“I firmly believe that acquisitions are an addiction, that once companies start to grow through acquisitions, they cannot stop. Everything about the M&A process has all the hallmarks of an addiction. If you look at the collective evidence across acquisitions, this is the most value destructive action a company can take.”
 
                                                                             -      Aswath Damodaran 

Earlier this week, Dollar Tree announced it was spinning off its Family Dollar unit, which it acquired in 2015. Companies spinning off holdings aren’t uncommon. In fact, companies divesting units acquired within the past decade also aren’t unusual. But most importantly (and sadly), companies selling off former acquisitions at significant losses are incredibly common. We will get into those details later, but let's first take a look at the Dollar Tree/Family Dollar debacle. 
 
In 2015, the Dollar Tree Board of Directors issued the following statement to the management of Family Dollar. 
 
“The Board of Directors of Dollar General is pleased to submit a proposal to you and the Board of Directors of Family Dollar that offers Family Dollar shareholders $78.50 per share in cash for all outstanding shares, providing them with superior value and immediate and certain liquidity for their shares. Not only is our offer superior in price, it is 100% cash, as compared to the mix of cash and stock being offered by Dollar Tree.

Our proposal provides Family Dollar’s shareholders with approximately $466 million of additional aggregate value over Dollar Tree’s offer and represents a premium of 29.4% over the closing price of $60.66 for Family Dollar stock on the day prior to the Dollar Tree announcement.” (Emphasis is mine)
 
The concept was that by partnering with Family Dollar, Dollar General could create a low-cost giant that significantly expanded its customer base, achieved cost savings through those elusive “synergies, " and kept Dollar General in check. The latter had made an earlier bid for Family Dollar. 
 
The acquisition worked out poorly from day one. The synergies the company thought could be achieved were a mirage. Family Dollar stores were in extremely poor condition, plagued by inadequate maintenance, high refurbishment costs, and excessive overlap with Dollar General locations. How this could not be foreseen is a mystery. Too put a punctuation point on how badly the Family Dollar maintenance had fallen, the company was forced to pay $42M in fines after regulators found a supply warehouse overrun by live, dying, dead, and rotting rats. Wall Street started to lose confidence in the deal and the company’s management at the same time. Over the past three years, Dollar General’s stock has declined by 63% in value.  

After attempting to staunch the bleeding by closing hundreds of locations and investing considerable capital to upgrade the Family Dollar brand and shopping experience, Dollar General raised the white flag and announced this week that it is selling the entire Family Dollar brand to private equity groups Brigade Capital Management and Macellum Capital Management for approximately $ 1 billion. If you calculate the cost of $78.50 for every publicly traded share of Family Dollar in 2015, Dollar General paid around $9 billion for its acquisition. It should be emphasized that they paid in cash. The Dollar General Board issued the following statement earlier this week to announce the sale:
 
“The Dollar Tree leadership team and Board of Directors determined that a sale of Family Dollar to Brigade and Macellum best unlocks value for Dollar Tree shareholders and positions Family Dollar for future success.”
 
It may have been better if the Board had rephrased the statement to indicate that they had determined the sale would result in a $900M cash loss instead of unlocking value for Dollar Tree shareholders. 
 
M&A: A Destructive Addiction
 
KPMG (the consulting/accounting behemoth) examines acquisitions annually to assess their success and questions whether they have generally been effective or ineffective at creating shareholder value. The short answer is that they are not effective at all. However, that information doesn’t reach the C-suite or boardrooms. There is a significant disparity between management's perception of their success rate and the actual rate. This “perception gap” is remarkably wide - 93% of companies surveyed by KPMG believed their deals enhanced value, and over a third stated they would not approach their next deal any differently. Yet, KPMG's objective analysis of whether deals enhanced or reduced value revealed that only 31% of these deals actually enhanced value.[1] Wow. Even after all these statistics, most Boards wouldn’t change a thing regarding conducting acquisitions. 
 
Examining the history of mergers and acquisitions reveals that Dollar General’s disastrous acquisition of Family Dollar is merely typical of Wall Street’s M&A activity. Here are some interesting facts.
 

1. Dollar General’s recent announcement that it is spinning off Family Dollar only seven years after acquiring the company isn’t particularly surprising - half of all mergers are reversed within 10 years. 
2. McKinsey reports that approximately half of acquirers significantly fail in their due diligence work. In one of their latest studies (M&A Insights, February 2025), the company reveals that nearly three-quarters of recent technology M&A encounters have failed during the due diligence research. 
3. Trends pushed by large consulting firms drive much M&A activity. A case in point is the latest surge in artificial intelligence (AI) merger activity. KPMG featured the headline: “KPMG and HP make M&A integration easier by harnessing AI and automation technologies.” Gartner reports, “GenAI MActivity will lead the way.” Lastly, OutSystems states, “AI M&A: The Biggest Deals Yet?”

 
At a Columbia Business School symposium, a presenter noted that M&A completed in any given year’s “hot/fad” markets had a 2-3 times greater chance of failure than those in more stable markets.  
 
Conclusions
 
Dollar General’s acquisition of Family Dollar was typical when it was announced. The company grossly overpaid after conducting inadequate due diligence. In its press release, you can almost hear the frantic panting of management fearing it would be outdone by Dollar Tree. The spin-off of Family Dollar earlier this year marks the conclusion of a saga that severely damaged Dollar General’s financials, consumed far too much attention from the company’s C-Suite and Board, and inadvertently aided its competitor through its misstep. 
 
At Nintai Investments, we typically sell a holding if it announces a large M&A deal. We feel even more strongly when they use words like transformative, synergies, or maximizing shareholder value. A recent example is Masimo’s (MASI) acquisition of Sound United. Masimo possessed an exceptional business with a moat developed around its oximeter technology (the device you place on the tip of your finger to measure your oxygen saturation rate), generating high returns on invested capital and maintaining a balance sheet with no short- or long-term debt. Management went out and acquired a consumer electronics company with the intent of transforming (there’s that word!) their business model into an ambulatory home health company. Less than two years later, the company announced it was splitting into a consumer audio and a consumer healthcare company. It appears much like the two companies did before the acquisition. The announcement included the typical “maximizing shareholder value” language. We sold a few weeks after the acquisition announcement was made, viewing it as a method of destroying a perfectly wonderful small-cap, wide-moat company. We’re very happy we did. 
 
Whenever you hear management announce an M&A deal that promises to transform the business or achieve significant cost savings through synergies, consider carefully whether you want to partner with that management. Ultimately, they are likely to change the company, though not in the way they envisioned. As Mr. Damodaran mentioned, this kind of addiction can be very costly for the company’s and acquisition’s employees, their management, and most importantly, their shareholders. 
 
Disclosure: Nintai Investments does not own any shares in the companies mentioned in this article and does not intend to purchase them in the next 60 days since publication. 
 


[1] “The Morning After: Driving for Post-Deal Success,” KPMG Transaction Services, 2024

We thought with everything we've seen over the past several months with the Magnificent Seven stocks, we'd revisit a piece we did on why Nintai tries to avoid the fear-of-missing-out (FOMO).

"If you took our top fifteen decisions out, we’d have a pretty average record. It wasn’t hyperactivity, but a hell of a lot of patience. You stuck to your principles, and when opportunities came along, you pounced on them with vigor."
 
                                                                                           -     Charlie Munger 

During a press conference, President John F. Kennedy was asked whether he got impatient at being unable to accomplish everything he wanted. He smiled and discussed how important it was to be ready to act when an opportunity came along to further his goals. He then told the following story. 
 
“The great French Marshal Lyautey once asked his gardener to plant a tree. The gardener objected that the tree was slow-growing and would not mature for 100 years. The marshal replied: ‘In that case, you better plant it this afternoon.’”
 
A Tale of Two Returns
 
For those who have invested in the markets over the past several years, many have noticed a trend of bifurcated returns. The so-called Magnificent Seven (Microsoft, Nvidia, Google/Alphabet, Apple, Meta, Amazon, and Tesla) accounted for roughly 92% of the total gains of the S&P 500 in 2023 alone. As shown in the graphic below, the returns of the Not-So-Magnificent 493 were not impressive. (Please excuse the rather gaudy nature of the Goldman graphic!)

