“Being an investment manager doesn’t require just our fiduciary stewardship of your assets invested with us. It also requires we provide you with the most relevant, timely, and useful information to understanding our methodology, purchases, sales, and performance. As an investment partner, we look to provide you with the same service we would look for if we were a customer. Partnership requires honest and fair dealing – with both the investment of your money and with information about your investments.”
                                    -   Nintai Investment “Statement of Investment Partnership”   

When one considers performance of active versus passive (index) investing, many times you will hear about how some markets are great for indexing - like the last 10-year bull market[1]. Of course, those arguing that bull markets are great for indexing and make it difficult for active investors to outperform are - wait for it - active investment managers. Indeed, the last 10 years (through 2018) have been cruel years for both value and growth investors[2]. For Large Cap (Growth, Blend, and Value) investors, only 9.6% of funds survived and beat their respective index. It was slightly better for Mid-Cap investors (18.2%), and for Small-Cap investors (19.5%). The disparity between the highest and lowest funds was shocking. For instance, in the Large-Cap category 15.7% of the least expensive funds beat their proxy while only 5.3% of the most expensive funds beat the same proxy. For Mid-Caps, 24.1% of the least expensive funds outperformed their proxy while only 10.2% of the most expensive compiled such a record. For Small-Caps, 23.9% of the cheapest funds outperformed versus 12.6% for the most expensive.

No matter how you slice it, those are difficult numbers to absorb as an investor looking to fund their retirement or child’s college education. It’s not difficult to see why the last decade has seen a massive influx into index funds. Yet, even with these numbers over half of total investments in the United States are still in actively managed funds (roughly 52% active versus 48% passive in 2019 according to Morningstar).     

It Isn’t Just Underperformance, But Also Under-Reporting

None of this information should be a great shock to investors (or fund managers), but sadly it is. As an active investment manager myself, I find not only outperformance is required to grow my asset base, but providing my investment partners with accurate, relevant data is essential as well. After considering this - along with the aforementioned performance data - I decided to investigate what type of information is provided to fund owners with a particular focus on the distinction between high- expense funds versus low-expense funds. After all, with such a larger group of high-expense funds underperforming, you would think they would have considerably more explaining to do.

I couldn’t have been more wrong. I divided quarterly reports into several major areas to see how each group does in terms of level of disclosure or discussion. These include investment strategy, portfolio holdings discussion, investment buy/sell criteria, and valuation of a holding at the time of purchase or sale. For the most expensive funds, a sample of 37 funds showed roughly 55% discussed their investment strategy while 45% did not. Roughly 35% did a cursory overview of portfolio holdings while 65% did not. Only 18% specifically discussed the business case for specific additions or sales to the portfolio. 82% made no mention. Finally, only 27% discussed valuations related to specific purchases or sales. The least expensive were considerably more forthcoming with data and discussions. A sample of 32 funds showed that 78% discussed their investment strategy. Nearly 60% discussed a percentage of their holdings (usually the top 10). A whopping 71% discussed specific purchases or sales (versus just 18%!). Only in the discussion of valuations related to purchase or sales were the two groups similar in percentage, with 34% of least-expensive funds discussing this subject.

So what should we make of this? Not only do funds with higher expenses underperform at an alarmingly higher rate than the least expensive funds, they also disclose far less in terms of portfolio specifics. Only in one area do high-expense funds out do low-expense funds – discussion of macro-economic issues. Presumably this is because they have less incentives to discuss performance and more to convince their investors why they are relevant.   
 
What Needs To Be Discussed

In my mind, the more information I share with my investment partners the better. That doesn’t mean every one of my investors reads everything I provide. But overall, I think it should be the investor’s decision - not mine - to decide what is too much and what is enough. Over time, I’ve found the following four items give my investors the best chance at fully understanding my investment strategy and decisions surrounding their portfolio holdings.

Explanation of Investment Philosophy
Whether it is Berkshire Hathaway’s “Owner’s Manual” or Nintai Investment’s “Statement of Investment Partnership”, every quarterly and annual report should include a summary of the investment manager’s methodology. Even better, examples of this including recent purchases and sales in the portfolio should leave investors with a clear understanding of what and how the manager is looking to achieve long-term outperformance versus their respective proxy. I include Nintai’s “Statement” at the beginning of each annual report and include an example of a portfolio holding’s purchase or sale with an explanation of its relevance to my core strategy.  

Investment Cases for New Investments
Each time I make a purchase or sale in any Nintai portfolio, I send each impacted investor (I may not necessarily purchase or sell a holding in all accounts) a detailed business case about the holding including a numbers-based summary (returns, free cash flow, debt, etc.), investment thesis, business overview, market characteristics, competitive analysis, business case risks, and valuation summary. In general this is 3-4 pages in length.  

Valuation Methodology and Estimated Intrinsic Value
I also send a summary valuation spreadsheet that includes a free cash flow valuation worksheet and multiple tabs that include return on capital calculations, balance sheet strength, allocation of capital, cash return, rate of return, etc. This gives the investor a chance to roll up their sleeves (if they so choose) and better understand why I think the price of the asset offers an adequate margin of safety and how I derived an estimated intrinsic value.   

Evaluation of Performance
The performance of Nintai Investment’s portfolio is front and center in each of my quarterly and annual reports. This includes both good and bad data (thankfully the good has far outweighed the bad, though past performance is no assurance of future returns!). I like to discuss those companies that added the most to returns and those that detracted the most. In the latter case, I find it helpful to outline how and where I got the investment case wrong and what steps can be taken to turn things around. This includes a frank discussion on what data points or results might require taking losses and moving on. I measure performance against both the S&P 500 TR (whch many see as a proxy for the market) as well as a individualized portfolio that best matches the portfolio but based on a collection of index funds and cash such as 15% Vanguard US Small Cap Index, 35% Vanguard Mid Cap Index, 35% Vanguard S&P 500 Index, and 15% Vanguard Short Term Government Bond Index.
Not every fund manager is going to be able to provide this to their investors. Funds with 1,200 holdings or 350% turnover are unlikely to be able to (or be financially capable of) providing such information on a quarterly basis. But when asked, they should be able to provide such data. It is their investors’ money after all for heaven’s sake.  

Conclusions

Active investment managers haven’t done a very good job of demonstrating an ability to outperform their respective index. They’ve done an even greater disservice to their investment partners at reporting and discussing as little as possible about their methodology, process - and most importantly - their performance. If we are - as a collection of investment professionals - going to change the trend of investors moving to passive investments versus active management, then we not only need to better our performance, but do a better job communicating with our investment partners. Underperformance requires more communication, not less. While it doesn’t make underperformance any easier to take for investors, they will at least better understand how and why such underperformance is taking place and how managers intend to turn things around. It’s the least active manages can do to allay the fears of a rightfully frustrated investor base.  

-------------------------------------------------
 
[1] This is true in some ways but doesn’t tell the whole story. Many stock segments are performing quite poorly when compared to the S&P500 (the largest 500 companies publicly traded). For instance, Morningstar reports that nearly 25% of all publicly traded stocks are currently (as of April, 2019) trading in bear market territory. But overall, the last 10 years have been on average a tremendous bull market that has lifted the majority of all boats.  
[2] Data for this section comes from Morningstar’s Active/Passive Barometer. Information is from the 2018 report published in March 2018. The authors are Ben Johnson CFA and Alex Bryan.

The writer Ernest Hemingway was having lunch with friends when he was bet by friends that he couldn’t write an entire story in just six words. When you think about it, it does sound impossible – how do you get around the requirements of character introduction, plot development, character relationships, etc.? Hemingway quickly took the bet and scratched his story on a cocktail napkin. He passed around the following:
 
                                              “FOR SALE: BABY SHOES, NEVER WORN”
 
What a remarkable effort. Utilizing six words, he told a story that has so many possibilities and an infinite amount of beginnings and endings. His friends admitted that while the story missed what many classic literature instructors would consider essential (such as those listed earlier), the reality was that the 6 words appeared to tell a story of particularly melancholy nature[1]. 
 
I bring this story up because I’m frequently asked why I run a focused portfolio of roughly 20 - 25 stocks. For me, the idea is similar to Hemingway - can I outperform the markets with portfolios having a limited beginning and end? It’s an interesting dilemma. Much like Hemingway, in my portfolio I have a tendency to miss what are considered essential components of modern portfolio theory. These include considerable diversification in both number of stocks and industries. I didn’t develop such an investment approach because of a bet to see whether I could consistently beat the markets with such a small group of holdings (though the approach has worked out quite well for my investors[2]). I developed the portfolio strategy over time simply because I found I couldn’t tell my portfolio “story” if I had too many “words” (stocks). I’m simply not smart enough to keep track of more than 25 stocks.
 
