"The huge volatility of the market broke down all but the most fundamental relationships between markets and securities.  The usual day-to-day world where investors cared about subtleties like corporate earnings or analysts’ forecasts dissolved as the energy of the market was turned up.  All stocks moved together; if it was a stock, it was sold like it was plasma physics: as matter becomes hotter, it becomes less differentiated.  The forces that bond atoms together in the form of molecules are overwhelmed, so that rather than having a myriad of different substances, we have the elemental building blocks of the atoms.  Turn up the heat even more and the atoms themselves are melded into plasma, positively charged ions and negatively charged free electrons; matter in its most uniform and non-differentiated state, no longer hydrogen atoms and oxygen atoms, just a seething white-hot blur of matter.”
                                         -          Richard Bookstaber, “A Demon of Our Own Design”
​
During times of crisis, it’s often said that multiple correlations all converge at 1 as panic settles in – REIT owners, preferred stock owners, and even bond owners all look at their assets through identical lenses. As fear grows increasingly into panic, investors begin to see the heat rise even further into that “seething white-hot blur of matter” that Bookstaber discusses. Soon all assets – bonds, stocks, even derivatives – begin to narrow their correlation until it that trade near 1.

Morningstar just published a great article on why correlations tighten until they hit 1 during market corrections[1].  It’s important to remember that not every downturn in the markets drives correlations to near equal status. During the 1998 Asian currency crisis, all the categories of US diversified stock funds losses ranged from 1.7% to 22.6%. Not even close to a tight correlation. However, the coronavirus has induced a level of panic in the markets that selling (and buying) have pushed correlations the closest to 1 since the great recession.

So what makes this latest crash so intriguing? First, when Morningstar looked at all nine categories of UD diversified stock funds, the range in average losses was incredibly narrow and small – ranging from 10.8% and 11.6% starting from Feb. 19 - the S&P 500 high - and Feb. 27. Historically, this is a remarkably small range. What makes the small range so interesting, is the data show it to exist in nearly every respective type of fund. The most interesting to us at Nintai - and likely everyone at GuruFocus - is the difference between growth and value. It’s been a near given mantra that value will outperform growth during downdrafts in the market. So how did value do against the market in the initial period of collapse from February 19 -  February 27?
It turns out during the virus-induced crash, there was very little difference between value and growth performance. During the period, value funds on average posted losses of 11.25% versus an 11.11% average drop for growth funds. The second category that Morningstar looked at was the difference between small-caps and large-caps. Again the difference was minimal between the two – small-caps posted a negative return of 10.94% versus a large-cap return of a negative 11.30%.    
      
Of course, the S&P 5000 has dropped roughly 32% since its peak in February. Have the numbers changed any as the losses have increased? The initial review of the data suggest not. Value funds have lost roughly 31.6% since market highs while growth funds have lost roughly 33.2% during the same time. At its most basic, this market crash - driven by a virus of unknown nature, pathology, and treatment - has driven correlations to 1 from the onset of the disease/crash to its current state.     

What Does All This Mean?
All of this has left us with some heady questions between the cause of the crash, the impact of the disease, and potential length and depth of the market crash. Here are some of the theories we are working on to think ahead for the next emergency similar to this one.

1. Stock Prices Were Inflated
I’m not sure of many on Wall Street that wouldn’t have argued that stocks were due for a tumble some point. Record high P/E ratios, a 10 year bull market, and slowing growth all gave off the feeling that the bull market was nearing its end. At Nintai we had reached nearly 30% cash in some portfolios being unable to find anything that met our criteria or margin of safety. With the rebound in prices over the past few days, most buying opportunities have passed by already.   

Greater Fear (As per VIX) Leads to More 1-Based Correlation
During the crash of February and March 2019, the VIX reached its highest level since the Great Recession. When the VIX reaches such stratospheric levels (66.2 in December 2008 and 65.65 on March 27 2020) nearly every asset is correlated. In other words, there are very few places to hide when the vast majority of investors are convinced the markets will drop.

