I recently got done writing a multi-part series on how value investors got the credit crisis and Great Recession of 2008 - 2010 so wrong. A weakness many investors and financial writers have is the inability to find in themselves the same faults they find in others. There’s the old adage that history doesn’t exactly repeat itself, but it often rhymes. This past year, I made a mistake that - while not an exact repeat of the errors made by value investors in the Great Recession - certainly rhymed. In this mistake, I made a considerable error in mixing up my thinking about company growth and company valuation.
 
Growth and Value: The Foundation of Fuzzy Thinking
 
One of the things that Warren Buffett has spoken about many times is the fact that making the distinction between growth and value can lead to fuzzy thinking. Buffett frequently makes the point that all value investing is about growth investing. In his 1992 Berkshire Hathaway Annual Report, he wrote:
 
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
 
He further elaborated his thinking in his 2000 Annual Report writing:
 
“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation, except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component - usually a plus, sometimes a minus - in the value equation.”
 
I bring up the distinction between growth and value because I made a fundamental mistake recently in my calculation of the value of Veeva (VEEV) - which led me to sell the stock from client portfolios. My error – which I will discuss in much greater detail below - was thinking that growth in the stock price was rising (and would continue to rise) at a faster rate than my estimated intrinsic value ever could. That is to say Veeva’s valuation would never keep up with its growth.
 
A Little Background
 
Veeva Systems was a group of individuals who worked with Salesforce (CRM), a customer relationship management (CRM) software provider. This group believed their expertise in the pharmaceutical market could lead to high growth and significant market share. The company was a success from the beginning. Since 2011, Veeva grew revenue per share from $0.25/share to $5.52/share in 2019. The past 5 year annual growth rates for revenue, earnings per share, and free cash flow have been 16.6%, 55.7%, and 40.2% respectively. The company averaged return on capital in the low 80% range and grew free cash flow margins from roughly 15% in 2011 to nearly 42% by 2019. The company has never carried any short or long-term debt and increased cash/marketable securities on the balance sheet from $17M in 2012 to $1.43B in 2019.
 
Veeva also happened to be in a market vertical where Nintai Partners had deep experience. Most of Veeva’s clients were Nintai’s consulting clients and their work in informatics coincided with Nintai’s core competency. We deeply respected Veeva’s management, their product and services, and their market strategy. In essence, Nintai Partner’s legacy knowledge allowed the new Nintai Investments LLC to be comfortable partnering with an outstanding company and management team all in a growing market.
 
The Decision (or How We Blew It) 
 
Nintai Investments LLC had owned Veeva since opening its doors (it had been a holding in the Nintai Charitable Trust since 2005). We originally purchased the stock in February 2018. In May 2019 - after a blow out quarterly earnings announcement - we sent out the following to our investment partners.
 
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To Our Investment Partners:
 
Yesterday, Veeva (VEEV) announced Q1 earnings. They were superb. The stock is trading up 14% today. Q1 revenue grew 25% year over year to $245 million, while normalized EPS grew 52% year over year to $0.50. Subscription revenue increased 27% year over year, while services revenue increased 18%. Deferred revenue increased 26%. Operating margins increased from 32% to 38% compared to last year. Bookings and service revenue look outstanding. Guidance for the remainder of 2019 was ahead of our expectations. We expect to increase our estimated fair value by roughly 8% bringing it to around $100/share. 
 
The position has returned 168% since our initial purchase in February 2018. The stock currently trades at roughly a 54% premium to our estimated intrinsic value. At that level we frequently sell out of the entire position. However, because of the uncertain potential of adjacent market opportunities (the company announced deals in chemicals and consumer goods recently), we only sold 40% of our existing position and will retain a position in the company.  
 
Please feel free to email or call with any questions. My best wishes. 
 
Tom
 
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So far our investment partners had nothing to complain about. We had a holding with outstanding returns though now trading at a significant premium to our estimated intrinsic value. Here was the rub however. Conservative value investment theory would have us sell the position at such a premium. No matter how successful we felt the company could be, we felt we couldn’t be guilty of recency bias or hold on to the stock simply because of how well it had performed in the past. Be ruled by the head and not by the heart.
 
