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. 
    

“The greater the fear, the greater the chance that correlations between different asset classes will begin to merge closer to 1. Overtime, this makes the investment universe less and less protected against risk. Theoretically, the correlation between corporate debt with a BBB rating issued by a company with a $10B in debt, $50M in cash, and negative free cash flow should be drastically different than corporate debt issued by a company with an AA credit rating, no debt, and high free cash margins. Yet in October 2008, we found over 50 cases where such disparate corporate debt traded at a nearly perfect 1.0 correlative factor. Go figure."           
                                                                             -     Simon R. Bellows

Asset correlation is a measure of how investments move in relation to one another and when those movements happen. When assets move in the same direction at the same time, they are considered to be highly correlated. When one asset tends to move up when the another goes down, the two assets are considered to be negatively correlated. Fidelity describes correlation from 100% to -100%. In their “The Pros Guide to Diversification” they state:

“Correlation is a number from -100% to 100% that is computed using historical returns. A correlation of 50% between two stocks, for example, means that in the past when the return on one stock was going up, then about 50% of the time they return on the other stock was going up, too. A correlation of -70% tells you that historically, 70% of the time they were moving in opposite directions—one stock was going up, and the other was going down. A correlation of 0 means that the returns of assets are completely uncorrelated. If two assets are considered to be non-correlated, the price movement of one asset has no effect on the price movement of the other asset. 

In a great article by Mark Maggiulli of Marker[1], he pointed out the difference between correlation of returns between assets during the credit asset market crash in 2008 - 2009 and the market crash in February - March 2020 brought on by the coronavirus. In the former crash (see Figure 1), the red lines show a positive correlation between the higher risk assets such as US stocks, international stocks, REITs, and emerging markets equities. Conversely, the blue lines show a negative correlation between lower risk assets (such as 20 year treasuries) versus the entire higher risk category of equites. In the coronavirus crash of 2020, it’s easy to see the nearly complete panic setting in as nearly every asset correlation showed a positive correlation with every other asset class (see Figure 2). 

​Figure 1: +/- Correlation Between Risky and Non-Risky Assets: Credit Asset Market Crash 2008-2009 Source: Marker.com

​Figure 2: + Correlation Between Risky and Non-Risky Assets: Corona Virus Market Crash 2020 Source: Marker.com

​What This Means
Two clear differences between the credit asset market crash in 2008 - 2009 and the coronavirus crash in February - March 2020 was both the speed in which the crashes took place and the drastic differences in correlations between “risky” and “safe” asset classes. 

Time and Correlation in the Credit Asset Market Crash
In the credit asset market collapse, the bear market took a series of cascading events that brought the market to its final lows. Events such as Bear Stearns’ collapse, Lehman Brothers’ bankruptcy, the AIG/Freddie and Fannie bail outs - all led to a slow draw down in the markets followed by a relatively classic recession. The only difference was the length and duration of the recovery with some industries disappearing entirely. However, unemployment peaked at roughly 10.5% or less than half of the Great Depression from 1929 - 1940. During this crash and ensuing recession, Figure 1 shows that there was both positive and negative correlations between asset classes. There was a positive correlation between risky assets (meaning domestic and US-stocks moved in a similar fashion (usually down!) but there was a negative correlation between higher risk (stocks, real estate, etc.) and lower risk assets (bonds, treasuries, etc.) As stocks went down, bonds remained flat or increased in value.
      
Time and Correlation in the Coronavirus Market Crash
The coronavirus crash was like nothing I’ve seen in my investing career. Compared to the credit asset market crash, the coronavirus crash exploded onto the world stage in roughly 60 days. By March 18th, the S&P 500 was down 27% YTD, the German DAX was down 38%, and the Japanese Nikkei was down 29%. These drops mostly happened in just 45 days or less. The credit markets came under enormous strain and even US Treasuries were sold in droves. In a mere month, the entire global economy seemed to have suffered a massive cardiac event. Combine this with a global pandemic that went from roughly 100 cases in January 2020 to over 4,000,000 by May 2020, with over 300,000 confirmed deaths worldwide and nearly 90,000 in the US by May 2020. Unemployment in the US jumped by roughly 30,000,000 cases in just 6 weeks reaching unemployment rates we haven’t seen since the Great Depression. The speed and scope of the crash was like nothing we’ve seen in nearly 90 years. Equally important - as Figure 2 shows - there was absolutely no place to hide (save cash) as nearly every asset cash’s correlation factor went to 1.    
 
Looking Forward
You often hear that investors get caught fighting the current war with the last war’s weapons. That was certainly the case in this year’s crash. While investors worried about asset prices, debt levels, and valuations (which all mattered), no one could possibly have guessed a global pandemic would close down the entire global economy and suddenly having us face a global depression. As always, I think there are several key takeaways from such debacles in the market place. 

Cash Will Always Be King. All Hail the King
During downturns like we saw in February, March, and April, cash is the only asset with liquidity, value, and stability that can save investors from truly awful losses. At Nintai Investments LLC, our average investment partner portfolio had somewhere between 15 – 30% of assets under management in cash. We didn’t have any special crystal ball which foresaw with a market crash or a global pandemic. Rather we saw nearly every asset class was (and still is) overvalued. This could mean only one thing – during a crash nearly every asset would be equally correlated to its neighbor – US stocks to emerging market stocks to global debt. Nearly every overpriced asset would see a dramatic drop in value – with the exception of cash.   

Panic Leads to Matching Correlation……..
When a real panic sets in – and a pandemic that effects 400,000,000 people, killing 313,000, and shuts down nearly the entire global economy – can create such a scenario, then you will see investors selling nearly every investment they can lay their hands on. Whether it be municipal bond mutual funds to triple leveraged oil futures funds, outright panic impacts everything from the credit markets, to the real estate market, to precious metals and other commodities. Figure 2 shows that the latest crash – combined with the economic cardio infarction – brings nearly every asset class into perfect correlative alignment.   

