"The strategy of buying what's in favor is a fool's errand, ensuring long-term underperformance. Only by standing against the prevailing winds - selectively, but resolutely - can an investor prosper over time. But for a while, a value investor typically underperforms."
 
                                                                                              -     Seth Klarman 

I recently read an article ("Investing When Everything is Expensive") by John Rekenthaler, Vice President of Research at Morningstar[1]. He discusses why it might be necessary to rethink the concept of "core" and "explore." The former is plain old generic stuff such as blue-chip US/foreign equities and high-quality debt. The latter are investments that might seem more risky but likely to outperform over the investor's lifetime. For me, the article resonated because Nintai has found itself looking like one of those dogs trying to find just the right spot for their morning business. We all know the look - nose to the ground, running in circles, revisiting spots they just investigated a minute before. When every asset class is inflated in price - core or explore, bond or stocks, domestic or foreign, wide moat or no moat - we find ourselves trotting around, looking at every class for some obscure gem of an investment. We got into investing in 2003-2004, so Nintai missed that period in 1999-2000 when many stocks were egregiously overpriced. But even then, many bargains were to be had in non-"e” or technology such as manufacturing or utilities. In today's market, every asset class we play in is overvalued. We don't see any screaming bargains in our investment horizon. 
 
What makes this particularly painful is that our investment partner portfolios have underperformed over the past twelve to eighteen months as we hold significant cash positions, and our portfolio stocks have been hit hard after nearly a decade of outperformance. Nothing is more frustrating and stomach-churning than underperforming and knowing there is little you can do about it. "These are the times that try men's souls," said Thomas Paine. Mr. Paine had the heart of a value investor experiencing a sustained bull market. 
 
A Quick Review on Strategy 
 
Before I get into why it is so challenging to be a value investor in expensive markets, I thought I'd quickly review our investment methodology here at Nintai and how it relates to our actions in these overpriced times.
 
Focused Portfolios: At Nintai, we operate in a relatively simple format of being invested or not. We run a focused portfolio (anywhere between 15 - 25 positions dependent on size or investment need. As I've discussed previously, we focus on companies with high returns on assets/capital/earnings, fortress-like balance sheets, deep competitive moats, and managed by great capital allocators. After running a search with such criteria, there are generally only 150-175 companies worldwide the meet our demands. By its very nature, our investment strategy forces us to focus on just a few holdings and to hold them for the long term. 
 
We Hedge with Cash: We use a simple model when it comes to investing. We are invested in our focused portfolio holdings, or we hold cash. We aren't limited to any particular model in our investment management agreements. We could use actively managed funds, ETFs, or even individual debt instruments as hedging tools. I don't do this for the simple reason our partners invest with us to use Nintai's strategy – not for me to use a competitor's model. Consequently, when no opportunities arise with Nintai's strategy, I will hold cash. This can sometimes drive cash to 30-35% of total assets under management. 
 
Valuation Drives Portfolio Holding Make-Up: How much we hold in equities or cash is driven solely by valuation. By this, I mean that we use two distinct valuation measures – one individual and one broad. The first is the valuation of each holding. If we think the valuation of a specific stock is compelling, we will likely add to the position, thereby necessarily driving down the portfolio's cash position. The second (and somewhat in congruence with the first point) is that I will likely hold more cash if I feel the markets – as an aggregate - are overpriced. Conversely, if I think markets have gotten far ahead of themselves (an example might be our aggregate portfolio is 125% above our estimated intrinsic value), I will sometimes shave 5% off every individual portfolio position.

Where We Stand Today
 
As of November 29, 2021, the S&P 500 stands at 4668, up roughly 22% year-to-date and roughly doubled over the past five years. Morningstar currently has its total rated stock universe approximately 4% above fair value. It calculates that the healthcare and financial sectors (by far Nintai's majority of holdings are in these two sectors) are 6% and 10% above intrinsic value, respectively. Other indicators reflect a much higher valuation versus historical data. For instance, the Schiller PE ratio has only been higher once before in the late-1990s before the technology bubble and crash. From the old-fashioned PE ratio to the newer PEG ratio, nearly every historical measure is at all-time highs. Fighting this trend, the current Nintai holdings are trading – in aggregate – roughly 11% below our estimated intrinsic value. The aggregate PE ratio of most portfolios is less than half the S&P 500s. At the same time, returns on equity, capital, and assets are substantially higher than the market averages. 
 
Nintai has been down this path before when we thought markets were wildly expensive. Our last experience was during 2006 – 2007, just before the real estate crash and the ensuing global credit crisis. For almost the entire year of 2006, the Nintai Partners fund held nearly 45% of total assets in cash. We avoided corporate and government debt as fervently as equities. As a result, we could find little value in domestic or foreign markets, debt, or equities. In the ensuing market crash, we significantly outperformed the markets after trailing for several years of slight underperformance. Indeed, much of our long-term outperformance was generated in the single year of 2007 when we beat the S&P 500 by nearly 30%. 
  
We are currently looking for ways to batten down the hatches but not get left behind by the S&P 500's double-digit annual returns. This is the rub, of course. You must attempt to prevent a permanent loss of capital in a sudden market crash but at the same time stay as invested as possible to allow compounding to work its magic. As we take the necessary steps to obtain that balance, we try to focus on several core tenets.  
 
To thine own self be true (your process is your guide)
Generally, value investors underperform in prolonged bull markets. It can seem that every decision you make has the markets go against them. Stocks that you purchase drop by another 30% over the first few weeks. Even companies that present shining earnings quarter after quarter can stagnate and underperform for years at a time. No matter how much you hear about the latest nanotechnology, day trading with options, or how value investing is dead, your process must always be the anchor in your decision-making. Your process must be your guide. As a value investor, your methodology rests on the simple premise that a company's share price will inevitably be matched by its intrinsic value. It can take years for the markets to reach these same conclusions, and to date, they usually do so. Hold on to that fact dearly. 
 
This ain't no fantasy football (valuations are only reasonable when based in reality)
One of the problems with expensive markets is the growing ability of Wall Street, investment advisors, and personal investors to convince themselves that prices really aren't that bad. That 55% projected growth rate over the next decade might just be reasonable if you hold your nose and believe in management's claims. Never, ever do this. Your job as a value investor is to question everything in your investment case - including claims by management and your assumptions for valuation. Every investment debacle I've had (and there have been quite a few) has been caused by my inability to force some form of brutal reality into my assumptions.    
 
Just because the market is crazy doesn't mean you should be too 
A corollary to the previous point can be summed up by that phrase so many of us heard from our parents. "You wouldn't jump off the bridge because everyone else is doing it, would you?". We would frequently answer that; of course, we wouldn't do something so ridiculous. If you wouldn't do it as an eighteen-year-old, why do it as a seasoned value investor? Of course, the pressure is intense when talking heads slam buttons that scream "Buy! Buy! Buy!" or you read how some new prodigy achieved 94% returns on only ONE stock that he's more than happy to share with you for only just $499 right now!  Just because networks allow this type of behavior on their shows doesn't mean you need to listen. Base your decisions on a well-reasoned and well-researched process that meets your goals. Anything else looks like a lemming running at top speed with all its friends and relatives, and we know how that ends.   
 
Conclusions
 
Investing in expensive markets can be costly in more than one way. Elevated prices supported by nearly a decade of steady gains can make you want to overpay for a stock that looks so good on quick review. It looks even better when you hear about it at the staff Christmas party or your New Year's party with your neighbors. You can frequently hear them talking about how 
 
their outstanding stock-picking abilities paid for that BMW or pool. Don't believe it for a moment. Most gains in the market are made by purchasing shares at a reasonable price and selling them when overvalued. That's value investing. Buying expensive stocks and selling them after they become more expensive (hopefully) is a process dependent on the greater fool. When stocks are trading at such all-time highs and nosebleed valuations, it's hard to know who's the real fool. Be careful. It might just be you.
 
As always, I look forward to your thoughts and comments. 
 
DISCLOSURE: I have no positions in any stocks mentioned in this article.


[1] John is a brilliant writer with the rare attribute of being able to see the investment process from many different angles and disciplines. I highly encourage my readers to go to Morningstar and become regular readers of John’s “Rekenthaler Report”. You can find his writing here.  

"The first thing [in credit] is character, before money or anything else. Money cannot buy it. A man I do not trust could not get money from me on all the bonds in Christendom. I think that is the fundamental basis of business".
                                                                -   J.P. Morgan in testimony to the Pujo Committee, 1912
 
"Nobody who has run a business thinks 'Geez, I'd like to run this thing right into the ground, make the business so worthless that some could buy it pennies on the dollar.' No, most managers want to make the most prudent decisions to maximize the value of the company. Being a good manager isn't the best training at being a value manager". 
                                                                -  Joel Alscot   

When I first began investing (and this takes me back nearly 40 years ago) in an economics class, I saw stocks simply as a symbol in the financial section of our local newspaper. How quaint. An actual physical newspaper. My understanding of management was absolutely nil. That changed after I graduated from college, and several friends and I started a company together. I knew nothing about running a business or my relationship with shareholders (shareholders?) vis a vis being a senior executive. I got an education very quickly, starting with my first Board meeting. I quickly learned several lessons that were pounded into me by several members. 
 
