I recently had the pleasure speaking to an Ivy League school’s endowment board of directors about the future of value investing. The Board has been struggling with roughly a decade of relatively poor performance compared to the S&P 500. A couple of particular sticking points have been high turnover in the portfolio along with fees charged by the endowment’s fund managers. (I should note the directors have no one to blame but themselves since they sign the contracts). About mid-way through our time together, it became clear the investment structure, management organization, and decision processes had no alignment with their goals for the endowment’s assets. At this point I discussed Nintai’s use of an intellectual framework and process that provides it with the means to actualize the company’s investment tenets and rules.
At Nintai, we practice our own unique version of value investing that focuses on price, value, and quality. These three legs of our investment triangle are sometimes disputed to be growth-at-a-reasonable (GARP) and not true value investing. We discussed this all the way back in 2015 in an article entitled “Am I a Value Investor?”. Since we focus on not overpaying and look for a substantial discount to fair value when we purchase, we consider ourselves value investors. We break from more traditionalists by worrying less about certain ratios such as price to earnings or price to book, but this certainly doesn’t mean we think value has no role in investment selection.
As value investors (now that we’ve settled that!), we focus on three core tenets that drive our overall investment philosophy and strategy. These are the impact of quality on value investing, making a clear distinction between a quality company and a quality investment, and creating an investment process that works for you. These tenets overlay four rules that make value investing work over the long term. These include cutting down on turnover/reducing trading and fees, mastering human emotions during good and bad times, creating a work ethic that makes you a learning machine, and understanding the relationship between value and price is the basis for outperforming the general markets.
At Nintai, we think these seven tenets and rules have created an intellectual process that gives us an advantage over most of Wall Street. None of it is rocket science. None of it requires advanced mathematics. None of it even requires a master’s degree in business administration. In fact, we’ve found much advanced educational and professional training is detrimental to being a successful value investor and more suited to speculation and market timing. I recommended to the University Endowment’s Board they get back to basics and follow these time-tested philosophy’s and perhaps (of course past performance is no guarantee of future returns) they might see a reduction in fees, costs and turnover all while increasing long term performance.
Value Investing and Quality
Ever since Warren Buffett partnered with Charlie Munger, there has been a robust debate about the definition of value investing. One school comes from the more traditional models of Benjamin Graham – sometimes referred to as “cigar butt” investing - in which the investor looks to purchase a company where the current assets (cash, cash equivalents, inventory, etc.) exceed the total liabilities of the company. That’s a complex way to say the company has got more than it owes. This type of investment (called a “net/net” by Ben Graham) would be part of a basket of such stocks where one might make a handsome profit when the markets realized such pricing discrepancy. The other school of thought looks for outstanding companies trading at fair prices. This might be a company with high return on capital, solid long-term growth, and solid balance sheet trading at roughly seventy-five cents on the dollar. In the former, an investor purchases a company with little long term future but a hope the markets recognize the mispricing of assets. In the latter, an investor refuses to overpay for assets but looks for long term value generation to compound over the long term. It is critical that an investor know why it’s important to build a portfolio around quality investments and how you go about finding them.
Quality Investments versus Quality Companies
Finding a quality investment is distinct from finding a quality business. For instance you may find a business with outstanding characteristics such as high return on capital, but trading at a 60% premium to your estimated value. This would be a quality company that is likely to be a poor investment. Conversely you might find a rather pedestrian company trading at a 15% discount to your estimated value. This would be a non-quality company at a compelling price. Should you buy either? It is vital that investors know the difference between a quality company and a quality investment. More importantly, they must know the core requirements that make up a quality company and how an investor goes about finding them.
Defining Your Path
Much like Warren Buffett, my career as an investment manager has migrated from the short-term cigar butt investor to one looking for long-term capital compounders. My record as a short-term investor wasn’t great and I found it didn’t meet my natural predilection for positive, long-term growth stories. It was a great first lesson - to thine own self be true. Create and stick with an investment approach that reflects your inner self. In abandoning the cigar butt methodology, I wasn’t making any moral judgement about investors who took such an approach. One thing you will learn on Wall Street is that there are many, many ways to make (and lose!) money. It is vital an investor creates their own investment operation that can help them sleep well at night.
