- Seth Klarman
I recently read an article ("Investing When Everything is Expensive") by John Rekenthaler, Vice President of Research at Morningstar. He discusses why it might be necessary to rethink the concept of "core" and "explore." The former is plain old generic stuff such as blue-chip US/foreign equities and high-quality debt. The latter are investments that might seem more risky but likely to outperform over the investor's lifetime. For me, the article resonated because Nintai has found itself looking like one of those dogs trying to find just the right spot for their morning business. We all know the look - nose to the ground, running in circles, revisiting spots they just investigated a minute before. When every asset class is inflated in price - core or explore, bond or stocks, domestic or foreign, wide moat or no moat - we find ourselves trotting around, looking at every class for some obscure gem of an investment. We got into investing in 2003-2004, so Nintai missed that period in 1999-2000 when many stocks were egregiously overpriced. But even then, many bargains were to be had in non-"e” or technology such as manufacturing or utilities. In today's market, every asset class we play in is overvalued. We don't see any screaming bargains in our investment horizon.
What makes this particularly painful is that our investment partner portfolios have underperformed over the past twelve to eighteen months as we hold significant cash positions, and our portfolio stocks have been hit hard after nearly a decade of outperformance. Nothing is more frustrating and stomach-churning than underperforming and knowing there is little you can do about it. "These are the times that try men's souls," said Thomas Paine. Mr. Paine had the heart of a value investor experiencing a sustained bull market.
A Quick Review on Strategy
Before I get into why it is so challenging to be a value investor in expensive markets, I thought I'd quickly review our investment methodology here at Nintai and how it relates to our actions in these overpriced times.
Focused Portfolios: At Nintai, we operate in a relatively simple format of being invested or not. We run a focused portfolio (anywhere between 15 - 25 positions dependent on size or investment need. As I've discussed previously, we focus on companies with high returns on assets/capital/earnings, fortress-like balance sheets, deep competitive moats, and managed by great capital allocators. After running a search with such criteria, there are generally only 150-175 companies worldwide the meet our demands. By its very nature, our investment strategy forces us to focus on just a few holdings and to hold them for the long term.
We Hedge with Cash: We use a simple model when it comes to investing. We are invested in our focused portfolio holdings, or we hold cash. We aren't limited to any particular model in our investment management agreements. We could use actively managed funds, ETFs, or even individual debt instruments as hedging tools. I don't do this for the simple reason our partners invest with us to use Nintai's strategy – not for me to use a competitor's model. Consequently, when no opportunities arise with Nintai's strategy, I will hold cash. This can sometimes drive cash to 30-35% of total assets under management.
Valuation Drives Portfolio Holding Make-Up: How much we hold in equities or cash is driven solely by valuation. By this, I mean that we use two distinct valuation measures – one individual and one broad. The first is the valuation of each holding. If we think the valuation of a specific stock is compelling, we will likely add to the position, thereby necessarily driving down the portfolio's cash position. The second (and somewhat in congruence with the first point) is that I will likely hold more cash if I feel the markets – as an aggregate - are overpriced. Conversely, if I think markets have gotten far ahead of themselves (an example might be our aggregate portfolio is 125% above our estimated intrinsic value), I will sometimes shave 5% off every individual portfolio position.
Where We Stand Today
As of November 29, 2021, the S&P 500 stands at 4668, up roughly 22% year-to-date and roughly doubled over the past five years. Morningstar currently has its total rated stock universe approximately 4% above fair value. It calculates that the healthcare and financial sectors (by far Nintai's majority of holdings are in these two sectors) are 6% and 10% above intrinsic value, respectively. Other indicators reflect a much higher valuation versus historical data. For instance, the Schiller PE ratio has only been higher once before in the late-1990s before the technology bubble and crash. From the old-fashioned PE ratio to the newer PEG ratio, nearly every historical measure is at all-time highs. Fighting this trend, the current Nintai holdings are trading – in aggregate – roughly 11% below our estimated intrinsic value. The aggregate PE ratio of most portfolios is less than half the S&P 500s. At the same time, returns on equity, capital, and assets are substantially higher than the market averages.