The Requirements for a Successful “Six Word” Portfolio
 
Much like summing up your life in 6 words, a very focused portfolio designed to - and capable of - beating the general markets year after year is a tough nut to crack. First, it requires a set of criteria that can choose stocks with the best chance to outperform the general markets in the long term. Second, it creates a process that gathers the greatest amount of relevant information yet weeds out vast amounts of inconsequential data. The ultimate goal is to have as much deep, proprietary knowledge as can be gathered for each portfolio holding. This allows you to have a clear competitive advantage on other investment managers who own 500 stocks with a turnover rate of 150% annually. With only 20 stocks, these are the major areas of knowledge I use to make sure I have the deepest level of knowledge possible and increase my chances to outperform the S&P500 over the long term.
 
Financial Data and Updates
Accounting is the language of business so you’d better be fluent in all aspects – balance sheet, income statement, statement of cash flows, 10-Qs, 10-Ks, management notes, actual earnings, pro-forma earnings and EBITDA. The list is endless. Much like accents in certain geographic areas, every company and its management have their own take on reporting the numbers. It’s amazing how many shenanigans can go on in federally mandated reports or filings. Every year a portfolio holding releases one 10-K and annual report, 4 10-Qs, any number of unplanned updates announced in 8-Ks, S-4s for mergers and acquisitions or exchange offerings (better look that one up!), and 11-Ks for employee stock purchases or plans. Everyone of these filings can hold a critical piece of information that might confirm – or far worse – deny a basic assumption in your investment thesis. In my portfolio of 20 – 25 holdings I will generally read roughly 200-300 pages of filings per holding annually or nearly 6,000 – 7,000 pages of filings each year. Think about the work required if you had 200 holdings and 100% annual turnover.     
 
In reading all these pages I focus on three buckets of information that will help me understand the issues within the portfolio holding. First is any change in the capital structure. As a common stock, preferred stock, or bond holder, I want to know about any changes such as drawdown on the company credit line, issuance of new stock or debt instruments, or issuance of stock options and/or warrants. All of these will have an impact on the estimated valuation of the company and my holdings. Second, I want to know about any major strategic efforts or changes that might require a shift in company assets, changes in capital allocation, or large increases in research and development. Changes in strategy can be expensive in terms of time and money. As a log-term value investor, I look to partner with executives who make as few changes as I do in the portfolio. Last, I want to know about any changes in how the company operates. This includes everything from decreasing margins to increased CAPEX that might require more spending. For instance, new hires in the sales force might be a clue that market dynamics are shifting or the economy might be slowing.
 
Marketplace Developments
The latter changes (such as hiring new sales reps) is information that not only tells me about potential changes in the company’s financials, but changes in the marketplace. Sources of this type of information include trade journals, proprietary research, trade events, competitive reports, etc. In this area, I look more outside the company for information. Subjects in this area include the following.
 
Product and Service Development
Companies work in ecosystems that are always changing and evolving. New products and services are constantly being developed and launched. It is essential that as a value investor, you know these dangers to each of your holdings. Press releases and trade journals are great sources of new product announcements. Masimo (MASI)[3] - a medical device company - is constantly looking to expand its product range or product functionality. For instance, Masimo looks at improving its oximeter (the little clip that goes on your finger tip to measure your oxygen saturation rate) by integrating it deeper into the patient care platform. Reading up on trade journals or attending conferences can give you a great idea on how and where competition is making its move. Your understanding of both the product and your portfolio holding’s competitors can pay huge dividends in the long run.    
 
Micro-Economics
Another area of interest are micro-economic developments and pressures. Examples of this are changes in interest rates, localized employment numbers, and raw materials cost pressures in a specific suburban area like Scottsdale if you own a homebuilder. An example of this was research we conducted on the long-term capital allocation decisions in for-profit versus not-for-profit hospitals when it comes to magnetic resonance imaging (MRI) machines. In areas with large university health care systems (think Boston) versus mostly private (think Dallas), sales and growth can be greatly impacted at iRadimed (IRMD) a Nintai Investments holding. Understanding these local environments allowed us to test management’s growth estimates.  
 
Competitive Strategy
Changes in competitive strategies is another area of huge interest. Reading competitive documents/filings and talking to customers is a great way to get a sense of any impending shifts in how competition thinks. An example of this was reading Fidelity’s internal presentations and talking to mutual fund investors to get a feel on how Fidelity’s shift in pricing affected T. Rowe Price (TROW)[4]. Understanding the major components of the mutual fund industry – ranging from the 1940 Investment Company Act to the mutual fund, its independent advisor, the fund’s directors, were all vital in understanding how and why Fidelity can create “free” index funds. After an extensive review it was clear Vanguard was Fidelity’s target and there would be minimal impact on T. Rowe Price.
 
New Technologies and Delivery Models
Last is understanding what new technologies and delivery models might be occurring out there that can cause real grief to one of your holdings’ business model. One needs to look no further than Amazon to see this at work. An example is drug distribution. Since the 1980s and the creation of drug wholesalers and pharmacy benefit managers (PBMs), there have been three waves of mergers and acquisitions (pharmaceuticals buying PBMs, pharmaceuticals divesting PBMs, pharmacies buying PBMs), 28 specific pieces of federal legislation involving drug distribution (safety, fake drugs, illegal importation, rebates, etc.), and three major new delivery models (cold chain supply systems, supply hub, etc.). All of these transactions, regulations, and legislation are simply to deal with drug distribution. Imagine if you had to understand 150 more industry-specific technology and delivery model changes.     
 
As you can imagine, understanding how each of these four areas can impact each of your investment holdings can be a real challenge and require a huge effort. In this research not only does the focused number of companies really help, but the industry focus (Nintai Investments only invests in 5 of 11 S&P’s industry groups) really allows us to focus in much greater detail than other investment managers.    
 
Scuttlebutt
 
An enormous amount of trade and proprietary company information is disclosed and discussed everyday on our beloved interwebs. Scuttlebutt can be achieved through discussions with customers, suppliers, reading online customer reviews, or even using a web crawler for searching local papers (reports on layoffs or a new plant). But I’ve found the most cost-effective tool is finding a specific industry scuttlebutt site, saddling up to the virtual watercooler, and look interested.  For instance, anybody who invests in the biopharmaceutical industry must join the website CafePharma. This site is packed with information on everything from how effective or incompetent management is to issues related to a new manufacturing plant in Romania. You can find out how likely that new product management assured investors about in the Annual Report will meet its numbers. You might find out which drug has hit a bottleneck due to a shortage of raw materials or which product launch date might be soft because a consulting physician was drunk at the FDA meeting (yes…that was an actual posting). Every tidbit of information that you can find in this fashion gives you a leg up on valuing or deciding to hold on to one of your investment holdings.
 
What I Don’t Waste Time On  
 
Issues that add no competitive edge to my investment decisions or add no real insight into the value of a holding are areas I steer well clear of through the course of my research. Some of these include the debate on whether the fed will raise rates, whether GDP growth will be 3.2% or 3.4% in the next quarter, or whether a new tweet from the President will raise tariffs on sweet gherkin pickles. The advantage in being a focused value investor means I can spend an inordinate amount of time researching in areas where larger investors simply don’t have the time or resources. As much as you want your investment holdings’ managers to wisely allocate capital, it is imperative you wisely allocate your “time” capital as well.
 
Conclusions
 
Part of the genius of Ernest Hemingway was that he had a gift for not wasting words. He made every word count. By creating a story of only six words, he demonstrated that a few words could tell a whole story. Focused value investing can achieve the same end. I firmly believe that living within my intellectual means, I can - in the long term - outperform the general markets with a “six word” portfolio. Of course, past performance doesn’t assure future returns. But I recommend everyone try creating their own focused portfolio, put in the research legwork, and test your returns against the general markets. Who knows? You might walk away from the table a little bit richer like Hemingway.
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: I own TROW, MASI in both individual and institutional accounts.   
 

[1] There is a great book that took the concept of the “six word” story and asked famous – and non-famous - individuals to create their own six-word memoirs. It is entitled “Not Quite What I Was Planning” by Larry Smith and Rachel Fershleiser. One of my favorites (other than the title) was Stephen Colbert’s “Well, I thought it was funny”.

[2] It goes without saying – though I’m required to say it! – that past performance is not an assurance of future returns.

[3] Masimo is a holding in both institutional and individual accounts at Nintai Investments LLC.

[4] T. Rowe Price is a holding in both institutional and individual accounts at Nintai Investments LLC. 

Samuel Untermeyer: "Is not commercial credit based primarily upon money or property?"
J.P. Morgan: "No, sir; the first thing is character."
Untermeyer: "Before money or property?"
J.P. Morgan: "Before money or anything else. Money cannot buy it.”
 
From J.P. Morgan’s testimony before the House Committee on Banking and Currency in December 1912[1]. 
 
