October 2020
 
To Our Officers and Investors:
 
Enclosed you will find our report on the Q3 2020 performance of the Nintai Investments LLC Composite Portfolio managed by Nintai Investments LLC. Returns reflect performance since October 31 2017 when the company began operations. 
 
Q3 2020 Returns
 
Last quarter we mentioned the economy and markets were marred by the constant increase in COVID infections and deaths. We stated that during Q2 we reached roughly 1,600,000 cases and 100,000 deaths - combined with high unemployment - which made deploying capital a risky venture (it’s always risky - the exception here is that uncertainty far outweighs risks). The situation in Q3 has not improved very much. By the end of Q3, total COVID cases in the US has grown to roughly 7,200,000 cases and 210,000 deaths. These numbers are simply dreadful. Until the country takes the pandemic seriously - mandatory mask wearing at all times, social distancing, limited group interactions, etc. - then the disease will continue to be a story of immense human tragedy and drag on the long term growth of the US economy. Unemployment has improved – dropping from a 24% unemployment rate to 8.4% by October 1. While coming down, that is still a shocking number which places an enormous strain on consumer spending (75% of total GDP), our social safety networks, and the service economy in general. Finally, the search for a COVID-19 vaccine is on-going, with a concern of the general public the FDA will rush approval and allow the launch of a product with an insufficient safety profile. As scientists and researchers continue to better understand the virus, it appears utilizing a herd-type immunity will be increasingly difficult to achieve. Overall, the team at Nintai finds it hard to create a risk/uncertainty model that protects to the downside while offering sufficient reward to the upside. Consequently you may see cash positions as a percent of total assets under management reach new highs.     
 
Overall, Q3 2020 wasn’t a very successful period for our investment portfolios. We underperformed the S&P 500 by 4.97% with many holdings performing poorly. Our showing against our two other comparable indexes wasn’t as bad. We underperformed the Russell 2000 by roughly 0.87% and the MSCI ACWI ex-US by roughly 2.14%. 
 
As we mentioned in our Q2 update, the reversion to the mean (to the downside in this case) can prove to be a taxing process. We are comfortable each portfolio holding remains financially solid, has a strong competitive position, and is led by a management team with a firm eye on investment return on capital. As you can see from our latest investment cases (mailed out last month), we remain confident that each holding should perform well over the long-term (past performance of course is no assurance of future returns). The valuation spreadsheets tell a different story. Many portfolio holdings have highly elevated valuations. In our update “When the Economy and the Markets Disagree”, I stated we are left with the quandary 
 
of holding outstanding companies with inflated valuations. In principal, we’ve been holding onto these companies simply because we cannot replace them with any other company that we feel could compete (from a return and quality perspective) over the next decade or two. This has held us in good stead until this previous quarter. For now, we see no reason to change course and actively sell large positions out of the portfolio. 
 
For the quarter, the Nintai Composite Portfolio generated a (+4.07%) return (including fees) versus (+8.93%) for the S&P 500, (+4.93%) for the Russell 2000, and a (+6.28%) for the MSCI ACWI ex-US Index. For the 1 Year period, the Nintai Composite Portfolio generated a (+24.11%) return (including fees) versus (+15.15%) for the S&P 500, (+0.39%) for the Russell 2000, and a (+3.16%) for the MSCI ACWI ex-US Index. Since inception (on an annualized basis), the Nintai Composite Portfolio has generated a (+17.18%) return versus the S&P 500’s (+6.91% including reinvested dividends), the Russell 2000’s (+0.83%), and the MSCI ACWI ex-US’ (+1.37%)return.
 
It goes without saying we are very pleased with long-term numbers, but disappointed with the quarterly returns. In last quarter’s report, we stated:
 
 “….it should be pointed out that Nintai Investments LLC (and its predecessor Nintai Partners) typically gains its advantages in truly abysmal years. Our risk averse approach generally shines in moments of significant drawdowns in the markets.”
 
This certainly been the case in 2020. During Q1 (with the onset of the Corina virus pandemic), the S&P 500 achieved returns of (-0.04%) in January, (-8.23%) in February, and (-12.35%) in March. The Nintai Composite Portfolio achieved returns of (+0.68%) in January, (-6.12%) in February, and (-5.28%) in March. The portfolio outperformed the S&P 500 by a cumulative (-10.72%) to (-20.62%) respectively (or by 9.54%). 
 
Q3 tells an entirely different story (or inverts the findings as I am fond of saying). The S&P 500 achieved returns of (+5.64%) in July, (+7.19%) in August, and (-3.80%) in September. The Nintai Composite Portfolio achieved returns of (+4.36%) in July, (+1.71%) in August, and (-1.81%) in September. The portfolio underperformed the S&P 500 by a cumulative (+4.06%) to (+9.03%) respectively (or by 4.97%).
 
Seen below are results for Q3 2020, year-to-date, one year, and since inception (annualized). Note we have removed the Index Blend 85% Stocks as the portfolio no longer tracks to the indexes percentages.  
 

​Portfolio Changes
 
For individual portfolio members only
 
Winners and Losers
 
For individual portfolio members only
 
Portfolio Characteristics
 
The current Abacus view as of September 2020 shows that the Nintai Composite Portfolio holdings are roughly 25% below in value to the S&P500 and projected to grow earnings at a 20% greater rate than the S&P500 over the next five years. Combining these two gives us an Abacus Comparative Value (ACV) of +45. The ACV is a simple tool which tells us how the portfolio stacks up against the S&P 500 from both a valuation and an estimated earnings growth stand point. The number shows a portfolio much cheaper in value with much greater profitability and a sharply higher projected growth. We like to see the ACV above 20, thereby giving the portfolio the best chance at outperforming the general markets.
 

​Portfolio Industries 
 
I remain highly focused in my industry and sector weightings.  I currently have holdings in only 4 of the S&P 500’s 11 categories – financial services, industrials, technology and healthcare. 

Final Thoughts
 
The third quarter of 2020 was the first time the Nintai Investment’s individual investment portfolios truly had a miserable performance against their proxies. As I pointed out earlier, our holdings generally outperform in down markets. This quarter represented an explosion in market enthusiasm as investors feel we turned the corner on COVID. Even with the infection of the President we are seeing this isn’t necessarily correct. There also seems to be (and we hate this phrase) an irrational exuberance in relationship to the recovery from the COVID-based recession. Again, we are in a minority that feels we have a long way to go in getting all parts of the economy back to operating on all cylinders.  
 
Last quarter we wrote there were three main issues we felt would drive longer term returns for the markets. We think these three themes are unchanged since we first wrote about them. We have added a fourth as the United States’ approach to dealing with the COVID-19 has been woefully inadequate and will continue to be so until we get a new administration with a more systemic - and systematic - approach. 
 
1. Stock prices - relative to price over earnings, price over cash flow, and price over estimated earnings growth - seem quite high in historical terms. While interest rates remain at historical lows, Nintai believes this doesn’t offset the full risk of such high process.  

2. With over 7.45M cases (averaging roughly 35,000 new cases every day) and 212,000 deaths (averaging roughly 400 new deaths per day), the United States’ economy and overall consumer purchasing power will be severely hampered and unable to reach full potential. Any projection in earnings, growth rates, or profitability will be very hard to support until the pandemic is under control.   

