In 1815 at the battle of Waterloo, forces of the Allies defeated the Napoleonic forces in a violent two-day battle. The leader of the British forces, Lord Wellington, was famously quoted as saying it “was the nearest run thing”. Less quoted but far more interesting in our eyes was his response to the question of how he defeated the greatest living general of his time. “Oh”, he responded, “they came at us in the same way and we beat them back in the same old way.” Napoleon was suffering from confirmation bias – the idea that what had worked so many times before would work again. In his eyes, how would an army of shopkeepers stand against the flower of the French army?

We think this story is quite illustrative in today’s markets. We often hear about confirmation bias during bull markets, but we rarely hear about it in the context of buying stocks during market crashes. During days when the markets drop by 5+% and some stocks on your watch list drop in synch, do you often think bargains are to be had? Do you immediately see bargains where there were none just the day before? You wouldn't be alone. We all suffer from confirmation bias. But drops of 10% to 20% do not guarantee great investment opportunities. As usual, the drop in price must be put in the context of value. We believe the past few days have shown an enormous reaction based on confirmation bias.

To See and Not Believe 

In Daniel Gilbert’s published article “How Mental Systems Believe [1]”, he wrote that understanding a statement begins with our attempt to believe it. Danny Kahneman is his “Thinking, Fast and Slow” stated that this attempt at believing is the basis for confirmation bias. He wrote, “You must first know what the idea would mean if it were true. Only then can you decide whether or not to unbelieve it. [2]” He went on to describe the attempt to believe is processed through System 1 (the more automatic and accepting process) while attempting to unbelieve (or test the idea) is processed through System 2 (more associated with critical thinking).

The past week has greatly activated many value investors’ System 1 thinking. Huge drops in the markets must mean there are significant values to be had if you only look close enough. On Monday, anchors on Bloomberg stated they heard investors were purchasing stocks “with both hands” and “hand over fist”.

But is it really the best time to buy shares in the market? We would propose that confirmation bias is as dangerous in market drops as it is in bull markets. Just because a stock has dropped suddenly by 10% does not make it an automatic value. Even though every emotion in our investing mind is telling us to buy, we must engage our System 2 and engage in critical thinking. More importantly we must focus on one specific question: What is the new price relative to the company’s value?

Confirmation Bias: A Working Example

As an example of this we wanted to use one of our current holdings – Ansys (NASDAQ:ANSS). We first purchased its shares in December 2008 at $28.14/share. On Aug. 21, the shares peaked at roughly $97/share. Within the two trading days, the stock price had dropped to roughly $86/share. During trading on Aug. 24, the stock was briefly down 8%. By the end of that day several individuals had written to me asking if we would be purchasing additional shares.

I must admit out initial reaction was to salivate at the price drop. Over the next 24 hours we took a look at the history of our holding, its valuation, and price movement. On Oct. 24, 2014 the stock was priced at roughly $72/share. In January of this year we estimated an intrinsic value of $84/share. By August, when the stock was trading at $97/share we believed the stock was priced roughly 15% above fair value. The rapid drop of 10% during Aug. 21 to 24 had simply brought the shares in line with our estimates. It was still trading $12/share more than it was less than nine months before. If we didn’t purchase it in October 2014, then why would we purchase in August 2015? With our intrinsic value being static, the decision to pass was a not a hard choice. But getting to that decision certainly was difficult. Confirmation bias – processed by System 1 – instinctively informed us a large price drop in a short time should be a buying moment. Only upon using System 2 were we able to critically analyze these emotions and make a more reasoned decision.

Switching Systems: Mauboussin’s Checklist

In Michael Mauboussin’s great book “Think Twice: The Power of Counterintuition [3]”, he suggests a checklist of five steps to avoid focusing on only System 1 thinking. In regards to the questions of purchasing additional shares in ANSS, they provided significant value in the decision making process. These include:

Explicitly Consider Alternatives: By reviewing Ansys’ past price history, its valuation, and our investment thesis, we found that such a significant price drop was inconsequential to purchasing the stock or changing our valuation.

Seek Dissent: Within an hour of discussing the stock, several individuals pointed out that the price drop didn't offset the run up over the past nine months. This forced us to broaden our outlook.

