I recently got done writing a multi-part series on how value investors got the credit crisis and Great Recession of 2008 - 2010 so wrong. A weakness many investors and financial writers have is the inability to find in themselves the same faults they find in others. There’s the old adage that history doesn’t exactly repeat itself, but it often rhymes. This past year, I made a mistake that - while not an exact repeat of the errors made by value investors in the Great Recession - certainly rhymed. In this mistake, I made a considerable error in mixing up my thinking about company growth and company valuation.
 
Growth and Value: The Foundation of Fuzzy Thinking
 
One of the things that Warren Buffett has spoken about many times is the fact that making the distinction between growth and value can lead to fuzzy thinking. Buffett frequently makes the point that all value investing is about growth investing. In his 1992 Berkshire Hathaway Annual Report, he wrote:
 
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
 
He further elaborated his thinking in his 2000 Annual Report writing:
 
“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation, except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component - usually a plus, sometimes a minus - in the value equation.”
 
I bring up the distinction between growth and value because I made a fundamental mistake recently in my calculation of the value of Veeva (VEEV) - which led me to sell the stock from client portfolios. My error – which I will discuss in much greater detail below - was thinking that growth in the stock price was rising (and would continue to rise) at a faster rate than my estimated intrinsic value ever could. That is to say Veeva’s valuation would never keep up with its growth.
 
A Little Background
 
Veeva Systems was a group of individuals who worked with Salesforce (CRM), a customer relationship management (CRM) software provider. This group believed their expertise in the pharmaceutical market could lead to high growth and significant market share. The company was a success from the beginning. Since 2011, Veeva grew revenue per share from $0.25/share to $5.52/share in 2019. The past 5 year annual growth rates for revenue, earnings per share, and free cash flow have been 16.6%, 55.7%, and 40.2% respectively. The company averaged return on capital in the low 80% range and grew free cash flow margins from roughly 15% in 2011 to nearly 42% by 2019. The company has never carried any short or long-term debt and increased cash/marketable securities on the balance sheet from $17M in 2012 to $1.43B in 2019.
 
Veeva also happened to be in a market vertical where Nintai Partners had deep experience. Most of Veeva’s clients were Nintai’s consulting clients and their work in informatics coincided with Nintai’s core competency. We deeply respected Veeva’s management, their product and services, and their market strategy. In essence, Nintai Partner’s legacy knowledge allowed the new Nintai Investments LLC to be comfortable partnering with an outstanding company and management team all in a growing market.
 
The Decision (or How We Blew It) 
 
Nintai Investments LLC had owned Veeva since opening its doors (it had been a holding in the Nintai Charitable Trust since 2005). We originally purchased the stock in February 2018. In May 2019 - after a blow out quarterly earnings announcement - we sent out the following to our investment partners.
 
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To Our Investment Partners:
 
Yesterday, Veeva (VEEV) announced Q1 earnings. They were superb. The stock is trading up 14% today. Q1 revenue grew 25% year over year to $245 million, while normalized EPS grew 52% year over year to $0.50. Subscription revenue increased 27% year over year, while services revenue increased 18%. Deferred revenue increased 26%. Operating margins increased from 32% to 38% compared to last year. Bookings and service revenue look outstanding. Guidance for the remainder of 2019 was ahead of our expectations. We expect to increase our estimated fair value by roughly 8% bringing it to around $100/share. 
 
The position has returned 168% since our initial purchase in February 2018. The stock currently trades at roughly a 54% premium to our estimated intrinsic value. At that level we frequently sell out of the entire position. However, because of the uncertain potential of adjacent market opportunities (the company announced deals in chemicals and consumer goods recently), we only sold 40% of our existing position and will retain a position in the company.  
 
Please feel free to email or call with any questions. My best wishes. 
 
Tom
 
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So far our investment partners had nothing to complain about. We had a holding with outstanding returns though now trading at a significant premium to our estimated intrinsic value. Here was the rub however. Conservative value investment theory would have us sell the position at such a premium. No matter how successful we felt the company could be, we felt we couldn’t be guilty of recency bias or hold on to the stock simply because of how well it had performed in the past. Be ruled by the head and not by the heart.
 
With 20/20 hindsight our mistake was startlingly obvious. In our “head-not-heart” mind set, we simply couldn’t believe a review (no matter how deep) in our valuation process would increase the valuation greater than the increase in the price. So - utilizing our supremely confident “we-must-be-supremely-heartless-and-coldly-rational” attitude, we sold out the entire position by end of July 2019. We congratulated ourselves on locking in a 168% return for our investment partners and began looking at new opportunities in which to allocate this capital.     
 
What Happened Next
 
After selling the stock and placing it on the watch list, Veeva came up for review relatively quickly. At Nintai, this annual process is quite extensive with a top to bottom breakdown of our investment case. Everything that can be used to better understand the competitive advantage and market moat is broken down with in-depth research. We look at product pipeline to sales force effectiveness, market satisfaction and adoption rates, customer reviews and purchasing budgets, regulatory filings and approval calendars. We also break down the company financials trying to get a deep understanding of the components that make up cash flows, income statement, and balance sheet. Particular focus is spent on capital allocation and free cash flow generation.
 
Without going into all the details, by the end of our review it became very clear we needed to seriously adjust our valuation upwards. In fact, the increase was so large we sent out a new update (barely two weeks after sending out why we felt compelled to sell the position).
 
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We spent this past Monday and Tuesday speaking with Veeva management, their largest customers, industry thought leaders, and regulatory officials. This completed our nearly two week review of the business, including our annual deep dive on competition, market growth, etc. After reviewing our findings it became clear that we had seriously undervalued the company.  Our revised valuation went from roughly $110/share to nearly $182/share. We have to say that this is the largest adjustment in intrinsic value we’ve ever made. Since July 15th Veeva’s stock price has dropped from $175 to today’s (September 13 2019) price of $139. This represents a 21% drop. At this price the stock trades at a 23% discount to our estimated intrinsic value. 
 
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John Maynard Keynes famously never-said[1], “When the facts change, I change my mind. What do you do, sir?”. It’s pretty wise advice no matter who you attribute it to. With as straight a face as we could muster, Nintai announced we were reversing course and adding Veeva back into the portfolio. It certainly wasn’t a banner day at Nintai world headquarters, but at least the facts backed us up……again.
 
What Can Be Learned
 
I could probably write a book just on the errors from the “Veeva Adventure” (as we refer to it now). That will have to wait for another day. For now, let me summarize the findings that are most applicable to every day investing theory and practices.
 
Don’t Ever ASSuME (You Know How the Rest of That Goes)
In my value investment trained mind, I had made the distinction that Warren Buffett had clearly warned led to fuzzy thinking. It is possible to have a value investment that has two seemingly contradictory attributes - high growth in revenues and free cash and trade at a significant discount to intrinsic value. The value investing world will not end when the two reside next to each other. It’s a lesson I seemingly need to (re)learn every couple of years.
 
Don’t Get Over Confident
When you start to think you know enough about the company or its markets without looking at new data, then you’ve got a real problem. Market dynamics can change by the day, so an investor should always base decisions on the latest well-researched statistics. The fact that I could be off by such an extent on Veeva’s valuation was an example of clear arrogance. Just because I knew a lot about the company’s past didn’t mean I was a greater predictor of its future.
 
If You Base Your Decisions on Facts, Then Be Damn Sure About Your Facts
One of the reasons why I always write an investment case for a potential investment, then turn around and write an anti-investment case, is to make sure I’ve seen both sides of the arguments and the facts support one more than the other. This means I have to know my facts cold. This also means I need to check and double check my facts. Not only was I guilty of intellectual arrogance when it came to Veeva, sadly I was guilty of intellectual indolence as well.
 
Conclusions
 
Being able to identify mistakes and finding the cause is really only half the battle. The second part is creating processes to prevent these types of errors from happening again and being able to verbalize what happened to individuals outside the decision process. This might include your investment partners, your Board of Directors, and you, the reader. I keep a running list of errors I’ve made in my investment process since 2004. That list includes 77 specific errors. Each one is identified, discussed, and then a solution is listed next to it. I’m glad to say I’ve only repeated a total of 6 errors or roughly 8% of the total list. Unfortunately, the underlying cause of the Veeva case is a repeat offender. In my next article I thought I’d discuss other cases similar to this, what solutions I’ve employed, and why I think they have failed.
 
Until then, I look forward to your thoughts and comments.
 
Disclosure: Portfolios that I personally manage own Veeva.     
     


[1] The quote has been attributed to Keynes for decades. Unfortunately - as Jason Zweig points out in a WSJ article - there is no direct evidence Keynes said ANYTHING like it. Keynes’ biographer, Lord Robert Skidelsky, believe the quote (along with the other gem “the market can remain irrational longer than you can remain solvent”) was “most likely apocryphal”.
 

 
In Part 2 on my series about value investing during the 2007 – 2009 Credit Crisis and market crash, I discussed some of the macro-issues that created an environment foreign to almost any value investor since the Great Depression of the late 1920’s and 1930s. Some of topics I covered were major trends leading up to the 2007 – 2009 Great Recession, how assets and liabilities were poorly structured nor aligned to reduce risk, and how innovation continues to put enormous strain on our major companies’ balance sheets and the greater economy.
 
In Part 3 of this series, I wanted to use a specific case (Washington Mutual, which was one of the country’s largest savings and loans institutions) to demonstrate the interconnected nature of compounding risk building up to the market crash in 2008. I will point out that many value investors approached this like any other fundamental market crisis - when in fact - what we faced was a fundamental financial structural crisis. This was not a misallocation of capital caused by market hysteria such as the 18th century South Seas venture or the 1990’s technology bubble. Rather, this was a crisis in scope and scale that we hadn’t seen since the Great Depression and would require an equally innovative and fast-acting group of leaders to prevent a far greater calamity than we actually saw in the darkest of days in 2007 - 2008. The Great Recession was caused by a fundamental failure in our financial model - where risk was seemingly whisked away by the wand of loose regulations and even looser credit rating agencies morals. It was compounded by building a system where bets on this risk were leveraged to the extent that no private company could afford to pay them off. It was - in fact - only sovereign governments that had the strength to step in and avoid a complete collapse of the world’s financial markets.            
 
As I’ve stated previously, I want to make clear this series of articles isn’t making a judgment about any particular value investor or value-based investment company. Most of those mentioned were doing the best they could in an almost surreal business environment. They were seeing behavior by shareholders, management and regulators that was completely foreign to their experience and fundamental values. Some were attempting to make sense of balance sheets that seemingly had a new land mine explode on a daily basis. Others were dealing with a system – in this case the debt and credit markets - based on unwitting (and sometimes quite witting!) fraud. A system that was supposedly based on hundreds of billions of dollars in rock-solid real estate debt that was in reality based on fool’s gold.
 
A Small Thermonuclear Financial Device: Washington Mutual
 
If one were to roll back the calendar and pick a date and a company that symbolized the strength – and ultimately the tragic weakness – of these markets, it would be year-end 2007 and the company would be Washington Mutual. Washington Mutual was considered one of the best run and most conservative savings and loan bank in the United States. By the end of 2007, WaMu had more than 43,000 employees, 2,200 branch offices in 15 states, and $188.3 billion in deposits. Its biggest customers were individuals and small businesses. On the cover of its 2007 annual report, management wrote,
 
“What does the future hold for our company? This report is dedicated to providing perspective on the past year and sharing our confidence in WaMu’s long-term future”.
 
It went on to describe that roughly 60 percent of its business came from retail banking and 20 percent came from credit cards. They then noted that only 14 percent of its business came from home loans. What they didn’t say - and simply couldn’t understand  - was that this seemingly insignificant 14% of their business was enough to destroy the bank and send it into bankruptcy. By the end of 2008, WaMu had become the largest failed bank in U.S. history. Washington Mutual was the largest canary in a very large coal mine.
 
The reasons for Wamu’s failure are far beyond my ability to fully discuss in 3 pages, but I will quickly sketch the issues and then discuss why traditional value investors had no investment “antibodies” to identify the disease and avoid its infection of their business.
 
WaMu’s home loan business was part of a greater web of leveraged debt and debt products that overwhelmed the credit markets. While only 14% of their business, WaMu made great profits by writing mortgages (many times writing mortgages that far exceeded the equity in the house) and then selling these into the secondary mortgage markets and removing them off their balance sheet. This model worked great based on two fundamental market conditions. First, home prices would continue to rise thereby creating steady demand for new mortgages as well as assure loans would not fall into “non-performing” or default status.
 