3. Geopolitical risks have never been higher with the US domestic political scene extremely volatile, the global energy markets in disarray, and the growth in nationalist/populist actively seeking to break up decades-old alliances. The 2020 US Presidential election only adds to these risks.  

4. China represents an entirely new competitor with significant strength generated by its recent economic power, as a significant holder of US debt, and its play for greater military strength in the Pacific.  

We generally don’t allow trends like these to drive our investment decisions or capital allocation. That said, the constant evolution of both US and global political economics can have an impact on individual portfolio holdings’ strategy and operations. As always, we will keep a sharp eye out for any impairment on our holdings’ valuations and/or competitive moat.     
 
We hate underperforming. Regardless of what events that are happening in the greater economy or geopolitical world, we have no excuse for our performance in Q3 2020. You have our word we will work diligently to better our results and get back to excelling over our indexes. That said, we recognize underperformance happens and we won’t be suddenly increasing portfolio turnover to 115% or leveraging our portfolio by 400%. Rather, we will focus on what we do best and focusing on improving our process where we can. 
 
Helping individuals and organizations achieve their life goals, support their corporate giving, or meet their retirement needs is a remarkable honor and mark of great trust. Every day we look to continue earning that trust. Should you have any questions, please do not hesitate to contact me by phone or email.  
 
 
Thomas Macpherson
tom@nintaiinvestments.net
603.512.5358 
 
My best wishes for a healthy and happy summer season. 

Over the course of the past 12 - 24 months performance within the Nintai Investment individual investment accounts have performed quite well against the major indexes we like to measure our performance against – the S&P 500TR, the Russell 2000, and the MSCI ACWI ex-US. Over the course of that run I’ve tried to be clear to all of our investment partners they should not expect the double digit (and even triple digit) returns we’ve seen over this time (I am even required to tell each of them and you that past performance is no guarantee of future returns). The last three months have proven that to be a wise policy. 
 
As you all know, I absolutely hate to underperform - even in the short term. The last 90 days has been extremely difficult with nearly every holding in our portfolios underperforming against the general markets. Reversion to the mean - to the downside - is not nearly as fun as the ride up. Whenever we have a stretch of underperformance here at Nintai, we do several things. First is get outdoors and get some exercise. This gets me away from the computer and reduces the risk of making a hasty decision that will likely only enhance the problem.  The second is I think of a story about Lyndon Johnson and John F Kennedy.  On election night of the 196o Presidential race there was a great deal of tension at the Kennedy headquarters as returns coming in showed the results were going to be very close (it was - Kennedy won the total popular vote of 64,329,141 by only 112,827 or 49.72% to 49.55%). In the middle of this chaotic night, many people remember Lyndon Johnson - the Democratic Vice Presidential candidate - calling John F. Kennedy  - the Democratic Presidential Candidate - and saying to him “I heard you’re losing in Ohio but we’re winning in Pennsylvania.”
 
As an investment advisor (and investor), I’ve never been impressed with money managers who take the LBJ way when it comes to reporting results. Many of them seem to live by the ancient Chinese proverb that says “victory has a thousand fathers but defeat is an orphan”. There will be no lonely orphans running around the Nintai Investment’s offices. The last three months have been tough on our portfolios. Though still up over the long term, these poor returns have eaten up half of our total outperformance. No one is responsible for that except me. I apologize for that.  
 
Being a value investor - particularly with other peoples’ money - is not easy. You are sometimes faced with very difficult choices. Occasionally share prices will dance right around purchase or sell prices but never send a clear signal. Sometimes company’s may take on debt yet remain an outstanding investment opportunity. These types of situations can challenge your investment strategy, your investment criteria, or both. Yet we get paid to make decisions (and that may mean doing nothing) in each of those scenarios.
 
The most difficult situation is when market currents flow in conflicting directions. During these times it seems like any investment decision is a “damned-if-you-do” or “damned-if-you-don’t” proposition. We are currently stuck in an unfortunate market situation where four underlying forces are at work.
 

1. the general markets are overvalued;
2. many individual positions in our portfolios are overvalued;
3. all the companies in our portfolios - in our estimation - are tremendous long term holdings; 
4. We find it impossible to time when - or if - prices will become more rational

 
These four currents have put us in somewhat of an investing bind. I thought I’d share some thoughts on each of these so my readers can better understand Nintai’s decision making process. 
 
General Markets are Overvalued 
Just recently (September 8, 2020), Stanley Druckenmiller (who I admire a great deal) stated the markets are in an “absolute raging mania”.  Morningstar would disagree with their “Market Fair Value” calculator showing a price to fair value of 1.01 (or 1% above fair value). Who’s right? Darned if I know, but I certainly lean more towards Druckenmiller’s view than Morningstar. It would seem to me a move from a market average PE of 14.8 in 2010 to 28.7 in 2020 is - in general - excessive. 
 
Individual Portfolio Positions are Overvalued
In November 2016 when we first started building out the Nintai Investment model portfolio, the average PE was 16.7. By September 2020 this has jumped to 25.9 with 7 out of 21 portfolio holdings having a PE of 40 or greater. In addition, the portfolio price-to-fair value has jumped from 0.91 (or 9% below fair value) to 1.07 (or 7% above fair value). We are in the very difficult position of holding a selection of outstanding companies with a many significantly overvalued. Do you hold on to these no matter what? Do you sell a portion? Do you sell the entire position with the hope to reinvest again after the price drops? There’s no easy answer to these questions. We’ve unfortunately chosen to sit tight and have lost some of the gains by not taking profits when we could. As Warren Buffett would say, we’ve been guilty of thumb sucking. 
 
All Our Portfolio Companies are Long-Term Holdings
As I mentioned earlier, all our portfolio holdings are led by outstanding capital allocators, have significant competitive moats, and maintain outstanding financials. We look to hold companies like this for decades and let management do the heavy lifting. As most of our investment partners have seen, Nintai’s typical turnover (unless receiving new assets on a regular basis) is less than 5-10% annually. We hate to take profits for several reasons. First, we have to be cognizant of taxes for most of our partners’ portfolios. Second, we hate to dilute or lose any part of a holding in such an outstanding company. Last, we have no idea what the short term price moves will be. For every price drop that takes place after taking some profits, there is an instance where the stock jumps by 30% the day after our sale. 
 
We are Terrible Market Timers
Which brings us to market timing. Even though many of our portfolio holdings are overvalued, we recognize that we have absolutely zero skill in timing the markets. We don’t believe many of our fellow investors have that skill either. We generally purchase shares of a company regardless of what the markets are doing. An example of this is a large pharmaceutical company. We are currently conducting in-depth research on the company and may purchase it into partner portfolios even though markets are flirting with new highs on a near daily basis. Our investment decisions are based on individual corporate valuations alone. 
 