Keep Track of Previous Decisions: Because we outlined our investment thesis and detailed our valuation methodology, we were able to see the price drop simply brought the stock in line with our current valuation model.

Avoid Making Decisions While at Emotional Extremes: Certainly when the Dow drops by over a 1000 points or the Nasdaq drops by 11%, the adrenaline starts to flow. It turns out that would have been exactly the wrong time to make the investment call.

Understand Incentives: We aren’t paid by the amount of trades. We are paid for performance with a risk incentive to protect to the downside. This form of incentive forced us to pause and reflect on both the risk and uncertainty of purchasing more shares in ANSS.

Conclusions

The ability to avoid confirmation bias – both on the upside and downside – becomes critical on days of extreme market gyrations. Sudden price movements can be incredibly tempting times. The emotional and intellectual pressure to act combined with our experiences make it vital to step back and allow our second systems time for critical thinking. In doing so, we can become far more successful in our decisions. Who knows, it might even prevent your own investing Waterloo.

[1] “How Mental Systems Believe” Daniel Gilbert, American Psychiatrist. Volume 46, Number 2, February 1991.

[2] “Thinking, Fast and Slow”, Daniel Kahneman, . Penguin Books Limited, 2011. p. 81.

[3] “Think Twice: The Power of Counterintuition”, Michael Mauboussin, Harvard Business Review Press, 2012

This year was truly a year of change at Nintai. Not only have we closed down our management consulting arm and internal fund, but we have created the Nintai Charitable Trust of which my current positions of Nintai Partners will be transferred. In addition, 2015 was a huge transition for our holdings. We have said goodbye to roughly 40% of the companies we owned at the beginning of the year such as FactSet Research (NYSE:FDS) and Manhattan Associates (NASDAQ:MANH). On the other side of the proverbial balance sheet, we have added holdings that we are truly excited about and expect to partner with for the long term. These include CBOE Holdings (NASDAQ:CBOE), Collectors Universe (NASDAQ:CLCT), Computer Modeling Group (TSK:CMG), Computer Systems and Programs (NASDAQ:CPSI), and SolarWinds (NYSE:SWI). Nearly all our decisions were based on valuation alone where we have focused on selling at high valuations and replacing at much lower valuations. In two areas we will not compromise: buying at a significant discount to fair value and the quality of the company’s financials/returns.

That having been said, we simply haven’t found opportunities to replace our sales, and our cash position ballooned to roughly 20% by end of last week. The past few days have - as one writer once eloquently said - “made the ears of the wolf twitch”. We love days like the past two. Mass selling can provide great opportunities in mispricing and yesterday we were happy to find one. It didn't make much of a dent in our cash position, but we are happy to put capital to work with such a company.

Linear Technology (NASDAQ:LLTC): Purchase

If you can believe, Linear has been on our watch list since 2004 (we almost purchased in 2009 but simply didn't have the cash having purchased several other positions at far deeper discounts). After updating our estimated intrinsic value in February 2015, we placed a limit order at $39.50/share. Management recently shared concerns about the September quarter speaking of broader economic issues rather than company specific problems. Combine this with the sudden drop in the past few days, and the stock price briefly touched our ask price and we became owners in the company. We couldn't be more pleased.

Linear is the type of company we love to purchase and hold for as long Mr. Market will allow. The company is the leader in high-performance analog (HPA) chips. These require extreme precision and very high reliability in devices used across multiple sectors. Currently, their highest need is in the automobile and industrial sectors. Because of the stress on reliability of the chip (combined with the small cost related to the entire piece of equipment), many of Linear’s clients are happy to pay top dollar for their chips. What we truly love about Linear’s chips is their long product life helping the business maintain extraordinarily low capital requirements. The inability for other competitors to create similar chips at cheaper prices, the depth of Linear’s relationships with key customers, and the skill of their work force give the company a wide competitive moat in our opinion.

We are also very impressed with Linear’s management. They have done an extraordinary job at maintaining a laser-like focus on the very profitable HPA market. They are quite willing to let projects go by if clients are unwilling to recognize the value of Linear’s product quality. With gross and net margins of 76% and 35% respectively, management has demonstrated their commitment to long-term profitability. In addition, over the past five years the company has generated an average ROE of 80%, free cash flow/total sales of 40%, and ROC of 38%. This is a company that is a true cash machine. Finally, the company has no short or long term debt, $1.2 billion of cash on the balance sheet and yields roughly 3%. Utilizing a DCF model, we believe shares of LLTC are worth roughly $49/share or trade at roughly a 22% discount to fair value.

