“Ambiguity is central to Boyd’s vision. It is not something to be feared but something that is a given . . . We never have complete and perfect information. The best way to succeed is to revel in ambiguity.” 
 
                                                                              -      Grant Hammond[1] 

In 1961, Colonel John Boyd – working with Thomas Christie – wrote an article named “Aerial Attack Study.” Boyd trained as a fighter pilot, but his mind quickly developed beyond the cockpit. Aerial Attack Study introduced the military to the concept of “Energy-Maneuverability Theory” (E-MT). Boyd’s and Christie’s work was vital in understanding the various tradeoffs when working on aircraft design. E-MT was a breakthrough of immense value because it gave engineers a process to calculate how any design can be superior or inferior when measured against another. E-MT analyzed how swiftly and efficiently an aircraft could change its energy use, speed, and acceleration or potential versus kinetic energy. This analysis could then be converted to a numerical value of how well a plane maneuvers under various conditions. This process enabled fighter pilots to “converse” with engineers in their language by describing dogfighting jargon in mathematical terms. E-MT had a significant impact in creating the leading fighter aircraft over the next generation, including the F-15 Eagle and F-16 Fighting Falcon.  
 
Boyd’s next project brought him even greater fame – in terms of both name recognition and scope of impact. It also is where his thinking can best be applied to value investing theory and practice. Thinking at a higher level than his E-MT work, Boyd began analyzing what systems could be put in place to improve a fighter pilot’s speed/effectiveness in thinking processes and decision-making skills. From this, he developed the OODA  (Observation, Orientation, Decision, and Act) Loop. 
 
The OODA Loop begins by making two assumptions. First, Boyd contends that all intelligent life and human-developed organizations continuously interact with their respective operating environment. Second, all of these interactions can be broken into four major groups or functions. 

1. Observe: The utilization of all major senses in the collection of data. Boyd made it clear that data was a snapshot of what was happening within a complex environment at any one time. Observation information becomes obsolete relatively quickly. Therefore, observation requires constantly updating your data. 
2. Orient: After collecting data through observation, comes the synthesis and analysis of the data. The orientation phase is about reflecting on the critical data captured during observation and considering the next steps. Above-average orientation skills require great situational awareness and a process that uses multiple mental models. Boyd saw this as the most essential function.
3. Decide: The decision phase develops a series of suggestions taking into account all potential outcomes. A key component in the decision process is creating a strategy that screens out extraneous inputs and allows management or the individual to focus on the best possible choices, not all choices. 
4. Act: The steps and actions necessary to carry out the decision. In Boyd’s final presentation on the OODA Loop, he placed “Test” directly next to “Act” (this was changed to “Unfolding Interaction with Environment” and “Feedback” in his later presentations). In doing so, he clarified that he saw the Loop not just as a decision-making process but as an individual or organization-learning process. Thus, not only should we be constantly updating inputs, but we should constantly test our mental models throughout the Loop. 

Source:    “Science, Strategy and War,” Frans P.B. Osinga, Routledge Press, December 2006 
                  “The Tao of Boyd: How to Master the OODA Loop,” AoM, November 2020
 
After developing the OODA Loop, Boyd developed several thoughts about its effectiveness and some caveats in its usage.

1. The OODA Loop is a means to operating in a complex environment. Multiple inputs are constantly changing. The faster someone can obtain inputs, the quicker someone can produce decisions.
2. The OODA loop is only as effective as the time it takes to execute a result.
3. The person or organization that completes multiple OODA loops first derives the most value. 
4. The person or organization that adapts/updates their observation and mental models quickest, thereby evolving their OODA Loop, derives the most value. 
5. Limiting extraneous factors that can needlessly slow down getting to decision and action phases can significantly impact. 

 
The OODA Loop and Value Investing
 
So what does all of this have to do with value investing? At their highest level, the description of the OODA Loop and value investing share many common attributes. For instance, the OODA Loop has been described as “a learning system, a method for dealing with uncertainty, and a strategy for winning head-to-head contests and competitions. Another description is “the OODA Loop is a means to a.) observing complex organisms, whether they be an enemy pilot or a competitive corporate threat, b.) developing possible counter-measures through situation awareness and mental models, and c.) acting on such chosen measures.” 
 
Compare that with the following description of value investing as “a trading process based on uncertainty and risk in which a.) an investor looks to identify a discrepancy between price and value identified by b.) observation of corporate data and ecosystem characteristics and c.) observable investor behavior that leads to d.) a decision to allocate capital in the security.” At Nintai, we believe the major steps in value investing consist of these steps. 

