"We have so much to be thankful for in this time of economic growth and prosperity. The markets keep going on their upward trend, jobs are plentiful, and opportunity is there for any who want to make a difference. In essence - be thankful, humble, and honored to be living in these most bountiful times.” 
 
                                                                                          -         Gerald Nye 

“All through life there are opportunities in allocating capital - it might be your own time or money in personal development. It might involve investing capital – with time, money, or something else - in the company you work for. Or it might be investing capital into our country or system - building new companies, new products, changing the world. In a capitalistic-based system like the United States, we have a 230 year history of generating enormous returns on capital. Being part of that process is a remarkable opportunity and honor”.
                                                                                         -        Sam Hallowell  

In 1973 my family came across the Canadian border as part of an agreement to become United States citizens if my father would transfer his service to the United States Army. On that long car ride, I remember reading Lincoln’s Emancipation Proclamation and hearing the phrase “all persons held as slaves within any State or designated part of a State, the people whereof shall then be in rebellion against the United States, shall be then, thenceforward, and forever free”. It gave me goose bumps then and still does today.
 
During this holiday season, I give thanks for several events in my life that made so much of my later success possible. The first is coming to the United States at the height of its influence as a young white male. Demographics and timing made a huge difference in my life. Second, I had parents who insisted that all their children attend the best schools for their abilities. My attendance at an Ivy League school opened an enormous network to me. Third, right out of college I was introduced to the American system of capital allocation. I’ve never faltered in my thinking - though it is dented and tarnished these days - there is no better system in creating long-term value.
 
As I worked my way up the greasy pole in the investment world, I began to realize nearly everything I did - from personal development to professional training to my role as an investment manager, was really about allocating capital. Whether it was my personal time and money, or my client’s hard earned capital being deployed into the markets, my job has been to maximize return on capital. Now that I’m older and wiser, I realize that while all that is true, the real blessings have been that I have lived in a time and place that made that type of career possible. Sitting around the house having survived another delicious meal, watched another badly played football game, solved all the world’s problems in a series of increasingly emotional arguments, I usually come to feel a great deal of thanks for several key factors in my life.
 
We Still Have the Best Capital Allocation System
Over the years I’ve written extensively about some of the issues I’ve seen developing in our capitalistic system. Whether it be Jack Bogle’s wonderful analysis of the shift from owner’s capitalism to manager’s capitalism[1] or the constant battle fought over fees, I’ve taken some rather heavy pot shots against our current capitalistic system. Having said that, I still believe our current economic system gives the most people the best opportunity at achieving financial success. Every day, millions of citizens get out of bed with the intention of starting a new business, deciding where its best to allocate their company’s capital, or where to allocate their assets as they think about retirement. Is the system perfect? Absolutely not. Can it use a real deep cleaning? You bet. But every morning as I prepare for the work day, I know I’m building a company that provides my investment partners with the chance to see their capital put to work and make their portfolio  - and their country - a little bit stronger.   
 
As Shareholders We Have Rights….Use Them!
Along with the ability to freely choose how, where, and when I allocate capital comes the responsibility to act as an owner. Each corporate share I own is a piece of an outstanding business that has passed my investment criteria. Being an owner comes with responsibilities – reading corporate documents, voting for my board candidates, and speaking out when I agree or disagree with a substantive issue. I am grateful that I have the chance to exercise this control, though sadly it is a responsibility badly neglected these days by individual and institutional investors alike. Much like voting in political elections, most of the work is done for you as a voter. Ballots are frequently mailed to you or available online. If one expects to be a successful investor, then you need to be a successful owner. Be thankful you have the rights of an owner….and use them!
 
We Are A Nation of Laws
If you look around the world – both the developed and underdeveloped – there aren’t many countries where investors have a near implicit faith in the underlying legal, regulatory, and policy structures that support individual businesses and the greater markets. That exception (though again somewhat battered and beaten down) would be the United States’ capitalistic system. Though it isn’t perfect, investors in the US can be confident that contract law provides legal protection, that regulatory agencies (generally) look out for owners, shareholders, and other stakeholders in a fair and just manner. Anybody who has tried to work in other countries where the political system is a single-party monopoly or the courts are mouthpieces for the powers that be, have found investing - or even simply doing business - is an act of risk of the highest order. During this holiday, be thankful that - even if a handshake isn’t as solid as it was - contract law remains as a solid foundation of the US economy as it ever has been.
 
Conclusions
 
As another year winds down and my family gathers to celebrate Thanksgiving, it’s important that we give thanks to living at a time, in a country, and in system that allows us to fully participate in the economic life of the country. Whether it be investing in a rental property, being a silent partner in a friend’s new restaurant, or being the smallest investor/owner of the largest operating company on Earth, we are blessed to be part of the greatest, most successful experiment in capital allocation the world has ever seen. After all the left overs are gone, the long naps been taken (along with all that antacid!) and the in-laws have driven home, roll up your sleeves and be prepared to get back to work. Being an investor is both a privilege and responsibility. There is much to be grateful for at this time. Accepting that - and being aware of all that requires of you - is the beginning of a tremendous journey that will educate you and be profitable in far more ways than dollar and cents. We hope everyone had a wonderful Thanksgiving and wish everyone a happy and safe upcoming holiday season.  
 
DISCLOSURES: NONE
  

[1] Jack Bogle, former CEO of Vanguard argued that over the past several decades, ownership has shifted from a traditional owner’s model where the owner put up 100% of the capital, took 100% of the risk, and received the vast majority of the rewards. In the manager’s capitalism model, the manager puts up little capital, takes on little risk, but receives a great amount of the reward. Bogle felt (and I completely agree) this greatly distorted the values, ethics, and financial outcomes of the capitalistic system. 

“We shortened sail in degrees, rolling in the headsail regularly, then taking the main off completely. The ride was exhilarating as the “Gigi” would surf on the long crests, skidding and squirming at breakneck speeds until the wave outpaced her. I have a vivid memory of being picked up by a wave, sinking down into it like an artillery shell into a howitzer, and then firing forward as the wave top overcame the base and started to break. It was madness. I can also recall seeing fish in the wave curls that were higher than we were.”
                                                                        -    Sailing a Serious Ocean, North 54 

“The Horn lived up to its reputation again. In twelve hours its malign influences had transformed an innocuous summer low coming in out of the Southern Ocean into the most dangerous of storms, what old time square rigger sailors used to call a Cape Horn Snorter.”

