We are pleased to announce that Tom's book "Seeking Wisdom: Thoughts on Value Investing" is available for Kindle pre-order. You can find it on the Amazon website. The hardcover version is expected to be released somewhat earlier. goo.gl/EVbKtE
Camouflage is an incredibly interesting area of research. Most people think of it as a means to blend into the background making it harder to be seen. In most cases, one is looking to passively blend into the environment. Techniques such as color matching, disruptive coloration (similar to camouflage seen on WWII shipping), and seasonal alteration (white smocks for winter campaigning) represent this method. This area of camouflage represents the vast majority of peoples’ views on the topic.
What makes the concept of camouflage so interesting is that the previous examples are only half of the possible solution. In their own way, they represent a passive approach. Another way to create camouflage is to actively create confusion in the processing of vision-induced data. Here the aim is to provide a pattern that - when seen by the naked eye - creates conflicting thoughts in the mind of the observer. The right eye is in conflict with the left eye creating a breakdown in interpreting what one believes they are seeing. An example of this is motion dazzling. A zebra is a great example of this technique. The bold white and black coloring – when seen at a high speed - creates confusion with predators over speed and direction. This difference between passively seeking to blend in versus an active creation of confusion can make the difference between life and death in the animal kingdom.
I bring this up because companies are often faced with a similar dichotomy. Some add value in un-sexy business lines like industrial parts supplies. In this field, Fastenal (FAST) is a company that blends into the general markets with its wide-moat business creating enormous free cash flow and high returns on equity, assets, and capital. These companies are hard to identify sometimes. Management is focused on running the business and uninterested in being on the cover of the Harvard Business Review. Their passive (and mostly unintentional) camouflage provides value investors an opportunity to scoop up gems after an awful lot of sifting.
Conversely, there are companies that actively seek to disorient investors with active camouflage efforts such as “great” marketing slogans (“Impossible is Nothing”), nonsensical business descriptions, (“paradigm shifting”, “game-changing”, or my personal favorite “creating synergies”), and remarkably opaque financials such as off-balance sheet special purpose entities (SPE), inflating earnings (popular!), accelerating revenue recognition, and counting non-existent inventory.
What makes these companies so successful in the beginning is that their camouflage is quite effective. They are - for lack of a better term - financially engineered zebras (if you are tired of hunting unicorns, I suggest this type of proverbial big game hunting). Using Valeant Pharmaceuticals (VRX) as an example, the company created an entirely new model in drug discovery, development, and distribution. By purchasing generic drug manufacturers with products beyond their exclusivity date (e.g. generics) and products treating orphan (or therapies with less than 50K patients) diseases, they raised prices at breathtaking rates. Having convinced themselves their efforts were providing a better experience for patients and HCPs, VRX camouflaged its efforts as providing drugs at “fair prices”. Yet this form of passive camouflage (“no reason to look here…good drugs…good prices…move along) was combined with the more egregious active forms as well. The constant drumming of Valeant’s new business paradigm based on lack of business valuation (“we don’t invest in businesses, we invest in management”), lack of understanding the basic industry requirements (“R&D is a loser’s game”), and a warped financialmodel. Like the proverbial squid squirting its ink in an attempt to confuse its predator, Valeant attempted to confuse investors with a host of active camouflage techniques. Alas, much like our squid that runs out of ink, Valeant ran out of ways to confuse its investors and the stock market in general.
The Art of Seeing Reality
For investors, the challenge is how to see companies for what they are, without being distracted by camouflage. I would suggest three (3) questions you should ask of any potential investment. While seeming quite general in their appearance, they are in fact questions that get to the root of any business’ long-term viability.
What does the company actually do?
You might laugh at this, but there have been many companies where investors couldn’t answer this question. For instance, what was Enron’s business? Most knew it was an “asset light” model based in energy services, but beyond that most couldn’t make head nor tails what CEO Jeff Skilling was talking about on his conference calls. In almost every case, companies like Enron camouflage their actions as providing a “new paradigm” or “disintermediation” of traditional business models. In such examples, the company’s services add value to only one audience – themselves. In a study by Nintai Partners in 2011, we found the fewer the words needed to describe the business in general indicated a higher investment return.
How does the company make money?
Some companies have gone from cradle to grave not making a dollar in profit. Think of Pets.com. Others started out losing enormous amounts of cash but have built up into profitable businesses. Think Amazon. Then there are companies that don’t really make money but camouflage their chicanery through financial engineering. You’d think it would be more difficult to hide this type of behavior with SEC reporting requirements and Wall Street analysts. But they rely on the ruse of the zebra – confusing the mind into believing they are an industry paradigm-shifting juggernaut. Think Enron.
How does the company add value to its customers?
Ask yourself whether the company adds value by providing answers to their clients’ most important issues. Not many great long-term investments’ strategy is to provide no value to their customer. Yet a company like this pops up every so often. Take a look at Valeant again. By raising prices by 1,000%, which of their customers received value from these actions? Patients? Doctors? Managed Care? The answer is it’s a very small list with one name - starting in V and ending in T.
The ability to use camouflage is both a benefit and a risk in the financial markets. On the good side, excellent companies (unless you are Berkshire Hathaway) generally find a way to keep their head down, focus on allocating capital, and growing the business. This passive form of letting the record speak for itself has made it possible to pick up some hidden gems over the years. Conversely, the ability to actively create camouflage can be used to deceive shareholders, confuse regulators, and fool the markets. By creating a simple process that cuts to the core of each potential investment can sometimes (but not always) assist you in avoiding the worst blow-ups. Otherwise you may fooled into thinking you are the predator when you are, in fact, the prey.
