I may be wrong in regard to any or all of them; but holding it a sound maxim, that it is better to be only sometimes right, than at all times wrong, so soon as I discover my opinions to be erroneous, I shall be ready to renounce them.”

                                                        ----- Abraham Lincoln, “Speeches and Writings: 1832-1858"
"I wonder where you got that idea from? I mean, the idea that it's feeble to change your mind once it's made up. That's a wrong idea, you know. Make up your mind about things, by all means – but if something happens to show that you are wrong, then it is feeble not to change your mind, Elizabeth. Only the strongest people have the pluck to change their minds and say so, if they see they have been wrong in their ideas.” – 

                                                        ---- Enid Blyton, “The Naughtiest Girl in School”

In a recent article by Science of Hitting, he discusses the reasons for selling his position in Staples (NASDAQ:SPLS). In essence, his investment was incorrect, and he decided his capital could be allocated more wisely. We applaud him for both his approach and ability to write about it in such a frank and honest manner.
One of the most difficult tasks to complete is to review your mistakes a short time after making them. As Philip Heymann said, “The wisest actions don’t confuse dealing with the danger and dealing with the anger.” At the Ninta Charitable Trust we think this quote defines the problem - –one certainly gets angry after losing a great deal of investment dollars, but the danger lies in doing or learning nothing as a consequence of that mistake. At Nintai we've made too many mistakes to discuss in a single article. What I thought might be helpful is reviewing how we got to our process – everything from identifying the mistake to institutionalizing the learnings. All while trying not confuse the danger with the anger.
1. What is the mistake and what steps can be taken to solve the problem?
In this phase we look to define the scope and component parts of our mistake. We attempt to make sure we define both the mistake and the steps required to get there. Additionally, we break down the decision tree that got us to the solution and rework each of the decision points, Ultimately we want to know:

1. Who were the decision makers?
2. What were the time constraints in making the decision?
3. What data were required to make the decision?
4. What key assumptions were used in making the decision?
5. What defines the major characteristics of the poor decision?

An example of this was our investment in Corporate Executive Board (formerly EXBD now CEB). After suffering from significant losses (explained in more detail here), we spent an enormous amount of time defining the problem that turned on purchasing the wrong stock at the wrong time and purchasing more on the way down. We defined the issues as a.) poor stock selection criteria, b.) flawed investment methodology and c.) inadequately thought out assumptions. From this came our first integrated internal review process with a substantial checklist to test our methodology.
2. What process and steps can be taken to evolve or change our current system to prevent this mistake from happening again?
It turns out the previous steps I listed above were only the beginning our learnings. Several months after reviewing the EXBD fiasco, we found ourselves facing a similar scenario with Thompson Creek Metals (NYSE:TC). We first purchased the stock at roughly $3.50 per share in 2009 and sold it in 2011 for roughly $12.50 per share. What seemed like a relatively good investment was – in reality – getting off the Titanic in Ireland just before it continued on its maiden cruise through the ice fields of the North Atlantic. Looking back at the investment decision, we found we had made very similar mistakes to those made in the EXBD investment case. At this point, we felt we needed to re-evaluate our investment process and add another layer of thinking. The core focus on these questions centered on a.) what we can control in this process and b.) how we can prevent additional failures.

1. What part of the investment review process do we control?
2. What parts reflect complex systems? Where can we mitigate risk with these?
3. What systems require human evaluation and technology valuation? Where do they blend?
4. What systems can we build that provide multiple checks at certain key junctures?

As we looked at the process to date, we recognized one glaring error: how do we get these thoughts and learnings throughout the entire organization? In other words, how do we make risk management a core value from top to bottom in the organization?

1. How do we institutionalize this learning across the organization?
2. How can we incentivize individuals to employ both process and findings going forward?
3. How do we measure the success of these new systems and findings and database?
4. How do we continue to improve these systems to further reduce risk yet be flexible enough to adapt to new data/findings?

After following all of these processes and systems, I’d like to say that we are better investors at the Nintai Charitable Trust, and I think we are. But this is a constant journey of learning. I would like to think we are on a constant and perpetual journey to improve our thinking and decision-making.
Conclusions
Oscar Wilde once wrote that experience is the name we give our mistakes. At the Nintai Charitable Trust, experience masquerading as mistakes has been a constant companion on our journey to be better investors. We like to think our errors have been vital building blocks in improving our investment models. Looking back, Lincoln came out all right with his maxim thatit is better to be only sometimes right, than at all times wrong. As a long-term investor – armed with a learning mind and investment processes – you can't do any better yourself.

Any time you manage other people’s money, risk management should be defined as preventing the permanent impairment of capital. Nothing can be riskier to an equity investor than losing all your money. Anybody who loses sight of this is – quite frankly – both a terrible fiduciary steward and value investor”
                                                   -    Duncan Farquhar

In a recent article (found here), Science of Hitting discussed the difficulty in adding to your position after Mr. Market plays havoc on the stock’s price and valuation. Making the decision to double down is tough for several reasons. First, is there something the markets know that you don’t know? Has your research been thorough enough to fully support our thesis? Second, allocating additional capital to the investment reduces your ability and flexibility as you move from cash. You have essentially lost a potential opportunity to invest in additional holdings. At the Nintai Charitable Trust we worry less about the latter (the “Opportunity Risk”) and much more on the former (“Downside Risk”). When a holding drops considerably in the portfolio, we focus less on the drop per se and more on the risk our capital could be permanently impaired. 