                                                                       -    Derek Lundy, The Way of a Ship
 
For thousands of years, human beings at sea were at the mercies of whatever direction the wind was blowing. If the wind was blowing in the direction you were going (known as “running” - hence the phrase “running with the wind”) that made things pretty easy. The difficulty began when you started the trip for home and you had to sail directly into the wind. With the physics of sails (which I will be mercifully brief about), one couldn’t just sail into the wind. Two basic principles made this impossible. The first is leeward drift or drag. This means the boat will inevitably drift in the course of the wind. Some boats are known as being particularly good at reducing such leeward drift. Others are sometimes referred to as “those horrible old f’ing Dutch buggers” - well…you get the drift (no pun intended). The second principle is lift. No different than airplanes, this is when you put an aerodynamic foil into the wind and have the air pass more quickly on one side and more slowly on the other, thus creating a force perpendicular to the sail. Using lift, a boat can sail somewhat into the wind (known as “reaching”). By utilizing multiple reaches (known as “tacking”) the sailor can make it home even with the wind against them. The most dangerous position for a sailor is to find the leeward drift exceeds their ability to reach. In these situations, if the boat can’t anchor it will be driven to leeward against the sailor’s will (known as the “horrors of a leeward shore”) until hits whatever object it first comes upon.
 
I bring all this up because over the past decade it seems like value investors have been sailing into relatively strong and steady winds and facing harsh leeward drift. For many, the horrors of a leeward shore are all too real by now. This thinking was captured quite eloquently in a recent Morningstar interview with Charles de Vaulx, Chief Investment Officer and portfolio manager at International Value Advisors. Previously de Vaulx was portfolio manager at First Eagle Global and First Eagle Overseas. The full interview “Charles de Vaulx: Why Value Investing Has Slumped but Will Rebound” can be found here (Morningstar premium membership required). I try not to shamelessly steal from someone else’s intellectual efforts, but I thought the concepts laid out in the interview were powerful enough to “forage liberally” as William T. Sherman so famously said.
 
Value Advisors International (IVIOX) and de Vaulx have certainly been victims of strong headwinds. The funds positioning in its category (Foreign Large Blend) quartile rank has been hard for managers and investors alike: 98th percentile YTD, 97th percentile 1 year, 99th percentile 3 year, 80th percentile 5 year, and 23rd percentile 10 year. But de Vaulx and his team aren’t tacking repeatedly and altering course on a regular basis. They believe their approach remains consistent with achieving long-term outperformance.  
 
In his interview with Morningstar’s Christine Benz and Jeffrey Ptak, de Vaulx discusses three trends which have provided tremendous headwinds for his funds and fellow value investors. The first is the three-decade long trend of lower interest rates. The steady decline has affected value investing in several ways. This includes DCF model discount rates, corporate free cash flow (as a percent of interest costs), and economic modeling results. The second trend is the pressure put on corporate managements to put low-earning cash to work, particularly in regards to corporate stock buybacks. The last trend is the Federal Reserve’s impact on business cycles making them shallower and longer. This has reduced stock price volatility and thereby investment opportunities for value investors. In combination, these have created such strong headwinds that value investors have seen a reduction in opportunities - and correspondingly results - since the early 1980s.   
 
 
 
 
 
A 36 Year Headwind: Interest Rates
 
Starting in 1982 - following Paul Volker’s aggressive efforts to wring inflation out of the US economy – interest rates have fallen from double digits to nearly negative in the US and truly negative around the world. Anybody who uses a discounted free cash model know the double impact of time and discount rates on corporate valuations. In an article from March 2019 (“Looking Back at Nintai’s Discounted Free Cash Flow Model” which can be found here), I discussed the impact of the discount rate on my estimated intrinsic value. The bottom line is that getting that rate wrong can dramatically impact your investment case – sometimes destroying it altogether.
The Federal funds rate dropped from its high of 20.6% in June, 1981 to its low of 0.06% in July 2011 (it has since jumped to 1.6% in November 2019). This represents a remarkable 98.6% drop. If we take a look at current Nintai Investments holding Veeva (VEEV), let’s see the impact of increasing aggressive changes in the discount rate on the company’s valuation.
 
As of November 2019, the stock trades at roughly $156 per share. In our discounted free cash flow model, we currently use a discount rate of roughly 7.5%[1]. Utilizing a 10-year time frame, we estimated the intrinsic fair value at around $173/share or an 11% discount to the current price. If we raise the discount rate by 3% to 10.5% the estimated intrinsic value drops to $89 per share or a decrease by nearly one-half. A 40% increase in the discount rate cuts the estimated intrinsic value in half! If we invert this, then it’s easy to see the three decade trend of falling rates puts a near perpetual increase in the discounted free cash flow-generated intrinsic value. If we look at a company like IBM, nearly 85% of the increase in stock price since 1982 can be explained by the falling discount rate. That doesn’t leave much room for finding a bargain price during that time.    
 
A Fake Floor: Stock Buy Backs
 
If the falling discount rate helped create an inflated stock price over the past 35+ years, then the growing trend of stock buybacks has helped solidify the concept of a fake price floor. Companies have spent hundreds of billions of dollars over the past
 
decade in repurchasing their stock. In some cases this has reduced overall outstanding shares by 40, 50, or even 60%. Some of these have been examples of outstanding capital allocation. In other cases companies have spent billions of dollars simply repurchasing the vast amount of options handed out to management. In these cases the number of outstanding shares have not gone down – and in some particularly egregious examples – outstanding shares have actually increased. No matter how these transactions add up, they frequently create a fake floor whereby potential investors see an illusionary minimum share price.
 
Using IBM as an example again, since 2004 the company has spent $148B repurchasing stock. That comes out to be roughly $1B each year. During that time total outstanding shares went from 1.7B to 893M – or a 47% in outstanding shares. In that same period earnings per share went from $4.38 per share in 2004 to $8.61 per share in 2019. Of note, earnings per share were $8.89 per share in 2008, peaked at $14.94 per share in 2013 before descending each year hitting $8.61 per share in 2019. You might think at some point such disappointing performance would create some fairly opportune buying moments, but sadly not. The company’s P/E ratio never dropped below 10 between 2004 – 2019. Rather it averaged nearly 15 during that time period. For a company that showed zero growth for 11 years (2008 – 2019) and a nearly 45% drop in earnings over the past 6 years (2013 – 2019), it seems the PE ratio was inflated beyond reason. I suspect the repurchase of shares played a role in convincing shareholders to pay a rather high premium for IBM shares. It would be interesting to hear Warren Buffett’s thoughts on this after his experience as an IBM shareholder.     
 
A Case of the Dog Not Barking: The Lack of Business Cycles
 
Perhaps the most interesting concept raised by de Vaulx was the dramatically different length and scope of business cycles in the US over the past two centuries. Utilizing data from Sanford Bernstein’s “An Economic History of Now” (which I highly recommend), de Vaulx points out the fact that the average time of economic expansion has increased dramatically (25 months in the 19th century, 44 months in the 20th century, and 101 months in the 21st century) while the average economic contraction decreased equally in magnitude (the average depth of GDP decline was 3.7% in the 19th century, 4.3% in the 20th century, and only 2.1% in the 21st century).  
 
 
So what’s happening here? In de Vaulx’s view – and I completely agree – the
decreased volatility in terms of time and magnitude has reduced the opportunities to employ value strategies. With smaller time frames and vastly decreased magnitude of contractions (investors in the 21st century have seen GDP declines be less than half those of the 20th century), the ability to capture inefficiencies in the market have dropped correspondingly.  
 