Second, the secondary mortgage market – made up of Fannie Mae, Freddie Mac, and other private companies – would continue to purchase these loans that originated at WaMu but were bundled up and sold in the secondary market as mortgage backed securities. As long as these two market conditions continued, then the Board was correct in looking forward to a bright future.   
 
Unfortunately, a series of events (which I will label 1A, 1B, etc.) took that 14% of the business and turned it into a small thermonuclear financial device. As these events unfolded, it became increasingly clear that most of them were interconnected in such a way that – like a ball of twine – it had to all be unwound at once – or not unwound at all. The latter was clearly not an option. That linkage took what seemed to be one small problem (“It’s only 14% of our business. How bad can it be?”) and - in its own Frankenstein moment - created a monster no one really understood until it was too late. 
 
In event 1A, housing prices declined for the first time since the Great Depression. The loans on WaMu’s balance sheet suddenly needed either a cash infusion or had to be sold into the secondary mortgage market - quickly. In event 1B, the mortgage backed securities market collapsed. WaMu could no longer remove the real estate liabilities from its balance sheet. In the fourth quarter of 2007, it wrote down $1.6 billion in defaulted mortgages. Bank regulators forced WaMu to set aside cash to provide for future losses. As a result, the bank reported a $2 billion net loss for the quarter. Its net loss for the year was $67 billion (the bank only made a profit of $3.6B in 2006 profit). In event 1C, Lehman Brothers declared bankruptcy on September 15, 2008. This led (here’s that linkage again) to a massive run on the bank with depositors withdrawing $16.7 billion or 9% of WaMu's total deposits. By then the Federal Deposit Insurance Corporation (FDIC) said the bank had insufficient funds to conduct day-to-day business and began looking for buyers. For a company that had looked towards such a bright future at the end of 2006, it was bankrupt by end of 2008.  
 
Like Sharks and Chum:  The Value Investment Titans
 
As the problems I just outlined began to develop at WaMu, value investors began to see a classic value investment opportunity in the making. Most classic value investors still saw this as a market crisis, not a fundamental financial system crisis. Here was a company that was predominantly based on consumer deposits (traditionally very sticky assets) which were federally insured by the FDIC. It seemed the real estate problem child of the bank could be walled off (“I mean, it’s only 14%. How bad can it be?”) and then - in classic value investment practice - investors could wait out the panic and watch the bank stock price rebound. It was the classic value investment approach creating a handsome profit for those willing to take the risk.  
 
Let’s take a step back from the Washington Mutual case, and look at the broader crisis as it was developing in 2007 – 2008. Many value investors at this point made major bets on a wide range of financial industry players. These included the largest commercial banks, investment banks, insurers, ratings agencies, even the quasi-government agencies of Fannie Mae and Freddie Mac. For most of those investors, the inner doubts of “did I buy too early?” became “should I have bought at all?”. By mid-summer 2008, many value investors were looking at staggering losses - and in many cases  -  permanent capital impairment.

​In an article published on the Motley Fool website on July 24, 2008 entitled “Value Investing Has Failed”, author Richard Gibbons said the following:
 
“One of the biggest losers is Bill Miller, who boasted a 15-year winning streak against the S&P 500. In the year ended June 30, Miller's Legg Mason Value Trust (LMVTX) lost more than 30%. He's not the only one. Over that same time period, Bill Nygren's Oakmark Select Fund (OAKLX) was down 30%, while Marty Whitman's Third Avenue Value Fund (TAVZX) fell behind the market, losing 18.9%. In each of these cases, the causes vary. Miller seems to have been completely oblivious to the possibility of a housing bust. He owned Countrywide Financial, Freddie Mac, Citigroup (C), Pulte Homes (PHM), Centex, and even Bear Stearns. In fact, it's hard finding a stock that got clobbered that Miller didn't own. In contrast, Bill Nygren was mainly hit by Washington Mutual (JPM). Back in 2004 the stock made up 16% of his fund's assets; it's still a top-10 holding. Whitman's returns have been hurt by his investment in Florida real estate company St. Joe (JOE) as well as his bets on financial insurer Ambac.”
 
Amazingly, it never occurred to the writer (and many value investors up until this point), that a common theme ran through all of those stocks Mr. Gibbons was writing about. It’s quite a list. Countrywide, Citigroup, Pulte Homes, St. Joes, Ambac, and yes, our old friend Washington Mutual. With 20/20 hindsight, it’s obvious to see that these companies were all part of that interrelated ball of
twine  - the real estate credit and financing ball - that was at that moment nearly bringing down the entire world financial markets. It’s oddly prescient that Mr. Gibbon’s only take away from the poor returns of these value investment titans was that value investing had failed. His article captured the same tunnel vision he was blaming on his value investment leaders.
 
Some Takeaways
 
As we look back at the Great Recession and the 2007 – 2009 market crash, it’s easy to think that value investing had become outdated and simply didn’t work anymore. But I think that’s similar to looking at advances in automobiles - larger engines, more gadgets, better safety features, and so forth - seeing increasing deaths in younger drivers and saying the brakes no longer work. The actual increase in deaths is a complex problem and some factors - like texting - have nothing to do with cars at all. Value investors got complacent in how they thought about risk. It wasn’t any fundamental flaw in their strategy, it was simply bad execution in the process. Here are some major issues that presented a problem and in some case still need to find a better solution.
 
Recency Bias and Saber Tooth Tigers
Much like the early Cro Magnon that learned over tens of thousands of years that following footsteps in the snow led to dinner, we have become genetically programmed to think that if something worked previously, it should keep working. Unfortunately, many Cro Magnon followed saber tooth tiger tracks and were removed from the gene pool before we could receive some of their powerful (albeit, very short-lived) wisdom. Prior to the 2007 – 2009 market crash, purchasing low price-to-book financial stocks had been a relatively successful strategy. Unfortunately, this approach turned out to have very large teeth and paws when combining high leverage and very poor credit quality.   
 
Complexity Is Here to Stay…But So Is Value Investing
Since the onset of the Great Recession I have often heard that value investing is dead. Granted, the returns of many of the value investor gurus haven’t been all that glittery over the past decade (though not a value investing guru, this writer shares the rather pedestrian record with his far more illustrious compatriots). But I think calling in the physician and “pronouncing” is a little bit premature. I don’t think the core concepts of value investing - whether that be low P/E, low P/B, or DCF intrinsic value - are dated at all. What it needs is an injection of youthful vigor in the way we approach gathering and looking at data of a prospective investment. Many value investors dropped the ball when they approached financial statements with a view from the 1980s. What we see today is financial engineering on a biblical scale - something even Noah would have been proud of in his time. As an example, whether we disagree or not, derivatives and all their associated noxious side effects are here to stay. Whether they crop up as credit default swaps or Bermuda options[1], value investors must understand what impact these type of products will have on their investment holding. Just like the individual who said “who would have thought a housing bust in Albuquerque could bring down Lehman Brothers”, value investors have to see things in a whole different way.
 
It's Always the Future That Catches You
There was a story about a state trooper conference that was taking place and a speaker was discussing the fact that roughly 70% of speeding tickets were given by officers who were ahead of the driver and not behind. From the back of the room someone could be heard saying “it’s always the future that fucks you up”. Please forgive me (and the trooper) the profanity, but that pretty much described what happened to value investors during the 2007 – 2009 crash. Far too many were fighting the last war and using processes that worked in many previous crashes. If you want to be a consistently successful value investor (and not one of the one-hit wonders who gets one call correct and the next 7 incorrect), then you need to be constantly asking “what future event could undo me?” and then follow that question up with “what form of adaptive thinking do I need to see that event?”. There are many bits of wisdom that convey this thinking - Wayne Gretzky’s “skate to where the puck will be, not where it is” or Mark Twain’s[2] “history doesn’t repeat itself but it often rhymes”. The bottom line is that bubbles are almost always caused by two things – rapid and unsustainable inflation in an asset price and interconnectivity of that asset with other unknown players in the economy. Keep your eyes open and constantly improve your thinking and you might have a chance of avoiding a beating like those value investors in the credit crisis. 
 
Conclusions
 
This is without a doubt the longest article – both stand alone and as a series – that I’ve ever written. If you’ve made it though all 3 parts then I hope I’ve successfully conveyed what happened in the 2007 -2009 market crash, why traditional value investors did so poorly, and what we can do to avoid such a situation again. Value investing isn’t easy. It isn’t meant to be. It requires two things that go against our very make up. First, we have to be contrarian and content to swim against the tides. It isn’t easy to zig when everyone else is zagging. Particularly when 70-80% of the time you look like a damn fool as you do it and your investment partners see others making money as they lose their own. This is an emotional challenge. This wasn’t really an issue in the credit crisis. The second is being able to take the same data that everyone else has and coming to very different conclusions. This requires an investor to build models that force them to look at things from multiple angles, pokes holes in their most sacred cows, and leads them to some truly startling conclusions (again: who would have thought a housing crash in Albuquerque could bring down Lehman Brothers? Answer: very few). This is a processing problem. This was the failure in 2007 – 2009. Too many value investors were complacent that if they followed A (contrarian thinking) then B (startling conclusions) would necessarily follow. Our great lesson is that the two things are interdependent in their process but independent in their outcomes. It takes enormous energy and focus to make both of them to work for you.


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[1] These are an actual thing. Unfortunately I can’t make out exactly what they do, which means I’m unlikely to use them in my investment process. If someone can figure out how they work, can explain how they work in three sentences or less, and can have a neutral party of one UN ambassador, a Wharton finance professor, and a Tibetan monk agree it’s a functional description, then I will provide that individual with a case of whatever beer they’d like. And that my readers, is about how derivatives work.  

[2] Although there’s no actual evidence Twain said this.

The past is a foreign country: they do things differently there”
           
                                                                    -        L.P. Hartley, “The Go-Between” 

In Part 2 of “Value Investing in Down Markets” (Part 1 can be found here) I wanted to take the time to better understand the major drivers in why some value investor leaders did so poorly in the 2007 - 2009 market crash. There isn’t any simple answer. It seems to me there was a combination of events  - intellectual complacency, a bias to follow what’s worked before, and some deeply hidden faults in our financial markets. Before going into the process itself (which will be Part 3 of this series), this article will look at a range of topics including the role of the balance sheet in deriving value, the changing make up of assets and liabilities, and issues driving the complexity of what exactly “value” means.
 
As they say, hindsight can be 20/20. The purpose of this piece isn’t to scorn or deride any particular value investor for their performance or strategy. Rather, I wanted to point out that blind spots to traditional value investment methodology ten to twelve years ago are just as prevalent today. As I read report after report and watch interview after interview, my concern is that we are as intellectually unprepared today as we were over a decade ago. If we are to maintain that value investing is the most successful form of long-term investing (indeed what other type of investing is there? Wouldn’t they be speculation?), then we need to perform better than we did in the last crash.   
 
Lessons from the 2007 - 2009 Crash
 
Bull markets generally end when some asset bubble finally pops. This might be the discovery of shockingly unethical banking and market behavior (The 1907 Stock Crash), finding out that tulip bulbs suddenly aren’t all the rage (the Tulip Bulb Bubble of 1637), or realizing that earnings projections of 50% growth for 50 years simple aren’t realistic (1999 - 2000 Technology Bubble). The Great Recession and Market Crash of 2007 - 2009 was no different. In this case a bubble in real estate - fueled by cheap credit, incredibly risky financial products, and failure by nearly every oversight player - caused enormous losses across the board. What made this crash unique and surprised many was that traditional value gurus performed as badly as the general markets. This was a complete reversal of fortune from a group that significantly outperformed as recently as the 2001- 2002 technology market crash.
 
