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

Source: Investment Company Institute and Morningstar

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."
    
                                                                                             -      Charles Munger 

“A company must necessarily achieve investment returns (note I say “investment,” not “investor”) that track similarly to its return on capital. No business scheme can achieve great investment returns if it cannot achieve great returns on capital.”
 
                                                                                             -     Nintai Partners Annual Report 2007   

Over the past decade, I have written extensively on our core strategies at Nintai Investments when looking for - and investing in - companies to add to our portfolios. Most of the qualifications we look for, such as no short or long-term debt, pale in their long-term impact compared to a company’s return on invested capital (ROIC). Distilled to its essence, ROIC is simply a measurement of how well a company uses its capital to generate profit. Comparing ROIC to a company’s weighted average cost of capital (WACC) can give an investor a quick and powerful tool for understanding whether the company can generate value for shareholders over the long term. It stands to reason that a company whose cost of capital is greater than its return on capital will not generate adequate returns (if any) to its investors. Conversely, as Charlie Munger states in the quote above, companies that can generate high ROIC over extended periods will likely (all other things being equal) help an investor outperform the general markets. The key attributes here are two-fold. First, the company must maintain a high ROIC over the same extended period as the investor holds it. High ROIC doesn’t help an investor in the short term. As we say (all too often) to our investors, we prefer portfolio-holding management to do the heavy lifting. 
 
To simplify the impact of ROIC versus WACC, let’s use our standby business - Sally’s Lemonade Stand  - to put this statement to the test. 
 
ROIC versus WACC: A Working Example
 
Imagine Sally has decided to expand her lemonade stand with the onset of the summer season. She has decided to invest in her business to allow for sales (and therefore production) to double. To do this, she will borrow from the venerated Bank of Dad $25 to buy additional raw materials and supplies. Taking on this debt will allow us to calculate her weighted average cost of capital. At the end of the year, we can calculate her return on this invested capital. The question we will look to answer is whether Sally was able to generate a higher return on invested capital versus her average cost of 
capital. More simply, was borrowing the money a wise business decision that added to the value of her business? 
 
To calculate the return on invested capital, we divide net operating profit after tax (NOPAT) by invested capital. To make this case as easy as possible, let’s assume Sally’s stand pays no taxes, and her NOPAT was $1.65 for the period in question (let’s face it, there isn’t much money in lemonade stands!). The invested capital was the $25.00 in debt from the Bank of Dad at an interest rate of 10%. 
 
The first thing that stands out is that Sally generated a lower return on invested capital in 2022. Even borrowing the $25.00 to boost her production ability and sales (and driving up total invested, her operating income dropped significantly. Second, with the assumption of the new loan from the Bank of Dad, she carries considerably more debt on her balance sheet. 
 
Calculating the weighted average cost of capital is achieved through the following formula. 
 
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
 
Here’s a breakdown of this formula’s components: E: Market value of firm’s equity, D: Market value of firm’s debt, V: Total value of capital (equity + debt), E/V: Percentage of capital that’s equity, D/V: Percentage of capital that’s debt, Re: Required rate of return, Rd: Cost of debt, T: Tax rate. 
 
I should point out that this formula is not required for a small, privately held 8-year-old’s lemonade stand. Instead, it’s safe to say we can use the interest rate on the debt (there is no equity) as the cost of capital. So, let’s say the WACC of Sally’s lemonade stand is 10% (the rate charged by the Bank of Dad). 
 
If we look at Sally’s return on invested capital of 8.37% in 2022 versus the WACC of 10%, we can estimate that the future returns of the stand are muted as they exist today. Over the long term, we can’t say we’d be excited about investing in Sally’s lemonade stand!
 
Why Return on Invested Capital Matters
 
I’ve written many times that a company that achieves high returns on invested capital over a decade or two is of immediate interest to Nintai Investments. A company that can achieve such results along with a significantly lower weighted average cost of capital is of even greater interest. So, why is that? A company that achieves higher ROIC than WACC over the long term is far more likely to generate greater returns than a company that does not. This is for several reasons. First, the company likely has a wide and deep competitive moat. Second, the company consistently finds opportunities to allocate capital that generates outstanding returns on that capital. Third, management has shown a propensity to focus on lines of business, business operations, and business strategies that generate exceptional returns over the long term. All three of these suggest an investment opportunity that an investor could hold for a decade or two, allowing management and the business to outperform the general markets. Let’s break down each of these three reasons in more detail. 
 