And Matching Correlations Provide no Hiding Place
I’ll be the first to admit that I’m very old fashioned when it comes to creating portfolios. I don’t like to try any type of new sexy “triple negative/positive absolute return exceptional fund” that nearly (but not always of course) states that you won’t lose money in such a fund. I’ve found that the more words in the name of a mutual fund the lesser chance an investor a.) understands the funds strategy or b.) it remotely hits its target returns over time. At Nintai Investments we tend to purchase only two 
things - publicly traded equities and a money market sweep account that holds assets as close to cash as possible. Very rarely do these two have positive correlations. Generally stocks either go up or down and the money market fund goes nowhere. In this model a generous percentage of our client AUM does nothing – it remains as an anchor preventing exorbitant losses (and exorbitant gains). This yin and yang of correlative values has allowed my portfolios at Nintai Partners and Nintai Investments to reap significant gains in market crashes. The past few months have been no different. If I lose several points to the upside while saving double digit losses on the downside, I am very comfortable with this model.     
 
Conclusions
The past quarter gave investors that rare insight when assets across the spectrum all near perfect correlation with each other. When this happens it mean one (or more) of several things. First, all assets are equally overvalued and the markets recognize them as such. Second, investors have reached a stage of complete and utter panic where they sell all assets regardless of type, their portfolio role, or their valuation. At Nintai Investments, we believe the sudden correlation of so many assets was a mix of both reasons. Investors have been part of a bull market that – with several exceptions – has seen markets (both equities and bonds) rise for nearly 10 straight years. In addition, in a very short three month period, the entire global economy collapsed under the weight of a novel coronavirus. Finally, many investors were fighting the last war looking for issues related to credit issues or real estate. 

​A rather simple lesson to learn from this recent crash has been to keep your portfolio design and selection as simple as possible. This doesn’t mean use only three index funds or two asset classes. But rather create a model that can easily adjust for rapid changes in the marketplace and the outside geopolitical and economic conditions. It might be as simple as moving 2% of your AUM into cash for every point above the markets’ fair value as calculated by Morningstar. Whatever you choose, make sure to keep it simple and that it allows you to sleep at night. 
 
As always, I look forward to your thoughts and comments 
DISCLOSURES: None

​[1] “How the Coronavirus Crash Is Different From the 2008 Financial Crisis”, Marker.com Mark Maggiulli, March 31, 2020. The article can be found here.

"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, 2016 Berkshire Annual Report
 
For decades there has been a raging debate about the index fund versus the actively managed model. Which model achieves best returns? Which model achieves the best risk/reward? Does low cost and low turnover beat out the efficient market theory? This debate will likely rage 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. But I also demand that companies be of the highest quality - no short/long term debt, high return on equity, return on assets, and return on equity (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 portfolio 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 crash.
 
The Returns Speak for Themselves
 
This crash has reopened the debate about active versus indexing. In the last 60 days alone there have been over 100 articles in major print financial journals about the war between active and indexing. As I mentioned, we think this is a rather stale argument. Seen 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 would be greater for actively managed funds.  

Without a doubt you can see a significant difference between the indexed funds and Nintai Investments LLC returns. (I should note the disparity between the two is consistent with Nintai Partner’s corporate fund returns). It’s not a pretty picture for even for index fund managers. Whether you accept that index or active managers get better returns in the short or long term, 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 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. As Warren Buffett said “you can’t separate them”.
 
Growth, Value, and Price: 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. (We love to joke about being G-VaP ((pronounced gee-vap)) investors) We think G-VaP gives investors the best chance at long-term outperformance of both active and 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, essentially……no growth. Compared to a Cognex (CGNX) which has grown free cash flow 25% annually 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 stealing one) is an essential tool to identify when to buy and how much you should pay.
 
Quality  
On Wall Street there is a hundred ways to skin a 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 is 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 defined earlier - no debt, high free cash flow, and customer-based tapeworm relationships with their customers. Those 80% losses can permanently impair your (or your investment partner’s) hard earned dollars.  
 
Conclusions
 
Many value investors practice one or two the value triangle (growth, valuation, and quality) I’ve outlined in this article. For instance, traditional value investors might seek low growth and low valuation, but unfortunately also 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 2020. 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, $492M in cash/short-term instruments, 25% ROE, 22.5% ROA, 39.5% ROIC, and 30.5% FCF margins. It has 97% retention with customers over the past 5 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 – comes along rarely – but more often than you think. Particularly after such a market crackup, it worth rummaging around and seeing what’s out there (hint: 7 of Nintai’s core holdings trade below 70% of their estimated intrinsic value as of April 27, 2020). 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.    
 
 

"The huge volatility of the market broke down all but the most fundamental relationships between markets and securities.  The usual day-to-day world where investors cared about subtleties like corporate earnings or analysts’ forecasts dissolved as the energy of the market was turned up.  All stocks moved together; if it was a stock, it was sold like it was plasma physics: as matter becomes hotter, it becomes less differentiated.  The forces that bond atoms together in the form of molecules are overwhelmed, so that rather than having a myriad of different substances, we have the elemental building blocks of the atoms.  Turn up the heat even more and the atoms themselves are melded into plasma, positively charged ions and negatively charged free electrons; matter in its most uniform and non-differentiated state, no longer hydrogen atoms and oxygen atoms, just a seething white-hot blur of matter.”
                                         -          Richard Bookstaber, “A Demon of Our Own Design”
​
During times of crisis, it’s often said that multiple correlations all converge at 1 as panic settles in – REIT owners, preferred stock owners, and even bond owners all look at their assets through identical lenses. As fear grows increasingly into panic, investors begin to see the heat rise even further into that “seething white-hot blur of matter” that Bookstaber discusses. Soon all assets – bonds, stocks, even derivatives – begin to narrow their correlation until it that trade near 1.

