“We shortened sail in degrees, rolling in the headsail regularly, then taking the main off completely. The ride was exhilarating as the “Gigi” would surf on the long crests, skidding and squirming at breakneck speeds until the wave outpaced her. I have a vivid memory of being picked up by a wave, sinking down into it like an artillery shell into a howitzer, and then firing forward as the wave top overcame the base and started to break. It was madness. I can also recall seeing fish in the wave curls that were higher than we were.”
                                                                        -    Sailing a Serious Ocean, North 54 

“The Horn lived up to its reputation again. In twelve hours its malign influences had transformed an innocuous summer low coming in out of the Southern Ocean into the most dangerous of storms, what old time square rigger sailors used to call a Cape Horn Snorter.”

                                                                       -    Derek Lundy, The Way of a Ship
 
For thousands of years, human beings at sea were at the mercies of whatever direction the wind was blowing. If the wind was blowing in the direction you were going (known as “running” - hence the phrase “running with the wind”) that made things pretty easy. The difficulty began when you started the trip for home and you had to sail directly into the wind. With the physics of sails (which I will be mercifully brief about), one couldn’t just sail into the wind. Two basic principles made this impossible. The first is leeward drift or drag. This means the boat will inevitably drift in the course of the wind. Some boats are known as being particularly good at reducing such leeward drift. Others are sometimes referred to as “those horrible old f’ing Dutch buggers” - well…you get the drift (no pun intended). The second principle is lift. No different than airplanes, this is when you put an aerodynamic foil into the wind and have the air pass more quickly on one side and more slowly on the other, thus creating a force perpendicular to the sail. Using lift, a boat can sail somewhat into the wind (known as “reaching”). By utilizing multiple reaches (known as “tacking”) the sailor can make it home even with the wind against them. The most dangerous position for a sailor is to find the leeward drift exceeds their ability to reach. In these situations, if the boat can’t anchor it will be driven to leeward against the sailor’s will (known as the “horrors of a leeward shore”) until hits whatever object it first comes upon.
 
I bring all this up because over the past decade it seems like value investors have been sailing into relatively strong and steady winds and facing harsh leeward drift. For many, the horrors of a leeward shore are all too real by now. This thinking was captured quite eloquently in a recent Morningstar interview with Charles de Vaulx, Chief Investment Officer and portfolio manager at International Value Advisors. Previously de Vaulx was portfolio manager at First Eagle Global and First Eagle Overseas. The full interview “Charles de Vaulx: Why Value Investing Has Slumped but Will Rebound” can be found here (Morningstar premium membership required). I try not to shamelessly steal from someone else’s intellectual efforts, but I thought the concepts laid out in the interview were powerful enough to “forage liberally” as William T. Sherman so famously said.
 
Value Advisors International (IVIOX) and de Vaulx have certainly been victims of strong headwinds. The funds positioning in its category (Foreign Large Blend) quartile rank has been hard for managers and investors alike: 98th percentile YTD, 97th percentile 1 year, 99th percentile 3 year, 80th percentile 5 year, and 23rd percentile 10 year. But de Vaulx and his team aren’t tacking repeatedly and altering course on a regular basis. They believe their approach remains consistent with achieving long-term outperformance.  
 
In his interview with Morningstar’s Christine Benz and Jeffrey Ptak, de Vaulx discusses three trends which have provided tremendous headwinds for his funds and fellow value investors. The first is the three-decade long trend of lower interest rates. The steady decline has affected value investing in several ways. This includes DCF model discount rates, corporate free cash flow (as a percent of interest costs), and economic modeling results. The second trend is the pressure put on corporate managements to put low-earning cash to work, particularly in regards to corporate stock buybacks. The last trend is the Federal Reserve’s impact on business cycles making them shallower and longer. This has reduced stock price volatility and thereby investment opportunities for value investors. In combination, these have created such strong headwinds that value investors have seen a reduction in opportunities - and correspondingly results - since the early 1980s.   
 
 
 
 
 
A 36 Year Headwind: Interest Rates
 
Starting in 1982 - following Paul Volker’s aggressive efforts to wring inflation out of the US economy – interest rates have fallen from double digits to nearly negative in the US and truly negative around the world. Anybody who uses a discounted free cash model know the double impact of time and discount rates on corporate valuations. In an article from March 2019 (“Looking Back at Nintai’s Discounted Free Cash Flow Model” which can be found here), I discussed the impact of the discount rate on my estimated intrinsic value. The bottom line is that getting that rate wrong can dramatically impact your investment case – sometimes destroying it altogether.
The Federal funds rate dropped from its high of 20.6% in June, 1981 to its low of 0.06% in July 2011 (it has since jumped to 1.6% in November 2019). This represents a remarkable 98.6% drop. If we take a look at current Nintai Investments holding Veeva (VEEV), let’s see the impact of increasing aggressive changes in the discount rate on the company’s valuation.
 
