- David Stockman
I’ve been involved in some way in the capitalistic system of the United States since I was 9 years old and delivered 112 newspapers on a route which I biked 6 days a week and collected exactly $21.60 in wages and somewhere between $20 - $30 in tips each week. It was a great experience in learning the core concepts of capitalism - seeing the conflict between management and labor (I couldn’t see why we weren’t paid more on Saturdays as the newspapers weighed exactly 1.8 times more than the other 5 days and it took twice as long to deliver that day’s papers), the importance of customer service and quality (delivering on time and in the location requested by customers meant better tips), and the power of a duopoly (there were only two newspapers in our town - the Concord Monitor and the Manchester Union Leader). My parents didn’t earn a lot of money in those days and sometimes borrowed from my tip jar to help pay the bills. They then scrupulously payed back the exact amount borrowed. I also learned that when Polonius said “neither a borrower or lender be” what he really meant was if you need to be one - be a lender.
Over time, my understanding of the capitalistic system became richer, deeper, and more profound as I helped found a small private-equity firm after earning my undergraduate degree and partnering with two friends who had both money and political connections. By the time I started Nintai Partners I had a pretty good understanding of the nature of competition, profit & loss, the power and danger of leverage, and the strength associated with free cash flow. As I transferred this knowledge from being the CEO of a boutique consulting firm to starting Nintai Investments LLC (a small registered investment advisory firm), I felt I had a very broad – and yet focused – knowledge on the type of company that I believe makes a powerful long-term investment prospect. I operated in this capitalistic system making
enough profits to help live a life filled with adventure, experience, and more than enough benefits to live quite happily.
My trip down memory lane isn’t the first sign of me losing my mind (at least I don’t think so!). Rather, I bring all this up as I’ve been giving a lot of thought of where my industry - which has been so good to me and so many others - is headed and what changes have taken place over the past 20 - 25 years. As I’ve moved full time into a role as a CEO of an investment advisory firm as well as chief investment officer, I’ve given a lot of thought about my experiences and what they taught me for being a quality investment manager.
In my article last week (“Quality in Investing – Part 2”, August 1 2020. It can be found here.), I ended my discussion about finding quality not just in your portfolio holding but also in your financial advisor. Since my first day as an investment manager I’ve held one tenet as the bedrock of my business values - I have a fiduciary responsibility to my investment partners. This simply means that my actions must take into account my clients first, and Nintai Investments’ needs second. Fiduciary responsibility can be a flexible concept. Some see how much (0.75% or 2%) you charge your clients while others see how (% of assets or 2/20) you charge them as the litmus test for fiduciary responsibility. Others see quality management as investing your own money as you do your clients’ (or as Warren Buffett said, “eating your own cooking” as Nintai does). There are many, many ways to achieve what appears to be a fair and equitable model. At Nintai, we think there are a set of core values that make up good fiduciary guidance and policy. I thought I’d share these with you today.
One of the questions you have to ask from the onset of opening your doors - and going forward until you close those doors - is the amount you will charge your investment partners for your services. The industry’s view on this has changed dramatically since the onset of “Bogles Folly” - Vanguard’s first index fund. Passive indexing means just that - there is no active component to managing client funds. An index fund simply follows its respective index (the S&P 500 TR, the Russell 2000, etc.) and rebalances once a year. The fees to manage such a fund are miniscule - in today’s world sometimes being less than 0.1% of AUM. It’s really only since around 2000 and the great “Tech Bubble” that saw fees began their dramatic descent. For instance, from 1979 - 1999 the average weighted expense ratio (with sales loads) increased from 1.50% to 1.52%. Since 2000, index funds have hammered the active fund management industry. The average annual management fee for actively managed funds from 2000 – 2019 has dropped 1.52% to 0.74%. Actively managed fund fees have been cut in half in the last 20 years. Overall, you’d think this would be a great trend for those invested in actively managed funds. But not so fast! During the period from 2000 - 2019, the total amount of revenues paid by investors (front end, back end, 12b-1, management fees, etc.) to mutual funds skyrocketed from roughly $45B in 2000 to nearly $107B in 2019. So much for cutting costs in half! In his classic book “The Battle for the Soul of Capitalism”, Jack Bogle writes that during 1997 – 2002 alone, the total revenues paid by investors to investment banking and brokerage firms exceeded $1 trillion, and payments to mutual funds exceeded $275 billion.
The arithmetic is simple in calculation and staggering in its impact. Let’s assume an investor starts out by investing $1M in a vanilla mutual fund that earns 6% annually. Let’s also assume a very helpful family member pays the small 0.1% management fee as an incentive to save. That $1M – with no fees – over 25 years would earn $330,000. Added to your initial $100,000 investment you’d have $430,000. Let assume life went another direction and no generous relative showed up and you invested your $100,000 in a fund that charged 2% (that’s not unreasonable for an active managed fund when you include all-in costs such as trading, differences in bid-ask, etc.). Paying those fees you’d earn $170,000. Added to your initial $100,000 investment you’d end up with $270,000. That’s quite a difference from $430,000. A 40% difference actually. So a 2% difference in fees can eat up 40% of your returns. That’s a lot of vacations, anniversary gifts, or heavens forbid medical care if you need it. Where are the customers’ yachts indeed? Where does all this money come from and where does it go? It’s pretty simple. Customers pay the fees and mutual fund executives and fund managers see the profits. As many of us know, paying all these fees doesn’t assure quality or outperformance. Amazingly, even after all these costs the vast majority of managers underperform a simple index fund. In investment management, you rarely get what you pay for when it comes to long-term returns.