Conclusions
 
The last year has shown the benefits and costs of a long-term investment horizon combined with high quality investment holdings. The first nine months were dream-like with the average Nintai portfolio returning 30 - 35% versus the S&P 500’s 15.8%. The next three months saw a horrible reversion to the mean with the average Nintai portfolio returning 5 - 7% versus the S&P 500’s 11.7%. Rather than taking the LBJ route (“we in Ohio versus you in Pennsylvania”), we recognize I am responsible for both the first 9 months as well as the latter 3 months of the past year. I have assured our investors we will take a look at these returns to see what learnings can be found to prevent such underperformance in the future. I’ve learned over my career sometimes you can find ways to improve and sometimes you are simply the victim of reversion to the mean. Either way, we will work hard to better understand the nature of our returns and report back to our investors any steps taken to improve our process. 
 
I hope everyone is staying safe, wearing your mask, and practicing social distancing. If you have any questions or comments, please feel to reach out. 
 
Disclosures: None
 
 
 
 

​In January 2015, I wrote about Abraham Wald and his research in World War II about bomber survivorship during raids over Germany. To quickly summarize Wald’s work, he was asked by senior leadership of the US Army Air Force to critique a study by an internal team analyzing bomber losses. Their study analyzed damage to bombers that made it back and found the following damage patterns. 

Aircraft damage across aircraft: WWII study

 
The study ascertained damage was centered on the mid-fuselage, outer wing tips, and the rear stabilizers. Since the damage patterns were so pronounced, the Air Force team’s recommendation was to reinforce these areas. 
 
Wald took one look at this and told the team their work was deeply flawed. By studying the planes that came back the researchers were seeing where the planes could withstand damage. The more interesting facts should be about the planes that didn't make it back. By analyzing where all the bullets holes and damage were (on the wing tips, mid-fuselage, and rear stabilizers) on the planes that made it back, he proposed strengthening the areas where there were no bullet holes (mid-wing and rear fuselage). Through his report thousands of bomber crew members were saved through the course of the war. Wald’s work is often used in survivorship bias studies - meaning we focus too much on survivors when we should be looking more closely at those that don’t make it.
 
In my article, I used Wald’s research as a prelude to looking at survivorship bias in mutual funds. Investors many times get hooked on - like air force leadership - the winners in mutual funds, rather than the losers (or those who “don’t make it home” in Wald’s words). In the article I discussed inverting and understanding how many mutual funds survived and beat the S&P 500 index over time. The data demonstrate the incredibly poor performance investment managers displayed for the years 2007 - 2011. I wrote:
 
“Roughly 9 out 10 funds underperformed before they were either merged away or simply closed. A loss that would have staggered Wald himself. It’s hard to imagine that trained professionals - with a wealth of technology, analytics, and treasure behind them - couldn't exceed the batting average of an AA baseball team third stringer. In fact it’s hard to imagine that throwing darts at a list of stocks and bonds couldn't have produced better results. For the investors who received such terrible returns from their investment managers, all they received was a letter quietly delivered to their mailbox informing them of the merger of their fund with an entirely new – and no doubt exciting and outperforming – investment opportunity.”
 
I thought it might useful to take a look to see if anything had changed in the last decade and whether the findings in “Mutual Fund Survivorship” still hold up. Morningstar recently published its latest Active/Passive Barometer report which can provide answers[1].  
 
Every month, Morningstar takes a look at both performance and survivability of active versus passive funds by fund category (e.g. large value, large growth, mid growth, etc.). They also report performance by management fee organized by decile. In August’s report Morningstar discussed their latest findings. 

1. Testing the theory that active funds can outperform passive funds during times of volatility, Morningstar measured all 20 fund categories performance (active and passive) for the first 6 months of 2020 including the period of the Corona virus market correction. Only 51% of active funds both outperformed and survived (or “made it home”) versus their passive cousin. Domestic funds actually did worse with just 48% outperforming. 
2. Active bond funds did worse than active stock funds with only 40% surviving and beating their respective index. 
3. Not surprisingly (in alignment with the “Mutual Fund Survivorship” article), long term performance was terrible. Only 24% were able to survive and beat their respective index over the 10 year period ending in 2020. Foreign stock, real estate, and bond funds (turning around their short term performance) were the best performers while US Large Cap were the worst performing. 
4. Another (non)-surprise was the fact that the cheapest funds had double the chance of surviving and beating their index versus the most expensive 34% to 16% respectively. 

 
Taking a deeper dive into the data shows that sometimes the findings aren’t as simple as they appear. For instance, why is it that nearly every growth fund decreased performance by nearly 15% from 2019 – 2020? Yes, we know growth went out of fashion, but why? Here are some other complexities investors should consider as they think about survivability and performance. 
 
Survivability is a Complex Problem with a Hybrid Solution
Having a fund merged away or closed is rarely due to a single issue. Many times it’s a combination of events. These include high costs versus both indexes as well as funds within their category (e.g. small growth), underperformance against both the S&P and other funds in their category, and a dwindling asset base. The answer to meeting these issues isn’t always easy. One and three are inextricably linked. If the fund lowers fees, then it might not maintain a level of profitability necessary to keep the fund going. But growing the asset base might require this if fund finds itself in a war against index pricing. The issue of performance is far trickier. The very choice of active management means the odds of beating the index has decreased versus an index fund (part of that of course is fees. Back to where we began!). The ability to pick stocks or bonds more successfully than an index fund – long term – is a very rare accomplishment.   
 
Survivability and Performance Isn’t Just About Active versus Passive
With the data as they are, it’s easy to say that passive beats active. But that’s not the case every time. In both survivability and performance passive generally beats performance. It’s important to remember that outperformance can vary dramatically by fund category (small cap, mid cap, etc.), methodology (growth, value, or blended), geography (domestic versus international), equity versus bond, or even by industry (real estate). It’s far too easy to simply write off a fund because it’s actively managed. It’s vital investors spend time reviewing short- and long-term performance, fees, and the fund’s strategy. Some funds might outperform the market by 30% for one year but underperform by 15% over a five year period.  
 
As Usual, Fees Greatly Affect Survivability and Performance  
One thing that hasn’t changed and continues to be one of the top issues affecting performance and survivability is fees. The funds with the highest fees (both passive and active) had a survivability rate of only 27% of those with the lowest management fees. Those management teams that are both actively managing and charging the highest fees survived only 16% of the time period versus 47% of the passively managed funds with the lowest fees. Bottom line? If you think your active management team has any chance of long term success, at least make sure they have the lowest fee structures. Bottom line? Jack Bogle 1 - High fee actively managed funds – 0. 
 
Conclusions
 
Since I published “Mutual Fund Survivorship” five years ago, not much has changed. We know active management generally is more expensive than passive and has a lower rate of survival. We also know the funds with the lowest management fees have better performance and longer survival than those with the highest fees. Actively managed funds with the highest fees have a pretty poor chance of “making it home”. As an active manager with a record of longer-term outperformance (remember: past performance is no guarantee of future returns!) we feel extraordinarily lucky to have investment partners who fully support our methods and strategy. Our goal of course is to provide them with long-term outperformance while maintaining a reasonable risk/reward profile. So far - with a generous amount of luck and some skill - we’ve been blessedly successful in these efforts. If we stick to our investment strategy, don’t wander too far from our circle of competence/comfort, and charge a reasonable fee, we can provide a real service to our partners. So far we seem to be on the right course. 
 
As always we look forward to hearing from our readers. Tom can be reached at tom@nintaiinvestments.net. 
 