​Examining the returns of the Magnificent Seven (M7) over the past several years makes it clear that investing in multiple stocks from this group is essential to outperform the S&P 500. Beating the S&P 493 would be much easier; however, that's not the index in question, whether it's a fortunate or unfortunate situation depending on your investment stance. 
 
But you don’t have to broaden your perspective too much to realize how remarkable the returns have been with the Magnificent Seven. If you examine the next 42 companies - not 493 - here’s how they compare to the M7. 

Compared to the next most extensive 42 stocks, the M7 appears inflated in terms of market value, sales, and profitability. These companies have 2.5 times the sales and twice the profitability.
 
Fear of Missing Out (FOMO) Syndrome
 
I bring this up because Nintai Investments has been one of the investment companies focusing on a much smaller market cap portfolio mix (unfortunately, in our case!). Not all of our underperformance over the past few years can be attributed to this, but it certainly hasn’t helped. Watching day after day as the M7 companies reach new price highs, year after year, hasn’t been the easiest experience. I must admit to feeling a slight tinge of Fear-of-Missing Out Syndrome (FOMO). That said, I believe that not experiencing FOMO is probably one of the top characteristics of successful investors. It is nearly impossible to maintain your investment strategy and invest for the long term when influenced by it.    
 
In this age of Bloomberg and CNBC's 24/7 business news, Reddit stock boards, and meme stocks, it seems that FOMO has become a driving force in modern 21st-century investing. It appears unlikely that an investor (are they really investors? Or would “ gambler “ be a better description?) who puts money into GameStop (GME) stock and observes its daily price fluctuate from $17.46 per share on May 1, 2024, to $30.45 on May 13, $48.75 on May 14, $39.55 on May 15, $27.67 on May 16, and finally $22.21 on May 17 (continuing down to $18.32 on May 23), will be able to outperform in the long run. 

If ever there was a case of FOMO driving a stock price, it would be MEME stocks like this. I would argue that much of the Magnificent Seven gains have been MEME stock-like writ large. 
 
Conclusions
 
As an investment manager, your primary goal is to outperform the greater markets over the long term. To meet that objective, sticking with the process that has brought you 
 
 
success is critical. Sometimes, that process will underperform. As I’ve said many times, to outperform, it is occasionally necessary to underperform (unless your name is Bernie 
Madoff). However, chasing returns driven by FOMO is an almost certain way to pursue highly volatile, short-term gains. This can lead to increased trading costs, a larger tax bill, and the loss of opportunities to let compounding work effectively. At Nintai, our first four years in business were exceptional, delivering significant outperformance nearly every year. The last three years, however, have shown a roughly mirror image. Nevertheless, we refuse to alter our methodology or start investing heavily in M7 stocks like Nvidia (NVDA) or meme stocks such as AMC Entertainment (AMC). Instead, we will heed President Kennedy’s advice from Marshal Lyautey and continue researching our long-term holdings like Veeva (VEEV) and iRadimed (IRMD). In fact, we’ll likely begin this afternoon. 
 
As always, we look forward to your thoughts and comments.
 
DISCLOSURE: Nintai Investments currently has holdings in Veeva (VEEV) and iRadimed (IRMD). We do not, nor do we intend to take a position, in Microsoft, Nvidia, Google/Alphabet, Apple, Meta, Amazon, Tesla, Berkshire Hathaway, Broadcom, JP Morgan Chase, United Health, Eli Lilly, GameStop, or AMC Entertainment. 

I've gotten quite a few requests to republish an article that I wrote roughly a decade a go about the power of inverted thinking and Abraham Wald. I republish it here in full. I hope you enjoy it.

Mutual Fund Survivorship: The Revenge of Abraham Wald
 
The story of Abraham Wald and the study of WWII bomber casualties is one of the more enlightening stories from the field of operational research. During the early days of the Allied strategic bombing campaign the amount of bombers not returning from their missions reached an unacceptable rate. In a desire to find out why, the USAAF completed a study on where the damage was taking place and where additional armor could be placed to make each bomber safer. Here Wald enters our story. Taking one look at the methodology and findings, Wald told the team they were looking at the problem the wrong way. 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 planes that made it back, he proposed strengthening the areas where there were no bullet holes. Through his report thousands of bomber crewmembers were saved through the course of the war. Wald’s report and methodology can be found here.
 
Wald’s technique would later be summarized quite pithily by Charlie Munger when he advised, “Invert. Always invert”. The use of Wald’s methodology can be applied in the investment world in many ways. Perhaps the greatest use is the study of mutual funds. Investors spend an inordinate amount of time studying mutual funds with fantastic records (such as Bill Miller’s Legg Mason Capital Management Value Trust fund during the 1990’s). Put in Wald’s context, these are the funds that made it home. But what about all those funds that didn't survive? The funds that didn't make it home? What can be learned from these? 
 
Before we get to that, let’s take a look at the numbers of mutual funds and find out their general survivor rate. In 2013 Vanguard released a study on fund survivorship (which can be found here) studying mutual funds from 1997 through 2011. At the start of the study period there were 5,108 funds available. By the end of 2011 2,364 of these funds had been closed or merged leaving 2,744 funds (or 54% of all funds) that survived for the entire period. In that period from 1997 through the end of 2011 roughly 1 out of 2 funds didn't make it home. Of the funds that didn't make it, roughly 80% (or roughly 1900) were merged away while the remaining 20% (roughly 470) were closed entirely. 
 
It’s how the funds performed where the story gets very interesting. Let’s start with the funds that existed for the entire period (or the funds that made it home). Of the 2,744 funds roughly 1/3rd ended up outperforming. So during the period of 1997 - 2011 if you could divine which fund might actually survive, you still had roughly a 2/3rds chance at underperforming the market.  

Let’s take a look at the funds that didn’t survive the period (or the ones who didn't make it home). Here the story is far more depressing. 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. 

​What Would Abraham Wald Say?
 
Wald approached the problem of aircraft losses very differently than the original assessment team. His ability to flip (or invert) the model allowed him to address the problem with an entirely fresh (and as it turns out - correct) approach. If we apply his methodology to the mutual fund industry there are several points which jump out that go far beyond the usual Wall Street talking points. 
 
It’s Not About Succeeding……. It’s About Not Failing
 
In the investment world action represents success. In reality active management (or action) represents a losing proposition. There’s an old adage that 90% of success is just showing up. It would seem the same rings true in investing - but with a twist. 90% of success is showing up, investing, and doing nothing.  Actively managed funds have demonstrated they have very little chance at beating the market indices. Indeed, if you add in the silent results of the funds that never made it, the odds of outperforming the markets are roughly 2 in 10. Active management - in general - is a loser’s bet. As personal investors this has equal import. By not making the simple mistakes - overpaying, trading too much, etc. - we can achieve remarkable returns. By not failing we can provide our investors an invaluable service. 
 
Evaluate An Investment Backwards
 
Many of us have a formalized process for evaluating investing opportunities. Some might use a DCF model while others use a dividend discount model. All too often we find comfort in using this process and we get lulled into a false confidence in our stock picking. At Nintai we frequently ask ourselves why we wouldn't invest in a certain company. By being the devil’s advocate we get a pretty good understanding of potential impairments to our investment case. Another tool is to build into your model the exact opposite assumptions and see where you end up. For instance if you project 8% FCF growth over the next 5 years, what would it look like if the company had -8% FCF growth instead. What impact would that have on EPS, balance sheet, etc.? Finally, we step away from our assumptions and become a competitor. What could I do strategically to beat the company? What new products could I develop? Do I have the financial ability to acquire them? All of these (and others) allow us to view our prospective investment from very different angles than our normal proprietary process. 
 