As Mr. Farquhar points out, managing other peoples’ money requires us to be both wise financial stewards and prudent investors. To achieve this, we think one of the first goals in investing is to protect to the ultimate downside – that unfortunate point when you know your investment has either suffered such losses it requires herculean efforts to get back to even or - worse – bankruptcy and the total impairment of capital.  

Getting to Zero

At the Nintai Charitable Trust, a key component in the investment selection process is creating models that get our investment to exactly that place – broken, impaired, bankrupt. As a means of achieving this, we will test each model, estimate, and assumption and find a way to reach a zero valuation. Put more simply, we want to know how this investment opportunity’s capital can be permanently impaired. 

We think this process is helpful in a couple of ways. First, we’ve found it more likely than naught that our investments drop in price after our initial purchase. In this case we are in the dilemma discussed by Science. By knowing what it will take to permanently impair our investment thesis, we are far more comfortable in making the decision to purchase additional shares or not. Second, breaking an investment thesis is as important as building one. I’ve found that we are far more receptive to data for having taken both sides. Cognitive dissonance is less, ego and bias’ impacts are reduced, and we see the company’s actions in a far different light. We think both of these reasons make us far better investors in the long term. 

Key Components

After we’ve gotten comfortable with a possible investment, we will generally deconstruct our business case and pressure test them in five (5) ways: revenue, credit/debt, management, competitive moat, and regulatory. The goal in each is to find what events and/or assumptions are required to break the business in terms of strategy, operations, and financial performance. 
​
A Macro Cardio Event - Revenue Collapses: We generally base this model on the economy having another event similar to the 2008-2009 recession. What impact would 10%, 25%, 50%, and even 75% reduction in revenue do to our valuation? What percent of the company’s customer base would need to stop buying? What events would be necessary to make that happen? We are surprised sometimes by the ease in which we can see these conditions develop. A great example of this has been natural resources. Whether in the oil industry or rare earth, we have seen some companies lose 50% of their revenue in roughly 6 months.  

Cut Off the Oxygen - Credit Markets I’ve written previously about how little thought we give to the credit markets until they don’t operate efficiently. Much like cutting off oxygen, it can get your attention real quick when it’s not available. We have a tendency to test this field in two ways. First, what happens if the company’s WACC is raised by 100%? Or 500%? Second, we test what happens to the company’s operations if credit was no longer available. Could the company still function? Would it still be a going concern? Don’t think this matters? During the 2007/2008 Great Recession, it was a frequently heard complaint that credit couldn’t be found on any terms.

Temporary Insanity - The Fallibility of Management: Finding management who are successful long-term allocators of capital is tough. What’s even tougher is waking up and reading your management has announced an M&A deal of a catastrophic nature. Since 80% of all deals destroy capital, it’s not far fetched to see your investment’s team making such a move. Here we create models based on both dilution and addition of debt. What impact will a deal that dilutes by 25% have on long-term returns? If the company takes on $2B in debt what impact does this have on the financial assumptions we have previously made? While not an M&A deal, we have seen a significant change in the allocation of capital at Nintai Charitable Trust holding Qualcomm (QCOM) through stock buybacks and the assumption of considerable long-term debt.  

The Competitive Moat is Filled: Most of the companies the Nintai Charitable Trust invests in have wide competitive moats. Before investing we will look for the impact competition might have in reducing returns, margins, or market share. In particular we look to measure the impact of any pricing or “commodification” of the company’s offerings.  At what point does competition begin to effect returns on equity and capital? Force increased R&D spending. Squeeze gross and net margins? All of these will be tested – along with assumptions – to hypothetically break the investment’s competitive moat.  

The Government Decides to Help: In today’s market environment, the regulatory stretch of both state and Federal government is wide and deep. In analyzing risk, another component we test to extreme is the chance that regulators get more involved in our investment’s business model. Here we test for pricing impact, compliance costs, or regulatory approvals. Nintai Charitable Trust holding Intuitive Surgical (ISRG) faces challenges in this area. Whether it be DDMAC marketing compliance to FDA product approval, we have modeled out to the extreme what impact these might have on our investment. 

Conclusions

I’ve written frequently about the idea that outperformance is really more about not losing than swinging for the fences. Nothing can devastate long-term returns than an investment that permanently impairs your capital. Just like a tech investor in 2000 or financials investor in 2007-2009, you will find how difficult it is to recover from catastrophic losses. At the Nintai Charitable Trust, we think the best way to manage risk against such events is to make them happen before you invest. By “getting to zero” before you invest a dime, we think you can both improve your investment returns and be a better financial steward of your - or your investors'  – capital.