“It is not so much that too many of our principals, our business leaders, seen less ethical, it is that our principles seem less ethical, somehow diluted. There seem to be far fewer absolute standards in the conduct of our affairs - the things that one just doesn’t do. Rather, we rely too heavily on relative standards - “Everyone else is doing it, so I can do it, too” - a concept that would have appalled the Reverends Makemie, Edwards, and Witherspoon, as well as our founding fathers.”[2]
 
                                                                                      -       John C. Bogle 

As an investment manager I spend an inordinate mount of time reading annual and quarterly reports that tell me quite about the operations of the company, its financial strength, risks, etc. While I can glean some information about management in the way they write, there really isn’t a great process to get a better understanding of the managers themselves. If the first thing is character – as J.P. Morgan believed – then how do you go about understanding a company’s leadership character?
 
What is Management Character?
 
It really doesn’t matter how large margins have expanded, or revenue grown, or costs cut if management lacks character. Without it, management can make decisions adverse to shareholders, enrich themselves from company coffers, be unable to see facts clearly, and develop strategies on completely flawed premises.  When I look for character in management, four major themes guide my evaluation.  
 
A Foundation of Fiduciary Responsibility: The Board of Directors of a company - elected by its shareholders - hire a chief executive officer to carry out a company’s strategy and operations that will maximize shareholder value. At the base of every action is the strong set of values reflecting fiduciary responsibility to his/her shareholders. Without this foundation, companies can be easily led astray. Just ask the shareholders of Enron, Lehman Brothers, Waste Management, or HealthSouth. Warren Buffett has famously said that when he finds one cockroach, there are generally many more. If senior management turns a blind eye to fiduciary responsibility, it won’t be long before it works its way deeper into the organization.   
 
An Ability to Hear, Speak, and Act on the Truth:  An area where my company has substantial knowledge – pharmaceuticals – has a long track record of remarkable failures in ethical leadership. Even large fines seem to make little impact on their behavior. GlaxoSmithKline ($3B), Pfizer ($2.3B), Johnson & Johnson ($2.2B), Abbott ($1.5B) have all been caught promoting drugs when the FDA has not approved them for a specific use. The scope of these illegal operations frequently goes to the top of the organization. If management is unwilling to act on knowledge of such behaviors, then what else will they do to maximize profits? 
 
Their Word is Their Bond: I remember once listening in to an earnings conference call when the management team announced the prudent use of cash on the balance sheet precluded any big M&A deals as they “almost always cost shareholders value”. Less than six months later, this same team announced an acquisition that would use nearly the entire cash balance. Within the first two years of closing, roughly 90% of the deal would be written off as good will. One thing was certain - if their word was their bond, then it was selling at a pretty large discount by year’s end.
 
Treating All With Respect: When I see companies where CEO’s have outrageous compensation packages (including cash, options, warrants, deferred compensation, jet use, private security…..the list goes on and on), I believe this shows complete disrespect to employees (almost always these companies have the largest gap between the highest paid and lowest paid employees) as well as disrespect to shareholders. Respect can be reflected in policies that show fairness to employees no matter the level or position. It can also mean utilizing the annual meeting to genuinely listen to shareholder concerns. Study after study show that companies with satisfied employees and active shareholders are generally the most successful.
 
How to Find It
 
The question of course is how do you find great management? If you focus solely on corporate performance you might end up with a company like Enron and Ken Lay as CEO of the year. If you focus solely on a CEO known as great person you might end up with tech start-up with its own employee barista and swimming pool that flames out in spectacular fashion.  Neither one is likely to lead to outstanding investment returns. So where to look? I suggest the following.
 
Previous Management Performance: The first of course is to see how the individual has performed in the past. If the individual has a history of growing revenue, increasing profitability, and retaining staff then that’s a good start. Reading through 10-Ks and 10Qs can give investors a pretty good idea about this information. A word of caution: those glossy Annual Reports drafted by agencies filled with glitzy graphics don’t hold a candle to a simple report written by the CEO themselves. For a contrast take a look at any Enron Annual Report versus Berkshire Hathaway’s.
 
Direct Conversation: If the company is small enough, then you might be fortunate enough to talk directly to the CEO. Sometimes you can speak to other senior executives. Either way, be prepared to have a list of questions that you can run through without hesitation. (For some thoughts on this see my article “Interviewing Management: Core Concepts”, June 2016) No senior executive likes to waste their time. 
 
Scuttlebutt: Another great source is Phil Fisher’s classic scuttlebutt. There are a host of websites (examples include “Glass Ceiling” for equal pay, “Fierce Biotech” for Biotechnology business news, and CafePharma for all kinds of business and personnel scuttlebutt) for each industry that generally dish everything from potential deals to reports on individuals (it was actually posted on one site that I had died until I confirmed I was quite alive!). Some sites have far greater credibility than others so use your discretion and try to multi-source any stories.  
 
Conclusions
 
Partnering with outstanding management is a multi-pronged approach. You are looking for great allocators of capital, individuals with sound judgement, great business acumen, outstanding intrapersonal skills, and a strong strategic vision of the business and industry. Is it possible to find any one person with all these skills? It’s unlikely, but possible. Over time, you will have to create a hierarchy of importance. For me, capital allocation comes first combined with a strong strategic vision. Yours may be strong personnel skills and outstanding business acumen. One thing is certain though: picking a bad manager outweighs almost any positive characteristics of the company.  As J.P. Morgan said, money and assets cannot trump character. And it’s hard to find fault in his results.
 
As always, I look forward to your thoughts and comments. 
 
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[1] Money Trust Investigation : Investigation of Financial and Monetary Conditions in the United States Under House Resolutions Nos. 429 and 504 Before a Subcommittee of the Committee on Banking and Currency, House of Representatives, (1912-1913)

[2] John C. Bogle, “Don’t Count On It!”, John Wiley & Sons, 2011

“I don’na mind I ain’t rich. And I don’na mind he ain’t poor. I just canna stand it ain’t ever gonna change, that’s all.”
                                                                -        Jock Druery (Fictional Character, 1857) 

“The greatest threat to capitalism is capitalists. When these individuals lose sight of the fact that capitalism is as much a hope-based system as a capitalist system, then the whole structure is threatened. Recently we’ve heard capitalist thinkers tell us that socialism is about shrinking the pie and that capitalism is about growing the pie. I wouldn’t question that thesis. But I would question whether growing the pie - and having a very select group of people eat greater and greater amounts of this growing pie is any different than their fears of socialism and a shrinking pie. Whether you go hungry because the system doesn’t manufacture enough bread or because an increasing amount of bread was made, and a few lucky individuals got to eat even more than ever, is irrelevant. You’re still hungry, and you still feel screwed. The latter is the threat to western capitalism, not the former. Anyone arguing the former simply has an insatiable hunger for bread”.

                                                              -         Sandra W. Hall 

I was recently reading Howard Marks’ latest memo in which he took issue with socialism and some of the ideas and recommendations from those in the “Democratic Socialist” wing of the Democratic Party. It’s not my intention to take a stand on any of the issues he brings up or the current political debate, but rather address the issue he never really fleshed out - the meaning of “responsible capitalism”[1].
 
Capitalism works best when capital is wisely allocated. The purpose of a group of businessmen gathering under a New York City buttonwood tree in May 1792 was to create an environment where companies could access capital and shareholders could enjoy the benefits of putting this capital to work. Successful capitalism requires a system where stakeholders – small businesses, vendors, local and state governments, etc. see direct - and indirect - benefits from having companies reside within their greater community. When all these individuals and institutions - the company, its employees, its shareholders, its vendors, the communities and people in which excess profits are spent - see the benefits of well-deployed capital, then that (at least to me) is the definition of “responsible capitalism”.
 
I thought I’d use Mr. Marks’ (along with my) industry - investment management - as a test to see how responsible capitalism has been over the past several decades. One of the roles of the financial investment industry is to allow the American worker to put their hard-earned capital to work and allow the strength of the US and international markets to grow this capital and generate adequate returns to meet their goals – whether it be their child’s education or their future retirement. For generations, workers have expected the financial industry – either through their pension plans or more recently 401k plans – to generate wealth and carry their half of the capitalist bargain – the worker toils to earn their wages and the financial community assists in meeting their long-term goals.
 
This model worked well for nearly all of the twentieth century. It made the American middle class the envy of the world. It’s what brought my family to this country. But somewhere in the latter part of the twentieth century capitalism and the functions the markets play in capital allocation changed. These changes can be summed up in the following ways.
 

1. The financial markets went from being a facilitator of corporate ownership (long-term investments) to corporate rentals (day trading and excessive portfolio turnover). The idea of owning a piece of a business went to the idea of trading pieces of paper or clicking on buy and sell keys.
2. The traditional risk/reward (an American worker invested in the economy through the stock market and was rewarded over time) was replaced by an agency model of heads I win, tails I win more. Over time, more and more individual investors have taken the risk but seen less rewards.
3. Frictional costs created by agency action (rapid trading, management fees, marketing fees, 2/20 agreements, etc.) are subtracting far more value than adding it to investor returns.       