Conclusions
 
Abraham Wald saved tens of thousands of flight crew lives during World War II. His ability to see things from a different perspective allowed him to solve a critical failing in the Allied war effort. More importantly he demonstrated the power of survivorship bias and how it can lead us to misguided assumptions. For investors – both mutual fund and individual – we can be blinded by our successes and not take sufficient care to understand and protect against the downside. That’s a shame. Sometimes there are more learnings from a mistake than a success. I encourage everyone to take a long, hard look at his or her failed investments and find out what went wrong. Sometimes simply getting these corrected is far more powerful than looking for the next Microsoft. In the final analysis the solution can occasionally be blindingly clear with a simple move to the left or right. Just ask Abraham Wald. 
 
As always we look forward to your thoughts and comments. 

“The ideal business is one that earns high returns on capital and can keep using lots of capital at those high returns. That becomes a compounding machine. If you can put $100 million into a business that earns 20% on capital, ideally, it would be able to earn 20% on $120 million the following year, $144 million the following year, and so on. You could keep redeploying capital at these same returns over time. But there are very, very, very few businesses like that.” 
 
                                                                                                -      Warren Buffett[1] 

Our recent annual report to our investment partners began by discussing some important numbers or characteristics we look for in an investment. I wrote:
 
“At Nintai, we manage a focused portfolio of about 20 – 25 positions, which we have held for decades. Because of that, we have specific criteria that we feel are vital to outperform the markets in the long term. Before we get into the requirements, some core beliefs drive our decision-making. First, free cash flow is a far better measure than earnings when calculating valuation. We believe earnings can be manipulated in so many ways that their utilization in valuation tools is a waste of time. Second, we believe the best measure of a wide competitive moat is the sustained outperformance of return on invested capital (ROIC) over the weighted average cost of capital (WACC). When a company can generate ROIC greater than its WACC for over one or two decades, it has a wide moat. Last, we look for investment opportunities where the company’s free cash flow grows, but its price keeps dropping. We see those opportunities as a spring getting increasingly tightened that must eventually be released.”
 
This overview briefly describes some key metrics that drive our investment decisions. But more detail might help with numbers. 
 
Two key metrics we use at Nintai Investments are a company’s return on invested capital (ROIC) and its weighted average cost of capital (WACC). We look for companies whose ROIC consistently outweighs their WACC for extended periods - usually one or two decades. I stress the word consistently because we aren’t fans where it might exceed for three or four years and then drop below for a year or two. We want to see ROIC beat WACC every year for a decade. Another number we look for is free cash flow. An investment should grow free cash flow annually for at least eight of the last ten years and continue that for the next decade or two. Eventually, that growth must, by the nature of its numbers, decrease over time as the company expands. It’s much easier to grow free cash flow 10% off a base of $100 million than $10 billion. Last, we would like to see the share price grow at a rate similar to that of the free cash flow. When the former grows faster than the latter, we can begin to see the price/valuation ratio force, which can lead us to reduce (or sell outright) our position. 
 
Purchasing a company with these characteristics doesn’t guarantee a quick gain. Charlie Munger clarified that you should likely outperform over the long term. But the difficult part is hanging in for the long term. At Nintai, we are content to wait for three, four, five, or more years if the conditions we’ve discussed are being met. If they are, and the share price continues to lag or go down, we will likely add to our position over time. 
 
Let’s use a specific example before I discuss how our model portfolio has performed over the last decade. One of our holdings is Veeva Systems (VEEV). We’ve held the stock (including in our previous firm, Nintai Partners) since 2004. Here are the first numbers we look at: free cash flow versus share price. 

​Veeva’s free cash flow has grown at an annual rate of 35.5% over the last decade. Through 2020, the stock price increased even faster. But starting in 2021, the stock price declined steadily as free cash flow maintained its steady growth (as you can see on the right side of the graph). We are happy to continue holding the stock (in this case, even adding to our position) until the markets recognize that the company’s value has increased. Why has the stock price decreased over the past five years? First, the price/value ratio was stretched in 2020. There was a case of irrational exuberance, for sure. But now? We think there has been a case of irrational depression. 
 
Here is the second set of numbers we discussed previously. (I'm sorry for the sizing issue. Excel doesn’t make this easy!)

​As you can see, over the past decade, the company’s ROIC has exceeded its WACC by a substantial margin. This demonstrates a deep and wide competitive moat, and we expect it to continue over the next decade or two. If it does (and there is no assurance it will), we should end up with a respectable long-run return to Charlie Munger's point.  
 
Let’s examine the aggregate Nintai Investments portfolio. Here, we see a tale of two returns similar to Veeva's. The portfolio's share price grew faster than free cash flow at the beginning of the decade, while it lagged over the last five years. 

​This reflects the change in market performance as the Magnificent Seven and artificial intelligence began driving returns while the rest of the markets lagged. 
 
How about the portfolio’s ROIC and WACC numbers? These show that, in the aggregate, the portfolio’s competitive moat remained deep and wide over the entire decade. In other words, the portfolio’s strength has not lagged even as its share price growth has over the past five years. 

Conclusions
 
Charlie Munger’s wisdom cut across many areas of knowledge. As he stated, he utilized a latticework of worldly wisdom. One of his remarkable insights was that return on invested on capital (ROIC) was an outstanding measure of how a company should perform (price-wise) over the long term. Comparing this against the weighted average cost of capital (WACC) should tell us whether the company has a wide competitive moat that can maintain high profitability. At Nintai, we seek out companies with high ROIC, substantial free cash flow margins, rock-solid balance sheets, and great managers keeping a hawk-like eye on these numbers. To Munger’s point, we think this will lead to long-term outperformance against the general markets. That said, it doesn’t mean the portfolio will consistently outperform. In the short term, there will be periods of underperformance. The challenge is remaining focused and controlling your emotions during these times. Investors should be handsomely rewarded over their investment career if they can do this. 
 
Disclosure: Veeva is a portfolio holding in Nintai Investment portfolios as well as Mr. Macpherson’s personal portfolio. 

​[1] “Buffett and Munger Unscripted,” Alex W. Morris, page 15, 2003 Berkshire Annual Meeting

“To be able to write, one must be able to read. Every hour of reading makes you a better writer.”

                                                                                                -    Robert Macfarlane 

Robert Macfarlane is an excellent writer who thinks a lot about words and places and how the interaction between them tells us about our or someone else’s culture. His quote above greatly impacted me when I sat down to write my first book “Seeking Wisdom: Thoughts on Value Investing.” Constant reading (or, as Charlie Munger’s family referred to him - “a book with legs.”) is essential not only to be able to write but also to continually develop and improve your investment process. 
 
At the beginning of each new year, I frequently write about one of the top questions I receive in my daily mail call. This year, I received quite a few questions about my daily reading.
 
Before I discuss what books I highly recommend for individual or institutional investors, I thought I’d discuss what makes a book compelling (at least to me.)  Before anything else, I find a book where the writing and use of words are precise and exceptionally lyric, a rare find. Beautiful writing is a craft and something to be sought out every day. As much as Warren Buffett’s writings seem to ring of folksy wisdom (which they are), his writing is crystal clear in its messages. It cuts through any confusion and brings immediate light to traditionally stuffy topics. Such writing is the foundation of brilliant thinking. 
 
In addition to writing of such a nature, there are four additional ways a writer can provide the reader with long-standing – and applied – wisdom. These include the following:
 

• A clear articulation of evidence 
• Bringing new evidence to light
• It uses a latticework model
• Changes the reader’s process of thinking

 
The first category is essential to making a strong case for your thesis. Jack Bogle’s books were outstanding in proving, time and again, that high fees were absolute killers when it comes to investor returns. The founding father of indexing used books such as “Common Sense on Mutual Funds” and “The Battle for the Soul of Capitalism” to provide irrefutable evidence that not only was it hard to beat the markets in general, but it was nigh impossible to beat them when you paid high management fees. His discussion of costs related to high portfolio turnover was an eye-opener on how managers see the long term as a disadvantage in their business model.   
 