As of November 2019, the stock trades at roughly $156 per share. In our discounted free cash flow model, we currently use a discount rate of roughly 7.5%[1]. Utilizing a 10-year time frame, we estimated the intrinsic fair value at around $173/share or an 11% discount to the current price. If we raise the discount rate by 3% to 10.5% the estimated intrinsic value drops to $89 per share or a decrease by nearly one-half. A 40% increase in the discount rate cuts the estimated intrinsic value in half! If we invert this, then it’s easy to see the three decade trend of falling rates puts a near perpetual increase in the discounted free cash flow-generated intrinsic value. If we look at a company like IBM, nearly 85% of the increase in stock price since 1982 can be explained by the falling discount rate. That doesn’t leave much room for finding a bargain price during that time.    
 
A Fake Floor: Stock Buy Backs
 
If the falling discount rate helped create an inflated stock price over the past 35+ years, then the growing trend of stock buybacks has helped solidify the concept of a fake price floor. Companies have spent hundreds of billions of dollars over the past
 
decade in repurchasing their stock. In some cases this has reduced overall outstanding shares by 40, 50, or even 60%. Some of these have been examples of outstanding capital allocation. In other cases companies have spent billions of dollars simply repurchasing the vast amount of options handed out to management. In these cases the number of outstanding shares have not gone down – and in some particularly egregious examples – outstanding shares have actually increased. No matter how these transactions add up, they frequently create a fake floor whereby potential investors see an illusionary minimum share price.
 
Using IBM as an example again, since 2004 the company has spent $148B repurchasing stock. That comes out to be roughly $1B each year. During that time total outstanding shares went from 1.7B to 893M – or a 47% in outstanding shares. In that same period earnings per share went from $4.38 per share in 2004 to $8.61 per share in 2019. Of note, earnings per share were $8.89 per share in 2008, peaked at $14.94 per share in 2013 before descending each year hitting $8.61 per share in 2019. You might think at some point such disappointing performance would create some fairly opportune buying moments, but sadly not. The company’s P/E ratio never dropped below 10 between 2004 – 2019. Rather it averaged nearly 15 during that time period. For a company that showed zero growth for 11 years (2008 – 2019) and a nearly 45% drop in earnings over the past 6 years (2013 – 2019), it seems the PE ratio was inflated beyond reason. I suspect the repurchase of shares played a role in convincing shareholders to pay a rather high premium for IBM shares. It would be interesting to hear Warren Buffett’s thoughts on this after his experience as an IBM shareholder.     
 
A Case of the Dog Not Barking: The Lack of Business Cycles
 
Perhaps the most interesting concept raised by de Vaulx was the dramatically different length and scope of business cycles in the US over the past two centuries. Utilizing data from Sanford Bernstein’s “An Economic History of Now” (which I highly recommend), de Vaulx points out the fact that the average time of economic expansion has increased dramatically (25 months in the 19th century, 44 months in the 20th century, and 101 months in the 21st century) while the average economic contraction decreased equally in magnitude (the average depth of GDP decline was 3.7% in the 19th century, 4.3% in the 20th century, and only 2.1% in the 21st century).  
 
 
So what’s happening here? In de Vaulx’s view – and I completely agree – the
decreased volatility in terms of time and magnitude has reduced the opportunities to employ value strategies. With smaller time frames and vastly decreased magnitude of contractions (investors in the 21st century have seen GDP declines be less than half those of the 20th century), the ability to capture inefficiencies in the market have dropped correspondingly.  
 
Conclusions
 
For any sailor who has spent an entire day beating into the wind, tack after tack, seeing their destination seemingly getting no closer, the limits of patience may be reached. They will employ every trick in the book to lay half a point closer to the wind. It’s no different for many value investors. The last ten years have been like that for many value investors. They’ve tried every trick in the book but unfortunately – as de Vaulx has so eloquently pointed out – the headwinds faced by these investors have been insurmountable. That said, I actually don’t think all is lost. Over the last 12 months we’ve seen volatility increase both in scope and length. The rapid drop – and size of it – at the end of 2018 brought many investors up short. Certainly anyone watching the VIX index and the drops in the major indexes thought the return of old fashioned value was upon us.   
 
At Nintai Investments we’ve done everything possible to create a weather proof boat design (think of this as your portfolio strategy and holdings), that can reduce the risk of rising seas while maintaining as much headway as possible (think of Nintai’s “Quality Portfolio/Value Pricing” from our last article), and has the strength to survive extraordinarily long voyages (think of Nintai’s companies that are decade long in their holding time). Whether you see it as a vessel to help you travel the globe or an investment vehicle to meet your retirement goals, there ARE ways to help defeat de Vaulx’s three great headwinds. I highly recommend readers review the Morningstar interview, take notes, and identify the issues as they exist in your portfolio. You might just find you have an all new confidence as you put to sea in your latest investing journey.
 


[1] The discount rate is made up of the current 10-year treasury rate (1.74% as of November 2019) plus factors for the company size, financial leverage, cyclicality, corporate governance, economic moat, and complexity. 

