“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. 

"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 seen a trend in bifurcated returns. The so-called Magnificent Seven (Microsoft, Nvidia, Google/Alphabet, Apple, Meta, Amazon, and Tesla) achieved roughly 92% of the total gains of the S&P 500 in 2003 alone. As seen in the graphic below, the returns of the Not-So-Magnificent 493 were nothing to write home about. (Please excuse the rather gaudy nature of the Goldman graphic!)

​Looking at the returns of the Magnificent Seven (M7) over the past several years, it becomes clear that you need to invest in several of these stocks to beat the S&P500. It would be much easier to beat the S&P493, but unfortunately (or fortunately, depending on your investment position), that’s not what the index follows. 
 
But you don’t have to broaden things that much to see how crazy the returns have been with the Magnificent Seven. If you look at the next 42 companies – not 493 – here’s how they compare against the M7. 

​Compared to the next largest 42 stocks, the M7 looks inflated by market value, sales, and profitability. These companies have 2.5x the sales and 2x 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 having a slight tinge of Fear-of-Missing Out Syndrome (FOMO). Having said that, I think not having FOMO is probably one of the top characteristics of successful investors. It is nearly impossible to retain your investment strategy and invest for the long term when under the influence of it.    
 
In this age of Bloomberg/CNBC 24/7 business news, Reddit stock boards, MEME stocks, etc., it seems FOMO has become a driving force in modern 21st-century investing. It seems unlikely that an investor (is that what these people are? Or would gambler be a better description?) who invests in GameStop (GME) stock and sees its daily price go from $17.46/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 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). But chasing returns driven by FOMO is an almost assured way to chase highly volatile, short-term returns, driving up trading costs, increasing your tax bill, and frittering away the chance to let compounding do its work. At Nintai, our first four years in business were outstanding, generating significant outperformance nearly every year. The last three have been a roughly mirror image. However, we refuse to change our methodology and begin loading up on M7 stocks like Nvidia (NVDA) or meme stocks like AMC Entertainment (AMC). Instead, we will take the advice of President Kennedy’s Marshal Lyautey and not just continue researching our long-term holdings like Veeva (VEEV) or iRadimed (IRMD). In fact, we’ll probably start 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. 
 

When we began thinking about the structure of Nintai Investments LLC back in 2017, one of our business goals was to give back to our community. Over the years, we came to see that making an impact in charitable giving meant 1.) making a substantial gift, 2.) giving in a very focused manner, 3.) making a long-term commitment, and 4.) placing few/no stipulations on the use of the donation. With that in mind, we mandated that 10% of all gross profits from Nintai’s operations will be used to source such a three-year charitable gift. 
 
In addition, we agreed to focus on two areas of need – assisting children and families who have suffered from societal trauma and supporting animals and shelters of last resort. This included such organizations as no-kill shelters for abandoned animals or organizations supporting children and families who have suffered from gun violence. 

In 2021, we began our second charitable capital donation with a three-year commitment to Tabby’s Place(www.tabbysplace.org), a kill-free, cage-free haven for cats in desperate situations in Ringoes, NJ. This donation was a three-year commitment to sponsor a care suite in Quinn’s Corner, a wing specially dedicated to cats who are FeLV+. This new wing will allow Tabby’s Place to double the number of cats saved and allow them to live a life renewed with love and compassion. We hope you will take a look at the incredible new facilities at Quinn’s Corner (https://qc.tabbysplace.org/all-about-quinns-corner/). In December 2023, we made our third - and last - installment of our capital commitment to Tabby’s. 

Beginning in 2024, we are pleased to announce the next recipient of our charitable giving. This year, we will be making our next multi-year commitment to another charity - the Catherine Violet Hubbard Animal Sanctuary (https://www.cvhfoundation.org). The sanctuary is an incredible monument to Catherine Violet Hubbard, a six-year-old victim in the Sandy Hook Elementary School tragedy. The Sanctuary pays tribute to Catherine and her spirit of kindness towards all living things by honoring the bond between humans, animals, and the environment. More can be learned by watching this video (https://youtu.be/E_VXSZzocis), where Catherine’s mother discusses the tenth anniversary of the Sanctuary and all the programs it offers. 
 
