“When you start looking at stock buybacks, you begin to realize you are playing a game of Three Card Monty. Nothing is really as it seems and the numbers never really add up. It truly is dealing with the cards stacked against you”.
                                                                            -       Robert G. Warren 

Several years ago I wrote about how many corporate executives buy back company stock at exactly the wrong time. They generally purchase as their share price hits an all-time high then cease all activity when the stock price crashes. I’ve always been cynical when corporate boards announce share buyback plans in the hundreds of millions (or even billions). After M&A activity, in general I can’t think of a worse use of capital.  
 
Buybacks: A Quick History
 
Traditionally stock buybacks were not held in very high regard. In 1932, The New York Times made three specific arguments against buybacks. First, they used up a corporation’s cash balance. Second, they were simply a cash transfer between the corporation and management/directors who were dumping their shares. Last, they focused management on the whims of the market (through stock price movement) and distracted them from the running of the business. The Securities and Exchange Committee made it more difficult in 1934 with the Securities and Exchange Act making stock buybacks (though not mentioned) a potential violation.  
 
The 1970’s provided middle ground by creating conflicting policy of either making buybacks flat out illegal to simply having a corporation disclose their intention to purchase their shares. The SEC never really came up with a good answer, flip flopping back and forth. Things took a big step in a different direction in 1982 with the SEC’s issuance of Rule 10b-18 which made it very difficult (if not impossible) to sue companies for stock buybacks. By removing mandatory disclosure requirements, companies received a green light to start buybacks with relative abandon.
 
Which brings us to today. The Trump tax cuts have brought buybacks into focus again. Indeed, buybacks - which have been increasing over the last decade - jumped about 50 percent last year to nearly $800 billion for the companies in the S&P 500. This is an all new high according to S&P Global. These data seem to contradict the claim that most of the tax cuts have gone towards reinvesting and growing company businesses. (Though to be fair some would argue share buybacks are a form of capital reinvestment). Since 2009 US companies have bought back roughly 80 billion shares, but total shares have increased from 289 billion in 2009 to 294 billion in 2019. It’s hard to argue that shareholders have been the winner in this binge of buying and lack of share reduction. 
​
In fact, much research has been published showing that buybacks add little, none, or even subtracts value from shareholder returns. One of the most interesting – which I encourage readers to download (sorry to say there is a license of $44USD) – is an excellent peer reviewed article[1] outlining that in many countries - whether investors use a dividend model or a total payout model to decompose equity returns - net buybacks explain more than 80% of the cross-sectional dispersion of stock market returns.
 
Another example of repurchases changing in their scope and value for corporations versus shareholders has been the explosion in repurchases. In a study by David
 
Ikenberry  Josef Lakonishok  Theo Vermaelen (“Stock Repurchases in Canada: Performance and Strategic Trading”), the authors state:
 
“In recent years, corporations have dramatically increased the amount of capital devoted to repurchasing their own shares. In the mid-1980s, repurchase program
announcements in the U.S. amounted to roughly $25 billion per year. Between 1996 and 1998 however, more than 4,000 open market repurchase programs were announced which, if fully completed, amount to roughly $550 billion. During the first quarter of 1999 alone, Securities Data Company reports nearly 350 program announcements totaling $40 billion. Interest in corporate repurchase programs is not limited to the U.S. as repurchase activity worldwide has grown in recent years. Countries such as Hong Kong and Japan recently implemented new regulations allowing companies for the first time to repurchase their shares. A recent Goldman Sachs study (March 1999) foresees stock repurchases becoming more common in Europe and discusses the potential impact on European equity values.”
 
Why This Matters
 
With this explosion in repurchases – yet no reduction in share counts – the obvious question is whether these actions have been a wise allocation of capital. If the answer is yes, then shareholders should whole heartedly encourage such behavior. If the answer is no, then shareholders – through their duly elected representatives on the company’s Board of Directors – should actively seek to stop these transactions.
 
Investors should look at share repurchases as no different than their value approach in their own investment process. If shares are bought at a discount to the company’s intrinsic value then this could be perceived as an appropriate allocation of capital. Repurchasing shares at prices higher than intrinsic value would be a poor use of capital.
 
Unfortunately, all evidence would suggest that companies go on repurchasing binges as share prices reach new highs and cease purchases as share prices reach new lows. The most recent example of this has been the example previously cited with new repurchase highs reached in 2019 as shares reached all time highs. Another example was the similar pattern in 2006 – 2009 as share repurchases reached all-time highs (for the time) in 2007 (the height of the mortgage asset bubble) only to see a near 75% drop in repurchases as the markets collapsed in 2008 – 2009 (see graph below). 
 
For any investor in a company that has followed this pattern of “buy high and stop buying when low”, they can safely assume management has a poor understanding of capital allocation. Any value investor should avoid companies run by such individuals.
 
Conclusions
 
The story of stock buybacks has been relatively consistent since the SEC’s policy change in the 1980s. The enormous number of buybacks – mostly purchased when stock prices are at all-time highs – have provided little to no advantage for the value investor. Only when enough shareholders speak up and force management – through Board oversight – to perceive stock buybacks as a means to improve shareholder returns will buybacks become sound capital allocation. As a value investor, I suggest readers find companies that have firm guidelines about buybacks which is tied directly to value versus intrinsic value. Partnering with such management gives an investor the best chance to see long term growth in their portfolio.


[1] “Net Buybacks and the Seven Dwarfs”, Jean-François L’Her , CFA, Tarek Masmoudi & Ram Karthik Krishnamoorthy , CFA, Financial Analysts Journal, December 12, 2018, pages 57 - 85

Just because everyone is doing it doesn’t make it right. Sometimes your way really is the best way. Just have the facts on your side.
 
“The young man knows the rules, but the old man knows the exceptions”.
 
                                                               -          Oliver Wendell Holmes Sr. 

“When the game is no longer played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were – not as they are. Essentially I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand even though it might mean forgoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully, and which, possibly, could lead to substantial permanent loss of capital”.

                                                             -            Warren Buffett (Partnership Letter, October 1967) 

In February 14 1797, a British fleet of 15 ships of the line under the command of Admiral Sir John Jervis met a Spanish force of nearly twice its size off Cape St. Vincent, Portugal. Two stories mark the initiative and confidence of the English navy at the time. In the first story, Admiral Jervis (soon to be Lord St. Vincent for his victory) sends a man to the foretop to tell him the size of the Spanish fleet. The following conversation took place between the lookout and Admiral Jervis.
 
"There are eight sail of the line, Sir John" 
"Very well, sir" 
"There are twenty sail of the line, Sir John" 
"Very well, sir" 
"There are twenty five sail of the line, Sir John" 
"Very well, sir" 
"There are twenty seven sail of the line, Sir John" 
"Enough, sir, no more of that; the die is cast, and if there are fifty sail I will go through them"
 
But that wasn’t the story that really made the Battle of Cape St. Vincent so famous. Rather it was the bursting forth of Horatio Nelson’s genius that stole the day. At a critical moment in the battle, when Jervis signaled for his ship to tack in succession (this maneuver called for each ship to turn through the wind in the same place as its leader and was a traditional ship handling instruction for the past 200 years), Nelson realized that such a maneuver would place the latter part of the English fleet in danger. He wore (the opposite of tacking) clearly in violation of his orders and proceeded to take on 6 of the largest Spanish ships with only his 64 gun Captain. This group included the Santísima Trinidad, the largest ship afloat at the time and mounting 130 guns, the San José, 112, Salvador del Mundo, 112, San Nicolás, 84, San Ysidro 74 and the Mexicano 112. Amazingly, Nelson succeeded fighting alone for 20 minutes and captured both the San Nicolas and the San Jose. It was the beginning of what was to be called the “Nelson Touch”.
 
Now that I’ve prattled on about maritime warfare in the early French Revolutionary wars, I wanted to discuss why both Nelson and Jervis’ rule breaking hold a great lesson for value investors. Many times, value investing isn’t dissimilar to heading into a fleet action like the Battle of Cape St. Vincent. There are many variables that impact decisions (the direction of the wind compared direction of market sentiment), the fog of war can be thick, loud, and disconcerting (think of the din of cannon fire and dense smoke and compare that to watching a re-rerun of any trading day in the two weeks following the collapse of Lehman Brothers), and the heightened emotions of winning or losing (think of the emotion of watching one of your fleet strike its colors versus seeing a portfolio holding drop 35% in two hours). The ability to stick to your process, and keep your emotions in check are as important today in front of your computer screen as it was on the quarterdeck of a flagship in the Age of Sail.      
 
Training Your Mind, Mastering Your Process  
One of the reasons why Admiral Jervis was so confident taking on the Spanish fleet (even if it numbered 50 ships) was the knowledge that his crews were the best trained in the world. Every ship was a well-oiled machine that Jarvis knew could hold its own against any two Spanish ships. This type of training and discipline is required in value investing as well. When a stock price drops dramatically, a value investor knows their process inside out and has the discipline to act only when it meets his or her criteria. For instance, at Nintai when a stock on the watch list drops by 5% or more in one trading day we know exactly what steps to take - read up on the latest corporate releases, search for competitive news stories, rerun the valuation model with any new inputs, etc. It’s a set process that we can run in less than 2 hours which gives our team the necessary facts to make a decision. Step two is having the discipline to follow the facts to their logical conclusion – a decision based on solid criteria we’ve followed for over a decade. The last thing a successful value investor does is run around and haphazardly purchase stocks because of Mr. Market’s manic moods. The discipline to find the right shares, at the right price, for the right portfolio are all earmarks of the tight discipline of a value investor.     
 
If Your Strategy is Sound, Follow Through With Everything You’ve Got
If you feel your investment strategy and process meets your goals and provides you with the best chance at outperformance, then never fear being aggressive in your actions. If you expect your results to be different than the major indexes, then your actions must be - by their very nature - different than those indexes. You can do this in several ways - have different portfolio holdings, have similar holdings but in very different percentages, or a combination of the two. Many successful value investors have been quite focused in their portfolio designs holding sometime as few as 5 stocks. At Nintai we generally hold no more than 20 holdings in our portfolios. We do this for several reasons. First, there simply aren’t that many companies that meet our investment criteria. Second, even fewer trade at enough of a discount to our estimated intrinsic value to meet our required margin of safety. Last, we want each position to be large enough to have a meaningful impact (both good and bad) on our performance. Several years after Horatio Nelson died, one of his “Band of Brothers” recalled “Nelson was entirely his own creature. People called his approach ‘The Nelson Touch’. It really was HIS approach. Nobody else could copy it. And no one achieved anything like his results after he passed from the scene.” Like Nelson, at Nintai we have our own unique investment methodology. Over time - and with the success we’ve had (though past performance is no assurance of future returns!) - we remain aggressive in our portfolio design. In the final analysis, our returns will certainly be our own. We are quite proud of that.     
 