 
Let’s take a look at these friction-related costs that no one seems to want to discuss yet play a devastating role in reducing the size of the pie. In 2004[2], investment bankers and brokers generated $220 billion, mutual fund fees were roughly $70 billion, pension management fees were $15 billion, hedge fund fees came in around $25 billion, and personal advisor fees around $5 billion. Note that these numbers don’t include investment services fees generated by banks and insurance companies (like the 1% fee layered on by many bank in-house investment management groups). Just these numbers alone come to roughly $350 billion directly deducted from investor returns. Adjusted to 2019 dollars, these numbers are estimated to be nearly $680 billion dollars. That’s nearly two-thirds of a trillion dollars in one year.
 
As I said earlier, capitalism works best when capital is allocated wisely. In the case of the investment management business -for all of these hundreds of billions paid - you would think that capital has flowed to agencies because they provide additional returns to investors. That assumption couldn’t be more wrong. Going through each category we find that each agency has deducted from investor returns and simply made profits for their respective function.
 
Investment bankers and brokers work to bring companies together to conduct mergers and acquisitions. Yet, according to the Harvard Business Review, 70-90% of those mergers and acquisitions are value destroyers for investors[3]. In 2018 alone, the total global value of mergers and acquisitions came to $3.8 trillion dollars[4]. Assuming the HBR failure rate, that’s an extraordinary amount of capital destruction. Who pays for this? Shareholders as good will is slashed from the balance sheet over time. 
 
Actively managed mutual funds have an abysmal record in outperforming index funds. In my article “Mutual Fund Survivorship: The Revenge of Abraham Wald” of January 2 2015, between 1997 – 2011, roughly nine out of ten actively managed funds underperformed their index fund proxy. 46% of the fund were simply closed or merged away they were doing so poorly. Additionally, funds are simply charging too much to compete with index funds. In another article, “Are Management Fees Coming Down? Yes, Sort Of…..”, April 28 2015, I write that fees are not coming down proportional to the growth of assets under management (i.e. no economy of scale).
 
As of September 2018, local and state government pension funds have $4.41 trillion in assets under management. Putting aside the accuracy of pension actuarial assumptions, pension funds have a long history of underperforming due to several reasons. First, their expenses - after layering on for fees charged by their holdings such as mutual funds or hedge funds - make it nearly impossible to outperform the general markers. Second, pension fund investments in hedge funds have proven to be an expensive experiment in poor returns (see hedge funds section). The Center for Retirement Research at Boston College (CRR) took a look into the variation of returns to investigate why some plans perform better or worse than others. The study examined the period from 2001 to 2016, during which public plans earned an annualized return of 5.5 percent, well below the average return assumption of about 7.6 percent. Who receives either a lower pension payment or increases in deductions? Pension plan participants (i.e. the common worker).
 
Why This Matters
 
When Howard Marks talks about socialism and the danger of a shrinking pie, I think he (and all of us who are professional capitalists) have to take a long hard look at how well we’ve done in both growing the pie and sharing that pie with individual investors. From the college student or blue-collar worker who puts their hard earned $50 into their IRA or 401k, to the retiree who relies on their pension plan to enjoy their retirement, these individuals deserve their share as much as any hedge fund manager making $5 billion a year in New York City. True parity and fairness would require “responsible capitalism”.
 
Don’t get me wrong. My family came to this country because it was the capitalist engine (combined with a democratic republic) that drove world growth. I couldn’t have been more proud then - or now  - to be an American and taking part in a capitalistic system that rewards (generally) hard work, diligence, and acquired education. As a professional capitalist I think it’s the best system in the world. But there are improvements that could improve the system to make it a more “responsible” in Mr. Marks’ words. Here are a few ideas I humbly suggest.
 
Too Many Fees, Not Enough Value: The amount of value extracted from our capitalistic system by the financial industry far exceeds the value it brings to the table. Ranging from ridiculously high management fees to sky high turnover to even bank ATM fees, individual investors and consumers are increasingly demanding cheap and effective financial solutions. As an active investment manager, I see the warning signs everyday - the growth of passive/index investing, fund withdrawals, continued underperformance. This list goes on and on. If our industry wants to keep extracting so much capital from the markets, then it needs to either find a way to increase value or decrease costs.
 
To Much Selling, Not Enough Thinking: In many ways, the investment management business has become like the pharmaceutical business – to much focus of sales and promotion and not enough on R&D and science. It seems every major investment house has become a marketing machine – touting short term Morningstar star ratings and turning over entire portfolios in 6-12 months. Not enough time is spent on thinking about long-term value, customer needs, simply being patient, and letting the magic of compounding do its work.
 
Too Much Pie Subtraction, Not Enough Pie Sharing: All too often Wall Street spends its time thinking about new (and of course expensive) ways to convince investors to spend their hard-earned dollars on products that have little chance to deliver outperformance - or even adequate performance. How many individual investors really need a triple leveraged short-based ETF on oil futures? When I was growing up, I had a paper route where I delivered 127 newspapers daily. It took three runs on my bicycle but I realized that if I did my job, delivered the papers on time, in good condition, and treated my customers with respect, then I would do pretty well when it came to payday on Saturday mornings. The editor of the paper said to me once, ‘the more complicated you make the product or the services, the more the customer pays and the less value they get. And most people aren’t stupid. They’ll find another way to get the news when they realize they’re getting screwed’. I tell my clients my services are pretty simple - I allocate their money and charge them a modest rate with the goal of meeting their financial needs. That’s about pie sharing, not about pie consumption.
 
Conclusions
 
It wasn’t my intention to write an article on the issues of improving capitalism, nor making it the longest article I’ve ever written. But as a professional money manager with clients seeking to achieve their financial goals, I think it’s important that as professionals we take a long hard look at the issues which are causing tectonic shifts in our industry. We can only succeed when our clients succeed. That means getting back to the basics which made capitalism great - getting the largest amount of individuals to share in the risk and rewards of a growing economy and making sure as many feel and see these rewards as possible. In the end, it might just mean eating some humble pie.
 
----------------------------------------------------

[1] Ray Dalio had a slightly different take than Howard Marks in his rather contentious discussion about why capitalism needs to be reformed in an appearance on CNBC April 9 2019. Video can be seen here: https://www.marketwatch.com/story/watch-cnbc-host-get-into-heated-exchange-with-ray-dalio-over-capitalism-2019-04-08

[2] These numbers come from Jack Bogle’s research at the Bogle Financial Markets Research Center at Vanguard Corporation in Valley Forge, PA.

[3] Harvard Business Review, June, 2016. “M&A: The One Thing You Need To Get Right”. In 2015 Microsoft wrote off 96% of the value of the handset business it had acquired from Nokia for $7.9 billion the previous year. HP wrote off $8.8 billion of its $11.1 billion Autonomy acquisition. Finally, in 2011 News Corporation sold MySpace for $35 million after acquiring it for $580 million just six years earlier.

[4] Wall Street Journal, Money Beat http://graphics.wsj.com/investment-banking-scorecard/
 

With the opening of Nintai Investments LLC, I thought I’d go back to my previous method of reporting quarterly returns to the Gurufocus community and readers of my website’s blog. Before I get into the specifics, a few ground rules are in order.

• As a professional investment manager, I will not be providing a full list of portfolio holdings. My customers pay me to allocate their dollars in a specifically chosen portfolio – not announce their portfolio to website readers.
• Returns are a composite of the Hayashi Trust and individual investor portfolios.
• Inception date is October 15 2018 for the Hayashi Trust and January 1 2019 for individual portfolios.
• In my previous life, I was happy to discuss individual holdings and my rationale for their being in the portfolio. As a paid investment manager, I must necessarily be far more discreet in my answers to readers’ questions. 
• Of course, past performance does not promise future returns. Any company discussed will be identified as a portfolio holding if in either an individual investment account, the Hayashi Trust, or in my personal brokerage account.

 
As many of you know, I ran the Nintai Partners Portfolio – and then the Charitable Trust – from 2002 - 2015. In addition, I was a portfolio manager from 2015 - 2018 at Dorfman Value Investments. While very proud of those returns, I believe the results of Nintai Investments LLC must stand on their own and develop their own unique history. Going forward, when I discuss the Nintai Investments LLC portfolio, I will be referring to a composite of individual portfolios managed by Nintai Investments LLC and the Hayashi Trust portfolio managed by Nintai Investments LLC.
 
I was pleased with Q1 performance of the composite portfolio outperforming its benchmark, the S&P 500. I have also been very pleased with performance since inception. Seen below are the numbers for periods ended March 31 2019.
 