DISCLOSURE: The Nintai Charitable Trust - which I used to manage - was a holder of FAST. I do not know its current status in their portfolio.
 We shouldn’t just poke fun at Adidas. Dr. Pepper’s slogan of “It’s Not for Women!” was perhaps the worst in a deep pool of candidates.
 Actually Valeant only wins the silver medal for healthcare financial innovation. In 2002, Elan Pharmaceuticals looked to capture all revenue from its products but place their respective R&D “off-budget”, moving it to a small joint venture holding company. It didn’t work for Enron, and it didn’t work for Elan.
In World War II at the Battle of Samar, a task force of small US escort carriers and destroyers suddenly found itself facing an enormous Japanese fleet including the world’s largest battleship the Yamato. Completely outgunned, and without enough speed to outrun the enemy, it looked like the Task Force was guaranteed to be completely destroyed. As shots from Yamato’s huge 18 inch guns started to straddle one the carriers, an Ensign said with false eélan, “Don’t worry boys, we’re sucking ‘em into range. We got 'em right where want ‘em now”.
Sometimes successful value investing takes a certain form of bravado like our aforementioned naval ensign. But this type of enthusiasm can easily cross the line from supreme confidence to delusional thinking. Successful investors see that line quite clearly. Many unsuccessful investors cannot distinguish between the two.
How does one make a clear distinction between the two? How many of us have let our preconceived notions - or worse our emotional need - drive our investment decisions? It happens to all of us. I remember in my younger days estimating growth of X% for a company I admired. Later that afternoon I met with my partner to review my findings. His one comment was that my growth projections were double the historical rates of the corporation’s past 33 years. When eyed with a reptile-like steely gaze, my assumptions resembled Samuel Johnson’s definition of a second marriage - “a triumph of hope over experience”. Adam Smith pointed out that sometimes you provide information in a way to support your thesis (“The company growth will provide dramatic value over time”) or as a means to blame your holding for poor results (“It’s not my fault management blew the new product launch”).. What is most frightening in this case was that I either simply didn’t recognize a potentially bad investment or I had fooled myself into thinking it was a great company with high growth rates. Neither of these would likely lead to a successful investment strategy.
My mistake is quite common in the investing world and is known as optimism bias. Investors project estimates that will fit with their investment thesis and have a tendency to disregard information contrary to their investment outlook. This type of thinking can lead to devastating results. Many individuals (and professional money managers) simply could not accept the fact that in 1999-2000 technology spending growth had to drop dramatically. Even more importantly, many were simply unable to question analysts’ estimates that were later proven wildly inaccurate - and in some cases – grossly unethical.
As usual Michael Mauboussin captured the problem in a clear and concise manner. He states that insider optimism is susceptible to “anecdotal evidence and fallacious perceptions.” In this case, insider doesn’t refer to a company insider, but rather to an individual who looks inwardly for confirmation. He goes on to say that outside thinking “asks if there are similar situations that can provide a statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and, if so, what happened. The outside view is an unnatural way to think, precisely because it forces people to set aside all the cherished information they have gathered.”
The Children of Lake Wobegone
A 2006 study by Dresdner Kleinwort Wasserstein Macro Research makes a compelling case that investment managers are not immune to optimism bias. In a survey of 700 US and foreign-based investment managers, individuals were asked whether they thought they were above average at their job. Roughly 75% of respondents felt they were above average, 24% felt they were average, and less 1% felt they were below average. Anybody with a high-school level knowledge of statistics knows these results cannot possibly be accurate. Nearly 25% of the individuals most likely suffer from optimism bias (and an inflated ego).
So what can we take away from this? The main point is professional money managers - with years of hard performance data - have convinced themselves they are mostly above average in the skill sets. Second, optimism bias can lead you far astray from the cold hard facts. Yes, you might have a genuine affinity for making successful decisions, but only if the data support you in your claim. Last, an optimism bias can lead to rejection of information (or lack of information per Smith’s theory) essential to making wise decisions.
The line between reasoned optimism and optimism bias can be mighty thin sometimes. The ability to make that distinction by applying outside thinking and data means you have a leg up on most other investors. Don’t get me wrong. There’s nothing inherently bad about having a cheery disposition, but an investment manager utilizing such an outlook can cost his/her investors dearly. Like our sailors at Samar, sometimes a certain amount of bravado is required. Just not in investment management.
I look forward to your thoughts and comments.
 The story of the Battle of Saran and the fight of Taffy 3 is an extraordinary story. You can read more about the battle in the book “Last Stand of the Tin Can Sailors”, by James D. Hornfischer.
 For a wonderful and modern look at Adam Smith’s theories you should read “How Adam Smith Can Change Your Life”, Russ Roberts, 2014
 Think Twice: Harnessing the Power of Counterintuition, Michael J. Mauboussin, Harvard Business School Press, 2009
 “Behaving Badly”, Dresdner Kleinwort Wasserstein, February 2, 2006
We wanted to let everyone know that Tom sends his apologies for not posting recently. The past couple of months he has been in hospital quite ill. We hope to have him back shortly and posting to the site. Thanks for your patience.
