- Joseph “Vinegar Joe” Stillwell
“I like people admitting they were complete stupid horses' asses. I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.”
- Charlie Munger
Looking back, 2021 was when Nintai suffered from several organizational failures that led to poor investment decisions. This was most evident in our purchase of New Oriental Education and Technology (EDU). The stock has been the worst investment in our near twenty years in investment management. Following the collapse of the stock price in the summer of 2021, we focused on three areas. First, can an investment case still be made for New Oriental, or is the stock so impaired that we should write off the losses and move on? As a quick summary, we think there is a case to be made for holding the stock because our estimated intrinsic value exceeds its current stock price. Should the stock reach anywhere near that, we will exit the position entirely. Second, where exactly did we get the investment so wrong? What steps within our process failed? We’ve spent much time breaking down the process and have identified several significant problems. These include multiple instances of cognitive bias. In plain English, we found various ways in which our own brain developed muddled thinking habits over the years that blinded us to the warnings about the company. It also included a failure in our investment process. Specific cautionary steps we have created over the years failed regarding the New Oriental investment. Simply put, our process took on too much risk without fully understanding the perils of the investment environment. In part two of this section, I will detail the specific procedures that proved to be inadequate. Our last area of focus has been developing a way to prevent such a mistake again. We recognize that not every investment will turn out to be a winner (at least we learned that over the years!). We have developed a revised process that slows our thinking down, puts more checks and balances in place, and forces us to delve deeper, ask more questions, and rely on more disparate data than previously. We think these steps can help prevent another such decision like the one which led to the outsized losses of New Oriental Education investment.
The Dangers of Cognitive Bias
Cognitive biases develop when our brains simplify our thinking about complex problems. A good percentage of these biases have to do with memory – both our cognitive memory (the fear we had when we first had a stock significantly drop or feeling of satisfaction when we sold a position at a profit) and our genetically programmed “memory.” The latter can be seen when we mistakenly see a pattern where one doesn’t exist. In investing, seeing ten profitable earnings releases in a row might have you predict an eleventh without sufficient evidence to back up that prediction. This type of bias was formed tens of thousands of years ago. Our ancient hunter-gatherers recognized that a pattern of prints could be followed successfully for that night’s dinner. Our genetic memory doesn’t remember that 1 out of 100 of these trails led to a saber-toothed tiger, not a roebuck. In that one instance, the hunter-gatherer was the dinner. Other biases have to do with simplification created by lack of attention. We can’t remember everything all the time, so we make hierarchies of what’s important to notice, thereby making a shortcut in our decision-making process. There are dozens of identified cognitive biases, each capable of creating terrible damage in our decision-making process.
Here at Nintai Investments, we are as susceptible to these biases as any other human. We tried to build strategies that take these into account, and over the years, we’ve felt we did a pretty good job. And then 2021 came along. Our failings during the year were broad and diverse. Over the last sixty days, we’ve worked hard to identify what went wrong to improve our processes to prevent these mistakes from happening again. Here are some of the cognitive biases we identified that tripped us up in our investment with New Oriental Education.
Anchoring Bias: When you rely too much on an initial piece of information that keeps focused on old data. This “anchoring” means you don’t consider more recent data. In this case, Nintai had invested in New Oriental previously and made a considerable return on our investment. By anchoring our thinking on the previous investment, we lost sight of the risks associated with the current investment.
Blind Spot Bias: This is when you reject information because you think the source is biased (and it disagrees with your opinion or finding). For several years, we have heard that the Chinese Communist Party (CCP) felt the economy had moved too close to capitalistic practices. We chose to ignore this thinking. We chalked it up to the usual anti-Communist croaking by certain western writers when we should have talked to Jack Ma or people familiar with Jack’s experience with the CCP.
Confirmation Bias: Somewhat an inversion of the Blind Spot Bias, this one is where you lock on information that confirms your theory or decision to the detriment of information that contradicts it. For instance, looking back at our research of EDU, I found that we read pro-investment studies at nearly four times the rate of dissenting views. We fell prey to the same mistake many older value investors made in 2006-2007 with financials. Everyone had seen this before, so everyone did the same thing, regardless of the data that showed this time it was different. Our work with New Oriental mimicked this only too well.
