for outstanding companies trading at fair prices. This might be a company with high return on capital, solid long-term growth, and solid balance sheet trading at roughly seventy-five cents on the dollar. In the former, an investor purchases a company with little long term future but a hope the markets recognize the mispricing of assets. In the latter, an investor refuses to overpay for assets but looks for long term value generation to compound over the long term. It is critical that an investor know why it’s important to build a portfolio around quality investments and how you go about finding them. 
 
Quality Investments versus Quality Companies
Finding a quality investment is distinct from finding a quality business. For instance you may find a business with outstanding characteristics such as high return on capital, but trading at a 60% premium to your estimated value. This would be a quality company that is likely to be a poor investment. Conversely you might find a rather pedestrian company trading at a 15% discount to your estimated value. This would be a non-quality company at a compelling price. Should you buy either? It is vital that investors know the difference between a quality company and a quality investment. More importantly, they must know the core requirements that make up a quality company and how an investor goes about finding them. 
 
Defining Your Path
Much like Warren Buffett, my career as an investment manager has migrated from the short-term cigar butt investor to one looking for long-term capital compounders. My record as a short-term investor wasn’t great and I found it didn’t meet my natural predilection for positive, long-term growth stories. It was a great first lesson - to thine own self be true. Create and stick with an investment approach that reflects your inner self. In abandoning the cigar butt methodology, I wasn’t making any moral judgement about investors who took such an approach. One thing you will learn on Wall Street is that there are many, many ways to make (and lose!) money. It is vital an investor creates their own investment operation that can help them sleep well at night.    
 
It is critical to understand these basic tenets sit on a foundation of rules that are as immutable as any of Einstein’s theories on relativity. Investors should bear in mind that these rules work like a gravitational force in eating away at performance. Each of them can lead long term value and quality investors far astray from their goals. Conversely, when applied rationally they can provide individuals (or organizations) with an advantage at no cost to the patient, focused investor.   
 
Turnover and Trading
Turnover and trading are not characteristics of a long-term quality investor. You will often read an overview of an investment advisor’s investment case for purchasing a certain holding and then see it was traded out of the portfolio after just 6 months. It seems to me the adviser either knew too little about that holding or they let emotions get the best of them. How do I define trading? Buying and selling a holding within a 6 month to 1 year time period is a sign of a trading mentality. Turnover of 50% or more year (meaning the adviser buys or sells 50% of the entire portfolio in a 1 year period) are signs of an adviser’s proclivity to trade. It’s critical to remember that trading eats away at returns by expenses in brokerage fees, lost opportunity costs, and capital gains taxes.
 
Human Emotions
During periods of bull markets to bear markets – and all the spaces in between - many investors let their emotions get the best of them. Whether it be fear or greed, emotions can override some of the common senses rules you think you have down pat. How many investors have seen a holding drop by 30% in one day and sold it as quickly as their brokerage account could make the trade? What happened to well thought out business cases based on intrinsic value? Or even following the simple rule of “buy low and sell high”? Emotions have a way of making a hash of our best laid plans. To be a long term value investor, you must find a way to manage your emotions. 
 
Work Ethics
Value investing is hard work. While it may sound like I’m advising investors to find their 15-20 quality companies, make their purchases, and then check out for the decade. Nothing could be further from the truth. The ability to ascertain quality from both external and internal views (meaning internal metrics and external perceptions) takes an enormous amount of time. The investor must read, research, calculate, and synthesize a great deal of data and knowledge. You don’t need an IQ of 160 or have an MBA from Harvard, but you do need to make a commitment to always be learning about your portfolio holdings themselves and the markets in which they operate.
 
Price and Value Always Matters
No matter how outstanding the quality of a company, it will be difficult to obtain long term outperformance if you don’t know the value of what you purchasing and how that correlates to its price. If you purchased a basket of internet-based companies in January 2000 you had to be a relatively patient investor to see any positive returns and even longer for outperformance. One of Murphy’s Laws is that everything looks cheap when you don’t know its value. Wall Street cares little what you think about a company’s quality, and even less about how much you paid for a share of said company. Successful value investors simply predict value versus price better than other investors. It’s really that simple.  
     
These foundational rules - when applied properly - can provide long term value investors with a real leg up on Wall Street. For all the talk on financial networks, investing shows, and industry marketing, the vast majority of financial “experts” have little to no idea of how the markets or their clients’ portfolios will perform over the next 1 month, 3 months, 3 years, or even 30 years. Financial markets are made up of - most basically - human beings making decisions based on a blend of these rules.
 
A word of caution. These rules may seem easy to live by. In today’s markets, commercials make it sound convincing that with the right technology and management team investors can join a website, follow their recommendations, and retire at 45. It would seem to me that the lessons from the spring of 2000, the fall of 2007, and the spring of 2020 should enlighten most that investing is far more complex (though in some ways easier) than marketed, and demands steady effort over the long term. It is my belief the vast majority of underperformance can be attributed to violation of these rules. 
 
