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

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

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

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

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

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


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

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

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

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