It's all about allocation of capital: My job - I quickly learned - was to make decisions on allocating capital and achieving the best return I could for the company, and therefore, for our shareholders. Nothing was more essential, and nearly every major decision we made was part of this allocation process – human resources, deal structures, infrastructure spending, etc. By the end of the first year, I was thinking like a capital allocation machine. 
 
Honesty is still the best policy: My Board expected me to report the good and the bad clearly and succinctly without any gobbly-gook or hiding the facts. If we made a mistake, it was best to describe what happened and how we expected to prevent it from happening again. Our Board made it very clear: the worst thing we could do was make a mistake and hide it. When we did this we prevented them from assisting us in finding a solution. 
 
First principles thinking is the best thinking: The Chairman of our Board was a huge proponent of reasoning by first principles. This is a form of reverse-engineering a problem by removing the fuzziness and vagueness of assumptions and focusing on the essentials. Rather than assuming something works because others (our ourselves) have always done it in a particular way, you can go to the most basic level and assemble the building blocks based on facts. Many times you find assumptions can lead you far astray. 
 
After our fourth year in business, our company began an internal fund to invest our retained earnings and increase the book value of our shares. I quickly realized the views I had learned and adopted as an executive were the same values I wanted to see in companies that became our investments. I still think they are the best core values to find companies that will outperform over the long term. Here are a few examples of how I applied my learning in portfolio selection.
 
Allocation of Capital
 
When I first had a conversation with the senior management team of FactSet Research (FDS) in the 2000s, I was struck immediately by their focus on capital allocation. One executive said to me:
 
"We have a lot of choices in what we can do with our capital. We are an asset-light business, meaning it doesn't require a lot of assets to run our business, we are a relatively non-capital intensive business model. It could be easy for us to go out and do a zillion smaller acquisitions or one huge acquisition or buy a new technology for our operating platform. But you know what? We've run the numbers over and over. Frankly, we can achieve the best returns on capital by incrementally spending the money on our business and retaining capital on the balance sheet. Would it be sexy to do a huge deal? Sure! But it wouldn't be our shareholders who win. It would be investment bankers, accountants, and those of us in senior management. We try to remember every day we work for our shareholders. Return on capital means return to shareholders."  
 
From 2006 - 2020, FactSet achieved an average Return in Invested Capital (ROIC) of 34.6% versus an Average Weighted Cost of Capital (WACC) of 8.3% (source: Gurufocus). Over that fifteen-year time frame, WACC never exceeds ROIC in a single year. Now that's discipline in capital allocation.
 
Honesty and Integrity 
 
You get the feeling watching the news today that not many managers are a paragon of virtue. Stories of embezzlement, failure to pay vendors, gaming the numbers to meet earnings - the list goes on and on. At Nintai, the older we get, the more critical management becomes in the outperformance of our portfolio holdings. Negative things generally happen when good companies are taken over by bad managers (to paraphrase Warren Buffett). Some of the worst things happen when managers turn out to be untruthful or lack integrity. We haven't seen many companies implode when competent and ethical managers run them. Conversely, the investment journey is littered with companies led down the garden path by unscrupulous management. 
 
In 2019, we sold a biotechnology company out of our investment partner portfolios, the Nintai Trust portfolio, and my personal portfolio. The company was accused of overcharging the Center for Medicare/Medicaid Services (CMS) for its products. It's an all too common technique in the industry that provides a quick, highly profitable, (and illegal) manner for juicing revenue at no additional costs. The problem I've always had with this is two-fold. First, these types of issues always start at the top. You simply can't create an entirely 
 
fictional billing process along with a new revenue stream that impacts corporate revenue without senior executives' knowledge. Second, managers who believe these types of lies begin to push the envelope in other ways, such as off-label marketing and even fabricated research results. Executives willing to put patient lives at risk and overcharge those least capable of paying are some of the worst individuals I've been involved with and have happily cut all ties. 
 
First Principle Thinking
 
Applying first principle thinking isn't always a natural approach to problem-solving. In my case, it took years of note-taking and reminders to make the process a fundamental step in making decisions.  
 
A Lesson in Debt: While running my business (which I still do at Nintai Investments with only three shareholders), I quickly learned that debt could be a double-edged sword for the business. While it can provide opportunities to invest in growth, all too often, debt can be an albatross around the neck when times get hard. We've all heard the phrase "you can't go bankrupt without debt." First principle thinking allows us to break this down into different pieces. First, without debt, you can't go bankrupt. Second, debt can’t be serviced at the worst time. Third, companies often generate low returns on debt financing. Ergo, it's hard to get in trouble without debt. Consequently, in my history as a money manager, roughly 75-80% of my portfolio holdings have (or had) zero short- or long-term debt. 
 
A Lesson in Costs: When I talked to the former CEO of Fastenal (FAST) – a past holding in the Nintai portfolios – he frequently would tell me about how excited he was to obtain low costs, not just in his business, but even his personal life. Low costs were a passion for him and a sign of personal integrity. For example, he said to me once:
 
"What most people fail to understand is that to have low prices, you have to have low costs. I know that sounds crazy, but you'd be amazed by the examples I've seen where management thinks the company should have low costs, but management shouldn’t. Take a look at their corporate offices, their expense accounts, the flashy clothes. Rot starts at the head of the fish. If you want low prices, then low costs start at the very top – with the Board and the executives." 
 
His application of first principles came intuitively to him. Query: how do you achieve low costs and high returns to shareholders and customers? Answer: Have the lowest costs. It might not seem like rocket science, but frankly, I haven't found many other executives like him nor holdings as successful as Fastenal. 
 
What This All Means
 
So what does all this mean? Focusing on the lessons I learned from running my own business (both in the past and present) helped me to understand the type of company I'm looking to create and run is the type of company I would like to add to my portfolio. Several themes emerge from that.  
 
They're human beings, not robots
 
We often hear the comment that when you invest, you buy a piece of a business, not a stock share. That rule is equally valid when it comes to an investment's management. You are purchasing the qualities of a set of human beings, not a computer named Hal that runs the ship. First and foremost, managers are people just like you and me, filled with emotions like fear and joy or uncertainty and egoism. They have good days and bad days. What is necessary before anything else is that we are aware we are purchasing the rights to a human management team that reflects their emotions, skills, and values. These values will hopefully provide shareholders with adequate returns over the long term. Of course, as an investor, we expect management will make mistakes. That's part of being human. We just need to be made aware of them – quickly and openly – and plan accordingly. 
 
Values still matter
 
No matter what you may hear on the TV or read on the internet, at Nintai, we like to think that values still matter and good guys (and women) still finish first most of the time. Those that cut corners, fudge numbers to meet aggressive quarterly earnings, or create neat little off-balance sheet SIVs will eventually be hung up by their own petard. None of those scenarios are good for shareholders. Equally important is the way management communicates with shareholders. At Nintai, we like to invest in management who see us as business partners. Therefore, we want management to communicate with us in an honest and open approach helping to make the best investment decisions. When mistakes are made (see the previous point), we like our portfolio holdings' management to own up to them, explain what went wrong, and hear how they intend to prevent a repeat in the future. Bottom line: integrity still matters a lot. 
 
It's easy to forget what matters
 
I've noticed over the years our willingness to let unacceptable cases slide in some cases and not in others. It's important to realize that "it's OK because everybody does it" is just as dangerous as a case of apparent specific personal misconduct. Let me give you an example of what I mean.
 
Case 1: You read an article about a Wall Street financier who knowingly bundled together bad debt (voila! Let there be good debt) and created fictional debt instruments to be sold to unknowing investors. These instruments lead to the creation of a financial bubble that costs thousands of jobs and billions in dollars of losses. 
 
Case 2: A co-worker comes to you and asks for money to help fund a family member fighting cancer. After writing a check for $500, you find out the story was a lie, and there was no family member and no cancer. Instead, they used that money to finance a vacation to Bali. 
 
Now answer these questions as quickly and honestly as possible. 
 

1. Which case made you angrier at a purely emotional level?
2. Which individual would you least likely do business with in the future?

 
If we are being honest, just about everybody has a far more visceral reaction to the second case versus the first case. But as an investor, it's vitally important to see both as clear-cut cases to reject both individuals in a potential investment. Just because everybody is doing it (think about how widespread the problem was in the first case) doesn't make it right. On the other hand, the lack of individualized anger (such as case 2) also doesn't mean it's OK to ignore it. Have your standards and stick by them no matter the scope or size.
 
Conclusions
 
Another J.P. Morgan story relates that he thought someone failing to pay back five dollars told him more about somebody than not paying back five million dollars. Over time I've realized that genuinely great managers who produce outstanding long-term results have ethics that consider the small ($5) or very personal (the cancer scam) value just as much as driving overall corporate values. They all matter equally. Look for managers who, through their values, create value in your investments. It isn't easy. Doing the right thing isn't always the easiest path. But it is one we admire greatly at Nintai.  
 