Conclusions
 
For any sailor who has spent an entire day beating into the wind, tack after tack, seeing their destination seemingly getting no closer, the limits of patience may be reached. They will employ every trick in the book to lay half a point closer to the wind. It’s no different for many value investors. The last ten years have been like that for many value investors. They’ve tried every trick in the book but unfortunately – as de Vaulx has so eloquently pointed out – the headwinds faced by these investors have been insurmountable. That said, I actually don’t think all is lost. Over the last 12 months we’ve seen volatility increase both in scope and length. The rapid drop – and size of it – at the end of 2018 brought many investors up short. Certainly anyone watching the VIX index and the drops in the major indexes thought the return of old fashioned value was upon us.   
 
At Nintai Investments we’ve done everything possible to create a weather proof boat design (think of this as your portfolio strategy and holdings), that can reduce the risk of rising seas while maintaining as much headway as possible (think of Nintai’s “Quality Portfolio/Value Pricing” from our last article), and has the strength to survive extraordinarily long voyages (think of Nintai’s companies that are decade long in their holding time). Whether you see it as a vessel to help you travel the globe or an investment vehicle to meet your retirement goals, there ARE ways to help defeat de Vaulx’s three great headwinds. I highly recommend readers review the Morningstar interview, take notes, and identify the issues as they exist in your portfolio. You might just find you have an all new confidence as you put to sea in your latest investing journey.
 


[1] The discount rate is made up of the current 10-year treasury rate (1.74% as of November 2019) plus factors for the company size, financial leverage, cyclicality, corporate governance, economic moat, and complexity. 

“We’ve really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.
​
                                                                            -         Charlie Munger 

“The risk of paying too high a price for good-quality stocks - while a real one - is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.
                                                                          -          Benjamin Graham 

Since the 2009 bottom of the 2007 - 2009 market crash, we’ve had an over decade-long market expansion which has provided investors with the longest bull market in recent history. For those at the end of their investing career, this has been a huge tailwind allowing for far more generous performance any would have thought possible. During these types of market runs, the old adage of “a rising tide raises all boats” certainly rings true. Just look at these returns for 2019: Dow Jones up 21.7% YTD, NASDAQ up 28.2% YTD, S&P 500 TR up 26.1%, Russell 2000 up 18.9%. Every sector is up double digits in 2019 with the exception of Energy Capped (up 5.1% YTD). All other sectors range from a low of Healthcare (up 15.8% YTD) to a high of Technology (up 38.5% YTD). With such returns every investor is a hero of their own financial story.
 
I thought I’d take a different tack in this article to explain why Nintai Investments sees the past five years less through rose-tinted glasses and more through lenses that always see risk around the corner. Since opening our new investment services business in 2018, we’ve both underperformed (in the first year) and are now outperforming when measured since inception. We’ve really come into our own over the past quarter as the markets recognized the value of high-quality companies with strong returns on capital, equity and pristine financials. Our returns over the last 3 months have been 10.77% compared to the S&P 500’s 6.71%. (Note: past performance is no assurance of future returns). Our returns have been 15.72% (including fees) since inception versus the S&P 500’s 13.87%. This isn’t to boast about our performance (though we - and our investment partners - are pleased) but rather to point out that we believe Nintai’s approach of purchasing extremely high quality businesses at fair prices and holding them for extended periods can outperform both bull and bear markets (again: past performance is absolutely no assurance of future returns). As we look around and see record highs all around us, at Nintai we continue to clear the deck for foul weather and prepare for the inevitable (significant) market correction. With that in mind, I thought I’d discuss Nintai’s approach and the relatively simple process we employ in meeting our strategic goals.         
 
Better Quality, Cheaper Prices
 
At Nintai we believe in a fundamental investment concept. If we invest in a bucket of companies with significant advantages in quality (higher returns on capital, equity, assets, free cash flow margins, no debt, etc.) combined with valuations (a blend of cheaper attributes including estimated intrinsic value from our DCF models and cheaper PE ratios), over the long-term we can expect to outperform the broader markets. 
 
The concept of purchasing higher quality companies or looking to purchase shares at a discount to estimated intrinsic value isn’t anything new to the value investment community. I have found it is rarer to combine the two as a foundation for your investment strategy. When I utilize Morningstar’s portfolio manager research tools to find funds with a high match rate to Nintai’s holdings, I’ve found only 2 (two!) with a greater than 25% overlap with our portfolios. With numbers like this, you can see it’s rather rare to find the concept carried out on a regular basis. What’s equally rare (as far as I can see) is articulating the idea that the highest quality companies purchased at good prices can provide significant downside protection during a bear market. In general, I’ve found that companies and management that generate great returns on capital and have little or no debt are businesses that thrive in bull or bear markets and in expanding or recessionary economic times. Combined with holding significant cash, I feel comfortable that when the inevitable market tumble comes along, I’ve reduced the risk of capital impairment as best as I can in today’s markets. 
 
Nintai’s Abacus reports give a quick graphic overview in how we are doing in meeting the goals of a portfolio consisting of outstanding quality at value prices. Later on, I will walk readers through the summary report and take a look at how we are doing in meeting Nintai’s investment strategy.

It All Starts by Finding Corporate Excellence
 
Any research we do at Nintai starts with locating companies with outstanding business characteristics. We locate these in multiple ways – GuruFocus’ All-in-One Screener, conversations with thought leaders, meetings with corporate executives, etc. Once we’ve found a company that meets our criteria we will begin the in-depth process of really understanding the company’s strategy, products, markets, competitors, etc. If we’ve done our job we can run a summary “Quality” report on Nintai Abacus and make sure the portfolio is meeting our strategy.  
 
Let’s use a blend of our investment partner portfolios to demonstrate what I mean by a “Quality” summary report. In November 2019 on average, the Nintai Investment portfolios shared the following attributes: return on capital (42.8%), return on equity (31.7%), and return on assets (19.2%). This compares to the same numbers for the S&P500 (source: Morningstar’s “Portfolio X-Ray” reporting function): return on capital (3.28[1]), return on equity (1.21), and return on assets (2.11). These numbers show that – in general – Nintai’s portfolios have created a basket of holdings far more profitable than the S&P 500. Additionally, the debt-to-equity ratio of the S&P 500 (as of August 2019) stood at 0.89 (source: Haver Analytics and Standard & Poor’s) versus 0.023 for the Nintai portfolios.
 
Why are all the numbers important? First, a basic tenet at Nintai Investments is to prevent permanent impairment of our investment partners’ hard earned capital. We’ve found over time that companies with little or no debt[2] and who are also highly profitable (both from a free cash flow perspective as well as capital returns) minimize that risk. Second, we’ve found that management teams who act prudently with their investors’ capital are great stewards to partner with over a decade or two. Last, companies with these characteristics are generally outstanding businesses with outstanding fundamentals and deep competitive moats. All three of these play a vital role in preventing a blow up in the portfolio that can lead to truly horrendous losses. At Nintai, everything begins by investing in outstanding quality.      
 