In an article last year, I used a quote by Seth Klarman that said investing was an "arrogant act". Having just published my 100th article here on Gurufocus, it seems to me being a writer on value investing could fall under the same definition. First, one has to assume that he or she has something valuable to add to the dialogue. Second, one must be able to package this so-called wisdom in such as way to make your points succinctly and in an engaging style. Lastly, the writing must provide readers with an interesting perspective missing in the conversation. Each of these alone is a difficult goal to meet, but achieving a blend of all three really is a leap of faith - and ego.
I bring this up because this will be my last article on Gurufocus for the foreseeable future. I have greatly enjoyed meeting you either in person at the GF conference or via the GF website. It means a great deal that so many of you would take the time to read my writing, provide feedback (good and bad!), and ask incredibly astute questions. Without a doubt, the Gurufocus community has made me a better writer and investor.
I will likely be posting new articles on Dorfman Value Investments website http://www.dorfmanvalue.com. as well as here or on new sites. Feel free to visit to get updates and new content. I'm also in the throes of finishing a book that I hope to complete by the fall of 2017. It certainly portends to be an interesting time in both the markets and life in general.
As I look back at my writings over the past few years, I realize there has been several key themes. I thought in this last article I would summarize these.
Be Ruthless in Reviewing Your Process
All too often you hear about investment managers who remove their losers at the end of the quarter and replace them with stocks that did well. This process is called window dressing and should be a tremendous warning for investors. If a money manager takes the time to fool his investors, it isn’t a real leap before he begins fooling himself. A money manager should spend a great deal of time reviewing his picks’ performance and the process he utilized to select them. Before I remove or add anything to the portfolio, I write a detailed investment case that includes all my assumptions, estimates, and projections. Each year I review these to assist in writing my annual report. I am always surprised by what I got right - and more importantly – what I got wrong. Is it a fun exercise? Absolutely not. Is it a vital tool? You bet. Always strive to improve your process.
Never Stop Learning
Going hand in hand with the previous topic, never stop learning. One of my favorite stories is the Duke of Wellington’s answer to how he won at Waterloo, “Simple. They came on in the same old way, and we beat them back in the same old way.” Nothing is prone to failure so much as the oft-repeated method of victory. As a famous German general once said, “Victory achieved once brings confidence, multiple victories breed hubris. Do not fight this war using the strategy from the last war”. The key to success on Wall Street is a hybrid approach based on a firm value strategy flexible enough to change with the times. A great example of this was Warren Buffett’s acquisition of Burlington Northern Santa Fe. For decades the railroads had been a capital-intensive business with extremely low margins. The changes driven by intermodal transportation, cost cuts through increased productivity, and better use of assets created an entirely different industry in 2015 than it was in 1960. Buffet’s ability to maintain his value-based approach with a willingness to recognize changes in the railway industry led to a particularly profitable transaction.
Revel in the Role of Market Iconoclast
Being different and challenging the major tenets of Wall Street (frequent trading, high costs, etc.) are a must for beating the markets. As Jack Bogle pointed out, “If you invest in the market through an index, your return must be the market return less costs.” Beta – in many cases – is your friend. It might mean the stock doesn’t react the way the markets do, but how else can you beat the these very same markets? In Japanese, the verb to be wrong is “chigaimasu”. Interestingly the verb also means to be different. Most certainly, to be different on Wall Street does not always mean being wrong. Take heart in the fact that many of the most successful investors have been unique in their thinking.
Patience is Your Greatest Asset
I frequently quote the old adage that “to catch the biggest fish you must cast the longest line”. Compounding value takes time. For those lucky enough to double their portfolio in 6 months, I congratulate them. For the vast majority of us, slow and steady wins the race. The ability to be patient is perhaps the hardest trait to develop as a value investor. Everything on Wall Street shrieks action. From day trading to walking sound wave Jim Cramer, Wall Street begs you to take action right now. In most cases, it isn’t you on the winning side of such a bet.
Cash: The Once and Future King
One thing has never changed on Wall Street – cash is still king when all else fails. The 2008-2011 market returns showed those with a reasonable amount of cash were prepared to take advantage of depressed prices. In some cases the wisdom to avoid the bubble bursting or the courage to invest near the market bottom made the career of investment managers. In both cases, these managers needed cold hard cash to withstand the drawdown or load up before the bull market of the past seven-plus years. As hard as it may seem, the ability to hold cash – while painful at times – generally provides investors with options essential to success.
Leverage: Working with the Devil
The opposite of holding cash is the use of leverage – both on the level of your portfolio holdings (lots of short-term or long-term debt) and your portfolio itself (margin trading). Many people fail to realize that Triple Leveraged Oil Fund can drop just as spectacularly as it might move up. More importantly, margin calls generally happen at the worst of times forcing investors to sell assets at truly unfortunate prices. It’s no different for corporations. Valeant Pharmaceuticals is a walking example of this. The fire sale of its assets forced on the company will likely impair the company’s returns for the foreseeable future.
I’ve found following these rules has stood me in good stead through bull and bear markets alike. Is it for everybody? Absolutely not. But if nothing else I suggest investors focus on the first two subjects. Investing requires a solid process. Successful investing means spending the time to learn new approaches, new concepts, and new industries on a daily basis.
Thank you again for taking the time to read and comment on my writings over the years. It has been a real honor to be associated with Gurufocus and all of my readers. I wish you the best in your investing future. And for a final time, I look forward to your thoughts and comments.