It’s Not About Quantity, It’s About Quality
I’ve found over time that long-term success requires long-term quality. In the beginning of his career, Warren Buffett certainly had success with companies that meet the cigar-butt criteria. But Charlie Munger has argued the real investment successes at Berkshire Hathaway have come later, particularly after the tectonic shifting purchase of See’s Candies. At Nintai we drifted in a similar way, starting with the one-puff wonders we bought in March and sold in April after a 15% gain. Over time, I began to realize my more natural state was not the nail biting, manic purchasing and selling, constantly on the lookout for bad news, dyed-in-the-wool value investor of the 1950s-1960s. Rather I was far more slothful, indolent, and upbeat to really be able to enjoy that type of investment life. I learned – much like Nelson – that a smaller force made up of the highest quality could generate enormous success. It wasn’t just about the quality of my holdings though. It also was about the quality of my successes.  I had many small 5-10% gains with my cigar butts, but I found the 5 and ten-baggers were high quality companies that I bought and held for a decade or more. Simply put, quality companies mean higher quality successes.      
 
Conclusions
 
So what happened to Nelson after he violated Jervis’ orders? Old Jarvy was known for breaking an officer who willfully didn’t follow orders and there was certainly no clearer case than this. It is said that after climbing on to the deck of the Victory (Jarvis’ flagship), Jarvis hugged Nelson in a most un-seamanlike manner. Jarvis’ flag-captain - in a pique - after seeing a disobeying officer receive a hug (a hug forsooth!), complained to the Admiral that Nelson’s actions were a clear violation of his orders. Jarvis turned to him and said, “It certainly was so, and if you ever commit such a breach of orders, I will forgive you also.” Nelson went on the become a Knight of the Bath and win crushing victories in the Baltic, at the Nile, and of course his masterpiece, the Battle of Trafalgar which cost him his life.    
 
By following your own convictions and strategies in investing, it’s unlikely to cost you your life (or at least let’s hope so!). But the outcomes can certainly put your name in a book of rarified names. Not everybody who lives by their own rules will succeed like Nelson. But many of the greatest investors  - Warren Buffett, Jack Bogle, Michael Steinhardt, Charlie Munger, etc. - have withstood tremendous pressure to conform and give up their independent thinking. If your technique works for you (and that’s really the definition of success) then continue playing by your own rules. In the end, it’s really all you got.     
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: None

“When we control a company we get to allocate capital, whereas we are likely to have little or nothing to say about this process with marketable holdings. This point can be important because the heads of many companies are not skilled in capital allocation.  Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities.  They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.  To stretch the point, it's as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.”
 
                                                                                       -        Warren Buffett 

When my partners and I first came up with the idea of starting our second company, (which eventually went on to become Nintai Partners - a healthcare-focused consulting firm) we spent a great deal of time thinking about the areas of the business we performed poorly or in areas we simply didn’t perform at all. We eventually chose 3 areas to focus on:
 
Employee Ownership: We felt the strongest performance we saw in our field was driven by employee ownership. We didn’t mean stock options that represented 0.01% of the firm that vested after a ridiculous number of milestones had been met. We felt ownership should be achieved in a straight forward, substantial, and timely manner.
Compensation Driven by Customer Satisfaction: Most consulting firms have a pretty uniform approach. Partners create and maintain relationships that led to the largest engagements possible, middle-management/project leads look for as many project amendments that help beat revenue goals, and project staff work ridiculous hours in a controlled panic to achieve seemingly impossible project deadlines with little incentive to create long-term value. We designed a firm that compensated staff on long-term value created by their project. 
Retain Earnings to Drive Book Value: Our goal was to retain earnings and use them to create an internal investment fund. This fund would be the main driver of value for company shareholders. Owners could log on and see exactly how much each share was worth and calculate the value of their share of ownership.   
 
After several years of growing the business, attending Board meetings, and managing the internal investment fund, it suddenly became clear that I was engaged in an activity that no academic program had even remotely touched on - allocation of capital. It took several more years to define that role, create a process that could assist in making better decisions (there are no “best” decisions), and work with the Board to find a way to measure how successful we were in our efforts. Much like Warren Buffett’s comment, none of us in senior management had any real training or experience in allocating capital. One of the partners was great in sales and marketing, I was trained in operations management, and the other partner we used for their connections in the local business community. Each Board meeting turned out more excruciating than the last as one particular member hammered home that my job as managing partner was to “allocate capital - pure and simple”. When that job was complete he said, then I could hopefully return to my shareholders and convince them I had worked in their best interest. It was certainly a different way of looking at things. 
 
Allocating Capital: Everyday Life of the CEO
 
In the course of daily living, we are constantly making decisions about allocating capital. Ranging from whether that membership at the gym is worth it to deciding when to replace the old car with a new one, how we allocate our hard-earned dollars is a vital part of our daily life. Yet somehow - through the course of getting all that corporate in-house training or attending classes for that professional license  - many managers seem to have lost their ability to calculate whether that corporate porterhouse steak is more valuable than the filet they looked at last week. That’s truly unfortunate, because senior executives are faced with how, when, and where to allocate capital on a fairly regular basis. In the corporate world, allocation focuses on four major capital categories - mergers and acquisitions (M&A), capital expenditures (CapEx), dividends and share buybacks, or research and development (R&D).
 
It’s important to remember that not all capital allocation is equal in either complexity or impact. For instance, some CapEx is allocated specifically to grow the company. An example might be a new plant to increase manufacturing capacity. Staying with that example, replacing equipment in an existing plant might be solely for the maintenance of current manufacturing capacity. This distinction is vital when it comes time to calculating return on capital for the year. As a senior executive once said in a meeting to discuss capital spending “I don’t like to pay for the privilege of standing still. If I’m going to lay out some serious cash, let’s make sure we aim to grow and to win”.   
 
Management are better at certain types of capital allocation than others. For instance, we know the record for mergers and acquisitions is quite poor. Management has a tendency to get the animal juices flowing and the next thing you know we’re looking at a shiny new toy obtained at nose bleed prices. Management also does a relatively poor job when it comes to stock buybacks. Over time, we’ve come to see that management buys back shares when they are at their most expensive but stop buying when share prices drop. The link between price and value seems to be obscured if not entirely forgotten during these times. As Warren Buffett pointed out “the first law of capital allocation - whether the money is slated for acquisitions or share repurchases - is that what is smart at one price is dumb at another.”
 
So what are we to do if so many managers are so bad when it comes to allocation of capital? It’s not an idle question. Adam Weiss of Scout Capital pointed out that if you buy something with a 10% free cash flow yield and hold it for 3 years, management will be responsible for allocating a third of the intrinsic value of the company over that time. After ten years that jumps to 60%. As a shareholder, what could be more important than that? The answer is not much. So its beholden to shareholders - and through them Board members - to speak up and make sure senior managers understand its importance. At Nintai, we think there are three areas where focus  - through training and incentives  - should be applied. 
 
Establish a Link Between Price and Value
In many cases, senior management can lose sight of the requirement that value be commensurate with price when it comes to capital allocation (meaning you get a dollar – or more – back from the dollar you’ve allocated). An example of this is the history of value destruction through managements’ M&A activity. Until corporate boards make the link between what management pays and the value created (or not create in most cases) by acquisitions, it is likely we will continue to see deals driven solely by ego, empire building, and false hopes. In the words of Robert Fuller “tsk….tsk…what a way to run a railroad!”. 
 
Reward Management When Long-Term Value is Created
To reinforce the relationship between price and value, corporate boards should be looking for ways to compensate management for such value creation. Ways to measure such success should be left to board compensation committees, but it would seem to me several issues should be addressed in these awards. First, value creation should be focused on the long term. Second, a distinction should be made between value created by cutting costs and value created by growth. Third, value should be of a permanent nature, meaning growth isn’t transitory but multi-year in scope.
 
This Isn’t Just for the C-Suite
Understanding the link between price and value isn’t a concept for just senior management. Mid-level managers and line employees should be trained to think in such a manner from day one. If the expectation is that employees with strong performance records will find their way up the greasy pole, then corporate leadership should be thinking about training for all aspects of the business. A great example of this is training by Boston Consulting Group in their “CFO Excellence Series” (an overview can be found here). When one becomes aware that capital allocation is one of the most critical means of translating corporate strategy into action, then training can’t begin soon enough.
 
Not All Allocation of Capital is Created Equal
 
As I mentioned at the beginning of this article, there are four major ways that management can allocate capital - M&A, CapEx, Dividends/Buybacks, and R&D. Each of these require their own form of expertise. For instance, M&A center on two completely different - yet connected  - skill sets. In the first, management should have strong internal mental models on calculating valuation. Second, management should have extraordinary self-control that allows them to sit and take 20 pitches in one at bat without taking a swing. While these may seem mutually exclusive, the two skill sets actually are quite complimentary. In this case, the whole is greater than the sum of its parts.
 
 A distinction is made between capital allocation that is necessary to keep the doors open (defined as working capital) versus capital allocated to facilitate growth. Working capital is a simple calculation: current assets less current liabilities. It is possible that a company might have positive current assets - or even by technically profitable - but be forced to cease operations as it has insufficient liquidity. Because Nintai doesn’t invest in companies with such type of balance sheets or cash flows, there isn’t any reason to spend much time on this type of situation. 
 
But we are definitely interested in the distinction between allocating capital for growth and allocating capital for maintenance. At Nintai we generally avoid capital intensive industries. Examples are industries that require steady capital injunctions to simply keep up with competitors or keep the business running. This might include the railroads or the steel industries in the 1970s. Another example is industries that require significant R&D to simply find replacements for an ever evolving list of non-patented direct-to-consumer product. In both cases, capital is employed to maintain market share and less to drive growth.
   
Asset Light or Capital Light Models
 
At Nintai, we have a bias towards businesses that are asset light or capital light in their strategy or structure. These are businesses that require little capital to maintain the business. Any new capital can either be used to grow the business or be passed on to shareholders. Examples of this include Nintai holdings SEI Investments (SEIC), Veeva (VEEV), or Manhattan Associates (MANH). Each of these companies share similar capital structures – little-to-no-debt, low average weighted cost of capital, high return on capital, and very low capital needs.
 
Another aspect of these companies (it’s unclear which came first - the competitive moat or the asset light model. One thing is certain though - they intertwine) is the deep competitive moat surrounding each of them. Not only does it take little capital to maintain their outstanding business characteristics, but also their respective leads in their markets. For instance, Manhattan Associates currently fields a return of return on capital of 68% - rising steadily from 12.8% in 2010. As Manhattan has dug its moat deeper and wider it has achieved an increasing return on capital.
 
It should be stated that while some asset light companies achieve high returns on capital, not all do. Bausch Health Companies (BHC) - the former Valeant Pharmaceuticals - created an asset light business based on raising prices and in-licensing orphan drugs. While that worked for a while – the company grew revenue per share from $5.46/share in 2004 to $30.48/share in 2015 - the inevitable bill came due on $30 billion in debt - and the company saw return on capital collapse 34% to -2.4%. After teetering near bankruptcy for a short will and a fire sale of assets, the company is slowly righting itself.
 