Hyperbolic Discounting: This bias is when you look for a short-term gain (at much higher risk) over the more tedious and less heroic long-term gains achieved through patience and longer workout times. At Nintai, we’ve traditionally looked for companies that we can partner with for decades that hopefully achieve slow and steady growth in free cash flow. We’ve never been much to finding fallen angels and hope to see relatively quick profits. That is until New Oriental. Looking through our analysis, it’s clear that the idea of a relative short gain could help offset our underperformance through the year up to that point. We haven’t done that in our career previously, and we learned why we wouldn’t be doing it in the future.
These are four (and there were more!) cognitive biases that played a role in our poor decision to invest (and then double down) in New Oriental Education stock. I hope this helps illustrate some mistakes that Nintai was guilty of and hopefully learn from going forward.
How Did Nintai’s Process Come Up Short?
We’ve spent a great deal of time looking at what went wrong over the past year, with a particular emphasis on our decision-making surrounding New Oriental Education. I previously discussed the cognitive biases I was guilty of over the year. These I group as individual faults made through human miscalculations. The second large category of mistakes reflected a breakdown of an organizational nature. In these instances, business processes focused on factors that simply didn’t matter and missed things that mattered very much. These failures are easier to identify and remedy because they are process problems, not human problems. The breakdown in our organizational processes falls into four significant findings. Each of these on its own could have created the opportunity for poor decision-making. The presence of all four nearly assured it.
Breaking the case was inadequate: I have written previously about our process of “breaking the case,” or where we invert our assumptions to the point that the investment case is broken. We do this in many ways – decreasing free cash, decreasing market share, increasing sales and administration costs, creating litigation costs, etc. One of the things we’ve never really built into our models is the state government actively seeking to destroy an entire industry in one fell swoop. Our problem, in this case, was believing the Chinese government would want as many of its citizens educated and trained as possible. Overall, our breaking the case model had gaping holes in its methodology and scope.
New Oriental was out of our wheelhouse: Looking back over our investment career, most of our successful investments have been in two industry verticals – healthcare and technology. More particularly, many of these companies have been in either healthcare informatics or technology-based platforms. Some of our least successful – such as Computer Modelling Group (CMDXF) – have been industries where we have no distinct edge in knowledge (in CMDXF’s case, the energy industry). It should come as no surprise that New Oriental Education was not in any of our circles of competence. We had no edge in China as an investment environment or education as an industry vertical in this instance. Looking back, I would say both were almost anti-circles of competence.
We underestimated non-corporate risk: As I mentioned previously, it’s clear we have focused far too much on business risks to the detriment of regulatory or government risk. Interestingly, when we look at any possible healthcare investment, we spend an enormous amount of time understanding the risks related to FDA regulation, regulatory approvals, etc. In this case (again, because of our lack of industry and geographic knowledge), we spent far too little time understanding the CCP’s role in government regulations, setting industry priorities, or capitalistic models in the Chinese economy. While we did a decent job understanding the industry, competitors, and the company’s financials, we dropped the ball investigating outside the walls of New Oriental.
“Never Invest” wasn’t broad enough: W.C. Fields’ adage was that actors should never work with kids or animals. Over time, at Nintai, we’ve developed similar “Never Invest” conditions. These include significant debt, no moat, and low-margin businesses. For instance, we’ve never invested in the consumer retail space because they almost always have all those conditions, not just one. We overlooked when it comes to New Oriental that we should never invest in a country where the ruling government has the power/capabilities of disrupting or eliminating a company’s business model or industry. Though they may look like they are invested in a capitalistic model (like Russia or China), certain countries do not have the political or economic infrastructure to guarantee investor or corporate rights.
How to Prevent This Again
“We do not learn from experience; we learn from reflecting on experience.”
- John Dewey
Now that you (and we) know what went wrong in the New Oriental investment, I wanted to take the time to discuss what steps we’ve taken to make sure this doesn’t happen again.
Non-business risk is just as important as business risk: I’ve spent tens of thousands of hours learning what makes businesses tick for over two decades. I’ve learned what role strategy and operations can play in creating a moat, how the lack of access to capital can bring a company to its knees, and how unethical management can start rotting a company from the head down. One thing I haven’t focused on enough is that risks outside the company – governmental, socio-economic, or political – can be as severe in size (or even more severe) than those within the company I mentioned previously. It’s easy to make assumptions or have cognitive biases in such issues as the political structure of a country. For instance, in China, I made a mistake to assume that the ruling CCP would do what’s best for its people as seen through the eyes of a quasi-capitalistic system. I didn’t take into account two risks. First, the government would unilaterally act seemingly detrimental to its people (meaning millions will no longer have access to top-quality tutoring). Second, the government would act in such a manner as to call into question (from the West’s standpoint) an entire generation of capitalistic moves that created an opportunity for millions of its citizens.