We are so pleased to be able to support the CVH Animal Sanctuary. Working with the Sanctuary combines our two goals. First, we help further the legacy of an incredible young lady who worked so hard to be a force of good to all creatures, great and small. Second, we can help those in need by furthering the organization’s programs, allowing pets to stay with their elderly owners, regardless of their financial or physical needs. 
 
We believe a multi-year capital commitment is the best way to maximize our impact and focus our efforts on the limited amount we have to give. Working with the organization’s Board, we allow the organization to decide how the monies will be used. We generally look to give these donations as anonymous gifts unless the organization believes disclosing or using the source might encourage others to give. 
 
We feel so blessed and honored to meet individuals and organizations such as Tabby’s Place and the Catherine Violet Hubbard Animal Sanctuary. Their efforts make a powerful statement that we can do better, that we can care about our neighbors and our planet, but most of all, we can commit to reaching out and showing love and compassion for those in need. 
 
I want to thank our Board, employees, and investment partners for making this active giving possible. All of us at Nintai Investments feel so lucky to be part of such a corporate community. 
 

“You have got to somehow recognize a good business before it’s recognizable as a good business.”[1]
 
                                                                                  -      Charlie Munger 

 “The profound point is that the critical link between growth and value creation is the return on incremental capital. Since share prices tend to follow earnings over the long term, the more capital that can be deployed at high rates of return to drive greater earnings growth, the more valuable a company becomes. Warren Buffett summarized the point best: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” The best investments, in other words, combine strong growth with high returns on capital.”[2]
                                                                                   -     Lawrence Cunningham 

Over the past year or two, we have been asked quite a bit about how we make our stock selections at Nintai Investments. Before I delve into that, distinguishing between finding the right investment and purchasing the right one would be best. Finding a great investment is about identifying the characteristics of a company that you believe will generate better than average value in the long term. Note I mention nothing about price here. It is simply finding a company that meets your investment criteria – nothing more. The second piece of the process is assuring potential qualified investments meet the price-to-value requirements measured by its margin of safety. If a company meets both requirements, we will put significant capital to work since not many meet both. 
 
The quote at the beginning of this article by Charlie Munger sums up the plight succinctly (as usual). Finding a long-term compounding machine at a sufficient discount to your estimated intrinsic value usually means one of two things - you’ve either discovered a hidden gem unrecognized by the general markets, or you’ve found a gem that has already been discovered but discarded by the general markets. This might be due to a poor earnings report or a series of poor decisions by management. In either of these cases, you feel the problems can be solved, and the company’s value has not been permanently impaired. 
 
In today’s article, I will address the first of the two pieces - locating a company that meets our criteria for being a portfolio holding. In next month’s article, I will discuss the fine art of finding the right price to invest in such a company. 
 
Over the years, I’ve discussed some of the specific ratios or numbers-based criteria we look for in an investment. These include high returns on equity, assets, and capital. It also includes high free cash flow margins, little or no debt, and deep competitive moats. Rather than going through these in detail again (I can almost hear the eyes rolling across the internet), I wanted to step back and discuss the conditions that make those numbers possible in much greater detail. For instance, for a company to achieve high returns on invested capital, several things must happen. First, management must be great capital allocators, understanding what drives the highest capital returns and focusing on steps that achieve those conditions. Generally, excellent returns on capital don’t just happen; they are made. In this article, I want to describe what we look for in portfolio holdings that create such numbers. 
 