What Bausch Health and Manhattan Associates can tell us is that allocation of capital can bring either long-term success or long-term failure. A company simply can’t be successful when managers are poor capital allocators. As the former Valeant - now Bausch - shareholders can tell you, if your managers aren’t successful at allocating capital, then its shareholders won’t be successful investors. Traders may succeed - but not long-term shareholders.
 
Conclusions
 
At Nintai, we’ve learned over time (and through painful experience sometimes!) that our most successful investments have been with managers who created a business whereby they could generate high returns on capital and – in the long term - generate significant shareholder value. The characteristics of those businesses are:

• The company is run by managers who understand the link between price and value;
• The company’s average cost of capital far exceeds its return on capital;
• The managers create/sustain a business with a wide competitive moat;
• The company can employ capital internally to create additional growth, market share, and shareholder value

 
Given these characteristics, management can create a virtuous cycle that consistently - and profitably - grows the company creating long-term value for its shareholders. As Warren Buffett pointed out in the beginning, most managers aren’t trained to create and run such an investment gem. When you find management capable of creating and sustaining such a model, then hang on and let them do all the heavy lifting. The only real question is why do anything else?
 
As always I look forward to your thoughts and comments
 
DISCLOSURE: Nintai Investments has a long position in MANH, SEIC, VEEV

At a macroeconomic level, Nintai has never tried to divine exactly where the equity markets, US economy, or global economies are headed. It’s a loser’s game if an investor feels they can time their exposure to any of them. We have always tried to find companies with deep competitive advantages where their product and services are vital to their customers strategy and value proposition. Balancing that with incredibly strong financial performance and pristine balance sheets, we think our portfolio holdings will do well in nearly any market. 
 
Certainly Wall Street disagrees with Nintai’s methodology. An enormous amount of sweat and treasure goes into calculating exactly where the economy will be 18 months from now, or what the Federal funds rate will be after the next Board meeting, or how the slowdown in Chinese auto imports will affect US-based auto parts stores. There are thousands of very bright individuals who work day and night trying to gauge the impact on individual stock prices or even the broader market indexes. In this article, I thought I’d share Nintai’s thoughts on the role macroeconomics can play in portfolio management, why most data are irrelevant for the average investor, and what data are actually critical to a value investor.  
 
Geopolitics and Its Impact on Calculating Value
 
The recent events surrounding the Chinese/US trading relationship is an example of the complexity that macroeconomics can present in calculating a portfolio holding’s intrinsic value. A note before I begin: this discussion will inevitability wander into the realm of politics. In the context of value investing, I have little interest in our current political environment with the exception of what impact it might have on my clients’ portfolios. I ask that any comments avoid purely political views or opinions.
 
The current administration made it clear in both their campaign and through current policy that existing US policy towards trade with China needed to change dramatically. The big issues include the current trade deficit, intellectual property rights, market access, government industry subsidies, and currency exchange rates. At Nintai, the first step we take after identifying the core issues is to ascertain which holdings could be impacted by geopolitics. In this instance we might ask several questions that would help us identify these companies.

• Which holdings have the highest percentage of revenue generated overseas with a focus on mainland China? (Further research might entail which competitors would also be impacted, finding local Chinese-based companies that would not be impacted, or the stickiness/depth of the Chinese relationship)
• Which companies have supply chain or key outsourced partners in mainland China? (Here we would look to ascertain the complexity of the supply chain, number of subcontractors required, and location of alternate supply chain companies)
• How important are each of the five key issues listed above. For instance, which holdings are reliant upon intellectual property rights? This might be either in revenue generation (examples might include biopharmaceutical drug patents or author copyrights) or in operational costs (examples might include patent in production process or a technology patent in a product component).
• Which companies can find offsets to increased tariffs and what is the nature of those offsets? (examples might include passing them off further down to distributors or consumers or relocating parts of the supply chain)  
• Last - from a policy standpoint – which holdings are in industries most (or least) likely to have the financial and political wherewithal to seek (and get) exemptions from any possible new tariffs or regulatory policies such as non-importation bans? (An example might be Apple which received a waiver from the Trump Administration)

 
Answering these questions should give an investor a relatively comprehensive (but high level) view of the risks facing each of their respective holdings. Will it - or can it - give an investor enough information to make detailed changes in their estimated intrinsic value estimates? It’s unlikely. But can it answer the “bigger than a breadbox, smaller than elephant” when it comes to potential impact? Certainly. Answering these questions can give an investor broad enough knowledge to know which holdings are at risk, how big the risk is, and whether there are tools or processes that can help mitigate that risk.   
 
A Working Example: Skyworks Solutions
 
To show the difficulty in trying to define both the risk (where you can define possible outcomes) and uncertainties (where you cannot define possible outcomes) in a macroeconomic setting, I thought I’d use the China/US trade issues and look at current Nintai portfolio holding Skyworks Solutions (SWKS). Starting with President Trump’s statement in March 2018 that “trade wars are good, and easy to win”, the current Administration has made over 200 statements that a trade agreement with China is “very, very close”, “separated by the narrowest of margins”, “just about done”, “a done deal” to be compared with the less far less enthusiastic “a pretty significant gap”, “not much progress”, “they are going to have to give”. This isn’t making any judgment against the Trump Administration (though we might quibble with the idea that trade wars are easy to win). The whiplash from so many contradictory and misleading statements by administration spokespeople has made any of their predictive qualities useless going forward. With threats of tariffs ranging from 5 - 15% on everything from auto imports to flamethrowers (flamethrowers? Yup. Take a look at the full list here), it’s very difficult to make long term profit projections. It’s particularly hard if you do the bulk of your business in the international markets.
 
Skyworks has faced a double blow with the government’s on-again off-again tariff threats with China (theoretically resolved with the “Phase 1 Agreement” agreed to on December 13 2019) and its equally confusing approach to large Skyworks’ customer Huawei. The stock price over the past year has a range from $60 - $103 per share. Which price is closer to intrinsic value? Utilizing macro-economic issues, it’s pretty difficult to come up with any solid number. For instance, in its recent earnings call (November 2019) management stated earnings would have been 20% higher with business from Huawei (the company is currently banned by the U.S. government from purchasing chips from Skyworks).
 
Between the risk of certain tariffs (which we can define by products affected, tariff rates, etc.) and the uncertainty (we simply cannot measure the probabilities of the Trump Administration implementing such tariffs) of the US pressing forward, it is very difficult to estimate the possible impact on our estimated intrinsic value. What we can do is summarize some of the bigger issues and keep an eye on certain high level risks and uncertainties.

• Skyworks generates a significant amount of revenue from overseas markets. In particular, the company works with some of the largest players in 5G based in Asia. Any tariffs implemented with China would have a moderate impact on Skyworks’ revenue and thus our valuation.
• 47% of FY2018 revenue was from one customer - Apple (AAPL). As stated earlier, Apple received a waiver from the Trump Administration in relations to tariff’s placed on Chinese imports. This helps mitigate the impact of any tariffs that center on Apple products.
• Skyworks’ is limited in its ability to offset any additional costs related to new tariffs or regulations. The company will likely offset these with a blend of increased costs to customers and cost savings generated within the supply chain.
• Last, Skyworks faces threats in two of the five issues cited earlier. This includes intellectual property rights (China requires access to proprietary information as part of many contracts) and supply chain location (the greatest threat here are new tariffs proposed by the Trump Administration on Mexico).

 
In most cases I don’t go beyond this in terms of research. I’ve learned that great management is many, many steps ahead of me in identifying where the economy might be headed and how this might impact their core strategies, product development, competitive landscape, etc. Going forward, I will look for how management has addressed these issues and how successful their efforts have been.        
 
The Devil is in the Details
 
Having discussed why I place such limited concern and effort on macroeconomic issues, there is one large caveat to apply – a very small amount of macroeconomic data is essential to calculating intrinsic value. It’s not a lot and it doesn’t require an enormous amount of work to gather it and apply it to your valuation tools. But one of the most important legs in the value investing stool - calculating intrinsic value - is impossible without it. Here are the macroeconomic data I follow closely.
 
Interest Rates and Cost of Capital: Federal Reserve policy can have a huge impact on short and long term interest rates. This directly impacts a portfolio holdings’ average weight cost of capital (if they need to tap the debt markets). This in turn has an enormous impact on return on capital and investment value generation. I’ve discussed this in greater detail several times, but it’s important enough to summarize it again. When utilizing a discounted free cash flow model to generate intrinsic value, even the slightest change in Federal Reserve policy can move valuations by 5 – 10%. This can be the difference between an adequate margin of safety or not.
 
Regulatory and Compliance: Over time, changes in the macroeconomic environment can lead to significant changes in state and federal regulatory oversight. As an example, the crash in the credit derivatives market during the Great Recession forced the Federal Reserve and Congress to implement sweeping changes in the financial markets including new capital requirements and the elimination of several core business lines in the largest banks. At Nintai, we are always looking for macroeconomic data that might directly impact financial and valuation models specific to any of our portfolio holdings.  
 
Conclusions
 
I was once having a conversation with several co-workers when the issue of spousal jealousy came up. After several individuals bemoaned their lot in marital life, one individual said “our therapist said that jealousy is like paying interest on a loan you never took out”.  I’ve found that in most cases spending time worrying about macroeconomic issues is much like the therapist’s advice. In most cases, the data really aren’t that helpful in ascertaining how much investor value can be generated over the next decade or two. In those limited cases (such as the Fed funds rate) a simple check on the latest 10-year Treasury will tell you everything you need to know to get started on generating the company’s average weighted cost of capital. The most important thing is to understand which data can help you focus on truly important issues (such as calculating the company’s value) and disregard the rest. Over time you will be amazed how much time can be spent on company-specific research. Much like the therapist’s couple, you will be surprised how much easier life will be when you focus on the things that matter.
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: Nintai Investments LLC is long Skyworks Solutions.

"We have so much to be thankful for in this time of economic growth and prosperity. The markets keep going on their upward trend, jobs are plentiful, and opportunity is there for any who want to make a difference. In essence - be thankful, humble, and honored to be living in these most bountiful times.” 
 
                                                                                          -         Gerald Nye 

“All through life there are opportunities in allocating capital - it might be your own time or money in personal development. It might involve investing capital – with time, money, or something else - in the company you work for. Or it might be investing capital into our country or system - building new companies, new products, changing the world. In a capitalistic-based system like the United States, we have a 230 year history of generating enormous returns on capital. Being part of that process is a remarkable opportunity and honor”.
                                                                                         -        Sam Hallowell  

In 1973 my family came across the Canadian border as part of an agreement to become United States citizens if my father would transfer his service to the United States Army. On that long car ride, I remember reading Lincoln’s Emancipation Proclamation and hearing the phrase “all persons held as slaves within any State or designated part of a State, the people whereof shall then be in rebellion against the United States, shall be then, thenceforward, and forever free”. It gave me goose bumps then and still does today.
 