Another characteristic of a great investment book is how the writer brings new information to light. Benjamin Graham’s classic “Security Analysis” was brilliant in bringing forth an entirely new concept of understanding the value of an investment versus its price, which was critical to achieving excellent long-term results. His later book, “The Intelligent Investor,” was just as crucial in bringing the concept of margin of safety and Mr. Market to individual investors. The former became a handbook for professional investment managers, while the latter was written for private individual investors. Graham’s ability to bring forth new ideas in a simplified and easy-to-understand manner changed the dynamic entirely regarding investment management. 
 
Combining multiple subject matters, some with no seeming connection with investing, is another form of outstanding investment writing. Classically referred to as consilience, Charlie Munger created the term “latticework of mental models.” There have been quite a few great books covering this, including the works of Michael Mauboussin (“More Than You Know” and “Think Twice”) and Robert Hagstrom (“Investing: The Last Liberal Art”). I would be remiss not to mention Shane Parrish’s “The Great Mental Models, v. 1-4, along with his outstanding website, Farnam Street. 
 
Last but not least are books that can change the very process by which an investor looks at investing. I refer to it as how to invest rather than what to invest in. These books can have the most significant impact on your investment approach. The classics from Graham, Bogle, and Buffett are great examples. Switching from active investing to indexing and creating a value-based approach can completely change how investors allocate their capital.  However, there are other examples by lesser-known authors that are equally important. These include “Excess Returns” by Frederik Vanhaverbeke, “Investing for Growth” by Terry Smith, and “The Manual of Ideas” by John Mihaljevic. All of these are excellent editions by which to learn all new strategies and measures to improve your investment returns. 
 
While I’ve listed the criteria necessary for a great investment book, there are also some personal characteristics a successful value investor needs that complement whatever you might be reading. 
 
Always Keep Learning
A good investor has a mind that constantly thirsts for new theories and facts. I read at least two hours daily and could use two more each day. A great investor is open to all kinds of content, no matter how far away it might seem from investing. The great thing about learning is that it never gets old and, over time, can give you a significant advantage over other investors. What other fields have such opportunities? 
 
Always Question Your Hypothesis and Facts
At Nintai, we often use a process we refer to as breaking the case. In this process, we keep knocking down our assumptions (growth, free cash flow, competitive strength, etc.) until we reach a valuation that is wholly impaired. It is vital that investors be able to accept information and data that, no matter how unappealing, changes their business case or valuation. 
 
What Didn’t Work Before Might Be Great in the Future
Just because something worked in the past doesn’t mean it will work forever. It’s equally important to understand the inversion of that is equally valid. Just because a business model wasn’t a great investment opportunity in the past, things like technology innovation or regulatory changes might make the business model a better investment in the future. A great case of this is Warren Buffett’s investment in railroads. It has become an outstanding investment with changes in regulations, modal transportation transformation, and operational improvements.  
 
Keep Your Emotions in Check
Last, but most important, is the ability to keep your emotions under control. No matter what reading you do or the evolution of your investment approach, letting your emotions drive your decision-making will lead to truly awful results. 

Conclusions
 
It’s surprising how often I get questioned about what I read. As a writer, it’s a surprising amount. There is so much to learn in this world of the internet, e-books, and online learning. For those starting on their investment journey, developing a daily reading regimen is an outstanding way to understand better how to achieve better results. You will be surprised how a “latticework of mental models” will help you better understand the financial world and also help you understand the world in its entirety. Very little knowledge that you acquire will go to waste. If nothing else, you’ll be the life of the cocktail circuit, and there are worse things than that. 
 
DISCLOSURES: None
 
 
 
 

“They say misery loves company, but I’d just not prefer the misery, whoever is riding along beside me.” 

                                                                                             -   Allen Dulles 
​
Brown Capital and Nintai Investment’s Overlap
 
One of the things we do at Nintai is track funds that share common holdings with our funds. The one that has remained the closest since our inception has been Brown Capital Management Small Company (BCSIX). The fund is rated Gold by Morningstar and two stars for performance. It manages $1.3B in assets with a 12% turnover rate. Morningstar places it in its small growth investment style box (where the Nintai Model Portfolio sits). It currently shares four of its top ten holdings with Nintai, including Guidewire Software (GWRE), Manhattan Associates (MANH), Tyler Technologies (TYL), and Veeva Systems (VEEV). The fund has thirty-nine positions in its portfolio, of which seven are also in the Nintai Portfolios. 
 
Several characteristics drive these commonalities. First, Brown Capital looks for companies with strong growth characteristics and equally strong financials. Second, any holding should demonstrate a deep competitive moat, which helps maintain a strong competitive advantage. Last, Brown Capital is happy to allow compounding to work its magic over a decade or longer. These characteristics drive an extraordinarily low turnover rate similar to Nintai Investment’s. Brown Capital’s 2023 turnover was in the range of 12% compared to Nintai’s 8%. 
 
Issues with Brown Capital Management
 
Having highlighted the characteristics of Brown Capital Management’s and Nintai’s investment strategies, I should point out that the past three-and-a-half years have been extremely difficult for Brown Capital and Nintai.  The mutual fund’s total return was among the Small-Growth Morningstar Category’s worst from September 2020 through June 2024. Respectively, the fund has been placed in the category’s 92ndpercentile in 2021, 91st percentile in 2022, 33rd percentile in 2023, and 90th percentile through June 30, 2024. Compare this to the category’s 12th percentile in 2017, 20th percentile in 2018, 38thpercentile in 2019, and 30th percentile in 2020. 
 
So, what has happened since 2021? Has Brown Capital Management lost its mojo? Has a turnover in its ranks completely changed its investment strategy? The short answer is no. Manager Keith Lee has been with the fund since 1992 (wow!). His tenure includes a very similar downswing in the mid-2000s. 
 
The company will pay out a massive capital gain distribution at the end of 2024. It is expected to be nearly one-third of total investor share net asset value. You read that right. This payout is due for two reasons. First, the fund lost one of its largest customers, who pulled out significant assets. On top of that, individual investors pulled out nearly $1B during the year. This has required management to sell off quite a few positions. The good thing? Almost all of the distribution will be long-term capital gains. The fund tends to hold positions for five-to-ten years or longer. 
 
The issues that have dogged the Brown Capital team over the past four years have been similar to those of Nintai’s. First, they dramatically missed with their pick of Cryoport (CYRX), which, after peaking in November 2021 at $82/share, traded at roughly $7.75 this month. This is a shade of Nintai’s experience with New Oriental Education & Technology (EDU). Second, positions that were real winners during the COVID-19 epidemic returned to earth over the next several years. The company didn’t take profits when they had the chance and saw returns suffer accordingly. A company in Brown’s and Nintai’s portfolio, Veeva Systems (VEEV), generated huge returns between 2017 and 2021. It rose from $43/share at the beginning of 2017 to $320/share in July 2021. From there, the stock has slowly deflated to $225/share in December 2024. Multiple positions in Brown’s (and Nintai’s) portfolio generated similar results. Brown (and Nintai) could have locked in gains by taking profits in these instances. Unfortunately, that goes against the grain of holding for the genuine long term. Third, and deeply impacted by this pattern, Brown’s focus on small to mid-cap healthcare and technology (making up roughly 90% of total assets under management) stocks completely missed the large-cap run-up over the past three years. This is another attribute Nintai shares with Brown, with technology and healthcare making up roughly 80% of our total investment portfolio. 
 
Similarities to Nintai Investment Returns
 
We’ve greatly admired Brown Capital Management over the past twenty years that we’ve been in the investment management industry. 
 
Brown Capital and Nintai Investments share profound similarities. First, both companies look to invest long-term and seek companies with deep competitive moats and the ability to convert these into high free cash flow margins over time. These characteristics have proven to prevent permanent capital impairment and the ability to ride out market dislocations easily. Unfortunately, over the past several years, core fundamental strength has mattered little in generating market returns. Since 2021, it has been the Magnificent Seven (giant technology companies) followed by anything AI-related that has pushed markets to all-time highs. Since neither Brown nor Nintai invests in such companies, returns have suffered compared to these stocks. 
 