Finding Value in a Value Investment Strategy
 
Finding outstanding, profitable, and prudent companies is of course only half the battle. Buying them at a discount to my estimated intrinsic value is the second piece of equally important halves. In finding value, we use two different and distinct methods. The first is company specific. We utilize a discounted free cash flow model to ascertain the value of each individual holding (or potential holding). As this information is proprietary, I will simply say the aggregate price-to-value ratio for the Nintai portfolios is currently 0.91. This is to say our portfolios currently trade at a 9% discount to our estimated intrinsic value. Values range from 137% (overvalued) of our estimated value to 72% (undervalued). As a portfolio of individual stocks, we see some investment opportunities in several holdings trading at significant discounts to their estimated intrinsic values.     
 
The second approach we take to value is comparing the total portfolio to the S&P 500. This gives us an idea as to how the portfolio’s value is to the general markets. While we put a great deal of effort into the DCF model, we think looking at the broader markets is equally valuable. There are two numbers we look for in these market reviews. The first is how our portfolios’ price-to-earnings ratio look against the S&P 500’s ratio. This tells us how expensive the portfolios are against the broader markets. The second is analyzing the portfolios’ 5-year earnings growth projections against the S&P 500. This gives us a look at whether we are paying more or less for future growth versus the general markets.
 
The S&P 500’s price-to-earnings ratio - as of November 2019 - (source: www.multpl.com) stood at 22.95. The Nintai portfolios’ average price-to-earnings ratio was 18.8 at the same time - an 18.1% discount to the S&P 500 PE ratio. This tells us the Nintai portfolios are currently trading at a significantly cheaper rate than the S&P 500. Great news. In addition, the Nintai portfolios have a 5-year estimated earnings growth rate of 11.1%. This is roughly 17% greater than the estimated S&P 500 rate. We now know the portfolios are cheaper than the S&P 500 as well as estimated to grow earnings significantly faster. What’s not to like about those statistics? 
 
Putting It All Together
 
While it’s nice to have these numbers at our fingertips, they aren’t really that helpful to our investment partners. We created the Abacus reporting system to graphically demonstrate the quality and value components of each portfolio. This allows investors to use a single graphic to measure how their portfolio stacks up against the S&P 500. Seen below is a summary portfolio report of all the Nintai portfolios wrapped up in a single page report.

Our investment partners have a tendency to look at the rating arrows (all green is what they are looking for here) and ask any questions related to those. At the core, the graphic quickly encapsulates:

• Does the portfolio meet our quality criteria in general and against the S&P 500 specifically and;
• How does the portfolio compare in value against the S&P 500?

 
A number we look at carefully is the combination of the S&P 500 P/E relative number as well as the S&P 500 projected EPS growth relative number. Here we combine the fact that the portfolio is 18% cheaper than the S&P 500 and is estimated to grow 17% faster giving us a 35% “combined value rate (CVR)”. We are satisfied with a CVR over 25%. We have nearly always outperformed over the next 3 - 5 years if the number exceeds that amount. Equally important is adding up the S&P 500 relative number for ROC, ROE, and ROA. Here we look for a sum called the “combined quality value (CQV)” greater than 5. The current portfolio CQV is 6.6.
 
Why This Matters
 
A lot of readers will point out that looking for quality at good prices is just common sense. I completely agree. Yet its extraordinary to me that so few investment managers practice such an investment strategy. All too often I see far too active trading (even when a manager might own great companies), or a lack of concern about debt and credit quality. If you own a basket of outstanding companies with a long runway for growth, at Nintai we feel this tackles several issues. 
 
Watch Out Below
As mentioned earlier, one clear advantage of focusing on value and quality is the protection it provides on the downside. I wrote several years ago about how the highest quality stocks in our portfolios had performed the best during the 2007 - 2009 market crash. I firmly believe we will see similar movement when (and remember it’s not if – but when) the next crash happens. After an 11 year old bull market, I think the downside protection is worth even more. As a fiduciary steward, there is nothing more important than focusing on preventing the permanent impairment of my investment partner’s capital. I firmly believe a focus on quality and value is one of the more powerful tools in my arsenal to prevent such losses.
 
Let Management Do the Heavy Lifting
It’s been demonstrated many, many times that just a few items can severely damage investment returns over the long term. Under the broad category of “costs”, lie both transactional fees and taxes. One of the real benefits investing in a high quality stock at good value is the ability to hold it for the long term - meaning decades sometimes. This cuts down on transactional costs as well as any short or long-term capital gains. Why not let management allocate capital and do all the hard work when it comes value creation?
 
Finding Quality is a Difficult Task
While it may seem like a simple concept, finding quality at a value price is actually a rare and difficult thing to find in today’s market. Utilizing just Nintai’s quality measures (and not worrying about value pricing) leaves our team with less than 200 companies in the US and European markets. In addition, the company has to be in an industry, geography, business strategy, etc. that leads us to think we might be able to obtain a small knowledge-based competitive advantage against other investors. When we find a gem that meets all this criteria, at Nintai we are loathe to let them go.
 
Conclusions
 
As the latest bull market gets long in the tooth (and it’s narwhal long!), at Nintai we increasingly focus on the downside risk of the markets. We’ve found over time that two approaches serve us well in the latter stages of a bull market and for the duration of a bear market – hold significant cash and focus on quality. The (relatively) simple process of identifying outstanding companies with high returns and rock solid financials and purchasing those at fair value-based prices can cut down on risk dramatically. At Nintai, we highly recommend investors take a long hard look at their portfolios and look for companies and management that they can partner with over the decade or two. It’s hard to find ways to argue with Munger and Graham simultaneously. With a record like theirs, why even try?
    

“The two most powerful warriors are patience and time.”
 
                                                                     -      Leo Tolstoy 
“Great leadership is about continual change. An outstanding leader is always seeking opportunities in failure and always seeking improvement from success. Patience is key, but does not guarantee long-term prosperity.”
                                                                    -       Iwasaki Yatarō 

In Japan, the Sengoko period (or as translated into English “The Age of Warring States”) ran from roughly the mid-fifteenth century and ended with the Battle of Sekigahara in 1603. During that time, Japan was engaged in nearly constant civil wars as a series of very powerful regional leaders known as dâimyo battled to become the sole leader (the Shogun) of the country. One such leader named Takeda Shingen was considered an odds-on favorite - a great military leader, a wise civil administrator - he certainly had the credentials. Unfortunately, he ran up against two other leaders - Oda Nobunaga and Ieyasu Tokugawa - who would eventually precipitate his downfall. In a likely apocryphal story, a lead retainer sat with him and told him a story about a prince who worked hard at becoming the leader of his province. This prince spent all his time building, tearing down, fighting wars, and then rebuilding. It suddenly dawned on this prince that if he had simply been patient - allowed his population to grow, used a growing tax base to build out infrastructure, and so forth - he would have been far more powerful. In being so active, the prince had lost track of his greatest asset - time. Takeda recognized the point of his retainer’s story immediately. But by then it was too late. Within 5 years Takeda’s entire kingdom and family would be gone.
 