During this holiday season, I give thanks for several events in my life that made so much of my later success possible. The first is coming to the United States at the height of its influence as a young white male. Demographics and timing made a huge difference in my life. Second, I had parents who insisted that all their children attend the best schools for their abilities. My attendance at an Ivy League school opened an enormous network to me. Third, right out of college I was introduced to the American system of capital allocation. I’ve never faltered in my thinking - though it is dented and tarnished these days - there is no better system in creating long-term value.
 
As I worked my way up the greasy pole in the investment world, I began to realize nearly everything I did - from personal development to professional training to my role as an investment manager, was really about allocating capital. Whether it was my personal time and money, or my client’s hard earned capital being deployed into the markets, my job has been to maximize return on capital. Now that I’m older and wiser, I realize that while all that is true, the real blessings have been that I have lived in a time and place that made that type of career possible. Sitting around the house having survived another delicious meal, watched another badly played football game, solved all the world’s problems in a series of increasingly emotional arguments, I usually come to feel a great deal of thanks for several key factors in my life.
 
We Still Have the Best Capital Allocation System
Over the years I’ve written extensively about some of the issues I’ve seen developing in our capitalistic system. Whether it be Jack Bogle’s wonderful analysis of the shift from owner’s capitalism to manager’s capitalism[1] or the constant battle fought over fees, I’ve taken some rather heavy pot shots against our current capitalistic system. Having said that, I still believe our current economic system gives the most people the best opportunity at achieving financial success. Every day, millions of citizens get out of bed with the intention of starting a new business, deciding where its best to allocate their company’s capital, or where to allocate their assets as they think about retirement. Is the system perfect? Absolutely not. Can it use a real deep cleaning? You bet. But every morning as I prepare for the work day, I know I’m building a company that provides my investment partners with the chance to see their capital put to work and make their portfolio  - and their country - a little bit stronger.   
 
As Shareholders We Have Rights….Use Them!
Along with the ability to freely choose how, where, and when I allocate capital comes the responsibility to act as an owner. Each corporate share I own is a piece of an outstanding business that has passed my investment criteria. Being an owner comes with responsibilities – reading corporate documents, voting for my board candidates, and speaking out when I agree or disagree with a substantive issue. I am grateful that I have the chance to exercise this control, though sadly it is a responsibility badly neglected these days by individual and institutional investors alike. Much like voting in political elections, most of the work is done for you as a voter. Ballots are frequently mailed to you or available online. If one expects to be a successful investor, then you need to be a successful owner. Be thankful you have the rights of an owner….and use them!
 
We Are A Nation of Laws
If you look around the world – both the developed and underdeveloped – there aren’t many countries where investors have a near implicit faith in the underlying legal, regulatory, and policy structures that support individual businesses and the greater markets. That exception (though again somewhat battered and beaten down) would be the United States’ capitalistic system. Though it isn’t perfect, investors in the US can be confident that contract law provides legal protection, that regulatory agencies (generally) look out for owners, shareholders, and other stakeholders in a fair and just manner. Anybody who has tried to work in other countries where the political system is a single-party monopoly or the courts are mouthpieces for the powers that be, have found investing - or even simply doing business - is an act of risk of the highest order. During this holiday, be thankful that - even if a handshake isn’t as solid as it was - contract law remains as a solid foundation of the US economy as it ever has been.
 
Conclusions
 
As another year winds down and my family gathers to celebrate Thanksgiving, it’s important that we give thanks to living at a time, in a country, and in system that allows us to fully participate in the economic life of the country. Whether it be investing in a rental property, being a silent partner in a friend’s new restaurant, or being the smallest investor/owner of the largest operating company on Earth, we are blessed to be part of the greatest, most successful experiment in capital allocation the world has ever seen. After all the left overs are gone, the long naps been taken (along with all that antacid!) and the in-laws have driven home, roll up your sleeves and be prepared to get back to work. Being an investor is both a privilege and responsibility. There is much to be grateful for at this time. Accepting that - and being aware of all that requires of you - is the beginning of a tremendous journey that will educate you and be profitable in far more ways than dollar and cents. We hope everyone had a wonderful Thanksgiving and wish everyone a happy and safe upcoming holiday season.  
 
DISCLOSURES: NONE
  

[1] Jack Bogle, former CEO of Vanguard argued that over the past several decades, ownership has shifted from a traditional owner’s model where the owner put up 100% of the capital, took 100% of the risk, and received the vast majority of the rewards. In the manager’s capitalism model, the manager puts up little capital, takes on little risk, but receives a great amount of the reward. Bogle felt (and I completely agree) this greatly distorted the values, ethics, and financial outcomes of the capitalistic system. 

“We shortened sail in degrees, rolling in the headsail regularly, then taking the main off completely. The ride was exhilarating as the “Gigi” would surf on the long crests, skidding and squirming at breakneck speeds until the wave outpaced her. I have a vivid memory of being picked up by a wave, sinking down into it like an artillery shell into a howitzer, and then firing forward as the wave top overcame the base and started to break. It was madness. I can also recall seeing fish in the wave curls that were higher than we were.”
                                                                        -    Sailing a Serious Ocean, North 54 

“The Horn lived up to its reputation again. In twelve hours its malign influences had transformed an innocuous summer low coming in out of the Southern Ocean into the most dangerous of storms, what old time square rigger sailors used to call a Cape Horn Snorter.”

                                                                       -    Derek Lundy, The Way of a Ship
 
For thousands of years, human beings at sea were at the mercies of whatever direction the wind was blowing. If the wind was blowing in the direction you were going (known as “running” - hence the phrase “running with the wind”) that made things pretty easy. The difficulty began when you started the trip for home and you had to sail directly into the wind. With the physics of sails (which I will be mercifully brief about), one couldn’t just sail into the wind. Two basic principles made this impossible. The first is leeward drift or drag. This means the boat will inevitably drift in the course of the wind. Some boats are known as being particularly good at reducing such leeward drift. Others are sometimes referred to as “those horrible old f’ing Dutch buggers” - well…you get the drift (no pun intended). The second principle is lift. No different than airplanes, this is when you put an aerodynamic foil into the wind and have the air pass more quickly on one side and more slowly on the other, thus creating a force perpendicular to the sail. Using lift, a boat can sail somewhat into the wind (known as “reaching”). By utilizing multiple reaches (known as “tacking”) the sailor can make it home even with the wind against them. The most dangerous position for a sailor is to find the leeward drift exceeds their ability to reach. In these situations, if the boat can’t anchor it will be driven to leeward against the sailor’s will (known as the “horrors of a leeward shore”) until hits whatever object it first comes upon.
 
I bring all this up because over the past decade it seems like value investors have been sailing into relatively strong and steady winds and facing harsh leeward drift. For many, the horrors of a leeward shore are all too real by now. This thinking was captured quite eloquently in a recent Morningstar interview with Charles de Vaulx, Chief Investment Officer and portfolio manager at International Value Advisors. Previously de Vaulx was portfolio manager at First Eagle Global and First Eagle Overseas. The full interview “Charles de Vaulx: Why Value Investing Has Slumped but Will Rebound” can be found here (Morningstar premium membership required). I try not to shamelessly steal from someone else’s intellectual efforts, but I thought the concepts laid out in the interview were powerful enough to “forage liberally” as William T. Sherman so famously said.
 
Value Advisors International (IVIOX) and de Vaulx have certainly been victims of strong headwinds. The funds positioning in its category (Foreign Large Blend) quartile rank has been hard for managers and investors alike: 98th percentile YTD, 97th percentile 1 year, 99th percentile 3 year, 80th percentile 5 year, and 23rd percentile 10 year. But de Vaulx and his team aren’t tacking repeatedly and altering course on a regular basis. They believe their approach remains consistent with achieving long-term outperformance.  
 
In his interview with Morningstar’s Christine Benz and Jeffrey Ptak, de Vaulx discusses three trends which have provided tremendous headwinds for his funds and fellow value investors. The first is the three-decade long trend of lower interest rates. The steady decline has affected value investing in several ways. This includes DCF model discount rates, corporate free cash flow (as a percent of interest costs), and economic modeling results. The second trend is the pressure put on corporate managements to put low-earning cash to work, particularly in regards to corporate stock buybacks. The last trend is the Federal Reserve’s impact on business cycles making them shallower and longer. This has reduced stock price volatility and thereby investment opportunities for value investors. In combination, these have created such strong headwinds that value investors have seen a reduction in opportunities - and correspondingly results - since the early 1980s.   
 
 
 
 
 
A 36 Year Headwind: Interest Rates
 
Starting in 1982 - following Paul Volker’s aggressive efforts to wring inflation out of the US economy – interest rates have fallen from double digits to nearly negative in the US and truly negative around the world. Anybody who uses a discounted free cash model know the double impact of time and discount rates on corporate valuations. In an article from March 2019 (“Looking Back at Nintai’s Discounted Free Cash Flow Model” which can be found here), I discussed the impact of the discount rate on my estimated intrinsic value. The bottom line is that getting that rate wrong can dramatically impact your investment case – sometimes destroying it altogether.
The Federal funds rate dropped from its high of 20.6% in June, 1981 to its low of 0.06% in July 2011 (it has since jumped to 1.6% in November 2019). This represents a remarkable 98.6% drop. If we take a look at current Nintai Investments holding Veeva (VEEV), let’s see the impact of increasing aggressive changes in the discount rate on the company’s valuation.
 
As of November 2019, the stock trades at roughly $156 per share. In our discounted free cash flow model, we currently use a discount rate of roughly 7.5%[1]. Utilizing a 10-year time frame, we estimated the intrinsic fair value at around $173/share or an 11% discount to the current price. If we raise the discount rate by 3% to 10.5% the estimated intrinsic value drops to $89 per share or a decrease by nearly one-half. A 40% increase in the discount rate cuts the estimated intrinsic value in half! If we invert this, then it’s easy to see the three decade trend of falling rates puts a near perpetual increase in the discounted free cash flow-generated intrinsic value. If we look at a company like IBM, nearly 85% of the increase in stock price since 1982 can be explained by the falling discount rate. That doesn’t leave much room for finding a bargain price during that time.    
 
A Fake Floor: Stock Buy Backs
 
If the falling discount rate helped create an inflated stock price over the past 35+ years, then the growing trend of stock buybacks has helped solidify the concept of a fake price floor. Companies have spent hundreds of billions of dollars over the past
 
decade in repurchasing their stock. In some cases this has reduced overall outstanding shares by 40, 50, or even 60%. Some of these have been examples of outstanding capital allocation. In other cases companies have spent billions of dollars simply repurchasing the vast amount of options handed out to management. In these cases the number of outstanding shares have not gone down – and in some particularly egregious examples – outstanding shares have actually increased. No matter how these transactions add up, they frequently create a fake floor whereby potential investors see an illusionary minimum share price.
 