Total Returns Net of Fees

We added two new positions in Quarter 1. Making a return to the portfolio is F5 Networks (FFIV). I sold out of the entire position in 2018 when the company’s stock price hit 155% of my estimated intrinsic value. Total profit was 44% on the position which I held in the portfolio for roughly 19 months.  Year-to-date the stock has dropped roughly 8% while after reviewing the company I increased my estimated intrinsic value by 35%. The second purchase was PetMed Express (PETS). The company had been on my watchlist for 4 years. Over the past 1 year the company stock price has been cut by 50%. Free cash flow has grown by 14% annually over the past 5 years while earnings have grown by 18% over the same period. The stock yields 5.2%. There have been questions as to whether company has been selling Tramadol (a synthetic opioid pain medicine) to animal veterinarians to be sold or prescribed illegally for human use. To date, there has been no announcement of any investigations to support such an allegation.
 
This quarter I sold the entire stake in Allergan (AGN) after it was announced the company was charged with systematically overcharging the Centers for Medicare and Medicaid (CMS) by utilizing false data on average wholesale pricing (AWP). As I wrote at the time, this is a particularly egregious crime that steals money from the patients who can afford it the least and reduces government funding available for other treatments.  I simply will not tolerate such behavior by a holding’s management.
 
During the quarter I also added to 4 existing positions. Each holding was trading at a significant discount to my estimated intrinsic value at the time I added to the position.  
 
Winners and Losers
 
Two stocks led the way in Q1 - Veeva Systems (VEEV) and NIC (EGOV).  Veeva was up 38% in the quarter while NIC increased by 34%. Veeva’s February quarterly earnings exceeded both top and bottom lines. Management upped guidance as well. Over the last year, VEEV has increased free cash flow by 33%, EPS by 60%, and revenue by 24%. I increased Veeva’s estimated intrinsic value by roughly 13% in February 2019 after the company raised guidance. The position is currently up 115% since it was purchased in February 2018.
 
NIC recovered nicely after the markets recognized the loss of part of the company’s Texas website contract was not going to have a significantly adverse effect on the firm. Free cash flow actually grew by 1% after analysts estimated a 15-20% drop in 2018. While the quarter’s results were gratifying, the position is currently only breaking even. While Veeva and NIC had great quarters, I should point out that roughly half the portfolio holdings were up 20% or greater during the quarter.
 
It wouldn’t be value investing if you didn’t have to report on stocks that were the inverse to those winners. The ones that get you all puffed up and make you feel like the smartest person in the room. For the second quarter in a row, the largest drag on the portfolio was Biosyent (BIOYF) down -5.2%.  The company was a having a decent year until in the last days of Q1. Management announced they received two notice of deficiencies from Health Canada for their two new cardiovascular products.  The company has exclusive distribution rights to these drugs in the Canadian markets. At the time of this report, I’m still in discussions with Biosyent management, Health Canada clinical reviewers, and market analysts to judge the impact on my estimated intrinsic value.
 
Portfolio Characteristics
 
The current Abacus view as of March 31 2019 shows that the Nintai Portfolio holdings are slightly more expensive than the S&P500 and projected to grow earnings at a significantly greater rate than the S&P500 over the next five years. 

The additions of F5 Networks and PetMed Express along with the sale of Allergan brought the portfolio to 21 positions in total. If opportunities arise I will add or reduce position size. I might also swap out an entire position for a chance to invest in a situation with a better risk/reward profile. I am uncomfortable having the valuation of the portfolio be slightly higher than the S&P500. This explains the build-up in cash to roughly 20-25% over the quarter. I will be actively looking to take profits or find cheaper prospects over the next 6-9 months.
 
I remain highly focused in my industry and sector weightings.  I currently have holdings in only 5 of the S&P500’s 11 categories - financial services, technology, industrials, consumer defensive, and healthcare. Industrials and consumer defensive are both extremely small holdings with roughly 90% of holdings in just three categories – financial services, technology, and healthcare. However, I should point out I see the categorization of the portfolio slightly differently. For instance, Computer Modelling Group (CMDXF) is categorized as a technology company by the index. However, with 100% of its revenue derived in the oil and gas discovery process, I consider the company a way to gain exposure in the energy industry. 

​ Thoughts on Turnover and Cash
 
Turnover for the quarter was roughly 14%. I expect this to drop as assets under management increase. I try to look for turnover of roughly 5-10% annually. This is dependent of course on factors such as overall market performance (steady increases over the past few years have allowed me to take profits but also increase turnover) or individual stock performance (a sudden price drop of 20% might make for a compelling buy scenario). I have reached the upper end of stocks I look to own in the portfolio. It’s likely that most trading going forward will be additions or subtractions from existing positions. Occasionally opportunities may arise where I swap out an entire position for one that is either trading at a steeper discount to my intrinsic value and represents a step up in quality and potential long-term gains.
 
In regards to cash, the portfolio currently maintains roughly 20% of its assets in cash. I have been fortunate that 80% of the portfolio has easily outperformed 100% of the S&P500. How long that can continue is anybody’s guess. With the Abacus report showing the portfolio’s estimated 5-year earnings growth at 18% greater than the S&P500 while being equally valued, the data suggest there is at least a moderate chance this could continue. But as always, I want to point out that past performance does not ensure future returns.
 
Eating Our Own Cooking
 
As many of my readers may remember from my GuruFocus presentation in April 2016, I have the “honor” of having an extremely rare genetic mutation (the TRNT1 gene for those keeping track). This disease – known by its acronym SIFD – is found in only 18 individuals in the world. While my parents always told me to be different, I’m not sure this is what they meant! I bring this up because over the past 8 years of treatments I spent my entire life’s savings seeking care that would keep me alive (the US is both a great place and a terrible place to have a rare disease). Now that we’ve isolated the disease through modern genetic clinical research, I’m in the position to begin rebuilding my individual investment portfolio. I want to assure my readers and investors that every dollar invested will be in the same stocks I own in the Nintai Investments portfolio. It is my intention that I will most certainly be eating my own cooking.  
 
Making A Difference
 
At Nintai Investments, I take our social responsibility seriously. We (meaning myself and my shareholders) currently give 10% of net income to charitable causes that are making a difference in our communities. Each annual report I will highlight an organization that Nintai Investments has supported that year. As a corporate citizen, Nintai Investments has an equal – if not greater – responsibility to make a difference in our society. Having lived an immigrant life here in the United States, I have seen that capitalism produces enormous opportunities for all our citizens. But sometimes that isn’t enough - sometimes people need a helping hand. Having been blessed with a wonderful family, a great education, and a successful professional career, I feel Nintai Investments has a special responsibility to help provide that helping hand.  
 
                                                                  »»»»»»»»»»»»»
 
As Nintai Investments LLC begins its corporate journey, I take my responsibility seriously to wisely allocate capital, prudently manage risk, and attempt to generate adequate returns. Helping individuals and organizations achieve their life goals, support their corporate giving, or meet their retirement needs is a remarkable honor and mark of great trust. Every day we look to continue earning that trust. Should you have any questions, please do not hesitate to contact me by phone or email. 
 
Thomas Macpherson
tom@nintaiinvestments.net
603.512.5358
 
My best wishes for a wonderful spring season. 

“A lot of people think security analysis means sitting with green eyeshades and poring over financial statements. But it’s actually much more than that. Security analysis is made up of three major components – collecting and analyzing relevant and correct data, analyzing all the issues related to the management and company such as allocation of capital, capital structure, dividend policy, etc. and making a recommendation of buy, sell or hold based on these facts. These three steps require enormous research, industry knowledge, and business judgement. Being a security analyst isn’t just wearing green eyeshades but wearing multiple hats too”.
 
                                                                                             -   Richard A. Dixon 

I’ve often mentioned that during times of market highs - when I can find almost no new investment opportunities - I tend to go back to the basics and ground my thinking in the value investment classics. As of March 2019, my individual and institutional accounts are roughly 20 - 25% in cash as a percent of total assets under management. With the run up in Q12019, I could see this number going higher.  
 
My go-to classic is Benjamin Graham and David Dodd’s classic “Security Analysis” (1934 edition). I find there are many diamonds in what could be called a “literary rough.” Although it’s a tough slog, I suggest everyone read it from front to back at least once a year. (No cheating either! Though Bob Abbott on GuruFocus does a great job summarizing the classics, this one needs to be read in unadulterated form).   
 