In sum, at Nintai we use these tenets and rules as an intellectual framework to pose questions, conduct research, ascertain the qualitative nature of a potential investment, assign intrinsic value, and - finally - to make investment decisions to buy or sell. I should point out that following these rules in no way guarantees an investor will beat the S&P 500 every year for the next decade. We certainly haven’t at Nintai! Previous performance is no assurance of future returns. But I think a focus and applied approach to investing following these goals/rules can provide an investor with the possibility of preventing very painful losses and better long-term performance. 
 
------------------------------------------
[1] Cigar butts received their name from the concept than an investor might take one last hit from such a stock and purchase a dollar’s share of assets for fifty cents. For a non-investing description, imagine finding a nearly completely smoked cigar on the sidewalk, but having enough to take one more pull on it - hence cigar  

October 2020
 
To Our Officers and Investors:
 
Enclosed you will find our report on the Q3 2020 performance of the Nintai Investments LLC Composite Portfolio managed by Nintai Investments LLC. Returns reflect performance since October 31 2017 when the company began operations. 
 
Q3 2020 Returns
 
Last quarter we mentioned the economy and markets were marred by the constant increase in COVID infections and deaths. We stated that during Q2 we reached roughly 1,600,000 cases and 100,000 deaths - combined with high unemployment - which made deploying capital a risky venture (it’s always risky - the exception here is that uncertainty far outweighs risks). The situation in Q3 has not improved very much. By the end of Q3, total COVID cases in the US has grown to roughly 7,200,000 cases and 210,000 deaths. These numbers are simply dreadful. Until the country takes the pandemic seriously - mandatory mask wearing at all times, social distancing, limited group interactions, etc. - then the disease will continue to be a story of immense human tragedy and drag on the long term growth of the US economy. Unemployment has improved – dropping from a 24% unemployment rate to 8.4% by October 1. While coming down, that is still a shocking number which places an enormous strain on consumer spending (75% of total GDP), our social safety networks, and the service economy in general. Finally, the search for a COVID-19 vaccine is on-going, with a concern of the general public the FDA will rush approval and allow the launch of a product with an insufficient safety profile. As scientists and researchers continue to better understand the virus, it appears utilizing a herd-type immunity will be increasingly difficult to achieve. Overall, the team at Nintai finds it hard to create a risk/uncertainty model that protects to the downside while offering sufficient reward to the upside. Consequently you may see cash positions as a percent of total assets under management reach new highs.     
 
Overall, Q3 2020 wasn’t a very successful period for our investment portfolios. We underperformed the S&P 500 by 4.97% with many holdings performing poorly. Our showing against our two other comparable indexes wasn’t as bad. We underperformed the Russell 2000 by roughly 0.87% and the MSCI ACWI ex-US by roughly 2.14%. 
 
As we mentioned in our Q2 update, the reversion to the mean (to the downside in this case) can prove to be a taxing process. We are comfortable each portfolio holding remains financially solid, has a strong competitive position, and is led by a management team with a firm eye on investment return on capital. As you can see from our latest investment cases (mailed out last month), we remain confident that each holding should perform well over the long-term (past performance of course is no assurance of future returns). The valuation spreadsheets tell a different story. Many portfolio holdings have highly elevated valuations. In our update “When the Economy and the Markets Disagree”, I stated we are left with the quandary 
 
of holding outstanding companies with inflated valuations. In principal, we’ve been holding onto these companies simply because we cannot replace them with any other company that we feel could compete (from a return and quality perspective) over the next decade or two. This has held us in good stead until this previous quarter. For now, we see no reason to change course and actively sell large positions out of the portfolio. 
 
For the quarter, the Nintai Composite Portfolio generated a (+4.07%) return (including fees) versus (+8.93%) for the S&P 500, (+4.93%) for the Russell 2000, and a (+6.28%) for the MSCI ACWI ex-US Index. For the 1 Year period, the Nintai Composite Portfolio generated a (+24.11%) return (including fees) versus (+15.15%) for the S&P 500, (+0.39%) for the Russell 2000, and a (+3.16%) for the MSCI ACWI ex-US Index. Since inception (on an annualized basis), the Nintai Composite Portfolio has generated a (+17.18%) return versus the S&P 500’s (+6.91% including reinvested dividends), the Russell 2000’s (+0.83%), and the MSCI ACWI ex-US’ (+1.37%)return.
 
It goes without saying we are very pleased with long-term numbers, but disappointed with the quarterly returns. In last quarter’s report, we stated:
 
 “….it should be pointed out that Nintai Investments LLC (and its predecessor Nintai Partners) typically gains its advantages in truly abysmal years. Our risk averse approach generally shines in moments of significant drawdowns in the markets.”
 
