Over the course of the past 12 - 24 months performance within the Nintai Investment individual investment accounts have performed quite well against the major indexes we like to measure our performance against – the S&P 500TR, the Russell 2000, and the MSCI ACWI ex-US. Over the course of that run I’ve tried to be clear to all of our investment partners they should not expect the double digit (and even triple digit) returns we’ve seen over this time (I am even required to tell each of them and you that past performance is no guarantee of future returns). The last three months have proven that to be a wise policy. 
 
As you all know, I absolutely hate to underperform - even in the short term. The last 90 days has been extremely difficult with nearly every holding in our portfolios underperforming against the general markets. Reversion to the mean - to the downside - is not nearly as fun as the ride up. Whenever we have a stretch of underperformance here at Nintai, we do several things. First is get outdoors and get some exercise. This gets me away from the computer and reduces the risk of making a hasty decision that will likely only enhance the problem.  The second is I think of a story about Lyndon Johnson and John F Kennedy.  On election night of the 196o Presidential race there was a great deal of tension at the Kennedy headquarters as returns coming in showed the results were going to be very close (it was - Kennedy won the total popular vote of 64,329,141 by only 112,827 or 49.72% to 49.55%). In the middle of this chaotic night, many people remember Lyndon Johnson - the Democratic Vice Presidential candidate - calling John F. Kennedy  - the Democratic Presidential Candidate - and saying to him “I heard you’re losing in Ohio but we’re winning in Pennsylvania.”
 
As an investment advisor (and investor), I’ve never been impressed with money managers who take the LBJ way when it comes to reporting results. Many of them seem to live by the ancient Chinese proverb that says “victory has a thousand fathers but defeat is an orphan”. There will be no lonely orphans running around the Nintai Investment’s offices. The last three months have been tough on our portfolios. Though still up over the long term, these poor returns have eaten up half of our total outperformance. No one is responsible for that except me. I apologize for that.  
 
Being a value investor - particularly with other peoples’ money - is not easy. You are sometimes faced with very difficult choices. Occasionally share prices will dance right around purchase or sell prices but never send a clear signal. Sometimes company’s may take on debt yet remain an outstanding investment opportunity. These types of situations can challenge your investment strategy, your investment criteria, or both. Yet we get paid to make decisions (and that may mean doing nothing) in each of those scenarios.
 
The most difficult situation is when market currents flow in conflicting directions. During these times it seems like any investment decision is a “damned-if-you-do” or “damned-if-you-don’t” proposition. We are currently stuck in an unfortunate market situation where four underlying forces are at work.
 

1. the general markets are overvalued;
2. many individual positions in our portfolios are overvalued;
3. all the companies in our portfolios - in our estimation - are tremendous long term holdings; 
4. We find it impossible to time when - or if - prices will become more rational

 
These four currents have put us in somewhat of an investing bind. I thought I’d share some thoughts on each of these so my readers can better understand Nintai’s decision making process. 
 
General Markets are Overvalued 
Just recently (September 8, 2020), Stanley Druckenmiller (who I admire a great deal) stated the markets are in an “absolute raging mania”.  Morningstar would disagree with their “Market Fair Value” calculator showing a price to fair value of 1.01 (or 1% above fair value). Who’s right? Darned if I know, but I certainly lean more towards Druckenmiller’s view than Morningstar. It would seem to me a move from a market average PE of 14.8 in 2010 to 28.7 in 2020 is - in general - excessive. 
 
Individual Portfolio Positions are Overvalued
In November 2016 when we first started building out the Nintai Investment model portfolio, the average PE was 16.7. By September 2020 this has jumped to 25.9 with 7 out of 21 portfolio holdings having a PE of 40 or greater. In addition, the portfolio price-to-fair value has jumped from 0.91 (or 9% below fair value) to 1.07 (or 7% above fair value). We are in the very difficult position of holding a selection of outstanding companies with a many significantly overvalued. Do you hold on to these no matter what? Do you sell a portion? Do you sell the entire position with the hope to reinvest again after the price drops? There’s no easy answer to these questions. We’ve unfortunately chosen to sit tight and have lost some of the gains by not taking profits when we could. As Warren Buffett would say, we’ve been guilty of thumb sucking. 
 