[1] “Morningstar’s Active/Passive Barometer”, August 2020, Ben Johnson CFA 

Nintai Investments average portfolio has done quite well against the market indexes over the year-to-date as well as 1 year and 3 years. Our outperformance has a great amount to do with our returns in Q4 2018 (-2.78% for Nintai Investment portfolios versus -14.33% for S&P 500TR) and Q1 2020 (-12.25% for Nintai Investment portfolios versus -21.08% for S&P 500TR). By keeping an eye out for the downside, we have found returns will do fine over the long-term.
 
Use All Tools Available to Us Now
Fifty years ago, very few investors (individual or professional) had ever heard of behavioral finance. There has been an explosion in the last decade in our understanding about how the human mind thinks about investing, making and losing money, decision making during stressful times, etc. Almost none of it leads us to be better investors. In fact, the field of behavioral finance is largely about avoiding emotional responses and biases in our decision making. Spending a small amount of time understanding the topic and building steps into your investment decision making process can pay large dividends over the long term.   
 
Contrarian Thinking is Even Rarer Today
In 2009 index funds made up roughly 25% of all mutual fund assets. That’s now nearly 50% according to Morningstar. This growth of indexing has taken the art form of stock selection out of the hands of personal and professional investors and simply allowing computers and algorithms to make stock selections. At Nintai Investments, this has created an increasingly large gap between stocks that meet the needs of index funds and those that fall through the cracks. We think – over the long term – it’s never been (other than the 30’s and 40s of the last century) a better time to be an active manager in the value investment field. As jumbo cap companies take up an increasing amount of investment dollars (simply because they must be owned in most index funds), we find there are many small cap gems that are passed over and are diamonds in the rough ready to b scooped up. At Nintai, we strongly believe our performance reflects this type of thinking and success.    
 
Conclusions
 
At the time of writing this article (August 2020), the S&P 500 was on the verge of setting a new high on a near weekly basis. At the same time, roughly 175,000 Americans have died of the corona virus, there has been roughly 5.7 million cases nationwide, and roughly 1,000 additional patients die per day. In the race for a cure, citizens seem to be blissfully ignorant of how long it takes to develop a vaccine, how effective that vaccine will be, and whether we will be looking at a second wave of infections combined with the standard influenza later this fall and winter. In July, the unemployment rate declined by 0.9 percentage point to 10.2 percent, and the number of unemployed persons fell by 1.4 million to 16.3 million. Despite declines over the past 3 months, these measures are up by 6.7 percentage points and 10.6 million - respectively - since February. Huge swaths of the US economy - retail, restaurants, airlines, etc. - continue to face ominous reports that many of their brethren are simply not coming back (In New York City, it is estimated nearly one out of every three restaurants will not reopen their doors). 
 
With all of this going on, it’s hard to get your arms around the enormous gains made in the markets. Are investors simply ignorant, dumb or simply wildly optimistic? It’s hard to know because every bubble or pricey market is unique. There are so many variables it’s hard to build a model that takes everything into account. All that said, we try to keep our thinking straightforward and simple as possible. At Nintai, we think risks far outweigh rewards - this includes earnings growth, interest rates, debt levels, and general economic trends such as our politico-economic relations with China and the EU. We will continue to do what we do best by locating the highest quality companies that have been overlooked by the indexing world and trading at cheap prices relative to our estimated intrinsic value. We will also look for companies with rock solid financials with characteristics such as no debt, high free cash flow margins, and outstanding return on capital. Finally, we will continue to hold lots of dry powder until opportunities come along. We will work hard to avoid any unforced errors and not be rattled by bad news. In the final analysis, when markets are seemingly out of touch with the economy, its best to review your current holdings, work hard on your watch list and be patient. Anything else would be doing yourself and your investors a grave disservice.   

[1] “The Power of Dividends: Past, Present, and Future”, Hartford Funds 2020 Insights. The report can be found here.
​

“By then I knew one thing for certain: the Detroit-based auto industry was a debt- enfeebled house of cards that had been a Wall Street playpen of deal making and LBOs for years…it needed nothing so much as a cold bath of free market house cleaning, along with a drastic rollback of the preposterous $100,000 per year cost of UAW jobs.”
                                                                            -      David Stockman[1] 

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. 
 
Our Fees 
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%[2].  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[3].    
 
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[4]. 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! 
 
Our Returns
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. 
 
Our Communication
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.   
 
Our Ethics
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.    
 
Conclusions
 
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.  
 
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[1] “The Great Deformation: The Corruption of Capitalism in America”, David Stockman, PublicAffairs, Perseus Books Group, 2013

[2] Securities and Exchange Commission, Division of Investment Management, “ Report on Mutual Fund Fees and Expenses”, December 2000

[3] “The Battle for the Soul of Capitalism”, John C. Bogle, Yale University Press, 2006, page 11

[4] A special thanks to Vanguard for the basis of this example.

Low quality investment opportunities are actually quite easy to stumble on. Having a company implode from over indebtedness, corporate fraud, or simple gross incompetence is remarkably common in today’s “go-go” easy money markets. Finding quality - outstanding management, pristine balance sheets, deep competitive moats, and high customer satisfaction - is actually quite difficult.  
 
At Nintai Investments, we utilize roughly 16 measures that help us create a list of quality companies based financial, operational, strategic, market-based, and competitive characteristics. This leaves us with 41 of 3,671 (1.12%) total United States publicly traded companies, 305 of 17,602 (0.23%) total Asian publicly traded companies, and 88 of 8300 (0.49%) total European publicly traded companies. As one can see pretty quickly, the amount of companies that identify as quality is less than 1% world-wide. 
 
Last week I reviewed what we defined as poor quality at Nintai Investments. One might think that high-quality companies simply feature the opposite traits of poor-quality companies, but that’s not entirely accurate. A quality company has characteristics unique to their category - in much the same way as poor-quality have their own. As Tolstoy wrote, “All happy families are alike; each unhappy family is unhappy in its own way”. 
 
The kind of qualities we look for in at Nintai Investments fall into four key buckets. These include:
 
Excellence in Management: We look for management that have a vested interest in how the company performs (by purchasing shares in the open market, not stock option grants), provide a history of outstanding management candidates (similar to GE’s top 3 candidates for CEO - when one was chosen and the other two were considered outstanding managers in their own right and are expected to leave the company as CEO of another firm), deeply understand they work for both shareholders and their respective community, and finally achieve outstanding results in both operational measures (ROE, ROA) and strategic measures (ROIC, FCF margins). Most important than all of these, we look for management with a clear moral compass. This presents itself in forbidding financial transactions that profit management (such as renting a building they own directly or through corporate ownership), not using off-balance sheet gimmicks (such as special investment vehicles - SIVs), forbidding any type of family interactions with the business (such as placing family members on the Board), and the use of stock options as a transfer of wealth from corporate coffers to management’s pocket book. We feel strongly the fish rots from the head and it won’t be long before that rot works its way downwards.    
 