“We’ve really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.
​
                                                                            -         Charlie Munger 

“The risk of paying too high a price for good-quality stocks - while a real one - is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.
                                                                          -          Benjamin Graham 

Since the 2009 bottom of the 2007 - 2009 market crash, we’ve had an over decade-long market expansion which has provided investors with the longest bull market in recent history. For those at the end of their investing career, this has been a huge tailwind allowing for far more generous performance any would have thought possible. During these types of market runs, the old adage of “a rising tide raises all boats” certainly rings true. Just look at these returns for 2019: Dow Jones up 21.7% YTD, NASDAQ up 28.2% YTD, S&P 500 TR up 26.1%, Russell 2000 up 18.9%. Every sector is up double digits in 2019 with the exception of Energy Capped (up 5.1% YTD). All other sectors range from a low of Healthcare (up 15.8% YTD) to a high of Technology (up 38.5% YTD). With such returns every investor is a hero of their own financial story.
 
I thought I’d take a different tack in this article to explain why Nintai Investments sees the past five years less through rose-tinted glasses and more through lenses that always see risk around the corner. Since opening our new investment services business in 2018, we’ve both underperformed (in the first year) and are now outperforming when measured since inception. We’ve really come into our own over the past quarter as the markets recognized the value of high-quality companies with strong returns on capital, equity and pristine financials. Our returns over the last 3 months have been 10.77% compared to the S&P 500’s 6.71%. (Note: past performance is no assurance of future returns). Our returns have been 15.72% (including fees) since inception versus the S&P 500’s 13.87%. This isn’t to boast about our performance (though we - and our investment partners - are pleased) but rather to point out that we believe Nintai’s approach of purchasing extremely high quality businesses at fair prices and holding them for extended periods can outperform both bull and bear markets (again: past performance is absolutely no assurance of future returns). As we look around and see record highs all around us, at Nintai we continue to clear the deck for foul weather and prepare for the inevitable (significant) market correction. With that in mind, I thought I’d discuss Nintai’s approach and the relatively simple process we employ in meeting our strategic goals.         
 
Better Quality, Cheaper Prices
 
At Nintai we believe in a fundamental investment concept. If we invest in a bucket of companies with significant advantages in quality (higher returns on capital, equity, assets, free cash flow margins, no debt, etc.) combined with valuations (a blend of cheaper attributes including estimated intrinsic value from our DCF models and cheaper PE ratios), over the long-term we can expect to outperform the broader markets. 
 
The concept of purchasing higher quality companies or looking to purchase shares at a discount to estimated intrinsic value isn’t anything new to the value investment community. I have found it is rarer to combine the two as a foundation for your investment strategy. When I utilize Morningstar’s portfolio manager research tools to find funds with a high match rate to Nintai’s holdings, I’ve found only 2 (two!) with a greater than 25% overlap with our portfolios. With numbers like this, you can see it’s rather rare to find the concept carried out on a regular basis. What’s equally rare (as far as I can see) is articulating the idea that the highest quality companies purchased at good prices can provide significant downside protection during a bear market. In general, I’ve found that companies and management that generate great returns on capital and have little or no debt are businesses that thrive in bull or bear markets and in expanding or recessionary economic times. Combined with holding significant cash, I feel comfortable that when the inevitable market tumble comes along, I’ve reduced the risk of capital impairment as best as I can in today’s markets. 
 
Nintai’s Abacus reports give a quick graphic overview in how we are doing in meeting the goals of a portfolio consisting of outstanding quality at value prices. Later on, I will walk readers through the summary report and take a look at how we are doing in meeting Nintai’s investment strategy.

It All Starts by Finding Corporate Excellence
 
Any research we do at Nintai starts with locating companies with outstanding business characteristics. We locate these in multiple ways – GuruFocus’ All-in-One Screener, conversations with thought leaders, meetings with corporate executives, etc. Once we’ve found a company that meets our criteria we will begin the in-depth process of really understanding the company’s strategy, products, markets, competitors, etc. If we’ve done our job we can run a summary “Quality” report on Nintai Abacus and make sure the portfolio is meeting our strategy.  
 
Let’s use a blend of our investment partner portfolios to demonstrate what I mean by a “Quality” summary report. In November 2019 on average, the Nintai Investment portfolios shared the following attributes: return on capital (42.8%), return on equity (31.7%), and return on assets (19.2%). This compares to the same numbers for the S&P500 (source: Morningstar’s “Portfolio X-Ray” reporting function): return on capital (3.28[1]), return on equity (1.21), and return on assets (2.11). These numbers show that – in general – Nintai’s portfolios have created a basket of holdings far more profitable than the S&P 500. Additionally, the debt-to-equity ratio of the S&P 500 (as of August 2019) stood at 0.89 (source: Haver Analytics and Standard & Poor’s) versus 0.023 for the Nintai portfolios.
 
Why are all the numbers important? First, a basic tenet at Nintai Investments is to prevent permanent impairment of our investment partners’ hard earned capital. We’ve found over time that companies with little or no debt[2] and who are also highly profitable (both from a free cash flow perspective as well as capital returns) minimize that risk. Second, we’ve found that management teams who act prudently with their investors’ capital are great stewards to partner with over a decade or two. Last, companies with these characteristics are generally outstanding businesses with outstanding fundamentals and deep competitive moats. All three of these play a vital role in preventing a blow up in the portfolio that can lead to truly horrendous losses. At Nintai, everything begins by investing in outstanding quality.      
 