High ROIC Suggests a Deep Moat
As with nearly anything in life, success breeds imitators and competitors. If there is one salient fact in a capitalistic system, something that makes money will always find someone who wants to copy that success. A company that generates high returns on invested capital demonstrates the ability to hold such competition at bay. The longer it can do this, the greater the return to its shareholders. At Nintai, we look for companies with at least a decade of high ROIC and the ability to continue generating such returns for at least a few decades. This can be achieved in many ways – patents protecting intellectual property, difficulty in replacement, or pricing advantages. The list goes on. 
However it is achieved, investors must deeply understand the investment’s ecosystem, including industry trends, competition, technology development, customer demands, etc. 
 
High ROIC Suggests Profitable Investment Opportunities
To generate a high return on its capital, a company doesn’t need to have just a profitable business model. To maintain high ROIC, the company must have opportunities to invest its capital in perpetuating equally high returns. This type of “virtuous cycle” signifies a business operating an outstanding model and one that provides an excellent future of profitable growth. The ability to avoid value-destroying acquisitions, paying considerable fees to investment bankers, and the agony of integrating new businesses greatly reduce risks for any management team and its shareholders. At Nintai, we love companies that can quietly grow their business by seeding growth with free cash flow. It's even better when that capital can provide outstanding returns on that capital. Such investments rarely come along, but when they are found, we will wait a decade, if necessary, to purchase them at the right price.     
 
High ROIC Suggests an Outstanding Management Team
Anyone who has run a business with a shrewd set of investors will know that the most important thing an executive can do (besides being ethical and honest) is to be a wise steward of the company’s capital. Part of that is focusing on generating high returns on invested capital. The ability to achieve high returns on invested capital over the long term (here we mean a decade or longer) helps identify a management team that understands their business model, the, their markets and competition, and critical drivers of their business operations. Finding individuals who can achieve this isn't easy. At Nintai, we look to partner with such management and, as we say all too often, allow them to do the heavy lifting. 
 
Conclusions
 
I became a senior executive when my partners and I created our first business in 1996. New to the business world, I must confess, I knew nearly nothing about running a business or my fiduciary responsibilities to our shareholders. Fortunately, we had an outstanding Board of veteran business executives who patiently guided us through starting up, growing, and eventually selling our company. In my first meeting with our Board chairman, he told me the most important thing I would ever do would be to allocate capital. His lessons about business decisions, key measures, and outcomes of capital allocation made me a far better business owner and, eventually, an asset manager. When investigating a potential investment, always look for managers who understand that capital allocation will be the hardest (and most vital) aspect of their role as CEO. Companies led by individuals with this skill will significantly increase your chances of outperforming the broader markets.
 
We hope everyone is having a wonderful holiday season and look forward to your thoughts and comments.
 
DISCLOSURES: None

To Our Investment Partners:
 
Portfolio holding Abiomed (ABMD) announced it agreed to be acquired by Johnson & Johnson (JNJ) for an upfront payment of $380 per share, up 48% from yesterday’s close of $252 per share. Per the terms, Abiomed shareholders will initially receive $380.00 per share in cash, in addition to one non-tradeable contingent value right (CVR), under which they can receive up to $35.00 per share in cash if certain milestones are reached.
 
Abiomed was always one of our smaller holdings simply because we could not acquire shares at a reasonable discount to our estimated intrinsic value. While kicking myself for not investing more capital when we had the chance, that’s the downside of having an insistence on a margin of safety. This is one of those cases (like previous portfolio acquisitions) where we are happy to see others appreciate our investment thesis but also sad to see an outstanding company leave the portfolio. This deprives us of watching the magic of compounding over the next decade or two. That said, in this case, we will (happily) take our profits and move on to new investment pastures.  
 