As always, I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai has no positions in the companies mentioned within this article. 

“Ambiguity is central to Boyd’s vision. It is not something to be feared but something that is a given . . . We never have complete and perfect information. The best way to succeed is to revel in ambiguity.” 
 
                                                                              -      Grant Hammond[1] 

In 1961, Colonel John Boyd – working with Thomas Christie – wrote an article named “Aerial Attack Study.” Boyd trained as a fighter pilot, but his mind quickly developed beyond the cockpit. Aerial Attack Study introduced the military to the concept of “Energy-Maneuverability Theory” (E-MT). Boyd’s and Christie’s work was vital in understanding the various tradeoffs when working on aircraft design. E-MT was a breakthrough of immense value because it gave engineers a process to calculate how any design can be superior or inferior when measured against another. E-MT analyzed how swiftly and efficiently an aircraft could change its energy use, speed, and acceleration or potential versus kinetic energy. This analysis could then be converted to a numerical value of how well a plane maneuvers under various conditions. This process enabled fighter pilots to “converse” with engineers in their language by describing dogfighting jargon in mathematical terms. E-MT had a significant impact in creating the leading fighter aircraft over the next generation, including the F-15 Eagle and F-16 Fighting Falcon.  
 
Boyd’s next project brought him even greater fame – in terms of both name recognition and scope of impact. It also is where his thinking can best be applied to value investing theory and practice. Thinking at a higher level than his E-MT work, Boyd began analyzing what systems could be put in place to improve a fighter pilot’s speed/effectiveness in thinking processes and decision-making skills. From this, he developed the OODA  (Observation, Orientation, Decision, and Act) Loop. 
 
The OODA Loop begins by making two assumptions. First, Boyd contends that all intelligent life and human-developed organizations continuously interact with their respective operating environment. Second, all of these interactions can be broken into four major groups or functions. 

1. Observe: The utilization of all major senses in the collection of data. Boyd made it clear that data was a snapshot of what was happening within a complex environment at any one time. Observation information becomes obsolete relatively quickly. Therefore, observation requires constantly updating your data. 
2. Orient: After collecting data through observation, comes the synthesis and analysis of the data. The orientation phase is about reflecting on the critical data captured during observation and considering the next steps. Above-average orientation skills require great situational awareness and a process that uses multiple mental models. Boyd saw this as the most essential function.
3. Decide: The decision phase develops a series of suggestions taking into account all potential outcomes. A key component in the decision process is creating a strategy that screens out extraneous inputs and allows management or the individual to focus on the best possible choices, not all choices. 
4. Act: The steps and actions necessary to carry out the decision. In Boyd’s final presentation on the OODA Loop, he placed “Test” directly next to “Act” (this was changed to “Unfolding Interaction with Environment” and “Feedback” in his later presentations). In doing so, he clarified that he saw the Loop not just as a decision-making process but as an individual or organization-learning process. Thus, not only should we be constantly updating inputs, but we should constantly test our mental models throughout the Loop. 

Source:    “Science, Strategy and War,” Frans P.B. Osinga, Routledge Press, December 2006 
                  “The Tao of Boyd: How to Master the OODA Loop,” AoM, November 2020
 
After developing the OODA Loop, Boyd developed several thoughts about its effectiveness and some caveats in its usage.

1. The OODA Loop is a means to operating in a complex environment. Multiple inputs are constantly changing. The faster someone can obtain inputs, the quicker someone can produce decisions.
2. The OODA loop is only as effective as the time it takes to execute a result.
3. The person or organization that completes multiple OODA loops first derives the most value. 
4. The person or organization that adapts/updates their observation and mental models quickest, thereby evolving their OODA Loop, derives the most value. 
5. Limiting extraneous factors that can needlessly slow down getting to decision and action phases can significantly impact. 

 
The OODA Loop and Value Investing
 
So what does all of this have to do with value investing? At their highest level, the description of the OODA Loop and value investing share many common attributes. For instance, the OODA Loop has been described as “a learning system, a method for dealing with uncertainty, and a strategy for winning head-to-head contests and competitions. Another description is “the OODA Loop is a means to a.) observing complex organisms, whether they be an enemy pilot or a competitive corporate threat, b.) developing possible counter-measures through situation awareness and mental models, and c.) acting on such chosen measures.” 
 
Compare that with the following description of value investing as “a trading process based on uncertainty and risk in which a.) an investor looks to identify a discrepancy between price and value identified by b.) observation of corporate data and ecosystem characteristics and c.) observable investor behavior that leads to d.) a decision to allocate capital in the security.” At Nintai, we believe the major steps in value investing consist of these steps. 

• The investor sets specific criteria by which they search for possible investments. This can be by financial, capital return, industry, or country/region. As value investors, we are constantly updating both corporate and market information. Therefore, what may not meet our criteria one week might be ringing alarm bells just one week later. Similar to OODA Loop, “Observe.”
• Research is conducted through which estimated growth, profitability, market size, regulatory issues are identified and quantified. Information can be specific to a certain date (such as the balance sheet), a defined period (one-quarter, one calendar year, year-to-date, five-year average). A series of mental models will develop cross-functional ways to observe historical, current, and future value trends. Similar to OODA Loop “Orient.”
• Research ascertains the estimated intrinsic value of the company shares and matches it against its current trading price, and develops a series of possible recommendations. These might be to purchase at a specific strike price, buy increasing shares at share prices further decrease in price, sell a position when certain conditions are met (such as the holding taking on debt), or sell on specific market conditions (a competitor successfully launches a new FDA-approved drug). Similar to OODA Loop, “Decide.”
• When certain conditions are met (% discount from estimated intrinsic value) and reasonable suggested actions are offered (purchasing X number of shares representing only 30% of one day’s total trading volume), then action should place. Following up on these actions, we will spend a considerable amount of time evaluating the success or failure of the process. Similar to OODA Loop “Act.”

 
If this sounds similar to the OODA Loop, it should. Long-term successful value investors are constantly reevaluating not just their holdings (including management performance, product development, competition, market factors, etc.) but their very selection process (what factors are most important? How do we gather and collect data? How do we evaluate trends in the data, etc.?). At Nintai, we see the investment process must be continually reviewed and adapted to the ever-changing investment universe.
 
The Importance of Orientation
 
John Boyd felt the most important of the four steps in the OODA Loop was orientation. In one of his presentations, he stated: 
 
“Orientation isn’t just a state you’re in; it’s a process. You’re always orienting.”
 
As I pointed out in the last section, Nintai sees the process of orienting our thinking as a never-ending process. This is perhaps the greatest symmetry between Boyd’s work and value investing. One of the failings in nearly every value investor (this author included) is constantly failing to update our orientation. Too often, we get stuck in a pattern of thinking which locks us into a particular model or pattern of assumptions. For value investors, this can be costly. For fighter pilots, it can be fatal.
 
One method that Boyd suggests using is applying a set of mental models regularly until they become second nature in your thinking process. Boyd lists seven disciplines that are a must for any strategist. These include:

1. Mathematical Logic
2. Physics
3. Thermodynamics
4. Biology
5. Psychology
6. Anthropology
7. Conflict Resolution (Game Theory)

 
These models are essential for any person or organization to orient themselves in their environment. Understanding these disciplines allows an individual to see their position from many disparate and unique viewpoints. In addition, constant orientation leads to the ability to act quickly and – most importantly – with the best chance of obtaining outstanding results from your decision-making. 
 
Again, this sounds remarkably similar to Charlie Munger’s concept of a “Latticework of Mental Models,” which he believes creates a powerful method of objective – and evolving – thinking. Thus, while Charlie’s disciplines[1] may differ somewhat from Boyd’s, the concepts meld pretty easily. 
 
Conclusions
 
One thing that has always interested me in value investing is the constant need to acquire knowledge. Whether improving or altering my thought processes to the knowledge of a specific industry or market verticals, roughly 80-85% of my day is spent thinking and researching. Does this mean we get everything right? Absolutely not. But it does mean that Nintai can hopefully gain the ever-so-slight edge over the marketplace, which allows for long-term outperformance. Investors can continually adapt their thinking and investment processes by studying such works as Boyd’s. The history of business – and nations – are replete with organizations that got caught in a cycle of actions that never considered changes in their operating environment. As a value investor, the OODA Loop can be a helpful tool to evolve your thinking from valuing a business to understanding changes in specific industry verticals. Next month I will use a specific case study that discusses how Nintai uses Boyd’s work in understanding changes within a specific portfolio holding.   
 
Until then, I look forward to your thoughts or comments.
 

[1] Math and Inversion, Probability, Chemistry, Statistics, Economics, Evolutionary Biology, Psychology, and Engineering 

I recently discussed Nintai's performance numbers with a group of analysts who wanted to know the secret sauce that generates long-term outperformance. Many of the questions centered on our stock-picking ability, market timing, and ability to identify business trends leading to outstanding growth. I made it pretty clear the evidence suggests there aren't many individuals who can repeatedly pick stocks that outperform (certainly we can't!), there are even fewer who can choose the highs and lows of markets (definitely not Nintai!), nor do we have a business divining rod that identifies the next hot "it" thing in the markets (we are so far from what's hot in business, I'm not sure we would know "hot" if it hit us in the nose). At Nintai, we think the more active we are, the less effective we will be in the long term. Unfortunately, our circles of competence are limited, and our crystal balls are pretty fuzzy. So instead, I told this group of analysts that our success had been driven by finding several compounding machines throughout my investing career and riding them for as long as possible.
 