Finding Value in a Value Investment Strategy
 
Finding outstanding, profitable, and prudent companies is of course only half the battle. Buying them at a discount to my estimated intrinsic value is the second piece of equally important halves. In finding value, we use two different and distinct methods. The first is company specific. We utilize a discounted free cash flow model to ascertain the value of each individual holding (or potential holding). As this information is proprietary, I will simply say the aggregate price-to-value ratio for the Nintai portfolios is currently 0.91. This is to say our portfolios currently trade at a 9% discount to our estimated intrinsic value. Values range from 137% (overvalued) of our estimated value to 72% (undervalued). As a portfolio of individual stocks, we see some investment opportunities in several holdings trading at significant discounts to their estimated intrinsic values.     
 
The second approach we take to value is comparing the total portfolio to the S&P 500. This gives us an idea as to how the portfolio’s value is to the general markets. While we put a great deal of effort into the DCF model, we think looking at the broader markets is equally valuable. There are two numbers we look for in these market reviews. The first is how our portfolios’ price-to-earnings ratio look against the S&P 500’s ratio. This tells us how expensive the portfolios are against the broader markets. The second is analyzing the portfolios’ 5-year earnings growth projections against the S&P 500. This gives us a look at whether we are paying more or less for future growth versus the general markets.
 
The S&P 500’s price-to-earnings ratio - as of November 2019 - (source: www.multpl.com) stood at 22.95. The Nintai portfolios’ average price-to-earnings ratio was 18.8 at the same time - an 18.1% discount to the S&P 500 PE ratio. This tells us the Nintai portfolios are currently trading at a significantly cheaper rate than the S&P 500. Great news. In addition, the Nintai portfolios have a 5-year estimated earnings growth rate of 11.1%. This is roughly 17% greater than the estimated S&P 500 rate. We now know the portfolios are cheaper than the S&P 500 as well as estimated to grow earnings significantly faster. What’s not to like about those statistics? 
 
Putting It All Together
 
While it’s nice to have these numbers at our fingertips, they aren’t really that helpful to our investment partners. We created the Abacus reporting system to graphically demonstrate the quality and value components of each portfolio. This allows investors to use a single graphic to measure how their portfolio stacks up against the S&P 500. Seen below is a summary portfolio report of all the Nintai portfolios wrapped up in a single page report.

Our investment partners have a tendency to look at the rating arrows (all green is what they are looking for here) and ask any questions related to those. At the core, the graphic quickly encapsulates:

• Does the portfolio meet our quality criteria in general and against the S&P 500 specifically and;
• How does the portfolio compare in value against the S&P 500?

 
A number we look at carefully is the combination of the S&P 500 P/E relative number as well as the S&P 500 projected EPS growth relative number. Here we combine the fact that the portfolio is 18% cheaper than the S&P 500 and is estimated to grow 17% faster giving us a 35% “combined value rate (CVR)”. We are satisfied with a CVR over 25%. We have nearly always outperformed over the next 3 - 5 years if the number exceeds that amount. Equally important is adding up the S&P 500 relative number for ROC, ROE, and ROA. Here we look for a sum called the “combined quality value (CQV)” greater than 5. The current portfolio CQV is 6.6.
 
Why This Matters
 
A lot of readers will point out that looking for quality at good prices is just common sense. I completely agree. Yet its extraordinary to me that so few investment managers practice such an investment strategy. All too often I see far too active trading (even when a manager might own great companies), or a lack of concern about debt and credit quality. If you own a basket of outstanding companies with a long runway for growth, at Nintai we feel this tackles several issues. 
 
Watch Out Below
As mentioned earlier, one clear advantage of focusing on value and quality is the protection it provides on the downside. I wrote several years ago about how the highest quality stocks in our portfolios had performed the best during the 2007 - 2009 market crash. I firmly believe we will see similar movement when (and remember it’s not if – but when) the next crash happens. After an 11 year old bull market, I think the downside protection is worth even more. As a fiduciary steward, there is nothing more important than focusing on preventing the permanent impairment of my investment partner’s capital. I firmly believe a focus on quality and value is one of the more powerful tools in my arsenal to prevent such losses.
 
Let Management Do the Heavy Lifting
It’s been demonstrated many, many times that just a few items can severely damage investment returns over the long term. Under the broad category of “costs”, lie both transactional fees and taxes. One of the real benefits investing in a high quality stock at good value is the ability to hold it for the long term - meaning decades sometimes. This cuts down on transactional costs as well as any short or long-term capital gains. Why not let management allocate capital and do all the hard work when it comes value creation?
 
Finding Quality is a Difficult Task
While it may seem like a simple concept, finding quality at a value price is actually a rare and difficult thing to find in today’s market. Utilizing just Nintai’s quality measures (and not worrying about value pricing) leaves our team with less than 200 companies in the US and European markets. In addition, the company has to be in an industry, geography, business strategy, etc. that leads us to think we might be able to obtain a small knowledge-based competitive advantage against other investors. When we find a gem that meets all this criteria, at Nintai we are loathe to let them go.
 
Conclusions
 
As the latest bull market gets long in the tooth (and it’s narwhal long!), at Nintai we increasingly focus on the downside risk of the markets. We’ve found over time that two approaches serve us well in the latter stages of a bull market and for the duration of a bear market – hold significant cash and focus on quality. The (relatively) simple process of identifying outstanding companies with high returns and rock solid financials and purchasing those at fair value-based prices can cut down on risk dramatically. At Nintai, we highly recommend investors take a long hard look at their portfolios and look for companies and management that they can partner with over the decade or two. It’s hard to find ways to argue with Munger and Graham simultaneously. With a record like theirs, why even try?
    