Value investors who performed poorly did so for several reasons. First, some failed to fully understand the risk that lay below the surface of assets in their portfolio holdings’ balance sheets. Over time, it became clear that financial products rated AAA by credit agencies or mortgage backed securities (MBS) were worthless. Second, many value investors stuck with their game plan that had worked over the last 50 years - look for companies with low P/E or P/B and back up the truck. Unfortunately, the basis for “(E)arnings and “(B)ook” value were deeply flawed. As an example, many investors saw financial stocks as remarkably cheap according to traditional valuation methods. As investors piled into financial stocks trading at single digit price-to-earnings ratios and book values at less than 1.0, it made sense to many that prices would rebound after the panic was resolved. Unfortunately these stocks kept dropping in price until - in a process completely foreign to value investors- balance sheet assets were marked down to zero and companies became insolvent. For those holding shares in these firms, they were “merged” away for pennies on the dollar or were forced to accept Federal TARP dollars, cease dividends, and take on the government as their largest shareholder. For those older value investors, the tried-and-true approach to buy on the low side and patiently await a rebound in prices became a nightmare of permanent capital impairment and horrific losses.
 
So what happened? How was it that leaders in the value investment community suffered such extraordinary losses? I would suggest many of the losses were due to two thematic issues and some specific structural changes that took place in the mid-2000s.  These changes – and their associated impact on the financial markets - took many completely at unawares. First, the complexity of the financial markets created new products and services completely new to most investors. Examples of this included strategic shifts (collaterization created by demand for income) supported by new products (such as mortgage backed securities or credit default swaps). Second, the complexity of these products masked an interconnectivity where a seemingly isolated problem could create an enormous financial event. As one talking head asked, how could a housing market crash in Albuquerque bring down Lehman Brothers? Third, there was a broad-based push by both political parties to deregulate whole segments of the markets (such as the repeal of Glass Steagall) lead to a widespread outbreak of poor management oversight and aggressive risk-taking. Finally, there were the issues as old as when the first loans for grain crops were made in Sumeria - greed, outright cheating, and public/private corruption.
 
Here in Part 2,  I thought I’d discuss several areas of interest that - I believe over time - can assist individual investors dramatically reduce their risk in the next down market. I’ve stated before that thinking about how you invest is more important than what you invest in, and this section is a prime example of this. I won’t be giving a list of the latest and sexiest business models or investment ideas. Rather this section will help you think about how a value investor should be thinking about a business – how that business makes money and how that impacts your investment selection. Thinking about a corporate balance sheet and how you can find warning signs about the business can head off horrific losses in the long term. So let’s start there.
 
Troubles on the Balance Sheet
 
As you look back at the seeds of the Great Recession and the market crash of 2007 - 2009, many of the problem began on the corporate balance sheet. It turned out assets weren’t as valuable as we thought, their value was sometimes interlinked with seemingly unrelated products, and the risk associated with some assets was far higher than anybody knew.
 
The first thing to point out (thought it may seem obvious now) is that not all assets (or liabilities) are created equal. Ben Graham intuitively new this when he created different discount rates between cash and a production plant. The most important distinction is between current – or short-term – assets and liabilities versus long-term assets and liabilities. At a strategic level, a significant proportion of impaired capital was caused by two problems between current and long-term assets and liabilities. First, what appeared to be current (or short-term) assets with high liquidity simply were not. Whether it be a mortgage backed security with a AAA rating or some other derivative, the value of the product turned out not to be commensurate with its assigned value. This led to massive markdowns and blew some large holes on corporate balance sheets. Second, many of these assets turned out to be linked with other products which led to rippling detonations across entire markets.
 
In this section I want to address the four major sections of the balance sheet and discuss what investors should be looking for (in terms of safety) and what to avoid (in terms of risk to their investment capital.
 
Current (Short-Term) Assets
At Nintai, current assets play a vital role in ascertaining value and safety. We love cash and marketable securities on the balance sheet. While many investors don’t like to see excessive amounts sitting around, we rarely complain seeing cash making up 30 - 50% of assets as long as management continues to generate returns on capital in excess of 25%. Cash (and marketable securities to an extent) are oxygen in bear markets. Ask someone at the former Bear Stearns (now JPM) or Lehman Brothers how they feel about cash on the balance sheet today and compare that against their comments in 2006. You might be surprised by the difference in opinions.
 
Long-Term Assets
At Nintai, we generally invest in asset-light business models, so we put much less weight on this than other more traditional value investors. From our perspective, we look for management to utilize long-term assets to a.) create wide/deep competitive moats and b.) thereby generate superior returns on capital. One long-term asset that raises alarm bells at Nintai is goodwill. According to Investopedia goodwill is “recorded in a situation in which the purchase price is higher than the sum of the fair value of all identifiable tangible and intangible assets purchased in the acquisition and the liabilities assumed in the process.” In other words the acquirer has overpaid for the acquisition. For example, after Sprint (S) acquired a majority share of Nextel in a $35B stock deal in 2005, it took a $30B write down in 2008. This write down reflects that Sprint paid $35B for $5B in assets. Not what we consider outstanding allocation of capital.  This reduced total assets from $97B in 2006 to $64B in 2007 - a shocking 34% decrease. Return on assets went from 1.3% in 2006 to -36.6% in 2007. Any company carrying a goodwill as a large percent of total assets tells me management aren’t really savvy capital allocators and I likely don’t want them managing my capital.  
 
Current (Short-Term) Liabilities
One of the chief destroyers of investors’ capital during the 2007-2009 crash was the business model based on short-term financing combined with long-term lending. Consider Lehman Brothers. Without getting far too technical, Lehman was using short-term commercial credit paper as a means to fund daily operations. Lehman was dependent on other institutions to roll their debt every week. If that commercial paper couldn’t be rolled, Lehman could run out money real quick. Which it did. Without real solid liquidity (like cash), Lehman found itself at the mercy of the commercial paper market. Take a look at your portfolio holdings. How dependent is each one on short-term financing? If the company has a lot of short-term liabilities, make sure it has a lot of short-term assets.
 
Long-Term Liabilities
Two things are of concern in long-term liabilities. The first is long-term debt. Does the company have the ability to pay this off? I don’t mean by measuring it with some non-sensical formula like EBITDA. Can the company meet it’s debt obligations from operating cash flow? Second, if the company offers a pension, is it fully funded? If not, how much is the shortfall and how does management expect to address it? This can be a ticking time bomb if swept under the rug.   
 
As I mentioned earlier, many traditional value investors saw companies during the 2007 – 2009 crash and thought - from a balance sheet perspective - they looked pretty cheap. Unfortunately, the structure and make-up of assets completely fooled investors into thinking they were purchasing at a discount to fair value. In some cases, they couldn’t have been more wrong (just ask investors in any of the large investment banks of Bear Stearns, Lehman Brothers, or Merrill Lynch).
 
So what are we left with after cleaning up the wreckage of the crash? Do investors still face the same risks as those who saw investment opportunities in late 2007? Has Wall Street changed and mended its ways to prevent such a collapse again? The answer is yes and no. Today we are told that leverage on Wall Street is far down from the 40 - 45:1 ratios we saw in the real estate market heyday. That is certainly helpful. But I would argue there are three areas where risk has not been reduced and investors are still at risk of serious capital losses unless they roll up their sleeves and do a lot more research. In addition, I think there are still too many players who are fighting the last war – using traditional value measures that might miss underlying risk and leave them open to some very ugly returns.  
 
Innovation and the Balance Sheet
 
Innovation is still alive and well on Wall Street. We see it every day. For instance, Societe Generale has rolled out their total return swap product along with UBS’ bespoke trades via swaps, certificates and notes. Both look to take advantage of the last 30 minutes of frantic day trading. This type of innovation (though in this case for institutional investors) continues to be increasingly opaque in nature and incredibly niche-based in its usage. What’s most concerning has been the continuing innovation in products that end up on balance sheets and remain there like landmines waiting for the next market volatility to jostle them and set them off. Three of these are of particular interest to us at Nintai and we keep a close eye on them.
 
Covenant-Lite Loans
I wrote about these in detail in an earlier article (“Fata Morgana and the Illusion of Safety” which can be found here), but to summarize these are loans where companies provide little back-up information and collateral while the loaning entity has little recourse to collecting on defaulted agreements. By the time of crash, nearly 75% of all leveraged loans were covenant-light (cov-lite) loans. This market collapsed to less than 5% in 2009. But like many bad pennies on Wall Street, they seem to make a return as soon as the bright lights are turned down. As I mentioned in my article “Fata Morgana: The Illusion of Safety”, cov-lite loans are equal (percentage wise) to where they were in 2006. Dollar wise they are nearly 25% greater. What impact they will have on valuations isn’t really clear. For those institutions who make the loans, exactly how much strength can you place on getting a return of their capital? If defaults spike and the company has no recourse, will this drive valuations down even further?  
 
Securitization: The Rose Blooms Anew
A huge shock to older value investors was the interconnectivity between debt instruments which were like hidden booby traps that exploded across the financial markets leading to stunning bankruptcies, government takeovers, and Federal Reserve interventions. The seemingly random interactions and resulting shocks to the system led to considerable permanent impairment of investor capital (examples include Washington Mutual, Bear Stearns, Fannie/Freddie Mac, etc. etc. The list is profound in its size and scope).  One would have thought the markets would have learned from the mortgage backed securities (MBS) blow up or the credit default swap (CDS) debacles, but amazingly the asset backed security (ABS – of which MBS is part) market is nearing the three-quarters of the levels of 2007. The question going forward of course will be what asset class is at risk of touching off an entirely new credit crisis. It is unlikely to be a mirror image of the 2007 – 2009 crisis, but certainly will have the ability to create havoc in the general credit/debt markets.
 
Interconnectivity Between Debt and Other Obligations
It’s unclear what the risks are between markets that are increasingly securitized, products that are bundled far more frequently, and the far greater complexity of such products. For instance, a principle protected note is a fixed income security that guarantees a minimum return equal to the investor’s initial investment regardless of how the underlying asset performs. Theoretically, credit quality plays a role in the “guaranteed” minimum return unless the issuer goes bankrupt, because then nothing is guaranteed and you lose your entire investment. Another piece is that the investor must hold the note until maturity, otherwise they are at risk of losing principal. I only bring this up to point out that a principle protected note is far more complex than placing your money in a savings account. All of the dependencies to make the note work - credit quality (subject to change) interest rates (subject to change) length of ownership (subject to change), underlying asset returns (subject to change) - make for high interconnectivity. That then makes projections, returns, security, and risk highly variable and uncertain. Wall Street comes up with new concepts like the principle protected note on a daily basis. Being able to reliably imply fair value to such products is increasingly impossible. A traditional value investor finds themselves increasingly at sea when an investment opportunity might have hundreds of these situations on its balance sheet. 
 
Conclusions
 
During the 2007 - 2009 bear market, many traditional value investors saw opportunities and utilized a traditional approach in calculating value. This approach unfortunately misjudged a multitude of factors that changed the type and risk of assets on corporate balance sheets. Over the course of the bear market, a wide range of companies were forced into bankruptcies, merged away, or received large injections of capital from the Federal Reserve. Investments in many of these companies became permanently impaired as more information came out about the underlying value of the companies. For many older value investors, this period was akin to the great market crash of 1929. Methods which had worked for decades such as looking for companies with low price-to-earnings ratios or seeking out banks with price-to-book ratios of less than 1, proved to be disastrous as the complexity of the problems facing the economy and companies became clear. Not enough has changed to say we are out of the woods. Even today, when an investor looks at the balance sheet of a company today, you might see a financial model that has built in risk capable of all-too easy self-destruction. Especially in financial services sector - but certainly not limited to it - companies operate in an economic environment in a dizzying state of change. Everything from negative interest rates to a Wild West regulatory atmosphere are pushing the limits of traditional accounting and financial models. What caused significant damage to traditional value investors’ returns in the last bear market has the chance to wreak even greater havoc in the next.
 
In Part 3 of this series I will review the steps in value investing where the process went wrong and how to avoid it in the next bear market. Going forward, the challenge for investors will be how to apply our values (such as buying an asset at fifty cents to the dollar) which making sure of the underlying security of the implied value. Looking out at today’s world economies, monetary policies, and financial models, it can be challenging to find quality companies at reasonable prices. Nobody ever said it would be easy, but it certainly is an incredibly interesting time to be a value-based investment manager. 

“The difference between playing the stock market and the horses is that one of the horses must win.”
 
                                                                      -        Joey Adams 
“Not many like being an investor in down markets. Even fewer like it in bear markets. The latter is almost always made up of grinding weeks filled with lower lows, sometimes punctuated by a false rally, then returning to the gut-wrenching agony as markets continue their march downward. Anybody who lives through a bear market finds it hard to forget those memories. Anybody whose survived one – and was caught using leverage – never, ever forgets those memories.”
 