Abiomed is the fourth company in the Nintai Portfolios to be acquired, with the previous being Solarwinds, ARM Holdings, and Linear Technologies. 
 
Please let me know if you have any questions or comments. My best wishes.
 
Tom

“The underlying principles of sound investment should not alter from decade to decade, but the application of these principles must be adapted to significant changes in the financial mechanisms and climate.”
                                                                    -     Benjamin Graham 

“There are two ways to find and keeping your edge in investing. The first is locating and assimilating the best data available and then making the most intelligent decisions about individual companies and how successful they might be. This is damn hard. The second is having an emotional edge over the markets. This means keeping your head on your shoulders during bull and bear markets. This is even harder.”
                                                                   -      Austen Wheeler 

Gaining in Edge in Investing
 
It is inevitable that during bear markets and periods of underperformance – both of which we face today at Nintai – value investors question whether they still have the edge over the more general markets. At times like this, we try to remain focused like Lou Loomis (played by Bill Murray’s brother, Brian Doyle-Murray) at the end of Caddyshack, waiting for the ball to fall into the cup. While the sturm and drang of the bear market roar around us, we are trying to remain focused on what gives us the edge (over the long term) against the broader markets. 
 
We agree with the quote above that we have three possible edges when competing in the investing world. First, we choose to be value investors over any other strategy. At Nintai, we believe this is our fundamental edge. Before I get into the second and third edges, I’d like to briefly describe what I mean by value investing and how Nintai thinks about it as an investment house. 
 
Value Investing as an Edge
 
I break the definition of value investing into three schools of thought. The first one is very traditional, sticking to some of the earliest writings of Benjamin Graham. This tends to focus on such strategies as investing in “net-nets,” companies where the share price is less than its net current assets. This method takes cash and cash equivalents at 100% of value and discounts other assets (such as inventory or receivables) to perceived value at the point of liquidation. The “net-net” calculation is achieved by deducting total liabilities from the (adjusted) current assets. These types of investments were easier to find during the 1930s Depression-era stock markets but can still be found today on such sites as Gurufocus.com. The second school of thought focuses on the capitation of specific valuation metrics. Examples include not paying more than twelve times earnings or two times book value. While considered less restrictive than the “net-net” school, this form of investing has gotten harder as the economy has moved from capital-intensive to asset-light business models. This has driven valuation metrics higher and forced this investment strategy to focus less on technology or healthcare toward industries such as manufacturing or energy.  Unfortunately, investors with such focus have missed opportunities over the past few decades in some of the highest market gainers. The last school is value investors who have acknowledged many changes in the economy and markets but remain focused on purchasing companies at a substantial discount to their estimated intrinsic value. These investors (and we count Nintai Investments in this class) have seen the acceptable range of valuation metrics expand with time. Still, they believe it must reflect evolving business models and economic changes. 
 
The edge gained by value investing is quite simple. Determining a company's intrinsic value gives us a rough (I stress roughly!) estimate of how much we should pay to buy a piece of that business. By incorporating a margin of error into our purchase price, a portfolio of quality companies, purchased at a discount to their intrinsic value, can outperform the general markets in the long term. 

Information and behaviors are the second and third ways to gain an edge. I intend to briefly discuss the information edge in this article and follow up with potential behavioral advantages in my next article. 
 
Using Information as an Edge
 
An informational edge can be obtained in several ways. The first, and one with clear legal consequences, is achieved through non-public proprietary means. Until the SEC promulgated Rule FD (Fair Disclosure) in August 2000, many investors could obtain an information edge by receiving information that might not be available to other investors. Combined with illegal insider trading, this type of information edge was powerful and seriously skewed returns. Not surprisingly, there have been some well-known hedge fund managers whose returns had a mysterious reversion to the mean after Regulation FD went into effect.    
 
Having said that (and that certainly is not an investment recommendation!), there are still ways to achieve an information edge on individual companies or specific industries. These include deep industry expertise, sources of scuttlebutt, and paid third-party research. All three of these require a lot of work or money to achieve (and equally important, maintain). 
 