Portfolio Positioning

After all of these portfolio changes, the Nintai Charitable Trust is somewhat cheaper than the S&P500 Index, far more profitable, and is estimated to grow at roughly 30% faster than the S&P500.

After making these changes (producing an alarming turnover rate YTD of 47%) we are quite comfortable to sit back and let our portfolio companies and management do the heavy lifting in the future. We believe we are positioned to achieve signifiant compunding returns if we remain patient and diligent in our investment practices.

The Trust's current portfolio positions and weightings are as follows:

As always, we look forward to your thoughts and comments.

**Please note this article reflects my personal holdings in the Nintai Charitable Trust. Opinions expressed in this article are related to the Nintai Charitable Trust and the Trust alone. **

n 1888, a Harvard professor in biology gave a speech at the Lowell Foundation about the abilities of species to survive and thrive in a constantly evolving environment. During that speech he made a point that most successful species are good at two defined behaviors – finding nutrition and reproducing. Other specialized behaviors – from eating only plants from the yew tree to shooting insects from the sky with squirts of water – were interesting but essentially dangerous in species’ survival and proliferation. As a more modern biologist wrote – first bread and water then caviar.

I bring this up because we think some of the best value investors focus on bread and water issues before becoming grazers of knowledge across multiple subject matters. Over the past two decades, fields have developed that bring the art of consilience to new heights. Everything from behavioral economics to fractal theory is allowing investors to see investing from entirely new angles. We are a huge fan of these new areas of research. That being said, we think it’s far too easy to fall into the trap that all this knowledge is vital to being a better investor. Much like the species in the lecture, great investors understand that a lot of information is interesting or intriguing but not essential to their survival.

A lesson in survival

At the height of the market bubble in 2007, Bill Miller was riding high at Legg Mason where his Value Trust outperformed the S&P 500 from 1991 to 2005. An extraordinarily impressive result. By 2006 he had bought a huge yacht named “Utopia” and was sitting on top of the world. In his own words he had created what he thought were essential models to help understand and predict worst-case scenarios ranging from a war in the Middle East to a repeat of the Cuban Missile Crisis. All of these were fine intellectual exercises in their own right. The problem was they passed over one of the most vital aspects of corporate life – the credit markets. His models in no way took into account some of the more basic functions of corporate strategy and operations related to debt. It almost seemed impossible that one of the core underlying foundations of our economies could be so badly at risk.

In this way, Miller had been guilty of what was spoken about at Harvard back in the 19th century: that successful species find ways to be good at the core biological functions that really matter – nutrition and reproduction. Without these basics well in hand species will inevitably decline and move towards extinction. Access to capital – whether through the public exchanges or private credit markets – is one of these. The 2008/2009 credit crisis demonstrated that far too many companies relied on their existence to extremely risky nutrition – cheap credit.

So how did a person so bright as Bill Miller get it wrong? How did such a manager produce such abysmal results? It should be pointed out Miller wasn't alone. Many classic value investors posted truly catastrophic results in the same time frame. We humbly suggest there is some core knowledge that value investors must master and use as the basis for investment research and decision-making. Without these to build on, we are liable to be too clever by half. New knowledge works best when integrated into the core necessities for survival.

Food and water for the value investor

What are the knowledge parallels in value investing to the core values of nutrition and reproduction? We believe there are five (5) fields essential to making sure you understand how your investments have access to the resources necessary to survive (nutrition) and thrive (reproduction).

Mathematics and Statistics

Like it or not, numbers are the language of business. Without understanding a base level of mathematics and statistics, you will be unable to understand the underlying strength and growth abilities of your holdings. You don’t need to be the next Nobel Prize winner in the field, but a core set of tools will be essential to speaking the language of business. Mathematics tells us the dietary needs and intake of our holdings.

Necessary Subjects: Time/Value of Money, regression to the mean, distribution and standard deviation, basic accounting including credit/debit and financial statements.

Decision Making 

The ability to understand how others – and more importantly yourself – make decisions is a huge skill to offset both bad decisions and obtain an advantage over other investors. Nearly everyone overestimates their ability at decision making. Understanding yourself better is the start of real downside protection.