Non-Controllable Events Lead to More 1-Based Correlation
Fear can be generated by fear or uncertainty or both. In some economic situations fear can be driven by poor earnings results or missed expectations. Uncertainty can be caused by a simply non-measurable event – meaning there is no way to quantify both the odds of it happening and the scope of the event. Fear and uncertainty can be a deadly mix on wall street. When they say “Wall Street has to climb the wall of worry”, they aren’t kidding.    
​
Conclusions
Over the course of the last month, several key learnings have come back to haunt investors. The first is that fear - real gut wrenching, visceral fear - forces a wide range of investors to act in a similar way. This can be value versus growth, small-cap versus large-cap, low-yield versus high-yield. When investors panic, the phrase “no place to hide” really means that many seemingly different asset classes suddenly all begin correlate to each other. Stocks, bonds, energy, utilities, REITs, etc. all begin to drop in similar ways and in similar amounts. In other words - the dreadful 1-factor correlation. The second learning is that crashes like we’ve seen over the past month are by far easiest ways to differentiate your returns (for both good and bad) against the general markets and individual investors. At Nintai Investments, we’ve seen our outperformance with the Russell 2000 jump from roughly 2 - 5% at the beginning of February to 20 – 25% by the end of March 2020[2]. Which brings us to the third finding. To give yourself a chance at outperformance, you really need to invest differently than the indexes and other investors. Whether it be 30% cash, 20% in microcaps, or investments in only 4 of the 11 S&P 500 industry categories (all characteristics of Nintai Investment portfolios), investors should find their niche and make it their own. Great value investors find their niche - purchase shares at a considerable discount to fair value – and hang on for the journey. The ability to differentiate your investment from the dreaded bear market 1 correlation will in the end decide how successful you are in the long term.      
As always I look forward to your thoughts and comments.
DISCLOSURES: None

[1] “Correlations Going to 1: Amid Market Collapse, U.S. Stock Fund Fs Show Little Differentiation”, David Carey, Tom Lauricella, Mar 6, 2020
[2] Past investment performance does not ensure future returns

It isn’t often we see market actions like we’ve seen over the past few weeks. This is the kind of market where you see almost no correlation with corporate-specific data and individual stock prices. A company like Veeva (VEEV) - down from $165/share on February 20 2019 is trading at $135/share on March 12 2019 after announcing an outstanding quarter on March 4 (revenue up 34% Y/Y, earnings beat by $0.02, etc.). What is one to make from such markets? What protection is there in these conditions?
 
First, we recommend having confidence in the companies and managements that make up your portfolio. At Nintai, we seek out companies with high returns on capital, equity, assets, high free cash flow margins, deep competitive moats, and management who know how to create long term investor value. We can assure you that corporate operations, strategies, or management skill sets have not collapsed because the markets have entered bear market territory or the coronavirus has reached pandemic scale.
 
Equally, we are confident our investment partners are aware they still own a set of outstanding companies in their portfolios. Each of our portfolios have generous cash positions which provide both downside protection and the ability to add to existing positions as prices become increasingly compelling. Equally, companies in their portfolios have no debt that forces them to make desperate - and likely poor capital allocation - decisions. Occasionally you here about investors who became rich by selling at the top (like Joe Kennedy selling after his shoe shine boy recommended Hindenburg - “the moment a shoe shine boy gives you stock recommendations it’s time to get out of the markets”)  
 
But the vast majority of investors who outperform the general markets build up cash as the markets reach rarified levels, take their profits, build up cash, and await the inevitable crash. Yes, it’s the buy low, sell high concept. It doesn’t take a lot of intellectual quotient (IQ), but it takes a heck of a lot of emotional quotient (EQ) to successfully achieve this model. Here at Nintai Investments, we might not be the brightest lights on the block, but we firmly understand the concept of holding cash, buying low, and selling high. As I’ve mentioned before, we have a tendency to not make our money in bull markets, but rather preventing permanent capital losses in bear markets.
 