Morningstar just published a great article on why correlations tighten until they hit 1 during market corrections[1].  It’s important to remember that not every downturn in the markets drives correlations to near equal status. During the 1998 Asian currency crisis, all the categories of US diversified stock funds losses ranged from 1.7% to 22.6%. Not even close to a tight correlation. However, the coronavirus has induced a level of panic in the markets that selling (and buying) have pushed correlations the closest to 1 since the great recession.

So what makes this latest crash so intriguing? First, when Morningstar looked at all nine categories of UD diversified stock funds, the range in average losses was incredibly narrow and small – ranging from 10.8% and 11.6% starting from Feb. 19 - the S&P 500 high - and Feb. 27. Historically, this is a remarkably small range. What makes the small range so interesting, is the data show it to exist in nearly every respective type of fund. The most interesting to us at Nintai - and likely everyone at GuruFocus - is the difference between growth and value. It’s been a near given mantra that value will outperform growth during downdrafts in the market. So how did value do against the market in the initial period of collapse from February 19 -  February 27?
It turns out during the virus-induced crash, there was very little difference between value and growth performance. During the period, value funds on average posted losses of 11.25% versus an 11.11% average drop for growth funds. The second category that Morningstar looked at was the difference between small-caps and large-caps. Again the difference was minimal between the two – small-caps posted a negative return of 10.94% versus a large-cap return of a negative 11.30%.    
      
Of course, the S&P 5000 has dropped roughly 32% since its peak in February. Have the numbers changed any as the losses have increased? The initial review of the data suggest not. Value funds have lost roughly 31.6% since market highs while growth funds have lost roughly 33.2% during the same time. At its most basic, this market crash - driven by a virus of unknown nature, pathology, and treatment - has driven correlations to 1 from the onset of the disease/crash to its current state.     

What Does All This Mean?
All of this has left us with some heady questions between the cause of the crash, the impact of the disease, and potential length and depth of the market crash. Here are some of the theories we are working on to think ahead for the next emergency similar to this one.

1. Stock Prices Were Inflated
I’m not sure of many on Wall Street that wouldn’t have argued that stocks were due for a tumble some point. Record high P/E ratios, a 10 year bull market, and slowing growth all gave off the feeling that the bull market was nearing its end. At Nintai we had reached nearly 30% cash in some portfolios being unable to find anything that met our criteria or margin of safety. With the rebound in prices over the past few days, most buying opportunities have passed by already.   

Greater Fear (As per VIX) Leads to More 1-Based Correlation
During the crash of February and March 2019, the VIX reached its highest level since the Great Recession. When the VIX reaches such stratospheric levels (66.2 in December 2008 and 65.65 on March 27 2020) nearly every asset is correlated. In other words, there are very few places to hide when the vast majority of investors are convinced the markets will drop.

Non-Controllable Events Lead to More 1-Based Correlation
Fear can be generated by fear or uncertainty or both. In some economic situations fear can be driven by poor earnings results or missed expectations. Uncertainty can be caused by a simply non-measurable event – meaning there is no way to quantify both the odds of it happening and the scope of the event. Fear and uncertainty can be a deadly mix on wall street. When they say “Wall Street has to climb the wall of worry”, they aren’t kidding.    
​
Conclusions
Over the course of the last month, several key learnings have come back to haunt investors. The first is that fear - real gut wrenching, visceral fear - forces a wide range of investors to act in a similar way. This can be value versus growth, small-cap versus large-cap, low-yield versus high-yield. When investors panic, the phrase “no place to hide” really means that many seemingly different asset classes suddenly all begin correlate to each other. Stocks, bonds, energy, utilities, REITs, etc. all begin to drop in similar ways and in similar amounts. In other words - the dreadful 1-factor correlation. The second learning is that crashes like we’ve seen over the past month are by far easiest ways to differentiate your returns (for both good and bad) against the general markets and individual investors. At Nintai Investments, we’ve seen our outperformance with the Russell 2000 jump from roughly 2 - 5% at the beginning of February to 20 – 25% by the end of March 2020[2]. Which brings us to the third finding. To give yourself a chance at outperformance, you really need to invest differently than the indexes and other investors. Whether it be 30% cash, 20% in microcaps, or investments in only 4 of the 11 S&P 500 industry categories (all characteristics of Nintai Investment portfolios), investors should find their niche and make it their own. Great value investors find their niche - purchase shares at a considerable discount to fair value – and hang on for the journey. The ability to differentiate your investment from the dreaded bear market 1 correlation will in the end decide how successful you are in the long term.      
As always I look forward to your thoughts and comments.
DISCLOSURES: None

[1] “Correlations Going to 1: Amid Market Collapse, U.S. Stock Fund Fs Show Little Differentiation”, David Carey, Tom Lauricella, Mar 6, 2020
[2] Past investment performance does not ensure future returns

It isn’t often we see market actions like we’ve seen over the past few weeks. This is the kind of market where you see almost no correlation with corporate-specific data and individual stock prices. A company like Veeva (VEEV) - down from $165/share on February 20 2019 is trading at $135/share on March 12 2019 after announcing an outstanding quarter on March 4 (revenue up 34% Y/Y, earnings beat by $0.02, etc.). What is one to make from such markets? What protection is there in these conditions?
 
First, we recommend having confidence in the companies and managements that make up your portfolio. At Nintai, we seek out companies with high returns on capital, equity, assets, high free cash flow margins, deep competitive moats, and management who know how to create long term investor value. We can assure you that corporate operations, strategies, or management skill sets have not collapsed because the markets have entered bear market territory or the coronavirus has reached pandemic scale.
 