Using IBM as an example again, since 2004 the company has spent $148B repurchasing stock. That comes out to be roughly $1B each year. During that time total outstanding shares went from 1.7B to 893M – or a 47% in outstanding shares. In that same period earnings per share went from $4.38 per share in 2004 to $8.61 per share in 2019. Of note, earnings per share were $8.89 per share in 2008, peaked at $14.94 per share in 2013 before descending each year hitting $8.61 per share in 2019. You might think at some point such disappointing performance would create some fairly opportune buying moments, but sadly not. The company’s P/E ratio never dropped below 10 between 2004 – 2019. Rather it averaged nearly 15 during that time period. For a company that showed zero growth for 11 years (2008 – 2019) and a nearly 45% drop in earnings over the past 6 years (2013 – 2019), it seems the PE ratio was inflated beyond reason. I suspect the repurchase of shares played a role in convincing shareholders to pay a rather high premium for IBM shares. It would be interesting to hear Warren Buffett’s thoughts on this after his experience as an IBM shareholder.     
 
A Case of the Dog Not Barking: The Lack of Business Cycles
 
Perhaps the most interesting concept raised by de Vaulx was the dramatically different length and scope of business cycles in the US over the past two centuries. Utilizing data from Sanford Bernstein’s “An Economic History of Now” (which I highly recommend), de Vaulx points out the fact that the average time of economic expansion has increased dramatically (25 months in the 19th century, 44 months in the 20th century, and 101 months in the 21st century) while the average economic contraction decreased equally in magnitude (the average depth of GDP decline was 3.7% in the 19th century, 4.3% in the 20th century, and only 2.1% in the 21st century).  
 
 
So what’s happening here? In de Vaulx’s view – and I completely agree – the
decreased volatility in terms of time and magnitude has reduced the opportunities to employ value strategies. With smaller time frames and vastly decreased magnitude of contractions (investors in the 21st century have seen GDP declines be less than half those of the 20th century), the ability to capture inefficiencies in the market have dropped correspondingly.  
 
Conclusions
 
For any sailor who has spent an entire day beating into the wind, tack after tack, seeing their destination seemingly getting no closer, the limits of patience may be reached. They will employ every trick in the book to lay half a point closer to the wind. It’s no different for many value investors. The last ten years have been like that for many value investors. They’ve tried every trick in the book but unfortunately – as de Vaulx has so eloquently pointed out – the headwinds faced by these investors have been insurmountable. That said, I actually don’t think all is lost. Over the last 12 months we’ve seen volatility increase both in scope and length. The rapid drop – and size of it – at the end of 2018 brought many investors up short. Certainly anyone watching the VIX index and the drops in the major indexes thought the return of old fashioned value was upon us.   
 
At Nintai Investments we’ve done everything possible to create a weather proof boat design (think of this as your portfolio strategy and holdings), that can reduce the risk of rising seas while maintaining as much headway as possible (think of Nintai’s “Quality Portfolio/Value Pricing” from our last article), and has the strength to survive extraordinarily long voyages (think of Nintai’s companies that are decade long in their holding time). Whether you see it as a vessel to help you travel the globe or an investment vehicle to meet your retirement goals, there ARE ways to help defeat de Vaulx’s three great headwinds. I highly recommend readers review the Morningstar interview, take notes, and identify the issues as they exist in your portfolio. You might just find you have an all new confidence as you put to sea in your latest investing journey.
 


[1] The discount rate is made up of the current 10-year treasury rate (1.74% as of November 2019) plus factors for the company size, financial leverage, cyclicality, corporate governance, economic moat, and complexity. 

“We’ve really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high quality businesses. And most of the other people who’ve made a lot of money have done so in high quality businesses.
​
                                                                            -         Charlie Munger 

“The risk of paying too high a price for good-quality stocks - while a real one - is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.
                                                                          -          Benjamin Graham 

Since the 2009 bottom of the 2007 - 2009 market crash, we’ve had an over decade-long market expansion which has provided investors with the longest bull market in recent history. For those at the end of their investing career, this has been a huge tailwind allowing for far more generous performance any would have thought possible. During these types of market runs, the old adage of “a rising tide raises all boats” certainly rings true. Just look at these returns for 2019: Dow Jones up 21.7% YTD, NASDAQ up 28.2% YTD, S&P 500 TR up 26.1%, Russell 2000 up 18.9%. Every sector is up double digits in 2019 with the exception of Energy Capped (up 5.1% YTD). All other sectors range from a low of Healthcare (up 15.8% YTD) to a high of Technology (up 38.5% YTD). With such returns every investor is a hero of their own financial story.
 
I thought I’d take a different tack in this article to explain why Nintai Investments sees the past five years less through rose-tinted glasses and more through lenses that always see risk around the corner. Since opening our new investment services business in 2018, we’ve both underperformed (in the first year) and are now outperforming when measured since inception. We’ve really come into our own over the past quarter as the markets recognized the value of high-quality companies with strong returns on capital, equity and pristine financials. Our returns over the last 3 months have been 10.77% compared to the S&P 500’s 6.71%. (Note: past performance is no assurance of future returns). Our returns have been 15.72% (including fees) since inception versus the S&P 500’s 13.87%. This isn’t to boast about our performance (though we - and our investment partners - are pleased) but rather to point out that we believe Nintai’s approach of purchasing extremely high quality businesses at fair prices and holding them for extended periods can outperform both bull and bear markets (again: past performance is absolutely no assurance of future returns). As we look around and see record highs all around us, at Nintai we continue to clear the deck for foul weather and prepare for the inevitable (significant) market correction. With that in mind, I thought I’d discuss Nintai’s approach and the relatively simple process we employ in meeting our strategic goals.         
 
Better Quality, Cheaper Prices
 
At Nintai we believe in a fundamental investment concept. If we invest in a bucket of companies with significant advantages in quality (higher returns on capital, equity, assets, free cash flow margins, no debt, etc.) combined with valuations (a blend of cheaper attributes including estimated intrinsic value from our DCF models and cheaper PE ratios), over the long-term we can expect to outperform the broader markets. 
 
The concept of purchasing higher quality companies or looking to purchase shares at a discount to estimated intrinsic value isn’t anything new to the value investment community. I have found it is rarer to combine the two as a foundation for your investment strategy. When I utilize Morningstar’s portfolio manager research tools to find funds with a high match rate to Nintai’s holdings, I’ve found only 2 (two!) with a greater than 25% overlap with our portfolios. With numbers like this, you can see it’s rather rare to find the concept carried out on a regular basis. What’s equally rare (as far as I can see) is articulating the idea that the highest quality companies purchased at good prices can provide significant downside protection during a bear market. In general, I’ve found that companies and management that generate great returns on capital and have little or no debt are businesses that thrive in bull or bear markets and in expanding or recessionary economic times. Combined with holding significant cash, I feel comfortable that when the inevitable market tumble comes along, I’ve reduced the risk of capital impairment as best as I can in today’s markets. 
 
Nintai’s Abacus reports give a quick graphic overview in how we are doing in meeting the goals of a portfolio consisting of outstanding quality at value prices. Later on, I will walk readers through the summary report and take a look at how we are doing in meeting Nintai’s investment strategy.

It All Starts by Finding Corporate Excellence
 
Any research we do at Nintai starts with locating companies with outstanding business characteristics. We locate these in multiple ways – GuruFocus’ All-in-One Screener, conversations with thought leaders, meetings with corporate executives, etc. Once we’ve found a company that meets our criteria we will begin the in-depth process of really understanding the company’s strategy, products, markets, competitors, etc. If we’ve done our job we can run a summary “Quality” report on Nintai Abacus and make sure the portfolio is meeting our strategy.  
 
Let’s use a blend of our investment partner portfolios to demonstrate what I mean by a “Quality” summary report. In November 2019 on average, the Nintai Investment portfolios shared the following attributes: return on capital (42.8%), return on equity (31.7%), and return on assets (19.2%). This compares to the same numbers for the S&P500 (source: Morningstar’s “Portfolio X-Ray” reporting function): return on capital (3.28[1]), return on equity (1.21), and return on assets (2.11). These numbers show that – in general – Nintai’s portfolios have created a basket of holdings far more profitable than the S&P 500. Additionally, the debt-to-equity ratio of the S&P 500 (as of August 2019) stood at 0.89 (source: Haver Analytics and Standard & Poor’s) versus 0.023 for the Nintai portfolios.
 
Why are all the numbers important? First, a basic tenet at Nintai Investments is to prevent permanent impairment of our investment partners’ hard earned capital. We’ve found over time that companies with little or no debt[2] and who are also highly profitable (both from a free cash flow perspective as well as capital returns) minimize that risk. Second, we’ve found that management teams who act prudently with their investors’ capital are great stewards to partner with over a decade or two. Last, companies with these characteristics are generally outstanding businesses with outstanding fundamentals and deep competitive moats. All three of these play a vital role in preventing a blow up in the portfolio that can lead to truly horrendous losses. At Nintai, everything begins by investing in outstanding quality.      
 
Finding Value in a Value Investment Strategy
 
Finding outstanding, profitable, and prudent companies is of course only half the battle. Buying them at a discount to my estimated intrinsic value is the second piece of equally important halves. In finding value, we use two different and distinct methods. The first is company specific. We utilize a discounted free cash flow model to ascertain the value of each individual holding (or potential holding). As this information is proprietary, I will simply say the aggregate price-to-value ratio for the Nintai portfolios is currently 0.91. This is to say our portfolios currently trade at a 9% discount to our estimated intrinsic value. Values range from 137% (overvalued) of our estimated value to 72% (undervalued). As a portfolio of individual stocks, we see some investment opportunities in several holdings trading at significant discounts to their estimated intrinsic values.     
 
The second approach we take to value is comparing the total portfolio to the S&P 500. This gives us an idea as to how the portfolio’s value is to the general markets. While we put a great deal of effort into the DCF model, we think looking at the broader markets is equally valuable. There are two numbers we look for in these market reviews. The first is how our portfolios’ price-to-earnings ratio look against the S&P 500’s ratio. This tells us how expensive the portfolios are against the broader markets. The second is analyzing the portfolios’ 5-year earnings growth projections against the S&P 500. This gives us a look at whether we are paying more or less for future growth versus the general markets.
 
The S&P 500’s price-to-earnings ratio - as of November 2019 - (source: www.multpl.com) stood at 22.95. The Nintai portfolios’ average price-to-earnings ratio was 18.8 at the same time - an 18.1% discount to the S&P 500 PE ratio. This tells us the Nintai portfolios are currently trading at a significantly cheaper rate than the S&P 500. Great news. In addition, the Nintai portfolios have a 5-year estimated earnings growth rate of 11.1%. This is roughly 17% greater than the estimated S&P 500 rate. We now know the portfolios are cheaper than the S&P 500 as well as estimated to grow earnings significantly faster. What’s not to like about those statistics? 
 