Disclosure: No conflicts
“You can’t always get you want, but sometimes you get what you need”
- The Rolling Stones
“A lot of people ask me what index I use to measure against. I usually laugh and say the Consumer Price Index, that’s what I use. As long as I’m getting what I need for a happy retirement, what the hell do I care what my portfolio is doing versus the Dow Jones Index?”
- Carl A. Adams
“I think every day it's something to reflect on and think about "How do I become less competitive in order that I become more successful?"
- Peter Thiel
Anybody that has worked in the investment world for any stretch of time knows performance versus a proxy defines success or failure. Whether it is the S&P 500 or the MSCI EAFE, investment managers are always feeling pressure to outperform. Much like the nervous groom on wedding night, the reach for something spectacular can lead to stunning failures. In this instance, the groom has a lifetime to prove his case. For the investment manager, it is likely he is looking for a new employer. It isn’t just investment management though being driven by performance. Individual investors pile into funds after a short period of outperformance to see their portfolio suffer an extreme regression to the mean. Most studies have shown an alarming gap between investor returns versus fund returns.
So if the drive for outperformance leads many into unwise investments, poor fund selection, and outrageous trading fees, why do so many people blindly compete everyday against a market index? As a manager of other peoples’ money, I am aware that I too am a victim of such thinking. Underperforming against the S&P500 TR is an anathema to me. Accordingly the past five years have been a very long stretch with considerable heartburn.
Returns are Relative
After a recent board meeting at the Nintai Charitable Trust, I apologized to the Board of Directors for my record over the past few years. One of the Board members said, “Returns should always be taken in context. All I care about is that the fund can meet its current obligations and be ready for future ones. I don’t give a damn about the S&P500.”
I think this is an issue that is grossly undervalued in the investment world. The needs of the Nintai Charitable Trust are significantly different than a 72 widower surviving on investment income and social security payments. Trying to measure your performance against either an index (such as the S&P 500 TR) or a mixture of indices really isn’t an adequate measure of performance. Meeting my investors’ goals can sometimes be very different than how the targeted bogie does over a period of time. I want to be upfront that this is not an article condoning underperformance. As an investment manager myself, my animal spirits drive the competitive juices like most individuals. But what I am saying is that competitiveness in returns should sometimes be put in the proper context.
As an investor, I think there are three key questions that need to be asked as you create your portfolio.
Can You Live Your Goals As You Want?
It really doesn't matter what the markets are doing if your individual investment goals aren’t being met. For instance, a retiree may want to be in a 60% stock/40% bond portfolio and generate $36,000 in interest and dividend income from a $1.2M portfolio. If this individual cannot make her mortgage payment because she received on $29,000 in income, it really doesn't mean a helluva lot how her portfolio did versus the general markets. Conversely, a 35-year old attorney’s portfolio growth of capital will decide the status of his future retirement, so returns matter a great deal. He would be rightfully agitated if his portfolio returned substantially less than the market over a 10-year period. Comparing our retiree’s returns versus the S&P500 makes as much sense as comparing our attorney’s returns versus the Barclay’s US Aggregate Bond index.
Can You Sleep at Well at Night?
Nothing is more disheartening to investors than the permanent loss of capital. During market drawdowns, investors have a tendency to sell at exactly the wrong time. Those who make money in down times generally have several things in common, one of them being able to sleep well at night. If you aren’t comfortable travelling for 1 year with no internet access or means to check your portfolio, you aren’t invested in what you really need. Many people don’t need to listen to Jim Cramer every night and trade on a daily basis. A well thought out portfolio should give an investor confidence to focus on more important things in life.
How Much Time Do You Spend on Your Portfolio?
As a professional money manager, I spent a great deal of time reading, learning, and understanding about new companies or industries. But I must admit I spend little time thinking about my current portfolio (with the exception of corporate filings and the competitive landscape). If I put a company in the portfolio, I should be comfortable with a 10 – 20 year holding period. For many successful investors, about an hour a year is adequate to rebalance a bucket of index funds. If individuals are spending 30 hours a week trading stocks, graphing butter production in Bangladesh, or sitting with bated breath for the aforementioned Mr. Cramer’s Lightening Round, it is likely you are spending way too much thinking about your portfolio.
John Wooden once said, “Don't measure yourself by what you have accomplished, but by what you should have accomplished with your ability”. Investing is no different. Many investors should measure performance by what they need, rather than what they want. All too often investors feel pressure to buy stocks in companies “guaranteed to triple in 6 weeks” or in funds that provide “4 times the Federal Reserve rate with !!NO!! risk!” While these are returns we would all surely want, it’s extremely unlikely that’s what we would get. As Mr. Thiel pointed out so wisely, sometimes the less we compete the more successful we are in thr long term.
As always I look forward to your thoughts and comments.
DISCLOSURE: I have no holdings in the stocks discussed in this article, and no plans to establish holdings in the next three days.
 This is an actual a tool used by individual investors who believe that taking the change in butter production in Bangladesh and multiplying it by two will give you the exact percentage by which the S&P 500 Index will change in the year ahead. Based on that, a 5% increase in butter production leads to a 10% hike in the S&P. The same statistics are believed to hold true on the downside. Really. For an illuminating look at this, see http://shookrun.com/documents/stupidmining.pdf
“We’re interested in the mass-merchandising of anything. If there was a market in mass-produced portable nuclear weapons, we’d market them too.”