Equally, we are confident our investment partners are aware they still own a set of outstanding companies in their portfolios. Each of our portfolios have generous cash positions which provide both downside protection and the ability to add to existing positions as prices become increasingly compelling. Equally, companies in their portfolios have no debt that forces them to make desperate - and likely poor capital allocation - decisions. Occasionally you here about investors who became rich by selling at the top (like Joe Kennedy selling after his shoe shine boy recommended Hindenburg - “the moment a shoe shine boy gives you stock recommendations it’s time to get out of the markets”)  
 
But the vast majority of investors who outperform the general markets build up cash as the markets reach rarified levels, take their profits, build up cash, and await the inevitable crash. Yes, it’s the buy low, sell high concept. It doesn’t take a lot of intellectual quotient (IQ), but it takes a heck of a lot of emotional quotient (EQ) to successfully achieve this model. Here at Nintai Investments, we might not be the brightest lights on the block, but we firmly understand the concept of holding cash, buying low, and selling high. As I’ve mentioned before, we have a tendency to not make our money in bull markets, but rather preventing permanent capital losses in bear markets.
 
As for Veeva (VEEV) which I first discussed in this article, the company has no debt, roughly $1.1B USD cash on the balance sheet, grew revenue 25.8%, earnings by 50.3% and free cash flow by 60.4% over the past 5 years. Management has a clear view on where growth is coming from over the next 5 – 10 years, and are outstanding capital allocators. The fact the price has dropped by 18% in three weeks would suggest this rapid decrease represents increased value rather than increased risk.
 
As value investors - regardless of the knot in your stomach and that feeling of flight over fight - we live for moments like this. These are the days that test an investor’s ability to live by value-based credo – buy low, sell high, look for quality and value at a discount to your estimated intrinsic value, be patient and keep your emotions in check.
 
Our markets have survived a Civil War, the crashes of 1896, 1901, 1907, 1929, the Great Depression, two World Wars, the Cuban Missile Crisis, the 1973-1974 crash, the technology bubble, and the real estate bubble (just to name some!). At Nintai we believe that as prices continue their drop, opportunities at acquiring outstanding companies at a discount to their intrinsic value will provide some great opportunities going forward.        
 
By remaining calm and seeking out investment opportunities, we believe we can provide our investment partners with their best chance at long term market outperformance. As value investors, it’s what we do best. 

“We make money the old fashioned way. We earn it.”
 
                                                     -      John Houseman for Smith Barney 

If you are old enough you can remember those commercials in the early eighties with John Houseman sitting in front of a burning fire in some gentleman’s club telling viewers that Smith Barney makes money the old fashioned way - they earn it.  I was never quite sure what they meant by that, but it certainly was a great line delivered by a great actor.
 
At Nintai we like to think we make many the old fashioned was as well - by simply outperforming the markets. This too is also a great line, though we have no John Houseman to deliver it. Rather than a great marketing line, the only way we know of backing up our claim is through performance. During my time at Nintai Partners - and subsequently at Nintai Investments - there have been two salient facts that have driven our outperformance (of course past performance is no assurance of future returns).
First, the value of cash becomes outsized in that its value does not drop and its ability to purchase downtrodden stocks becomes vital. Having dry powder to take advantage of mispricing in the markets becomes essential for long-term outperformance. Second, during genuine market corrections (drops by at least 20%), correlative values (meaning the difference in returns between value and growth, small and large, etc.)  generally merge to roughly 1. This means everybody does equally poorly. If value stocks drop by 20%, then growth stocks drop by roughly 20%. Having the ability to remain calm and sticking to your core valuations - and buying when stock prices hit the required margin of safety - are two emotional and intellectual prerequisites to being a great value investor. In my next two articles I want to discuss these two factors – the strength of the cold hard cash and the drop to mutual correlative values in market corrections. In the final analysis, most of the value we add at Nintai Investments does not come in bull market, but rather our defensive nature and positioning when bear markets come about over time.  
 
In part 1, I thought I’d use three individual Nintai Investments to discuss the value (and cost) of holding large cash positions over the past year. Over the past several years,
 
 I‘ve written extensively about the underlying power of cash. I have described its strength in the terms of what the armed services refers to optionality. This means that
cash gives you the ability to play defensively and offensively when certain assets reach an adequate margin of safety.
 
Below, you will see 3 Nintai Investment individualized accounts breaking out cash as a percent of AUM, US equities and foreign equities as a percent of AUM, and the average portfolio equity market cap. The 3 portfolios’ cash positions range from 14% of total AUM to 33%. I should point out that Nintai Investments generally holds cash – not bonds – as we believe bond prices are as distorted as equity prices. 

​As seen below, looking at the difference between market highs (achieved February 20 2019) and the lows (achieved – so far – through March 6 2019), readers can see that cash positions provided an enormous brake on market losses compared to those achieved by the general markets.

Note: Some may be asking why the portfolio with the largest percent in cash lost the greatest percentage. The answer is quite simple – shares in this portfolio were bought closer to the market highs in February than the other two portfolios. 

I’ve often said that I made my record at Nintai Partners Fund by losing only 18% in 2008 and making 71% in 2009. Every other year was actually not that different thanthe general markets between 2002 - 2015. Indeed, some of these years (particularly 2013, 2014, and 2015 I really underperformed).   
 