I bring up the story of Takeda Shingen because many investors see their investment world through his eyes. They feel action is necessary to achieve success. That through inaction they are somehow losing a step on their road to financial success. Yet study after study has shown that inaction is a good thing. It cuts down on costs, it allows compounding to work its magic, and it allows an investor to get on with the most important things in life - living.
 
Why Time Matters  
 
It’s amazing when you think about. What is the only force guaranteed to fill in the mightiest competitive moat? Time. Have you ever seen the greatest monopoly beat Father Time? What strongest empire, what greatest military power, what most violent tyrant has ever beat out time? Who is the sibling of compounding that makes it the eighth wonder of the world? It is time of course. For compounding cannot grow, cannot prosper, nor create any change at all….without time. What is the cheapest asset in all the investor’s arsenal of weapons? Time! It costs nothing, it has no ego, it will not fight with you, it will simply and quietly provide you with companionship every step of your investment journey.
 
Outstanding businesses will utilize time as an asset to grow competitive advantages, open new markets, and deploy existing capital into profitable growth. At Nintai, we look for managers who find ways to create business growth where return on capital far exceeds weighted average cost of capital. Combining this in a business model that requires little capital to begin with (thus allowing for the creation of a fortress-like balance sheet), leadership has created a business with a long runway of profitable growth. At Nintai, we look for companies where that profitable growth and strong balance sheet can be estimated to survive - and thrive - for decades.   
 
Is There Such a Thing as Too Much Time?
 
Some of my readers might be thinking at this point that this is another article on the value of time and money (which I’ve written about previously). But as Robert Abbott has pointed out, I have a passion for inverting many issues. Why should the concept of time be any different? So today I thought I’d look at when time is the enemy of your investment holding. Much like Shingen, great companies can let time eat away at their advantages – ranging from competitors to regulatory approvals. Every quarter – when Nintai Investments quickly reviews portfolio holding performance – we keep an eye on several numbers that might reflect that time has eaten away at our investment case. If any changes in these areas show up, we will completely take apart the business case developed earlier in the year and rebuild it from the ground up.
 
Falling Return on Invested Capital (ROIC)
The first item we look at is to make sure management is still allocating capital at exceptional rates. ROIC is the amount of return a company makes above the average cost it pays for its debt and equity capital. If the holding is going to continue to generate long-term outperformance, it is vital that ROIC exceed the company’s weighted average cost of capital (WACC) by a generous margin. A fall in ROIC can tell you management has taken its eye off the ball in several ways - it might be having difficulty in finding profitable investment opportunities, competition may be cutting into core customers and industries, or might just have simply invested in some truly unfortunate ventures. Falling ROIC can sneak up on you. If you think Boards and management will keep an eye on it for you, think again. In a 2013 survey by McKinsey (McKinsey Quarterly, “Tapping the Strategic Potential of Boards”, February 2013), less 16% of Board members knew that ROIC is the primary driver of value. If you believe ROIC is such a powerful driver - which I do - then I highly recommend keeping a close eye on ROIC.   
 
Falling Free Cash Flow Margins
As a value investor who utilizes a discounted free cash flow model to calculate value, free cash flow (FCF) is one of the most important margin numbers I watch (compared to say gross or net margins). At the end of the day, cash keeps the doors open and free cash allows management strategic flexibility in terms of future capital allocation of returns to investors. FCF margins can drop for several reasons but the one that gives us the greatest concern at
 
Nintai is losing the ability to price products and services. Many great companies share the same attribute of making their product in the daily operations of their customers. It almost makes it impossible for the customer to haggle or obtain pricing power over the long term. Think of Guidewire’s (GWRE) InsurancePlatform which operates many property and casualty insurers claims, billing, and policy functions. The amount of effort it would take to change vendors, remove one system, install a new one - all while maintaining consistent uptime and coverage - is a difficult action to justify. Another reason might be a large increase in capital expenditures which might reflect the same type of problem - having to increase spending to fend off competitive inroads to a holding’s customer base. When I see a significant decrease in FCF margins, this will generally have a direct impact on my discount model’s valuation. It’s never a great way to start the day.    
 
Drop in Cash or Increase in New Debt
Another sign that will catch my attention is to see a drop in cash on the balance sheet or - more importantly - the issuance of new debt. Generally, Nintai Investments runs a focused portfolio of roughly 20 - 25 position. Of these, roughly three-quarters will have no short or long-term debt. Occasionally, companies will issue debt for larger capex projects or acquisitions. Examples this might include Nintai Investment holding Novo Nordisk (NVO) which usually runs a very tight balance sheet with very little short-term debt (in the tens of millions of $$) versus having billions of dollars or short term instruments. The company has recently expanded its debt for new acquisitions. Obviously we want to see these type of deals generate high ROIC and see real value from the risk generated by a weakened balance sheet. Another example which we see an a wholly negative light was former Nintai Partners holding Qualcomm (QCOM) which took on an enormous debt obligation to fund share repurchases. No matter the calculations made, we see this type of action indefensible related to investor risk/reward. In many cases these types of transactions are simply a transfer of wealth from option-enriched managers hitting pay dirt when investors buy back millions of shares at inflated prices. In Qualcomm’s situation, we sold out of our entire position and never looked back.  
 
Conclusions
 
Investing in a small business that generates high return on capital, equity, and assets, has high free cash flow margins, and deep competitive advantages can be a wonderful partnership that lasts for decades. It’s the backbone of our investment strategy at Nintai Investments LLC and has provided the firm and its investment partners with outstanding returns since 2002 (of course past performance is no assurance of future returns). Having said that, finding companies where time aids in their growth and only strengthens their businesses is hard work. Time can erode any competitive advantage, fill any moat, and weaken any management team. Keeping an eye on several core measures can make sure you move on in a timely manner. Change happens. None of us like it. But I guarantee you none enjoy it less than lose who some of the core building blocks of their portfolios or daily living. Just ask Takeda Shingen.
 
DISCLOSURE: Portfolios that I personally manage are long GWRE and NVO. Nintai has no position in QCOM.    
 

“The world as we have created it is a process of our thinking. It cannot be changed without changing our thinking.”
                                                             -        Albert Einstein
 
“I’ve always been warned that when people say ‘it’s different this time’ it really isn’t very different. Yet if I look back over the last decade and I see so much underperformance by value investors (both traditional and the more modern-approach), I think to myself, ‘is it really different this time? Does value investing not work anymore’”?  
                                                            -         Sally Jenkins 

In my past few articles, I’ve discussed the distinction between growth and value investing, value’s difficulties since the 2007 - 2009 market crash, and how that has been part of a greater discussion about the viability of value investing in today’s markets. In this article, I thought I’d tie together the two themes and - at a very high level - summarize what the last decade has told us in terms of investment learnings and how we might come to terms with the over decade-long short circuiting in value investing performance.
 