Second (and something that has hurt in the short term) has been Brown and Nintai’s commitment to holding on to portfolio holdings for decades. In the early 2000s, Warren Buffett talked about how he regretted not taking profits when Coca-Cola (KO) shares had reached all-time highs. In 2020, seven stocks in the Nintai portfolios and 15 stocks in Brown’s portfolios reached all-time highs. With 20/20 hindsight, it would have been best to dramatically cull these holdings and lock in profits. In Nintai’s case, we only did this in one case - Novo Nordisk (NVO). As Buffett would say, this was a perfect case of thumb-sucking on our part. 
 
Unfortunately, the similarities that matter are when it comes to returns. BCSIX and Nintai portfolios have underperformed dramatically over the past three years compared to the S&P 500 and the Russell 2000 indexes. I should note that Nintai uses the Russell 2000 Mid-Cap Growth Index as a comparator, whereas Brown Capital uses the Russell 2000 Small-Cap Growth Index.  
 
The returns for BCSIX and Nintai Investments are seen below. The three and five-year returns are pretty tough. They occurred at the height of the Magnificent Seven and AI booms. Since Brown and Nintai don’t invest in either group, the funds’ returns naturally underperformed. 
 
Brown Capital Small Company (BCSIX) Fund Returns

Conclusions
 
When we meet with potential (and existing) clients, we often stress the importance of thinking long-term regarding investment strategy and portfolio management. Because we invest with management with a history of outstanding capital allocation, we want compounding to do the heavy lifting in our portfolio holdings. Years of 
 
Underperformance can begin to eat away at even the most confident investment manager. Brown Capital Management’s investment woes give us some comfort that they aren’t a flaw specific to our model. Overall, we remain confident that returns will return to the mean when certain market bubbles inevitably collapse. Until then, we will seek comfort in knowing we are in the company of a great long-term investment management firm. But as Mr. Dulles said, while we enjoy the company of Brown Capital, we’d rather not go along for the ride at all. 
 
Disclosure: Nintai Investments holds Veeva, Guidewire, Manhattan Associates, and Tyler Technologies in all of its client portfolios. Mr. Macpherson also holds these stocks in his personal portfolio. 

“Occasionally, Wall Street gets things right. But most of the time, greed wins out, and some genuinely atrocious products are turned out. Most of them, like double or triple-leveraged funds, cost investors dearly. Sometimes, during moments of absolute gluttony, Wall Street creates things like mortgage-backed securities, which cost the country dearly. The difference is only the level of greed and stupidity.”
                                                                                    -  Albert Hastings II
 
Over the years, I’ve written about a range of gimmicks that Wall Street has successfully (most of the time) pawned off to entice individual investors. These have ranged from funds that track highly focused political angles (such as a MAGA fund) to the reverse-IPO model of special purpose acquisition companies (SPAC). Almost always, these products serve the best interests of Wall Street rather than individual investors. This is usually achieved through excessive management fees combined with underperformance. 
 
Bloomberg and Morningstar recently discussed a new Wall Street bonanza designed to capitalize on MicroStrategy’s investment in Bitcoin. As with many Wall Street offerings, the product capitalized on the hottest new trend with an overlay of unmitigated greed—for industry players rather than individual investors. 
 
Microstrategy, Bitcoin, and the Horror of 3X Single Stock ETFs
 
In mid-2020, MicroStrategy (NASDAQ: MSTR), a Virginia-based software analytics and services company, announced it would use Bitcoin as a component of its treasury reserve policy and as part of management’s stock price strategy. By the end of the year, MSTR had amassed roughly 105,000 bitcoins, spending approximately $2.5B. The acquisition was financed by issuing over $2B in corporate debt. By utilizing this strategy, MicroStrategy made itself more of a bet on the price of Bitcoin than on the business strategy and dynamics of its underlying business. 
 
The decision to utilize Bitcoin as a valuation tool immediately drove a series of non-investment players to the company’s stock. People who loved Bitcoin saw Bitcoin as a growth tool or wanted to be in on the newest hipster player on Wall Street, and they were all looking for new ways to invest in MicroStrategy stock. 
 
One of the most aggressive (or egregious as the case may be) players who saw a way to turbocharge an investor’s gains (or losses) was GraniteShares. The company is a UK-based issuer of exchange-traded funds (ETFs) focusing on leveraged single-stock ETFs. The idea is quite simple – if you like a company’s return, you’ll love an ETF that triples it (or its loss). One might think (and you’d be right) that it would be cheaper and safer to buy three times as many shares of your holding if you’d like to capture more potential gains. Let me explain why this is the case with our good friend MicroStrategy stock. 
 
For those investors who can’t get enough of MicroStrategy’s play on bitcoin, GraniteShares 3x Long MicroStrategy Daily ETP (LMI3) is just the ticket. With only $11M in assets under management, this is about as small and focused as an individual can find. The idea behind the ETP is simple. LMI3 is an exchange-traded product that offers investors three times the daily return of MicroStrategy’s stock. If MicroStrategy goes up 3% on Monday, LMI3 goes up 9%. If MicroStrategy goes down 5% on Tuesday, LMI decreases 15%. 
 
It all seems pretty straightforward until the idea hits a terrible wall, similar to Jack Bogle’s “tyranny of compounding costs.” For those who purchased the product thinking they would triple their gains when the stock went up, consider these returns: In 2024, MicroStrategy stock rose by 100%. In that same period, LMI3 dropped by roughly 82%. This return dynamic remains valid for one, three, and six months.[1]  
 
Something’s Fishy in ETF-Land
 
For any investor who purchased LMI3 last year to triple investment in MicroStrategy’s stock price and opened their brokerage account statement 6 months later, they were sadly abused by their strategy. For all those investors who filed complaints about their returns, it was in the disclosure provided by GraniteShares. Investors are told not to hold the instruments for the long term. They are frequently called “Same-Day” or “One-Day-Only” ETFs. The ability to triple your returns (or losses) is limited to….wait for it….only the first day. 
 
You own the ETF. (That description is generally accurate. There are ways to achieve these results over an extended period, but you need an advanced degree in mathematics to get there.) Greifield writes in her article:
 
“LMI3 does a good job of giving you three times the daily return of MicroStrategy but a horrific job of giving you three times the year-to-date return of MicroStrategy. (It gives approximately negative 0.8 times the year-to-date return.) The funds offer amped-up exposure only to a stock’s one-day return given that the daily rebalancing of the options book erodes returns over time.”
 
There’s a lot to unbundle here. That should tell most individual investors they are way over their heads, but that’s never been a significant deterrent on Wall Street. Here’s why the numbers seem so out of whack.
 
First, the ETF is designed to give an investor triple the return of the daily return of the stock on the day you buy it. The leverage is recalculated daily, so the fund starts fresh each morning with the current market price. This can lead to significant deviations from the underlying index over longer periods if the market experiences considerable volatility. This leads us to the second point. Volatility is fatal in the design of these ETFs. If the stock increased by 1% every day with no deviation, the ETF would act in the manner most investors assume they purchased it for. Unfortunately, volatility is disastrous for ETFs like LMI3. Because most of the stocks underlying triple-leveraged ETFs are highly volatile, holding a 3x leveraged single-stock ETF for more than a week can lead to shocking results. 
 
A Bugaboo Example
 
Let’s use a generic example to show why these two caveats are so vital to the returns of ETFs like LMI3. At the beginning of the trading week, an investor decides to invest in 3X Long Bugaboo Blast Daily ETF. Shares of the ETF trade for $100 per share. Shares for Bugaboo trade at the same price - $100 per share. (I know. I know. The odds of that happening are nil, but they make the example easier to work through.) The ETF is designed to expose you to the returns of three shares of Bugaboo.
 
On Monday, Bugaboo’s share price increased by 10%, which means that the ETF's share price will increase by 30%. The stock is now worth $110/share, and the ETF is worth $130/share. So far, so good. On Tuesday, the investor adds an additional share to your portfolio. At this point, the ETF must expose the investor to three times $130 worth of stock or 3.55 shares. On Wednesday, the stock price jumped another 10% (this investor knows how to pick stocks!). That means at the end of the trading day on Wednesday, the stock price sits at $121/share, and the ETF is at $169/share. ETF needed to purchase more shares on Monday and Tuesday nights to meet these requirements.
 