What To Learn from Severe Drawdowns
When markets drop 2-3% every day for 2 straight weeks, even the most sanguine investor can get sweaty palms and feel the first pangs of fear in the gut. But I’ve never been involved in severe drawdowns when there hasn’t been – beforehand - a run up of truly magnificent proportions. Whether it was the technology bubble in 1999 - 2000, the real estate/CDO/MBS bubble in 2006 – 2007, or the ten year bull market from 2009 - 2020, prices have generally reached nose-bleed levels before the inevitable sucking sound of the drawdown. During the end of those run ups, successful value investors will be arguing with other market participants that 30 - 40% cash positions aren’t that unreasonable.     
 
By the end of December, I found my investment partner portfolios were ranging from 15 - 30% cash. Any buys I might be adding to accounts were additions to existing positions. Nearly every report update had a section on cash - explaining why percentages were so high and its impact on returns. While slightly outperforming the markets, it was touch and go as the large cash positions were taking a toll on the continuous upward pressure of the bull market.
 
Then came the last two weeks at the end of February 2020 to the beginning of March 2020. During this time, the markets went on a roller coaster ride down 1,000 points one day and up 800 the next. However, the over trajectory was down - with the S&P 500 losing 14% over the roughly 2 week period. As I discussed earlier, the large cash positions helped each portfolio outperform the general markets.    
 
What Can Be Learned?
Most professional money managers don’t have the luxury of holding large percentages of their assets under management in cash. Many feel they must be “all in” when it comes to their clients funds as inaction represents lack of effort.
 
Cash Acts Like a Portfolio Anchor
At Nintai we feel very different than most players on Wall Street. Our actions – in this case represented by the holding of cash – represents wisdom in not overpaying for an asset and awaiting the right opportunity to come along to deploy capital. In these cases, cash acts as an anchor against permanently impairing capital in down markets. After a stock has dropped by 55% in 30 days, it’s pretty hard to see a recovery over the short - or even long - term, while cash hasn’t dropped an iota in the same scenario.     
 
Cash Has Immediate Use
One of the most powerful aspects of cash is the fact is you never have to think to act when action is necessary. If one owns bonds, then you have to calculate the bid/ask or the current price per share if you own them in a fund and calculate if you want to take the loss or pay the tax to cash out and use the proceeds in purchasing another asset. Not so with cash. You can purchase the asset in seconds and not give a thought to price conversions, long or short term capital gains, or whether the price is equal to the amount of shares you are looking to purchase. Cash has immediate purchasing power – which is a huge advantage in crazily volatile markets.     
 
Cash Can Go From Defensive to Offensive Instantly
Nothing beats cash when it comes to optionality. If you think a stock has reached its bottom, or even has just passed its point of an adequate margin of safety, then cash goes from an immediate defensive tool to an offensive tool. It no longer protects to the downside but rather covers the opportunity of the upside. There is simply no tool in the financial markets that can provide such a change in strategy so quickly.
 
Conclusions
 
In this time of financial volatility - when not every investor is asking “how much many will I make today” but rather cowering in their home unwilling to open their statements or go on the computer to check their balances - the ability to have an anchor to windward that protects against the downside and offers instant opportunity to take advantage of new opportunities is a powerful tool. The ability to sleep better at night because you know you’ve made provisions against the downside is vastly underrated as an investment position. If you have positions that are 20 - 30% above your estimated intrinsic value, don’t hesitate to pay the taxes, lock in the profit, and have some cash ready to purchase some potential long term bargains as the markets fluctuate as severely as they have in the past few weeks. My guess is you won’t regret it and you might it find yourself more relaxed and salivating at some potential stock you’ve had your eye on for several years but was never in your price range.       
 
As always, I look forward to your thoughts and comments. 

“The investment management business (it should be a profession but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.”

"Don't do anything because when you try to do something, it is on average a mistake." - Charles Ellis

Sittin’ on top of the world
Since the 2009 bottom of the credit crash, we’ve had an over decade-long market expansion which has provided investors with the longest bull market in recent history. For those at the end of their investing career, this has been a huge tailwind, allowing for far more generous performance any would have thought possible.

Better quality, cheaper prices

At Nintai, we believe in a fundamental investment concept. If we invest in a bucket of companies with significant advantages in quality (higher returns on capital, equity, assets, free cash flow margins, no debt, etc.) combined with valuations (a blend of cheaper attributes, including estimated intrinsic value from our discounted cash flow models and cheaper price-earnings ratios), we can expect to outperform the broader markets over the long term.The concept of purchasing higher-quality companies or looking to purchase shares at a discount to estimated intrinsic value isn’t anything new to the value investment community. I have found it is rarer to combine the two as a foundation for your investment strategy. When I utilize Morningstar’s portfolio manager research tools to find funds with a high portfolio match, I’ve found only two with a greater than 25% overlap of our holdings. About 45% had no stock in common at all. With numbers like this, the reader can see it’s pretty rare to find the concept carried out on a regular basis. What’s equally rare (as far as I can see) is articulating the idea that the highest-quality companies purchased at good prices can provide significant downside protection during a bear market. In general, I’ve found that companies and management that generate great returns on capital and have little or no debt are businesses that thrive in bull or bear markets, in expanding or recessionary economic times. Combined with holding significant cash, I feel comfortable that when the inevitable market tumble comes along, I’ve reduced the risk of capital impairment as best as I can in today’s markets.

Nintai’s Abacus reports give a quick graphic overview in how we are doing in meeting the goals of a portfolio consisting of outstanding quality at value prices. Later on, I will walk readers through the summary report and take a look at how we are doing in meeting Nintai’s investment strategy and check in on performance.