                                                                   -         Sally Hughes 

As an investment manager, my job is to continually weigh risk and uncertainty and develop the best approach to maximizing my investment partner’s returns. That may entail either capturing the most an upside market or minimizing losses in a downside market as best I can. As we approach the end of summer in 2019, we are caught in the midst of a tremendous tug-of-war. On one side we have proponents of an ongoing market expansion. We currently have record low unemployment, slow – with somewhat steady economic growth in the 2 - 3% range, low interest rates, and plentiful capital to fund further expansion in the national economy. On the other side we have a plethora of economists and pundits warning on an impending recession. These individuals cite slowing manufacturing, decreasing transport rates, an inverted yield curve, escalating trade wars, and multiple global economies sliding into their own respective recessions. As an individual investor (or even an institutional one at that!) one can become overwhelmed by the mixed messages presented by the markets. It come sometimes lead to poorly conceived strategies, emotional responses, and negative outcomes. When markets begin to swoon - as they have in Q42018 and later in 2019 - it’s critical to have some core values to guide you in your decision making. These values must be grounded in solid investment theory.
 
Bear Markets are Only Bull Markets Inverted
 
As a value investor, dealing with bear markets usually comes after a period of overvalued bull markets. One should never lose sight of that. Every decision in both rising and declining markets must be based on value. Cleaving away emotional biases, market noise, and an escalating market-based panic/euphoria will be vital to keeping your head and making sound business decisions. After all, investing really is all about business. So when you think about bear markets - and all the emotions and fears that come with them - remember: down markets are really only the inversion of up markets. You didn’t panic when that home-building stock went up 300% since 2015. So why get so nervous now?
 
One of the things I’ve noticed over the years is that investors often act similarly in peak bull and bear markets. Investors begin to lose focus on the value approach and begin to see things in a more emotional or speculative approach. As seen in the graphic below, it is much like a bowtie in which bull and bear market behavior are simply mirror images. The same but simply inverted. If that’s the case – which I believe to be true – then theoretically value investors should fear bear markets as little as they fear bull markets. In fact, truly great value investors have a love/hate relationship with bull markets (nothing to buy until bull markets lead to bear markets which means opportunity) and they love bear markets (back up the truck!). 

So think of bull and bear markets in the same way – events caused by irrational exuberance and irrational fear - where the former allows you to take profits and the latter allows you to make profits. Just always stay within your core value investment approach and you’ll be fine.
 
Ways to Mitigate Risk in Bear Markets
 
If we think of bear markets simply as an inversion of bull markets, how do mitigate risk as the markets turn? I thought I’d outline four major ways to mitigate this risk and discuss them in the context of our “bowtie model” I previously discussed.
 
Choice 1: Seek Neutrality By Taking Profits and Holding Cash
At Nintai, we see this as the closest method to sticking with our value investing approach. It prepares us to deal with both bull and bear markets. Remember our description: bull markets allow us to take profits and the bear markets allow us to make profits. At the height of a bull market, it is likely valuations will be stretched and likely to see some holdings reaching nose-bleed valuation levels. When this happens, be sure to happily sell some of your holdings (take profits) to that giddy person who irrationally thinks prices will always go up. In exchange for that, have cash available when the inevitable blow up happens and that poor giddy investor is now panic stricken and happy to sell you shares in great companies that are remarkably cheap compared to their intrinsic value (make profits). Use the inversion of market thinking to apply your core value investing approach.
 
Choice 2: Take Profits and Invest in Bonds
While this choice may have been the conservative one for the last generation of value investors, at Nintai we think this is more speculative than Choice 1 simply because of the structure and characteristics of the bond market in today’s world. With the explosion in lower credit quality and negative-yielding debt (I discuss this in greater detail in “Where Are The Prisoners: Debt and the Russell 2000”, found here, and “The Changing Face of Debt”, found here), simply using bonds as a parking place for cash is no longer a completely safe bet (US Treasuries might be the closest but even these face tremendous market pressures today). At Nintai, we don’t have the bandwidth to dig into individual debt instruments or bonds, and we think its likely most other individual value investors don’t either.
 
Choice 3:  Go Net Short 
Many hedge funds (hence the “hedge” in their name) will position their portfolios to be say 60% long and 70% short (using leverage) to be net short in their investment approach. This simply means they have positions that will hopefully increase in price (long) and positions where they hope the price goes down (short). When you sum the long positions versus the short positions, the fund will have more shorts then longs and hence be “net short”. We think this falls much further down the speculation part of our bow tie. One reason is that short positions have an unlimited amount of potential loss. This greatly changes the risk/reward dynamic placing far more risk into the equation. Second, we have found individuals need to have an extraordinary amount of knowledge about the company and its markets to bet on that venture’s failure. Unfortunately you see this type of investment approach happen more often at the end of bull markets. At Nintai, we’re not fans.
 
Choice 4: Bet on Volatility
As we reach peak bull markets and you sometimes have significant drawdowns like we did in Q42018, investors can see dramatic increases in the CBOE VIX index. This index (which can be traded on by using the VXX ETF) measures investor emotions by tracking S&P500. As described Investopedia: “The VIX is a real-time market index that represents the market's expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors' sentiments.” Let’s face it. If you had to look up the underlying a definition of some of this description, then you are at the very far end of the bowtie. In fact, you may be on the way to developing your own version of neck ware. At Nintai, we think on investment approach that - by its very definition is based on investor emotions - is the most rank form of speculation.  
 
It Always Comes Back to Value
 
In the opening of my book “Seeking Wisdom: Thoughts on Value Investing” I discussed why it’s equally (if not more) important to think about how you invest than what are you invest in your portfolio. As talk of an impending recession gets louder, I think this statement becomes even more important. How you think about investing in a bear market is more important than what you invest in during that market. If I had one piece of advice, it would be that the concept of value (buying an asset at a significant discount to your estimated intrinsic value) become
 
critical as you prepare for a downturn. At Nintai, our number one concern is preventing the permanent loss of our investment partners’ capital. That risk is far greater in a recessionary economy and/or bear market than during an economic expansion where the tide raises all boats. During down markets, to make sure we stay focused on value we adopt several processes.   
 
Our Arena is the Public Markets (or Stay Inside the Box)
As value investors, our arena is the domestic and international stock markets that trade securities. For the sake of my thinking, I limit my environment to these markets and these markets alone. It doesn’t include the larger investor community, the financial press, the commodity trading pits, investment blogs, or any other noisy and messy environment outside the NYSE, NASDAQ, the LSE, or the Paris bourse. The majority of my time is spent gathering data about companies that I own shares in. That vast cacophony of noise about interest rates, iron ore prices, the latest Presidential tweet, or what message the market is sending reading the latest inverted quadrangle ratio? It really means very little. All those magazines you read with the must own 30 stocks of 2020 or why the latest and greatest stock analyst only wears blue suits on triple witching day? Nope. Means nothing. And the fact that your neighbor made 6,000% on that closed-end fund that only invests in penny real estate stocks in Borneo? Nope. Nothing. Do yourself a favor. Draw a box on a piece of paper. Inside place the names of the stocks you own and the exchange they trade on. When something comes up on TV or in a meeting and you think it might be of interest in your investing, just check to see if it has anything to do with inside the box. If it doesn’t, it’s outside the box. And you know what that means.   
 
Invert the Average Investor’s Reactions
As I discussed previously, investor reaction to bull and bear markets is remarkably similar. In both cases, individuals find themselves separated from data-driven, value-based decision making. Rather, emotions such as greed (bull) and fear (bear) drive investment decision that for many are costly in the long-term. We suggest you stay dead center in your own particular bowtie – use value as the core for all decision making. Whether taking profits (bull markets) and making money (bear markets) don’t let emotions rule the day. At the old Nintai Partners, we actually had an investor who put on a bow tie every time the market had dropped by more than 10%. He said that when he began getting emotional about significant drawdowns in his portfolio, he would finger the center of the tie and remind himself – “stay in the center, not the edges”. I can’t say I recommend this approach, but whatever way you can stay focused, use it.
 
Value Should Drive You to Neutrality
In an earlier discussion, I stated that bear markets are almost inevitably preceded by bull markets. These are usually accompanied by some form of asset bubble such as credit/real estate in 2007 or stock/industry group leading a New Economy like technology in 1999. During these bubbles, it’s likely that much of your portfolio will be pushing the upper-range of your estimated intrinsic value. Many times you will see holdings reaching 130 – 140% of your estimate. If you are a disciplined value investor, you will be taking profits by either trimming positions or selling them outright. This conversion should drive cash as a percent of total holdings to what might be perceived as shocking levels. You will reach these levels because finding replacements for these holdings will be few and far between. Now you may be saying right now “Tom is an idiot. I know to buy low and sell high”. You may say that to yourself, but if you carry that out you will be the rare bird indeed. Peruse nearly any mutual fund material today and it is likely they still remain at less than 5% cash. With an average turnover of 75% - 100% annually, that means many funds may be selling - but they buying an awful lot of stocks at inflated prices. As an individual investor, you have the blessing of maintaining cash at any level you like. Let the bull market drive you into neutrality. Let value force you into cash by taking profits and not overpaying for replacements.
 
Conclusions
 
One of the major themes in the questions I receive has centered on how Nintai thinks about down markets and how Nintai Partners did so well in the last bear market. This is the first article in a series that will discuss how value investors might try to prepare for an oncoming bear market. This first looked - at a very high level  - at how the value process is actually similar in both bull and bear markets. It’s also about the importance of thinking about the “how” and not the “what” when it comes to value investing in down markets.
 
Speaking of the “how”, by their very nature it would seem that value investors have a leg up when it comes to preparing for the inevitable market crash. But that’s not necessarily the case. If you look at some the great value investors of the last several decades and their performance in the 2007 – 2009 market crash, it’s shocking to see that many of them underperformed the markets. In my next article, I will discuss how easy it is (even for value gurus) to wander away from core value principles. I will use the 2007 – 2009 crash as an example and discuss what happened in some specific cases. I will include several instances of Nintai’s forgetting about the “how” and focusing only on the “what”.   

“All men make mistakes, but a good man yields when he knows his course is wrong, and repairs the evil. The only sin is pride.”
                                                                             -        Sophocles 

“It is the highest form of self-respect to admit our errors and mistakes and make amends for them. To make a mistake is only an error in judgment, but to adhere to it when it is discovered shows infirmity of character.”
                                                                            -         Dale Turner 

Over the course of my investing career I’ve made some terrible investments. I’ve written about them before. In one I talk about the general concept of looking like an idiot (“The Fine Art of looking Stupid” here), in another I talked about education through ignorance  (“Learning from My Mistakes” here), and I’ve even discussed a specific case of ineptitude (“Anatomy of a Failed Investment” here). In this article, I thought I’d address an investment failure (so far) from the perspective that several readers have asked about – when do you know enough to stop being uncertain? Or put in a different way - how do you know you’ve reduced risk to a reasonable level?
 
Biosyent: An Investment Gone Awry
 
In October 2017, Nintai purchased shares in Biosyent (OTC: BIOYF or TSXV: RX), a specialty pharmaceutical company based in Mississauga, Canada. The company through its subsidiaries sources, acquires or in-licenses pharmaceutical products and markets them. In May 2018, I compared the company’s business model against that of then Valeant (now Bausch Health Companies: BHC) in an article entitled “Opposites Don’t Attract” (it can be found here). In the article I pointed out that Biosyent’s model was the opposite of Valeant’s – the company had no debt, it generated high return on equity, assets, and capital, and high free cash flow margins. Most importantly, while it in-licenses new products (similar to Valeant) its business model did not require increasing prices by 6,000% to survive. My overall thesis as stated in the article was Biosyent could take a great deal of pressure in a business downturn and still work out as an investment, whereas Valeant had little margin of error.
 
With all that research and industry expertise, you might ask how the companies have done over the past year? Well, talk about being hoisted on your own petard! BIOYF is down 38% versus BHC’s -10% return. BIOYF’s free cash flow is down -31% versus BHC’s drop of 1.5%. BIOYF’s revenue is down 15.8% versus BHC’s increase of 3.1%. Not a pretty picture. In just about every measure, Bausch has outperformed Biosyent.             
 