- Alan Sugar
“Arguing with idiots is like playing chess with a pigeon. No matter how good you are, the bird will crap on the board and strut around like it won anyway”.
Over the years I’ve taken to task money managers who charge egregious fees, underperform the markets, or flagrantly violate their own investment strategies. In general, I try to stay positive in my writing as most readers like to hear about solutions rather than problems. But much like the articles I just cited, occasionally a case comes along that practically begs for a little criticism.
In the past couple of weeks, the South Carolina Government Pension Plan has exploded into the news with an analysis revealing a stunning ineptitude and truly amazing greed. The state’s pension fund is overseen by a six-person board and an Executive Director. It was reported on December 4th, that the pension plan is currently funded to meet only 47% of its obligations. In addition, the general public was outraged to see that total investment management fees had jumped from $27M in the early 2000s to peak at $454M in 2014 . Even with this type of compensation, the plan grossly underperformed against a simple blend of equity and bond index funds.
Almost none of this should have been a surprise. In July, 2015, the Maryland Public Policy Institute published its “Wall Street Fees and Investment Returns for 33 State Pension Funds” . The report discussed several findings.
High Fees Gain You…..Net Negative?
Pension plans have paid an extraordinary amount of fees for underperformance. Indexing fees cost a state pension fund about 3 basis points yearly on invested capital versus 66 basis points for active management fees (or a savings of roughly 96.7%). The report goes on to state, “For the five years ending June 30, 2014, we were unable to find a positive correlation between high fees and high returns. In fact, we found a negative correlation.” The difference between 3 basis points and 66 basis points might not seem like much (it never does!) but the latter could have saved tens of billions of dollars for state pensions. As an example, a state pension fund of $50B would have an additional $6.8B after five years if indexed rather than using higher cost investments, assuming performance remained equal. For many underfunded plans, these numbers might be the difference between cuts in pension plans or meeting their current obligations.
No Proof that Higher Risk Means Higher Returns
According to the S&P Dow Jones Indices/SPIVA Scorecard YE 2014, over the five years ending December 31st, 2014, 84 percent of domestic equity funds failed to beat the S&P benchmark. I must be honest in saying the Nintai Charitable Trust also underperformed for this period. It is for this reason pensions plans have begun to diversify into the higher risk/higher reward investments such as hedge funds and private equity. The report showed both of these are a poor choice for increasing investment returns. Hedge funds used by state pension funds underperformed a blended 60/40 equity and bond portfolio by roughly 6.4 percentage points from 2009-2014. All of this at twice the rate of beta.
Many say the problem is simply with hedge funds. They had an awful run during the last five years. Private equity would surely be an entirely different kettle of fish. Investing in high growth opportunities without all that competition in the public markets would surely provide a tremendous shot in the arm to total returns. Sadly, this has turned out to be another dry well for pension funds. Private equity underperformed the same blend of index funds by 5.1 percentage points.
Sir Occam Was Right
Several years ago I wrote about Sir William Occam’s theory on the simplicity of solutions. Many times the simplest solution can also be the incorrect one. Think of the first Italian who mounted fake wings on his arms and hurled himself off the tallest building in Siena. A remarkably simple solution with remarkably bad results. Yet there is something to be said for good Sir Bill in some cases. Investing is one of those areas. Many of the worse cases of crash and burn (to continue in the vein of our poor human-avian example) have been systems created with such complexity even their designers couldn’t understand or quantify systemic risk. Returns such as those achieved by pension funds around the country have shown the best advice is to stick with Sir William and leave attempts to defy gravity to those with a much larger appetite for costs and thicker wallets.
All too often marketing beats results in investing. Much like the old Arab folk saying (trust your neighbor, but tie up your camel), investors simply must look at the record of their investment managers. I certainly don’t mean this in a trigger-happy manner but over a longer term (5-10 year). Not many investors have duration and size like that of large pension funds. South Carolina State Treasurer Curtis Loftis - one of the few heroes in this sordid story - summed it up best when he said, “Our attitude from 2006 to 2013 was, we wanted to be on the cutting edge of (investment) diversification and financial theory, but we were on the bleeding edge. We have lost so much money the state will be lucky to get out of it." The story of South Carolina’s pension debacle is a classic case of poor investment decision making, ignorance of marketing fables versus actual results, and a doubling down on mistakes. If investors keep an eye on costs and turn off the marketing channel known as CNBC, it is likely (but not certain) they can outperform the so-called Wizards of Wall Street. And that’s something that can really help your investment portfolio take flight.
Better to equivocate, when required, than to show conviction when it is not warranted”.
- John Rekenthaler
“This episode taught me the importance of always fearing being wrong, no matter how confident I am that I’m right. As a result, I began seeking out the smartest people I could find who disagreed with me so I could understand their reasoning. Only after I fully grasped their points of view could I decide to reject or accept them. By doing this again and again over the years, not only have I increased my chances of being right, but I have also learned a huge amount”.
- Ray Dalio
As many of you know, over the years I have written about the dangers of high portfolio turnover. It generally signifies someone is trying to time the markets (bad) and driving up frictional costs that eat up returns (really bad). It doesn't mean high turnover is always the wrong choice, but it certainly isn’t a great sign of a long term, patient investor. Conversely, maintaining an obstinate position in the face of changing data is little better. An investor has to remain open to changing dynamics about the strengths and weaknesses of their investment thesis.
