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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

                                                                                        -     John Templeton 

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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