So what happened? How did I get my investment thesis so wrong? Before I get into that, let me quickly review how Nintai generally deals with such a debacle. First - and before anything else - I will generally pick out some classical music, pour a glass of whisky, and roll up my sleeves at my desk. This is no time for hasty action. I will pull out my previous investment case and valuation spread sheet and begin to pull it apart piece by piece and assumption by
 
 
assumption. I will also review everything we had broken out as both a risk and an uncertainty. What I’m most interested in is whether there as a risk (where we could ascertain a percent chance 0f happening) we either overlooked or underestimated, or was it an uncertainty (an event we could not apply a reasonable percent chance of happening) that did my estimates in. One thing I find most helpful is writing to our investment partners about the investment and giving an overview of the investment and what’s happened since our initial investment. This process is very helpful in removing the emotions from the investment. The following is a letter that was sent to all our investment partners late last week discussing our investment in Biosyent.

                                                               -------------------------
 
To Our Investment Partners:
 
Biosyent (BIOYF) released its Q2 and H1 2019 results today and they were as ugly as we expected. Q2 2019 net revenues were $5,156,476 which is 13% decrease versus Q2 2018. H1 2019 net revenues of $9,635,290 which is 7% decrease versus H1 2018. Q2 2019 Canadian pharmaceutical net revenues of $4,844,090 decreased by 4% versus Q2 2018. H1 2019 Canadian pharmaceutical net revenues of $9,114,230 increased by 4% versus H1 2018. This was a pleasant surprise. However, the international numbers simply couldn’t be worse. Q2 2019 International pharmaceutical net revenues were $0 (yes, that’s nil) as compared to $511,483 for Q2 2018.  H1 2019 International pharmaceutical net revenues were $0 as compared to $1,077,324 for H1 2018. Ongoing import restrictions on FeraMAX® meant that no international shipments were made at all in H1 2019. Finally, it appears the decision to cancel regulatory submissions to Health Canada for two new cardiovascular products is final. The company took a one-time impairment loss on intangible assets of $424,941 with this decision.
 
With today’s losses our position currently stands at a roughly 31% loss on our initial investment. Over the coming week, we will be revisiting our investment case. We intend to speak with corporate management, strategic partners, customers, Health Canada officials, and industry thought leaders. On the positive side (if one can be found here), Biosyent has no short or long-term debt, still generates free cash flow, and is ready to launch a new product next year. We believe the value of our investment methodology is being proven in this case. A rock solid balance sheet, high returns on capital, and generous free cash flow as a percent of revenue gives us a significant leeway in terms of damage the company can withstand.  It also dramatically reduces the chances of a permanent impairment of our invested capital.   
 
That said, it’s not the drop in Biosyent’s price (in fact we like to see that in most cases) but the drop in our estimated intrinsic value that bothers us. A drop of 50% in our estimated value means we missed something significant in our due diligence. As Count Ciano said, “Success has many parents but failure is an orphan". At Nintai, failure is openly acknowledged and discussed. There will be no investing
Ospedale della Pietàins in our shop. We intend to go back and find out what went wrong and what we can learn from this. We will update you over the next 30 days and discuss these findings. Should you have any questions or comments before that, please do not hesitate to contact me at tom@nintaiinvestments.net or at 603.512.5358.
 
                                                           --------------------------

These types of letters aren’t the easiest to write. Opening up your books and revealing a flawed process is difficult on the investor’s ego. But I think over time, writing this type of update can get your mind thinking more clearly and helps you become a better investment manager.
 
Mistakes and Changing Perspectives
 
Quite a few readers have written asking about how we deal with risk and uncertainty when it comes to making an investment. At Nintai, we try to apply different mental models in decision making. This allows us to tease out different approaches when it comes to making a final choice. We recognize we will never be able to reduce risk to a perfect 0% level. Nor will we be able to reduce uncertainty to a “perfectly acceptable” level. For instance, when it comes to uncertainty in making a final choice, we found we share a similar dilemma to musicians.  At what point during a studio recording do musicians say “That’s it. That’s the final take.” What is it about that take which causes the musician to feel they can’t improve the song any more. Why not two takes before? Or three takes into the future? I find that many readers are asking a similar type of question in their emails – at what point can Nintai say “That’s it. I don’t need any more research or run any more numbers. I’m ready to put in the purchase order”. I thought it might be interesting to try to answer that question using Biosyent as a case study. After taking a shot at answering it, I thought I would then use the case to see if there isn’t a way to improve the process.
 
Looking back to October 2017, I felt confident that I had the right amount of data and research to say “I don’t need any additional work here. I’m ready to invest in Biosyent”. In light of a roughly 30% loss-to-date, however, something clearly wasn’t right. But the question is whether this was a problem in not understanding the risk or was it simply a case of not taking into account the uncertainty of investing in biopharma.  
 
Nintai’s Hierarchy of Risks
 
Whenever we think of investing, Nintai has a general hierarchy of risks (our apologies to Maslow) ranking from the very worst to those we place as least important. I’ve pointed out in previous articles how we see the difference between risk and uncertainty. For the sake of brevity, I will simply re-quote Nate Silver’s great description in his classic “The Signal and the Noise”.
 
"Risk, as first articulated by the economist Frank H. Knight in 1921, is something that you can put a price on. Say that you’ll win a poker hand unless your opponent draws to an inside straight: the chances of that happening are exactly 1 chance in 11. This is risk. It is not pleasant when you take a “bad beat” in poker, but at least you know the odds of it and can account for it ahead of time. In the long run, you’ll make a profit from your opponents making desperate draws with insufficient odds. Uncertainty, on the other hand, is risk that is hard to measure. You might have some vague awareness of the demons lurking out there. You might even be acutely concerned about them. But you have no real idea how many of them there are or when they might strike. Your back-of-the-envelope estimate might be off by a factor of 100 or by a factor of 1,000; there is no good way to know. This is uncertainty. Risk greases the wheels of a free-market economy; uncertainty grinds them to a halt.”
 
As we look to think about risk, we think there several macro-risks that are essential to take into account as an investment manager with fiduciary responsibility to our investment partners. They are listed in rank of significance.
 
Permanent Impairment of Capital
First, from the highest level of assessment, Nintai’s primary risk is the permanent impairment of our investors’ capital. We believe this mostly falls under risk, but there is certainly some uncertainty that comes into play.  To make such an event possible, we have to assume the possibility of several catastrophic events. One could be a massive and widespread case of accounting fraud. With a long history of audited financials that meet both FASB and Canadian regulatory requirements, we believe this is a very low risk. Second, is the complete shutdown of operations due to severe regulatory violations and non-compliance. Again, the company has a long history of meeting FDA, Canadian Food Inspection Agency (CFIA), and Health Canada inspections and we see this type of risk as minimal at best. Last, the company is unable to identify, locate, or purchase new in-license candidates and revenue collapses. While we’ve seen a few instances of product approval failures (such as the two recent cardiovascular products), this in no way has led to a collapse in revenue. Decreases yes. Collapses no. We believe this event would be a blend of risk (e.g. warnings such as audits with material weaknesses) and uncertainties (insider activities hidden by accounting fraud). We still rank this extremely low in as a possible risk.
 
Significant Reduction in Estimated Intrinsic Value
As an investment manager there is only thing worse than having to slash your intrinsic value (see previous). It happens more often than I like, but it’s bound to happen when you invest in companies that are sometimes going through difficulties. In Biosyent’s case, we didn’t think this was the case at all, and boy did we get that one. If you take a look at the previous 5 year annual growth rates versus the trailing twelve months it’s not a pretty picture.
 
                                                                                    5YR                 TTM
 
Revenue Growth                                                        21.2%               -2.4%
Operating Income Growth                                        20.8%               -9.2%
EPS Growth                                                               22.5%              -15.8%
Free Cash Growth                                                      24.1%              -31.0%
 
Any time you invest in biopharma you run the risk of not getting product approvals from the appropriate regulatory body. In Biosyent’s case, Nintai obviously did a poor job in breaking out the pipeline and assigning risk to each product. An obvious learning is to build out a far more robust evaluation process for an investment’s pipeline and model that against the investment’s valuation.
 
Risk-Driven Investment Paralysis
One the dangers of building out an outstanding risk-based assessment tool is creating a process that leads to investment paralysis. We know of one case where a firm had built out such an impressive risk assessment process that it became nearly impossible to build a case putting the firm’s capital in play. In the time that it took Nintai to build out a 20 company portfolio, the firm had not chosen a single holding. It is critical to remember that any system that incorporates risk and uncertainty must – by its very nature – be part art and part science. There will always be a human component to value investing. Whether it be that panicky feeling when the markets drop 5% in one day, or the feeling of greed when a portfolio holding jumps 18%, human emotion will always be something to master and take advantage of in investing. 
 
Conclusions
 
In March 2015, I wrote about the four interwoven factors that are essential to master if you look to be a successful value investor (“The Four Horsemen: Risk, Uncertainty, Price, and Value”, here). Every time an investor makes a decision to buy, sell, or hold they are creating an interplay between these four. What they tell the investor is partially driven by the inputs the investor uses, the questions the investor asks, and the value that is given to each individually. One thing is certain – working with them individually or together is as much art as it is science. As the reader can see, Nintai’s decision to invest in Biosyent - at the price we thought was a significant discount to fair value - was flawed at best. What we thought were clearly defined risks actually had underlying uncertainties. We have been saved from the worst possible consequences (so far) by building in a margin of safety that structurally makes it difficult to permanently impair value. Any process that can produce such results is worth revisiting on a regular basis. 

“I’m not lost for I know where I am. But however, where I am may be lost.”
 
                                                                         - A.A. Milne “Pooh Wisdom”
 
“Have you ever stopped to think that maybe you were wrong? Maybe, you only saw your point of view and you never once put yourself in the other person's shoes. Maybe, walking away from the senseless drama and spiteful criticism isn't the best thing to do. Maybe, for just once in your life you could wear another person's confusion, pain or misunderstanding. Maybe, your future doesn't require explaining yourself or offering an explanation for your indifference, but your character and reputation does. What if one day you find out that you didn't have all the information you thought you did?”
 
                                                                       - Shannon L. Alder
 
Looking back over the past five years or so, I estimate that I’ve authored roughly 1,000 pages of writing in about 350 articles and one book on value investing. You would like to think that each page contains a nugget of wisdom or perhaps an entire article can change a reader’s life. But it really doesn’t work that way. Nearly everything I’ve ever written about has been discussed previously - whether it be about value, risk, discounted free cash flow or even my sentimental favorite about Abraham Wald and inversion (you can read the article, “Mutual Fund Survivorship: The Revenge of Abraham Wald”, here ).
 
So it comes as some surprise that I find myself in the same position as Pooh. I’m not lost because I know where I am. But where I am may be lost. In my comparably short twenty years of investment management, some things seem pretty familiar (slowing economic data, arguing over Federal Reserve rate policy, high deficit spending, etc.). However, I increasingly find myself at sea in conditions I’ve never witnessed - let alone considered. These include negative yields, tariff wars, and a Federal government that increasingly resembles a completely dysfunctional reality television show.
 
Some Things Remain The Same...
 
There are some things that have remained the same over the past several years as the markets have become increasingly volatile and upended. For instance, I remain strongly resolved in my investment strategy and criteria. I still believe finding companies working in a monopoly/duopoly environment and deeply embedded in their customers’ operations leads to long-term growth. I still believe companies generating high returns on capital and converting a significant percentage of revenue into free cash flow are the best investments over the long term. I still believe overpaying and not having a margin of safety creates the best odds for long-term underperformance. Finally, I still firmly believe partnering with moral leaders who are outstanding capital allocators is the engine that drives decades long market outperformance.
 
It isn’t just my investment criteria that have remained mostly consistent. Some market issues are the same today as they were decades ago. The battle between balanced budgets and deficit spending  - while not as thunderous as in the Reagan years - are still fought out in the halls of Congress. The debate about the role of financial policy versus monetary policy echoes between 1600 Pennsylvania Avenue and the Capital just as strong as when FDR landed on the shores of Keynesism. The argument of when to raise or ease the Federal funds rate is as cantankerous today as when Bill Martin threatened to take the punch bowl away in 1955.
 
...But Some Things Are Completely Different
 
As we look out and see many issues that resemble the past, there are some conditions that are so strikingly new, investors (both individual and institutional) have no historical data to help them make informed decisions. For value investors, these issues are creating a deep fog which is nearly impenetrable in their complexity and novel nature. There are three which I believe have the capacity to create the next severe market dislocation.
 