“The two most powerful warriors are patience and time.”
 
                                                                     -      Leo Tolstoy 
“Great leadership is about continual change. An outstanding leader is always seeking opportunities in failure and always seeking improvement from success. Patience is key, but does not guarantee long-term prosperity.”
                                                                    -       Iwasaki Yatarō 

In Japan, the Sengoko period (or as translated into English “The Age of Warring States”) ran from roughly the mid-fifteenth century and ended with the Battle of Sekigahara in 1603. During that time, Japan was engaged in nearly constant civil wars as a series of very powerful regional leaders known as dâimyo battled to become the sole leader (the Shogun) of the country. One such leader named Takeda Shingen was considered an odds-on favorite - a great military leader, a wise civil administrator - he certainly had the credentials. Unfortunately, he ran up against two other leaders - Oda Nobunaga and Ieyasu Tokugawa - who would eventually precipitate his downfall. In a likely apocryphal story, a lead retainer sat with him and told him a story about a prince who worked hard at becoming the leader of his province. This prince spent all his time building, tearing down, fighting wars, and then rebuilding. It suddenly dawned on this prince that if he had simply been patient - allowed his population to grow, used a growing tax base to build out infrastructure, and so forth - he would have been far more powerful. In being so active, the prince had lost track of his greatest asset - time. Takeda recognized the point of his retainer’s story immediately. But by then it was too late. Within 5 years Takeda’s entire kingdom and family would be gone.
 
I bring up the story of Takeda Shingen because many investors see their investment world through his eyes. They feel action is necessary to achieve success. That through inaction they are somehow losing a step on their road to financial success. Yet study after study has shown that inaction is a good thing. It cuts down on costs, it allows compounding to work its magic, and it allows an investor to get on with the most important things in life - living.
 
Why Time Matters  
 
It’s amazing when you think about. What is the only force guaranteed to fill in the mightiest competitive moat? Time. Have you ever seen the greatest monopoly beat Father Time? What strongest empire, what greatest military power, what most violent tyrant has ever beat out time? Who is the sibling of compounding that makes it the eighth wonder of the world? It is time of course. For compounding cannot grow, cannot prosper, nor create any change at all….without time. What is the cheapest asset in all the investor’s arsenal of weapons? Time! It costs nothing, it has no ego, it will not fight with you, it will simply and quietly provide you with companionship every step of your investment journey.
 
Outstanding businesses will utilize time as an asset to grow competitive advantages, open new markets, and deploy existing capital into profitable growth. At Nintai, we look for managers who find ways to create business growth where return on capital far exceeds weighted average cost of capital. Combining this in a business model that requires little capital to begin with (thus allowing for the creation of a fortress-like balance sheet), leadership has created a business with a long runway of profitable growth. At Nintai, we look for companies where that profitable growth and strong balance sheet can be estimated to survive - and thrive - for decades.   
 
Is There Such a Thing as Too Much Time?
 
Some of my readers might be thinking at this point that this is another article on the value of time and money (which I’ve written about previously). But as Robert Abbott has pointed out, I have a passion for inverting many issues. Why should the concept of time be any different? So today I thought I’d look at when time is the enemy of your investment holding. Much like Shingen, great companies can let time eat away at their advantages – ranging from competitors to regulatory approvals. Every quarter – when Nintai Investments quickly reviews portfolio holding performance – we keep an eye on several numbers that might reflect that time has eaten away at our investment case. If any changes in these areas show up, we will completely take apart the business case developed earlier in the year and rebuild it from the ground up.
 
Falling Return on Invested Capital (ROIC)
The first item we look at is to make sure management is still allocating capital at exceptional rates. ROIC is the amount of return a company makes above the average cost it pays for its debt and equity capital. If the holding is going to continue to generate long-term outperformance, it is vital that ROIC exceed the company’s weighted average cost of capital (WACC) by a generous margin. A fall in ROIC can tell you management has taken its eye off the ball in several ways - it might be having difficulty in finding profitable investment opportunities, competition may be cutting into core customers and industries, or might just have simply invested in some truly unfortunate ventures. Falling ROIC can sneak up on you. If you think Boards and management will keep an eye on it for you, think again. In a 2013 survey by McKinsey (McKinsey Quarterly, “Tapping the Strategic Potential of Boards”, February 2013), less 16% of Board members knew that ROIC is the primary driver of value. If you believe ROIC is such a powerful driver - which I do - then I highly recommend keeping a close eye on ROIC.   
 