What We Look for in a Portfolio Holding
 
Before I start, I wanted to say a few quick words on quality and what that means to Nintai Investments. Within the three major domestic (meaning US-based) stock exchanges (The New Your Stock Exchange, the NASDAQ, and the Over-The-Counter (OTC), roughly 10,000 stocks are being traded. According to Investopedia, at the end of 2023, approximately 55,200 companies were being traded globally. That’s a lot of companies to follow! At Nintai, we generally only follow US, European, UK, and Japanese stocks. This decreases the number by over half, but it’s still a lot. Using our primary screen on Gurufocus.com, which has 12 criteria[3], our complete researchable yield is only 385 companies. That’s a lot more manageable! Of these, roughly 185 are in the United States, and 200 are in the UK, Europe, or Japan. 
 
As we begin to take a look at the remaining companies on our list, there are five major items we look to investigate in each case. These five are:
 

1. Does the company operate in Nintai’s circle of competence?
2. Does management show skill in capital allocation?
3. How sizable are the opportunities for growth within their current customers, markets, and adjacent markets?
4. How deeply embedded is the company with its customers’ operations?
5. Does the company have a history of long-term success?

 
The five questions and their respective research can help provide specific data that gives us confidence in the company’s potential as a long-term portfolio holding. For instance, to better understand management’s track record in capital allocation (history of acquisitions, organic growth record, etc.), we can better understand the background of the company’s return on invested capital or return on equity ratios. 
 
The Major Areas of Research
 
Once we have identified a company that broadly meets our investment qualities, we begin the research of the five questions previously listed. Here’s the type of information we are seeking and what we look to find through this research. 
 
Circle of Competence
 
At Nintai, we have a small circle of competence. In general, we invest in three major areas. First is healthcare and healthcare informatics. These include biotechnology firms, informatics (using data to drive business strategy and operations), and healthcare technology platforms (platforms that capture data across functional areas of a healthcare company). Examples of these include Veeva (VEEV) and Simulations Plus (SLP). Veeva is the global leading supplier of cloud-based software solutions for the life sciences industry. Its two main products are Veeva CRM, a customer relationship management platform for companies with a salesforce, and Veeva Vault, a content management platform that tackles various functions within any life sciences company. The company provides a platform that cuts across nearly every primary function in a life sciences or biotechnology company. Simulations Plus develops and produces software for pharmaceutical research and education and provides consulting and contract research services to the pharmaceutical industry. The company is a leader in utilizing data and advanced research models to increase the speed of drug discovery. 

The second major circle of competence is technology platform providers. These companies create fully integrated systems that allow organizations to better use data and informatics from across the organizations. This can increase product speed to market, achieve cost savings, or obtain strategic insights to grow the business. An example of this includes SEI Investments (SEIC). SEI Investments provides investment processing, management, and operations services to financial institutions, asset managers, asset owners, and financial advisors in four material segments: private banks, investment advisors, institutional investors, and investment managers. By providing a fully integrated platform, SEI allows investment managers to better market and cross-sell their products and services, meet regulatory requirements, and manage diverse financial accounts.
 
The last are companies that have built wide-moat businesses in selective niche markets. Examples include Expeditors International (EXPD) and MarketAxess (MKTX). Expeditors International is a non-asset-based third-party logistics provider focused on international freight forwarding. It offers freight consolidation and forwarding, customs brokerage, warehousing and distribution, purchase order management, vendor consolidation, and numerous other value-added logistics services. It employs sophisticated IT systems and contracts with airlines and ocean carriers to move customers' freight globally. MarketAxess is a leading electronic fixed-income trading platform that connects broker/dealers and institutional investors. The company primarily focuses on credit-based fixed-income securities, with its main trading products being U.S. investment-grade and high-yield bonds, Eurobonds, and Emerging Market corporate debt. Both of these companies have built a wide-moat company providing a particular offering that is very difficult to replicate. In addition, they overlap with our circle of competence within platform companies.
 