Negative Yielding Debt
Let’s take negative yielding bonds for instance. Throughout history, people have saved by loaning the government their cash with the idea of getting their principal back plus interest. As of 2019, sovereign governments are being paid for borrowing money (or by inverting it: people are paying the government to invest their cash). This has been driven by desperate savers trying to find any safe option for their more liquid investments. Starting with Sweden and followed by other countries including Germany, $16 trillion in global debt is now being traded at negative yields. The impact of such conditions is relatively uncertain, but what we are learning about some of them isn’t pretty. For instance, Denmark is currently offering negative yield mortgages, meaning a bank will pay you to finance the purchase of your home. Many are realizing this model will provide an enormous pressure on housing prices (who wouldn’t borrow under these conditions? Who wouldn’t borrow as much as you can? The more you borrow, the bigger the check). As almost all market crashes are brought on by a.) easy credit standards b.) too much leverage and c.) and concentrated asset price inflation. Does no one see a potential problem here?
 
U.S. Debt Default
Regardless of your political affiliation, I believe it’s safe to say no net-saver has heard - or ever wanted to hear - the President of the U.S. say the federal government could simply renegotiate/default on its debt obligations in the case of a recession. In an interview in May 2016 then-candidate Donald Trump said:
 
“I would borrow knowing that if the economy crashed you could make a deal. And if the economy was good it was good so therefore you can't lose. It's like you make a deal before you go into a poker game. And your odds are much better.”
 
For over a century the U.S.'s debt has been the perceived as the rock of the global financial markets. Yet, over the past 10 years we have seen filibusters on increasing the debt limit (or as one pundit called it “a rolling, bumbling uninformed default”), and a downgrade by Fitch in 2011 by one notch from AAA+ (the highest possible rating) to AA+ with a negative outlook. In 2013, as a result of the aforementioned filibuster, rating agencies threatened to downgrade US debt credit rating again due to “political brinksmanship”. With the current administration we have seen an increase in financial and budgetary uncertainty. The 2017 tax cuts will add roughly $2 trillion towards our national debt. This allowed the President to follow up his renegotiate/default statement with his view to not worry about this new debt because “he won’t be around” to see its impact. Interest payments - as a percent of the total federal budget  - will reach record highs through 2022.
 
Free Trade to Trade Wars
Another change has been the complete rejection of the post-WWII push for free trade and open markets with multiple trade wars and tariffs on friend and foe alike. New tariffs on Mexico, Canada, China and potentially all of Europe have injected enormous fear and uncertainty on where the world economy is headed and whether we are suddenly barreling towards a global recession. Just in the past few years we have seen the US scrap the NAFTA Treaty between the US, Canada, and Mexico with a new as-yet-proposed USMCA (United States, Mexico, Canada Agreement[1]). China trade talks have been placed on hold as the US has pressed forward with wide-ranging tariffs on nearly every import into the US from China. Things have gotten ugly enough that President Xi was called “the enemy” (along with the Federal Reserve Chair!) in an August 2019 presidential tweet.
 
What This All Means
 
The question for investors  - both individual and institutional - is where do we go from here? How do we take into account all of these changes into our investment strategies? As Shannon Alder said, what if we find out one day that we don’t have all the information we thought we did? To offset these concerns and worries, I suggest investors ask themselves the following questions.
 
Are My Goals Impacted By These Events?
I recently overheard a great comment in a conversation between two investors. The first investor asked the second what impact the President’s tweets had on his retirement strategy. The second replied “Not a damn thing. My goals haven’t changed a bit. My goal was to fully retire at 70. Has any tweet changed that? Nope. Have they helped me get there? If anything, they’ve made it harder.” Remember that for all the noise going on out there - whatever your goal is - stick with it. Keep your eye on that ball because it’s the only one that matters.
 
What Part of My Investment Strategy is Impacted By These Events?
Take a sheet of paper, divide it in half, on the left side put the major components of your investment strategy (invest in stocks with 10 year ROE > 15%, invest in companies with no debt, etc.) and then put the major issues happening in the market place (China tariffs of 15% on X products, $15T in negative yield bonds, etc.) on the right side. Begin by assessing exactly what impact the right will have on the left. Really drill down to what is a risk (an event with a defined % chance of happening) and what is an uncertainty (the chance of it happening can’t be quantified). Then ask yourself what changes you might need to make to keep up with your goals.
 
What Part of My Portfolio is at Risk?
After assessing the risk on your strategy, begin trying to calculate what effects these market events will have on your portfolio companies. Remember: some of these risks and potential outcomes are simply unknowable. We’ve never seen negative yield government bonds from Germany. We’ve never seen 15% tariffs on nearly all Chinese imports. The ability to see impacts from both an integrated level (how do US Chinese tariffs impact Germany’s 0% economic growth rate?) as well as time-wise (How long would it take to for a negative yield bond environment to impact the US housing refinance market? Two years? Three years? Five years?) can be very helpful as you try to calculate into the future.
 
What Steps Can I Take to Mitigate These Risks?
Finally, you need to ask yourself, how do I mitigate risks that I‘ve identified in these market conditions? If your retirement income is going to fall short by roughly 25%, what steps are a.) required and b.) possible to fill that gap? It will be essential to model in ranges simply because so many of this is based on unmeasurable factors – uncertainties not risks. Always remember that this planning and estimation is an art not a science. You are seeking a margin of error, not a bullseye.
 
Conclusions
 
The past decade has taken investors on a whirlwind tour. Starting with the 2007 – 2009 Great Recession and associated market crash, this has been followed by a 10 year bull market accompanied by sluggish growth and startling political instability. It’s been a period when investors have become remarkably complacent in nature, with the VIX achieving all- time lows. Since December 2018 volatility has roared back with dramatic swings in the markets, politics has become increasingly bellicose and unhinged from reality, and companies going on debt-fueled stock buy backs. As I’ve written previously, danger signs are flashing across the markets and the economy. In this time of uncertainty and economic "creativity", investors have all the reasons in the world to go back to their core values – investing in value not price - buying the tried and true, and deleveraging your personal and investment lives. Be like Pooh. When a crisis hits know where you are – and most important – know where you are going.
 
As always, I look forward to your thoughts and comments.


[1] The treaty has come under intense pressure after the US announced new tariffs on Mexico and Canada in a clear violation of the new agreement. In fact, it hasn’t even been approved by the United States Senate as of August 2019.
 

“Debt, we've learned, is the match that lights the fire of every crisis. Every crisis has its own set of villains - pick your favorite: bankers, regulators, central bankers, politicians, overzealous consumers, credit rating agencies - but all require one similar ingredient to create a true crisis: too much leverage.” 
 
                                                                                                   -     Andrew Ross Sorkin 

“No man’s credit is as good as his money.”                                -     John Dewey
 
 
Early this summer I wrote about debt and the Russell 2000 (“Where Are the Prisoners? Debt and the Russell 2000”. The article can be found here.) In the article I discussed Stanley Druckenmiller’s comments that pointed out two salient points. First, debt in the Russell 2000 was growing far faster than profits (debt grew by 65% from 2010-2018 while profits grew by 29% in the same period). Second, between 2010-2018, stock buybacks ($5.7T) far exceeded capital expenditures ($2.2T). This is a complete reversal of the last 35 years which averaged buybacks (20%) versus capex (80%). I also wrote about the changing structure of corporate debt in “Fata Morgana and the Illusion of Safety” (which can be found here). In that article, I write about the explosion in “covenant-lite” loans (essentially debt requiring little or no collateral as well as little to no documentation) from less than 5% of total leveraged loans to roughly 75% today.
 
I bring this up again as there was a great discussion which took place at the Morningstar Investment Conference earlier this year in Chicago. In an article and transcript of a panel conversation (“Rates, Spreads, and Credits”, Morningstar Magazine, Fall 2019, page 56), there was a great discussion about the changes in both the debt being issued (quality, etc.) as well as the form it is being invested in by the markets (cov-lite, etc.). Combined with my earlier discussion, I think it is wise for all investors  - institutional or individual - to take a closer look at and how it might impact both the overall markets, individual portfolios, and sovereign economies.
 
The Changing Face of Debt      
 
We know that each new financial crisis is a pale cousin of the last, though - as Andrew Ross Sorkin wisely states - there is almost always a component based on leverage and excessive debt in the mix. Looking out over the debt markets, its seems some of the novel products or the move to passive indexing have completely upended the debt markets over the past two decades.  
 
Credit Standards Have Dropped to Alarming Levels
 
At the Morningstar conference, it was pointed out that roughly one-half of all corporate debt is made up of BBB-rated quality (one notch above junk status). According to Morningstar, the composition of a US Core Bond Index fund has seen its credit quality drop from A in 2008 to A- in 2018. BBB credits as a percent of corporate market value (meaning what percent of total corporate debt) has risen from 27.8% in 2008 to 48.9% at year-end 2018. Additionally, (and perhaps more frightening) the percent of BBB credits that make up the total market value of the index has risen from 9.2% in 2008 to 19.1% at year-end 2018. This means that the individual investor has seen their typical core bond index fund double its share of BBB credits - just one notch short of junk status - over the last decade. One can only imagine what type of returns an investor might see should they find themselves in a 2007-2009 credit crisis again.
 
What We Mean by “Core” Has Changed A Lot
In 2008, government debt made up roughly 31% of a core index bond fund. By year end 2018 that number had increased to 42%. A real change was agency debt. This has dropped from 7.5% in 2008 to just 1.3% in 2018.  The largest change - in percentages and dollars - was the decrease in mortgage-backed securities. This was the debt that played a critical role in the US housing market bubble and the subsequent crash. This debt went from 43% of the US core bond index in 2008 to just 29% at year-end 2018. All of these changes have fundamentally changed what investors have in their portfolio when they invest in a “core” bond index fund. Combined with the changes discussed earlier in corporate credit quality, investors are looking at a substantially riskier product.  
 
Rates are Increasingly Volatile in Nature
Since authoring my articles about corporate debt roughly 5 months ago, we have seen some extraordinary changes in the bond markets. The US treasury yield has inverted, the Chinese/US trade conflict has moved closer to a trade war, the President of the United States is threatening the Chairman of the Federal Reserve and calling him “clueless”, and over $15 trillion (with a “T”) of global sovereign debt has a negative yield. We also see the UK careening towards a completely Wild West Brexit, several of the world’s largest economies teetering on the edge of recession, and Hong Kong simmering on the brink of revolt against mainland China oversight. How to navigate these waters and find security in the bond markets is becoming increasingly hazardous.  
 
Passive Indexing Has Affected Bond Market Liquidity
The ability to connect a buyer and seller (or market liquidity) - even during times of market difficulties  - is essential to maintain asset prices. When liquidity breaks down, investors can begin to see distortions in pricing. Until 2008, the largest bond brokers warehoused bonds assuring there was adequate liquidity and seamless trading in the debt markets. In 2018, that model is nearly completely gone. For instance, in 2007, there was roughly $7T in outstanding corporate debt. Dealer inventories were roughly $250B. By 2018, this had changed dramatically. At year end, there was roughly $10T in outstanding corporate debt (an increase of 43% between 2007 - 2018) but dealer inventories had dropped $12B (a decrease of 95% between 2007 - 2018).  This collapse in inventories will create an enormous crimp on liquidity should we face another credit crisis similar to 2007-2008.
 
What This Means
 
For individual or institutional value investors managing portfolios heavily tilted to equities, this whole conversation about the evolution of the debt markets may seem beyond their interest or investment scope. I would hasten to remind portfolio managers who saw no connection between mortgage-backed securities and the S&P 500 to reflect back on those “halcyon” days of late 2007 through 2008 when most major stock indexes dropped 35-40%. The bond markets act as the lungs to the greater asset markets ranging from equity indexes to venture capital. When the lungs stop breathing, it’s safe to say it catches most peoples’ attention. It has in every other crisis and the next one will be no different.
 
As an institutional investor, I have a fiduciary responsibility to my investment partners to prevent the permanent impairment of their capital. Whether that is a portfolio made up of 95% equities with a 100 year time horizon, or one made up of 90% bonds paying for a planned 15 year retirement, the bond (and credit) markets can make and break returns. Bearing that in mind, here are a few rules which I try to live by in this wildly fluctuating market.
 