Falling Free Cash Flow Margins
As a value investor who utilizes a discounted free cash flow model to calculate value, free cash flow (FCF) is one of the most important margin numbers I watch (compared to say gross or net margins). At the end of the day, cash keeps the doors open and free cash allows management strategic flexibility in terms of future capital allocation of returns to investors. FCF margins can drop for several reasons but the one that gives us the greatest concern at
 
Nintai is losing the ability to price products and services. Many great companies share the same attribute of making their product in the daily operations of their customers. It almost makes it impossible for the customer to haggle or obtain pricing power over the long term. Think of Guidewire’s (GWRE) InsurancePlatform which operates many property and casualty insurers claims, billing, and policy functions. The amount of effort it would take to change vendors, remove one system, install a new one - all while maintaining consistent uptime and coverage - is a difficult action to justify. Another reason might be a large increase in capital expenditures which might reflect the same type of problem - having to increase spending to fend off competitive inroads to a holding’s customer base. When I see a significant decrease in FCF margins, this will generally have a direct impact on my discount model’s valuation. It’s never a great way to start the day.    
 
Drop in Cash or Increase in New Debt
Another sign that will catch my attention is to see a drop in cash on the balance sheet or - more importantly - the issuance of new debt. Generally, Nintai Investments runs a focused portfolio of roughly 20 - 25 position. Of these, roughly three-quarters will have no short or long-term debt. Occasionally, companies will issue debt for larger capex projects or acquisitions. Examples this might include Nintai Investment holding Novo Nordisk (NVO) which usually runs a very tight balance sheet with very little short-term debt (in the tens of millions of $$) versus having billions of dollars or short term instruments. The company has recently expanded its debt for new acquisitions. Obviously we want to see these type of deals generate high ROIC and see real value from the risk generated by a weakened balance sheet. Another example which we see an a wholly negative light was former Nintai Partners holding Qualcomm (QCOM) which took on an enormous debt obligation to fund share repurchases. No matter the calculations made, we see this type of action indefensible related to investor risk/reward. In many cases these types of transactions are simply a transfer of wealth from option-enriched managers hitting pay dirt when investors buy back millions of shares at inflated prices. In Qualcomm’s situation, we sold out of our entire position and never looked back.  
 
Conclusions
 
Investing in a small business that generates high return on capital, equity, and assets, has high free cash flow margins, and deep competitive advantages can be a wonderful partnership that lasts for decades. It’s the backbone of our investment strategy at Nintai Investments LLC and has provided the firm and its investment partners with outstanding returns since 2002 (of course past performance is no assurance of future returns). Having said that, finding companies where time aids in their growth and only strengthens their businesses is hard work. Time can erode any competitive advantage, fill any moat, and weaken any management team. Keeping an eye on several core measures can make sure you move on in a timely manner. Change happens. None of us like it. But I guarantee you none enjoy it less than lose who some of the core building blocks of their portfolios or daily living. Just ask Takeda Shingen.
 
DISCLOSURE: Portfolios that I personally manage are long GWRE and NVO. Nintai has no position in QCOM.    
 

“The world as we have created it is a process of our thinking. It cannot be changed without changing our thinking.”
                                                             -        Albert Einstein
 
“I’ve always been warned that when people say ‘it’s different this time’ it really isn’t very different. Yet if I look back over the last decade and I see so much underperformance by value investors (both traditional and the more modern-approach), I think to myself, ‘is it really different this time? Does value investing not work anymore’”?  
                                                            -         Sally Jenkins 

In my past few articles, I’ve discussed the distinction between growth and value investing, value’s difficulties since the 2007 - 2009 market crash, and how that has been part of a greater discussion about the viability of value investing in today’s markets. In this article, I thought I’d tie together the two themes and - at a very high level - summarize what the last decade has told us in terms of investment learnings and how we might come to terms with the over decade-long short circuiting in value investing performance.
 
At Nintai, we divide the market returns since the height of the technology bubble into four phases. Phase one was the run up into the technology bubble running roughly from 1998 - 2000. Traditional value investors - in general - did poorly as they continued to invest along more classic value investing guidelines. Many value investor shareholders began to get nervous as they opened their returns and saw underperformance being led by such staid companies as industrial parts supplier Fastenal (FAST) or spectrometry provider to biopharma Waters (WAT).[1] Some truly great investors closed their doors at the height of the bubble commenting on the fact they simply didn’t understand the market anymore. Phase two was the period of 2001 - 2006 when value investing roared back and more traditional companies like Proctor & Gamble (PG) or Coca Cola (KO) saw great returns while technology stars of the bubble sustained losses of up to 90% or even bankruptcy. It was rare to see such a clear vindication of value investment theory and practice. Phase three was the market crash of 2007 - 2009 led by the financial and credit markets starting with Bear Stearns and Lehman Brothers all the way to the government interventions of Fannie and Freddie Mac. There was a huge distinction though between the bursting of the technology bubble and the bursting of the credit/real estate market bubble. In the latter, many traditional value investors lost as heavily (and sometimes even more) as the general markets and even growth investors. Famous value investors who had been hailed as geniuses just half a decade before were chalking up 30, 40, and even 50% losses as their traditional value methods of using low price-to-book or price-to-revenue models imploded. Phase four added to the agony as the general markets powered through a nearly decade long recovery. While this was happening, traditional value returned paltry returns in what traditionally would have been a golden era for that investment style. Rather, you saw an entire generation of value investment leaders struggle for the entire decade. It was reflected in returns and even more importantly in their assets under management. The list is long and well-respected. Marty Whitman ($4.6B AUM in 2011 to $1.19B AUM in 2019), John Hussmann ($5.4B AUM in 2011 to $350M AUM in 2019), and David Dreman ($5.3B AUM in 2011 to $220M AUM in 2019).  Wally Weitz can be considered a success by seeing a rather slim increase in AUM (going from $2.3B in 2012 to $2.52B in 2019). Perhaps the harshest lessons were learned by David Winters, going from value investing rock star and CIO of Wintergreen Fund with $1.5B in AUM in 2012 to shuttering his doors in 2019 with less than $90M in assets. This humbled writer/investment manager had a dismal record with my own corporate internal fund (and eventual Charitable Trust) which was outperformed 4 out 5 years from 2011 - 2015 before I left the fund for greener pastures.
 