Graham and Dodd’s Security Analyst: Job Description
 
Almost everyone skips the beginning chapters of the book eagerly looking to investigate the authors’ descriptions of margin of safety and other core concepts of value investing. I think most readers miss some of the most important thinking in the history of value investing by giving a fleeting glance to Chapter One entitled The Scope and Limitations of Security Analysis: The Concept of Intrinsic Value. This first chapter is essential to understanding why your role as a security analyst is essential to being a successful value investor. It isn’t often that you hear an individual or institutional investor call themselves a security analyst. Rather they refer to themselves as a value investor. I would posit that Graham and Dodd argue that one cannot be a value investor without mastering the requirements of being a security analyst. In today’s world, most would think of a security analyst as someone with a specific degree (MBA) or professional license (CFA) than as an investor with a broader set of research/evaluation skills and personal behavioral characteristics. But as a reader digs deeper into Chapter 1 of Security Analysis, Graham and Dodd outline the necessary skill sets, intellectual framework, and emotional tools that make not only a qualified security analyst, but a successful value investor.  
 
They break the role and skills of a security analyst into three buckets – descriptive, selective, and critical. It isn’t – and can’t be - in the scope of this article to fully describe each of Graham/Dodd’s three attributes, but I thought it might be helpful to briefly describe each and discuss their relevance to effective value investing.
 
Descriptive
As described by Graham and Dodd, descriptive security analysis consists of “marshalling the necessary forces” and presenting the company’s data in a clear and concise fashion. Descriptive can also include a deeper dive into the company’s strengths and weaknesses including its financials, competitive strength, operating markets, and strategic outlook. At Nintai Investments, we see this as an essential component of building out the business case used to make the decision about an investment's role in the portfolio. Descriptive security analysis is truly business analysis and requires an enormous amount of learning - marketplace characteristics, competition, regulatory, technological innovations, etc. If you’ve listened to successful value investors, it’s always surprising the level of detail these individuals retain about their portfolio holdings. Whether it’s discussing the company’s research & development budget and projected return on investments or the vital statistics in product design, these investors see descriptive security analysis as the foundation for their competitive advantage.    
 
Selective
Selective collates the descriptive analysis and uses it to suggest or recommend whether the security should be bought, sold, or held in its respective portfolio. This part of security analysis is where the role of intrinsic value versus market pricing plays an enormous role. Great value investors can utilize the selective process to make quick judgements on potential investments. A great example was Warren Buffett’s decision to invest in CNOOC (CEO). He stated at the time that he made the decision to invest in about half-an-hour based on selective analysis alone. When combined with robust descriptive research, value investors can achieve markedly improved chances at reducing permanent impairment of capital.
 
An example of this at work was Nintai Investments purchase of Veeva Systems (VEEV). An enormous amount of work went into the descriptive portion of the security’s analysis. Understanding the company’s product, its deep relationships in life sciences, its powerful value in the discovery, development and sales/promotion of drugs, and its wide competitive moat made the selective portion of the Veeva analysis much, much easier. By the time it came to make the decision to add or not add the company to the portfolio (and at what size), the answer practically delivered itself. Being a security analyst made my job as an investment manager that much easier and (hopefully) that much more successful.
 
Critical
As an investor who takes long positions in equities only, critical security analysis has less to do with the strength of the offering placement (as a common stock holder I will be - after all - at the end of the bankruptcy asset line). Rather my concern will focus on the totality of obligations the company has (common stock, preferred stock, short and long-term debt, warrants, off-balance sheet entities, etc.) and the overall strength of the company to meet its obligations. If a company’s debt is selling at a 35% discount to par, then I’m going to want to know what bondholders know. Th difference between the thinking and concerns of stock holders is quite different than those holding the company’s debt obligations. When Wall Street was pumping Enron stock as the latest and greatest, it was obvious to security analysts who did their critical security analysis that something was terribly wrong with company’s financial structure - in particular its off-balance sheet entities and its ability to support such a financial structure.  
 
Conclusions
 
Before Graham and Dodd introduced the idea of margin of safety and other themes that have become the foundation of value investing, they created the idea that security analysis as a profession was essential to understanding the concept of intrinsic value. Without the structure of researching key components of a potential investment - its business, finances, markets, competitors, and structure of its public financial offerings - then investors simply could not derive an intrinsic value of their potential asset they were looking to purchase. At Nintai Investments we couldn’t agree more. Many times, we refer to ourselves as security analysts. Sometimes people ask if we work with prisons. Sometimes they think we are in the business of protecting homes or business data. That’s all fine with us. The less people know what security analysis entails or its importance to being a successful value investor, the happier we are as it relates to our competitive strength. We encourage our readers to break out their green eyeshades and embrace their own security analyst genes. It’s unlikely you will regret it in the long run.
 
As always I look forward to your thoughts and comments
 
DISCLOSURE: I own Veeva Systems in individual and institutional portfolios I personally manag

“Failure is central to engineering. Every single calculation that an engineer makes is a failure calculation. Successful engineering is all about understanding how things break or fail.”
         
​                                                                                                - Henry Petroski
​
During the 1890s, the 3rd Marquess of Salisbury was debating whether to electrify his house. His country estate, Hatfield, was (and still is) one of the most famous houses in England (Queen Elizabeth I grew up there) and considered a national treasure. No one wanted to see it go up in flames. In fact, his grandmother – dressed in those enormous dresses of the early 1800s – caught fire and burned to death shortly after the 3rd Marquess’ birth.

But, Lord Salisbury’s great interest in science overcame all these fears. He eventually installed some of first residential electric lights through the house. His children could remember throwing pillows at the wires in some rooms as they sparked and smoked to prevent fires from breaking out and burning down the house. There was even a servant who had the rather unfortunate - and fatal - experience of stepping on one of the uninsulated power lines in the gardens. Asked whether he thought the “Great Experiment” (as it was laughingly known to the family) was worth it, Salisbury is remembered as saying, “Sometimes advancement in science isn’t perfect. But if you plan for things to go wrong, it’s much easier to eventually make them go right,”[1]

I bring all this ghoulish history up in relation to a conversation I was having with a fellow value investor who asked me, “If you were allowed just one, what would be the most important lesson would you give to somebody starting out in their investing career?” Since that conversation I’ve given a lot of thought to what that one piece of wisdom might be. I might suggest “margin of safety.” That certainly is critical to any value-based investor. Another might be the power of compounding. Or, perhaps, the development and practice of patience. All of these are extraordinarily powerful concepts, but when I really thought about what has made the greatest impact on my investment theory and results, it would be this one thing: Think like an engineer and always plan for failure.

Most investors I know don’t like to dwell on potentially horrific results – the sudden and sickening drop of a holding’s stock price by 15%, the reporting of accounting fraud or the infamous “death spiral” one hears about as revenue slows, the balance sheet weakens and bonds sell at a 40% discount to par. But the startling fact is that this happens all too often to individual and institutional investors. With all the suddenness of a bridge collapsing or airplane crashing, the best laid plans of the investor suddenly have to take into account serious - and sometimes catastrophic  - losses in their portfolio. When these events happen, it is all too common to blame the events on bad management, flawed corporate strategy or the amorphous “market forces” at play.

I find that most of the time (note I don’t say all the time), events such as these could have been headed off by applying Petroski’s thought: “Successful engineering is all about understanding how things break or fail.” I say this because I think most successful value investors also happen to be successful engineers (at least by Petroski’s measures). These investors can take almost any business case and find a way to break it. That doesn’t mean that particular scenario will play out, but rather they have thought about it and planned accordingly. Forewarned is forearmed as they say.

I was talking to an investor who had a 30-year run of great returns and I asked him the key to his success. He told me he saw every company as sum of its parts that – when engineered properly – create a machine that works seamlessly at generating revenue and free cash flow. Maintenance of course is required, in the form of research and development, capital spending, and sales and marketing.
He imagined taking apart this machine - piece by piece - and looking at each component to see how it might fail. As we discussed this method, we agreed there are several major components that need to be reverse engineered to better understand their design, function, weaknesses and possible improvements. As an investor, if you see no improvement (or worse, no acknowledgement of a problem), then it’s probably best to simply move on. The most important parts of an investment that require great engineering are the following.

Management
The first and most vital piece of a business is its management. Are they capable of surrounding themselves with strong leaders? Does management see itself as allocator of capital there to maximize shareholder returns? Are they compensated in a way they feel is good for them, the company and its shareholders? Finally — and most importantly — is this a group of people who will provide moral and ethical leadership to the company's employees, its board and its community? Can they convey and demonstrate that moral leadership is good corporate leadership?
Understanding how good management works and what bad leadership looks like is one of the first steps in avoiding investing in a company with a limited future. As an investor, consistently low returns in capital, equity and assets demonstrate a management team just not up to snuff. Additionally, outrageous pay packages, stock option grants and so forth show that management work for themselves, not you as a shareholder.

Operational issues
You frequently read about bad execution or operational issues as a weight on corporate profitability and investment returns. Every company will at some point have glitches in execution. Companies with chronically low margins or increasing SG&A, combined with decreasing revenue, can tell an investor that operations-level managers and systems personnel simply haven’t figured out the best operational processes.