Industry Expertise: At Nintai, before opening Nintai Investments, our staff were healthcare consultants for over twenty years, working with industry c-suite and Boards on strategy, financial models, and corporate operations. Our staff developed a deep knowledge of industry trends, systems players, and technologies during that time. This expertise allows Nintai to understand better what potential investment opportunities exist in the marketplace. For instance. Our investment in Veeva (VEEV) was predicated on understanding the depth of the company’s reach within the biopharma industry, including sales, promotion, research & development, and document management. Understanding the company's role in such vital issues as integrating DDMAC reporting requirements, FDA privacy regulations, and cross-functional content management allowed us to understand the business case and valuation assumptions better. Does that guarantee a better-than-average investment return? Not necessarily, but we think it gives Nintai a slight advantage in valuing the investment. 
 
Scuttlebutt[1]: Phil Fisher believed that industry scuttlebutt was a vital tool in value investing. He wrote:
 
“The business grapevine is a remarkable thing. It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a representative cross-section of the opinions of those who in one way or another are concerned with any particular company.”
 
The challenge in utilizing scuttlebutt is that it must be accurate and it must be timely. (It goes without saying that it must also be non-proprietary in the sense of SEC regulatory requirements). It’s incredible how much scuttlebutt can be acquired simply by keeping your eyes and ears open and your mouth shut. Within Biopharma, for example, the website CafePharma has a host of information openly discussed by industry workers and researchers. Here you might find that a vital new product is receiving horrendous reviews from high-prescribing physicians. Conversely, you might read that a key management figure is rumored to leave the company for its chief competitor soon. Knowing where this information can be found while staying clear of Regulation FD issues can give an investor a leg up on critical information about a potential investment.   
 
 Third-Party Research/Thought Leaders: Many organizations or individuals that know a great deal about industries or companies either sell their product (third-party research parties) or post their research/thoughts/comments on blogs free of charge or websites behind paywalls. A tremendous amount of information can be obtained free of charge. For instance, within the Biopharma space, Derek Lowe’s blog “In The Pipeline” is a first-class discussion of research and development within the Biopharma industry, including information on specific drug classes, FDA filings, and new drug launches. Derek writes with remarkable clarity and from an inside-baseball view, being a drug researcher. 
 
Keeping up to date on all three informational edges can be a full-time job. At Nintai, we spend roughly 30-35 hours weekly on the three. We generally talk to 8-10 thought leaders, read approximately 10-12 scuttlebutt/thought leader blogs and websites, and thumb through 5-10 research reports each week. 
 
Conclusions
 
Succeeding at value investing isn’t easy. If it were, many more people would be doing it. Achieving an edge takes developing and implementing a set process that must be followed day after day, month after month, and year after year. You don’t have to be a rocket scientist or have a genius-level IQ to achieve success. In this article, I’ve discussed how information can be gathered and used to get a leg up on other investors. Finding the best sources, testing the facts of those sources, and understanding why those facts are essential to a potential (or existing) holding can make you a better investor. The challenge is having the discipline to achieve it. In my next article, I will discuss how gaining an informational edge can be easier in some ways that acquiring a behavioral edge. Getting our minds to work in a manner to be a better investors can sometimes mean fighting against tens of thousands of years of neurological evolution. 
 
As always, I look forward to your thoughts and comments.
 
DISCLOSURE: As of publication, Nintai Investments LLC and Mr. Macpherson’s personal investment portfolio holds Veeva in their respective portfolio.


[1] The butt was a keg used to serve liquid to sailors in the 18 and 19th century Royal Navy. A scuttle was a hole in the butt to draw out the water. The term scuttlebutt came about as a description of the place where sailors would inevitably exchange news or rumors.   

“We run fastest and farthest when we run from ourselves.”
                                                                                                      -     Eric Hoffer 

“We do not free ourselves from something by avoiding it, but only by living through it.”
         