With 20/20 hindsight our mistake was startlingly obvious. In our “head-not-heart” mind set, we simply couldn’t believe a review (no matter how deep) in our valuation process would increase the valuation greater than the increase in the price. So - utilizing our supremely confident “we-must-be-supremely-heartless-and-coldly-rational” attitude, we sold out the entire position by end of July 2019. We congratulated ourselves on locking in a 168% return for our investment partners and began looking at new opportunities in which to allocate this capital.     
 
What Happened Next
 
After selling the stock and placing it on the watch list, Veeva came up for review relatively quickly. At Nintai, this annual process is quite extensive with a top to bottom breakdown of our investment case. Everything that can be used to better understand the competitive advantage and market moat is broken down with in-depth research. We look at product pipeline to sales force effectiveness, market satisfaction and adoption rates, customer reviews and purchasing budgets, regulatory filings and approval calendars. We also break down the company financials trying to get a deep understanding of the components that make up cash flows, income statement, and balance sheet. Particular focus is spent on capital allocation and free cash flow generation.
 
Without going into all the details, by the end of our review it became very clear we needed to seriously adjust our valuation upwards. In fact, the increase was so large we sent out a new update (barely two weeks after sending out why we felt compelled to sell the position).
 
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We spent this past Monday and Tuesday speaking with Veeva management, their largest customers, industry thought leaders, and regulatory officials. This completed our nearly two week review of the business, including our annual deep dive on competition, market growth, etc. After reviewing our findings it became clear that we had seriously undervalued the company.  Our revised valuation went from roughly $110/share to nearly $182/share. We have to say that this is the largest adjustment in intrinsic value we’ve ever made. Since July 15th Veeva’s stock price has dropped from $175 to today’s (September 13 2019) price of $139. This represents a 21% drop. At this price the stock trades at a 23% discount to our estimated intrinsic value. 
 
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John Maynard Keynes famously never-said[1], “When the facts change, I change my mind. What do you do, sir?”. It’s pretty wise advice no matter who you attribute it to. With as straight a face as we could muster, Nintai announced we were reversing course and adding Veeva back into the portfolio. It certainly wasn’t a banner day at Nintai world headquarters, but at least the facts backed us up……again.
 
What Can Be Learned
 
I could probably write a book just on the errors from the “Veeva Adventure” (as we refer to it now). That will have to wait for another day. For now, let me summarize the findings that are most applicable to every day investing theory and practices.
 
Don’t Ever ASSuME (You Know How the Rest of That Goes)
In my value investment trained mind, I had made the distinction that Warren Buffett had clearly warned led to fuzzy thinking. It is possible to have a value investment that has two seemingly contradictory attributes - high growth in revenues and free cash and trade at a significant discount to intrinsic value. The value investing world will not end when the two reside next to each other. It’s a lesson I seemingly need to (re)learn every couple of years.
 
Don’t Get Over Confident
When you start to think you know enough about the company or its markets without looking at new data, then you’ve got a real problem. Market dynamics can change by the day, so an investor should always base decisions on the latest well-researched statistics. The fact that I could be off by such an extent on Veeva’s valuation was an example of clear arrogance. Just because I knew a lot about the company’s past didn’t mean I was a greater predictor of its future.
 
If You Base Your Decisions on Facts, Then Be Damn Sure About Your Facts
One of the reasons why I always write an investment case for a potential investment, then turn around and write an anti-investment case, is to make sure I’ve seen both sides of the arguments and the facts support one more than the other. This means I have to know my facts cold. This also means I need to check and double check my facts. Not only was I guilty of intellectual arrogance when it came to Veeva, sadly I was guilty of intellectual indolence as well.
 
Conclusions
 
Being able to identify mistakes and finding the cause is really only half the battle. The second part is creating processes to prevent these types of errors from happening again and being able to verbalize what happened to individuals outside the decision process. This might include your investment partners, your Board of Directors, and you, the reader. I keep a running list of errors I’ve made in my investment process since 2004. That list includes 77 specific errors. Each one is identified, discussed, and then a solution is listed next to it. I’m glad to say I’ve only repeated a total of 6 errors or roughly 8% of the total list. Unfortunately, the underlying cause of the Veeva case is a repeat offender. In my next article I thought I’d discuss other cases similar to this, what solutions I’ve employed, and why I think they have failed.
 
Until then, I look forward to your thoughts and comments.
 
Disclosure: Portfolios that I personally manage own Veeva.     
     


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

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

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


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

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

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

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

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

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

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