I bring this up because I generally don’t sell too many positions (my turnover rate since inception at the Nintai Charitable Trust is 5.4% annually). This number could tell me several things. One is that I’m content to let my holdings compound value over the long term (true). Second, I may be holding on to my winners or losers too long (somewhat true). Last, the possibility is that I’m simply too slothful to find new investment opportunities on a weekly basis and spend my time trading (absolutely true).
It’s the second option I wanted to discuss today. In particular, hanging on for far too long with my losing positions. It fortunately hasn’t happened too much over the years. But when it does, it’s generally a real doozy. I wrote about one here that I still haven’t lived down. I should make it clear nobody twisted my arm or convinced me to hold on. This was a genuinely unforced error brought on by bad modeling, closed thinking, and hubris involving my circle of competence. I have unfortunately committed another such blunder with my investment in Computer Programs and Systems (CPSI).
CPSI: Anatomy of a Mistake
It seems like yesterday when I wrote about CPSI in my article “Thoughts on Return on Capital vs. Return of Capital” (it was actually on August 1, 2016). In that article I talked about how I had allocated roughly $400,000 of Nintai Trust dollars only to see that value drop by 25% in the two months I had owned it. I made the point that my losses had been mitigated by a dividend yield of roughly 6%. My confidence in my industry knowledge – as well as faith in management – quickly clapped a stopper on any doubts I might have been harboring.
I published my well thought out defense on August 1, 2016. One week later the bottom dropped out of the stock price – dropping from $39.10 on August 4th, to $27.47 by end of day August 5th. Just to be clear, at this point my average purchase price was $51.40. The price dropped all the way to $22.90 by November 10th representing a whopping 55% (paper) loss.
So what happened? How in the world did I get an investment so wrong? More importantly, what should I do with it now? Before making any snap decision, I sat down with three years worth of 10-K, 10-Qs, and a list of customers to call to ascertain any long term change in my estimates. I also looked at my written investment thesis/assumptions and mapped them against actual results. One thing was crystal clear – this was not an example of Murray Gell-Mann’s random accident. Oh no. As I mentioned, this was a full blown unforced error with your writer bearing full responsibility. While the results of my review would take an entire article to outline, three findings became apparent that I thought I would share.
Too Confident in My Circle of Competence
Having been in healthcare consulting for nearly two decades, I assumed CPSI lay well within my circle of competence. To put it succinctly, it wasn’t. I was wildly off in my estimates of market growth, adoption rates, technology implications, and impact on CPSI’s financials. All of these led me to entirely wrong conclusions and estimates.
Didn't Listen to Counter Arguments
As if erroneous estimates weren’t enough, I chose to ignore counter arguments to my investment thesis. There were warning signs that should have given me pause. As my constitutional law professor used to say, “extreme cases make bad law”. Information that contradicted my model were regarded as “extreme” and removed from the calculations. In addition, several Nintai Board members involved in healthcare asked some very astute questions. I simply didn’t utilize their expertise. Hubris indeed.
Ignored Management’s Warnings
In plain sight were warnings by management the electronic health record market in rural hospitals was saturated. While management didn’t explicitly state this explicitly, they were clearly moving into the informatics management side of the business. This was further reinforced by their acquisition of Healthland. While I believe it is a wise strategic move, this choice made my initial thesis entirely outdated. My inability to acknowledge this was a key mistake in the process.
What Can Be Learned?
We all know the adage that mistakes are some of the great teachers of wisdom. If that’s the case, I should have a PhD with this investment. That said, I think there are three lessons I can take away and apply going forward.
Write Down your Investment Thesis
You can’t learn from your mistakes if you don’t have a clear record of your choices. In CPSI’s case, I had detailed records of my customer interactions, market growth estimates, and financial models. All of these – including my assumptions – could be tested against actual events. Let’s just say it wasn’t a very pretty picture.
Track Quarterly Statements with Your Thesis
It is vital to take a look at your investment’s 10-Qs with a detailed eye. Information in these – such as the Management’s Discussion section – can give you early warning of changes or issues that need to be reflected in your model. Every quarter you should be able to predict – within a range – the chances your investment thesis remains valid.
Have a Firm Definition on Why and When to Sell
As conditions change and your investment thesis gets increasingly out of whack, it is no time for what Warren Buffett calls “thumb sucking”. A dispassionate look at the data should tell you to buy additional shares, stand pat, or sell. You should have firm criteria for this decision-making. Whether it’s based on valuation or stock price increase/decrease it should be clear when you need to act. In my case, thumb sucking has proven to be an expensive mistake.
Readers likely want to know what we did with our holdings in CPSI. I continue to hold my shares for a couple of reasons. The company’s strategy to focus on data and informatics is a solid one. New federal outcomes requirements along with reimbursement tools are already starting to make EMR outcomes data quite valuable. Second is valuation. Since the company has dropped roughly 50% since our purchase we believe the stock is undervalued. Building out an entirely new valuation model, we think current price is significantly below my estimated intrinsic value.
Nobody bats 1.000 in baseball or investing. You are sure to make mistakes on the way. As I’ve written about before, it’s less about winning and more about not losing. My investment in CPSI clearly violates the latter. Huge losses are hard to recover from even in the long term. Going forward, I’m looking to strengthen my research process. I regularly try to break an investment process through sharp discounts to actual growth. This clearly was not enough in this case. The ability to process alternate views on market assumptions (such as competitors, adoption rates, etc.) needs to take place earlier and be far more robust. The measure of my learning will be the absence of new investments similar to CPSI.