What exactly is a "Compounding Machine"?
 
Compounding machines are simply companies that consistently grow free cash flow at substantial rates over a decade or two creating long-term value. This can be achieved through competitive advantages gained through internal and externally-facing moats. Additionally, these companies often generate high returns on capital and maintain fortress-like balance sheets. These attributes drive steady growth in the intrinsic value of the business. When I describe it like that, it seems like a pretty straightforward process. You simply have to find these types of companies, back up the truck, purchase a significant number of shares, and merely wait ten to twenty years as management and the company work their magic. What an easy world value investing would be if it was so simple. But, of course, we all know it doesn't work quite like that.  
 
Finding compounding machines requires several major buckets of data. Some are easier to find, while others are more difficult. Overall, it requires a significant effort to create a process, identify opportunities, research candidates, and track holdings. The primary information and process requirements can include the following. 
 
Quantifiable Data
 
In some ways, this is the easiest part of the process. A single search query can identify some (but certainly not all!) compounding machines on a search platform such as Gurufocus' All-in-One Screener. Search criteria might include the following.
 
Return on Equity (10 Year Average) > 15%
Return on Assets (10 Year Average) > 15%
Return on Capital (10 Year Average) > 15%
Free Cash Flow Margins (10 Year Average) > 25%
Free Cash Flow Growth (10 Year Average) > 10%
Debt/Equity Ratio (1, 3, 5, and 10 Year) < or = 0
 
This search on Gurufocus will likely generate less than 100 companies, and we haven't even begun to screen on valuation. An investor could probably do fine simply by investing in a broad bucket of such companies trading near their 52-week lows.
 
Non-Quantifiable Data
 
A simple query in a database can't discover some characteristics. While such searches can sometimes be good starting places, many compounding machines can only be found through the hard work achieved by rolling up the sleeves and better understanding specific industries or verticals. This includes a lot of time researching individual companies, their operations, competitors, product development, regulatory challenges, etc. In the course of this research, an investor should be looking for four broad themes.

Outstanding Capital Allocation
This is a multi-faceted attribute. It includes management that can identify great capital investment opportunities. It also requires management to say no to opportunities that might not reflect their core competence or provide adequate margins. Finally, it includes creating a business that operates in an environment where opportunities exist for allocating capital in existing business lines that can generate long-term runways for growth. 

Deep and Wide Inward/Outward-Looking Moats
In last month's presentation to the Gurufocus's "Value Investing Live" series, I discussed in depth the idea of inward and outward-looking moats. In summary, outward-facing moats keep competitors at bay through a series of strategic and operational advantages.  Inward-facing moats keep customers locked in by having products or services essential to their customer's business model, strategy, and operations. Capital compounders must have strengths in both of these, not just one.  

Expanding Market Opportunities   
This, too, is multi-faceted in that opportunities must be both in existing customers (by selling deeper into the organization) and new customers in either existing markets or new markets (this can be demographically and functionally). Compounding machines are generally strong in both of these but lean towards the former (broadening existing bases) and aim for the latter. Most avoid costly acquisitions as a means to growing market share or revenue. 

Self-Fund Growth with Existing Internal Capital
​Compounding machines tend to require very little capital to achieve growth. Because of this, nearly all new opportunities can be funded with either free cash flow or cash on the balance sheet. Most of these companies have extremely strong balance sheets with little or no debt and very high free cash flow margins (meaning the percentage of revenue converted into free cash). With extremely low weighted average cost of capital (WACC), compounding machines can achieve high returns on even lower margin growth. 
 
An Example: Veeva (VEEV)
I have written about Veeva extensively over the last two years (including a recent presentation on Gurufocus' Value Investing Live), so I won't spend a lot of time rehashing previous content. Instead, I wanted to show a graphic that demonstrates the compounding nature of the company. Seen below is a quick overview of the growth in the company's free cash flow, earnings, returns, and valuation. The reader can see strong growth combined with consistent profitability and high returns. In combination, these drive an ever-increasing estimated intrinsic value. 

Nintai estimates growth and returns will be very similar over the next decade or two (with slowing growth rates due to size). Veeva is the very image of a compounding machine. 
 
Conclusions
 
The goal of every value investor - indeed every investor - is to create value over the long term that outperforms the general markets. Compounding machines can play a huge role in achieving those results. Finding companies with wide moats run by great capital allocators in growing markets is the holy grail at Nintai Investments. When we can find a company with these attributes (and the price is right), we will generally invest a substantial portion of our capital in the stock. We will then try to sit quietly and let management do the heavy lifting and perform their wonders. A successful investor once said that it isn't the investment manager that produces excellent returns but rather the management and companies in the portfolio. That individual understood the concept of compounding machines. It would behoove all investors to follow her lead.    

Tom Macpherson presented on Gurufocus' Value Investing Live, a series of presentations and interviews of today's leading value investors. Thank you to the Gurufocus team and members for such a great experience!

"As the hunter-gatherers began to identify certain species of game easiest to kill, humans began to understand that habitation in the areas where these species abounded was just as important. It wasn't just the roebuck that was important, but the habitat where they lived that meant life or death for their clan".
                                                                                  -     Richard Daly 

For value investors, one of the holy grails has been finding companies with wide competitive moats. These are investments with common characteristics – return on capital higher than the cost of capital, high margins, steady revenue/earnings growth, and dominant market share. These companies can be tremendous long-term investment opportunities. As an investor becomes more experienced in research and identifying such companies, it becomes apparent that such investment opportunities are often clumped in industries with a penchant for individual-wide moat investments. Much like our hunter-gatherer ancestors learned, it isn't just the individual investment but the industry/market that can lead to long-term outperformance. This is an ecosystem that creates an environment which - by its very nature - is conducive to deep competitive advantages. There is, of course, no hard and fast rule, but over time at Nintai, we've identified several critical aspects within specific industries that lead to high percentages of investment opportunities. 
 
Asset Light and Capital Light: Generally, industries and their companies that require high capital infusions, are asset-heavy, and have significant organizational needs (such as unfunded pensions for tens of thousands of former employees) and complex infrastructures (large manufacturing plants). They also have lower gross and net margins, lower free cash flow, and significant capital requirements. An example of this is large legacy manufacturing industries on which the great American middle class was created – steel, automobiles, etc. During the mid-20th century, these companies were able to achieve significant competitive advantages against other global competitors. But much like England in the early-20th century, competition in Asia slowly ate into profits and provided much cheaper labor and operating costs. The steel and automobile industry simply couldn't keep up with the demands for expensive pensions, new capital improvements, or new technologies that increased operating efficiencies. That doesn't mean there aren't some gems in such industries. Companies such as Fastenal (FAST) or Graco (GGG) operate in traditional manufacturing yet achieve outstanding results with high return on capital and equity while maintaining extremely low debt margins. 
 
In the last several decades, new industries have developed in the United States – technology, data & informatics, pharmaceuticals, etc. – that don't require significant capital injections, don't use sizeable unionized labor forces, and don't have many assets on the balance sheet. These companies came about in the early 2000s and became known as "asset-light" companies. Even large businesses like Schering-Plough (now Merck & Co.) were famous for shedding assets, moving employees from pensions to 401(k)s, and outsourcing core functions like research and development. These actions completely changed the business model, driving returns on capital and equity higher, increasing gross and net margins, and making these companies look much less like traditional research and manufacturing companies and more a modern marketing healthcare company. Some examples of industries with asset-light models include technology (software, informatics - meaning the integration and usage of data), health care (contract research organizations - CROs), and financial services (credit card processing, asset management)   
 
Ease of Competitive Dominance: In these asset-light industries, the ability to achieve competitive advantages is easier than others. Please note I didn't say they are easy; they are easier than others. These companies are run by focused, driven management teams that make dominance seem easy. But looks can be curiously deceptive. It can be easier to develop a competitive moat because the market conditions, product/service offerings, and raw materials might be subject to easier dominance. For instance, there are very few areas in the automobile industry where a company might capture significant competitive advantages. There is little need or ability to acquire intellectual property rights to lock out competition. The products are generally the same in concept (a four-wheel gas or electric vehicle with certain unique design features) and built/sold in remarkably the same way (internal design teams, multi-stage manufacturing processes, dealer-based sales). For instance, a company will likely achieve a limited dominance in certain demographic or regional areas through branding efforts or marketing messaging. Nowhere in this process is there a means to map out twenty years of market dominance. 
 