At Nintai, we divide the market returns since the height of the technology bubble into four phases. Phase one was the run up into the technology bubble running roughly from 1998 - 2000. Traditional value investors - in general - did poorly as they continued to invest along more classic value investing guidelines. Many value investor shareholders began to get nervous as they opened their returns and saw underperformance being led by such staid companies as industrial parts supplier Fastenal (FAST) or spectrometry provider to biopharma Waters (WAT).[1] Some truly great investors closed their doors at the height of the bubble commenting on the fact they simply didn’t understand the market anymore. Phase two was the period of 2001 - 2006 when value investing roared back and more traditional companies like Proctor & Gamble (PG) or Coca Cola (KO) saw great returns while technology stars of the bubble sustained losses of up to 90% or even bankruptcy. It was rare to see such a clear vindication of value investment theory and practice. Phase three was the market crash of 2007 - 2009 led by the financial and credit markets starting with Bear Stearns and Lehman Brothers all the way to the government interventions of Fannie and Freddie Mac. There was a huge distinction though between the bursting of the technology bubble and the bursting of the credit/real estate market bubble. In the latter, many traditional value investors lost as heavily (and sometimes even more) as the general markets and even growth investors. Famous value investors who had been hailed as geniuses just half a decade before were chalking up 30, 40, and even 50% losses as their traditional value methods of using low price-to-book or price-to-revenue models imploded. Phase four added to the agony as the general markets powered through a nearly decade long recovery. While this was happening, traditional value returned paltry returns in what traditionally would have been a golden era for that investment style. Rather, you saw an entire generation of value investment leaders struggle for the entire decade. It was reflected in returns and even more importantly in their assets under management. The list is long and well-respected. Marty Whitman ($4.6B AUM in 2011 to $1.19B AUM in 2019), John Hussmann ($5.4B AUM in 2011 to $350M AUM in 2019), and David Dreman ($5.3B AUM in 2011 to $220M AUM in 2019).  Wally Weitz can be considered a success by seeing a rather slim increase in AUM (going from $2.3B in 2012 to $2.52B in 2019). Perhaps the harshest lessons were learned by David Winters, going from value investing rock star and CIO of Wintergreen Fund with $1.5B in AUM in 2012 to shuttering his doors in 2019 with less than $90M in assets. This humbled writer/investment manager had a dismal record with my own corporate internal fund (and eventual Charitable Trust) which was outperformed 4 out 5 years from 2011 - 2015 before I left the fund for greener pastures.
 
Is Value Investing Dead or Has It Simply Genetically Evolved?
 
In a recent Westwood Insights (“Value Stocks are Screaming for a Reversion to the Mean. Is Anyone Listening?”. It can be found here.) there is a segment describing the end of Julian Robertson’s career in March, 2000. It reads:
 
“It was an unseasonably warm 58 degrees in New York City on March 30, 2000. Winter white was just a faint memory on that Thursday, and the thoughts of bustling commuters had turned to spring. All was not balmy in the canyons of Wall Street, however, as the shock heard around the investing world had been announced that morning. Before the New York Stock Exchange opened, value investing legend Julian Robertson, age 67, announced that he was calling it quits, and would return the $13 billion that he managed to his 700 shareholders. He planned to shut down his fund and walk away.
 
At his fund’s peak in 1998, Robertson managed $22 billion, but he had seen withdrawals of $8 billion over the previous two years, including $1 billion in the first quarter of 2000. His fund had lost 19 percent in 1999, badly trailing the 21 percent gain in the S&P 500 index. He had lost another 14 percent in the first quarter of 2000. The New York Times summed up his predicament the day after his announcement, saying that Robertson ‘had essentially decided to stop driving the wrong way down the one-way technology thoroughfare that Wall Street has become.’
 
Robertson, a giant of the hedge fund and value investing worlds for more than 30 years, was a casualty of the technology stock euphoria that the prior five years had wrought on traditional value investors. ‘I’m not going to quit investing. I don’t mind people calling me an old-economy investor, but it doesn’t go over well with the clients,’ Robertson noted in his farewell.”
 
With the nearly decade-long underperformance (nearly twice as long as Robertson’s), that last paragraph wrings eerily true for many value investors as they gaze back at their record. It certainly hasn’t gone over well with their clients as well. But is it enough to simply say these days that value investors are just “old-economy” or is there something far more fundamentally wrong here? Is the very structure and model of value investing broken? 
 
Looking back over the last decade, I would argue value investing was already evolving before this last decade. Thinking and strategy had started to bifurcate as two distinct approaches began to appear. The first was based in the more traditional lower price-to-book and lower price-to-earnings (such as looking for companies with less than a 12-15 P/E ratio). These types of investors are generally descended more from the Ben Graham risk-focused, cigar-butt DNA.  The second approach - sometimes referred to as value investing 2.0 - is more in the what was referred to as GARP (growth-at-a-reasonable-price) investing. As an example, this is where a value investor is willing to place value on less-traditional assets such as technology or informatics platforms than a physical manufacturing plant or equipment (I confess I fall clearly in the latter category). What makes this dichotomy interesting is that value investors (2.0) have generated better returns over the last decade than the more traditional value investors. Part of that seems to be based on investment strategy (where growth stocks have been outperforming value) and part of it on individual stock selection (higher quality stocks have done equally well - if not better in some cases - than less quality picks).   
 
Putting aside the debate about more traditional value investing and value investing 2.0, the great question is whether value investing - in general - has gone the way of the dodo or great auk. One side of the argument argues that value investing (defined as low price/book ratio) has actually performed as you would think it would (meaning neither out or underperformed). It has been growth investing that has significantly outperformed its benchmarks over the past decade. In a recent report from Dimensional Investing (“Value Judgments: Viewing the Premium’s Performance Through History’s Lens” which can be found here), the authors discuss the fact that value stocks actually have underperformed growth stocks 11.4% to 14.7% for the period 2010 – 2019. But the way we look at this underperformance is likely skewing the debate about the longer term viability of value investing. The authors contend the issue is less about value stocks underperforming but more about growth stocks outperforming. They go on to demonstrate that value stocks over the past decade have traded similar to what you would expect over a longer-term duration that include several market cycles. Value stock decade-long (2010 - 2019) returns of 11.4% track closely to their 11.9% return since 1979. The interesting data show up in the growth stocks. This segment’s previous decade (2010 - 2019) returns of 14.7% have far outperformed their 11.3% return from the period 1979 - 2019. Dimensional can’t isolate any particular reason why growth stocks have achieved such abnormally higher returns over the past decade. The authors say the data do not support any of the theories proposed by market analysts including low interest rates, quantitative easing programs by central banks, and the outsize influence of the so-called FAANG stocks, a group of stocks that include Amazon (AMZN), Apple (AAPL), and Facebook (FB). In this thesis, the bottom line is that value stocks (as defined by Dimensional) have produced similar returns over both decade-long and three decade-long time frames. The simply have not been able to keep up with a decade-long outperformance (for which we can’t account) in growth stocks.
 