As always I look forward to your thoughts and comments.
Disclosure: The Nintai Charitable Trust is long CPSI.
 Murray Gell-Mann is considered a leader in understanding complex systems. He outlines two key themes – fundamental laws and random accidents. Random accidents are actions where there can be multiple possible outcomes. These accidents – and those that follow – are “frozen” in the history of that system and provide it with complexity. See https://www.edge.org/conversation/murray_gell_mann-chapter-19-plectics for more information.
 The company took on $150 million in long-term debt thereby violating another core requirement in my investment selection process.
“One of the most demanding times is when you underperform. Whether it’s an individual stock that drops by 30% in one day or the entire portfolio grinding down month after month, stress can reach an intolerable level. Nobody said this would be easy. I always think these are times to really review your process. Is there something you are missing? Are there inputs that might give slightly different or better insights? I also see this time as a teaching moment for my clients. Do they understand why I am underperforming? Am I explaining it well enough. Most importantly, do I understand why I’m underperforming?
- Ted Regina, PhD
One of the most overlooked sections in great value investing writing is Chapter 2 in Benjamin Graham and David Dodd’s classic “Security Analysis”. Entitled “Fundamental Elements in the Problem of Analysis. Quantitative and Qualitative Factors”, the chapter is filled with insights on both an investor’s approach and views on data/information about possible investments. I think many investors prefer Graham’s “Intelligent Investor” because of its length (575 vs. 733 pages) and Warren Buffett’s very vocal support of Chapters 8 (“The Investor and Market Fluctuations”) and 20 (“Margin of Safety as the Central Concept of Investment”).
During times of underperformance I generally turn to the investment classics to clear my head of the worries, doubts, and emotions that come with it. And boy have I been reading a lot over the past quarter. Nintai and Dorfman Value holdings Novo Nordisk (NVO) down -36.4% YTD, Hargreaves Lansdown (HRGLF) down -38.4% YTD, Manhattan Associates (MANH) down -24.5% YTD, and T Rowe Price (TROW) down -11.6% YTD. Just a solid wall of red across the board.
Returns like this can make you question your investment process. The pressure can get immense to tweak the system or make hasty changes to try to stop the losses. I know I’ve spent many days listening to quarterly earnings calls, reading through 10-Qs, and talking to customers of our holdings. But I think one of the more important things is to go back to Chapter 2 in Security Analysis and re-read it after taking a deep breath (and maybe pouring yourself a wee dram if that kind of thing works for you).
In this chapter, Graham and Dodd start out by discussing four fundamental elements necessary to answering this question: should security (S) be bought, sold, or held at this price (P) at this time (T) and by this individual (I)?
(S) The Security
Here Graham and Dodd look to answer three questions. First is defining the business. Do we understand how it makes its profits? Second, what is the price of the security? Are the terms offered going to provide us with an adequate return? Last, define the security itself. Where do we stand as share holders or debt holders? I would add one additional item - corporate financial statements. Investors should know these to an in-depth degree for each of their holdings.
Price is what you pay, value is what you get. How many times have we heard this phrase (far too many times in my view)? Graham and Dodd point out the danger of paying the wrong price is equal to buying the wrong issue. They end this section by saying, “…the new-era theory of investment left price out of the reckoning, and that this omission was productive of most disastrous consequences.” I couldn’t agree more. Which is what makes such significant price drops in my holdings so painful.
Graham and Dodd point out that an investment can look vastly different depending on the time. Tech stocks certainly looked different in March, 1999 versus March, 2002. It’s important that your models work in most settings - such as 1999 or 2002 - and can adapt to new information. The authors state, “security analysis, as a study, must necessarily concern itself as much as possible with principles and methods which are valid at all times – or, at least, under all ordinary conditions.” Being able to adapt with the times is essential.
(I) The Individual
Before any investment is made, it should be assured it meets the investment criteria of the potential holder. I have been remarkably fortunate in having investment partners that have extremely long time horizons (such as the Nintai Charitable Trust) or individual investors with great patience. It is during periods like right now - when underperformance is a very real concern - that you find whether your investors’ needs are aligned with your investment approach.
Breath in Patience, Breath out….Profanity?
I’m not a real proponent of checklists. I understand their value to some – just ask any airline passenger flying with a captain who hasn’t done his pre-flight checklist. In general I’ve found that a structured process is better for me than the list. With the latter, too many times I became focused on one particular item at the expense of several others. Process looks at the process more holistically while the checklist is driven by data. I generally look for a process that keeps emotions in check allowing for a more integrated and objective look at the data. An old friend of mine said that problems begin when you don’t let the profanity out. This is what makes Security Analysis’ Chapter 2 so vital. In its own way it allows investors to expunge the fear and terror as they watch their investments drop in price (along with a steady stream of epithets).
Every investor will go through a dramatic period of underperformance in his/her career. It’s just a question of whose turn it is to be - as John Dorfman and I say– “in the barrel”. It’s safe to say the past 30 days it’s been this humbled writer’s turn to go over the falls. It isn’t very pleasant for me as an investment advisor and even less fun for my investors. The key is to avoid making any hasty decisions that assure locking in bad decisions through uncontrolled emotions. Each time I read Chapter 2 it allows me to reel these in and get back to basics. By answering Graham and Dodd’s question, I can feel comfortable the smartest move might be to do nothing at all.
