- Wallace Weitz
“When you underperform for a few months, you shake it off as an anomaly. When you underperform for six months, you go back and check all your numbers and process. When you underperform for more than a year, you begin to question your abilities and your sanity. Losing isn’t easy. And it shouldn’t be. But how you respond to it separates great investors from average investors.”
- Russell Wang
The past six months have been tough for nearly every investment class. You name it - stocks, bonds, value, growth, small-cap, or large-cap. There is red ink for as far as the eyes can see. As of June 30, 2022, the S&P 500 was down nearly 21% year-to-date. The NASDAQ was down 30% over the same period. In June 2022, every one of the eleven sectors in the S&P 500 suffered double-digit losses. The second quarter was the most difficult, with the S&P 500 down 16%, the Russell 2000 down 17%, and the Russell Mid Cap Growth Index (the Nintai Investments Model Portfolio proxy) down a whopping 21%. Nintai Investments has not discovered a magic bullet to these market conditions. Our portfolios dropped by roughly 4% in June, significantly less than the major indexes. During the second quarter of 2022, the Nintai Investments Model Portfolio was down 14%, beating nearly every major index.
Relative versus Absolute Returns in Bear Markets
As a professional money manager, I spend much time comparing Nintai’s results against a select group of indexes. Of course, the granddaddy of them all is the S&P 500 Index. No matter what style you use or what the average size of your holding is, it is expected that you will measure your performance against this index. After that, you try to find an index closest to your style (value or growth) and your portfolio holdings characteristics/size (small, mid, or large-cap). The goal is to outperform these indexes over the long term.
All this chasing performance can sometimes lead an investor astray. At Nintai Investments, we are proud to be beating our proxy over the short and long term. But it is essential to remember that absolute returns are equally important. If the S&P 500 loses 25% over the next six months and we lose only 22% over the same period, that outperformance might only be a pyrrhic victory. Many investors look at 22% or 25% losses in the same light - losing lots of money. In this case, beating the markets isn’t what it’s cracked up to be.
For instance, in 1926, Benjamin Graham set up his second fund, the Graham Joint Account. This replaced his first fund (Grahar Corporation), which he had started in 1925 with Louis Harris. Over the first three years, 1926 to 1928, Graham’s new fund earned 25.7% annually against the Dow’s 20.2%. Not a bad performance record! He also beat the markets on the way down. From 1929 to 1932, Graham’s fund lost 70% compared to the Dow’s 80% loss. While he was pleased by the outperformance when the markets went up, his 1929 – 1932 outperformance ate at him. He often spoke about this period of his investment career as an abject failure. The bottom line was that he knew he had barely survived the worst four-year period in the stock market’s history.
After outperforming the S&P 500 for three out of our first four years, (2017, 2018, and 2020), we felt much like Graham did in the bubble years of the mid - 1920s. I confess we felt similarly to Graham again after a very difficult stretch between July 2021 - July 2022. “Only” losing 26% versus our proxy’s loss of nearly 30% didn’t bring much solace as an investment manager or to my investment partners. When performance is abysmal, it doesn’t matter how bad everyone else is doing. They say misery loves company, but I prefer not to be miserable, and I think most of our investment partners feel the same way.
Even though absolute losses like we’ve seen in the first half of 2022 can be emotionally challenging and make you want to pull in your horns, you can’t think that history necessarily represents the future. Relying on the facts and your judgment must force you to invest in the future, not the past. But it’s not easy. Deploying millions of cash assets during a rapidly developing bear market take intestinal fortitude and go against every emotional response your body may have. Graham used to say that you can’t run your investments as if a repeat of 1932 is around the corner. We will have market crashes and recessions in the future. But you can’t invest thinking about these things all the time. People who do miss out on tremendous market returns in the future.
Investing When Things Are Down
Human beings have wonderful processes genetically built into our bodies that assisted us in staying alive for tens of thousands of years. An example is our fight or flight response (more formally known as “acute stress response”), first described in 1915 by Water Bradford Cannon, Chairman of the Harvard Medical School’s Physiology Department. This response was originally seen as an either/or scenario where an animal (we are, after all, animals ourselves) would either run like hell or fight like hell in times of danger. These processes enable us to be aware of danger (in this case, the possibility of incurring financial losses through dropping market prices) and kick our autonomic nervous system into gear. In general, these mental shortcuts have saved time (and even our lives) over the tens of thousands of years of modern man’s existence. But they can also lead us dangerously astray. For every time our instinct to run was the best choice, there was an occasional poor choice to fight, not flee. In the instances when we chose to fight - and our adversary was a Saber-Toothed Tiger - the outcomes generally weren’t great.
Here are some other cognitive biases and heuristics that play a role in our investment decisions when markets drop significantly. The challenge is identifying them, recognizing when they come into play, and mitigating the damage they do in our investment decision-making.