Create Deep External Facing and Inward looking Moats: In both good times and bad, we look for managers who can create exceptional defensive moats that can keep competitors at bay as well as drive significant value for their customers creating a moat that keeps them from seeking out replacement products and services. Sometimes managers can spend blood and capital digging a defensive moat but they spend little time listening to their customers’ needs. This type of one-way thinking can create significant weaknesses in looking for new offensive opportunities in existing customers, markets, or adjacent markets. An inward looking moat means management has developed the means to make their products and services essential to their customers’ strategy and operations. This type of in-depth value - for lack of a better term “the tape worm approach” - demands a nearly constant improvement in quality, scope of offering, and new products/services on a daily basis. It’s hard to find management and corporate structures that have the drive to approach each work day as means to radically improve their value to their clients. A great example of this is Veeva’s constant evolution of products and services in the biotechnology industry. In the past 5 years the company has launched 116 new offerings and made over 1200 changes to existing offerings. That’s a launch or change nearly every 2 days.        
 
Creates a Rock Solid Financial Castle: At Nintai Investments, we look for investment opportunities that can survive the most violent shock to its foundations. This can include a sudden elimination of access to any capital (the type of shock that overcame the financial markets in 2007 - 2009), a rapid increase/decrease in the Federal Reserves’ prime rate, or the LTCM failure demanding government intervention to stave off financial disaster. All of these led to some form of catastrophic market failure.  We look for a company that is reliant upon no one or no institution for survival or financial bailout in a time of market crisis. This requires a balance sheet with little to no debt (or the ability to pay 100% of liabilities with 1 year of free cash flow), high free cash flow yield, and outstanding returns on capital, equity, and assets. This demands we focus on cash rather than earnings because we believe in Alfred Rappaports’s “profits are an opinion, cash is a fact”. We recognize its is very difficult to sniff out financial shenanigans if management is intent on cheating and the consequences be damned. But we think keeping a hawk eye on cash gives us the best chance to avoid partnering with an unethical management team. 
 
A Singular Focus on Market Domination: We look for companies that seek to wholly dominate a market so large that the runway for growth is roughly 15 – 20 years. We want to know with some assurance the company will be in the same markets (or adjacent ones) dominating them with high market share, outstanding returns, and great gross and net margins for an extended period of time. Obviously it is difficult to find a company that operates in a monopoly or duopoly environment at a discount to our estimated intrinsic value, but it is possible in the micro to small-cap markets. Examples of this include iRadimed (IRMD), Computer Modelling Group (CMDXF), and Veeva (VEEV). Finding these hidden gems – which requires an awful lot of research and industry knowledge - can successfully drive investment returns for decades. We’ve often stated that two companies - Factset Research (FDS) and Manhattan Associates (MANH) - drove nearly 80% of the Nintai Partner’s internal investment fund’s outperformance. We still believe a combination of these gems with some larger companies that meet our criteria can provide outperformance with less risk. 
 
A Final Note
 
I would be remiss to say that successful investing isn’t about just quality companies. We firmly believe your financial investment advisors core intellectual (and emotional) models matter equally. These models should include acting on facts rather than emotions (in both bull and bear markets), always being intellectually open to new ideas, new industries, and new companies, being humble about your success and even more humble about failures, and reveling in diagnosing and discussing investment screw-ups. I’ve found over the years the latter is one of the greatest distinctions between Nintai and our competitors. While we have the same animal spirits as others in this field and are driven by our competition, we actually enjoy writing about our mistakes. Perhaps enjoy is too strong a word (after all we hate losing our investment partners’ hard earned capital), but we find discussing these occasional debacles helps ground our egos and forces us to better understand what happened, why it happened, and how to prevent it from happening again. So while quality investments drive returns, an investment manager should have qualities of excellence as well. 
 
We look forward to hearing your thoughts and comments. 
 
DISCLOSURE: Nintai Investments LLC has positions in iRadimed, Computer Modelling Group, Veeva, and Manhattan Associates in either or both business investment accounts or individual investment partner accounts.       
​

During the dog days of summer, we usually move everything outside, work on the deck, and suck up the summer sun. We take the down time to evaluate roughly one-half to two-thirds of our portfolio holdings. This includes taking apart the business case, looking at the competitive markets, diving into new products and services, and completing a truly deep dive on the company financials. We do this for two reasons – one is we want be assured each and every portfolio holding can still be considered very high quality. Second, we want to look back at our projections (strategic, operational, and financial) and be assured our assumptions are valid, valuations have not decreased (hopefully increased!), and the share price has not gotten too far ahead of our estimated intrinsic value. 
 
For some of our investment partners, these revised investment cases and valuation spreadsheets are like Christmas in July and August. For others, they go the pile to read after a relaxing summer vacation. We’re fine with either. We simply want our partners to have as much knowledge as we would like if we were in their shoes. 
 
I thought I’d break this in to two separate articles. The first part is reviewing what we would consider obstacles in defining quality for a possible investment. This isn’t a complete list. It isn’t even a full description of each item on this list. But I wanted to make it as simple as possible for investors to understand why poor quality can impair your returns. The second part is describing what we consider quality at Nintai Investments. Some readers will say “Oh God. I’ve heard all this before”. If you are a long term reader of my writing then you probably have. As Aristotle said “We are what we repeatedly do. Excellence, then, is not an act, but a habit”. Nintai Investments (and its predecessor Nintai Partners) would have achieved very little as a company or an investment manager if we didn’t constantly hammer away on the concept of value. Looking through my last 100 articles, the second most common word was “quality” – coming up a total of 232 times. (“Value” was the number one word cited 431 times).  
 
Obstacles 
In some ways it’s much easier to identify what’s NOT quality than defining what IS quality. Some attributes that make up a non-quality company are the following.
 
Excess Goodwill: In almost any acquisition, the agreement between acquiree and acquirer involves a certain amount of negotiating that leads to overpayment. At Nintai Investments we recognize that’s part of the animal spirits that make up the capitalistic system. Having said that, I can remember a management team that completed $23.6B in acquisitions from 1998-2002. Over the period of 2003 – 2006 the company wrote off $23.2B of those acquisitions (a whopping 99%!). Management claimed this was a victimless crime – acquisitions were made nearly entirely in stock so who was harmed? Let me just say that when management can’t see the damage from the the evaporation of over 65% of total assets on the balance sheet, then they certainly don’t represent quality in our books.

Excessive Stock-Based Compensation: A cousin of the goodwill excess, is the gross overuse of stock-based compensation. Again, many claim this is a victimless crime until the payments are expensed under the cash flow statements. This snaps many heads around. For many companies, this type of executive compensation is simply a transfer of wealth as the company announces billions in stock buybacks while simply seeing those very stocks slide out the side door as enormous pay packages for executives. When you see a company announce a $500M stock buy back and total shares outstanding either remain flat (or worse increases) then it’s a good chance this is not an excellent company. 

WACC Exceeds ROIC: Don’t get hung up on the acronyms in this section. This simply means the company’s return on capital is less than its cost of capital. Let’s use a simple example to highlight this problem. Imagine you see that steak is on sale by 8% this week at the supermarket. Excited at the thought of eating steak all week, you whip out your credit card and purchase $100 worth of beautiful Delmonicos. You smile at the 8% in savings. Yet consider the other end of the transaction. The rate you pay your credit card is 24%. So while you’ve saved that 8%, the cost of that return is 24%. The formula is simple: 8% - 24% = -16%. Your return on invested capital has been far exceeded by your weighted average cost of capital. This type of disastrous financial model is sometimes explained away by the famous (or infamous) line – “don’t worry we’ll make it up on volume”. Any company that shares similarities to this example is certainly not a quality company. 
 