Going forward, we have broadened our risk assessment tools adding new sections on government and politics. This will include new sections specifically discussing the nature of these risks and any mitigation steps Nintai can take before investing. This might range from requiring a more significant margin of safety to adding the company to the “Never Invest” category. In addition, we have built new steps in our modeling (such as “Breaking the Case”) where non-business risks impact valuations to a greater degree. This includes government intervention in customer markets, unilateral powers vested in the government, or actions are taken to retain control that impacts the company or its business model.
Clearly define your circles of competence: At Nintai, we’ve never explicitly stated what lies within our circles of competence. Our corporate structure and management agreements do not prohibit me from investing in any type of industry or specific company as Chief Investment Officer. Over time, we have recognized that our expertise lies in the areas where Nintai Partners conducted business. This included healthcare, healthcare informatics (the use of information and data in strategy and operations), and technology platform companies (where the company provides a platform that integrates a client’s information systems). Secondary (but equally important) are companies that meet specific characteristics in the structure and operations. These include high returns on capital/equity/assets, high free cash as a percent of revenue, little or no debt, a competitive moat, excellent capital allocation skills by management, and trading a discount to our estimated intrinsic value. Unfortunately, New Oriental was far outside our circles of competence regarding knowledge about the investment country or the industry. If we were asked today to check off the significant characteristics cited, it would go something like “little to no knowledge of Chinese economic policy?” Check. “Little to no understanding of the Chinese educational system?” Check. “Little to no understanding of the ESL/tutoring/certification studies market?” Check. It is not a great performance from our risk management process.
Going forward, we have created a system that makes a structured view of our circles of competence, including industries, geographies, markets, regulations, etc. This new system requires that any potential investment be vetted through these circles’ characteristics. Any company that meets less than an 80% overlap is immediately rejected. We will also be adding this to Nintai’s annual review of current holding to make sure the holding hasn’t drifted outside our circles of competence.
New categories of “Never Invest”: As I’ve mentioned previously, over time, we’ve developed a list of “Never Invest” companies or industries that don’t meet our investment standards are we don’t understand. Until this year, we’ve eliminated companies or industries because we couldn’t quantify the risk. For instance, in many biotechnology companies, we simply cannot tell the odds of a company getting FDA approval for a new product. We know it’s low, just not exactly how low. With our investment in New Oriental Education, we realize that there are opportunities where the level of risk can be quantified, and it’s simply far too much. In this instance, the risk is that the CCP can eliminate the company’s entire business model in one brief announcement. While it might seem unlikely they would do this, the consequence could be (and have been) catastrophic.
Going forward, we have added a new bucket of “Never Invest” companies and industries driven by the fact that outside risks are simply far too impactful, no matter what the chance. This might include companies that are beholden to one or two products for most of their revenue or similarly might count on a single client for much of their revenue (Skyworks Solutions came close to this with their Apple relationship). It will also include risks outside of the business (such as New Oriental) where a single event such as an earthquake or governmental edict can impair our investment case. Hopefully, this new addition to our risk assessment process will prevent another poor investment outcome, such as New Oriental Education.
2021 was another year dominated by COVID, though there was some heartening news when several effective vaccines became available. We found out exactly how resilient the economy was as we had several new waves of variants without a dramatic impact. Unfortunately, we saw an increasing polarization within our political system, starting with the January 6 insurrection and attack on the Capitol. The markets had another banner year, with the S&P 500 gaining nearly 27%, the Dow Jones roughly 19%, and the NASDAQ 21%. It was the twelfth year of a bull market that started at the end of the Great Recession.
2021 was undoubtedly a disappointment to Nintai Investments and most of our investment partner portfolios. No investment manager will ever get every pick correct unless your first name is BERNIE and your last name starts with M_A_D_O_F. Confessing poor judgment and owning up to your mistakes is never easy, even if you are Charlie Munger. But as an investment manager, I feel it is my responsibility to take credit (not sure that’s the word I’m looking for) for the wins and the losses. More importantly, I believe each of our investment partners is due to an explanation as to how we will prevent such a mistake going forward. I hope this report has provided that to our investment partners.