Cash Is Still King
As John Dewey points out, no man’s credit is as good as his money. Regardless of how secure you think debt may be, it’s still not better than cash. Even US Treasuries - considered the safest investment in the world - can be dramatically impacted when the President of the United States suggests we could simply renegotiate our debt at will. It could also equally be affected by Congress simply not increasing the United States government’s debt limit. While running from the risk of inflation or lost opportunity costs, the holding of cash is sometimes the best of a bad lot.
 
Debt is Never Stagnant in Price or Value
Unless the investor intends to purchase debt at par and hold for its duration or until it is called (while still running the risk of default), the pressures of inflation, the Federal funds rate, currency exchange, etc. can make bonds surprisingly fluid in their valuations. As one looks at the changes in a US core bond index fund, you can see dramatic changes in risk and uncertainty in just the past 10 years. Always remember that bond pricing - and valuation - is not stagnant. One can overpay or suffer permanent capital impairment in bonds just as easily as equities.
 
Valuation and Risk Assessment is Vital
Just as a good value investor will look at the act of equity investing as purchasing a part of a business, investing in debt is no different. Though you might be higher on the bankruptcy totem pole, this doesn’t assure you of a positive return. Much the same as purchasing a stock, an investor should spend a considerable amount of time studying the company’s financial statements, competition, markets, etc. Significant focus should be on the ability of the company to meet current and future debt servicing requirements.
 
Conclusions
 
The debt markets are a foreign concept to many value investors. For most, a simple bond index fund or ETF will take care of any bond coverage they feel they need. It’s rare to hear individual or institutional value investors discussing the purchase of individual bonds. Because of that, it’s even more important to understand the general debt markets, their trends, their risks, and what story they are telling us at the moment. At Nintai we have an almost unhealthy focus on risk mitigation. Every day we ask what market data can warn us of risk and uncertainty in the markets. Right now the debt markets are telling us that markets are - in general - overpriced, the risk of both a US and global slowdown is higher than appreciated, and that cheap debt is at risk of rate fluctuation or slowing growth. Those messages - taken in context with our portfolio positioning - means we are prudent in our assessment of debt carried by our holding companies, ruthless in credit quality requirements, and we maintain large cash positions.    
 
As always I look forward to your thoughts and comments.
 
DISCLOSURES: None
  
 
 
 
 
 

As a long time value investor, I’ve grown up with the first principle that market downturns allow you to buy more of the stocks you love the most. Who can forget Warren Buffett’s classic analogy about buying steak or hamburger on sale? But like many of those things that good for you in theory but truly wretched in practice (prune juice, 530AM exercise routines, or the dreaded tetanus shot), watching the prices of your investment partners’ assets take some dizzying drops really isn’t a lot of fun. In theory, watching iRadimed - with its FDA-mandated medical device monopoly - become 1/3rd cheaper without any apparent change in its valuation is theoretically exciting. Watching it happen in real time on your computer is - as Keb’ Mo said  - “a whole notha’ thang”.
 
That said, it is equally exciting - but in a far more pleasant way - watching a company on your watch list announce a slight miss in this quarter’s earnings (along with a slight downward revision in their guidance) drop by 35% in a single day of trading. It’s days like this that make for a happy value investor and a proud new owner of an outstanding asset.
 
I bring this up because we saw the market react with its usual hyper-sensitivity as it measured the risk brought on by a 31 word tweet by the President of the United States and an equally short and brusque retort by the Peoples’ Republic of China. Across the board we saw these two things create wreckage within our investment partner’s portfolios – Adobe down 4.6%, Guidewire down 4.7%, even Mastercard down 4.7%. Our portfolios were down from 1.68% to 2.17% today.
 
Competence and Comfort Revisited
 
Over the past week we’ve been helped tremendously by the same things that held us in good stead in the 2007 – 2009 crash. A healthy cash balance (from 19% to 28%) and a range of companies with extraordinary strengths such as business monopolies/duopolies, returns on capital in the mid-60s, and debt-free balance sheets. While it’s agonizing to see large drops in price like this week, not once over the past week have I been concerned about a permanent impairment of any of our investment partners’ capital. I’ve written previously about our dual circles of competence and comfort. This past week has challenged Nintai in both spheres. We are quite comfortable that our investment holdings (about 20 as of August 1 2019) are in industries or business models that we feel we have a knowledge-based competitive advantage. To paraphrase Tom Watson, we know our spots and we stick close to them. But it’s days like Monday, August 5th - when the market drops by 3% - that we really get to test our circles of comfort. There isn’t any real-time way to test how successful you have been until you get ready to sleep and your level of discomfort is no different at 8pm than it was at 8am. It turns out I was as relaxed on Monday night as I was Monday morning. We didn’t wander too far from our circle of comfort as well. Several things made this possible.
 
Characteristics of Comfort (Derived from Competence)
 
First, no matter what the President might tweet out at 1AM or should he unexpectedly raise tariffs, people will still need MRI imaging of their bodies (iRadimed), doctors will still need to measure their patients oxygen rates (Masimo), and businesses will still need to know exactly how much inventory is in their warehouse (Manhattan Associates). Our portfolio companies have products and services that are deeply embedded in their customers’ operations (SEI Investments), are vital in patient clinical care (Craneware) or even provide the some of the most powerful daily living tools of modern society (Mastercard).
 
Second, the vast majority of our investment partners’ portfolio holdings (16 of 21 total companies) have no short or long-term debt. On average, these companies convert one-third of their revenue into free cash. Over one-half have reduced total outstanding shares by 10% or more over the past 5 years. The company with the largest debt (Biogen) currently has $6.4B in long-term debt (no short-term debt) but has $3.0B in cash/short-term securities and generated $6.3B in free cash flow over the trailing twelve months. These are portfolios made up of companies with fortress-like financials - including pristine balance sheets and staggering free cash flows.   
 
Last, in our portfolios we have partnered with managers who have a long history of outstanding capital allocation. Whether it be Rene Goehrum (Biosyent) with a 5 year average ROE of 27% or 5 year average ROC of 68% or Robert Willett (Cognex) with a 5 year average ROE of 19% or 5 year average ROC of 52%, we go to bed each night knowing that each portfolio holding has a management team dedicated to driving outstanding shareholder returns. Each has an outstanding record of achieving great operational and strategic results. We simply couldn’t be in better hands.
 
All three of these characteristics give us great comfort in times of market volatility and geopolitical uncertainty. It also gives us the confidence that we can take advantage of days when we might see a significant drop in one of our watch list companies. Because we stick to our circles of competence and comfort, we have found that companies in the same industry, similar business model, and comfort characteristics (as discussed above) can be outstanding candidates for Nintai’s capital. For instance, with our knowledge gained from several healthcare holdings, Nintai was able to make a quick - but we think remarkably structured and researched - decision to snap up Abiomed after it dropped over 30% in a single trading day after disappointing Wall Street with quarterly earnings and reducing its full-year guidance. With similar characteristics to several existing holdings, we were able to deploy capital with a high degree of confidence and comfort.
 
I would be remiss to point out that even after the stürm and drang of the past week Nintai’s cash positions remain between 15 - 20% of total assets under management. We’ve reached the maximum number of positions we like to manage, so any capital put to work go forward will likely be additions to existing positions. With most Nintai portfolios trading at roughly 10% below our estimated intrinsic value, we don’t see a lot of value out there – even taking into account some of the big market moves we’ve seen recently.
 
What We Have (Re)Learned
 
Much as the Talking Heads said that it’s the “same as it ever was”, all the recent geopolitical drama and market drawdowns have confirmed some of our core principles.
 
Noise Reduction Headphones and the Mute Button are Your Friends: If you happened to be watching any financial news channels over the past week you would have been whipsawed by claims that the global economy is melting down, the US economy is melting down, US earnings were better than we expected, the Fed was a patsy to the White House, the Fed didn’t listen to the White House, stocks were melting down, stocks were melting up. All of this usually emblazoned in capital letters and a size 48 font. My advice? Turn off the Wall Street Wall of Sound, put on some meditation music, and go for a walk in the woods. With the exception of a single new purchase, Nintai’s portfolios are the same today as they were 3 months ago. Patience isn’t just a virtue, it’s a winning strategy.
 
The Circles Work: By understanding your portfolio holdings – from their balance sheet to their place in their industry ecosystem – and purchasing companies that are financial fortresses, your circles of competence and comfort will generally show their value in times of dramatic market volatility. If you feel comfortable heading out this week on vacation, leaving all access to the markets and your brokerage accounts behind, and not hearing a single bit of news for two weeks, then congratulations. You’ve achieved investing nirvana. If you can’t, then roll up your sleeves. You’ve got work to do.
 
Remember - Glory Comes in Bear Markets: Nearly every value investor I know who has a great record earned it during down markets. They made it because they understand the real meaning of “value”. They recognize that bull markets end up resulting in long-term overvalue. In these times, they’ve sold out of many of their positions and focus on the fact that any real value in down markets is in assets immune to emotional turmoil and investor fear - like cold, hard cash. Value investor stars salivate for those trading days and weeks that continually grind downwards. That’s when real “value” is generated for such investors.
 
As we enter another period of volatility similar to 2018’s 4th quarter, Nintai is planning on enjoying the last hazy days of summer, enjoying time away from the office, and enjoying listening to crickets along with some Mozart. We suggest everyone do the same. Let the markets generate investment opportunities through their emotional overreactions to quarterly earnings and Presidential tweets. As value investors, we know that great companies occasionally go on sale and investor panic creates the basis for long-term returns. By focusing on two simple circles, the recent market fluctuations can create outperformance and emotional balance. Don’t let those opportunities slip by.
 
As always, I look forward to your thoughts and comments.
 
DISCLOSURE: Nintai currently has long positions in Adobe, Guidewire, Mastercard, iRadimed, Masimo, Manhattan Associates, SEI Investments, Craneware, Biosyent, Cognex, and Abiomed.      
 

“A customer talking about their experience with you is worth ten times that which you write or say about yourself.” 
                                                                                     -         David J. Greer 

“Investment managers think their professional life centers around beating their respective index. No doubt this has a lot to do with the long-term success of their fund or role with the investment firm. Surprisingly though, that isn’t the most important thing when working with their clients. How they deal with their investors, what level of trust they enjoy, or how much they listen can have twice the impact as to how they perform against their index. Twice as much! That’s something you never hear about from the investment profession.”
                                                                                    -         Alan Hurd   

I’ve often talked about our investment philosophy, our investment process, and our investment returns. I thought I’d share with readers some interesting aspects of being an investment manager beyond those. I wanted to talk about the side of investment management that rarely gets discussed - the client - or as Nintai Investments calls them -  our investment partners.
 
As with any service industry, investment managers focus on outcomes that are the most obvious and measurable - in this case their own portfolio performance versus their respective benchmark such as the S&P 500 or the Russell 2000. I certainly lie awake at night running my fund performances against my benchmark. However, there is a secondary part of being an investment manager that rarely comes up in discussions, but one I think is vital in maintain and growing our assets under management - client support and communication. After reading the latest update to the “Advisor Alpha” report, I was surprised by the level of importance that clients put on their advisor’s client communication and support functions.
 
Poor Returns Don't Always Create Unhappy Clients
 
Each year, Vanguard publishes its annual update to “Vanguard’s Advisor Alpha” report. In creating the original “Adviser’s Alpha” concept and report in 2001 (US-only), the company outlined how advisers could add value - or alpha - through relationship-oriented services such as financial planning and behavioral training (among others) rather than by trying to simply outperform the market. Vanguard believes that implementing their “Adviser’s Alpha” framework may add roughly 3% in net returns for an advisor’s clients. All this while differentiating their soft-skills and their investment practice. For those with greater interest in the Vanguard’s “Advisor Alpha” program, feel free to visit the site here.
 
It’s the 2018 update[1] that I wanted to focus on in this article. In this report was a section that discussed the major reasons why investors terminated their contract with their advisors. Their research divided the reasons into three buckets: personality/service levels, performance/portfolio, and advisor left for new firm. The researchers also broke the respondents into three categories: mass affluent, high net worth, and ultra-high net worth. Reading through the results, several findings really jumped out.
 