As for Veeva (VEEV) which I first discussed in this article, the company has no debt, roughly $1.1B USD cash on the balance sheet, grew revenue 25.8%, earnings by 50.3% and free cash flow by 60.4% over the past 5 years. Management has a clear view on where growth is coming from over the next 5 – 10 years, and are outstanding capital allocators. The fact the price has dropped by 18% in three weeks would suggest this rapid decrease represents increased value rather than increased risk.
 
As value investors - regardless of the knot in your stomach and that feeling of flight over fight - we live for moments like this. These are the days that test an investor’s ability to live by value-based credo – buy low, sell high, look for quality and value at a discount to your estimated intrinsic value, be patient and keep your emotions in check.
 
Our markets have survived a Civil War, the crashes of 1896, 1901, 1907, 1929, the Great Depression, two World Wars, the Cuban Missile Crisis, the 1973-1974 crash, the technology bubble, and the real estate bubble (just to name some!). At Nintai we believe that as prices continue their drop, opportunities at acquiring outstanding companies at a discount to their intrinsic value will provide some great opportunities going forward.        
 
By remaining calm and seeking out investment opportunities, we believe we can provide our investment partners with their best chance at long term market outperformance. As value investors, it’s what we do best. 

“We make money the old fashioned way. We earn it.”
 
                                                     -      John Houseman for Smith Barney 

If you are old enough you can remember those commercials in the early eighties with John Houseman sitting in front of a burning fire in some gentleman’s club telling viewers that Smith Barney makes money the old fashioned way - they earn it.  I was never quite sure what they meant by that, but it certainly was a great line delivered by a great actor.
 
At Nintai we like to think we make many the old fashioned was as well - by simply outperforming the markets. This too is also a great line, though we have no John Houseman to deliver it. Rather than a great marketing line, the only way we know of backing up our claim is through performance. During my time at Nintai Partners - and subsequently at Nintai Investments - there have been two salient facts that have driven our outperformance (of course past performance is no assurance of future returns).
First, the value of cash becomes outsized in that its value does not drop and its ability to purchase downtrodden stocks becomes vital. Having dry powder to take advantage of mispricing in the markets becomes essential for long-term outperformance. Second, during genuine market corrections (drops by at least 20%), correlative values (meaning the difference in returns between value and growth, small and large, etc.)  generally merge to roughly 1. This means everybody does equally poorly. If value stocks drop by 20%, then growth stocks drop by roughly 20%. Having the ability to remain calm and sticking to your core valuations - and buying when stock prices hit the required margin of safety - are two emotional and intellectual prerequisites to being a great value investor. In my next two articles I want to discuss these two factors – the strength of the cold hard cash and the drop to mutual correlative values in market corrections. In the final analysis, most of the value we add at Nintai Investments does not come in bull market, but rather our defensive nature and positioning when bear markets come about over time.  
 
In part 1, I thought I’d use three individual Nintai Investments to discuss the value (and cost) of holding large cash positions over the past year. Over the past several years,
 
 I‘ve written extensively about the underlying power of cash. I have described its strength in the terms of what the armed services refers to optionality. This means that
cash gives you the ability to play defensively and offensively when certain assets reach an adequate margin of safety.
 
Below, you will see 3 Nintai Investment individualized accounts breaking out cash as a percent of AUM, US equities and foreign equities as a percent of AUM, and the average portfolio equity market cap. The 3 portfolios’ cash positions range from 14% of total AUM to 33%. I should point out that Nintai Investments generally holds cash – not bonds – as we believe bond prices are as distorted as equity prices. 

​As seen below, looking at the difference between market highs (achieved February 20 2019) and the lows (achieved – so far – through March 6 2019), readers can see that cash positions provided an enormous brake on market losses compared to those achieved by the general markets.

Note: Some may be asking why the portfolio with the largest percent in cash lost the greatest percentage. The answer is quite simple – shares in this portfolio were bought closer to the market highs in February than the other two portfolios. 

