“The young man knows the rules, but the old man knows the exceptions”.
- Oliver Wendell Holmes Sr.
“When the game is no longer played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were – not as they are. Essentially I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand even though it might mean forgoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully, and which, possibly, could lead to substantial permanent loss of capital”.
- Warren Buffett (Partnership Letter, October 1967)
In February 14 1797, a British fleet of 15 ships of the line under the command of Admiral Sir John Jervis met a Spanish force of nearly twice its size off Cape St. Vincent, Portugal. Two stories mark the initiative and confidence of the English navy at the time. In the first story, Admiral Jervis (soon to be Lord St. Vincent for his victory) sends a man to the foretop to tell him the size of the Spanish fleet. The following conversation took place between the lookout and Admiral Jervis.
"There are eight sail of the line, Sir John"
"Very well, sir"
"There are twenty sail of the line, Sir John"
"Very well, sir"
"There are twenty five sail of the line, Sir John"
"Very well, sir"
"There are twenty seven sail of the line, Sir John"
"Enough, sir, no more of that; the die is cast, and if there are fifty sail I will go through them"
But that wasn’t the story that really made the Battle of Cape St. Vincent so famous. Rather it was the bursting forth of Horatio Nelson’s genius that stole the day. At a critical moment in the battle, when Jervis signaled for his ship to tack in succession (this maneuver called for each ship to turn through the wind in the same place as its leader and was a traditional ship handling instruction for the past 200 years), Nelson realized that such a maneuver would place the latter part of the English fleet in danger. He wore (the opposite of tacking) clearly in violation of his orders and proceeded to take on 6 of the largest Spanish ships with only his 64 gun Captain. This group included the Santísima Trinidad, the largest ship afloat at the time and mounting 130 guns, the San José, 112, Salvador del Mundo, 112, San Nicolás, 84, San Ysidro 74 and the Mexicano 112. Amazingly, Nelson succeeded fighting alone for 20 minutes and captured both the San Nicolas and the San Jose. It was the beginning of what was to be called the “Nelson Touch”.
Now that I’ve prattled on about maritime warfare in the early French Revolutionary wars, I wanted to discuss why both Nelson and Jervis’ rule breaking hold a great lesson for value investors. Many times, value investing isn’t dissimilar to heading into a fleet action like the Battle of Cape St. Vincent. There are many variables that impact decisions (the direction of the wind compared direction of market sentiment), the fog of war can be thick, loud, and disconcerting (think of the din of cannon fire and dense smoke and compare that to watching a re-rerun of any trading day in the two weeks following the collapse of Lehman Brothers), and the heightened emotions of winning or losing (think of the emotion of watching one of your fleet strike its colors versus seeing a portfolio holding drop 35% in two hours). The ability to stick to your process, and keep your emotions in check are as important today in front of your computer screen as it was on the quarterdeck of a flagship in the Age of Sail.
Training Your Mind, Mastering Your Process
One of the reasons why Admiral Jervis was so confident taking on the Spanish fleet (even if it numbered 50 ships) was the knowledge that his crews were the best trained in the world. Every ship was a well-oiled machine that Jarvis knew could hold its own against any two Spanish ships. This type of training and discipline is required in value investing as well. When a stock price drops dramatically, a value investor knows their process inside out and has the discipline to act only when it meets his or her criteria. For instance, at Nintai when a stock on the watch list drops by 5% or more in one trading day we know exactly what steps to take - read up on the latest corporate releases, search for competitive news stories, rerun the valuation model with any new inputs, etc. It’s a set process that we can run in less than 2 hours which gives our team the necessary facts to make a decision. Step two is having the discipline to follow the facts to their logical conclusion – a decision based on solid criteria we’ve followed for over a decade. The last thing a successful value investor does is run around and haphazardly purchase stocks because of Mr. Market’s manic moods. The discipline to find the right shares, at the right price, for the right portfolio are all earmarks of the tight discipline of a value investor.
If Your Strategy is Sound, Follow Through With Everything You’ve Got
If you feel your investment strategy and process meets your goals and provides you with the best chance at outperformance, then never fear being aggressive in your actions. If you expect your results to be different than the major indexes, then your actions must be - by their very nature - different than those indexes. You can do this in several ways - have different portfolio holdings, have similar holdings but in very different percentages, or a combination of the two. Many successful value investors have been quite focused in their portfolio designs holding sometime as few as 5 stocks. At Nintai we generally hold no more than 20 holdings in our portfolios. We do this for several reasons. First, there simply aren’t that many companies that meet our investment criteria. Second, even fewer trade at enough of a discount to our estimated intrinsic value to meet our required margin of safety. Last, we want each position to be large enough to have a meaningful impact (both good and bad) on our performance. Several years after Horatio Nelson died, one of his “Band of Brothers” recalled “Nelson was entirely his own creature. People called his approach ‘The Nelson Touch’. It really was HIS approach. Nobody else could copy it. And no one achieved anything like his results after he passed from the scene.” Like Nelson, at Nintai we have our own unique investment methodology. Over time - and with the success we’ve had (though past performance is no assurance of future returns!) - we remain aggressive in our portfolio design. In the final analysis, our returns will certainly be our own. We are quite proud of that.
It’s Not About Quantity, It’s About Quality
I’ve found over time that long-term success requires long-term quality. In the beginning of his career, Warren Buffett certainly had success with companies that meet the cigar-butt criteria. But Charlie Munger has argued the real investment successes at Berkshire Hathaway have come later, particularly after the tectonic shifting purchase of See’s Candies. At Nintai we drifted in a similar way, starting with the one-puff wonders we bought in March and sold in April after a 15% gain. Over time, I began to realize my more natural state was not the nail biting, manic purchasing and selling, constantly on the lookout for bad news, dyed-in-the-wool value investor of the 1950s-1960s. Rather I was far more slothful, indolent, and upbeat to really be able to enjoy that type of investment life. I learned – much like Nelson – that a smaller force made up of the highest quality could generate enormous success. It wasn’t just about the quality of my holdings though. It also was about the quality of my successes. I had many small 5-10% gains with my cigar butts, but I found the 5 and ten-baggers were high quality companies that I bought and held for a decade or more. Simply put, quality companies mean higher quality successes.
So what happened to Nelson after he violated Jervis’ orders? Old Jarvy was known for breaking an officer who willfully didn’t follow orders and there was certainly no clearer case than this. It is said that after climbing on to the deck of the Victory (Jarvis’ flagship), Jarvis hugged Nelson in a most un-seamanlike manner. Jarvis’ flag-captain - in a pique - after seeing a disobeying officer receive a hug (a hug forsooth!), complained to the Admiral that Nelson’s actions were a clear violation of his orders. Jarvis turned to him and said, “It certainly was so, and if you ever commit such a breach of orders, I will forgive you also.” Nelson went on the become a Knight of the Bath and win crushing victories in the Baltic, at the Nile, and of course his masterpiece, the Battle of Trafalgar which cost him his life.
By following your own convictions and strategies in investing, it’s unlikely to cost you your life (or at least let’s hope so!). But the outcomes can certainly put your name in a book of rarified names. Not everybody who lives by their own rules will succeed like Nelson. But many of the greatest investors - Warren Buffett, Jack Bogle, Michael Steinhardt, Charlie Munger, etc. - have withstood tremendous pressure to conform and give up their independent thinking. If your technique works for you (and that’s really the definition of success) then continue playing by your own rules. In the end, it’s really all you got.
As always I look forward to your thoughts and comments.