Necessary Subjects: Inversion theory, the dynamics of incentives, decision trees, how you make decisions yourself.

Credit Markets 

As we learned in 2008/2009, credit is the lifeblood of so many aspects of the modern economy. Ranging from airline lease agreements to synthetic collateralized debt obligations (CDO), credit has become so arcane and deeply embedded in our finances that even the slightest ripple can produce extreme results. We believe the absence of knowledge in this area is the number one risk to value investing today.

Necessary Subjects: Forms of credit, use of credit, credit markets, risks related to credit, interdependencies of debt agreements.

Risk and Risk Mitigation

Inevitably we think we have a better understanding – and protection – against risk than we even remotely plan against for the future. Understanding risk interdependencies was one of the cheap culprits in nearly every market bubble since the South Seas crisis in the 18th century.

Necessary Subjects: Definition of risk, risk interdependencies, risk mitigation, understanding the difference between risk and uncertainty.

Excellent Writing Skills

Writing skills are far more important than just penning a nifty article to be published here on GuruFocus. Great writing requires investors to comprehend complex issues, structure arguments and counterarguments, synthesize findings and explain issues with exceptional clarity. The writings of Warren Buffett (Trades, Portfolio) and other guru investors can be deceivingly simple in their wisdom. Don’t be fooled by this. Behind such writing is almost always an exceptional mind.

Necessary Subjects: Critical thinking, writing style, written comprehension

Conclusions

Much like our Harvard professor, we would posit that increasing your knowledge alone does not make you a better investor. By focusing on what is necessary for a company to survive (and thrive), we can mitigate risk by not investing in companies that face possible extinction. We have nothing against all the new fields of research we see out there, but it’s important to realize that knowledge is only valuable if it builds on the foundation of core concepts. We think some of the greatest investors focus on the nutrition and reproduction skills of their investment holdings. When we see investors or corporate management carried away in intricate systems analysis or arcane financial planning, we usually step away and force ourselves to go back to basics. In this time of ever growing complexity and data, we think this can provide us as individual investors a true advantage over the larger players. And that certainly lessens the risk of our own extinction.

I wanted to start off my article today by announcing a relatively significant change in my career. As many of you know, Nintai – which was a management consulting business with its own internal fund – has been winding down operations and will shortly be nothing but a memory. Any assets in the firm will likely be fully dispersed by the time of publication. The only remaining part of the business will be my own managed portfolio of the newly created Nintai Charitable Trust. Accordingly, any mention I may make going forward referring to “Nintai” will be strictly associated with any trades or positions in the Trust portfolio.

Additionally, (and far more importantly!) I am very excited to announce that I will be joining Dorfman Value Investments as Director of Marketing. Some of you may already know John through his writing here on GuruFocus. For those who don’t know, John has a tremendous record as a value investor and has long been seen on Bloomberg, CNBC, as well as a writer and editor at the Wall Street Journal and Forbes. It is an extraordinary privilege to be working with John and his team.

In the inevitable reflection that happens when shutting down operations, I began thinking about other funds that have closed over the years. I began to wonder what made these close and if many ceased operations at the height of their performance or at a trough of underperformance. It should be stated up front that not many professionals retire or leave their profession in their prime and when success is assured by their past record. In the investment world the most obvious cases are Buffett’s Partnerships, Joel Greenblatt (Trades, Portfolio)’s Gotham Capital, and Julian Robertson (Trades, Portfolio)’s Tiger Fund. Unfortunately most portfolio managers – or at least those considered real stars such as Bill Miller at Legg Mason – face the inevitable humbling of reversion to the mean. While in no way equating our own skills with Warren Buffett et al, we feel comfortable Nintai is leaving our investors with a more than adequate return over the long term.

Back to the future

In our article “Mutual Fund Survivorship: The Revenge of Abraham Wald” (found here), we discussed a 2013 Vanguard study that looked at fund survivorship from 1997 through 2011. Using this as a jumping off point, we thought it would be interesting to analyze the cause of these fund closures. Since we were knee deep in the data, we thought we might additionally check in to see how the funds that were merged – rather than closed – performed after exiting from the investment stage.