                                                                                                      -    Cesare Pavese 

“When you’re afraid, you run. When you are afraid of a bear market, you run by selling. But much like with a bear, running rarely saves you. You have to stand fast, take the measure of your decisions, and decide to buy, sell, or hold. A good investor gets excited in bear markets, not fearful.”
 
                                                                                                      -      Thomas Gates 

2022 hasn’t been easy on investors. Through September 27th, the S&P 500 has lost 23.1%. Over the past thirty days, the index has lost 8.5% alone. There hasn’t been any place to hide. Domestic stocks, bonds, international stocks, you name it. All there is to see is an ocean of red. In a recent interview, I was asked what I thought was an astute question. The interviewer asked me, “what do you think is the most important thing as an investor in a bear market?” She also asked, “what do you think is not important in a bear market?”  I thought I’d take the time to briefly sketch out an answer to those questions. 
 
I frequently quote Shelby Davis: "You make most of your money in a bear market; you just don't realize it at the time.” We sure hope that’s true since we technically tipped into a bear market this week. We agree completely with Mr. Davis. It is nearly impossible to beat the markets without one of three things: buying low and selling high, buying high and having the stock go much higher, and/or reducing costs to a minimum. A combination of the first and last are the attributes of many great value investors. To achieve the first - buying low and selling high - bear markets are a great place to start. So, let’s begin there ourselves.  
 
Important Things for a Bear Market
 
When bear markets settle in, the fear of losses can shake up the best of us. Many individuals sometimes find themselves frozen and unable to make any decision. Others sell quickly, regardless of any well-thought-out investment process or valuations. The great investors I’ve known have a few immediate reactions, which are very different from most. First, they aren’t scared by bear markets but rather excited by them. They see a marketplace filled with bargains as far as the eye can see (remember: buy low and sell high!). Second, along with this excitement comes a certain Zen-based calm where they can apply their investment process and utilize data to make decisions, not their emotions. Last, they tend to shut down any media that might be available – no CNBC, no Bloomberg, no Jim Cramer. They might not watch a lot to begin with, but now they watch none. They focus their attention on what can help them - data such as annual reports, financials, market research, etc.
 
I think this is 90% of the battle in making money in bear markets, but not all of it. The factors I discuss next are just as important for investors in any market. But during a bear market, they play an outsized role in reducing risk and creating long-term value for shareholders. If an investor can get their emotions in check and then keep an eye on the following few things I discuss, I think they have a better shot than most at making a bear market work for them. 
 
“Must-Have” rather than “Like-to-Have.”
 
It’s incredible how quickly a company can ascertain the strength of its customer needs for its product/services during a bear market. Nothing shows the depth of a portfolio holding’s moat depth than when faced with the sudden loss of easy money. Anybody who has run a business can tell you how quickly buying decisions can change when the markets and the economy head south. When this happens, you want a portfolio company deeply embedded in its customers' strategy and operations. Many of Nintai’s portfolio holdings have mission-critical products and services for their clients, ranging from Manhattan Associates (MANH) supply chain solutions to iRadimed’s (IRMD) MRI-compliant IV pumps. 
 
Deep Financial Strength
 
While this is always a requirement for any holding Nintai Investment portfolios, it’s essential in bear markets. Frequently, economic disruption is part of bear markets, including such things as recessions and disruption of the credit markets. Because of this, it is critical that a portfolio holding has both the strength on its balance sheet (no debt, significant cash) and cash flow statement (high free cash flow margins) to survive any downturn. You never notice the lack of cash until you don’t have it, which usually comes at the worst time. Thirteen of twenty stocks in the Nintai Investments portfolios have no short or long-term debt, and nineteen of twenty have free cash flow margins greater than 25%. Examples include Gentex (GNTX) and Abiomed (ABMD).
 