Another industry - informatics - is entirely different. The ability to capture market dominance is easier because nearly every product feature is based on intellectual property. For instance, IMS Health (the company merged with Quintiles and renamed IQVIA in 2017) was known for collecting healthcare data, including de-identified pharmacy data, pharmaceutical sales data, medical claims, and other data. The company had a monopoly on prescribing data that they sold to pharmaceuticals, thereby capturing a market essential to guiding pharmaceuticals to market and promote to in their sales teams. No other could provide this data as IMS had exclusivity in its sources. Thousands of companies have access to proprietary data when you think of it, which they repackage and sell to customers. The informatics market is replete with wide moat, small companies which are outstanding investment opportunities.
 
Examples of Small Wide Moat Markets: Some examples of markets can be found in all parts of the economy. Some include financials, healthcare, technology, and others. Nearly all of these are niche markets with similar characteristics – proprietary technology/data and platforms deeply embedded in client operations. The first is financial data. Examples of this include former Nintai holding FactSet Research (FDS), another former Nintai holding Morningstar (MORN), and Bloomberg (privately held). These three companies have growing opportunities in the financial industry with a focus on stock information, trading data, etc. Their proprietary databases and platforms are essential tools, and their platforms are an intricate part of much of the industry's operations. Many companies simply couldn't run without their services. 
 
Another industry is healthcare informatics. Here there are several sub-markets with powerful competitive moats. The first is pharmaceutical prescription data which I discussed previously using IQVIA as an example. A second is the electronic health record (EHR) market. Nearly every hospital utilizes an EHR to coordinate patient care, manage patient records, oversee drug prescribing, and control imaging such as x-rays or MRIs. EHRs are the platform on which nearly every hospital's operations run these days. Making a decision on which vendor to use is not only a multi-million dollar commitment but a decade-long decision that requires years of planning, training, implementation, and maintenance. Once a health system decides on which EHR vendor to work with, it takes something pretty drastic to force them to replace that vendor. Consequently, the EHR market is replete with highly profitable, wide-moat companies.      
 
High Margin Business Models: There are many business models that generate hefty profits even with small margins. An example of this includes the big box retailers, including both general merchandisers like Walmart (WMT) and Target (TGT) and specialty retailers such as Home Depot (HD), Lowes (LOW), or Best Buy (BBY). These companies can create wide moats but generally don't meet the quality standards we look for at Nintai. Using Walmart as an example, let's compare it versus Nintai Investments' holding Masimo (MASI). Walmart's gross, net, and free cash flow margins were 24.8%, 2.4%, and 4.6% in 2020. During the same period, Masimo generated 65.0%, 21.0%, and 16.3%, respectively. Walmart generated a return on invested capital of 8.3%, while Masimo generated a 39.7% ROIC. Walmart's debt to equity ratio (meaning how much debt does the company have as a percentage of its total equity) is 0.78 (short-term debt and capital lease obligation of $5.3B plus long-term debt and capital lease obligations of $60.0B versus total equity of $81.3B). Masimo's debt to equity ratio is 0.02 (no debt and total capital lease obligations of $34M versus total equity of $1.41B)  
 
While both companies have wide moats, Walmart's financial quality is considerably less than Masimo's (at least using Nintai's criteria). Masimo is more profitable, utilizes capital at a much higher rate, and has a fortress-like balance sheet. I should point out either company could be an outstanding or poor investment candidate given certain conditions. Walmart has been an excellent investment over the past 40 years. But given our druthers at Nintai, we'd prefer a company with high margins in a high margin business model than a low margin business in a moderate profit business model.    
 
Product/Services Create Monopolistic Opportunities: One of the things most overlooked in finding quality investment opportunities is seeking out companies that operate in industries where their product or service inherently creates quality and profitability in both good and bad economies. To do this, a company must have a product that is part of their customers' core business by its very nature. This is different than the EHR model I discussed earlier. There the product was deeply embedded in the business process of their customer. Would it be hard to rip the product out and replace it? Absolutely. Could the hospital operate if the systems went down? Surely. With difficulty, but they could certainly still operate. In this category, we look for companies that as the customer utilizes the product, it becomes nearly impossible to function without it.
 
A great example of this is credit cards. Try to imagine going through an average day having only checks and cash (since most credit card issuer networks also issue debit cards, I count them as the same for this exercise). Think of the daily activities where it takes a credit card to complete the transaction. Everything from purchasing gas to shopping at Amazon, renting a car, or staying at a hotel, many consumers would have to change their daily schedule drastically – or eliminate some tasks – if they lost the ability to use a credit card.  
 
Issues to Think About
 
Identifying industries or markets that have high percentages of quality-driven companies is only part of the research necessary. Whenever you find a niche that allows for highly profitable business models, you will likely find competition close on the leader’s heels. Capital flows to business strategies and markets that generate high returns. It makes sense. Success breeds success. Success breeds envy. Envy breeds greed. And greed breeds competition. So when you find that highly successful business model or market, remember to think about the following issues.  
 
Capital Flows to Success: Name any type of business that successfully grew from a startup to an industry heavyweight, and you will find numberless competitors seeking to break into the same market. A great example of this was office supply big-box stores. After the success of Staples, an astounding 131 companies received venture capital or private equity funding over the next half-decade. A company that creates a market niche with high profits will inevitably face an onslaught of new competitors seeking to steal that company's customers or market share. To see this in action, take any six months and follow the investments of the private equity community. You will likely see many investments in one niche market where managers have focused on outsized profits. One quarter might be drug laboratories and the following real estate informatics. Inevitably, profits in those markets drop after such a massive influx of capital.
 
Speed of Innovation/Product Development: Some industries see innovation take place much faster than others. For instance, the automobile industry has been notoriously slow in adopting innovation. The combustion engine has reigned supreme for nearly one hundred years regardless of new technologies that would be far energy efficient. On the other hand, the semiconductor industry has been a continuous struggle to keep up with innovation. Here moats are dug and filled in no time. Finding an industry where innovation widens moats over time is a prescription for long-term outperformance. 
 
Customer Fads: Some industries are prone to customer fads that come and go with remarkable speed. We've all heard of them – Ouija Boards, Game Boys, Beanie Babies, and Rubik's Cubes. These times may temporarily cause stock prices to suddenly soar but are just as likely to drop like a…..pet rock. Certain industries – like consumer electronics – come to mind when you think of industries that suffer from such market fads. If you choose to dip your toes in these waters, just be aware of the strength and depth of the moat. There's a big difference between a game whose name becomes part of our lexicon like Monopoly ("you're spending like it's monopoly money") versus Tickle Me Elmo. 
 
Conclusions
 
The adage goes, "fish where the fish are." No doubt, sound advice if your survival depends on successfully catching fish. Investing is no different. When looking for value-priced quality companies, start looking in industries with a penchant for wide-moat businesses. These markets may be hard to locate initially. Some industries take a great deal of research to find the underlying reasons for their wide moat (pharmaceutical informatics) versus those staring us in the face (pipelines). But once you've found such a sweet spot, spend a good deal of time understanding the industry dynamics and the sources of its moats. Like the hunter-gatherers of old, you might be fishing there for quite a while. 

"Don't worry. We might be losing a penny on each sale, but we can make it up on volume."  
 
                                                                                         -       Anonymous 
 "The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine."
 
                                                                                         -      Warren Buffett 

Revisiting Weighted Average Cost of Capital
 
One of the most interesting stories in the past 18 months has been the lack of discussion about the rapid fall and rise in the US 10-year Treasury yield. It isn't my intention to discuss the reasons for the changes or their meaning for the economy, but rather its simple impact on stock valuation. Such increases and decreases mean that any borrower will see a dramatic effect on their average cost of capital. With rates peaking at roughly 3.1% in October 2018, companies saw the rate drop by approximately 80% over the next 18 months. In less than six months, the 10-year US Treasury rate rose from 0.53% in October 2020 to 1.63% in March 2021. 
 
It's hard to overstate the impact these swings should have on the valuations of publicly traded equities. For those who use a discounted cash flow model (which we do at Nintai investments), a vital component in getting to an estimated intrinsic share value is calculating a company's average cost of capital. In our models, the most significant impact on that calculation is the 10-year Treasury yield. 
 
Before I get into that, a quick overview of United States Treasury note yields, how they are calculated, and their role in our financial markets. The Treasury note yield is the current interest rate paid on the 10-year United States Government Treasury note. The government pays the yields as interest for borrowing money through debt sales at monthly auctions. When the auctions take place, the government sells a specific dollar amount of bills (duration less than one year), notes (sold in 2, 3, 5, 7, and 10-year maturities), and bonds (30 years, reintroduced in February 2006).  For the sake of this discussion, we are only interested in the 10-year note.   
 
Once the debt has been sold, bills, notes, and bonds are traded on public markets, with investors buying and selling this debt and creating a market-driven interest rate. The rates generated in these markets for the 10-year note are vital in the financial markets. For instance, it is the proxy for many financial services such as mortgage rates. It is also used in determining interest rates on credit card debt. Trillions of dollars of financial instruments are affected by changes in these rates. 
 