Others Say Not So Fast
 
Another school of thought has developed counter to the thinking of Dimensional’s theory. An example of this is a recent paper by Baruch Lev and Anup Srivastava entitled “Explaining the Recent Failure of Value Investing” (it can be here). In the abstract of their work, they summarize their view that value investing’s best days are behind it:
 
“It is widely believed that the long-standing and highly popular value investing strategy—investing in low-valued stocks and selling short high-valued equities—lost its edge in the past 10 - 12 years. The reasons for this putative failure of value investing elude investors and academics, making it a challenge to assess the likelihood of the return of value investing to its days of glory. Based on extensive data analysis we show that value investing has generally been unprofitable for almost 30 years, barring a brief resurrection following the dotcom bust. We identify two major reasons for the failure of value investing: (1) accounting deficiencies causing systematic misidentification of value, and particularly of glamour (growth) stocks, and (2) fundamental economic developments which slowed down significantly the reshuffling of value and glamour stocks (mean reversion) which drove the erstwhile gains from the value strategy.”
 
The author’s argument in many inverts the thinking behind the team at Dimensional. They believe the overperformance of value investing post-technology bubble was not the mean but rather an anomaly in a longer history of underperformance since the late 1980’s. They state (somewhat in agreement with Dimensional) that there is no specific market-driven item that can be identified as eliminating value’s edge. Rather, they believe it was changes in how we value companies – rather than process of picking low P/E stocks – that eliminated value investing’s edge. From their paper they write:
 
“The expensing of intangibles, leading to their absence from book values, started to have a major effect on financial data (book values, earnings) from the late 1980s, due to the growth of corporate investment in intangibles. This book value mismeasurement was a major contributor to the demise of value investing which started in the late 1980s.”
 
The failure of value investing during the credit/real estate crash of 2007 – 2009 layered on another shift in economic changes (not market changes). They state that more traditional value companies (particularly those with debt loaded balance sheets ranging from manufacturing firms to larger financial institutions) lost their access to capital. Meanwhile, the more glamorous asset-light companies (technology and biopharma) became Wall Street and credit provider darlings leading to a distinct economic advantage for the latter.   
 
Since there has been little change in this newer economic model, Lev and Srivastava don’t see value investing making any big comeback soon.
 
 What This All Means
 
All of this data brings us back to the core questions surrounding the prognosis for value investing. Is it really different this time? Are the prognosticators of doom finally correct?   
 
The simple - and most honest - answer is we simply have no idea what the future holds for those investors who follow a value investment strategy[2]. For those who suffered tremendous losses in the 2007 - 2009 crash (where value methods should have prevented such results) followed by multi-year underperformance in a record setting bull market (again, where there should be some outperformance in value in the years following a bear market), the question is almost moot. If your investment strategy fails you in both bull and bear markets, then it’s not irrational to call into question the fundamentals of such an approach.
 
At Nintai, the entire debate is more academic than practical in our view. As investors in assets trading at a discount to our estimated intrinsic value, we think this puts us clearly in the value investment approach. Whether that is based on hard assets on the balance sheets or value derived from the future cash flow of an asset-light business model is irrelevant. We think the focus on value makes you a value investor – nothing more and nothing less.
 
Having said that (and there’s always a “but” in any good argument!), we do believe that value investing 2.0 has had a leg up on more traditional value investing over the last decade. I have no data to support such a claim nor do I have any specific reason (like Dimensional) why that would be the case. My only idea is that over the long term (here I mean a time frame greater than a decade), buying quality companies at fair prices will generate better returns than purchasing medium/poor quality companies at great prices. Again, I want to point out I have no data to support such a claim. Most of it likely lies in the fact I’m simply more comfortable investing with those caveats in mind[3].
 
The larger debate about whether value investing (regardless of more traditional or 2.0) is dead really isn’t all that clear. If you argue like Lev and Srivastava the edge has been gone for over 4 decades, then there isn’t much to debate. If you take the more nuanced view such as the Dimensional team then there is still room for debate about value investing’s future.  
 
In the final analysis, it’s up to each individual investor to develop their own investment style that meets a couple of needs: it lets them sleep well night and it produces returns adequate to meet their financial requirements. Whether that’s achieved through a more traditional value approach, value 2.0 approach, or growth investing approach is up to them. But as a portfolio manager myself, I wouldn’t rule out value investing yet. There are still people outperforming the market who all share the same genetic roots from Graham and Doddsville. Whether the causation and pool of candidates are as large as when Warren Buffett first brought the concept to the investing world’s attention, it can’t be denied it’s still there. It may be different this time, but it doesn’t mean value investing is dead yet. 


[1] These were two companies I owed at the time I was personally managing the Nintai Partner private investment fund. They certainly weren’t the WorldCom’s or the Cisco’s of the investment world.

[2] It should be said this applies to any investment approach or for the markets in general.

[3] As I’ve discussed previously, over the time frame of 2002 – 2015 the portfolios I personally managed were able to outperform the markets by a considerable margin (past results are no guarantees of future returns!). From my limited perspective, my hybrid value approach has worked well meeting my investment needs.

I recently got done writing a multi-part series on how value investors got the credit crisis and Great Recession of 2008 - 2010 so wrong. A weakness many investors and financial writers have is the inability to find in themselves the same faults they find in others. There’s the old adage that history doesn’t exactly repeat itself, but it often rhymes. This past year, I made a mistake that - while not an exact repeat of the errors made by value investors in the Great Recession - certainly rhymed. In this mistake, I made a considerable error in mixing up my thinking about company growth and company valuation.
 
Growth and Value: The Foundation of Fuzzy Thinking
 
One of the things that Warren Buffett has spoken about many times is the fact that making the distinction between growth and value can lead to fuzzy thinking. Buffett frequently makes the point that all value investing is about growth investing. In his 1992 Berkshire Hathaway Annual Report, he wrote:
 
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
 
He further elaborated his thinking in his 2000 Annual Report writing:
 
“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation, except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component - usually a plus, sometimes a minus - in the value equation.”
 
I bring up the distinction between growth and value because I made a fundamental mistake recently in my calculation of the value of Veeva (VEEV) - which led me to sell the stock from client portfolios. My error – which I will discuss in much greater detail below - was thinking that growth in the stock price was rising (and would continue to rise) at a faster rate than my estimated intrinsic value ever could. That is to say Veeva’s valuation would never keep up with its growth.
 
A Little Background
 
Veeva Systems was a group of individuals who worked with Salesforce (CRM), a customer relationship management (CRM) software provider. This group believed their expertise in the pharmaceutical market could lead to high growth and significant market share. The company was a success from the beginning. Since 2011, Veeva grew revenue per share from $0.25/share to $5.52/share in 2019. The past 5 year annual growth rates for revenue, earnings per share, and free cash flow have been 16.6%, 55.7%, and 40.2% respectively. The company averaged return on capital in the low 80% range and grew free cash flow margins from roughly 15% in 2011 to nearly 42% by 2019. The company has never carried any short or long-term debt and increased cash/marketable securities on the balance sheet from $17M in 2012 to $1.43B in 2019.
 