Here’s a much simpler way to look at how the ETF operates: “Every time the stock goes up X% and then down Y%, the ETF goes up 3X%, and then down 3Y% of a bigger number, so the loss is greater. And every time the stock goes down Y% and then up X%, the ETF goes down 3Y% and then up 3X% of a smaller number, so the gain is smaller. The ETF is forced to buy shares every time they go up and sell shares every time they go down, which has to be a drag on returns.”[2]
 
Katie Greifield points out that these intuitions only work if the stock steadily goes up or down. Suppose the stock prices see wide price swings, like up 16% on Monday, down 19% on Tuesday, up 22% on Wednesday, and down 17%. Thursday, then it’s likely that we will not come close to reaching 3X returns. You might achieve a -X% return. Another way of generating inferior returns is to employ a buy-and-hold strategy for the 3X Long Bugaboo Blast Daily ETF. 
 
To get back to our reality-based example of MicroStrategy and the LMI3 ETF, here’s a  summary of investment strategies that have proven to produce adverse outcomes:

1. Investing for the long-term.
2. Investing for the medium term.
3. Investing for more than three days.
4. Investing during mild volatility.
5. Investing during high volatility.
6. Investing thinking you will get 3X the return of MicroStrategy stock.

 
You get the gist of where this is headed. Or at least, I hope you get the gist. For further edification, here is a comparative chart of the return of MicroStrategy stock versus the return of the LMI3 ETF. The blue tracking line represents the return of MicroStrategy since January 2024. The red tracking line represents the return of the GraniteShares 3X Long MicroStrategy Daily ETP. You might understand the confusion of a private investor who thought they would obtain a 3X retorn on 110%. -81% is about as far away as can be imagined!

Conclusions
 
The GraniteShares 3X Long MicroStrategy Daily ETP is just the kind of investment designed for savvy investors looking for opportunities to enhance their daily returns. It is in no way, shape, or form an investment product for an individual investor. In its most common form, it is a tool created by Wall Street for Wall Street as a means to suck people into thinking they are more intelligent than they genuinely are. When investors open their latest statements, the difference between a +110% return and a -81 % return can be pretty shocking. Granted, an individual investor shouldn’t invest in LMI3, regardless of the potential return.  
 
As with most things in life, when things seem too good to be true, they are. Certainly, GraniteShares’ LMI3 fits that mold. Even if the idea of 3X MicroStrategy’s stock returns were plausible, the volatility and costs would leave returns much to be desired. Our advice at Nintai remains straightforward: find a low-cost index fund, rebalance when required, and let compounding work its magic. 
 
DISCLOSURE: NONE
 
As of publication, Nintai Investments LLC has no shares or plans to purchase shares cited in the article. 

[1] I am deeply indebted to Katie Griefield’s research done for her article “One-Day-Only ETFs Are Jack Bogles Nightmare Brought To Life.” The article can be found here.

[2] Ibid

The Ability to Pay: Graham’s Great Distinction (One of Many)
 
“The difference between stupidity and genius is that genius has its limits.”
 
                                                                                        -      Albert Einstein 

I’ve often mentioned that during times of continued market highs, I spend an awful lot of time reading the value investment classics. This helps me keep my eye on the “value” ball and grounds me in my more natural condition of trading sloth and indolence. This week I started my 11th full read-through of Benjamin Graham and David Dodd’s classic “Security Analysis.”  To be honest, this tome is a much greater slog than Graham’s “The Intelligent Investor”, but I highly recommend every investment manager and individual investor read it at least once. There seems to always be a diamond in each chapter that turns up through each reading. 
 
Most investors tend to skim - or skip entirely - the sections on fixed income investing. This is unfortunate. These chapters have an enormous amount of insights that are transferrable between bonds and equities. To Graham and Dodd both types of assets are dependent upon price versus value first, and risk versus uncertainty second. Overpaying for a bond is as poor a decision as overpaying for a stock. Miscalculating risk is equally dangerous. So, I encourage everyone to roll up their sleeves, gird their intellectual loins, and do some additional reading. It will be well worth it in the long run of your investment education.  
 
In reading Chapter 6, “The Selection of Fixed-Value Investments[1]”, investors get their first view of the now standard discussion of the rights of bondholders versus shareholders (hint: the former come first). Traditionally we think of an investor’s position in terms of ownership as bondholders, preferred shareholders, and shareholders respectively. We are also told to look at either a stock or bond investment as the purchase of a piece of a business. This is all very true. All too often investors (both individual and institutional) look at their purchase as a piece of paper or a digital number on a screen. 
 
But in this chapter, we are told looking at your investment as a part of a business is really only half the equation. As Graham and Dodd point out, understanding the investment company’s ability to pay is equally - if not more important - than your placement in the rights to assets/profits hierarchy. They write:
 
“In the past the primary emphasis was laid upon the specific security, i.e. the character and supposed value of the property on which the bonds hold a lien. From our standpoint this consideration is quite secondary; the dominant element must be the strength and soundness of the obligor enterprise. There is here a clear-cut distinction between two points of view. On the one hand the bond is regarded as a claim against property; on the other hand, as a claim against a business.”  
 
At Nintai Investments we think this is a tremendously important concept whether you are bond investor or stockholder. The old phrase “you can’t blood from a stone” applies as much to a turnip[2] as it does a cash flow negative investment holding. It doesn’t matter what your rights position is if the company has no ability to pay out – either in terms of cash flow or assets remaining on the balance sheet. 
 
Why This Matters
 
It’s always best to look ahead and not fight the last war. The 2008-2009 Great Recession was (in part) caused by derivatives that blew up on company balance sheets with shocking speed and devastation. Just ask anybody who was invested in Washington Mutual (now part of J.P. Morgan). Another issue was the sudden elimination of access to short term debt. In this case, ask GE investors or anybody invested in business development corporations (BDCs). In some of these aforementioned instances, the investor found themselves owning a piece of a business – wherever they were on the rights continuum – that simply had no way of meeting their obligations. When Graham and Dodd wrote about “the dominant element must be the strength and soundness of the obligor enterprise”, they really weren’t kidding. 
 
I would suggest there are three important lessons equity investors can take from this section.  
 
There Will Always Be Future Rainy Days
No matter how rosy a picture management paints about the future, there will be inevitable downturns. Bad product launches, operational failures, or market downturns will inevitably place stress on your investment’s financial and competitive strength. In a recent call I listened to corporate management discuss the fact that revenue could decrease by 25% for the next five years and they could still pay the current dividend, fund current operations, and increase research and development without tapping their credit line. That’s what I call planning for a rainy day. 
 
It’s Always Darkest Before It Goes Pitch Black
In 2008, I was participating on a conference call trying to get a better understanding of a company’s assets on the balance sheet. During the call the CEO announced they felt that while things were dark, they had reached a nadir in their financial distress. Over the next 6 months they wrote down an astounding additional 81% of total assets. Don’t let management fool you, things can always get worse when they don’t understand their very own assets. In this case, the company had no “strength or soundness” to meet their obligations. 
 
The Future is Unknowable, But Cash Will Always Be King
It’s a fool’s errand to try to predict the directions of the markets. It would be quite a feat if someone had correctly predicted the length of the current bull market. One thing I’m comfortable predicting is that it will end. I haven’t the foggiest idea when, but I know it will end. When that time comes and confidence collapses, investors sell regardless of price/value, corporations will reduce spending across the board, and cash will be king. The ability to pay – so important to Graham & Dodd – will become a simple question of free cash generated and cash on the balance sheet. 
 
Conclusions
 
Some writing is timeless. Graham and Dodd’s “Security Analysis” certainly falls in that category. The wisdom to be found in their writing can assist investors in both ascending as well as descending markets. More importantly, some suggestions by the writers apply to all types of securities whether they be bonds or stocks. The concept of buying a piece of a business is a great way to look at investing. Buying a piece of a business that can afford to pay its bills – regardless of market or economic conditions – is great value investing. The difference can make all the difference in your long-term returns. 
 