Capital Allocation
 
One of the most essential skills for a senior manager is the ability to allocate capital successfully. To work successfully for their shareholders, management faces three significant options – return capital excess capital to shareholders through dividends or stock buybacks, allocate capital to internal/organic growth opportunities, or utilize capital for acquisitions. The ability to decide the best use of the company’s capital essentially decides whether their stewardship will be successful over the long term. The first decision is to decide whether there is any opportunity to utilize capital for internal or external growth opportunities. Share buybacks or a dividend announcement might be the best action if not. Why are there no such opportunities? Has the business reached a dead end of sorts in its growth? If so, why? At Nintai, we look for long-term value compounders. If the company pays out a special dividend because there is little opportunity to allocate capital to the business, we will likely pass. The next thing to look at is management’s track record at acquisitions. The data suggest that most acquisitions are capital destroyers, not capital compounders. The exception is minor “tuck-in” deals that might help solidify a company’s moat or add a new product offering that customers have frequently sought. But for most managers with a history of capital allocation centered on acquisitions, we generally see empire builders seeking personal aggrandizement, not shareholder value creation. Good capital allocators will find uses of capital that achieve high returns. And frankly, there aren’t many of those out there. 
 
Growth Opportunities
 
Management capital allocation skills generally go hand-in-hand with growth opportunities available to the company. We see companies having three primary ways to grow - expanding the business within its current customer base, capturing increased market share in its current space, or building out its base in adjacent markets with similar characteristics to its existing market. As we pointed out in the previous section, jumping into entirely new markets is usually achieved by acquisitions, which are extremely difficult to pull off successfully. We see the best opportunities as a mix of all three, maximizing capital returns, not reinventing the wheel, and sticking to their core knitting. Nintai holding Guidewire Software (GWRE) is an excellent example of this. The company focuses on converting the P&C (Property & Casualty) Insurance sector into the digital age. The company started by literally converting paper-based models into a digitized format. They are now expanding that into a SaaS (software-as-a-service) model by moving the product (and customers) into the “cloud.” The company looks to dominate the P&C space and gradually move into adjacent insurance spaces, leveraging its core product and experience without recreating the wheel. This has provided the company with a long runway of high-return growth while smartly focusing on wise capital allocation.
 
Depth of Customer Integration
 
 Our type of dream company has created a series of products and services that rely on a platform fully integrated into its customers’ operations. By getting embedded into the core operations of a business, it becomes tough to replace the company after installation, training, and efficiency costs are considered. In creating such a business, we believe the holding has a very deep moat that can provide highly profitable growth over a long period. An example of this is iRadimed (IRMD). iRadimed develops, manufactures, and sells a Magnetic Resonance Imaging (MRI) compatible intravenous (IV) infusion pump system and MRI-compatible patient vital signs monitoring system. They also sell accessories and services relating to them. The company has a monopoly on providing a non-magnetic IV infusion pump system designed to be safe for use during MRI procedures. Once iRadimed’s products are installed in a hospital or acute care facility, it is nearly impossible to have them replaced, and they become an integral part of the organization’s imaging capital budget.  
 
A Run of Success
 
At Nintai, we frequently joke (half joke?) that we like to find great companies led by extraordinary leaders, purchase them at the right price, and then sit back and let the managers do the heavy lifting. We firmly believe that Charlie Munger was right when he said the only natural way of getting rich was getting rich slowly. Unless you were smart enough (or lucky enough) to pick the Powerball numbers or purchase a Reubens at a yard sale, then you are a person who needs to let compounding do its magic patiently. That’s why we look for companies to invest in that have a long(ish) story of success with steady management changes, increasing free cash flow year after year, and a long runway of potential growth (see “Growth Opportunities”). We think quality small and mid-cap stocks are the best candidates for this type of compounding value. The secret to bringing this full circle is what Charlie Munger said at the beginning of this article – “You have got to somehow recognize a good business before it’s recognizable as a good business.” It isn’t just our smaller holdings that generate outstanding returns. We acquired shares in Novo Nordisk (NVO) over five years ago, and we think the company can run for another decade, though its share price has tripled since we purchased it. 
 