Competition
Some of the worst investments I’ve made in my career have been where either me, my team or my holding's management misjudged the competition. This can be anything from launching a new product, creating a great marketing campaign or misjudging the marketplace’s future demands.
When I look to deconstruct this piece of the business, I look to see ratio of SG&A to sales, advertising awards, market share, along with other numbers to see how the company is doing relative to its competitors. I remember one holding that saw its sales and marketing budget triple over three years and market share drop by 25% in the same time. Knowing beforehand that competition and the company’s lack of customer knowledge would destroy a great franchise could have saved me a lot of time and money.

Regulations
Some businesses – like pharmaceuticals or tobacco – you know will be impacted by different political regimes and their views on regulatory affairs. There are occasionally some – like the recent Boeing 737 Max – where a series of events can lead to regulatory action, leading to some truly horrendous results for investors (obviously this is nothing compared to the passengers, flight crews and their families).
Investors should always be thinking about how regulators – either from a legacy standpoint or new transactional event) might impact their potential holding. One might not think much about railroad regulations (instead focusing on capital expenditures) until a car derailment leads to a large toxic cloud requiring an entire town to be evacuated.

All of these categories require an investor to use an engineering approach to think about failure – how and what conditions can lead to permanent capital impairment. At Nintai Investments, this engineering process is coupled with the financial “breaking the case” - the process in which we find what type of financial stress can lead to bankruptcy.

Conclusions
Most engineers will tell you the time to find, isolate and solve the problem is in the design process. As an investor, the research phase of your investment process is the equivalent to the engineer’s design phase. By preventing yourself from buying into a potential corporate failure (defined as permanent capital loss), you avoid all the work necessary to breaking the corporation down to its integral parts and trying to find out if the problems can be resolved. As Petroski said, “Every single calculation that an engineer makes is a failure calculation.” Every decision to invest or not invest should be a similar calculation – is this a company that will be a success or failure in my long-term portfolio returns? You might not be an engineer by training, but thinking like one can certainly help you in the long run.

“Active management is a zero-sum game before cost, and the winners have to win at the expense of the losers.”
                                                                                      -      Eugene Fama 

“The results of this study are not good news for investors who purchase actively managed mutual funds. No investment style generates positive abnormal returns over the 1965-1998 sample period. The sample includes 4,686 funds covering 26,564 fund-years."

                                                                                    -      James L. Davis  

Being an active investment manager in 2019 can make you feel like the salesperson trying to sell rotary phones in 1999. Each year the evidence piles up that active fund management cannot compete with passive (or index) investing over the long haul. One of the great tools to follow the performance gap between the two investment styles is the S&P Dow Jones Indices Annual SPIVA US Year-End Scorecard. In its sixteenth year of publication, the report is unique in that it compares apples to apples, takes into account survivorship bias, and reports equal and asset-weighted returns.
 
I think the report adds significantly to both individual investors’ as well as institutional investors’ knowledge. For individual investors, the data show how difficult it is to create an actively managed portfolio that can outperform an index-based approach over the long term. This is demonstrated clearly with outstanding data, great graphics, and down-to-earth descriptions of complex issues. For the institutional investor, the data break through some of the perceived notions and hardened views on why and how we (money managers) feel we will always be the exception to the rule. When I talk to my fellow institutional investors, I rarely hear about the fact that many haven’t beaten their respective index in 3, 5, 10, 15, and sometimes even 20 years. This industry has far too many underperforming managers making far too much money.   
 
The 2018 annual report was published on March 11 2019[1] and it – as usual – has little good news for active managers. For the ninth consecutive year, the majority (65%) of large-cap funds underperformed the S&P 500. Small-cap equity managers also found 2018’s gains and draw-downs difficult to manage with a large majority (68%) lagging the S&P SmallCap 600. Diving deeper into market segmentation, small-cap value and small-cap core had an abysmal 2018 with 83% and 88% underperforming their respective categories. In both the large-cap and small-cap categories, the idea that market turbulence creates a “stock picker’s market” was simply washed away with shockingly widespread underperformance.  In fact, compared with results from 2017, there was a 27% and 46% percentage point increase in the proportion of funds lagging the S&P 500 Growth and S&P SmallCap 600 Growth indices. Internationally things were no better. 96% (46 of 48!) of the S&P Global BMI’s 48 country markets declined. International and emerging market funds also struggled tremendously, with 77% of international funds lagging the S&P 700. The majority of emerging market managers failed to beat the S&P/IFCI Composite. As an example, even though the S&P Developed Ex-U.S. SmallCap index dropped over 18%, two-thirds (66%) of international small-cap funds failed to outperform their benchmark. With such results in “stock-pickers’ markets”, index funds have never looked better. 
 
However, the report shows that not all was a washout in 2018. U.S. large-cap value broke its losing streak with roughly 54% of the managers in the category beating the S&P 500 Value. In a strange (and seemingly inexplicable) finding, 84% of actively managed mid-cap growth funds beat the S&P MidCap 400 Growth index for the second year in a row. Another strange result was from bond fund market. 83% of government long funds and 91% of investment-grade long funds outperformed over the one-year horizon in 2018. In a true case of inversion and the fact that past results are no guarantee of future returns, over 90% of both categories lagged over the three-year period.
 
That seems to be about as good as the news gets in this year’s report. Funds continued their long-term underperformance with every category having over 80% of active managers underperforming their benchmark in both 10 and 15-year time periods.  The issue of survival continues to be a major issue. 57% of domestic equity funds, 49% of international equity funds, and 52% of all fixed income funds were merged or liquidated over the 15-year horizon. These numbers point out - with unusual clarity - the importance of correcting for survivorship bias.
 
What This All Means
 
The past 10 years have been very difficult stretch for active investment managers – whether they be value or growth, small or large-cap, foreign versus domestic. One of the mantras has been that long-term bull markets make everyone (and especially index funds) look like geniuses. We are told that once market volatility returns and stock prices began to wobble, then active managers will really begin to show their worth. The 2018 S&P Dow Jones Indices Annual SPIVA US Year-End Scorecard (along with other reports over the past 18-24 months) has knocked this theory into a cocked hat.
 
If the premise that volatility and draw-downs create the perfect opportunities for active fund managers is false, then where does this leave us? How do institutional and individual investors go about creating a portfolio that can successfully compete against their respective benchmarks?  First, I should say I have a vested interest in this debate. As an active investment manager, I believe my short and long-term records show it is possible to beat the markets over time. Utilizing data from my time at Dorfman Value Investments and my new firm Nintai Investments LLC, a composite of my individual account returns looks like this:

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*Macpherson DVI/Nintai Investments LLC Inception Date: September 2016
Macpherson DVI/Nintai Investments LLC returns reflect a blended management fee of 0.75% for Macpherson Nintai LLC and 1.5% for Dorfman Value Investments
***Previous performance is no guarantee of future returns***

Certainly a 2 ½ year time frame doesn’t offer a long-term perspective of my investment skills or abilities. Yet I think combined with my record from Nintai Partners (from 2002 - 2015), my outperformance of both the S&P500, the MSCI ACWI ex US, and an Index Blend show I have produced more than adequate returns for my investors over the years.   

Second, I believe there are some core tenets that apply to active management that can assist managers to beat their respective benchmarks. These can be found in reports like the S&P Dow Jones Indices Annual SPIVA US Year-End Scorecard and other performance studies. There are three that I think are vital to achieving long-term outperformance.

Underperformance is Often Tied to Survivability
Whenever you are reading a fund prospectus or listening to a presentation by a fund family, ask them a very simple question: How many of their funds have been closed or merged away over the last decade? Have the returns of those funds been included separately in their total return numbers – or included? For instance, many fund companies will take Fund X - which had a terrible performance record over the last decade – and merge into Fund Y with a much better return and voilà! The company no longer has a good return (Fund Y) and a bad return (Fund X), but now a single good return (Fund Y only) and the disappearance of bad data (sayonara Fund X). Even better is reading the corporate PR announcing such a merger. You will hear management discussing “remarkable synergies”, “outstanding fund leadership”, and “exciting new opportunities”. Always remember: if management can try to fool their shareholders so easily, it isn’t long before they begin fooling themselves. 

Turnover - Whether Portfolio or Managers - is Generally Bad
Nearly all turnover in the investment management business is an acknowledgment of an alternative outcome from the original plan. Some examples might be the investment thesis is broken/impaired, they partnered with the wrong management team, or they overpaid for the asset. I can’t think of many investment processes that are successful in the long-term that include high turnover as part of their strategy. Even in today’s investment world – where data is plentiful, easy to locate and even easier to utilize – turnover requires an enormous amount of effort to find investment opportunities, fully research the potential investment’s management, market, competition, product development, financials, etc. The US tax system penalizes investors for high turnover and the investment community preys on investors with every sort of fee that can be devised by mankind related to turnover. Finally, turnover robs an investor of the eighth wonder of the world – compounding. Every actively managed portfolio fight against these market characteristics on a regular basis. 