As always, I look forward to your thoughts and comments.     


[1] Benjamin Graham and David L. Dodd, “Security Analysis”, 6th Edition, McGraw Hill, 2009, pages 141-153

[2] Many people have different versions of this phrase. The original phrase seems to be “you can’t get blood from that wall” or “to go about to fetch blood out of a turnip” as used by Giovanni Torriano in an Italian/English translation manual. Why he chose a root vegetable is beyond the purview of this writer’s knowledge but might be worth a future article by a GuruFocus author. Investment knowledge can never be too esoteric.
 

“If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it…….The more symbols they could work into their writing the more they were revered……If you stand up in front of a business class and say a bird in the hand is worth two in the bush, you won’t get tenure…. Higher mathematics may be dangerous and lead you down pathways that are better left untrod.”
 
                                                                                                         -     Warren Buffett 

In the fall of 2015, Jack Bogle and Michael Nolan published an article[1] which discussed how Sir William Occam’s Law of Parsimony could be utilized to create a model that could estimate reasonable expectations for capital market returns. The model was, indeed, quite simple. In the article, Bogle and Nolan described it as thus:
 
Projected Return = Starting Dividend Yield + Earnings Growth Rate + % Change in PE Ratio
 
Bogle labeled each of these factors as dividend return, investment return, and speculative return. He labeled the first two as “investment” returns and the last as “speculative” returns.
 
Dividend Return: is the one inarguable factor in the model. For instance, today’s (July 26, 2024) S&P 500 yields are 1.32%, considerably below the 50-year average of 2.8%.
 
Earnings Return: It is impossible to say what market (or your portfolio’s) earnings will be five to ten years from now. For instance, the S&P 500’s earnings per share grew an inflation-adjusted 2.4% a year in the 1970s, fell 0.7% in the 1980s, grew 4.7% in the 1990s, contracted 1.9% in the 2000s and dramatically increased by 8.7% in the 2010s. Some feel it is best to use the 50-year average, while others add or subtract by where they think we are in the economic cycle. It’s up to each investor to derive the number they believe best represents the future of earnings.
 
Of course, earnings can’t be measured without factoring in inflation. One of the more sound ways we’ve seen of calculating this is the difference in yield between 10-year Treasury notes and 10-year inflation-indexed Treasurys. As of today, this would show an estimated future inflation rate of -1.6%. By adding the dividend rate plus the earnings growth rate and subtracting the inflation rate, an investor gets the estimated “investment” return of the markets or their portfolio. 
 
P/E Ratio Change: The change in P/E ratios reflects how much investors are willing to pay for stocks. Higher P/E ratios suggest that investors are willing to pay more for future growth while decreasing P/E ratios reflect that investors will pay less for growth. This is why Bogle refers to this as speculative growth. It builds in what an investor thinks about the level of risk (or speculation) fellow market participants will be willing to pay in the future. Of all three factors in the formula, this is, without a doubt, the hardest to get right. So many factors drive investor attitudes. Having said that, we firmly believe that utilizing a long-term average and then assuming a regression to the mean can guide whether you think P/E ratios will increase or decrease. 
 
So, how does the model work? For example, let’s see how the model would have predicted the S&P 500 for the period 2010 - 2020. 

Even with 20/20 hindsight, we can see the formula was off considerably compared to actual returns. This means one of three things: The actual earnings growth rate was considerably higher, the P/E annual increase was more significant, or a combination of both. 
 
Why This Matters
 
I bring Bogle/Nolan’s model up because it’s a great way to see what’s happened to the Nintai portfolio since its inception. We can divide the portfolio performance into two phases – “Super Alpha” (2018 – 2020) and “Definitely Not Super Alpha” (2021 - 2024). I should point out that the portfolios seem to be leaning back to the “Super Alpha” model this quarter. My fingers are crossed. 
 
In the Super Alpha period, the Bogle/Nolan model shows two variable factors in their formula (earnings growth and speculative growth), estimating extraordinary growth. Earnings growth is estimated at 10.7%, and the PE expansion growth exploded at 11.2%. Combined with the 1.07% dividend yield, the estimated annual growth was 23.2%. As you can see, nearly 50% of the estimated growth came from expansion in the P/E ratio. The portfolio’s P/E ratio went from 17.7 in 2018 to 24.7 in 2021. 
 
In fact, the formula overestimated growth for the period. The model showed 23.2%, while actual portfolio growth came in at 19.8%. The Nintai portfolio enjoyed extraordinary earnings growth (investment return) and P/E growth (speculative return).  

So what happened in the next (“Definitely Not Super Alpha”) period: 2021 - 2024? The Bogle/Nolan model does a great job of showing the reasons for underperformance during this time. In essence, the portfolio demonstrated solid investment returns through solid earnings growth (though at a slower rate) and a near-collapse in speculative return with a significant decrease in the P/E ratio during the period. 
 
During the period, the S&P 500 outperformed the Nintai portfolio by nearly 9.8% annually. This was achieved in two ways. While the Nintai portfolio earnings growth in the formula dropped from 10.7% to 3.6%, the S&P saw its earnings grow steadily, if not increase. Additionally, the speculative (P/E growth) return in the Nintai portfolio dropped to a negative 3.8% while the S&P 500 increased again.  

During Nintai’s most successful years, the portfolio’s investment return (Dividend % Rate + Earnings Growth Rate) and speculative return (the P/E ratio growth rate) dramatically outperformed the S&P 500. Not only were the portfolio companies growing faster than the S&P 500, but investors were willing to pay more than the index. The exact opposite happened in the past several years. Investment return has slowed, and investors are not willing to pay as much for those earnings. 
 
Conclusions
 
While not perfect, Bogle and Nolan’s performance prediction model is pretty nifty – and simplistic – to estimate how your portfolio will perform over an extended period. Using historical data with some educated guesses on where we are regarding economic and market cycles, an investor can make an educated guess on how their portfolio might perform in the future. Additionally, it’s a straightforward tool to demonstrate how and why portfolios outperform and underperform over specific periods. I highly recommend setting up a model and giving it a try yourself. If nothing else, it’s an outstanding tool to teach investors what drives market returns. And you can’t knock that. 
 
I look forward to your thoughts and comments. 
 
Disclosures: None

[1] “Occam’s Razor Redux: Establishing Reasonable Expectations for Financial Market Returns,” The Journal of Portfolio Management Vol 42 Issue 1, Fall 2015
​

“Sometimes things go against you for months, quarters, and even years. It’s hard when the whole market is going down with you, but it’s tough when your positions drop and others keep going up. But you can’t lose faith in your process. If you believe you are correct, you must ride it out.”

                                                                                -      Charles Tompkins  

Last month, I talked about the Magnificent Seven (M7) and the role of the fear of missing out (FOMO). Indeed, many investors have had to confront this as the M7 continues its surge forward as we near the year's halfway point. I thought it might be interesting to compare the rise in M7 stocks versus some of Nintai’s portfolio holdings and discuss the difference in performance. 
 
One of the peculiar distinctions over the past several years between M7 stocks and Nintai Investments portfolio holdings is the disconnect between growth in free cash flow versus stock price appreciation. For the M7 stocks, the percent increase in free cash flow has generally been exceeded by the percent in stock appreciation, meaning that as the company has increased free cash flow by 15% annually, the stock price has appreciated by 25% annually. This has led to ever-increasing P/E and P/FCF ratios. For instance, Meta’s P/E ratio has gone from 14.01 in 2022 to 28.3 in 2024. Nvidia’s P/E ratio has gone from 21.7 in 2019 to 75.8 in 2024. These increases in P/E ratios are the clearest indication that prices are advancing far quicker than earnings. Conversely, Nintai holding Veeva’s P/E ratio has gone from 117.1 in 2021 to 47.3 in 2024. 
 
Before I discuss the differences between Nintai’s holdings and the M7 stocks, I thought I would add some additional data to the conversation.  
 