Loss Aversion: Sometimes called prospect theory, loss aversion is the tendency to want to avoid a loss of a particular value more than a gain of the same value. In other words, most people take the loss of 25% of their investment far harder than a 25% gain. Since first identifying prospect theory, we have been able to quantify the general ratio of the sensitivity of loss to gain –roughly three times stronger in a loss versus a comparable gain. This unequal response rate means that investors have a far more emotional response when stocks drop in value than when stocks increase. This can be seen in nearly every bear market by the rate of the VIX’s increase versus its decrease in bull markets.
Anchoring Bias: As investors, humans tend to think the first piece of data acquired is the most important (meaning it becomes “the anchor” for future thinking). As an example, if an investor learns that a company is expected to increase its next year’s earnings estimates, then two days later reads the company has fired its CFO and COO, it is likely they will place more value on the first (and positive) piece of data versus the second. This might lead them to purchase shares because of the anchoring on the first (and sound) piece of data. Someone hearing the news in the opposite order would be far more likely not to purchase shares in the company. The challenge is to apply knowledge in a regulated process and allow it to impact our decisions regardless of timing or order. Relevant data can be timely, historical, or first or second in processing.
Recency Bias: Recency bias is precisely what it sounds like. Sometimes an investor will decide that because the proposition was confirmed in the past, it should be true today (and in the future). An example is when an investor repurchases shares in a company they previously held and did well on the past investment. For instance, an individual purchased shares in Coca-Cola (KO) in the mid-1990s and did well, locking in considerable capital gains when the price exceeded intrinsic value. When the stock price drops in the future, the investor might show recency bias by purchasing shares without doing robust research because the investment did so well previously. Just like all investment advisors regularly disclose, past performance is no guarantee of future returns.
Hindsight Bias: The old phrase goes, “hindsight is 20/20”. We generally think we are more intelligent than we are, assuming we could predict things when, in reality, we weren’t even close. For example, many investors will chalk up good investment returns to well-chosen stocks and stock-picking wisdom. It turns out that much of this is hindsight bias and that those golden returns have a lot more to do with luck than anything else. All too often, we shake our heads or roll our eyes when we hear a co-worker or friend say, “Oh, I knew that all along.” It’s important to remember that those very friends and co-workers are likely doing the same head-shaking and eye-rolling about us. The fight against hindsight bias begins with a small amount of humble pie with a dash of ill-tasting crow.
All these processes come to the fore during bear markets. As the losses build up, our palms grow sweatier, our minds race a little faster, and our nervous system begins to near the red line. Bear markets are when we need to think clearest and allow our brain's rational components to function most efficiently. Unfortunately, we usually get the exact opposite. At Nintai Investments, we are no different. We are human beings, facing the same emotional responses, the same fears, and the same cognitive biases as any other investor. We believe we have a slight advantage over others because we’ve built processes to corral those attributes that can be so dangerous in times like today.
Steps to Conquer Poor Bear Market Thinking
I’ve said that Nintai’s long-term outperformance is generally achieved in bear markets, not bull markets. We don’t succeed by being correct; we usually succeed by making fewer mistakes. That, of course, doesn’t mean we don’t make some real whoppers. We do. Just ask our investment partners, family, and friends. But over the past twenty years, our significant outperformance has happened in brief spurts during bear markets. For instance, during the period 2004 - 2013, the Nintai Portfolio only outperformed the S&P 500 in four of the ten calendar years. But in 2007 and 2009, we outperformed the markets by 17% and 21%, respectively. Those two years essentially made our record for an entire decade.
How did we achieve those results? A few things. First, we have a process that identifies companies that can weather genuinely horrific conditions. Things like the collapse of capital markets, significant economic slowdowns, and tectonic shifts in the companies' ecosystems, including competition, technology development, and product displacement. This is building a portfolio with a clear and measurable focus on quality. Second, we have developed a process that forces us to react logically and not emotionally. This consists of basing investment decisions on price versus intrinsic value, allowing for a margin of safety in our calculations, and having a relentless focus on data. Last, we firmly believe our actions outside the investment world are critical. These are the things we can control, allowing us to stand back from the pressure cooker environment of the investment advisor world and keep our emotions in check. Until you’ve made decisions that can affect tens of millions of dollars of other people's money, it’s hard to understand the impact of six months, one year, or even five years of underperformance on your mental and physical health.
It’s How You Invest, and Less What You Invest In
One of the things that will carry you through a bear market is having a firm understanding of how you invest. A well-defined process with clear criteria and methodology is vital to maintaining your sanity when your portfolio enters a bear market. For example, at Nintai Investments, the “how” we invest is a clearly defined road map consisting of the following statements.
Invest for the long term. Once we establish a position, we should exit that position under only a few conditions, including (but not limited to) share price greatly exceeding our estimated intrinsic value, the investment/business case being impaired, or there is a more compelling opportunity where capital is required. We strongly believe in letting great capital allocators do the heavy lifting over decades of partnership.
Great companies generate outstanding capital returns. The greatest investments in Nintai’s history have been companies with outstanding opportunities to deploy capital over the long term. These opportunities generate exceptional returns on capital with a low average cost of capital. Outstanding investor returns are generated by such opportunities carried out over several decades.