High Return on Capital
 
An investor should keep an eye on - whether the stock markets are in a bull or bear market –that their portfolio company generates a high return on invested capital. Much like the investor who has dry powder in a bear market, companies can accelerate their value generation when the markets are at their lowest ebb if they wisely put capital to work. That means finding acquisitions at dirt cheap prices or simply buying back its stock when shares are trading at a significant discount to their intrinsic value. Great companies can set themselves up for long-term success by judicious use of capital allocation in bear markets.  The average return on invested capital in the Nintai Investments portfolios is 41%, significantly greater than the S&P 500’s 10.2%.  Examples include Expeditors International (EXPD) and SEI Investments (SEIC)
 
Things to Not Worry About
 
As important as keeping your eyes on the things that matter, it is equally important to ignore things that cause your mind to get muddled in its thinking. This can be difficult. During bear markets, all kinds of things can rush through your head, with the flight or fight response being the most powerful. It’s easy to grasp any tidbit of news or advice as something that might stop the pain. Here are a few things that can quickly lead you astray from your investment process. 
 
Market Predictions
 
There is no end to the predictions you can hear about the markets, whether in a bull or bear. What’s most challenging with these predictions in a bear market is that your mind is most susceptible to accepting some terrible advice. Statements like “in the past 60 years, during the autumn period, when there is a shortage of energy products, combined with predictions for a strong Christmas season and warmer weather, 75% of the time, markets have gone up from here” sound like they are well reasoned, but meaningless to any value investor. Sometimes market predictions are simpler like “the market has nowhere to go but up from here.” Actually, the market has two places it can go – higher or lower - so that one isn’t even close to being true. In a bear market, turn off the media, but down the iPad, and focus on things you can control. Trust me. Wall Street market predictions aren’t one of them. 
 
Timing the Market Bottom
 
This one is the kissing cousin of “Market Predictions.” If I had a nickel for every person who has told me they invested in a particular stock right at the bottom of the market, I’d have……. lots of nickels. In the hundreds of years of the United States markets, the reality is nobody has been successful at making a career of timing the markets[1]. The last thing an investor should worry about is correctly calling the exact time and place of the low. As the saying goes, it is better to be approximately correct than precisely wrong. Investors can always dollar-cost-average further down and make slightly less on their investment. 
 
Finding New Opportunities
 
This might sound counterintuitive, but if the companies you own in your portfolio had the suitable characteristics to purchase and that remains the same even in the bear market, an investor should look to load up on additional shares. Though it may seem exciting to find fifty other companies that look like potential investments, the place to start is the companies you already own. If you liked them at bull market prices, you should love them at bear market prices. A caveat: sometimes we get things wrong when building an investment case and a company we have chosen sees its business case deteriorate in a bear market. In these cases, an investor would be wise to dump that holding and perhaps look for something new. But, in general, look to add to existing positions before casting about for new opportunities. 
 
Conclusions
 
In any bear market, there are two things an investor must focus on to be successful. The first is getting their emotions under control. If that can be achieved, it can drastically reduce the unforced errors that happen so frequently during a bear market. The second is to focus on the things that matter (and what you can control) and ignore the things that don’t matter. It helps to have an investment process in place before the bear market sets in so that you help data and process drive your decision-making process. A successful investor is usually pretty good at shutting out the stuff that doesn’t matter – the talking (or screaming in some cases) heads, the market experts with a 22% accuracy rate, or sometimes simply the noise that goes along with fear on Wall Street. While we're not perfect here at Nintai, we think bear markets are a good opportunity to reevaluate our investment cases, dollar-cost-average on existing positions with compelling discounts to intrinsic value, and if there are no current opportunities, look for new investment opportunities outside the portfolio. We wish you luck as we enter this new investment phase. 
 
I look forward to your thoughts and comments. 
 
DISCLOSURES: Nintai currently owns shares of Manhattan Associates (MANH), iRadimed (IRMD), Gentex (GNTX), Abiomed (ABMD), Expeditors International (EXPD), and SEI Investments (SEIC) in client portfolios, the Nintai Investments corporate portfolio, as well as my personal and family portfolios.  

[1] The one exception I am aware of is the infamous “Haynes Bottom,” when Mark Haynes, the former host of CNBC’s Squawk Box, called a market low on the exact day (March 9, 2009). You can see it here: (https://www.youtube.com/watch?v=S-81qgyRQzA)  I concede I was a massive fan of Mark.