This certainly been the case in 2020. During Q1 (with the onset of the Corina virus pandemic), the S&P 500 achieved returns of (-0.04%) in January, (-8.23%) in February, and (-12.35%) in March. The Nintai Composite Portfolio achieved returns of (+0.68%) in January, (-6.12%) in February, and (-5.28%) in March. The portfolio outperformed the S&P 500 by a cumulative (-10.72%) to (-20.62%) respectively (or by 9.54%). 
 
Q3 tells an entirely different story (or inverts the findings as I am fond of saying). The S&P 500 achieved returns of (+5.64%) in July, (+7.19%) in August, and (-3.80%) in September. The Nintai Composite Portfolio achieved returns of (+4.36%) in July, (+1.71%) in August, and (-1.81%) in September. The portfolio underperformed the S&P 500 by a cumulative (+4.06%) to (+9.03%) respectively (or by 4.97%).
 
Seen below are results for Q3 2020, year-to-date, one year, and since inception (annualized). Note we have removed the Index Blend 85% Stocks as the portfolio no longer tracks to the indexes percentages.  
 

​Portfolio Changes
 
For individual portfolio members only
 
Winners and Losers
 
For individual portfolio members only
 
Portfolio Characteristics
 
The current Abacus view as of September 2020 shows that the Nintai Composite Portfolio holdings are roughly 25% below in value to the S&P500 and projected to grow earnings at a 20% greater rate than the S&P500 over the next five years. Combining these two gives us an Abacus Comparative Value (ACV) of +45. The ACV is a simple tool which tells us how the portfolio stacks up against the S&P 500 from both a valuation and an estimated earnings growth stand point. The number shows a portfolio much cheaper in value with much greater profitability and a sharply higher projected growth. We like to see the ACV above 20, thereby giving the portfolio the best chance at outperforming the general markets.
 

​Portfolio Industries 
 
I remain highly focused in my industry and sector weightings.  I currently have holdings in only 4 of the S&P 500’s 11 categories – financial services, industrials, technology and healthcare. 

Final Thoughts
 
The third quarter of 2020 was the first time the Nintai Investment’s individual investment portfolios truly had a miserable performance against their proxies. As I pointed out earlier, our holdings generally outperform in down markets. This quarter represented an explosion in market enthusiasm as investors feel we turned the corner on COVID. Even with the infection of the President we are seeing this isn’t necessarily correct. There also seems to be (and we hate this phrase) an irrational exuberance in relationship to the recovery from the COVID-based recession. Again, we are in a minority that feels we have a long way to go in getting all parts of the economy back to operating on all cylinders.  
 
Last quarter we wrote there were three main issues we felt would drive longer term returns for the markets. We think these three themes are unchanged since we first wrote about them. We have added a fourth as the United States’ approach to dealing with the COVID-19 has been woefully inadequate and will continue to be so until we get a new administration with a more systemic - and systematic - approach. 
 
1. Stock prices - relative to price over earnings, price over cash flow, and price over estimated earnings growth - seem quite high in historical terms. While interest rates remain at historical lows, Nintai believes this doesn’t offset the full risk of such high process.  

2. With over 7.45M cases (averaging roughly 35,000 new cases every day) and 212,000 deaths (averaging roughly 400 new deaths per day), the United States’ economy and overall consumer purchasing power will be severely hampered and unable to reach full potential. Any projection in earnings, growth rates, or profitability will be very hard to support until the pandemic is under control.   

3. Geopolitical risks have never been higher with the US domestic political scene extremely volatile, the global energy markets in disarray, and the growth in nationalist/populist actively seeking to break up decades-old alliances. The 2020 US Presidential election only adds to these risks.  

4. China represents an entirely new competitor with significant strength generated by its recent economic power, as a significant holder of US debt, and its play for greater military strength in the Pacific.  

We generally don’t allow trends like these to drive our investment decisions or capital allocation. That said, the constant evolution of both US and global political economics can have an impact on individual portfolio holdings’ strategy and operations. As always, we will keep a sharp eye out for any impairment on our holdings’ valuations and/or competitive moat.     
 
We hate underperforming. Regardless of what events that are happening in the greater economy or geopolitical world, we have no excuse for our performance in Q3 2020. You have our word we will work diligently to better our results and get back to excelling over our indexes. That said, we recognize underperformance happens and we won’t be suddenly increasing portfolio turnover to 115% or leveraging our portfolio by 400%. Rather, we will focus on what we do best and focusing on improving our process where we can. 
 
Helping individuals and organizations achieve their life goals, support their corporate giving, or meet their retirement needs is a remarkable honor and mark of great trust. Every day we look to continue earning that trust. Should you have any questions, please do not hesitate to contact me by phone or email.  
 
 
Thomas Macpherson
tom@nintaiinvestments.net
603.512.5358 
 
My best wishes for a healthy and happy summer season.