Is Value Investing Dead or Has It Simply Genetically Evolved?
 
In a recent Westwood Insights (“Value Stocks are Screaming for a Reversion to the Mean. Is Anyone Listening?”. It can be found here.) there is a segment describing the end of Julian Robertson’s career in March, 2000. It reads:
 
“It was an unseasonably warm 58 degrees in New York City on March 30, 2000. Winter white was just a faint memory on that Thursday, and the thoughts of bustling commuters had turned to spring. All was not balmy in the canyons of Wall Street, however, as the shock heard around the investing world had been announced that morning. Before the New York Stock Exchange opened, value investing legend Julian Robertson, age 67, announced that he was calling it quits, and would return the $13 billion that he managed to his 700 shareholders. He planned to shut down his fund and walk away.
 
At his fund’s peak in 1998, Robertson managed $22 billion, but he had seen withdrawals of $8 billion over the previous two years, including $1 billion in the first quarter of 2000. His fund had lost 19 percent in 1999, badly trailing the 21 percent gain in the S&P 500 index. He had lost another 14 percent in the first quarter of 2000. The New York Times summed up his predicament the day after his announcement, saying that Robertson ‘had essentially decided to stop driving the wrong way down the one-way technology thoroughfare that Wall Street has become.’
 
Robertson, a giant of the hedge fund and value investing worlds for more than 30 years, was a casualty of the technology stock euphoria that the prior five years had wrought on traditional value investors. ‘I’m not going to quit investing. I don’t mind people calling me an old-economy investor, but it doesn’t go over well with the clients,’ Robertson noted in his farewell.”
 
With the nearly decade-long underperformance (nearly twice as long as Robertson’s), that last paragraph wrings eerily true for many value investors as they gaze back at their record. It certainly hasn’t gone over well with their clients as well. But is it enough to simply say these days that value investors are just “old-economy” or is there something far more fundamentally wrong here? Is the very structure and model of value investing broken? 
 
Looking back over the last decade, I would argue value investing was already evolving before this last decade. Thinking and strategy had started to bifurcate as two distinct approaches began to appear. The first was based in the more traditional lower price-to-book and lower price-to-earnings (such as looking for companies with less than a 12-15 P/E ratio). These types of investors are generally descended more from the Ben Graham risk-focused, cigar-butt DNA.  The second approach - sometimes referred to as value investing 2.0 - is more in the what was referred to as GARP (growth-at-a-reasonable-price) investing. As an example, this is where a value investor is willing to place value on less-traditional assets such as technology or informatics platforms than a physical manufacturing plant or equipment (I confess I fall clearly in the latter category). What makes this dichotomy interesting is that value investors (2.0) have generated better returns over the last decade than the more traditional value investors. Part of that seems to be based on investment strategy (where growth stocks have been outperforming value) and part of it on individual stock selection (higher quality stocks have done equally well - if not better in some cases - than less quality picks).   
 
Putting aside the debate about more traditional value investing and value investing 2.0, the great question is whether value investing - in general - has gone the way of the dodo or great auk. One side of the argument argues that value investing (defined as low price/book ratio) has actually performed as you would think it would (meaning neither out or underperformed). It has been growth investing that has significantly outperformed its benchmarks over the past decade. In a recent report from Dimensional Investing (“Value Judgments: Viewing the Premium’s Performance Through History’s Lens” which can be found here), the authors discuss the fact that value stocks actually have underperformed growth stocks 11.4% to 14.7% for the period 2010 – 2019. But the way we look at this underperformance is likely skewing the debate about the longer term viability of value investing. The authors contend the issue is less about value stocks underperforming but more about growth stocks outperforming. They go on to demonstrate that value stocks over the past decade have traded similar to what you would expect over a longer-term duration that include several market cycles. Value stock decade-long (2010 - 2019) returns of 11.4% track closely to their 11.9% return since 1979. The interesting data show up in the growth stocks. This segment’s previous decade (2010 - 2019) returns of 14.7% have far outperformed their 11.3% return from the period 1979 - 2019. Dimensional can’t isolate any particular reason why growth stocks have achieved such abnormally higher returns over the past decade. The authors say the data do not support any of the theories proposed by market analysts including low interest rates, quantitative easing programs by central banks, and the outsize influence of the so-called FAANG stocks, a group of stocks that include Amazon (AMZN), Apple (AAPL), and Facebook (FB). In this thesis, the bottom line is that value stocks (as defined by Dimensional) have produced similar returns over both decade-long and three decade-long time frames. The simply have not been able to keep up with a decade-long outperformance (for which we can’t account) in growth stocks.
 