As always I look forward to your thoughts and comments.
Disclosure: Nintai Charitable Trust is long NVO, HRGLF, MANH and TROW, as are some individual accounts at Dorfman Value Investments.
 “Security Analysis”, Sixth Edition, Benjamin Graham and David L. Dodd, McGraw Hill, 2009
 We can take heart in the fact 60% of all funds that outperformed their bogey over a 15-year period (1998-2013) underperformed in 7 of those years. See here for more information.
 Graham and Dodd are addressing more “timing” than “time”. Utilizing time as risk mitigation is an entirely separate concept deserving it’s own article.
“Nothing is possible without three essential elements: a great root of faith, a great ball of doubt, and a fierce tenacity of purpose”.
- Neville Schuman
My fellow value investor John Dorfman and I were speaking earlier this month about outperforming and underperforming the market. I’ve written a couple of times about value investing and underperformance (you can find the articles here and here). At both the Nintai Charitable Trust and Dorfman Value Investments, the last five years have been difficult, as the broader indices have outpaced their respective returns.
In an article last year (“Underperformance and Value Investing”, April 10th, 2015) I discussed that vexing question of how long is too long for your investment manager to underperform. In that article I wrote:
“Studies have shown the famous Super Investors of Graham and Doddsville underperformed the markets roughly one-third of their investing career. What’s particularly difficult to understand is that it takes times of underperformance to achieve long-term outperformance. This is for several reasons. First, if a value strategy beat the general markets every year, then it is likely far more investors would follow this path. It’s the underperformance that drives most of these investors from the value model. Simply put, most people don't have the temperament to hold on through the down times. Second, companies purchased by value investors are likely undervalued and perceived in a negative light. The markets will eventually recognize their value but we – and here’s the kicker – just don't know when. This can lead to significant periods of underperformance. Last, there are periods (such as seen in the past few years) where investors focus on lower quality, higher-risk stocks that generate high returns. Why buy a company that makes farm tools when you can purchase a cloud-based green network that has doubled in the past 12 weeks?”
Since I wrote that, the Nintai Charitable Trust portfolio has been fortunate in outperforming the general markets. But our three (3) and five (5)-year performance numbers are difficult to explain to our investors. As seen in the table below, mid-term (meaning three to five years) performance has significantly lagged the S&P 500TR.
Volatility and Risk: The Other Pieces of the Return Puzzle
As disappointing as the Nintai’s three and five year returns have been, there are some mitigating data that offset the negatives. Three characteristics are seen in the portfolio that partially explains its underperformance – beta, valuation, and leverage. On all three counts the Nintai portfolio has been lower (less volatility, cheaper valuation, and less leverage) than the general markets.
Over the past three years, the Nintai Charitable Trust’s beta has averaged 0.83. This means the portfolio has been 17% less volatile than the general markets. Combined with the fact 13% of the portfolio is currently in cash, volatility is considerably less than either the S&P500 or the Morningstar US Market Index. Volatility in itself isn’t necessarily a bad thing – large swings in prices provide value investors with buying opportunities. But market volatility frequently suggests market uncertainty. Companies in the Nintai Charitable Trust portfolio are generally more stable (from stronger financials and wider competitive moats) and better understood than other stocks.
Over the past 5 years the Nintai Charitable Trust portfolio has traded – on average – between 5 to 15% below our estimated intrinsic value. As of September 30th, it is trading at a 9% discount. During the last 5 years the portfolio has captured roughly 2/3 of the S&P 500 gains. Looked at in a different light, the Nintai Charitable Trust Portfolio’s P/E has gone from 22 in 2011 to a P/E of 20 in 2016. The S&P 500 TR’s P/E has gone from 15 in 2011 to 25 as of September 30th, 2016. Much of the S&P 500’s gains came from P/E expansion (paying more for future earnings) making the index appreciably more expensive each year. Conversely, the Nintai Charitable Trust portfolio has decreased in expense (paying less for future earnings) and hence lagged the S&P 500 returns. Much like a spring contracting, the Nintai portfolio should (and that’s the operative word!) bounce back over time.
Generally long bull markets assist in raising all boats. This includes companies that might not look so good when fundamentals shift – increased interest rates, consumer spending decreases, or limited access to the credit markets. The Nintai Charitable Trust (as well my holdings in Dorfman Value) tend to have extremely strong financials – little/no debt, generous free cash flow as a percentage of revenue, and high returns on equity, assets, and capital. Over the past three years we have seen the opposite of these stocks take flight – high debt, lower returns, and lower/no free cash flow. We think this is setting investors up for considerable losses if the credit markets tighten and/or an economic slow down happens. As Nintai’s former lead Board member once said, “it’s hard to go bankrupt when you don’t owe anybody money”. We couldn’t agree more. While not capturing the full upside of this bull market, we feel comfortable we are better protected on the down side.
It’s never easy as an investment manager to underperform the markets. An intense amount of self-imposed (along with investor) pressure begins to press for changes in the portfolio or the holding selection process. Charlie Munger said it best when he stated this isn’t supposed to be easy. The past 5 years has made his point all too clear. By keeping an eye on valuations, competitive moats, and financial strength our portfolio should experience lower volatility and greater protection on the downside. If that makes my role as capital allocator for investor funds more difficult, I can live with that. Our investors deserve nothing less.
Mr. Macpherson is Chief Investment Officer of Nintai Partners Investment Services and the Nintai Charitable Trust.