At the beginning of 1997 there were 5,108 active funds. By 2011 2,364 of these were closed/merged or roughly 46%[1].Of these funds that didn't survive the period from 1997-2011, 1,915 (81%) were merged with other funds and 449 (19%) were closed outright. Of the closed funds, 87 (19%) were closed due solely to performance, 261 (58%) were closed due to insufficient AUM, 101 (23%) due to an aggregate of both, and exactly 1 fund was closed due to a fund manager leaving. Of interest, this fund was the only one to have beaten its respective index over the previous 5 year period. Of the merged funds, 1,115 (58%) went to the mutual fund pearly gates due to lack of AUM, and 800 (42%) were closed due poor performance[2].

Of the 2,364 funds that didn't survive the measured period, exactly one was closed that had outperformed the market index S&P500. For the vast majority of the remaining funds, the story was unfortunately one of past underperformance and future underperformance. The active fund is dead. Long live the active fund.

With friends like these …

It turns out that it really doesn't mean much to underperform and its impact on investor returns. The inability for a fund to be profitable to the fund’s mutual fund company is the seeming driver for closing or merging away a fund. How do we know this? Actual fund return data show us the priority of many mutual fund companies.

We see this when we look at the 958 funds merged into surviving funds. This includes both equity and fixed income funds. Of these, 87% or 834 funds were underperforming against their respective index by a median 2.3%. We would expect this as their records were nothing to crow about. Certainly more distressing is the fact that post-merger roughly 73% or 747 funds still underperformed their respective index. Seen below are the results by category.

Conclusions

We all know it’s extraordinarily difficult to outperform our respective indexes over time. Managers who outperform are diamonds in the rough. More importantly, managers who either close their funds or are merged after a period of outperformance are even more rare birds. The ability to willingly go out on top is at odds with nearly every emotional aspect that assisted you (and me) getting there – confidence in your ability, a healthy ego to place substantive bets against the general markets, patient and understanding investors willing to invest for the long haul, and a remarkably intelligent support staff that assists in everything from keeping you from making poor decisions to getting you to a meeting on time. Of equal importance has been all that I’ve learned here on GuruFocus from all of you who have taken the time to read and comment on my ramblings. Although it was never stated, each of you helped make Nintai the success it was over the years. Leaving all this behind is painful from a personal, emotional and professional level. My time at Nintai was a fantastic experience as well as a profitable venture for our investors. However, I look forward to the next phase of the journey with intense delight and great expectations. I hope you will join me on the trip.

[1] Information for this article was from another outstanding Vanguard report entitled “The Mutual Fund Graveyard: An Analysis of Dead Funds”, by Todd Schlanger and Christopher B. Philips, January, 2013.

[2] There is a question about whether lack of AUM or poor performance is the lead reasons for closure. There aren’t many fund companies that will say “our lack of AUM was driven by poor performance”, so much like the chicken/egg dilemma it’s difficult to state an exact cause. We chose the reasons as stated by the mutual fund company itself.

We were recently talking to a fellow investment manager and somewhere in the conversation - quite nonchalantly - they mentioned that we weren't really value investors. I laughed at the comment and asked why they thought that was the case. They stated (and I paraphrase here) that essentially we were growth-at-a-reasonable price investors because we didn't invest in true value companies. They went on to say our companies were too successful (measurement wise), had not suffered recent operational or strategic crises, and were too richly valued to be considered truly "value" stocks.

This gave me great pause as I truly respect and admire this individual's insights and investment prowess. Are we well and truly GARP investors? Has all that time spent reading the great investment gurus' writings and creating valuation models and tools been a waste of time? I have always believed much like Buffett that all investing is value investing. Anything else is speculation, and I’m pretty sure we haven’t been speculating all these years.

In our definition, equity value investing is purchasing shares of a corporation in which the markets have created a significant variant between the price of the stock and the intrinsic value of the company’s shares. Nowhere does that require investment in net-nets, cigar butts, or turnarounds. Nor does it mean a company must have a low PE ratio, low price to sales ratio, or other “value” measures (though they may include one, some, or all of these attributes). I happen to believe that strong fundamentals such as return on capital, rock solid balance sheets, and high profitability provide significant downside protection of our investments. For Nintai, the defining factor is the discount to intrinsic value. Without it, we simply will not invest. To me that puts our investment style in the value investor camp.