At Nintai Investments, we charge 0.75% of all assets under management. We have an internal policy that should an individual’s personal investment account underperform its proxy (generally the Russell 2000 or S&P 500TR), for two straight years we reduce our management fee to 0.50%. After three years of underperformance we reduce the fee to 0.25%. If longer, it’s likely the Board will suggest we look for a career outside investment management!
We’ve all seen the disclaimer (usually in a ridiculously small font) that “past results are no guarantee of future returns” or something of the like. It’s probably one of the most accurate statements you’ll read in all your interactions with Wall Street. Because it is true. As an investment manager myself I have no idea what my returns will be in 1 year, 3 years, or 5 years. I certainly hope they will outperform the greater markets. But in reality I have no idea. Being honest about that to both your investors and yourself must be a bedrock intellectual foundation throughout your investment career. Bad things happen to both parties when a manager loses sight of this. Scenarios from simple pig-headed investment strategies to Bernie Madoff debacles are the inevitable by-product of those who are convinced they know more - and that they will always outperform - the markets in general.
Another critical trait in the investment returns of the great investors is the recognition that if you can avoid the truly horrific downturns (particularly those that permanently impair capital) the upside will take care of itself. At Nintai Investments, we spend an extraordinary amount of time looking for companies that meet our quality criteria (see our two-part series “Quality in Investing” published earlier in July/August 2020) that help us avoid significant drawdowns. If we can find companies with fortress-like balance sheets, strong free cash flow, deep competitive moats and trading at reasonable prices, then we are comfortable (but it is not guaranteed!) that the company can generate adequate returns over the next 10 - 20 years.
Nintai’s clients have been fortunate in that we have - on average - had investment partner portfolios beat the S&P 500TR by roughly 16% since inception and the Russell 2000 (a closer proxy) by 24% since inception. As we are required to say (and understand all too clearly), past performance is no guarantee of future returns.
For decades, the practice of many money managers was to issue an annual letter (or God forbid a quarterly letter!) that briefly outlined fund performance (usually skimpy in numbers or so complicated they were impossible to understand, but no happy medium). The manager would then spend a vast amount of the report pontificating on where the economy was going, what tax laws were going to change, and finishing with some inexecrable use of industry jargon like “synthetic options triple witching”. Overall, it was a report useful mostly for starting a wood fire or when you run short of vital bathroom supplies.
At Nintai we take a different approach. We like to provide our investment partners with content we’d like to receive ourselves if we were in their shoes. This includes investment cases and valuation spreadsheets on each of our portfolio holdings, quarterly reports which explain – in plain terms – how their portfolios performed, what went right, and more importantly, what went wrong. We want our investment partners to feel just that – partners in making investment decisions. If an investment manager can’t describe why they own a holding, how much that holding is worth, or discuss the major characteristics of the holding (products, services, competition, markets, etc.) then they really aren’t managing anything, other than collecting their fees.
When individuals discuss ethics, they generally are referring to the investment managers personal ethics – do they have any sanctions or settlements in their past, have they stolen from their clients, etc. At Nintai, we believe that’s important. But equally important is the ethics of both the company and management outside the business. We believe strongly ethics means a positive and active engagement by management in their community, supporting people, organizations (even animals) in need, or helping those who simply need a hand up. It also means the company actively supports charitable giving. We live and work in a system - and country - that has provided us with enormous opportunity. Our corporate ethics requires us to help those who don’t have the same advantages or opportunities. So while we pledge to provide ethical management in our investment business, we also pledge to be ethical in our compensation to support staff, to our vendors who do the hundreds of things that make our business run, and to regulators who have provided us with voluntary guidance and assistance. Next time you think of the ethics of an investment manager, remember they don’t operate in a bubble, or only work with you. Make sure they provide a global view of doing the right thing. It makes all of us better workers, citizens, and human beings on an increasingly integrated planet.
I’ve given a lot of thought to the David Stockman quote at the beginning of this article. Here was a man who had everything in the world and yet as a senior partner at a private equity company participated in the very process he so aggrievedly writes about. He is right about nearly everything he discusses without understanding the irony that he helped create and engage in this very activity and helped design the system. His work at Blackstone – and later Heartland – is a record of all the characteristics one should avoid in an investment manager. The fee structure of Heartland Industrial Partners assured the winning hands were weighted heavily against the investor. His returns were abysmal leading to Steve Schwarzman (CEO of Blackstone) cutting him off from investment deals . His record was even worse at Heartland leading to a $340M loss in in its Collins & Aikman investment. His ethics certainly took a hit when federal prosecutors indicted Stockman and the SEC brought civil charges. Both were related to “a scheme to defraud Collins & Aikman's investors, banks and creditors by manipulating C&A's reported revenues and earnings.” In fairness, it should be noted the federal prosecutors dropped their charges in 2009.
When one is looking for quality in an investment manager, I feel strongly the individual should have traits more in alignment with Nintai’s than Mr. Stockman’s. Fees and returns should prove the manager has both the skills and emotions to be a successful long-term investor. Communications between the investor and manager should be clear and concise discussing returns and other issues in a manner where the investor comes away satisfied they know everything necessary to explain their portfolio. Finally, the manager and his/her organization should have a deeply ethical framework in their personal and professional actions and decision making. Finding such a manager might be difficult, but certainly possible. There are many outstanding investors and investment teams who meet these criteria. Choosing one will be one of the best investment decisions you will ever make.
 “The Great Deformation: The Corruption of Capitalism in America”, David Stockman, PublicAffairs, Perseus Books Group, 2013
 Securities and Exchange Commission, Division of Investment Management, “ Report on Mutual Fund Fees and Expenses”, December 2000
 “The Battle for the Soul of Capitalism”, John C. Bogle, Yale University Press, 2006, page 11
 A special thanks to Vanguard for the basis of this example.