All Our Portfolio Companies are Long-Term Holdings
As I mentioned earlier, all our portfolio holdings are led by outstanding capital allocators, have significant competitive moats, and maintain outstanding financials. We look to hold companies like this for decades and let management do the heavy lifting. As most of our investment partners have seen, Nintai’s typical turnover (unless receiving new assets on a regular basis) is less than 5-10% annually. We hate to take profits for several reasons. First, we have to be cognizant of taxes for most of our partners’ portfolios. Second, we hate to dilute or lose any part of a holding in such an outstanding company. Last, we have no idea what the short term price moves will be. For every price drop that takes place after taking some profits, there is an instance where the stock jumps by 30% the day after our sale. 
 
We are Terrible Market Timers
Which brings us to market timing. Even though many of our portfolio holdings are overvalued, we recognize that we have absolutely zero skill in timing the markets. We don’t believe many of our fellow investors have that skill either. We generally purchase shares of a company regardless of what the markets are doing. An example of this is a large pharmaceutical company. We are currently conducting in-depth research on the company and may purchase it into partner portfolios even though markets are flirting with new highs on a near daily basis. Our investment decisions are based on individual corporate valuations alone. 
 
Conclusions
 
The last year has shown the benefits and costs of a long-term investment horizon combined with high quality investment holdings. The first nine months were dream-like with the average Nintai portfolio returning 30 - 35% versus the S&P 500’s 15.8%. The next three months saw a horrible reversion to the mean with the average Nintai portfolio returning 5 - 7% versus the S&P 500’s 11.7%. Rather than taking the LBJ route (“we in Ohio versus you in Pennsylvania”), we recognize I am responsible for both the first 9 months as well as the latter 3 months of the past year. I have assured our investors we will take a look at these returns to see what learnings can be found to prevent such underperformance in the future. I’ve learned over my career sometimes you can find ways to improve and sometimes you are simply the victim of reversion to the mean. Either way, we will work hard to better understand the nature of our returns and report back to our investors any steps taken to improve our process. 
 
I hope everyone is staying safe, wearing your mask, and practicing social distancing. If you have any questions or comments, please feel to reach out. 
 
Disclosures: None
 
 
 
 

​In January 2015, I wrote about Abraham Wald and his research in World War II about bomber survivorship during raids over Germany. To quickly summarize Wald’s work, he was asked by senior leadership of the US Army Air Force to critique a study by an internal team analyzing bomber losses. Their study analyzed damage to bombers that made it back and found the following damage patterns. 

Aircraft damage across aircraft: WWII study

 
The study ascertained damage was centered on the mid-fuselage, outer wing tips, and the rear stabilizers. Since the damage patterns were so pronounced, the Air Force team’s recommendation was to reinforce these areas. 
 
Wald took one look at this and told the team their work was deeply flawed. By studying the planes that came back the researchers were seeing where the planes could withstand damage. The more interesting facts should be about the planes that didn't make it back. By analyzing where all the bullets holes and damage were (on the wing tips, mid-fuselage, and rear stabilizers) on the planes that made it back, he proposed strengthening the areas where there were no bullet holes (mid-wing and rear fuselage). Through his report thousands of bomber crew members were saved through the course of the war. Wald’s work is often used in survivorship bias studies - meaning we focus too much on survivors when we should be looking more closely at those that don’t make it.
 
In my article, I used Wald’s research as a prelude to looking at survivorship bias in mutual funds. Investors many times get hooked on - like air force leadership - the winners in mutual funds, rather than the losers (or those who “don’t make it home” in Wald’s words). In the article I discussed inverting and understanding how many mutual funds survived and beat the S&P 500 index over time. The data demonstrate the incredibly poor performance investment managers displayed for the years 2007 - 2011. I wrote:
 
“Roughly 9 out 10 funds underperformed before they were either merged away or simply closed. A loss that would have staggered Wald himself. It’s hard to imagine that trained professionals - with a wealth of technology, analytics, and treasure behind them - couldn't exceed the batting average of an AA baseball team third stringer. In fact it’s hard to imagine that throwing darts at a list of stocks and bonds couldn't have produced better results. For the investors who received such terrible returns from their investment managers, all they received was a letter quietly delivered to their mailbox informing them of the merger of their fund with an entirely new – and no doubt exciting and outperforming – investment opportunity.”
 
I thought it might useful to take a look to see if anything had changed in the last decade and whether the findings in “Mutual Fund Survivorship” still hold up. Morningstar recently published its latest Active/Passive Barometer report which can provide answers[1].  
 