Conclusions
 
Having a set criteria to identify the kind of company in your portfolio is the first step in building a quality portfolio built for compounding value. The second part, which we will go into in detail next month, is figuring out the best way to calculate its value and how much margin of safety is required to purchase it. Following the process discussed in today’s article doesn’t guarantee future returns. Nothing can do that. However, building a quality-based portfolio of highly profitable companies run by intelligent managers with deep moats can improve the odds of avoiding occasional blowouts. 
 
As usual, I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai Investments and my personal portfolio have holdings in the following companies discussed in this article: Veeva (VEEV), Simulations Plus (SLP), SEI Investments (SEIC), Expeditors International of Washington (EXPD), MarketAxess (MKTX), Guidewire Software (GWRE), iRadimed (IRMD), and Novo Nordisk (NVO)

[1] Daily Journal Corporation Annual Shareholders Meeting, February 15th, 2023

[2] “Quality Investing: Owning the Best Companies for the Long Term,” Lawrence A. Cunningham, Harriman House, January 2016

[3] Most of these are what I’ve discussed previously, such as return on equity 10-year average > 15%, short and long-term debt = $0, etc.

For ths month's article, I am posting a two-part series first published in 2015, then revised/revewed in 2021. In them, I discuss how an nvestor and fund manager should look at the question of "How long is too long?". As many investors and fund managers have seen, the last three years have been topsy-turvy in regards to performance by asset class, size, or style. Many individuals are asking whether they should stay with their advisor after perhaps 5 years of overperformance and then three years of underperformance. In January I will be posting a review of thoughts we have grappled with the past 12 - 24 months.  

How Long is Too Long?
 
We were reading two very interesting articles in the past few days. The first was The Science of Hitting's "Process vs. Outcomes, Revisited "of April 7th, 2015 and the second was "False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas”, by L. Barras, O. Scaillet and R. Wermers[1].
 
Each of these articles helped provoke thinking around the office that finally settled on one specific question: how long is too long for your investment managers to underperform? This is quite relevant today as many value investors - including Nintai - have underperformed the greater markets over the last three (3) year period. With said, how long of a leash do you think is adequate to understand whether your managers are successful or simply not cutting it? 
 
There's no set answer to this question. Traditionally endowments and pension funds have been very hesitant to replace underperforming outside investment managers. This is probably wise. In a great 2008 study[2], Amit Goyal and Sunil Wahal demonstrated that “excess returns after terminations are typically indistinguishable from zero but in some cases positive. In a sample of round-trip firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be no different from those delivered by newly hired managers”. That either reflects poorly on the plan sponsors, investment managers, or both. 
 
Retail investors are vastly different. They are capable of surprising agility in their hiring and firing of investment managers. The Quantitative Analysis of Investor Behavior[3] shows the average mutual fund equity investor holds a fund for an average of 3.3 years. For bond fund investors, the average holding period is less than 3 years. It is estimated that retail investors look to begin selling their mutual funds after two quarters of underperformance and individual equities after just one week of losses. Fair weather friends indeed. 
 
And yet there funds and managers who buck this trend. An example of this is Ken Fisher of Fisher Investments. Mr. Fisher comes with the following recommendations:
 
“He has been writing Forbes' prestigious "Portfolio Strategy" column for over two decades, making him one of the longest running columnists in the magazine's 85+ year history”.
 
“During his many years of money management and market commentary, Ken has distinguished himself by making numerous, accurate market calls, often in direct opposition to Wall Street's consensus forecasts”
 
“He is the son of legendary investor Philip A. Fisher, and Ken is the only industry professional his father ever trained”. 
 
Pretty heady stuff. Writer of several books and talking head on every major business network, Mr. Fisher is omnipresent. He’s been so good at appearing as a true market guru his assets under management have increased from $3B in 2003 to $47B in 2015. 
 