I’ve often said that I made my record at Nintai Partners Fund by losing only 18% in 2008 and making 71% in 2009. Every other year was actually not that different thanthe general markets between 2002 - 2015. Indeed, some of these years (particularly 2013, 2014, and 2015 I really underperformed).   
 
What To Learn from Severe Drawdowns
When markets drop 2-3% every day for 2 straight weeks, even the most sanguine investor can get sweaty palms and feel the first pangs of fear in the gut. But I’ve never been involved in severe drawdowns when there hasn’t been – beforehand - a run up of truly magnificent proportions. Whether it was the technology bubble in 1999 - 2000, the real estate/CDO/MBS bubble in 2006 – 2007, or the ten year bull market from 2009 - 2020, prices have generally reached nose-bleed levels before the inevitable sucking sound of the drawdown. During the end of those run ups, successful value investors will be arguing with other market participants that 30 - 40% cash positions aren’t that unreasonable.     
 
By the end of December, I found my investment partner portfolios were ranging from 15 - 30% cash. Any buys I might be adding to accounts were additions to existing positions. Nearly every report update had a section on cash - explaining why percentages were so high and its impact on returns. While slightly outperforming the markets, it was touch and go as the large cash positions were taking a toll on the continuous upward pressure of the bull market.
 
Then came the last two weeks at the end of February 2020 to the beginning of March 2020. During this time, the markets went on a roller coaster ride down 1,000 points one day and up 800 the next. However, the over trajectory was down - with the S&P 500 losing 14% over the roughly 2 week period. As I discussed earlier, the large cash positions helped each portfolio outperform the general markets.    
 
What Can Be Learned?
Most professional money managers don’t have the luxury of holding large percentages of their assets under management in cash. Many feel they must be “all in” when it comes to their clients funds as inaction represents lack of effort.
 
Cash Acts Like a Portfolio Anchor
At Nintai we feel very different than most players on Wall Street. Our actions – in this case represented by the holding of cash – represents wisdom in not overpaying for an asset and awaiting the right opportunity to come along to deploy capital. In these cases, cash acts as an anchor against permanently impairing capital in down markets. After a stock has dropped by 55% in 30 days, it’s pretty hard to see a recovery over the short - or even long - term, while cash hasn’t dropped an iota in the same scenario.     
 
Cash Has Immediate Use
One of the most powerful aspects of cash is the fact is you never have to think to act when action is necessary. If one owns bonds, then you have to calculate the bid/ask or the current price per share if you own them in a fund and calculate if you want to take the loss or pay the tax to cash out and use the proceeds in purchasing another asset. Not so with cash. You can purchase the asset in seconds and not give a thought to price conversions, long or short term capital gains, or whether the price is equal to the amount of shares you are looking to purchase. Cash has immediate purchasing power – which is a huge advantage in crazily volatile markets.     
 
Cash Can Go From Defensive to Offensive Instantly
Nothing beats cash when it comes to optionality. If you think a stock has reached its bottom, or even has just passed its point of an adequate margin of safety, then cash goes from an immediate defensive tool to an offensive tool. It no longer protects to the downside but rather covers the opportunity of the upside. There is simply no tool in the financial markets that can provide such a change in strategy so quickly.
 
Conclusions
 
In this time of financial volatility - when not every investor is asking “how much many will I make today” but rather cowering in their home unwilling to open their statements or go on the computer to check their balances - the ability to have an anchor to windward that protects against the downside and offers instant opportunity to take advantage of new opportunities is a powerful tool. The ability to sleep better at night because you know you’ve made provisions against the downside is vastly underrated as an investment position. If you have positions that are 20 - 30% above your estimated intrinsic value, don’t hesitate to pay the taxes, lock in the profit, and have some cash ready to purchase some potential long term bargains as the markets fluctuate as severely as they have in the past few weeks. My guess is you won’t regret it and you might it find yourself more relaxed and salivating at some potential stock you’ve had your eye on for several years but was never in your price range.       
 
As always, I look forward to your thoughts and comments.