Putting It All Together
 
While it’s nice to have these numbers at our fingertips, they aren’t really that helpful to our investment partners. We created the Abacus reporting system to graphically demonstrate the quality and value components of each portfolio. This allows investors to use a single graphic to measure how their portfolio stacks up against the S&P 500. Seen below is a summary portfolio report of all the Nintai portfolios wrapped up in a single page report.

Our investment partners have a tendency to look at the rating arrows (all green is what they are looking for here) and ask any questions related to those. At the core, the graphic quickly encapsulates:

• Does the portfolio meet our quality criteria in general and against the S&P 500 specifically and;
• How does the portfolio compare in value against the S&P 500?

 
A number we look at carefully is the combination of the S&P 500 P/E relative number as well as the S&P 500 projected EPS growth relative number. Here we combine the fact that the portfolio is 18% cheaper than the S&P 500 and is estimated to grow 17% faster giving us a 35% “combined value rate (CVR)”. We are satisfied with a CVR over 25%. We have nearly always outperformed over the next 3 - 5 years if the number exceeds that amount. Equally important is adding up the S&P 500 relative number for ROC, ROE, and ROA. Here we look for a sum called the “combined quality value (CQV)” greater than 5. The current portfolio CQV is 6.6.
 
Why This Matters
 
A lot of readers will point out that looking for quality at good prices is just common sense. I completely agree. Yet its extraordinary to me that so few investment managers practice such an investment strategy. All too often I see far too active trading (even when a manager might own great companies), or a lack of concern about debt and credit quality. If you own a basket of outstanding companies with a long runway for growth, at Nintai we feel this tackles several issues. 
 
Watch Out Below
As mentioned earlier, one clear advantage of focusing on value and quality is the protection it provides on the downside. I wrote several years ago about how the highest quality stocks in our portfolios had performed the best during the 2007 - 2009 market crash. I firmly believe we will see similar movement when (and remember it’s not if – but when) the next crash happens. After an 11 year old bull market, I think the downside protection is worth even more. As a fiduciary steward, there is nothing more important than focusing on preventing the permanent impairment of my investment partner’s capital. I firmly believe a focus on quality and value is one of the more powerful tools in my arsenal to prevent such losses.
 
Let Management Do the Heavy Lifting
It’s been demonstrated many, many times that just a few items can severely damage investment returns over the long term. Under the broad category of “costs”, lie both transactional fees and taxes. One of the real benefits investing in a high quality stock at good value is the ability to hold it for the long term - meaning decades sometimes. This cuts down on transactional costs as well as any short or long-term capital gains. Why not let management allocate capital and do all the hard work when it comes value creation?
 
Finding Quality is a Difficult Task
While it may seem like a simple concept, finding quality at a value price is actually a rare and difficult thing to find in today’s market. Utilizing just Nintai’s quality measures (and not worrying about value pricing) leaves our team with less than 200 companies in the US and European markets. In addition, the company has to be in an industry, geography, business strategy, etc. that leads us to think we might be able to obtain a small knowledge-based competitive advantage against other investors. When we find a gem that meets all this criteria, at Nintai we are loathe to let them go.
 
Conclusions
 
As the latest bull market gets long in the tooth (and it’s narwhal long!), at Nintai we increasingly focus on the downside risk of the markets. We’ve found over time that two approaches serve us well in the latter stages of a bull market and for the duration of a bear market – hold significant cash and focus on quality. The (relatively) simple process of identifying outstanding companies with high returns and rock solid financials and purchasing those at fair value-based prices can cut down on risk dramatically. At Nintai, we highly recommend investors take a long hard look at their portfolios and look for companies and management that they can partner with over the decade or two. It’s hard to find ways to argue with Munger and Graham simultaneously. With a record like theirs, why even try?
    

“The two most powerful warriors are patience and time.”
 
                                                                     -      Leo Tolstoy 
“Great leadership is about continual change. An outstanding leader is always seeking opportunities in failure and always seeking improvement from success. Patience is key, but does not guarantee long-term prosperity.”
                                                                    -       Iwasaki Yatarō 

In Japan, the Sengoko period (or as translated into English “The Age of Warring States”) ran from roughly the mid-fifteenth century and ended with the Battle of Sekigahara in 1603. During that time, Japan was engaged in nearly constant civil wars as a series of very powerful regional leaders known as dâimyo battled to become the sole leader (the Shogun) of the country. One such leader named Takeda Shingen was considered an odds-on favorite - a great military leader, a wise civil administrator - he certainly had the credentials. Unfortunately, he ran up against two other leaders - Oda Nobunaga and Ieyasu Tokugawa - who would eventually precipitate his downfall. In a likely apocryphal story, a lead retainer sat with him and told him a story about a prince who worked hard at becoming the leader of his province. This prince spent all his time building, tearing down, fighting wars, and then rebuilding. It suddenly dawned on this prince that if he had simply been patient - allowed his population to grow, used a growing tax base to build out infrastructure, and so forth - he would have been far more powerful. In being so active, the prince had lost track of his greatest asset - time. Takeda recognized the point of his retainer’s story immediately. But by then it was too late. Within 5 years Takeda’s entire kingdom and family would be gone.
 
I bring up the story of Takeda Shingen because many investors see their investment world through his eyes. They feel action is necessary to achieve success. That through inaction they are somehow losing a step on their road to financial success. Yet study after study has shown that inaction is a good thing. It cuts down on costs, it allows compounding to work its magic, and it allows an investor to get on with the most important things in life - living.
 
Why Time Matters  
 
It’s amazing when you think about. What is the only force guaranteed to fill in the mightiest competitive moat? Time. Have you ever seen the greatest monopoly beat Father Time? What strongest empire, what greatest military power, what most violent tyrant has ever beat out time? Who is the sibling of compounding that makes it the eighth wonder of the world? It is time of course. For compounding cannot grow, cannot prosper, nor create any change at all….without time. What is the cheapest asset in all the investor’s arsenal of weapons? Time! It costs nothing, it has no ego, it will not fight with you, it will simply and quietly provide you with companionship every step of your investment journey.
 
Outstanding businesses will utilize time as an asset to grow competitive advantages, open new markets, and deploy existing capital into profitable growth. At Nintai, we look for managers who find ways to create business growth where return on capital far exceeds weighted average cost of capital. Combining this in a business model that requires little capital to begin with (thus allowing for the creation of a fortress-like balance sheet), leadership has created a business with a long runway of profitable growth. At Nintai, we look for companies where that profitable growth and strong balance sheet can be estimated to survive - and thrive - for decades.   
 
Is There Such a Thing as Too Much Time?
 
Some of my readers might be thinking at this point that this is another article on the value of time and money (which I’ve written about previously). But as Robert Abbott has pointed out, I have a passion for inverting many issues. Why should the concept of time be any different? So today I thought I’d look at when time is the enemy of your investment holding. Much like Shingen, great companies can let time eat away at their advantages – ranging from competitors to regulatory approvals. Every quarter – when Nintai Investments quickly reviews portfolio holding performance – we keep an eye on several numbers that might reflect that time has eaten away at our investment case. If any changes in these areas show up, we will completely take apart the business case developed earlier in the year and rebuild it from the ground up.
 
Falling Return on Invested Capital (ROIC)
The first item we look at is to make sure management is still allocating capital at exceptional rates. ROIC is the amount of return a company makes above the average cost it pays for its debt and equity capital. If the holding is going to continue to generate long-term outperformance, it is vital that ROIC exceed the company’s weighted average cost of capital (WACC) by a generous margin. A fall in ROIC can tell you management has taken its eye off the ball in several ways - it might be having difficulty in finding profitable investment opportunities, competition may be cutting into core customers and industries, or might just have simply invested in some truly unfortunate ventures. Falling ROIC can sneak up on you. If you think Boards and management will keep an eye on it for you, think again. In a 2013 survey by McKinsey (McKinsey Quarterly, “Tapping the Strategic Potential of Boards”, February 2013), less 16% of Board members knew that ROIC is the primary driver of value. If you believe ROIC is such a powerful driver - which I do - then I highly recommend keeping a close eye on ROIC.   
 
Falling Free Cash Flow Margins
As a value investor who utilizes a discounted free cash flow model to calculate value, free cash flow (FCF) is one of the most important margin numbers I watch (compared to say gross or net margins). At the end of the day, cash keeps the doors open and free cash allows management strategic flexibility in terms of future capital allocation of returns to investors. FCF margins can drop for several reasons but the one that gives us the greatest concern at
 
Nintai is losing the ability to price products and services. Many great companies share the same attribute of making their product in the daily operations of their customers. It almost makes it impossible for the customer to haggle or obtain pricing power over the long term. Think of Guidewire’s (GWRE) InsurancePlatform which operates many property and casualty insurers claims, billing, and policy functions. The amount of effort it would take to change vendors, remove one system, install a new one - all while maintaining consistent uptime and coverage - is a difficult action to justify. Another reason might be a large increase in capital expenditures which might reflect the same type of problem - having to increase spending to fend off competitive inroads to a holding’s customer base. When I see a significant decrease in FCF margins, this will generally have a direct impact on my discount model’s valuation. It’s never a great way to start the day.    
 
Drop in Cash or Increase in New Debt
Another sign that will catch my attention is to see a drop in cash on the balance sheet or - more importantly - the issuance of new debt. Generally, Nintai Investments runs a focused portfolio of roughly 20 - 25 position. Of these, roughly three-quarters will have no short or long-term debt. Occasionally, companies will issue debt for larger capex projects or acquisitions. Examples this might include Nintai Investment holding Novo Nordisk (NVO) which usually runs a very tight balance sheet with very little short-term debt (in the tens of millions of $$) versus having billions of dollars or short term instruments. The company has recently expanded its debt for new acquisitions. Obviously we want to see these type of deals generate high ROIC and see real value from the risk generated by a weakened balance sheet. Another example which we see an a wholly negative light was former Nintai Partners holding Qualcomm (QCOM) which took on an enormous debt obligation to fund share repurchases. No matter the calculations made, we see this type of action indefensible related to investor risk/reward. In many cases these types of transactions are simply a transfer of wealth from option-enriched managers hitting pay dirt when investors buy back millions of shares at inflated prices. In Qualcomm’s situation, we sold out of our entire position and never looked back.  
 
Conclusions
 
Investing in a small business that generates high return on capital, equity, and assets, has high free cash flow margins, and deep competitive advantages can be a wonderful partnership that lasts for decades. It’s the backbone of our investment strategy at Nintai Investments LLC and has provided the firm and its investment partners with outstanding returns since 2002 (of course past performance is no assurance of future returns). Having said that, finding companies where time aids in their growth and only strengthens their businesses is hard work. Time can erode any competitive advantage, fill any moat, and weaken any management team. Keeping an eye on several core measures can make sure you move on in a timely manner. Change happens. None of us like it. But I guarantee you none enjoy it less than lose who some of the core building blocks of their portfolios or daily living. Just ask Takeda Shingen.
 