Veeva also happened to be in a market vertical where Nintai Partners had deep experience. Most of Veeva’s clients were Nintai’s consulting clients and their work in informatics coincided with Nintai’s core competency. We deeply respected Veeva’s management, their product and services, and their market strategy. In essence, Nintai Partner’s legacy knowledge allowed the new Nintai Investments LLC to be comfortable partnering with an outstanding company and management team all in a growing market.
 
The Decision (or How We Blew It) 
 
Nintai Investments LLC had owned Veeva since opening its doors (it had been a holding in the Nintai Charitable Trust since 2005). We originally purchased the stock in February 2018. In May 2019 - after a blow out quarterly earnings announcement - we sent out the following to our investment partners.
 
 -----------------------------------------------------

To Our Investment Partners:
 
Yesterday, Veeva (VEEV) announced Q1 earnings. They were superb. The stock is trading up 14% today. Q1 revenue grew 25% year over year to $245 million, while normalized EPS grew 52% year over year to $0.50. Subscription revenue increased 27% year over year, while services revenue increased 18%. Deferred revenue increased 26%. Operating margins increased from 32% to 38% compared to last year. Bookings and service revenue look outstanding. Guidance for the remainder of 2019 was ahead of our expectations. We expect to increase our estimated fair value by roughly 8% bringing it to around $100/share. 
 
The position has returned 168% since our initial purchase in February 2018. The stock currently trades at roughly a 54% premium to our estimated intrinsic value. At that level we frequently sell out of the entire position. However, because of the uncertain potential of adjacent market opportunities (the company announced deals in chemicals and consumer goods recently), we only sold 40% of our existing position and will retain a position in the company.  
 
Please feel free to email or call with any questions. My best wishes. 
 
Tom
 
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So far our investment partners had nothing to complain about. We had a holding with outstanding returns though now trading at a significant premium to our estimated intrinsic value. Here was the rub however. Conservative value investment theory would have us sell the position at such a premium. No matter how successful we felt the company could be, we felt we couldn’t be guilty of recency bias or hold on to the stock simply because of how well it had performed in the past. Be ruled by the head and not by the heart.
 
With 20/20 hindsight our mistake was startlingly obvious. In our “head-not-heart” mind set, we simply couldn’t believe a review (no matter how deep) in our valuation process would increase the valuation greater than the increase in the price. So - utilizing our supremely confident “we-must-be-supremely-heartless-and-coldly-rational” attitude, we sold out the entire position by end of July 2019. We congratulated ourselves on locking in a 168% return for our investment partners and began looking at new opportunities in which to allocate this capital.     
 
What Happened Next
 
After selling the stock and placing it on the watch list, Veeva came up for review relatively quickly. At Nintai, this annual process is quite extensive with a top to bottom breakdown of our investment case. Everything that can be used to better understand the competitive advantage and market moat is broken down with in-depth research. We look at product pipeline to sales force effectiveness, market satisfaction and adoption rates, customer reviews and purchasing budgets, regulatory filings and approval calendars. We also break down the company financials trying to get a deep understanding of the components that make up cash flows, income statement, and balance sheet. Particular focus is spent on capital allocation and free cash flow generation.
 
Without going into all the details, by the end of our review it became very clear we needed to seriously adjust our valuation upwards. In fact, the increase was so large we sent out a new update (barely two weeks after sending out why we felt compelled to sell the position).
 
------------------------------------------------
 
We spent this past Monday and Tuesday speaking with Veeva management, their largest customers, industry thought leaders, and regulatory officials. This completed our nearly two week review of the business, including our annual deep dive on competition, market growth, etc. After reviewing our findings it became clear that we had seriously undervalued the company.  Our revised valuation went from roughly $110/share to nearly $182/share. We have to say that this is the largest adjustment in intrinsic value we’ve ever made. Since July 15th Veeva’s stock price has dropped from $175 to today’s (September 13 2019) price of $139. This represents a 21% drop. At this price the stock trades at a 23% discount to our estimated intrinsic value. 
 
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John Maynard Keynes famously never-said[1], “When the facts change, I change my mind. What do you do, sir?”. It’s pretty wise advice no matter who you attribute it to. With as straight a face as we could muster, Nintai announced we were reversing course and adding Veeva back into the portfolio. It certainly wasn’t a banner day at Nintai world headquarters, but at least the facts backed us up……again.
 
What Can Be Learned
 
I could probably write a book just on the errors from the “Veeva Adventure” (as we refer to it now). That will have to wait for another day. For now, let me summarize the findings that are most applicable to every day investing theory and practices.
 
Don’t Ever ASSuME (You Know How the Rest of That Goes)
In my value investment trained mind, I had made the distinction that Warren Buffett had clearly warned led to fuzzy thinking. It is possible to have a value investment that has two seemingly contradictory attributes - high growth in revenues and free cash and trade at a significant discount to intrinsic value. The value investing world will not end when the two reside next to each other. It’s a lesson I seemingly need to (re)learn every couple of years.
 
Don’t Get Over Confident
When you start to think you know enough about the company or its markets without looking at new data, then you’ve got a real problem. Market dynamics can change by the day, so an investor should always base decisions on the latest well-researched statistics. The fact that I could be off by such an extent on Veeva’s valuation was an example of clear arrogance. Just because I knew a lot about the company’s past didn’t mean I was a greater predictor of its future.
 
If You Base Your Decisions on Facts, Then Be Damn Sure About Your Facts
One of the reasons why I always write an investment case for a potential investment, then turn around and write an anti-investment case, is to make sure I’ve seen both sides of the arguments and the facts support one more than the other. This means I have to know my facts cold. This also means I need to check and double check my facts. Not only was I guilty of intellectual arrogance when it came to Veeva, sadly I was guilty of intellectual indolence as well.
 
Conclusions
 
Being able to identify mistakes and finding the cause is really only half the battle. The second part is creating processes to prevent these types of errors from happening again and being able to verbalize what happened to individuals outside the decision process. This might include your investment partners, your Board of Directors, and you, the reader. I keep a running list of errors I’ve made in my investment process since 2004. That list includes 77 specific errors. Each one is identified, discussed, and then a solution is listed next to it. I’m glad to say I’ve only repeated a total of 6 errors or roughly 8% of the total list. Unfortunately, the underlying cause of the Veeva case is a repeat offender. In my next article I thought I’d discuss other cases similar to this, what solutions I’ve employed, and why I think they have failed.
 
Until then, I look forward to your thoughts and comments.
 
Disclosure: Portfolios that I personally manage own Veeva.     
     


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

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

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


------------------------------------

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

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

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

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

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

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

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

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

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

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

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

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