“Once a thing has been done, even the fool sees it.”
                                                                                        -     Homer                                                       
“The best way for an investor to avoid popular delusions is to focus not on outlook but on value.”

                                                                                        -     John Templeton 

At Nintai Investments, we look for high-quality[1] investments that we can hold for the long term and let value accumulate over time. A key component in maintaining quality in the portfolio is finding companies with excellent management with a long history of outstanding capital allocation. Warren Buffett's famous adage is that he always invests in companies an idiot could run because one day, one will. We agree with this. We also try to avoid such situations before said idiots rise to the top. 
 
But even with the best planning, an investor can occasionally find themselves in a situation where a high-quality company’s management suddenly runs itself (and the company) right off the rails. In most cases, these are utterly unforced errors, with either the Board making a poor decision in hiring managers or senior executives falling prey to empire building and other poor capital allocation decisions. At Nintai Investments, perhaps nothing aggravates us more than when management suddenly alters course with a genuinely bone-headed decision that puts our entire investment thesis and valuation at risk. 
 
Masimo: “A Brilliant Little Cash Machine”
 
In 2021, Nintai Investments initiated a position in Masimo (MASI), a medical device company specializing in measuring blood oxygenation levels. The company sells oximeters (the device the nurse clips on the end of your finger to measure your oxygen saturation rates), along with monitors and other technologies that support these measurement tools. Masimo first came to our attention in early 2010, and we first purchased shares in the former Nintai Partners Charitable Trust in May 2010. 
 
When we issued our initial investment case, we summarized the company in the following manner:
 
“Masimo is a gem of a business. Positioned to take advantage of increasingly personalized healthcare and the move from the fee-for-service model, we see the company growing free cash flow by 12-14% annually over the next decade. The company has a clean balance sheet, high returns on assets, equity, and capital, and no debt. The management team has traditionally focused on organic growth funded by free cash flow.”
 
This is a company we look to hold for decades, if not forever. The company has an extremely deep moat with hundreds of patents protecting its core technology and market acceptance as the clear leader in its field. We greatly admired a management team conservative in its capital allocation seeking small bolt-on acquisitions and a focus on high capital return organic growth. We were pleased to own a company that kept a laser-like focus on its capital returns while dominating its niche market. 
 
Sound United: “A Genius Move or Pure Madness”
 
Our investment thesis in Masimo was dramatically altered when the company announced in February 2022 that they were acquiring Sound United, a leader in consumer audio products. I will briefly go into our thoughts on the acquisition, but the markets were not pleased with the announcement. The stock dropped from $229/share on the day before the announcement to $144/share on the day of the announcement. Our thoughts were much the same. Our initial assessment of the deal centered on several core issues.
 

1. It was tough to see how United Sound would play a role in the future growth of Masimo’s oximetry technology. Sound United states, “(The company) was founded in 2012 with a simple mission - to bring joy to the world through sound”. How bringing joy through sound was a fit with medical technology seemed quite a stretch. 
2. The company’s deal to buy Sound United for $1.03B means the company had to leverage the balance sheet. At the time of the announcement, the company had about $745M in cash, no debt, and generated roughly $230M in free cash flow. The company utilized approximately $500M of its cash and is expected to finance the remaining $500M with long-term debt. 
3. Sound United’s consumer audio business has nothing like the characteristics of Masimo’s oximetry business. It generates a far lower return on capital, return on assets, and far smaller gross and net margins. We estimate it has no moat. Our business valuation - taking into the SU acquisition and its effect on the company’s financials, margins, return on capital, etc. - has dropped by roughly 25%, reduced from $200/share in January 2022 to $155/share in June 2022. 

 
A Very Poor Explanation 
 
In general, we think management owes its shareholders a clear explanation when a transformative deal is announced. This includes what the acquisition brings to a company’s strategy and operations, how its products and services will add value, the estimated value generation of the deal in both the short- and long-term, and thoroughly explains the impact on the company’s financials. This is why we present each of our investment partners with a detailed investment case and valuation spreadsheet for every new holding that goes into our portfolios. We think Masimo’s management has done a terrible job explaining this deal to their shareholders. As an example, I include part of the latest quarterly earnings call. In it, analysts were eager to understand the Sound United deal better. I’ve included a small segment from the call where Mike Matson from Needham & Company asks Joe Kiani, CEO, about how the company expects Sound United’s and Masimo’s technology to compete with other competitors, in particular, Apple’s “Apple Watch”. 
 