DISCLOSURE: Portfolios that I personally manage are long GWRE and NVO. Nintai has no position in QCOM.    
 

“The world as we have created it is a process of our thinking. It cannot be changed without changing our thinking.”
                                                             -        Albert Einstein
 
“I’ve always been warned that when people say ‘it’s different this time’ it really isn’t very different. Yet if I look back over the last decade and I see so much underperformance by value investors (both traditional and the more modern-approach), I think to myself, ‘is it really different this time? Does value investing not work anymore’”?  
                                                            -         Sally Jenkins 

In my past few articles, I’ve discussed the distinction between growth and value investing, value’s difficulties since the 2007 - 2009 market crash, and how that has been part of a greater discussion about the viability of value investing in today’s markets. In this article, I thought I’d tie together the two themes and - at a very high level - summarize what the last decade has told us in terms of investment learnings and how we might come to terms with the over decade-long short circuiting in value investing performance.
 
At Nintai, we divide the market returns since the height of the technology bubble into four phases. Phase one was the run up into the technology bubble running roughly from 1998 - 2000. Traditional value investors - in general - did poorly as they continued to invest along more classic value investing guidelines. Many value investor shareholders began to get nervous as they opened their returns and saw underperformance being led by such staid companies as industrial parts supplier Fastenal (FAST) or spectrometry provider to biopharma Waters (WAT).[1] Some truly great investors closed their doors at the height of the bubble commenting on the fact they simply didn’t understand the market anymore. Phase two was the period of 2001 - 2006 when value investing roared back and more traditional companies like Proctor & Gamble (PG) or Coca Cola (KO) saw great returns while technology stars of the bubble sustained losses of up to 90% or even bankruptcy. It was rare to see such a clear vindication of value investment theory and practice. Phase three was the market crash of 2007 - 2009 led by the financial and credit markets starting with Bear Stearns and Lehman Brothers all the way to the government interventions of Fannie and Freddie Mac. There was a huge distinction though between the bursting of the technology bubble and the bursting of the credit/real estate market bubble. In the latter, many traditional value investors lost as heavily (and sometimes even more) as the general markets and even growth investors. Famous value investors who had been hailed as geniuses just half a decade before were chalking up 30, 40, and even 50% losses as their traditional value methods of using low price-to-book or price-to-revenue models imploded. Phase four added to the agony as the general markets powered through a nearly decade long recovery. While this was happening, traditional value returned paltry returns in what traditionally would have been a golden era for that investment style. Rather, you saw an entire generation of value investment leaders struggle for the entire decade. It was reflected in returns and even more importantly in their assets under management. The list is long and well-respected. Marty Whitman ($4.6B AUM in 2011 to $1.19B AUM in 2019), John Hussmann ($5.4B AUM in 2011 to $350M AUM in 2019), and David Dreman ($5.3B AUM in 2011 to $220M AUM in 2019).  Wally Weitz can be considered a success by seeing a rather slim increase in AUM (going from $2.3B in 2012 to $2.52B in 2019). Perhaps the harshest lessons were learned by David Winters, going from value investing rock star and CIO of Wintergreen Fund with $1.5B in AUM in 2012 to shuttering his doors in 2019 with less than $90M in assets. This humbled writer/investment manager had a dismal record with my own corporate internal fund (and eventual Charitable Trust) which was outperformed 4 out 5 years from 2011 - 2015 before I left the fund for greener pastures.
 
Is Value Investing Dead or Has It Simply Genetically Evolved?
 
In a recent Westwood Insights (“Value Stocks are Screaming for a Reversion to the Mean. Is Anyone Listening?”. It can be found here.) there is a segment describing the end of Julian Robertson’s career in March, 2000. It reads:
 
“It was an unseasonably warm 58 degrees in New York City on March 30, 2000. Winter white was just a faint memory on that Thursday, and the thoughts of bustling commuters had turned to spring. All was not balmy in the canyons of Wall Street, however, as the shock heard around the investing world had been announced that morning. Before the New York Stock Exchange opened, value investing legend Julian Robertson, age 67, announced that he was calling it quits, and would return the $13 billion that he managed to his 700 shareholders. He planned to shut down his fund and walk away.
 
At his fund’s peak in 1998, Robertson managed $22 billion, but he had seen withdrawals of $8 billion over the previous two years, including $1 billion in the first quarter of 2000. His fund had lost 19 percent in 1999, badly trailing the 21 percent gain in the S&P 500 index. He had lost another 14 percent in the first quarter of 2000. The New York Times summed up his predicament the day after his announcement, saying that Robertson ‘had essentially decided to stop driving the wrong way down the one-way technology thoroughfare that Wall Street has become.’
 
Robertson, a giant of the hedge fund and value investing worlds for more than 30 years, was a casualty of the technology stock euphoria that the prior five years had wrought on traditional value investors. ‘I’m not going to quit investing. I don’t mind people calling me an old-economy investor, but it doesn’t go over well with the clients,’ Robertson noted in his farewell.”
 
With the nearly decade-long underperformance (nearly twice as long as Robertson’s), that last paragraph wrings eerily true for many value investors as they gaze back at their record. It certainly hasn’t gone over well with their clients as well. But is it enough to simply say these days that value investors are just “old-economy” or is there something far more fundamentally wrong here? Is the very structure and model of value investing broken? 
 
Looking back over the last decade, I would argue value investing was already evolving before this last decade. Thinking and strategy had started to bifurcate as two distinct approaches began to appear. The first was based in the more traditional lower price-to-book and lower price-to-earnings (such as looking for companies with less than a 12-15 P/E ratio). These types of investors are generally descended more from the Ben Graham risk-focused, cigar-butt DNA.  The second approach - sometimes referred to as value investing 2.0 - is more in the what was referred to as GARP (growth-at-a-reasonable-price) investing. As an example, this is where a value investor is willing to place value on less-traditional assets such as technology or informatics platforms than a physical manufacturing plant or equipment (I confess I fall clearly in the latter category). What makes this dichotomy interesting is that value investors (2.0) have generated better returns over the last decade than the more traditional value investors. Part of that seems to be based on investment strategy (where growth stocks have been outperforming value) and part of it on individual stock selection (higher quality stocks have done equally well - if not better in some cases - than less quality picks).   
 
Putting aside the debate about more traditional value investing and value investing 2.0, the great question is whether value investing - in general - has gone the way of the dodo or great auk. One side of the argument argues that value investing (defined as low price/book ratio) has actually performed as you would think it would (meaning neither out or underperformed). It has been growth investing that has significantly outperformed its benchmarks over the past decade. In a recent report from Dimensional Investing (“Value Judgments: Viewing the Premium’s Performance Through History’s Lens” which can be found here), the authors discuss the fact that value stocks actually have underperformed growth stocks 11.4% to 14.7% for the period 2010 – 2019. But the way we look at this underperformance is likely skewing the debate about the longer term viability of value investing. The authors contend the issue is less about value stocks underperforming but more about growth stocks outperforming. They go on to demonstrate that value stocks over the past decade have traded similar to what you would expect over a longer-term duration that include several market cycles. Value stock decade-long (2010 - 2019) returns of 11.4% track closely to their 11.9% return since 1979. The interesting data show up in the growth stocks. This segment’s previous decade (2010 - 2019) returns of 14.7% have far outperformed their 11.3% return from the period 1979 - 2019. Dimensional can’t isolate any particular reason why growth stocks have achieved such abnormally higher returns over the past decade. The authors say the data do not support any of the theories proposed by market analysts including low interest rates, quantitative easing programs by central banks, and the outsize influence of the so-called FAANG stocks, a group of stocks that include Amazon (AMZN), Apple (AAPL), and Facebook (FB). In this thesis, the bottom line is that value stocks (as defined by Dimensional) have produced similar returns over both decade-long and three decade-long time frames. The simply have not been able to keep up with a decade-long outperformance (for which we can’t account) in growth stocks.
 
Others Say Not So Fast
 
Another school of thought has developed counter to the thinking of Dimensional’s theory. An example of this is a recent paper by Baruch Lev and Anup Srivastava entitled “Explaining the Recent Failure of Value Investing” (it can be here). In the abstract of their work, they summarize their view that value investing’s best days are behind it:
 
“It is widely believed that the long-standing and highly popular value investing strategy—investing in low-valued stocks and selling short high-valued equities—lost its edge in the past 10 - 12 years. The reasons for this putative failure of value investing elude investors and academics, making it a challenge to assess the likelihood of the return of value investing to its days of glory. Based on extensive data analysis we show that value investing has generally been unprofitable for almost 30 years, barring a brief resurrection following the dotcom bust. We identify two major reasons for the failure of value investing: (1) accounting deficiencies causing systematic misidentification of value, and particularly of glamour (growth) stocks, and (2) fundamental economic developments which slowed down significantly the reshuffling of value and glamour stocks (mean reversion) which drove the erstwhile gains from the value strategy.”
 
The author’s argument in many inverts the thinking behind the team at Dimensional. They believe the overperformance of value investing post-technology bubble was not the mean but rather an anomaly in a longer history of underperformance since the late 1980’s. They state (somewhat in agreement with Dimensional) that there is no specific market-driven item that can be identified as eliminating value’s edge. Rather, they believe it was changes in how we value companies – rather than process of picking low P/E stocks – that eliminated value investing’s edge. From their paper they write:
 
“The expensing of intangibles, leading to their absence from book values, started to have a major effect on financial data (book values, earnings) from the late 1980s, due to the growth of corporate investment in intangibles. This book value mismeasurement was a major contributor to the demise of value investing which started in the late 1980s.”
 
The failure of value investing during the credit/real estate crash of 2007 – 2009 layered on another shift in economic changes (not market changes). They state that more traditional value companies (particularly those with debt loaded balance sheets ranging from manufacturing firms to larger financial institutions) lost their access to capital. Meanwhile, the more glamorous asset-light companies (technology and biopharma) became Wall Street and credit provider darlings leading to a distinct economic advantage for the latter.   
 
Since there has been little change in this newer economic model, Lev and Srivastava don’t see value investing making any big comeback soon.
 
 What This All Means
 
All of this data brings us back to the core questions surrounding the prognosis for value investing. Is it really different this time? Are the prognosticators of doom finally correct?   
 
The simple - and most honest - answer is we simply have no idea what the future holds for those investors who follow a value investment strategy[2]. For those who suffered tremendous losses in the 2007 - 2009 crash (where value methods should have prevented such results) followed by multi-year underperformance in a record setting bull market (again, where there should be some outperformance in value in the years following a bear market), the question is almost moot. If your investment strategy fails you in both bull and bear markets, then it’s not irrational to call into question the fundamentals of such an approach.
 
