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Thomas Macpherson
Thomas Macpherson
Articles (191)  | Author's Website |

Passive or Active Investing - A Third Way

The battle between passive and active is a zero sum game, but how about a little from both?

April 28, 2020

"Over the years, I've often been asked for investment advice, and in the process of answering I've learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion. I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I've given it to them."

- Warren Buffett (Trades, Portfolio), 2016 Berkshire Annual Report

For decades, there has been a raging debate about the index fund versus the actively managed model. Which model achieves the best returns? Which model achieves the best risk/reward ratios? Does low cost and low turnover beat out the efficient market theory? This debate will likely be here for another century with no consensus being reached.

I’ve found the debate to be a waste of time and print. I think the answer – like most of life’s thorny issues – is a hybrid solution. Value investing is no different. I firmly believe that successful investing requires purchasing an asset for an adequate discount to its estimated fair value. I also think that discount must contain an adequate margin of safety.

I also demand that companies be of the highest quality, with no short/long term debt and high return on equity and assets (meaning greater that 15-20%). I also look for free cash margins of 25% or greater. Finally, I look for what my business partner once called “the tapeworm effect,” where the company’s products and services are deeply embedded in the infrastructure, making it nearly impossible to swap out to a competitor.

This blend of depressed prices merged with high quality has worked well for me. My investment partners have seen significant outperformance, particularly since the Covid-19 market crash.

The returns speak for themselves

This crash has reopened the debate about active investing versus indexing. In the last 60 days alone, there have been over 100 articles in major print financial journals about the war between these two methods of capital allocation. As I mentioned above, we think this is a rather stale argument. Below is a graphic representing the average return for Nintai Investment’s customers versus several key bogies. Note that all of these represent indexed funds. Losses could be greater for many actively managed funds (note that "since inception" is "since Sept. 30, 2017).

You can see a significant difference between the indexed funds and Nintai Investments LLC's  corporate fund returns. Whether you accept that index or active managers could get better returns in the short or long term depending on your time frame, the bottom line is both groups lost abysmally in the first quarter of 2020.

In the same period, you can see Nintai Investment’s average portfolio return was –9.20%. While not anything to write home about, it’s roughly half of the S&P 500's loss and nearly 60% better than the Russell 2000 (Nintai’s preferred proxy due to portfolio size). This isn’t to boast about Nintai’s portfolio (though we are very pleased for our investment partners). Rather, we think this demonstrates the thin gruel passed off in the argument about value versus growth styles of investing. As Warren Buffett (Trades, Portfolio) said, “you can’t separate them.”

Why limit yourself?

We think outperformance in both Nintai Partner’s internal fund as well as Nintai Investment’s short-term record demonstrate that growth, valuation and quality are the most potent combination for limiting loss while acheiving good results. We think this "G-VaP" strategy gives investors the best chance at long-term outperformance compared to strictly active or value indexing. Here’s why.

Growth

An asset can’t grow in price long-term without… growth. It may increase due to inflation or investor passions, but nearly always tumbles back. Gold is an example of this. There is a limited amount of gold in the world with a certain amount of small additions extracted from mines around the world, but it has no earnings, no free cash flow and essentially no growth. Compared to a Cognex (CGNX), which has grown free cash flow 25% per year on average over the last 10 years, gold has a long way to go.

Valuation

When an investor overpays for an asset, it becomes increasingly hard to see outperformance in the long-term. One only has to think of buying technology stocks in late-1999, funds invested in triple leveraged mortgage-backed securities in 2007 or Bitcoin in December 2017. Timing isn’t everything, but pricing means an awful lot. Developing a valuation model (or borrowing one) is an essential tool to identify when to buy and how much you should pay.

Quality

On Wall Street, there are a hundred ways to skin the proverbial cat, but the real money isn’t made in upcycles, it’s made in the down cycles. Let’s assume you were unfortunately gullible (and greedy) in December 2019, and you bought Acme Rubber Band Company at $100 per share. During Q1, the stock dropped 80% to $20 per share. Bad luck! But there are even worse mathematics at play. You will now need a 500% increase to get back to even.

These types of losses rarely happen to companies of extremely high quality (like those with no debt, high free cash flow and "tapeworm" relationships). Those 80% losses can permanently impair your (or your investment partners') hard earned dollars.

Conclusions

Many value investors practice one or two of the value investing triangle (growth, valuation and quality) that I've outlined in this article. For instance, traditional value investors might seek low growth and low valuation, but unfortunately often get poor quality.

Building a portfolio of companies with all three attributes is difficult, but possible. Just take a look at this latest crash in Q1 2020. A company like Abiomed (ABMD) dropped from $450 per share to a low of roughly $130 per share on March 20. Has the company’s value dropped by roughly 65% in a little over one year? In the last 12 months, free cash flow has grown 35%, earnings have grown 12% and revenue has grown 14.7%. Compared to ten year numbers, nearly every category has decreased. It is still a company that has no debt, $492 million in cash and short-term instruments, 25% ROE, 22.5% ROA, 39.5% ROIC and 30.5% free cash flow margins. It had a 97% retention with customers over the past five years. Does such a company merit such a drop in share price? We don’t think so.

Companies with all three attributes present at one time come along rarely but more often than you might think. Especially after such a market crackup, it its worth rummaging around and seeing what’s out there. For example, seven of Nintai’s core holdings trade below 70% of their estimated intrinsic value as of April 27. You might be surprised how quickly you can start building your own "G-VaP" portfolio.

As always, I look forward to your thoughts and comments.

DISCLOSURE: Nintai Investments LLC owns Cognex in both investment partner portfolios and Nintai Investment’s own portfolio. Nintai Investments LLC holds Abiomed in some investment partner portfolios.

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About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


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