The 10 Year Treasury Yield and Stock Valuation
 
For value investors, the 10-year note's yield has (or should have) an enormous impact on the valuation of publicly traded equities. When an investor looks to value a business, there are two calculations that play a tremendous role in estimating its long-term intrinsic value. The first is the company's return on capital (ROC). The second is its average weighted cost of capital (WACC). One of the most critical aspects of finding quality in a potential investment opportunity is a having a high return on capital. At Nintai, we look for companies that achieve 15% or greater ROC over the past decade. ROC is an excellent tool for getting a grasp on how well management teams allocate capital. But it's only half the equation (literally and figuratively!). Equally important is the company's weighted average cost of capital. A company always wants ROC to be significantly greater than WACC. It doesn't matter if they can generate an ROIC of 15% if their cost of capital is 18%. (Hence the opening quote about losing a small amount on each transaction, but making up for it in volume)
 
The weighted average cost of capital is one of those topics that inevitably leave peoples’ eyes glazed over when you bring it up. It's like discussing the interest rate you will be paying on that brand new sports car in the driveway. Not many people insist on diligently reading the term sheet. Instead, most dream of taking those sharp turns or doing racing changes on the interstate before trying to measure how the cost of capital might impact the long-term value of that new sports car. 
 
Return on Capital versus Cost of Capital: A Simple Example  
 
Let's use an example of an investor choosing to use cash obtained from a credit card advance to invest in stocks. It sounds crazy, but I've seen things more insane in my investing career. For example, let's start with the cost of capital. A cash advance can be obtained for the average credit card owner with two main items driving calculating the cost of that capital.
 
First, the card company will charge a fee which is generally based on the percentage of the transaction. For the sake of this exercise, let's assume the cash advance is $25,000. According to CNBC, the average transaction charge usually is between 3 – 5% of the advance amount. For this case, let's cut it down the middle and call it 4%. In this example, the individual will pay $1000 for the advance (25,000 x 4%). Second, the credit card company charges an annual interest rate fee on the balance. Let's assume the individual is not planning on paying off the balance for the first year but pay any fees and interest charges. According to the website creditcard.com, the average interest rate charged by the credit card company is 16.15%. For the first year, the individual will pay $4,037.50 (25,000 x 16.15%).
 
In this instance, cost of capital would be $1,000 + $4,037.50 or a total of $5,037.50. Put in the Wall Street terms, the cost of capital would be 4% + 16.15% or 20.15%. Of course, this number means nothing until we calculate the return on capital and see how the two numbers compare. 
 
To calculate return on capital, let's assume the individual wants to invest in a hot-shot stock growth fund that she's been assured is a real winner. We'll call this the "UltraHype Growth Fund" (which goes by the ticker BLECH). Over the past ten years, the BLECH fund has returned 11.2% annually. This is the starting point on the return on capital, but sadly not the final figure. The fund charges are very high – a 1.8% management fee. This is subtracted from returns, reducing the returns to 9.4% annually. Let's be generous and assume there are no additional costs like a load fee of 5.5% or 12b-1 fees or redemption fees. 
 
The return on capital number will be 11.2% of $25,000 or a return of $2,800. From that, we subtract the 1.8% management fee or $450. This leaves the individual with a net return of $2,350. Another way to calculate it is 11.2% - 1.8%, which generates a return on capital of 9.4%. 
 
It should be pointed out here, calculating the weighted average cost of capital and return on capital can be - and usually is - far more complex. It helps to have a calculator or Excel spreadsheet handy. For instance, the actual formula looks like this.

Suffice it to say our calculation in getting a cost of capital in this example is conceptually the same, but woefully deficient in terms of completeness. This is an article for investors, not a graduate accounting class!
 
So, where does this leave our individual? Did their move of taking a cash advance on their credit card pay off by investing in their expensive, hot-shot growth fund? The answer is a clear no. Their return on capital of 9.4% was swamped by their cost of capital of 20.15%. While it may seem obvious to any investor, it's important to point out this is a terrible use of capital. 
 
Cost of Capital and Stock Valuations
 
Having your return on capital exceed your cost of capital really shouldn't be that profound of a concept for individual investors, professional money managers, or senior corporate executives. Is should also be pretty clear that rising input costs in calculating your cost of capital will lead to higher cost of capital. The dramatic movement in treasury yields cited earlier will dramatically impact a company’s cost of capital. With rising Treasury yields, many company’s suddenly began to see WACC exceeding ROC in their returns. These changes should have been seen in valuations if investors were taking these changes into account. The exact opposite has happened. Except for the sharp drop in valuation in the spring of 2020 and their subsequent - and relatively rapid - recovery, the trend in stock prices has been nearly always upward. 
 
To apply this concept and see this disconnect in real terms, I want to use a holding in many of Nintai Investments’ individual portfolios - SEI Investments (SEIC). In December 2019, we estimated the company's weighted average cost of capital was roughly 9.4%. In that calculation, we included the federal funds rate of 1.87%. At that time, we estimated the intrinsic value of the company's stock was $55.20 per share. It was trading at roughly $66.00 per share or approximately 20% above fair value. By any standards, the stock was not a compelling buy. By December 2020, we estimated the company's weighted average cost of capital at roughly 7.9%. Nearly all the decrease in the WACC was the drop in the 10-year note yield. In our calculation, not much else changed. Revenue was flat, free cash flow was down slightly, and publicly traded shares were down slightly. There wasn't much to change valuation except the drop in the funds rate. But, boy, did that change our valuation. The $66 per share in December 2019 had jumped to $73 per share in December 2020. With the stock trading at $56 per share, the company was now trading at 23% below fair value - an enormous change in roughly one year. What had been a moderately overvalue company was now trading moderately below intrinsic value. On these numbers, we purchased shares in our portfolios. What a difference a year makes. 
 
But our example doesn't end there. The exact opposite happened from October 2020 to March 2021. The 10-year note rate jumped 0.53% in October to 1.63% just six months later. The example we just showed went in the exact opposite direction. With such a massive jump in the 10-year rate, companies' valuations took a whopper of a hit. SEIC's valuation dropped from $73/share back to $61 per share. With shares trading at $60 per share, they were now at fair value instead of 23% below intrinsic value.
 
Talk about a whipsaw! In a little over 16 months, SEIC went from moderately overpriced to moderately underpriced to roughly fair value, all due mainly to changes in the 10-year Treasury note yield which then impacted the company's weighted average cost of capital.  SEI Investments wasn't the only company that saw its valuations affected by its drop in the weighted average cost of capital. Every company in the public markets was impacted – some more than SEI, some less. Throughout all of this, overall yields didn't move much. The 10 Year US Treasury note yield was 1.73% on December 3, 2019, 0.92% on December 1, 2020, and 1.45% on March 1, 2021. But there was quite a gap between highs and lows. In August 2020, rates hit their low  0.52% and hit their high in December 2019 at 1.93%.
 
It's important to note that the markets overall were minimally impacted by these changes. From December 2019 to March 2021, the S&P 500 gained 25.4% rising from roughly 3150 to 3850. This even includes the massive drop in the spring of 2020 when the S&P dropped nearly 30%. 
 
What This Means
 
For all this data and heavy reading, you might be asking yourself at this point what this all means. It's a good question and an important one to answer. The most important lesson to understand is that having cost of capital exceed return on capital is not a recipe for outstanding long-term stock returns. It should be common sense to any investor, but roughly one-third of all publicly traded companies currently have WACC exceed ROC. Somebody is investing in these companies, so not everybody has learned this lesson.  Here are some other learnings to think about. 
 
WACC and ROC Must Be Measured Together: I have to concede that I searched for companies with extremely high ROC at the beginning of my investing career but never screened them for WACC. There is a particular bias that a company with high ROC couldn't possibly have even higher WACC. It happens, though. And like any other company with a negative ratio, it's a company that doesn't generate value. Always remember to look at both ratios, not just one. 
 
The 10 Year Treasury Yield Has a Big Impact: I used to denigrate investors who took a lot of time looking at macroeconomic issues because I felt they play a minor role in the business. I was right about that. What I was wrong about is that it plays a massive role in the stock. Remember: sometimes, a company's stock (and its price) has little to do with the company. This type of disconnect happens all the time. A significant rise in the 10-year note rate can drive up the cost of capital, making a dollar in the future worth a lot less. While the company might remain the same, its intrinsic value might decrease significantly. Never lose sight of the role of interest rates in valuation. 
 
In the Short Term Voting Machines, In the Long Term Weighing Machines: Having said that interest rates could affect valuation, it's important to remember the longer the holding and the greater the business's success (through quality and value) the less the impact of interest rates will be. This is a convoluted way to say that time and business excellence overrides the shorter-term impact of interest rates. Being patient and allowing time to work its magic can dramatically reduce some of the risks (but not all!) associated with cost of capital. 
 
Conclusions
 
For any long-term value investor (and what other kind is there? “Short-term value investor” is undoubtedly a contradiction in terms), the ability to find a business and management team that can produce value over a decade or two is the means to creating investment gains. The underlying foundation of this value creation is the ability to have the return on capital far exceed the cost of capital.  Given time and allowing for the weighing machine of the markets to work their magic, companies can become compounding machines for their shareholders. 
 