At Nintai, the entire debate is more academic than practical in our view. As investors in assets trading at a discount to our estimated intrinsic value, we think this puts us clearly in the value investment approach. Whether that is based on hard assets on the balance sheets or value derived from the future cash flow of an asset-light business model is irrelevant. We think the focus on value makes you a value investor – nothing more and nothing less.
 
Having said that (and there’s always a “but” in any good argument!), we do believe that value investing 2.0 has had a leg up on more traditional value investing over the last decade. I have no data to support such a claim nor do I have any specific reason (like Dimensional) why that would be the case. My only idea is that over the long term (here I mean a time frame greater than a decade), buying quality companies at fair prices will generate better returns than purchasing medium/poor quality companies at great prices. Again, I want to point out I have no data to support such a claim. Most of it likely lies in the fact I’m simply more comfortable investing with those caveats in mind[3].
 
The larger debate about whether value investing (regardless of more traditional or 2.0) is dead really isn’t all that clear. If you argue like Lev and Srivastava the edge has been gone for over 4 decades, then there isn’t much to debate. If you take the more nuanced view such as the Dimensional team then there is still room for debate about value investing’s future.  
 
In the final analysis, it’s up to each individual investor to develop their own investment style that meets a couple of needs: it lets them sleep well night and it produces returns adequate to meet their financial requirements. Whether that’s achieved through a more traditional value approach, value 2.0 approach, or growth investing approach is up to them. But as a portfolio manager myself, I wouldn’t rule out value investing yet. There are still people outperforming the market who all share the same genetic roots from Graham and Doddsville. Whether the causation and pool of candidates are as large as when Warren Buffett first brought the concept to the investing world’s attention, it can’t be denied it’s still there. It may be different this time, but it doesn’t mean value investing is dead yet. 


[1] These were two companies I owed at the time I was personally managing the Nintai Partner private investment fund. They certainly weren’t the WorldCom’s or the Cisco’s of the investment world.

[2] It should be said this applies to any investment approach or for the markets in general.

[3] As I’ve discussed previously, over the time frame of 2002 – 2015 the portfolios I personally managed were able to outperform the markets by a considerable margin (past results are no guarantees of future returns!). From my limited perspective, my hybrid value approach has worked well meeting my investment needs.

I recently got done writing a multi-part series on how value investors got the credit crisis and Great Recession of 2008 - 2010 so wrong. A weakness many investors and financial writers have is the inability to find in themselves the same faults they find in others. There’s the old adage that history doesn’t exactly repeat itself, but it often rhymes. This past year, I made a mistake that - while not an exact repeat of the errors made by value investors in the Great Recession - certainly rhymed. In this mistake, I made a considerable error in mixing up my thinking about company growth and company valuation.
 
Growth and Value: The Foundation of Fuzzy Thinking
 
One of the things that Warren Buffett has spoken about many times is the fact that making the distinction between growth and value can lead to fuzzy thinking. Buffett frequently makes the point that all value investing is about growth investing. In his 1992 Berkshire Hathaway Annual Report, he wrote:
 
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
 
He further elaborated his thinking in his 2000 Annual Report writing:
 
“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation, except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component - usually a plus, sometimes a minus - in the value equation.”
 
I bring up the distinction between growth and value because I made a fundamental mistake recently in my calculation of the value of Veeva (VEEV) - which led me to sell the stock from client portfolios. My error – which I will discuss in much greater detail below - was thinking that growth in the stock price was rising (and would continue to rise) at a faster rate than my estimated intrinsic value ever could. That is to say Veeva’s valuation would never keep up with its growth.
 
A Little Background
 
Veeva Systems was a group of individuals who worked with Salesforce (CRM), a customer relationship management (CRM) software provider. This group believed their expertise in the pharmaceutical market could lead to high growth and significant market share. The company was a success from the beginning. Since 2011, Veeva grew revenue per share from $0.25/share to $5.52/share in 2019. The past 5 year annual growth rates for revenue, earnings per share, and free cash flow have been 16.6%, 55.7%, and 40.2% respectively. The company averaged return on capital in the low 80% range and grew free cash flow margins from roughly 15% in 2011 to nearly 42% by 2019. The company has never carried any short or long-term debt and increased cash/marketable securities on the balance sheet from $17M in 2012 to $1.43B in 2019.
 
Veeva also happened to be in a market vertical where Nintai Partners had deep experience. Most of Veeva’s clients were Nintai’s consulting clients and their work in informatics coincided with Nintai’s core competency. We deeply respected Veeva’s management, their product and services, and their market strategy. In essence, Nintai Partner’s legacy knowledge allowed the new Nintai Investments LLC to be comfortable partnering with an outstanding company and management team all in a growing market.
 
The Decision (or How We Blew It) 
 
Nintai Investments LLC had owned Veeva since opening its doors (it had been a holding in the Nintai Charitable Trust since 2005). We originally purchased the stock in February 2018. In May 2019 - after a blow out quarterly earnings announcement - we sent out the following to our investment partners.
 
 -----------------------------------------------------

To Our Investment Partners:
 
Yesterday, Veeva (VEEV) announced Q1 earnings. They were superb. The stock is trading up 14% today. Q1 revenue grew 25% year over year to $245 million, while normalized EPS grew 52% year over year to $0.50. Subscription revenue increased 27% year over year, while services revenue increased 18%. Deferred revenue increased 26%. Operating margins increased from 32% to 38% compared to last year. Bookings and service revenue look outstanding. Guidance for the remainder of 2019 was ahead of our expectations. We expect to increase our estimated fair value by roughly 8% bringing it to around $100/share. 
 
The position has returned 168% since our initial purchase in February 2018. The stock currently trades at roughly a 54% premium to our estimated intrinsic value. At that level we frequently sell out of the entire position. However, because of the uncertain potential of adjacent market opportunities (the company announced deals in chemicals and consumer goods recently), we only sold 40% of our existing position and will retain a position in the company.  
 
Please feel free to email or call with any questions. My best wishes. 
 
Tom
 
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So far our investment partners had nothing to complain about. We had a holding with outstanding returns though now trading at a significant premium to our estimated intrinsic value. Here was the rub however. Conservative value investment theory would have us sell the position at such a premium. No matter how successful we felt the company could be, we felt we couldn’t be guilty of recency bias or hold on to the stock simply because of how well it had performed in the past. Be ruled by the head and not by the heart.
 
With 20/20 hindsight our mistake was startlingly obvious. In our “head-not-heart” mind set, we simply couldn’t believe a review (no matter how deep) in our valuation process would increase the valuation greater than the increase in the price. So - utilizing our supremely confident “we-must-be-supremely-heartless-and-coldly-rational” attitude, we sold out the entire position by end of July 2019. We congratulated ourselves on locking in a 168% return for our investment partners and began looking at new opportunities in which to allocate this capital.     
 
What Happened Next
 
After selling the stock and placing it on the watch list, Veeva came up for review relatively quickly. At Nintai, this annual process is quite extensive with a top to bottom breakdown of our investment case. Everything that can be used to better understand the competitive advantage and market moat is broken down with in-depth research. We look at product pipeline to sales force effectiveness, market satisfaction and adoption rates, customer reviews and purchasing budgets, regulatory filings and approval calendars. We also break down the company financials trying to get a deep understanding of the components that make up cash flows, income statement, and balance sheet. Particular focus is spent on capital allocation and free cash flow generation.
 
Without going into all the details, by the end of our review it became very clear we needed to seriously adjust our valuation upwards. In fact, the increase was so large we sent out a new update (barely two weeks after sending out why we felt compelled to sell the position).
 
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We spent this past Monday and Tuesday speaking with Veeva management, their largest customers, industry thought leaders, and regulatory officials. This completed our nearly two week review of the business, including our annual deep dive on competition, market growth, etc. After reviewing our findings it became clear that we had seriously undervalued the company.  Our revised valuation went from roughly $110/share to nearly $182/share. We have to say that this is the largest adjustment in intrinsic value we’ve ever made. Since July 15th Veeva’s stock price has dropped from $175 to today’s (September 13 2019) price of $139. This represents a 21% drop. At this price the stock trades at a 23% discount to our estimated intrinsic value. 
 
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John Maynard Keynes famously never-said[1], “When the facts change, I change my mind. What do you do, sir?”. It’s pretty wise advice no matter who you attribute it to. With as straight a face as we could muster, Nintai announced we were reversing course and adding Veeva back into the portfolio. It certainly wasn’t a banner day at Nintai world headquarters, but at least the facts backed us up……again.
 
What Can Be Learned
 
I could probably write a book just on the errors from the “Veeva Adventure” (as we refer to it now). That will have to wait for another day. For now, let me summarize the findings that are most applicable to every day investing theory and practices.
 
Don’t Ever ASSuME (You Know How the Rest of That Goes)
In my value investment trained mind, I had made the distinction that Warren Buffett had clearly warned led to fuzzy thinking. It is possible to have a value investment that has two seemingly contradictory attributes - high growth in revenues and free cash and trade at a significant discount to intrinsic value. The value investing world will not end when the two reside next to each other. It’s a lesson I seemingly need to (re)learn every couple of years.
 
Don’t Get Over Confident
When you start to think you know enough about the company or its markets without looking at new data, then you’ve got a real problem. Market dynamics can change by the day, so an investor should always base decisions on the latest well-researched statistics. The fact that I could be off by such an extent on Veeva’s valuation was an example of clear arrogance. Just because I knew a lot about the company’s past didn’t mean I was a greater predictor of its future.
 
If You Base Your Decisions on Facts, Then Be Damn Sure About Your Facts
One of the reasons why I always write an investment case for a potential investment, then turn around and write an anti-investment case, is to make sure I’ve seen both sides of the arguments and the facts support one more than the other. This means I have to know my facts cold. This also means I need to check and double check my facts. Not only was I guilty of intellectual arrogance when it came to Veeva, sadly I was guilty of intellectual indolence as well.
 
Conclusions
 
Being able to identify mistakes and finding the cause is really only half the battle. The second part is creating processes to prevent these types of errors from happening again and being able to verbalize what happened to individuals outside the decision process. This might include your investment partners, your Board of Directors, and you, the reader. I keep a running list of errors I’ve made in my investment process since 2004. That list includes 77 specific errors. Each one is identified, discussed, and then a solution is listed next to it. I’m glad to say I’ve only repeated a total of 6 errors or roughly 8% of the total list. Unfortunately, the underlying cause of the Veeva case is a repeat offender. In my next article I thought I’d discuss other cases similar to this, what solutions I’ve employed, and why I think they have failed.
 
Until then, I look forward to your thoughts and comments.
 
Disclosure: Portfolios that I personally manage own Veeva.     
     


[1] The quote has been attributed to Keynes for decades. Unfortunately - as Jason Zweig points out in a WSJ article - there is no direct evidence Keynes said ANYTHING like it. Keynes’ biographer, Lord Robert Skidelsky, believe the quote (along with the other gem “the market can remain irrational longer than you can remain solvent”) was “most likely apocryphal”.