Nintai has been down this path before when we thought markets were wildly expensive. Our last experience was during 2006 – 2007, just before the real estate crash and the ensuing global credit crisis. For almost the entire year of 2006, the Nintai Partners fund held nearly 45% of total assets in cash. We avoided corporate and government debt as fervently as equities. As a result, we could find little value in domestic or foreign markets, debt, or equities. In the ensuing market crash, we significantly outperformed the markets after trailing for several years of slight underperformance. Indeed, much of our long-term outperformance was generated in the single year of 2007 when we beat the S&P 500 by nearly 30%.
We are currently looking for ways to batten down the hatches but not get left behind by the S&P 500's double-digit annual returns. This is the rub, of course. You must attempt to prevent a permanent loss of capital in a sudden market crash but at the same time stay as invested as possible to allow compounding to work its magic. As we take the necessary steps to obtain that balance, we try to focus on several core tenets.
To thine own self be true (your process is your guide)
Generally, value investors underperform in prolonged bull markets. It can seem that every decision you make has the markets go against them. Stocks that you purchase drop by another 30% over the first few weeks. Even companies that present shining earnings quarter after quarter can stagnate and underperform for years at a time. No matter how much you hear about the latest nanotechnology, day trading with options, or how value investing is dead, your process must always be the anchor in your decision-making. Your process must be your guide. As a value investor, your methodology rests on the simple premise that a company's share price will inevitably be matched by its intrinsic value. It can take years for the markets to reach these same conclusions, and to date, they usually do so. Hold on to that fact dearly.
This ain't no fantasy football (valuations are only reasonable when based in reality)
One of the problems with expensive markets is the growing ability of Wall Street, investment advisors, and personal investors to convince themselves that prices really aren't that bad. That 55% projected growth rate over the next decade might just be reasonable if you hold your nose and believe in management's claims. Never, ever do this. Your job as a value investor is to question everything in your investment case - including claims by management and your assumptions for valuation. Every investment debacle I've had (and there have been quite a few) has been caused by my inability to force some form of brutal reality into my assumptions.
Just because the market is crazy doesn't mean you should be too
A corollary to the previous point can be summed up by that phrase so many of us heard from our parents. "You wouldn't jump off the bridge because everyone else is doing it, would you?". We would frequently answer that; of course, we wouldn't do something so ridiculous. If you wouldn't do it as an eighteen-year-old, why do it as a seasoned value investor? Of course, the pressure is intense when talking heads slam buttons that scream "Buy! Buy! Buy!" or you read how some new prodigy achieved 94% returns on only ONE stock that he's more than happy to share with you for only just $499 right now! Just because networks allow this type of behavior on their shows doesn't mean you need to listen. Base your decisions on a well-reasoned and well-researched process that meets your goals. Anything else looks like a lemming running at top speed with all its friends and relatives, and we know how that ends.
Investing in expensive markets can be costly in more than one way. Elevated prices supported by nearly a decade of steady gains can make you want to overpay for a stock that looks so good on quick review. It looks even better when you hear about it at the staff Christmas party or your New Year's party with your neighbors. You can frequently hear them talking about how
their outstanding stock-picking abilities paid for that BMW or pool. Don't believe it for a moment. Most gains in the market are made by purchasing shares at a reasonable price and selling them when overvalued. That's value investing. Buying expensive stocks and selling them after they become more expensive (hopefully) is a process dependent on the greater fool. When stocks are trading at such all-time highs and nosebleed valuations, it's hard to know who's the real fool. Be careful. It might just be you.
As always, I look forward to your thoughts and comments.
DISCLOSURE: I have no positions in any stocks mentioned in this article.
 John is a brilliant writer with the rare attribute of being able to see the investment process from many different angles and disciplines. I highly encourage my readers to go to Morningstar and become regular readers of John’s “Rekenthaler Report”. You can find his writing here.