It all starts by finding corporate excellence

Any research we do at Nintai starts with locating companies with outstanding business characteristics. We locate these in multiple ways – GuruFocus’ All-in-One Screener, conversations with thought leaders, meetings with corporate executives and so on. Once we’ve found a company that meets our criteria, we will begin the in-depth process of really understanding the company’s strategy, products, markets and competitors. If we’ve done our job, we can run a summary “quality” report on Nintai Abacus and make sure the portfolio is meeting our strategy.
​
Let’s use a blend of our investment partner portfolios to demonstrate what I mean by a “quality” summary report. In November 2019 on average, the Nintai Investment portfolios shared the following attributes: return on capital (42.8%), return on equity (31.7%) and return on assets (19.2%). This compares to the same numbers for the S&P500 (source: Morningstar’s “Portfolio X-Ray” reporting function): return on capital (3.28%[1]), return on equity (1.21%), and return on assets (2.11%). These numbers show that - in general - Nintai’s portfolios have created a basket of holdings far more profitable than the S&P 500. Additionally, the debt-to-equity ratio of the S&P 500 (as of August 2019) stood at 0.89 (source: Haver Analytics and Standard & Poor’s) versus 0.023 for the Nintai portfolios.
Why are all the numbers important? First, a basic tenant at Nintai Investments is to prevent permanent impairment of our investment partners’ hard-earned capital. We’ve found over time that companies with little or no debt[2] and who are also highly profitable (both from a free cash flow perspective as well as capital returns) minimize that risk. Second, we’ve found that management teams who act prudently with their investors’ capital are great stewards to partner with over a decade or two. Last, companies with these characteristics are generally outstanding businesses with outstanding fundamentals and deep competitive moats. All three of these play a vital role in having a blow up in the portfolio that can lead to truly horrendous losses. At Nintai, everything begins by investing in outstanding quality.

Finding value in a value investment strategy

Finding outstanding, profitable and prudent companies is, of course, only half the battle. Buying them at a discount to my estimated intrinsic value is the second piece of equally important halves. In finding value, we use two different and distinct methods. The first is company specific. We utilize a discounted free cash flow model to ascertain the value of each individual holding (or potential holding). As this information is proprietary, I will simply say the aggregate price-value ratio for the Nintai portfolios is 0.91. This is to say our portfolios currently trade at a 9% discount to our estimated intrinsic value. Value ranges from 137% (overvalued) of our estimated value to 72% (undervalued). As a portfolio of individual stocks, we see some investment opportunities in several holdings trading at significant discounts to their estimated intrinsic values.

The second approach we take to value is comparing the total portfolio to the S&P 500. This gives us an idea as to how the portfolio’s value is to the general markets. While we put a great deal of effort into the DCF model, we think looking at the broader markets is equally valuable. There are two numbers we look for in the broader markets review. First is how our portfolio price-earnings ratio looks against the S&P 500’s ratio. This tells us how expensive the portfolio is against the broader markets. The second is analyzing the portfolio’s five-year earnings growth projections against the S&P 500. This gives us a look at whether we are paying more or less for future growth versus the general markets.
The S&P 500’s price-earnings ratio - as of November 2019 - stood at 22.95. The Nintai portfolios average price-earnings ratio was 18.8 at the same time - an 18.1% discount to the S&P 500's price-earnings ratio. This tells us the Nintai portfolios are currently trading significantly cheaper than the S&P 500. Great news. In addition, the Nintai portfolios have a five-year estimated earnings growth rate of 11.1%. This is roughly 17% greater rate than the estimated S&P 500 rate. We now know the portfolios are cheaper than the S&P 500 as well as estimated to grow much faster. What’s not to like about those statistics?

Putting it all together

All of these numbers can certainly make your head spin and do nothing but sow confusion among our investment partners. Because of this we created the Abacus reporting system, which can show these numbers in an easy-to-read graphic. Seen below is the past few pages of content in a format that is much easier to understand.

Our investment partners have a tendency to look at the rating arrows (all green is what they are looking for here) and ask any questions related to those. At the core, the graphic quickly encapsulates

• Does the portfolio meet our quality criteria in general and against the S&P 500?
• How does the portfolio compare in value against the S&P 500?

A number we look at carefully is the combination of the S&P 500 price-earnings relative number as well as the S&P 500 projected earnings per share growth relative number. Here we combine the fact that the portfolio is 18% cheaper than the S&P 500 and is estimated to grow 17% faster, giving us a 35% “combined value rate (CVR).” We are satisfied with a CVR over 25%. We have nearly always outperformed over the next three to five years if the number exceeds that amount. Equally important is adding up the S&P 500 relative number for return on capital, return on equity and return on assets. Here we look for a sum called the “combined quality value (CQV)” greater than 5. The current portfolio CQV is 6.6.

Conclusions

I’ve written about the Abacus tool we use several times before. The reason for its importance is that it provides a quick way to ascertain how your portfolio stacks up against the S&P 500 from a quality and value standpoint. At Nintai, we think a combination of buying a set of stocks that are qualitatively better and provide greater value provides an investor with a better chance at outperformance - in the long term - than any other investment approach.

As always, I would love to hear your thoughts and comments.

[1] Meaning the Nintai Portfolio return on capital is 3.21 x the S&P 500’s return on capital
[2] Out of roughly 20 – 25 Nintai holdings, at least 15 holdings will generally have no short or long-term debt.

When you have to make a choice and don’t make it, that is in itself a choice.”
 
                                                                            -       William James 

One evening a Cherokee elder told his grandson about a battle that goes on inside people.
He said, “My son, the battle is between two “wolves” inside us all. One is Evil. It is anger, envy, jealousy, sorrow, regret, greed, arrogance, self-pity, guilt, resentment, inferiority, lies, false pride, superiority, and ego. The other is Good. It is joy, peace, love, hope, serenity, humility, kindness, benevolence, empathy, generosity, truth, compassion, and faith.” The grandson thought about it for a minute and then asked his grandfather, “Which wolf wins?” The old Cherokee simply replied, “The one you feed.”
                                                                          -       Ancient American Indian Parable
 
Over the years, I’ve been asked many times what is the one major question I ask when looking to invest in a stock. It’s pretty difficult to pick just one thing. For instance, in most cases it is critical that the company has a management team focused on costs and capital returns. In some industries where margins are tight, the ability to focus on costs, production methods, and distribution costs is vital. In some industries the ability to navigate research and development and meet regulatory requirements is vital.
 