Others Say Not So Fast
 
Another school of thought has developed counter to the thinking of Dimensional’s theory. An example of this is a recent paper by Baruch Lev and Anup Srivastava entitled “Explaining the Recent Failure of Value Investing” (it can be here). In the abstract of their work, they summarize their view that value investing’s best days are behind it:
 
“It is widely believed that the long-standing and highly popular value investing strategy—investing in low-valued stocks and selling short high-valued equities—lost its edge in the past 10 - 12 years. The reasons for this putative failure of value investing elude investors and academics, making it a challenge to assess the likelihood of the return of value investing to its days of glory. Based on extensive data analysis we show that value investing has generally been unprofitable for almost 30 years, barring a brief resurrection following the dotcom bust. We identify two major reasons for the failure of value investing: (1) accounting deficiencies causing systematic misidentification of value, and particularly of glamour (growth) stocks, and (2) fundamental economic developments which slowed down significantly the reshuffling of value and glamour stocks (mean reversion) which drove the erstwhile gains from the value strategy.”
 
The author’s argument in many inverts the thinking behind the team at Dimensional. They believe the overperformance of value investing post-technology bubble was not the mean but rather an anomaly in a longer history of underperformance since the late 1980’s. They state (somewhat in agreement with Dimensional) that there is no specific market-driven item that can be identified as eliminating value’s edge. Rather, they believe it was changes in how we value companies – rather than process of picking low P/E stocks – that eliminated value investing’s edge. From their paper they write:
 
“The expensing of intangibles, leading to their absence from book values, started to have a major effect on financial data (book values, earnings) from the late 1980s, due to the growth of corporate investment in intangibles. This book value mismeasurement was a major contributor to the demise of value investing which started in the late 1980s.”
 
The failure of value investing during the credit/real estate crash of 2007 – 2009 layered on another shift in economic changes (not market changes). They state that more traditional value companies (particularly those with debt loaded balance sheets ranging from manufacturing firms to larger financial institutions) lost their access to capital. Meanwhile, the more glamorous asset-light companies (technology and biopharma) became Wall Street and credit provider darlings leading to a distinct economic advantage for the latter.   
 
Since there has been little change in this newer economic model, Lev and Srivastava don’t see value investing making any big comeback soon.
 
 What This All Means
 
All of this data brings us back to the core questions surrounding the prognosis for value investing. Is it really different this time? Are the prognosticators of doom finally correct?   
 
The simple - and most honest - answer is we simply have no idea what the future holds for those investors who follow a value investment strategy[2]. For those who suffered tremendous losses in the 2007 - 2009 crash (where value methods should have prevented such results) followed by multi-year underperformance in a record setting bull market (again, where there should be some outperformance in value in the years following a bear market), the question is almost moot. If your investment strategy fails you in both bull and bear markets, then it’s not irrational to call into question the fundamentals of such an approach.
 
At Nintai, the entire debate is more academic than practical in our view. As investors in assets trading at a discount to our estimated intrinsic value, we think this puts us clearly in the value investment approach. Whether that is based on hard assets on the balance sheets or value derived from the future cash flow of an asset-light business model is irrelevant. We think the focus on value makes you a value investor – nothing more and nothing less.
 
Having said that (and there’s always a “but” in any good argument!), we do believe that value investing 2.0 has had a leg up on more traditional value investing over the last decade. I have no data to support such a claim nor do I have any specific reason (like Dimensional) why that would be the case. My only idea is that over the long term (here I mean a time frame greater than a decade), buying quality companies at fair prices will generate better returns than purchasing medium/poor quality companies at great prices. Again, I want to point out I have no data to support such a claim. Most of it likely lies in the fact I’m simply more comfortable investing with those caveats in mind[3].
 
The larger debate about whether value investing (regardless of more traditional or 2.0) is dead really isn’t all that clear. If you argue like Lev and Srivastava the edge has been gone for over 4 decades, then there isn’t much to debate. If you take the more nuanced view such as the Dimensional team then there is still room for debate about value investing’s future.  
 
In the final analysis, it’s up to each individual investor to develop their own investment style that meets a couple of needs: it lets them sleep well night and it produces returns adequate to meet their financial requirements. Whether that’s achieved through a more traditional value approach, value 2.0 approach, or growth investing approach is up to them. But as a portfolio manager myself, I wouldn’t rule out value investing yet. There are still people outperforming the market who all share the same genetic roots from Graham and Doddsville. Whether the causation and pool of candidates are as large as when Warren Buffett first brought the concept to the investing world’s attention, it can’t be denied it’s still there. It may be different this time, but it doesn’t mean value investing is dead yet. 


[1] These were two companies I owed at the time I was personally managing the Nintai Partner private investment fund. They certainly weren’t the WorldCom’s or the Cisco’s of the investment world.

[2] It should be said this applies to any investment approach or for the markets in general.

[3] As I’ve discussed previously, over the time frame of 2002 – 2015 the portfolios I personally managed were able to outperform the markets by a considerable margin (past results are no guarantees of future returns!). From my limited perspective, my hybrid value approach has worked well meeting my investment needs.