Customer Churn/Turnover is in the Double Digits: A company that relies on constant turnover and finding new customers is highly likely to be a low-margin business with no moat. Some businesses are notorious for churn which further drives down margins. Take for example wireless phone companies. You constantly hear of dissatisfied customers, switching from Sprint, to Verizon Wireless, to US Cellular, to AT&T Wireless. It’s a never-ending movement seeking the Shangra-La of coverage with constant rebate offers, and fine print that can only be found on the seventh level of Hell.   

The Company’s Product Is A Nice-to-Have: The road to personal wealth is littered with the wreck of thousands of businesses that were the “new hot thing” until they weren’t. You’ve probable owned one of these in either your personal or professional lives. These are products or services you swear you can’t survive without until the next recession hits and you have to choose between keeping the lights on or having that $59/month answering service. The one that provides an $8/hour operator with the most gorgeous Scots accent and gives your company that “international” flavor. Pretty cool when you are rolling in dough, but the first to go in tough times. The company’s price falls 85% before filing for bankruptcy late Friday night when it’s impossible to save even the smallest part of your investment. 

Capital is Essential to Business Operations: The first trading under the buttonwood tree on Wall Street was designed to meet the needs that all capital markets provide – creating access to capital. Well run markets and companies will dip their toes (hell…even their entire lower waist) to obtain capital to increase production, complete an acquisition, or extend operations overseas. This financing can be in either debt or equity in structure. The trouble begins when debt (or issuance of equity) becomes necessary simply to keep the doors open. When a holding maxes out its credit line or raises $2B in convertible debt to “explore strategic solutions”, this certainly isn’t a quality company.            

Conclusions
 
There are many ways to make money on Wall Street. Since its first trades in the 18th century, the New York Stock Exchange has seen hundreds – if not thousands – of techniques used to make money in the buying and selling of equities. Since then we’ve had an explosion in the number of exchanges along with the types of things to trade ranging from corn futures to collaterized mortgage securities. At Nintai Investments, we’ve tried to keep our investment model simple and limited in its adoption of risk. We don’t trade derivatives in any way, shape or form, we don’t short, we don’t trade debt, and we avoid anything but the highest quality in companies. This article has briefly discussed what is not quality. The next article will discuss the qualities we look for in an investment - and more importantly – why its critical to our long term success as investment managers. Please feel free to send in any comments or questions and we will try to reply as soon as possible. We hope everyone finds a way to stay cool. 
 
 

To Our Investment Partners:

Enclosed you will find the first batch of revised investment cases and valuation spreadsheets of Nintai Investment portfolio holding companies. These are for the first half of 2020. Some of these you may own, some you may not. We have included all of them, so that you might get a better sense of understanding of our methodology and selection process. 

An issue too large to ignore is the COVID-19 pandemic. Dependent on where you or your portfolio companies reside, you might see little impact to significant disruption. Worldwide there have been 13.8M confirmed cases through July 15 2020. Roughly 7.74M individuals have recovered with 591,000 confirmed deaths. Here in the United States where Nintai Investments is headquartered, there have been 3.53M confirmed cases along with 178,000 confirmed deaths. Basic math shows the US has been hit particularly hard. Regardless of your political persuasion, these numbers show that American business has taken a very real hit. 

So what does this mean for your portfolios and impact on returns? A couple of things. First, the type of holding we seek at Nintai Investments has the financial and business acumen to withstand very hard shots to the system. Company’s have little or no leverage so there is little pressure for debt servicing. Second, competitive moats are very broad and deep assuring both strength against competitors and continued demand from customers. Additionally, valuations are as likely to go up as come down. We see this playing out in Q2 2020. Finally, prices are far more stable and will likely recover more quickly. Again, we see this playing out in Q2 2020. 

Some of the companies in our portfolio are taking longer to report their returns or it is taking longer to generate reports because we can’t talk to customers or vendors. An example is FANUC, located in India where the country has been swamped by over 1M COVID cases. We also have not been able to chat with over 50% of the customers and vendors that assist us in better understanding the company’s results. Consequently several reports will be delayed. On a more personal note, two individuals we’ve known for decades and who have been both tremendous sources of data and teachers, we lost to COVID-19. Things like that put it all in perspective. We will miss Sanjay and Billy tremendously and send our love and prayers to their families and loved ones. 

Enclosed you will find three of the first investment cases and valuation spreadsheets - Biogen, F5, and Check Point. Fanuc has been delayed due to company issues and the loss of Sanjay. Next week’s batch  - Biosyent, SEI Investments, Guidewire, and Novo Nordisk will be delivered on Friday, July 24 2020. Please don’t hesitate to contact me with any questions. My best wishes. 

Tom
   

A moat wasn’t always used to just protect against enemy attack. During a siege the moat made it equally difficult for the defenders to sortie from the castle. It’s no different in business. A moat can also make it difficult for the customer leave and hire a competitor. Finding such a company - either as a vendor or potential investment - requires a Goldilocks company.
 
In 1864, Ulysses Grant became commander of all Union forces. Choosing to lead while attaching himself to the Army of the Potomac, several senior officers started warning him about how gifted Robert E. Lee – commander of the opposing Confederate Army of Northern Virginia – was and how he could do things no other general could conceive. After hearing these claims just a little too much, Grant finally burst out saying “Let’s stop worrying about what Lee does, and worry about what we are going to do to beat him”. In the end of course, Grant forced Lee to the point he lost the ability to maintain the initiative and ended the war a year later at Appomattox Court House. 
 
I bring up this story because I think many investors sometimes get the wrong end of the intellectual stick when it comes to the concept of moats. The idea of a competitive moat comes from Warren Buffett and has - like the concept of Mr. Market - been invaluable to investors to understanding core concepts in value investing. The idea is simple: much like a Middle Age castle that dug a moat to protect against attack, so a company will build a moat to protect its products and services from competition.  In a recent article I discussed that sometimes the best measures of diagnosing a moat are outside of the standard measures of return on capital, return on equity, gross/net margins, etc. In the article, I discussed how utilizing data from a holdings customers and other such data not found in more traditional research can make a huge difference in finding compounding machines. I used Veeva (VEEV) and Adobe (ADBE) as working examples. 
 
In this article, I thought I’d invert the concept of moats and take a look at the concept from a more distinct - and often overlooked - view that can greatly impact one’s valuation and decision to include in the portfolio.   
 
Rethinking the Moat Concept
 
Many people think of moats from this competitive perspective. With an eye towards competition, the company will try to utilize internal development, R&D, acquisitions (large & small) and constant quality improvements to stay ahead of their competition. At Nintai Investments, we think about moats somewhat differently. We think moats can be perceived as keeping competitors at bay as well as keeping customers even closer. Rather than just keeping competitors out, we like to think that a good moat will also keep customers in, with a portfolio holding continually broadening the moat to keep the customer purchasing ever greater products and services. By inverting the standard moat approach, I think an investor can identify some of the strongest companies in the market. Not only can evaluate how growth might slow, you also identify where growth will come over the next decade or two.   
 