 Mike Matson (Needham & Company)
 
“Yes, thanks for taking my question. I guess where I can start, with the consumer strategy and the smartwatch. Maybe you could talk about what you think it is about your smartwatch either the W1 or this upcoming brand watch, it's really going to kind of help differentiate you in the market versus some of the bigger companies out there like Apple or Samsung.”
 
Joe Kiani (Chief Executive Officer)
 
“Well, during this limited marketed release phase, I'll tell you what our customers are telling us. They have never had a product that allows them to do the things they've been wanting to do. So, for example, the continuous and accurate information on oxygen saturation and pulse rate. It's not been there. And whether it's used for sending patients home from hospitals, patients that are at risk that what that needs to be monitored remotely, or even athletes that use some of that information for better training, and better preparing for competition, they're telling us, it is different. It's unique. And it's compelling. And in addition, we have some unique new parameters that have never been released in a commercial watch before, for both healthcare and consumer wellness, which we're hoping to release with the launch of W1. And then as far as FREEDOM, I want to just tell you the things I said before are no more because of the competitive nature of this business. But we believe we have a compelling design, we believe with the addition of the Android features, and some unique features that, again, have never been made available before. We think we have a great product. So we think we have a product that should command 100% market share, which is what you want to have, what you want, for your team to feel. So the question is, do we have now the right distribution channel and the right salesforce, to hopefully make the most out of it? And time will tell, but we've never been better prepared. And we, I can tell you, the whole united Masimo team is excited. We're all grateful for the efforts that they have put into date. But we're going to have much work ahead of us. And I think it's revitalizing our team.”
 
This interaction gives me little confidence in the future integration of Sound United’s technology or how the acquisition will work with Masimo’s current product lines. I hear a lot of “it’s unique” and “it’s compelling,” but absolutely no clarity on why consumer audio will play an integral role in the future of oximetry technology. Mr. Kiani’s answer (and others on the call) provides no clear explanation as to how it impacts Masimo’s long-term strategy, how it will add to the company’s intrinsic value, nor was there any explanation of the impact on the company’s financials. 
 
Where Do We Go From Here?
 
Management has outlined a path forward in which United Sound’s audio technology is integrated into Masimo’s consumer home-based products, such as their new watch and monitors. In addition, the company expects to utilize Sound United’s extensive retail direct-to-consumer sales and distribution channel. Masimo’s senior executives insist the future of personalized medicine (in their oximeter market) will be an integration of more traditional consumer-based electronics (such as Sound United’s audio products) integrated into traditionally hospital-based healthcare technology (such as Masimo’s oximeter monitors). Will this come true? It’s far too early to tell, but the company has done a pretty poor job laying out that future and its associated strategy to investors.   
 
Masimo has a long history of improving its core oximetry technology and product lines. It has been extremely conservative with its balance sheet and produced excellent returns on capital. Over the past twenty years, management has earned my respect as savvy business leaders capable of outstanding capital allocation and a strong understanding of their core markets. Because of that, we will continue to hold our shares in our portfolios. That said, our confidence in Joe Kiani and his team has been shaken, and the leeway we give Masimo has certainly lessened. 
 
Disclosure: I own Masimo in both Nintai Investment’s client portfolios as well as my own personal portfolio. 


[1] I’ve often discussed how Nintai’s investment criteria limit us to roughly 150 -175 companies in the US and European markets. Many companies trading in the public markets don’t have the financial strength to meet our investment needs. It is rare to find a company with no debt, high returns on equity/capital, high free cash flow margins, a competitive moat, and trade at a reasonable discount to our estimated intrinsic value. These are the objective standards needed to meet our watch list requirements. 
 

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

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

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

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

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

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

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

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

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

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

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

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

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

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