It is critical to understand these basic tenets sit on a foundation of rules that are as immutable as any of Einstein’s theories on relativity. Investors should bear in mind that these rules work like a gravitational force in eating away at performance. Each of them can lead long term value and quality investors far astray from their goals. Conversely, when applied rationally they can provide individuals (or organizations) with an advantage at no cost to the patient, focused investor.
Turnover and Trading
Turnover and trading are not characteristics of a long-term quality investor. You will often read an overview of an investment advisor’s investment case for purchasing a certain holding and then see it was traded out of the portfolio after just 6 months. It seems to me the adviser either knew too little about that holding or they let emotions get the best of them. How do I define trading? Buying and selling a holding within a 6 month to 1 year time period is a sign of a trading mentality. Turnover of 50% or more year (meaning the adviser buys or sells 50% of the entire portfolio in a 1 year period) are signs of an adviser’s proclivity to trade. It’s critical to remember that trading eats away at returns by expenses in brokerage fees, lost opportunity costs, and capital gains taxes.
During periods of bull markets to bear markets – and all the spaces in between - many investors let their emotions get the best of them. Whether it be fear or greed, emotions can override some of the common senses rules you think you have down pat. How many investors have seen a holding drop by 30% in one day and sold it as quickly as their brokerage account could make the trade? What happened to well thought out business cases based on intrinsic value? Or even following the simple rule of “buy low and sell high”? Emotions have a way of making a hash of our best laid plans. To be a long term value investor, you must find a way to manage your emotions.
Value investing is hard work. While it may sound like I’m advising investors to find their 15-20 quality companies, make their purchases, and then check out for the decade. Nothing could be further from the truth. The ability to ascertain quality from both external and internal views (meaning internal metrics and external perceptions) takes an enormous amount of time. The investor must read, research, calculate, and synthesize a great deal of data and knowledge. You don’t need an IQ of 160 or have an MBA from Harvard, but you do need to make a commitment to always be learning about your portfolio holdings themselves and the markets in which they operate.
Price and Value Always Matters
No matter how outstanding the quality of a company, it will be difficult to obtain long term outperformance if you don’t know the value of what you purchasing and how that correlates to its price. If you purchased a basket of internet-based companies in January 2000 you had to be a relatively patient investor to see any positive returns and even longer for outperformance. One of Murphy’s Laws is that everything looks cheap when you don’t know its value. Wall Street cares little what you think about a company’s quality, and even less about how much you paid for a share of said company. Successful value investors simply predict value versus price better than other investors. It’s really that simple.
These foundational rules - when applied properly - can provide long term value investors with a real leg up on Wall Street. For all the talk on financial networks, investing shows, and industry marketing, the vast majority of financial “experts” have little to no idea of how the markets or their clients’ portfolios will perform over the next 1 month, 3 months, 3 years, or even 30 years. Financial markets are made up of - most basically - human beings making decisions based on a blend of these rules.
A word of caution. These rules may seem easy to live by. In today’s markets, commercials make it sound convincing that with the right technology and management team investors can join a website, follow their recommendations, and retire at 45. It would seem to me that the lessons from the spring of 2000, the fall of 2007, and the spring of 2020 should enlighten most that investing is far more complex (though in some ways easier) than marketed, and demands steady effort over the long term. It is my belief the vast majority of underperformance can be attributed to violation of these rules.
In sum, at Nintai we use these tenets and rules as an intellectual framework to pose questions, conduct research, ascertain the qualitative nature of a potential investment, assign intrinsic value, and - finally - to make investment decisions to buy or sell. I should point out that following these rules in no way guarantees an investor will beat the S&P 500 every year for the next decade. We certainly haven’t at Nintai! Previous performance is no assurance of future returns. But I think a focus and applied approach to investing following these goals/rules can provide an investor with the possibility of preventing very painful losses and better long-term performance.
 Cigar butts received their name from the concept than an investor might take one last hit from such a stock and purchase a dollar’s share of assets for fifty cents. For a non-investing description, imagine finding a nearly completely smoked cigar on the sidewalk, but having enough to take one more pull on it - hence cigar