Every month, Morningstar takes a look at both performance and survivability of active versus passive funds by fund category (e.g. large value, large growth, mid growth, etc.). They also report performance by management fee organized by decile. In August’s report Morningstar discussed their latest findings. 

1. Testing the theory that active funds can outperform passive funds during times of volatility, Morningstar measured all 20 fund categories performance (active and passive) for the first 6 months of 2020 including the period of the Corona virus market correction. Only 51% of active funds both outperformed and survived (or “made it home”) versus their passive cousin. Domestic funds actually did worse with just 48% outperforming. 
2. Active bond funds did worse than active stock funds with only 40% surviving and beating their respective index. 
3. Not surprisingly (in alignment with the “Mutual Fund Survivorship” article), long term performance was terrible. Only 24% were able to survive and beat their respective index over the 10 year period ending in 2020. Foreign stock, real estate, and bond funds (turning around their short term performance) were the best performers while US Large Cap were the worst performing. 
4. Another (non)-surprise was the fact that the cheapest funds had double the chance of surviving and beating their index versus the most expensive 34% to 16% respectively. 

 
Taking a deeper dive into the data shows that sometimes the findings aren’t as simple as they appear. For instance, why is it that nearly every growth fund decreased performance by nearly 15% from 2019 – 2020? Yes, we know growth went out of fashion, but why? Here are some other complexities investors should consider as they think about survivability and performance. 
 
Survivability is a Complex Problem with a Hybrid Solution
Having a fund merged away or closed is rarely due to a single issue. Many times it’s a combination of events. These include high costs versus both indexes as well as funds within their category (e.g. small growth), underperformance against both the S&P and other funds in their category, and a dwindling asset base. The answer to meeting these issues isn’t always easy. One and three are inextricably linked. If the fund lowers fees, then it might not maintain a level of profitability necessary to keep the fund going. But growing the asset base might require this if fund finds itself in a war against index pricing. The issue of performance is far trickier. The very choice of active management means the odds of beating the index has decreased versus an index fund (part of that of course is fees. Back to where we began!). The ability to pick stocks or bonds more successfully than an index fund – long term – is a very rare accomplishment.   
 
Survivability and Performance Isn’t Just About Active versus Passive
With the data as they are, it’s easy to say that passive beats active. But that’s not the case every time. In both survivability and performance passive generally beats performance. It’s important to remember that outperformance can vary dramatically by fund category (small cap, mid cap, etc.), methodology (growth, value, or blended), geography (domestic versus international), equity versus bond, or even by industry (real estate). It’s far too easy to simply write off a fund because it’s actively managed. It’s vital investors spend time reviewing short- and long-term performance, fees, and the fund’s strategy. Some funds might outperform the market by 30% for one year but underperform by 15% over a five year period.  
 
As Usual, Fees Greatly Affect Survivability and Performance  
One thing that hasn’t changed and continues to be one of the top issues affecting performance and survivability is fees. The funds with the highest fees (both passive and active) had a survivability rate of only 27% of those with the lowest management fees. Those management teams that are both actively managing and charging the highest fees survived only 16% of the time period versus 47% of the passively managed funds with the lowest fees. Bottom line? If you think your active management team has any chance of long term success, at least make sure they have the lowest fee structures. Bottom line? Jack Bogle 1 - High fee actively managed funds – 0. 
 
Conclusions
 
Since I published “Mutual Fund Survivorship” five years ago, not much has changed. We know active management generally is more expensive than passive and has a lower rate of survival. We also know the funds with the lowest management fees have better performance and longer survival than those with the highest fees. Actively managed funds with the highest fees have a pretty poor chance of “making it home”. As an active manager with a record of longer-term outperformance (remember: past performance is no guarantee of future returns!) we feel extraordinarily lucky to have investment partners who fully support our methods and strategy. Our goal of course is to provide them with long-term outperformance while maintaining a reasonable risk/reward profile. So far - with a generous amount of luck and some skill - we’ve been blessedly successful in these efforts. If we stick to our investment strategy, don’t wander too far from our circle of competence/comfort, and charge a reasonable fee, we can provide a real service to our partners. So far we seem to be on the right course. 
 
As always we look forward to hearing from our readers. Tom can be reached at tom@nintaiinvestments.net. 
 


[1] “Morningstar’s Active/Passive Barometer”, August 2020, Ben Johnson CFA