The only problem with this picture is that his investment calls have underperformed both their bogey and the S&P 500 for nearly every measurable period. As an example, his Purisima Total Return Fund (PURIX) has underperformed the S&P 500 in the 1 Year, 3 Year, 5 Year, 10, Year, and 15 Year time frame. When compared against Morningstar’s recommended bogey of MSCI ACWI Ex US (World Stock) the fund has underperformed its 3 Year, 5 Year, 10 Year, and 15 Year measured periods. Yet by 2015 this fund over $300 million under management. 
 
My goal isn’t to pick on Mr. Fisher. I’m sure he has a reasonable answer for this performance. I bring it up because it seems to fly in the face of rational investment theory. Why would a fund grow assets for so long with such a pedestrian – if not losing - record? How long is too long for investors in the Purisima Total Return Fund? 
 
Part of the answer lies - as always - in investor psychology. One of the great understandings in behavioral finance is that if you appear to a winner, then you are a winner, and will likely always be a winner. In other words what goes up will continue to go up. Conversely, the same goes for funds or company stocks that suffer truly horrible losses. The lasting view of investors is that the fund/equity will always be a loser. A great example of this is the annual study conducted by Franklin Templeton[4]. Investors were asked about stock market performance following the crash of 2008. The S&P 500 was down 37% that year but up 26.5%, 15.1%, 2.1%, and 16% in the next respective four years. Investor impressions were exactly the opposite as seen in the graphic below. Respondents saw these years as additional losses ranging from 31% to 70%. 

Why This Is Important
 
For individual investors and money managers alike there are some key lessons to be learned as we think about the question of “how long is too long”? 
 
Trends Are Your Friends…Until They Aren’t
As prototypical homo sapiens we are particularly susceptible to riding trends that either work or don’t work for far too long. As money managers we fight it every day. Examples include holding that stock of a company that you insist still has upside potential because it has always gone up or never investing in an industry because thirty years ago it was ridiculously unprofitable. The ability to test your thesis and assumptions on a regular basis is the only way to avoid falling into these traps. 
 
The Only One With the Correct Answer is You
 
Reaching a definition of “too long” is a wholly subjective answer. Not everyone’s will be the same. For investors in the Purisima Total Return Funds 25 years is not too long. For others the time frame may be days rather than years. In the final analysis only you can make the decision and definition about “too long”.  Dependent upon your risk level, investment strategy, and personal needs, you will need to decide if or when to pull the plug. 
 
 Data Must be the Core Decision Tool of “Too Long”
 
At Nintai underperformance or short term stock drops are absolutely painful. A recent example was our recommendation of Computer Programs and Sciences (CPSI) and having it drop 14% that very day. For us one day of ownership felt like too long. Another was our ownership of Manhattan Associates (MANH) and our behavioral and emotional difficulty in recognizing the stock was so far overvalued we need to sell out of our total position. These are the moments when we must ruthlessly employ data. Whether we felt holding for reasons of loss or gain, the data will dictate what is too long (or too short) in regards to investing your hard earned capital. Equally, fund investors should employ hard data – historical returns, costs, and portfolios to decide whether you have partnered with a financial manager for longer than the data recommends. 
 
Conclusions
 
No matter what people will say, there is simply no mathematical formula that can definitively tell how long is “too long”. But we can say is that some of the worst decisions we’ve made in regards to this have been emotional decisions rather than a data driven process. Deciding whether your financial advisor or manager has had enough time to prove them selves is a particularly personal decision. A blend of what allows you to sleep at night, your financial goals, and your investing knowledge will dictate an answer to that vexing question. That - combined with historical data – will help investors make an informed decision.  
 
As always we look forward to your thoughts and comments. 
 
[1] “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” L. Barras, O. Scaillet and R. Wermer, July 2006

[2] “The Selection and Termination of Investment Management Firms by Plan Sponsors”, Amit Goyal and Sunil Wahal, Journal of Finance, August 2008

[3] The full report can be found at http://www.qaib.com/public/default.aspx (Membership required)

[4] Franklin Templeton “Investor Sentiment Survey”, 2010-2013