Understanding the dynamics of what constitutes the cost of capital and its relationship to return on capital is one of the most powerful concepts to a value investor. Looking at both and understanding the drivers of each, an investor has the tools necessary for making the best investment decisions possible. Will the markets always agree with you? Absolutely not. But an investor can go to bed each night fully understanding their investment has created value that day, that week, that month, that year, and hopefully the next decade or two. 
 
I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai Investments has no positions in any stock mentioned.

Yesterday, we learned about the death of Charles de Vaulx by suicide at his offices in New York City. Before anything else, this is a human tragedy. By every measure, Charles was a diligent, hardworking, and incredibly thoughtful value manager. He leaves behind a wife and two children. Everyone at Nintai sends our condolences to his family at this very difficult time. 
 
Charles was a value investor who represented the best of the Old Guard. By that, I mean in thinking, not in age. He was only 59 and still had much to offer the investment community. I refer to his investment thesis, portfolio management theory, and investment practices. First and most important, he always insisted on a reasonable margin of safety. He was willing to go to what is considered today heretical, extraordinarily high percentages of cash, reaching 40% of total AUM sometimes. He insisted, much like his mentor Jean-Marie Eveillard, in holding actual gold in portfolios as a means to offset risk. Last, he saw his job’s role as a means to retain wealth, not just createwealth. His passion for reducing risk for his clients’ assets was legendary. 
 
All of that was, of course, profoundly out of step in today’s investment world. Nearly every core concept Charles held dearly has been tossed topsy-turvy over the last decade. Interest rates continued their downward trend that had started in the 1980s, finally turning negative (!) in many countries around the world over the past few years. His remarkably high cash position was a terrible drag over the past decade. Interestingly, even that didn’t help when the market suffered its collapse in the spring of 2020 with the onset of COVID. Even with so much cash, IVA funds saw share price drops of over 25%.  
 
The last year had been difficult for IVA and Charles. Total assets had dropped from a peak of nearly $20B to less than $1B this year. In July last year, Charles’ co-investment manager Chuck de Lardemelle left the firm. In December, another founding partner, Michael Malafronte, left the firm for health reasons. The final blow was a dreadful 2020, with both funds underperforming their index by nearly 15 percentage points. The end came on March 10, 2021, when IVA filed with the SEC that it intended to liquidate its two mutual funds – IVA Worldwide and IVA Global and shutter the firm altogether.
 
The Weight of Professional Asset Management
 
There is a vast distinction between managing your own money and doing it professionally. It’s hard to describe the pressure one feels as underperformance piles up. The markets are famously unfeeling. You wake up every morning, and you compete against a faceless index. There is no emotion or subjectivity to what a professional investment manager does. You either outperform the market, or you don’t. You can come up with many reasons why your picks have performed poorly, but there is simply no hiding from the numbers.
 
For many value managers, the past decade or more have been a grueling experience having to report -  year after year - underperformance to their investors. After the first few years, it becomes increasingly difficult not to question your methodology. After a decade, it becomes hard not to question your entire investing career. Was initial success just luck? Is it possible to add value to your clients? Is it even worth continuing?
 
When I listened to Charles on Morningstar’s “The Long View” in November 2019, it was clear IVA and the investment management team still felt their underperformance would turn around. The markets would return to some form of sanity after nearly a decade of seeming craziness. Somewhere between then and March of this year, their view fundamentally changed.   
 
I can only speak from my perspective of having an abysmal 12 month run over the past year. I find I don’t sleep as well. I spend days evaluating current holdings, re-running our investment thesis, tweaking the numbers until there isn’t much else to do. I find it takes about six months of straight underperformance before I question not only the investment thesis but whether Nintai’s strategy is flawed. In this business, I think three major themes can significantly (and negatively) impact a professional value manager these days. 
 
Some Important Themes
 
Competition is Brutal
I’m not sure you will find an industry with such widespread competition as investment management. At the strategic level, competition takes place against other active managers and against index (or passive) funds. With fellow active investors, a manager competes on her stock-picking abilities and his management fee. Against index funds, the battles rest more on price (it’s hard to compete when you give away 1.5% at the top every year) and secondarily on stock picking. At the tactical level, competition is intense as data and content have become democratized. The days of finding net/nets by reviewing individual annual reports or Value Line surveys has been replaced by utilizing a search query of GuruFocus that takes roughly 25 seconds to run. Nearly every competitive advantage a value investor brought to the table 25-30 years ago is gone in today’s investment world. 
 
Generally, Your Behavior is Your Enemy
Value investors operate in a field where nearly every genetically programmed behavior is contrary to what it takes to be successful. Everything from confirmation bias to loss aversion pushes an active manager to behave against their investors’ best interests. The ability to control your emotions and focus on what works – regardless of your native impulses – is vital to success. As almost anybody who has invested for more than a decade can tell you, that sure as hell isn’t easy. 
 
Time Should Be Your Friends, But Sometimes Isn’t
The past decade has added an enemy to many value investors that have always been one of their greatest allies. Warren Buffett said that a key to investment success is to find wet snow and a very long hill. For nearly every decade since the 1920s, it was assumed the long hill ran downwards. The past 12 years have been a long uphill climb for value investors. Nearly every investment thesis and process has been challenged or simply not worked since 2009. That’s a long uphill climb. 
 
Conclusions
 
I can’t say Charles de Vaulx was an acquaintance, let alone a friend. I met him several times, and I treasured our conversations. I first knew of him because I admired his investment record over the long term, the brilliance and clarity of his intellectual frameworks, and his ability to stick to his core convictions. (I highly recommend the aforementioned “The Long View” interview on Morningstar. It can be found here.) It’s unlikely we will ever be sure what happened over the last few months of his life. Still, we can be pretty sure he looked out over the previous decade as every value investor has and saw a challenging period that posed a risk to his very professional being. He isn’t alone. But it’s important to realize that at its most fundamental, value investing is about human beings making judgment calls on the long-term future of a possible investment. Charles was human, and he also happened to be a good human being. I’m glad I met him, and I’m even more glad I got to understand his skills better, thinking, and convictions. He will be missed.  

We are pleased to announce that Tom's book "Seeking Wisdom: Thoughts on Value Investing" is now available on Audible. A compilation of Tom's articles written for the website Gurufocus, the book has a great deal of original content as well. For those looking to listen and learn about value investing from diverse angles, "Seeking Wisdom" is sure to get you thinking differently about investing. You can find it here: https://tinyurl.com/yt7ac3uv

"When you combine ignorance and leverage, you get some pretty interesting results." 
 
                                                                                 - Warren Buffett
 
Margin Debt: A Brief History
 
Margin debt is when an investor uses assets provided by a third party - in many cases, the investor's brokerage house - to purchase more shares than they usually could using just the cash assets available to them at the time of purchase. This means opening a margin account and utilizing the credit line on the account to make such a purchase. For instance, assume an investor has $1,000,000 in cash in their brokerage sweep account to make purchases. Also, they have a margin account with a credit limit of $500,000. The investor wants to purchase $1,000,000 worth of a particular stock. They can use the $750,000 available in their sweep account, and they borrow $250,000 on their margin account and make the purchase. This means the investor has $250,000 in cash as collateral for the $250,000 balance on their margin account. This has allowed the investor to boost their share purchase by $250,000 while still leaving cash in their sweep account.  
 
It's important to note a few things. The Federal Reserve Board's Regulation T limits the broker to lending up to 50% of the initial investment. This puts a hard cap on how much margin the investor can borrow. Second, many brokerage houses have their own regulations that may be more stringent than Regulation T. 
 
This, of course, is all fine and good if the stock goes up. Using leverage (or gearing as they call it in the UK and Australia), investors can make more profits than they could have if they only used their own cash. But what if the stock goes down? If that's the case, then the investor's losses would be much more significant than if they only used their own cash. One of the worst possible scenarios is when the stock price drops so low, the brokerage company makes a "margin call," essentially demanding the investor pay back some - or all - of the total amount of margin borrowed. Margin calls can force investors to sell other assets to raise cash at precisely the wrong time, wiping out gains or even bankrupting them. As usual, there is no free lunch, and increased returns always come with higher risk. At Nintai, we have an official policy that bans the use of leverage - or margin - in both individually managed as well as our internal fund.   
 
So why bring up margin loans/debt at this point in the market cycle? The major indexes are near all-time highs, and the economy is slowly recovering from the COVID crisis. What's to worry about?        
 
A Remarkable Twenty Year Run: 2000 - 2020
 
Below you will find a chart mapping two trends – the returns of the S&P 500 (the blue line centered on the right axis in terms of trading price) and the amount of margin debt (the red line centered on the left axis in billions of US dollars). The chart begins in 1997 because this was the year of the margin debt reporting changed dramatically. Before 1997, margin debt data was available for only the New York Stock Exchange (NYSE) members. Post-1997, the NYSE closed down its data collection and allowed the Financial Industry Regulatory Authority (FINRA) to capture data from all major exchanges such as NASDAQ and NYSE.   
 