It’s pretty hard to nail down one specific thing that would make Nintai Investments say “Aha! That’s the perfect investment. We MUST have it in the portfolio”. There are a lot of moving parts that make for a great company.  So how do you rate each component? Which piece is the keystone block that holds it all together?
 
Invest In What Got You There: Your Competitive Moat
 
Of all the statistics and the ratios that drive my interest in a company, the cap or keystone is the company’s competitive moat. A great moat drives high return on capital, high return on equity, high free cash flow ratios, and other sustained high margins. Great management will focus on how to always widen and strengthen their moat. They realize they need to dance with the one who brought them there.
 
Morningstar has the view there are five sources of a competitive moat - the network effect, customer switching costs, intangible assets, efficiency scale, and cost advantage. Most companies with a wide competitive moat will have at least one of these competitive advantages - and likely - have more than one. Every company I own in a Nintai portfolio has a laser like focus on one of these advantages. Everyday when they head to the office they think of how to maximize their strategy and operations to widen any one of these advantages.
 
The Network Effect 
Every day, leaders of Nintai holding Mastercard (MA) look for ways to strengthen their company’s network advantage. Whether it be against fellow duopoly member Visa (V) or a smaller up and comer like Discover Cards (DFS), Mastercard’s network - who uses their cards and who accepts their cards  - constantly strives to find new tools, advantages, discounts, etc. as a tool to bring in new customers and maintain existing ones. This competitive strength will continue to drive Mastercard’s competitive advantage for decades to come. As a shareholder we look to see revenue growth and higher returns on equity as some the statistics showing the continued strength of the company’s moat.
 
Customer Switching Costs
SEI Investments (SEIC) provides investment processing, management, and operations services to financial institutions, asset managers, asset owners, and financial advisors in four material segments: private banks, investment advisors, institutional investors, and investment managers. It’s services are deeply embedded in all of their customers’ operations. The cost and time requirements to switch their systems to a new vendor is staggering. The potential for errors in the transfer of data, downtime in the course of switching vendors, and amount of time teaching a new internal system are all deeply complex and involve high risk.  Combine this with the risk placed on the core functions of the customers’ systems – daily fund accounting, SEC filings, etc. and one can see how difficult it is to make the decision to pull the plug on SEI Investment’s product and suddenly move to a new vendor.
 
Intangible Assets
Novo Nordisk (NVO) has been a leader in the treatment of diabetes for almost a hundred years. Armed with intangible assets such as FDA (US-based) and EMA (European-based) regulatory approvals, patents for drug levers of action, and intensely deep organizational knowledge about diabetes (the disease) and diabetes (the treatment history), it’s hard to see a new competitor come along and suddenly start competing with Novo Nordisk’s competitive advantage in these intangible assets. Combined with a network effect of prescribing physicians who implicitly trust Novo Nordisk’s knowledge with the disease along with billions of dollars sitting on the balance sheet while producing billions more in free cash flow and what you’ve got is a company with a wonderfully deep moat.
 
Efficiency Scale
Veeva Systems (VEEV) has the most in-depth customer relationship management (CRM) vertically focused on life sciences (pharmaceuticals). The efficiency that Veeva brings to their space has driven out nearly every home-grown model and small boutique player. There simply isn’t room for another player than Veeva within the space. The company is now taking that industrial dominance and looking to add new verticals to its expertise such as consumer goods, chemicals, and cosmetics (all industries with similar CRM and regulatory needs). Veeva’s extraordinary depth of knowledge drives out a need for other competitors. By constantly focusing on adding new functionality, new applications, and new knowledge, the company continues to widen its moat.
 
Cost Advantage
By far, this is Nintai’s smallest source of competitive advantage or moat. As Amazon (AMZN) has always said “your margin is my opportunity”.  Even Walmart (WMT) - the king of margins - for decades found itself unprepared for Amazon’s pricing revolution. At Nintai, we believe this is the weakest of all moat characteristics. The closest we’ve come to owning a company that made price a key component of its competitive offering was Fastenal (FAST - we sold the position in 2015). Management for the longest time utilized cost structure as a means for driving business to Fastenal distribution centers. They focused this along with the ability to carry nearly every part (in a just-in-time model) and the company dominated the industry parts business. This has changed somewhat as they have focused more on a network effect with vending machines on site allowing customers to not even have to wait for delivery. 
 
Conclusions
 
Nintai focuses on companies with high returns on capital, equity, and assets, high free cash flow margins, growing businesses, and management focused on maintaining - if not increasing - those previously mentioned measures. The ways to get there is to identify your core competitive advantage and focus on making it better every day. That’s why you don’t see Novo Nordisk suddenly purchasing an oncology immunotherapy firm. Or you don’t SEI Investments purchasing a publishing company on investment management. The Nintai portfolios are made up of companies that know what they do best and they stick with it. With a portfolio run by such management – with companies with such attributes – you really need to sit back and make sure management has its eye on the ball and generates numbers that demonstrate their excellence in making the company grow. After that, let time do its magic and you’ll be surprised how well your portfolio will do over time[1].
 
As always, I look forward to your thoughts and comments.
 
DISCLOSURE: Nintai maintains positions in MA, SEIC, NVO, and VEEV  
 
[1] Of course past performance is no assurance of future returns.