Nvidia & Generative AI Hype: On a day (June 13, 2024) when the Nintai Model Portfolio was down -0.37%, and Nvidia was up +3.52%, it seems pertinent to point out some information regarding Nvidia and the Generative Artificial Intelligence hype cycle. Through May 30, 2024, Nvidia (NVDA) has accounted for approximately one-third of the S&P 500 Index's return. That isn’t a typo: one company out of 500 accounts for 33% of the S&P 500's return. With no exposure to Nvidia in 2024 - due to our assessment that the stock has generally been priced at a premium to fair value - approximately 36% of the Nintai Investments portfolios’ underperformance has come from its lack of Nvidia.
 
The Magnificent Seven: The Magnificent Seven stocks (Alphabet (GOOGL), Amazon (AMZN), Apple (AAPL), Meta (META), Microsoft (MSFT), Nvidia, and Tesla (TSLA)) accounted for more than 50% of the S&P 500 Index's YTD returns - and that includes pretty poor starts to the year from Tesla and Apple. Excluding these two laggards, nearly 60% of the S&P 500 YTD returns are explained by the remaining Magnificent Five companies.
 
Stock Selections: Several stocks in the Morningstar Moat Index in Nintai Investment portfolios have posted disappointing returns in 2024 due to investor emotions and macro-driven concerns. That is not to say that others have not performed well.

Of course, Nintai has had several stocks not large enough to be in the S&P 500 that have generated equally detracting returns YTD. These include Paycom (PAYC) -29.9% return, Genmab’s (GMAB) -17.1% return, and Veeva’s (VEEV) -20.1% return. 
 
Free Cash Flow Growth and Stock Price: A Lack of Correlation
 
So, what’s going on here? Why has the M7 made up such a significant component of returns of the &P 500? Perhaps the most central issue from our perspective at Nintai is the lack of correlation between free cash flow growth and a company’s stock price. As we’ve stated many times before, we don’t use earnings as a major component in assessing intrinsic value in our corporate valuation tools. As the classic adage (somewhat) goes, earnings are an opinion; free cash flow is a fact. 
 
Our valuation tools work under the assumption that long-term free cash flow growth will ultimately lead to an increase in intrinsic value. The inverse is equally true. That said, occasionally, markets will diverge from this model – the stock price will increase without a commensurate increase in free cash flow, or the stock price will go down even though the company is seeing strong growth in free cash flow. Unfortunately, in the past couple of years, we’ve had both examples of this. In the past several years, the M7 has seen stock prices increase far more than free cash flow growth, while Nintai portfolio positions have seen stock prices decline even as their free cash growth has been substantial. Let’s take a look at some cases. 
 
Meta Platforms
 
In the case of Meta Platforms (META - until recently known as Facebook), the share price has roughly tracked its free cash flow growth. As free cash flow dramatically dropped in 2022, so did the company’s stock price. Conversely, as free cash flow recovered in 2023 and 2024, so did the stock price. However, as with many M7 stocks, the increase in stock price by percentage exceeds the growth in the free cash. For instance, Meta’s stock price increased by nearly double the rate of free cash flow growth during the previously mentioned time frame. 

Another M7 stock followed a very similar pattern. Nvidia is the poster child for M7 excess in terms of price becoming disconnected from free cash flow. 
 
Nvidia
 
From 2018 – 2024, Nvidia increased its annual free cash flow from $4.69 per share to $32 per share. During that time, the company grew free cash flow at a 31.6% CAGR.  In the same period, the company stock price went from $35.94 per share to $1,164.37 per share, or a 64.4% CAGR. Seen from a different angle, investors were willing to pay very generously for Nvidia’s growth in free cash flow.

This has been a prevailing trend in the M7 stocks and is one of the main reasons why these stocks have generated such a large percentage of the S&P 500’s gains over the past few years. For fund managers who invest in smaller holdings or even stocks that represent the remaining S&P 493, their returns have suffered significantly. 
 
Similar Companies, Different Results
 
One of the most frustrating aspects of being an investor over the past several years has been watching returns of Nintai’s holdings. Many of the stocks in our portfolios have grown free cash flows at outstanding rates and seen stock prices drop in many cases. Two cases tell very similar stories. 
 
Veeva Systems
 
Veeva has been a long-term holding in Nintai portfolios. The company converts roughly 40% of revenue into free cash, generates a return on equity in the high-20s and return on capital in the mid-30s, carries no short—or long-term debt, and has over $1B in cash/short-term securities on the balance sheet. In the past (from 2013 – 2020), investors priced shares at a premium, similar to how they look at Nvidia today. But looking at the graph below, one can see a rapid reversion starting in 2021 and carrying through today.  The stock price has dropped from a high of $276 in 2021 to $173 in 2024 even though free cash has increased by roughly 11% CAGR ($4.80 in 2021 to $7.12 in 2024). 

​A question that we ask at Nintai is, what happened after 2020? Why did the markets suddenly change their view on the company even though its fundamentals remained so strong? Veeva wasn’t alone in this trend. 
 
Skyworks Solutions
 
Skyworks Solutions, another Nintai holding, had a very similar trend. In the period from 2021 to 2024, the stock price dropped by 45% from $165 to $91. In the same period, free cash flow rose by 62%.  

What This Means
 
In our first four years, the Nintai Investment portfolios significantly outperformed the S&P 500. The last three years have seen a near mirror image of these results. During those initial four years, investors paid an increasing amount for each dollar of free cash flow, with many portfolio holdings generating significant returns. Starting in 2020 – 2021, many of these same companies continue to grow free cash flow, remain debt-free, and generate outstanding return on capital.  
 
So what happened? First, it’s always important to remember the concept of reversion to the mean. For stocks or portfolios that outperform for stretches of time, it is frequent to see stretches of underperformance to follow. Outperformance can’t last forever (unless, of course, your name is Bernie Madoff). To outperform, you must necessarily underperform at some point. Reversion to the mean is an ugly process to endure, but as a long-term overperformer, you will have stretches like this to endure. 
 
Second, markets are prone to emotional bursts of irrational exuberance for certain types of stocks (the 20s Conglomerates, the 70s Nifty Fifty, the 90s Tech Stocks, etc.) or for certain industries (Biotechnology in the 90s, Nanotechnology late 2000s, et.). We are currently in a run of three hyped trends – crypto/digital currency, artificial intelligence, and MEME stocks. In the first case, we have companies based on fancifully named “coins” with no way to value them in any rational financial or economic model. This was the first craze that took the wind from the sales of quality companies earning real free cash like those in Nintai portfolios. The crash of the cyber markets has led to a new gold rush in Artificial Intelligence (AI), seen as the next “it” thing that will change the foundations of our societies and economies. Last are the MEME stocks, which are usually found on internet discussion sites such as Reddit. These stocks’ prices can rise or fall by as much as 100%, dependent upon comments from writers with strange animal names with little or no financial background. 
 
Unfortunately (or actually, fortunately), stocks in the Nintai portfolios reflect none of the characteristics of these three stocks. Combined with reversion to the mean, we think our portfolio holdings are suffering from a general rejection of staid, high-quality companies that generate significant free cash flow, keep their noses down, and focus on their core business. 
 
Conclusions
 
We’ve been talking about the same thing during our times of outperformance and during times of underperformance. We look for find companies with significant competitive moats that generate high returns on capital, convert a significant percentage of revenue into free cash flow, have little/no debt, and are run by trustworthy management. We think over the long term these companies will outperform the general markets and generate adequate returns to our investors (and our own internal investors since we invest in the same companies).  
 
Of course, the greatest challenge is holding steady during times of underperformance. But when you look at the performance of companies like Veeva or Skyworks (or any other company in Nintai portfolio, for that matter), we feel comfortable the companies are building long-term intrinsic value which will be recognized at some point. 
 
We hope you have found this analysis of some interest, and as always, look forward to your thoughts and comments.
 
DISCLOSURE: Nintai Investments and its staff currently have positions in MarketAxess, Biogen, Paycom, Genmab, Veeva, and Skyworks.