Edward Huang said that every single person has a different perspective when looking at the same thing. We couldn't agree more. At Nintai it is a frequent event to find significant disagreements about a possible investment opportunity. During this process we look to find an investment that meets Seth Klarman (Trades, Portfolio)’s description of Buffett “buying great companies at great prices”. Our internal disagreements always center on the two descriptors: great companies and great prices.

At Nintai we have a relatively set criteria for defining a great company (see our article on our investment criteria here): high ROA, ROE, ROC, little/no debt, significant FCF, and a competitive advantage in the marketplace. The tricky part is defining a great price. We use a proprietary hybrid DCF method to get to a value per share, but generally defining what is a great price is relatively subjective. Our recent purchases (SWI, CBOE, CLCT, CPSI) we believe represent great companies at great prices. We expect to be owners of these businesses for the long term and are excited to see them grow for many years to come. We don’t believe we paid excessively for growth but rather obtained an adequate margin of safety in each respective investment case.

Seeking Value Today

The reason we bring this up is two-fold. First, we sometimes find individuals and institutions can get too caught up in creating a definition for value investing. Attempting to set strict criteria can blind us to opportunities which - in the long term - might provide significant returns. In addition, it can block out means and methods that might provide us with valuable tools in our hunt for value.

Second, we are frequently asked about finding investment opportunities in today’s market environment. With our recent purchases, we still remain at a roughly 20% cash position. As value investors, we simply cannot find that many opportunities in today’s market. That said, we currently have two companies on our watch list that intrigue us and could be added to the portfolio if either their intrinsic value grew or their price per share dropped (or both would be best). Neither would be considered a Ben Graham value stock – they are quite profitable, generate high returns, have no debt, and a generous amount of cash on the balance sheet. Management are great allocators of capital. They clearly meet our criteria as great companies. Unfortunately they aren’t valued as great prices. If the gap between the value and price widened more we would certainly be investors.

Linear Technology (NASDAQ:LLTC)

The first stock is Linear Technology. Linear Technology designs and manufactures standard high-performance analog (HPA) integrated circuits for an immensely diverse customer base spanning industrial, automotive, communications, and high-end consumer electronics. Linear is a cash-generating machine. Lothar Maier, CEO, has kept a laser focus on sticking with products and clients who are willing to pay for quality. The company generated 38% ROE, 28% ROA, and 58% ROC. The company converts roughly 40% of revenue into free cash. It has no short or long-term debt and roughly $570M cash on the balance sheet. It’s product, processes, and expertise provide the company with an extensive competitive moat. It currently yields 2.8%. Obviously a great company. The only problem is that our estimated fair value is $44/share or a 7% discount to intrinsic value – not a great price. So we wait.

United-Guardian (NASDAQ:UG)

Our second company is United-Guardian. The company through its Guardian Laboratories Division manufactures and markets cosmetic ingredients, personal care products, pharmaceuticals, medical and health care products, and specialty industrial products. It also conducts research and development, primarily related to the development of new and unique cosmetic and personal care products. The company generated 28% ROE, 25% ROA, and 61% ROC. The company converts 32% of revenue into free cash. It has no short or long-term debt and roughly $6M cash on the balance sheet. It currently yields 4.2%. While down roughly 23% over the past year, the stock still only trades at a 7% discount to our estimated fair value.

Neither of these companies would be held up as the model value stock. With PEs of 20 and 22 respectively they certainly wouldn't be considered cheap by traditional value investors. By using multiple measurement tools it is likely several value investors would come to the same conclusion – neither company provides a satisfactory investment opportunity. However, at Nintai we keep an eagle eye on two things – the company financial criteria and its price to value ratio. We care little about PE or PEG ratios. While different than a more traditional value model we all get to the same finding – neither provides an adequate margin of safety at this time.

Conclusions

We don’t think having strict quality criteria makes Nintai any less of a value shop than low turnover or PEG requirements. Our main focus – from the beginning of investigating a potential investment until its sale – is the disparity between value and price. There are many roads to the Forum but all take you to Rome. We think there are as many methods to value investing as there are roads leading from the Italian countryside to center city. We avidly read about other value investors’ methodology because we know we can always learn more about what makes a successful value investor. In the end, that’s what makes this such an interesting career. We wouldn't want it any other way.