Components for Keeping the Customer
 
As you invert the moat model, it’s important to realize you are now looking at the relationship between your portfolio holding and their customers, not their competitors. Looking outwards, one views the moat and ascertains the risks associated with other companies that might assault it with new products, price reductions, increased quality, patent challenges etc. These all have the ability to impede future growth. Looking inward, we are more interested in seeing how your portfolio company has created ties with its customers that make it both difficult to move to a competitor and increase revenue through increased sales. The former (moat as competitive deterrent) is about reacting defensively to outside forces. The latter (moat as binding portfolio holding with its customers) is about reacting offensively and creating new opportunities for growth and profits. 
 
It’s critically important that investors see this distinction and be able to evaluate the moat from both perspectives. One requires significant knowledge of competitors, market trends, and technology innovation. The other requires extremely deep understanding of customer strategy and operations, organizational structure, vendor contracting practices, etc. The ability to see both views will give you more knowledge about your portfolio holding than most analysts have on Wall Street. I should point out the ability to achieve success with so much research requires individual investors (and small investment shops) to run a relatively focused portfolio. 
 
A Working Example
 
To get a better understanding of this dual approach I thought I’d use one of the same companies discussed in my last article (and Nintai Investment portfolio holding) Veeva (VEEV). Veeva operates two major businesses. The first - Veeva Commercial Cloud - is a vertically integrated customer relationship management (CRM) services. Cloud is designed to create real time collaboration between different components of a life science company’s sales, marketing, and promotion components of a product team. It also has a regulatory component which is critical to making sure the customer doesn’t run afoul of anti-kickback laws and statutes. The company currently has 80% market share (and growing) with extraordinarily high retention rates. The second offering - Veeva Vault - grew out of Life Science’s needs for assistance outside of their CRM efforts. Vault provides products for the remaining business units in Life Sciences - regulatory and compliance, manufacturing quality (CGMP or current good manufacturing practices regulations), safety (OSHA requirements), and R&D (clinical discovery and development). 
 
The Moat as Defensive Weapon
 
 As Veeva looks outwards, they want their moat to protect against individual competitor’s products and services, technological innovation, and market innovations. As Veeva’s platform is built on Salesforce (CRM) technology and the Veeva team is former CRM team members, Salesforce is not seen as a direct competitor at this time (it may be later, but not for now). Currently, Veeva’s major competitors are companies such as Open Text (OTEX), IQVIA (IQV), Oracle (ORCL), Kapture, and PharmaCODE (Softdent), etc. There isn’t a company (perhaps other than Oracle) that competes against Veeva in all of its offerings. 
 
Veeva spends $227M in research and development or roughly 21% of total revenue. This is a substantial percentage compared to its competitors and demonstrates the intensity in which it confronts competitors. This spending has dug a significant moat around both its offerings in biopharma and has allowed for a head start in several industries with similar characteristics. These include cosmetics, food manufacturers, and other regulated production and marketing processes. 
 
As a defensive tool, Veeva’s moat works in several ways in keeping its competitors at bay. These include technological advances, new (and trademarked) products and services, and increased functionality. 
 
Technological Advances
Veeva continues to utilize technology as a differentiator in its battle with competitors. Examples of this include Veeva CRM Approved Notes (May 2019) and Veeva CRM’s Autosync (August 2019). Veeva CRM Approved Notes is designed to make it easier for sales representatives to utilize free text (not like drop down boxes where the user is limited to pre-set answers). Veeva Approved Messaging will add support for messaging applications such as WeChat and WhatsApp to open up new digital channels for compliant engagement. Ultimately, this will allow users to apply artificial intelligence (AI). Veeva Autosync makes it possible for all information - regardless of device - to be consistent. Activity, customer, and product data will automatically synchronize and always be available from any Apple and Windows phone, tablet, and laptop. This is a huge step in meeting intra-company interoperability. 
 
New and Trademarked Products
A key competitive advantage is the ability to protect your product with a patent or trademark. Patents are the number one source of moats for biopharmaceuticals allowing exclusivity for 12 – 20 years for each new product. Veeva currently has 25 approved patents. Each of these makes up a facet of its competitive moat. These patents range from “System and method for creating a new account in CRM” 
(patent #: 10467629 November 9 2015) to “System and method for controlling electronic communications”, (patent #: 10169480 January 1 2019). These patents protect major components of Veeva’s products. 
 
Increased Functionality  
To stay ahead of competitors, it is critical for a company to continually add functionality to its existing systems as it builds out entirely new offerings. In Veeva’s case, an example of this is their rolling out of several new functionalities to its CRM product. At its Barcelona Users Summit in 2019, the company rolled out new functionality that allows its customers greater flexibility for improved collaboration and productivity. This increased functionality increased Veeva’s lead in the biopharma space and widened its competitive moat against new competitive efforts. 
 
All three of these are designed to separate Veeva from its competitors and create a wide competitive moat. A quick look at the numbers show the efforts are paying off. Patient churn (those not reupping current services) is less than 1.2%. Return on invested capital of 65% far exceeds its weighted average cost of capital of 5.6%. Free cash margins are roughly 40%. All of these numbers reflect a company with a strong competitive advantage.  
 
The Moat as Offensive Weapon
 
But this rally only tells half the story. A deep moat also makes it hard for a customer to jump ship and join a competitor. The moat should be as powerful holding customers in as it is keeping customers out. It’s easy to forget this. Sometimes companies are so focused on customers they fail to satisfy their customers. Inverted, it can be equally true - companies so focused on their customers can some time lose sight of where their competitors are headed. If I had my druthers, I would certainly pick the former over the latter. 
 
When analyzing a moat as a tool for looking inward, there are three factors you should look for - deep subject matter/customer knowledge, customized applications, and the ability to bring whatever resources are necessary to the table.    
 
Deep Subject Matter/Customer Knowledge
Veeva has extraordinary depth of knowledge in the life sciences and pharmaceutical industries. For over 13 years the company has worked exclusively in the space. Its customers have been clients for a decade or more. They have deep ties with both C-Suite and operational leaders and an intimate understanding of their needs. Having branched into nearly every part of the business, Veeva staff can create fully integrated products that seamlessly fit into their clients’ model. They can listen to some the more esoteric parts of the business and be able to find how that might integrate this into another business segment and increase both components’ value. In short, they are truly subject matter experts. 
 
Customized Applications
Such a deep understanding of each client’s needs means Veeva can create products to meet industry needs or customize these to individual company needs. For instance, a company with a deep focus on R&D in oncology immunotherapy will have very 
 
different product needs than a large biopharma with several large blockbuster drugs and a strategy to build growth with smaller snap on acquisitions. The demand to focus on large CRM systems will be much less in the former than the latter. Conversely, the latter will need an extremely robust CRM component to track sales, marketing, and promotion for its large product teams in the field. 
 
Ability to Bring Resources to the Table    
Finding a vendor that can be flexible and nimble in its thought processes and also have the resources to fund multiple options can be very difficult. That vendor must reside – in Stephen Hawking’s phrase – where the environment must be “just right”. This Goldilocks company must be nimble enough to keep up with industry innovations, individual customization, and complex technology problem solving. The company must have enough cash flow to pay for ongoing customer-driven R&D, while utilizing additional dollars to identify and create products for new industries. This takes a company with a rock solid balance sheet and high free cash flow margins. 
 