Achieve patience by mastering your emotions. I find Ieyasu Tokugawa - one of the founders of modern Japan - a most remarkable individual (he was the real-life person behind the character Toranaga in James Clavell’s “Shôgun.” He was famous for his ability to restrain his emotions and outwait his opponents. He codified his life’s creeds into a document called The Tokugawa Legacy. In it, he wrote about the central requirement for leaders to be patient.
"The strong ones in life are those who understand the meaning of the word patience. Patience means restraining one's inclinations. There are seven emotions: joy, anger, anxiety, adoration, grief, fear, and hate, and if a man does not give way to these, he can be called patient. I am not as strong as I might be, but I have long known and practiced patience. And if my descendants wish to be as I am, they must study patience."
Notice that Tokugawa doesn’t say to eliminate the seven emotions. He simply suggests that one must restrain their inclinations. At Nintai, we’ve found that nearly all our greatest mistakes happen when we become impatient.
Always invert and review your data: When things start to sour in our portfolios, I’ve found it helpful to return to my initial investment case and recheck our assumptions. Part of mastering your emotions and being patient can be achieved by staring at numbers and data. I’ve found it’s pretty hard to get emotionally worked up when I’m staring at a fourteen-tab spreadsheet filled with net margin and free cash flow projections. I’ve also found it’s beneficial to invert our projections and play with the numbers until I’m comfortable that things aren’t as bad as they seem. They usually aren’t. But on those occasions when you’ve cocked up well and good, running the numbers can objectively tell you where and when you got things wrong and whether there is a possibility to recover.
Your Personality and Surviving Bear Markets
Having a process and following it are vital to surviving bear markets. I’ve also found that developing personal traits can also save you an awful lot of grief when things look bleak. Here are a few I practice every day. I emphasize these when the news isn’t great for the markets or our portfolios.
Step back and hit the pause button: No matter how severe the downturn, not much will happen over the course of a day, let alone an hour. As an individual investor or small money manager, you have the luxury of stepping back and taking the time to think about what’s happening. Turn off the screaming talking heads with their “BUY! BUY! BUY!”, ignore the panicked announcers, and just sit and think. There is nothing wrong with pausing and reviewing your investment strategy, portfolio selections, and any investment case assumptions. Over the course of my investment career, I’ve seen so many instances of hasty decisions made without much thinking. In investing, nobody forces you to purchase or sell a stock. You can take as long as you want and take as many swings as you like. Use that to your advantage.
Don’t take yourself so seriously: Making mistakes is part of the daily routine here at Nintai Investments. We’ve learned not to take ourselves too seriously. Every day we learn something new about one of our existing holdings, a potential holding, or a new tidbit about ourselves and the world we live in. It may seem that your decisions are the be-all, end-all of your investment world. We aren’t omnipotent in our knowledge or decision-making. Always remember that the markets can humble you on any given day. Never be afraid to admit your mistakes and always learn from them.
Investing is part of your life, not your whole life: As a full-time investment manager overseeing tens of millions of dollars of other people’s money, it’s very easy to let times of underperformance change your whole life’s outlook. The past year has been awful for me personally. I find I sleep less well at night. I’m more anxious and find myself checking the markets more frequently than I have over my investing career. It’s taken me a great deal of time to realize that the markets and their returns shouldn’t define the direction of my life or how successful I feel about my career. Bear markets can tell you quite a bit about how your portfolio holdings adjust to adverse markets and how that impacts your portfolio value. Remember that they don’t tell you much about your personal value. It doesn’t define what you bring to the world as a parent, a non-for-profit volunteer, or simply the person who gets up and tries to make a difference every day. It is - after all - only investing. Make sure to keep it that way.
Investing in bear markets is an extraordinarily difficult task for a human investor (compared to those computer/AI-driven models and algorithms). The components of such a market - falling prices, lost portfolio value, and the constant drumbeat of the financial media - trigger cognitive biases and emotional responses that push us to make bad decisions. As investors, our minds and bodies want to flee and seek what we perceive to be the safest ground. Like some diabolical plane from Dante, bear markets are when we need the greatest courage. Doing what seems to be the craziest of all things – putting capital to work – is usually the safest course in the long term. The greatest investors have processes in place to take advantage of these times by coldly looking at the numbers, devoid of all the noise accompanying them during bear markets. They also can master their emotions, overcoming the fear and flight sensations that come on so strong when the markets take their nosedive. Having a process that you know works for you and considers your intellectual and emotional weaknesses will go a long way in mitigating the risk of bear markets.
What works for you during these trying times? I look forward to hearing your thoughts and comments.
 “Bodily Changes in Pain, Hunger, Fear, and Rage: An Account of Recent Researches Into the Function of Emotional Excitement,” D Appleton & Company, 1915
 This has been modified since by including the additional possibility of freezing or standing rigidly still (hence the more contemporary name “fight, flight or freeze response”).