Utilize a Tool Fund Managers Generally Can’t: Cash
If you look at almost any actively managed fund you will find cash is 5% of assets or less. As an investment manager you will often here the old adage “I don’t pay you to hold cash”. As an investment manager myself, I make it clear to my investment partners/clients that cash can range anywhere
from 5 - 30% of total assets under management. In fact, I believe my investors do pay me to hold cash sometimes simply to not overpay for new assets or to sell assets when they are grossly overvalued. As of March 2019, I hold between roughly 15 - 30% cash in my individually managed portfolios. Individual investors have the luxury of holding as much cash as the case deems appropriate.  

Conclusions

The performance gap between actively managed portfolios and index-based investing continues to widen with time. It’s now 9 years since a majority of actively managed funds have outperformed index funds. The last several years show the gap growing, not shrinking. One of the last pillars in defense of actively-based investing (“we active managers will outperform when volatility rises and markets begin to oscillate”) has cracked and tottered in the last 6 months while markets swooned and returns dropped dramatically. For all the talk about how indexing has gotten too large and unwieldy, it’s important to realize that over two-thirds of invested dollars are still in actively managed funds. Until the large fund companies learn some new tricks, reports like the latest S&P Dow Jones Indices Annual SPIVA US Year-End Scorecard will continue to deliver grim news, and that’s not what any actively managed portfolio investor wants to hear. 

As always I look forward to your thoughts and comments. 

Disclosure: None

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[1] The actual report can be found here: https://bit.ly/2XZ8VVO. I highly recommend all investors read this report. The numbers provide real clarity on the chances of beating a generic index. Data like these – with years of outstanding insights – can provide investment managers and individual investors untainted information on the chances of outperforming their respective index. Such information can bring hard but necessary reality to investors of all stripes.  

“A man always has two reasons for doing anything: a good reason and the real reason.”
                                                                           
​                                                                                            -      J.P. Morgan 

‘I asked the investor why he was withdrawing from the fund and he said he thought we were stupid. When I pointed out that our long term-term track record was superb, he said ‘I can take you lookin’ smart for years, but when you look stupid, that don’t look or feel good no matter how smart you might be’”.
                                                                                           -     An Anonymous Fund Manager  
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Over the course of my investment career, I’ve often run my portfolios slightly different than the rest of the financial services industry. With the blessings, investors in my old firm did well over time (though I must by conscience and law state that past returns do not guarantee future results). It wasn’t all peaches and cream though. There were times that my corporate investors and employees questioned not only my intelligence but sometimes even my sanity. It’s easy to look stupid in the investment world. That being said, I would argue there is distinct line between looking stupid and acting stupid, but they can look awfully similar at times. 
 
Most Wall street fund managers prefer not to look stupid in their own right. Given the choice, billions of dollars will be allowed to run like lemmings right off a cliff without a whiff of remorse – as long as they go as a crowd. It isn’t just publicly traded companies and their investment management owners. Private equity acts in a similar fashion. One year all the rage will be dental supply companies, then lab testing facilities, followed by auto supply parts dealers. Like the thundering herds of buffalo of old, investment money and its managers can rarely be blamed for moving in such an enormous mass.
 
This herd mentality combined with the growth of index or passive investing through ETFs had led to an enormous amount of closet indexing. This means an investment manager might have a portfolio with a 97% match to some index such as the S&P500 or Russell 2000 guaranteeing they never lose (or gain) more than the 3% of the index yet charge 1.25% for the privilege of doing so. It has a very poor track record of making investors rich, but making money managers quite wealthy in their own right. Where are the customers yachts indeed?     
 
In 2007, my portfolio at Nintai Partners had become vastly different in make-up than most anything else on Wall Street. Roughly 35% of my total assets were in cash. Not short-term bond funds. Not even short-term US Treasuries, but cold hard cash sitting in our corporate checking and savings accounts.  (My current portfolios at Nintai Investments LLC aren’t much different as of March 2018 ranging from 20-30% in cash as a percent of AUM) At the time, many people – including active money managers, corporate directors, and my fellow employees/investors thought I was looking quite silly for arguing there simply no places to safely employ our capital. The economy seemed to be moving from strength to strength, the VIX was at all-time lows, and we seemed to have put the technology bubble well and far behind us.
 
Unfortunately, the line between looking stupid and acting stupid can be crossed without ever recognizing what happened along the way. A rather unfortunate example of this has been Bruce Berkowitz’s Fairholme Fund (FAIRX). I should be upfront that this look at Mr. Berkowitz’s isn’t an attack or judgment on his process. He’s proven many times over that fortune favors the bold. I tip my hat to Fairholme and Berkowitz for not giving up on a process that has worked 30 years. Indeed, in 2010 Berkowitz was awarded Morningstar’s manager of the decade 2000-2010. 
 
All that said, the Fairholme Fund has absolutely devastated its long-term return history over the past decade with huge bets in Sears Holding (filed for Chapter 11 bankruptcy protection in October 2018), St. Joes Holdings (Berkowitz serves as Chairman of the Board and the stock has returned -8.2% annually since for the past 10 years), and Imperial Metals III (-35.7% annualized return since 2013). These returns have produced an underperformance of the S&P500 by -7.8% over the last 10 years and -14.6% over the past 5 years. During his successful run many claimed Berkowitz looked stupid (but nobody laughed from 2000-2010), but many more feel today he has acted stupidly. The answer? Who knows. Stupidity – much like beauty – is in the eyes of the beholder. 
 
Why This Matters
 
The concept of looking stupid can play a huge role in an individual or institutional investor’s thinking and application of their investment process. For someone like Bruce Berkowitz, it means very little – his confidence in his process has been honed over 30 years – and allows him to continue to choose and hold investments regardless of how others perceive his abilities (It should be noted he’s had significant redemptions combined with the aforementioned losses).
 
Looking Stupid versus Acting Stupid: Internal versus External Thinking
One of the distinctions I think that exists between looking and acting stupid are based on internal versus external perceptions. For instance, the act of looking stupid is generated nearly entirely by outside views of your actions – meaning your investors (if you are a money manager) and other investors think you are stupid. I find it rare when individuals themselves think they are stupid. The assumption is that most investors who think that way about themselves would find a new line of work or suddenly become tremendously excited about index funds. 
 
Looking Stupid versus Acting Stupid: System 1 vs System 2 Thinking
I have found that most of the time acting stupid is generated internally by bad thinking – generally letting what Danny Kanhemann calls System 1 thinking overriding the individual’s System 2 thinking. A classic example would be selling a stock simply because it dropped 30% (System 1 thinking) versus ascertaining why it dropped and what its current worth is at the time (System 2 thinking). This type of behavior could be classified as acting stupid, not looking stupid (though it may be both).
 
So what’s an investor to do? How do you know you are simply looking stupid and not acting stupid?  I might suggest there are several things to implement in your investment process to help discern between the two.

1. Develop and Stick With Your Process: Much like any other professions, if you have a process that has achieved success then stick with it. As the saying goes, dance with the one that brought you. Over 25 – 30 years, most investors have gone through several business cycles that tests whether their investment process is viable. Having others call you stupid is one thing, but feeling that you are acting stupid means you’ve lost confidence in your process. This rarely leads to positive outcomes.
2. Patience, Patience, Patience: Every investment process – growth versus value, small-cap versus large-cap will have its good and bad years. The key is avoiding emotional decision-making or being placed in situations where your decision making is forced outside of your process. If you’ve been previously successful, have the confidence to wait out the markets and let your process work for you.  
3. Be Your Own Palm Tree: Strong But Flexible: If you are relatively new to the investment world, I always suggest investors develop their own investment process (or mimic one) but be flexible enough to learn from their mistakes and tweak the system as they go along. Think of this as a pre-cursor to recommendation numbers 1 and 2. But don’t mistake: no investment dog is too old to learn new tricks.

 
Conclusions
 
On March 11 2019 - after 4 months of in-depth research including reviewing financials, talking to management, customers, thought-leaders, and competitors - I decided to purchase F5 Networks (FFIV) back into my individually managed portfolios. I had sold it over a year ago after its price reached over 155% of my estimated intrinsic value at the time. A drop in price combined with a substantial increase in my estimated valuation brought the stock back into but territory. All of this followed my process that has worked for me over 20 years. On Tuesday, March 12 2019 – the day after purchasing shares – the stock dropped 12%. I can’t think of a better example of looking stupid. But did I act stupid? Time will tell but certainly the drop in price (and its associated news) – had zero impact on my estimated intrinsic value. By sticking with my process and being patient, I feel confident I will avoid acting stupid.
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: I hold F5 Networks (FFIV) in several investment accounts I personally manage.