​“The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions”
                                                                              -       Benjamin Graham  

“You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting - how to read and interpret financial statements - you really shouldn’t select stocks yourself” 

                                                                            -        Warren Buffett  

There are so many ways to approach value investing that sometimes one wonders there is a single description that works for them all. I’ve tended to focus on a proposed definition by one of my first investment mentors (paraphrasing Benjamin Graham).
 
“Value investment is purchasing an asset at a discount to its estimated intrinsic value. Nothing more and nothing less. Anything else is the same as gambling without knowing the odds and will likely make you look like a damn fool”.
 
At Nintai that means calculating value before anything else. Yes, we do use screens to help identify companies that meet our investment criteria. But it’s important to understand these screens give us an idea of a company - not its industry, its SIC code, its competition or management team. These screens simply give us a list of companies that have characteristics of high-quality securities trading at a reasonable price. Only after we’ve run a high level valuation spreadsheet tab do we begin to ascertain the specifics of the potential target. Sometimes identifying this information is enough to rule out any further research. For instance, one time after finding a target turned out to be in the grocery business, we removed it right away from the watch list.
 
There are three major areas which I believe drive long-term competitive advantages. These include structural cash advantages, long-term cash generation, and long-term value generation.
 
Structural Cash Advantages
 
The first - structural cash advantages - is the type of opportunities where the company generates excess cash and has opportunities to deploy this capital generating returns on capital far in excess if its cost of capital. These are companies that can provide decades of profitable growth for equally patient investors. Examples of this type of business include Fastenal (FAST) and Expeditors International (EXPD). Both companies generated ROCs in the high 20s versus a weighted average cost of capital in the mid-single digits. These are companies with opportunities to seek growth in their existing markets without having to overpay or take risks in the M&A marketplace. Deployment of capital is done with a clear focus in return on capital exceeding cost of capital.
 
Cash Flow and Balance Sheet Strength
 
The second category are companies with a long history of free cash flow generation and pristine balance sheets. These are companies with deep and wide competitive moats allowing for pricing strength and the free cash flow growth over generations. This can be achieved though brand strength, product monopoly or duopoly, or the strength of its competitive position. Companies with these traits include Computer Modelling Group (CMDXF) or Fanuc (FANUY) which use their competitive advantages to generate positive free cash. In addition, these companies are wide enough to know how and when to use their capital for snap on acquisitions that generate positive value for their shareholders.     
 
Retain Earnings and Intrinsic Value Growth     
 
The last type of company that Nintai looks for is one that has long history of retained earnings used to adding additional companies (along with their retained earnings) to build value over the long term. In these companies, management makes the decision that M&A (generally through smaller M&A) can substantially increase the book value of their firms – and hence reward their long term shareholders. Companies in this category consist of firms like Berkshire Hathaway (BRK-B) or Cognex (CGNX). In the case of Cognex the company has increased retained earnings from $284M USD in 2004 to $682M USD in 2019.
 
Why This Matters
 
In general, great wealth has been made in the “slow-is-steady” routine. For nearly ever great value investor, there is one who made a killing on one major bet. Many times, hedge funds are held out as the poster child for slow and steady returns. In fact, when one looks at hedge fund returns, we frequently find a good bet locked in solid returns over the next few years followed by substantial underperformance. An example of the hit-it-big then mostly lose it all is Paulson & Co’s bet against the credit markets. This single bet brought the company’s AUM up to $36B USD in 2011. By 2019 this number had dwindled to just $8.7B of which nearly 80-85% was Paulson’s own personal funds. The Financial Times reported on January 22 2019 that Paulson was considering closing the fund and converting it to a family office.
 
Another example has been value investors who have generally performed poorly since their doors opened. Examples of these include Ronald Muhlenkamp (underperformed S&P 3 Year: -9.4%, 5 Year: -9.7%, 10 Year: -6.5%, 15 Year: -5.3%, and 20 Year: -0.7%), who record is a truly abysmal performance versus the S&P 500. David Winters is another example of long-term underperformance withdrawals. Wintergreen Fund saw total assets under management (AUM) drop by roughly 90% between October 2005 – January 2019 before shutting down the fund.
 
One of the common themes one sees in these guru performances is a remarkable hubris that since their initial big-win. Many great value gurus think the previous victories can be replicated over and over again. But much like Tolstoy’s unhappy families, "Happy families are all alike; every unhappy family is unhappy in its own way." So goes value investing - every bear market is unhappy to its shareholders in its own unique way. Whether it be Paulson’s short on the mortgage asset business or Ronald Muhlenkamp’s description of his business as “intelligent investment management to emphasize that we remove the emotion from investing. We might also be described as “common sense” or “no BS” investment managers...” value investors can get caught in the same confirmation feedback loop as any investor.
 
Conclusions
 
Value investing is about having a core set of values flexible enough to change with the times. I remember reading how Warren Buffett (BRK-B) had first invested in the Washington Post in 1973 at $11M USD. When Buffett was planning on the transaction to spin off hid 23.4% holdings in the Post to Graham Holdings (GHC), his stake in the Post was now worth $1.1B USD. Perhaps one of Buffett’s greatest attributes has been his ability to evolve with the investment times. Perhaps his greatest - and most profitable - shift has been from the cigar butt model to purchasing great companies at fair prices.  In my investing career I’ve certainly exchanged some expansively acquired theories for those with more modern trends. By focusing on higher quality (defined by structural cash advantages, cash flow/balance sheet strength, and intrinsic value growth) my ability to add vale to investor portfolios has increased dramatically. By finding great companies at fair prices, I’ve found ways to decrease turnover, reduce long-term tax liabilities, and let management do the heavy lifting. You can do the same by evolving your own standards.      
 
As always, I look forward to your thoughts and comments,
 
DISCLOSURES: Nintai retains positions in CMDXF, FANUY, CGNX,