Conclusions
 
Finding a company where the moat is just as effective at keeping competitors out as keeping customers in is a difficult proposition. It requires a tremendous amount of legwork as only some of he data is publicly available. As a biopharma company, finding a vendor that meets the criteria outlined as equally hard for an investor. I’ve written before that the research criteria I use on GuruFocus gets me a list of roughly 150 companies that might be a company like the ones I’ve described. I say “might” because meeting search criteria can answer general questions about margins, free cash flow, or cash on the balance sheet. It doesn’t tell us how good their relationships are with management, or how innovative they are, or the flexibility in their thinking to meet individual company needs. These latter characteristics are essential to finding the 10 baggers that all investors seek and why they are so hard to find.
 
As always I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai Investments LLC owns shares of Veeva and Adobe in client accounts.   

“We define an economic – or competitive – moat as the ability of a portfolio company to create a product or service that is essential to their customer’s strategy or operations. An example of this might be a platform that is essential to capture, analyze and report customer usage data. There are companies like this – Veeva being an example – that are essential to life sciences drug development, promotion, and sales. This in turn generates extraordinary return on capital. Over time, you end up with a holding that is an essential part of their customer’s business that generates extraordinary profits. What’s not to like?”

                                                                                   -        Nintai Investments LLC 

What Makes A Quality Investment?
Over the course of my investment career, I’ve invested in roughly 250 companies. Holding times have ranged from 6 months to 12 years. All of them have met certain criteria which I’ve written about over the years - high returns on capital, equity, assets, high free cash flow margins, and low to no debt. But there are intangible qualities to each of these companies that might create competitive advantages that can’t be simply quantified though a set of ratios.  
 
Importance to Strategy and Operations
A key characteristic we look for at Nintai Investments is a company that produces products or services that are essential in assisting their customers carry out their strategies and operations. This might include everything from creative work (slogans, product jingoes) to building parts essential to making the product operate at peak efficiency. Simply put, their customers wouldn’t be nearly as successful without your portfolio company’s products and services.   
 
Replacement Difficulty
Another sign of quality is the difficulty of a customer in finding a replacement for that specific portfolio holding. An example of this is Fastenal (FAST). The company maintains thousands of vending machines and local shops that supply parts nearly instantaneously keeping manufacturing floor downtime to a minimum. Most companies simply don’t have the scope of product to meet those needs. 
 
Embedded Strength
Any company with a deep and wide moat should have relationship deeply embedded with their costumer’s senior management team. This means a strong web of corporate relationships, a deep sense of trust that the company can meet its promises and deliver product on time, and a long history of quality. These types of intangibles make it hard for any competitor to make inroads in terms of relationships with the customer.    
 
Industrial Expertise
Finally, the portfolio holding should have both a wide and deep knowledge of the industry of their customers. The company should be able to brain storm with middle to senior executives on problem solving potential issues from customer needs to plant operations. This type of knowledge allows a portfolio holding to not only build on existing product lines but develop new solutions unheard or unthought of previously.
 
A Working Example
 
A working example of how Nintai Investments evaluates both existing and potential investment holdings was the purchase of Veeva (VEEV) and Adobe (ADBE) during the market drops in December 2018. Both companies have Pfizer (PFE) as customers and we decided to evaluate the two holdings versus three different vendors who also work with Pfizer - Microsoft (MSFT), ICON Plc (a contract research organization or CRO), and Omnicom (an advertising agency). In Figure 1 is the summary report of the five companies and their respective ratings. 
 
This graphic is typical of the type of work that we generate during research at Nintai Investments LLC. It helps us understand where the strength – and weaknesses – lie with both a potential investment as well as other major vendors at key customers. The goal of course is to isolate the possible weaknesses in our investment case as well as test our knowledge of both a typical customer along with its market. We will generally test these graphics (and the associated ratings) with individuals in the customer we are evaluating (in this case Pfizer) as well as individuals we might know at the competitors listed.   

​In May 2018, Nintai Investments LLC completed an in-depth survey with Pfizer’s middle and senior level executives to discuss the importance the company perceived in two of our portfolio holdings - Veeva (VEEV) and Adobe (ADBE). We then matched these with three other vendors working with Pfizer. The intention of the research was to measure the strength of the intangible qualities of the companies’ moats. In other words, did Veeva and Adobe have stronger (or said differently - “deeper”) roots into their customer Pfizer. 
 
What We Found
 
Over time, Nintai Investments has spent an inordinate amount of time trying to better understand what makes a moat deeper, wider, and increasingly difficult to overcome. What we’ve come to think (and this in no way makes it true) is the previously mentioned intangibles - only found in deep industry and corporate knowledge - are the key components that drive long-term moat duration. Here’s why: 
      
Depth of Relationship Increases Returns
As a portfolio holding company offers an increasing number of products and services, the company should increase returns over time (see “New Markets are Less Capital Intensive” for more thoughts on this). Done successfully, these products and services embed the portfolio company deeper and deeper into their customers’ operations. For instance, Veeva began by offering customer relationship management software for sales and promotion. The company spread its products and services into research site operations, clinical data management, clinical operations, regulatory requirements, etc. As the number of offerings increase, their strength is magnified by their integrative capabilities. At this point, Veeva is so deeply embedded in life sciences it would be extraordinarily difficult to displace them.  
 
Industrial Knowledge Provides A Huge Edge
When a company like Veeva focuses on one particular market (in this case life sciences) and learns what makes the industry really tick (for instance reimbursement is more important that physician prescribing for some drug classes), a company can begin to really dominate a market and provide a great growth story. For instance, Veeva currently dominates Life Sciences CRM and has seen earnings growth of 50% and free cash flow growth of 60% over the past 5 years. Omnicom has no clear dominance in any market and has seen roughly 8% and 5% growth respectively over the same time period. Which company has a potentially greater growth story? Obviously nothing is written in stone, but my money currently is on Veeva.    
 
New Markets are Less Capital Intensive
When an investor looks at a Veeva or Adobe, it becomes apparent their strategy is to move into adjacent industries where capital outlays are limited by the existence of current products and similarities between industries. For instance, Veeva’s move into cosmetics makes sense in the fact the industry faces very similar operations as life sciences - design and testing of human-usage products, federal regulatory requirements, product safety, etc. The ability to remain asset and capital light in its research and development, product manufacturing, etc. continues to push margins and returns on capital higher. 
 
Conclusions
 
Finding an investment with high quality characteristics is both a numbers driven and industry/company specific process. Running a screen that gives you a list of companies with high returns on capital and equity, no debt, and high free cash flow margins is only 15 - 20% of the research process. The ability to define why and how a company achieves those numbers and how it can maintain them for the next two decades requires an enormous amount of contacts, industry journal reading, and interviews (both potential investment management, customers, industry leaders, etc.). At Nintai Investments, we believe we have enough knowledge in perhaps 50 - 75 companies and 2 - 3 industries to invest in over the next decade. Understanding the quality of those companies - both numbers wise and in a broader business sense can give you an edge that not many players on Wall Street can compete with over a 10 year period. 
 
As always, I look forward to your thoughts and comments. 
 
DISCOSURES: Nintai Investments owns positions in Veeva and Adobe in individual privately managed accounts.