Personality/Service Outweighs Performance
64% of mass affluent, 65% of high net worth, and 70% of ultra-high net worth (a blended rate of 65%) clients left their advisor because of personality and/or services. This compares to 38% of mass affluent, 41% of high net worth, and 53% of ultra-high net worth (a blended rate of 39%)[2] who left due to performance or the structure of their portfolio. In general, an advisor’s inability to communicate well and build trust caused more clients - and sometimes nearly double the number - to leave their advisors versus those who left due to performance or the make up of their portfolio. For advisors who think the numbers speak for themselves, they should think again. 
 
The Perception of Bad Investment Choices was Most Painful
Investors were more likely to leave their advisor after perceiving they were poor stock pickers (18%) versus if they felt their advisor had a poor response to a market downturn (12%) or if they were underperforming their peers (10%). In this case, the advisor violated the investors’ first principles (“don’t lose my money”) versus the analogous model of peer-based performance or more general market themes (“well, we’re all losing money in such a down market”).
 
I should note that while it’s surprising how important the relationship is between the advisor and the investor, in no ways should this diminish the importance of achieving adequate results in the eyes of the investor. For instance, for ultra-high net worth investors, 53% stated that performance was a reason for leaving their advisor versus 70% stating it was due to their relationship or level of service. What these numbers show is that an advisor needs to keep an eye on both service and performance for the ultra-high net worth.  
 
What This Means
 
We have frequently taken a (good-natured) ribbing at Nintai Investments for the amount of communication that takes place between our investment partners and our staff. We make a strong commitment - from our Statement of Investment Partnership to our weekly musings on Gurufocus - to communicate with our investment partners on anything that might interest the Nintai team. We love to learn and we love to share our learnings. We try to make an effort to establish great communication and a strong sense of trust before we even sign a contract.
 
Establishing the Relationship
Before we partner with any investor, we think there is knowledge we should convey and a significant of learning we can get back from the prospect. Outgoing knowledge is conveyed in two documents and any number of phone calls. The “Nintai Capabilities” presentation and “Statement of Investment Partnership” convey to any prospective partner our investment strategy, our portfolio theory, and our expectations of how Nintai will communicate and support each investment partner. Equally important is the incoming learning we get from our “Client Profile Form” combined with several lengthy conversations to discuss anything of importance to the partner we may have missed. All these forms can be found on our website.
 
This process hopefully ensures our new investment “partner” feels just that - an equal in the process with the rights to open, clear two-way communication. We want our partners to feel free to call anytime - with questions about their individual goals, their portfolio, or to simply to discuss their thoughts on value investing. It is essential from the beginning that we as the advisor become intimately aware of our partners goals, fears, past experiences, and expectations going forward. We hope to learn as much from them as they learn from us.
 
An Open and Honest Dialogue
When he have a new investment partner, its important we establish an open and honest relationship. This involves developing a deep trust that - as an advisor - we will do everything in our power to meet our fiduciary responsibilities. Not just to the letter of the law, but in the best spirit of it as well. Vanguard Adviser Alpha describes trust in three major buckets - functional (does the advisor do what she says she will), emotional (I sleep better at night), and ethical (she act in my best interest all the time). I have found over time that any advisor who can build such a trust construct with their investment partners will have a great long-term relationship.
 
In support of building such trust, at Nintai we provide our investment partners with a detailed business case and valuation spreadsheet of each prospective holding in their portfolio. This allows our partner to see that we invest in companies that faithfully meet our criteria (functional), that these companies have rock-solid financials, deep competitive moats, and trade at a significant margin of safety (emotional), and will likely purchase the same shares in our personal accounts. Our investment partners get to see we eat our own cooking (ethical). Our quarterly and annual reports discuss our winners and losers with a discussion on what we learned and how we will try to implement this new knowledge.
 
Finally, we treat our investment partners as we would our family. We share food, rare wine, and even rarer whisky with our partners - not because it’s good business - but because it’s what friends do. While we understand our role is to be exceptional allocators of capital, we enjoy celebrating life as much as seeing stocks double in price. Who better to share the fine things in life than with those you trust and respect?
 
Conclusions
 
The latest Vanguard “Advisor Alpha” reinforces the message that trust and service play an equal – if not more important role – than historical portfolio performance. Establishing a personal support process, having respect and trust for your clients, and using each point of contact as a chance to learn more about them can create real value over time. Only an advisor who feels this sincerely will make this work. If there’s anything worse than no service, it’s bad service with fake sincerity. So the next time you think of yourself as the next Seth Klarman of value investing, remember that the ability to create open and trusting relationships will see you through the difficult investing times. It’s something we aspire to every day at Nintai Investing.
 

[1] “The Evolution of Vanguard Advisor’s Alpha”: From Portfolios to People”, Donald G. Bennyhoff, CFA; Francis M. Kinniry Jr., CFA; and Michael A. DiJoseph, CFA January 2018

[2] Some individuals left for multiple reasons thus creating numbers that don’t add up to 100%. 

“When you first start to study a field, it seems like you have to memorize a zillion things. You don’t. What you need is to identify the core principles – generally three to twelve of them – that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles.”
 
                                                                            -       John Reed 

“Trying to figure out whether your core values are relevant in today’s world is a real struggle. We are told we can’t be a stick stuck in the mud, but we also can’t be shackled to out-of-date beliefs due to commitment bias. So which is it? All we can do is continually update our principles with new data, test them, and use a Bayesian approach. It’s not easy, but it’s the only way we know of updating our thinking in a rapidly changing world.”
                                                                           -       Hancock Brower 

Last week I wrote about how we approached our thinking at Nintai Investments by using a first principles approach. We’ve believed for a while - and seen evidence to reinforce this thinking - that this way of looking at the world provides us with a strong framework for analyzing long-term trends.
 
All that being said, I have found there are times when first principle thinking can lead you astray. The first large area of weakness is when the first principle thinker has little or no knowledge of the subject matter. In these cases it is possible for the person to get the entirely wrong end of the stick. Solid thinkers will realize in these cases that the first principle approach will be more powerful in asking pertinent questions than identifying basic building blocks of the subject matter. For instance, I’ve seen several brilliant first principle thinkers make terrible suggestions for improving the US health care system. In general, this is because the individuals have distilled first principles into facts that might seem as underlying the industry, but are rather far off from reality. As an example, some of the best minds have simply missed the fact that the US healthcare is made up of three distinct parts - federal and state social insurance (Medicare, Medicaid, etc.), for-profit corporations (Merck, Anthem, etc.) and not-for-profit organizations (Catholic Health Initiatives, Blue Cross Blue Shields, etc.). Any first principle has to address this very unique structure and how it might be improved. Ideas such as Medicare For All or a fully deregulated capitalistic health care system fall far from the basic realities of the current system.    
 
The second large area of weakness - and one that matters a great deal to traditional value investors - is when facts begin to emerge that fundamentally alter your first principles developed over time and experience. As an example of this, I have lived in a capitalistic system that has always operated under the principle that higher risk means higher rewards. This means that - in general - longer term bonds yield more than short term bonds (longer term agreements bear the higher risk of inflation than shorter term) or individuals/companies/countries with lower credit quality pay higher interest rates than those with great credit. Yet, we live in a time where the yield curve is not only inverted, but two additional facts are present.

1. As of the end of June 2019, the 10 Year US Treasury yield sat at 2.05% versus the Greek 10 Year at 1.98%. It’s hard to imagine the markets are trying to tell us the Greek government’s credit quality is better than the United States’.
2. As of the end of June 2019, there is $13T of sovereign debt yielding a negative interest rate. Negative interest rates? To this degree, this hasn’t happened in the history of modern finance.    

 
For many value investors (as well as economists and political consultants) first principles such as “higher risk/higher reward” have been falling like dominoes over the past decade. Yet, as I break down these realities down to their basic fundamental assumptions, they still make no sense to me. However, the old ways of doing things (analogies - like when I built out my first company) sometimes simply aren’t around anymore. 
 
To better understand what this means as a value investor, let’s break down the facts related to the $13T in negative interest rates. Utilizing first principle theory, we want to ask questions that will better define the main facts behind the theory - and practice - of central banks utilizing negative interest rates.

1. What is causing governments to issue debt at negative interest rates?
2. What impact does this have on the sovereign debt markets as well as larger overall debt markets?
3. What could cause this policy/market trend to end?

 
Question 1: Negative interest rates (as a government policy) were used by Sweden in 2009 when its Reserve Bank cut its overnight deposit rate to -0.25%. The European Central Bank was next when it lowered its deposit rate to -0.1% in 2014. Since then other countries in Europe and Japan have employed negative interest rates. Countries have employed negative interest rates for two reasons – trying to head off a deflationary cycle and to lower the value of their currency. In the former case, countries hope to stimulate lending (banks would rather lend - even at extremely low rates - than pay the Central Bank to hold their money) thereby heading off deflation. In the latter case, negative interest rates will weaken demand the country’s respective currency. A weaker currency will strengthen export demands and stimulate the economy.
 
Question 2: Certainly the greatest impact for most investors has been the stretch for yield. One of the side effects of that is seeing Greece 10YR yields be less than US 10YR yields. I don’t think anyone would confuse the fact that the United States sovereign debt has less risk than Greek sovereign debt. The second major side effect is that European and Japanese banks have seen their bottom line negatively impacted. Forcing banks to pay for parking their cash at the Central Bank - combined with low lending rates – is a recipe for decreasing earnings. As much as we would sweep these events aside, the bottom line is the $13T in sovereign debt and Greek/US yield abnormality are the reality of the markets as of today. Ugly facts are indeed still facts.
 
Question 3: The question is how this ends or - even more broadly - does this end? Obviously a stronger economy or rising inflationary rates will put an end to the negative rate environment. But what if the economies don’t improve? What if the United States dips into recession and its rates go negative? Then what seems like an anomaly becomes a new standard. The principle of higher risk/higher reward might become - for an extended time - irrelevant.  
 
Have Our First Principles Become Outdated?
 
So what’s a value investor to do? Are we destined to see this become a true “it’s different this time”? Or are we in a New Economy that was promised in 1999-2000? Have first principles – so long accepted in our capitalistic system – gone the way of the dodo? Or will we return to more classic economics that have driven capitalism since the time of the Dutch trading empire and Italian city states in the 15th and 16th centuries?
 
At Nintai Investments, we take a long-term view and see a middle-path going forward. The 2007- 2009 market crash and ensuing Great Recession fundamentally changed the way governments and their institutions see themselves in a capitalistic system. The interdependencies of the markets – along with risk whose depth and width is far broader than just three decades ago requires that sovereign nations find new solutions and roles for themselves going forward. Does this overturn the entire capitalistic/socialistic approaches that have driven US, European, and Asian economies over the last 50 years? We don’t think so.
 
But it does alter some of our first principles that have driven our thinking since getting into the business world all those years ago. We think some of the major assumptions we took for granted such as Keynesian economics (priming the pump), increasing multilateral approaches to the integration of the world economy (lower tariffs and international supply chains), and thoughtful, data-driven decision making will be altered or eliminated going forward. For instance - as an institutional investor - the very act of allocating capital continues to evolve. The long-term view continues to get shorter in length and decisions are increasingly made dependent on information from millisecond-driven social networks. Yet, increasing amounts of investors want nothing to do with high-fee, under performing active management. We see a current active managers have been swimming against only getting stronger. Has our first principles of patient, long-term investing based on valuation and margin of safety disappeared? We don’t think so. But it certainly continues to evolve.
 
Conclusions
 
In these topsy-turvy times, it seems like our guiding first principles have been eliminated as quickly and efficiently as the 1978 one-game playoff Boston Red Sox. However, we think it’s too early to write off some of value investing’s first principles. The bedrock concepts of value investing – valuation, margin of safety, and risk mitigation have not disappeared. But how we achieve these – and the frameworks we use to get there – have certainly changed in the last decade. Being able to adapt and evolve – while maintaining your first principles – has always been the mark of a great value investor. Whether it be Warren Buffett’s move from cigar-butt investing to great companies at fair prices or Nintai’s shift from quality balance sheets to hyper-quality balance sheets, if we don’t adapt then we die. By developing applying first principle thinking, the move along your own investing continuum doesn’t have to be - in John Foster Dulles’ classic phrase - an agonizing reappraisal. A well devised approach - as remarked on by Mr. Reed and Mr. Brower - can make evolution to your first principles as smooth as possible. In today’s raucous world, you can’t ask for anything more.
 
As always, I look forward to your thoughts and comments.
 
DISCLOSURE: None