As you can see, 1997 represents the nearly three-quarter point in the 1982 - 2000 bull market that culminated in the great technology bubble. Margin debt peaked in 2000 before reaching its nadir in 2003. It wasn't long after getting this bottom that investors forgot any lessons related to the risk of margin and market bubbles by pumping up margin debt to all-new high highs in July 2007 - just in time for the collapse of the next market bubble (the Great Credit Crash) leading to stunning losses in individual brokerage accounts accelerated by this considerable margin debt. But like Sisyphus (who really should be Wall Street's patron saint), investors started the cycle all over again (the third time in just ten years!). With the new bull market beginning sometime in 2009, margin debt has grown hand in hand with growth in the S&P 500 average, with total margin debt rising from roughly $250B in 2009 to nearly $800B in 2020. After the market correction in early 2020, margin debt fell from $600B at the beginning of 2019 to $475B after the correction. After such a reduction, any pessimistic feelings were immediately forgotten when debt rose from $475B in early 2020 to nearly $800B (!) by the end of the year – a staggering 68% increase in just nine months.  

Source: "Margin Debt and the Market: Up 2.6% in January, Continues Record Trend", Jill Mislinski, February 18, 2021

If we zoom in further and look at the tail end of the chart data, you can see the remarkable increase in margin debt. FINRA (through Investopedia) stated[1]:
 
"Margin debt has reached the highest point in two years as investors borrowed a record $722.1 billion against their investment portfolios through November, topping the previous high of $668.9 billion from May 2018, according to the Financial Industry Regulatory Authority (FINRA). This amount is a 28% increase since the same time last year and is up nearly 10% from $659.3 billion in Oct. 2020".
 
This massive increase was likely driven by the markets' assumptions that vaccines would bring an end to COVID-19 as an economic story. 

Source: FINRA, "Margin Statistics," January 2021

Why This Matters
 
Many readers may ask, "So what? The markets are going up. What's the big deal?". If markets continued to rise indefinitely, then the short answer would be there isn't much to worry about. But we all know markets don't go up indefinitely. An 11-year-old bull market will end. The question isn't if. The question is when? 
 
Margin debt is no different from corporate debt, except that margin debt would be considered short-term debt at all times. The reason why Nintai Investments is so averse to debt is that it seems to come due at the most inopportune time. Most companies borrow money when they need it but have to pay it back when they need it even more. This doesn't make for the best capital allocation decisions. 
 
Individual investors are no different than corporations when it comes to margin debt. Investors tap their margin credit lines when they want to purchase more shares and leverage their current assets. They need that credit even more, when markets crash and margin calls come flooding in. Much like the corporation, this doesn't lead to rational capital allocation decisions. 
 
A Useful Example
 
Let's assume Bob is an investor who considers his stock-picking abilities above average and is tired of just barely meeting the index's returns (which, when you think of it, makes him just average, but will let that go for the sake of our case). Bob has $600,000 of equities in his taxable brokerage account and $200,000 in cash in the brokerage account's sweep account. He has decided to leverage these assets and begin trading on margin. A quick reminder: in Bob's brokerage account (or cash account), all transactions must be made with the cash on hand in the account. A margin account allows the investor to borrow against the total value of assets in the cash account. In Bob's case, his cash account would be worth $800,000 ($600,000 in equities and $200,000 in cash). According to Regulation T, Bob's brokerage house can loan him up to 50% of the total purchase price. 
 
After considerable research, Bob has decided to purchase $250,000 of "Ted's Adventure Company" (note: this is a fictional corporation). When Bob purchases these shares on his margin account, he has one "payment period" (his brokerage account names this as five business days) to meet the Regulation T 50% margin requirement. Bob utilizes his cash and equities as collateral. He feels very comfortable knowing he has $800,000 in his cash account to post versus the $250,000 margin balance. Regulation T requires 50%, so Bob is required to cover $125,000 (which is 50% of 250,000 on margin). 
 
So far, so good. Bob is in fine shape unless one of three things happen. First, a general market decline decreases the value of both the stocks he borrowed against (Ted's) to buy (remember: the $200,000 balance remains the same). If the stock drops by 25%, then Bob now needs to have enough capital to cover the $250,000 initial loan plus the 20% decrease in the value of his shares bought with the loan ($250,000 x 20% = $50,000) In this case his margin balance increases from $250,000 to $300,000. The second action that impacts his margin status is if the value of the stocks he holds in collateral decreases. For instance should Bob’s equities also decrease by 20%, then his balance available as collateral drops from $600,000 to $480,000 ($600,000 - 20% = $480,000). If Bob is near the 50% required collateral level, he may be required to post additional assets to keep below the 50% mark. This is known as a margin call. I'll get into more detail about that shortly. The third action that would affect Bob's margin status is if he finds himself in need of cash and has to tap the $200,000 in his sweep account. Again, this might bring him below the required 50% margin coverage.
 
Unfortunately, rarely does one of these things happen alone. During a market crash, the stock price (Ted's) is likely to drop in addition to the value of the equities in Bob's brokerage account. Additionally, he may need cash from the sweep account because the market crash has accompanied an economic downturn and Bob's planned bonus never appeared. This would be known (and I hate the term) as "the perfect storm" for Bob's portfolio.      
 
The Margin Call
 
Now that we've walked through the logistics of using margin, let's look at the worst-case scenario when things go wrong – the dreaded margin call. A margin call happens when the amount of assets in the investor's margin account falls below the required amount. For instance, let's use the case of purchasing $250,000 of Ted's Adventure Co. Assuming our investor used $125,000 from their cash account and $125,000 from their margin account, they have barely met Regulation T that requires the amount of the margin purchase not to be more than 50% of the total price paid (Since the purchase was $250,000 in stock and the investor used $125,000 of their margin account, then just met Regulation T's 50% rule). Should the stock price start dropping, the brokerage house will begin the process of a margin call when the asset price falls below $125,000. For instance, should the stock drop 20%, then the stock's total value purchased on margin drops from $125,000 to $100,000. In this instance, the brokerage house would place a margin call for $25,000. This means the investor would need to place an additional $25,000 into the margin account. Since this event rarely happens in a vacuum, a margin call can put enormous strain on an investor. If the brokerage company doesn't receive its $25,000, it can liquidate other stocks - no matter the price - to meet the margin call. As I said, these events rarely happen in a vacuum, and the forced selling of additional prices likely will take place as those share prices are dropping as well. It's never good when you are forced to sell at any price. Particularly when the proceeds of any sale are needed to fill a gap caused by a margin call. When a margin call forces a sale, you can expect the prices your assets are sold will be to your disadvantage.
 
Final Thoughts on Margin Trading
 
As major indexes trade and margin debt both reach near all-time highs, any investor utilizing high amounts of leverage (margin debt) should consider the potential implications of a severe market drawdown. As I've explained earlier, generally, margin calls are part of an investor's perfect storm with the potential of causing catastrophic losses in their portfolios. Here are some thoughts I offer investors employing leverage in today's markets. 
 
Leverage Goes Both Ways
For every person who uses margin to increase their profits, some investors increased their losses by utilizing leverage. After such a long period of market gains, it's easy to lose sight of the fact that markets can drop - and drop fast. Just ask anybody who was highly leveraged in the spring of 2020. With valuations as tight as they are, it shouldn't surprise anyone to see a 25 - 30% correction at any time. If you are using a model that uses a significant increase in market prices, build in such a loss. Then double it again. You might be surprised by the results. 
 
Just Because You Can Doesn't Mean You Should
The recent events with RobinHood and GameStop (GME) trading have shown that not everybody should be trading on margin or shorting stocks. Just because an investor has access to margin accounts and trading doesn't mean they should employ such a strategy. Unless an investor has given considerable thought about the potential impact (and modeled possible results) of utilizing leverage, they should stay clear of any such market operations. Just because you have access to a margin account doesn't mean you should use it. 
 
Enough Can Truly Be Enough
After a twelve-year bull market, if - as an investor - you don't feel you've squeezed out every possible profit from your investments, then margin isn't the way to go. It seems the odds (though I have no real way to predict) predict a much lower growth rate or even net negative returns over the next decade. If this proves to be accurate, then margin isn't going to help squeeze any extra returns out of the market at this point. We highly recommend investors recognize they've gotten as much as possible from this bull market and head for safer investment waters. 
 
Conclusions
 
Just a few days ago, Charlie Munger commented on special purpose acquisition companies (SPACs), 
 
"This kind of crazy speculation, in enterprises not even found or picked out yet, is a sign of an irritating bubble. The investment-banking profession will sell shit as long as shit can be sold."
 
We think the use of margin accounts and leverage are similar for individual investors. Wall Street sells margin accounts because they can. In most cases, they are inappropriate for investors and allow them to take on terrible risks while only thinking about possible rewards. There are many safer ways for investors to increase returns. These include cutting down on management fees and reducing trading costs. The actions minimize the risk while generally increasing returns. As an individual investor, at Nintai, we suggest investors look for the low-hanging fruit and safest ways to juice (no pun intended!) returns. We think this is the smartest move available to individual investors by a wide margin (pun intended).   
 
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[1] https://www.finra.org/investors/learn-to-invest/advanced-investing/margin-statistics