• The investor sets specific criteria by which they search for possible investments. This can be by financial, capital return, industry, or country/region. As value investors, we are constantly updating both corporate and market information. Therefore, what may not meet our criteria one week might be ringing alarm bells just one week later. Similar to OODA Loop, “Observe.”
• Research is conducted through which estimated growth, profitability, market size, regulatory issues are identified and quantified. Information can be specific to a certain date (such as the balance sheet), a defined period (one-quarter, one calendar year, year-to-date, five-year average). A series of mental models will develop cross-functional ways to observe historical, current, and future value trends. Similar to OODA Loop “Orient.”
• Research ascertains the estimated intrinsic value of the company shares and matches it against its current trading price, and develops a series of possible recommendations. These might be to purchase at a specific strike price, buy increasing shares at share prices further decrease in price, sell a position when certain conditions are met (such as the holding taking on debt), or sell on specific market conditions (a competitor successfully launches a new FDA-approved drug). Similar to OODA Loop, “Decide.”
• When certain conditions are met (% discount from estimated intrinsic value) and reasonable suggested actions are offered (purchasing X number of shares representing only 30% of one day’s total trading volume), then action should place. Following up on these actions, we will spend a considerable amount of time evaluating the success or failure of the process. Similar to OODA Loop “Act.”

 
If this sounds similar to the OODA Loop, it should. Long-term successful value investors are constantly reevaluating not just their holdings (including management performance, product development, competition, market factors, etc.) but their very selection process (what factors are most important? How do we gather and collect data? How do we evaluate trends in the data, etc.?). At Nintai, we see the investment process must be continually reviewed and adapted to the ever-changing investment universe.
 
The Importance of Orientation
 
John Boyd felt the most important of the four steps in the OODA Loop was orientation. In one of his presentations, he stated: 
 
“Orientation isn’t just a state you’re in; it’s a process. You’re always orienting.”
 
As I pointed out in the last section, Nintai sees the process of orienting our thinking as a never-ending process. This is perhaps the greatest symmetry between Boyd’s work and value investing. One of the failings in nearly every value investor (this author included) is constantly failing to update our orientation. Too often, we get stuck in a pattern of thinking which locks us into a particular model or pattern of assumptions. For value investors, this can be costly. For fighter pilots, it can be fatal.
 
One method that Boyd suggests using is applying a set of mental models regularly until they become second nature in your thinking process. Boyd lists seven disciplines that are a must for any strategist. These include:

1. Mathematical Logic
2. Physics
3. Thermodynamics
4. Biology
5. Psychology
6. Anthropology
7. Conflict Resolution (Game Theory)

 
These models are essential for any person or organization to orient themselves in their environment. Understanding these disciplines allows an individual to see their position from many disparate and unique viewpoints. In addition, constant orientation leads to the ability to act quickly and – most importantly – with the best chance of obtaining outstanding results from your decision-making. 
 
Again, this sounds remarkably similar to Charlie Munger’s concept of a “Latticework of Mental Models,” which he believes creates a powerful method of objective – and evolving – thinking. Thus, while Charlie’s disciplines[1] may differ somewhat from Boyd’s, the concepts meld pretty easily. 
 
Conclusions
 
One thing that has always interested me in value investing is the constant need to acquire knowledge. Whether improving or altering my thought processes to the knowledge of a specific industry or market verticals, roughly 80-85% of my day is spent thinking and researching. Does this mean we get everything right? Absolutely not. But it does mean that Nintai can hopefully gain the ever-so-slight edge over the marketplace, which allows for long-term outperformance. Investors can continually adapt their thinking and investment processes by studying such works as Boyd’s. The history of business – and nations – are replete with organizations that got caught in a cycle of actions that never considered changes in their operating environment. As a value investor, the OODA Loop can be a helpful tool to evolve your thinking from valuing a business to understanding changes in specific industry verticals. Next month I will use a specific case study that discusses how Nintai uses Boyd’s work in understanding changes within a specific portfolio holding.   
 
Until then, I look forward to your thoughts or comments.
 

[1] Math and Inversion, Probability, Chemistry, Statistics, Economics, Evolutionary Biology, Psychology, and Engineering 

I recently discussed Nintai's performance numbers with a group of analysts who wanted to know the secret sauce that generates long-term outperformance. Many of the questions centered on our stock-picking ability, market timing, and ability to identify business trends leading to outstanding growth. I made it pretty clear the evidence suggests there aren't many individuals who can repeatedly pick stocks that outperform (certainly we can't!), there are even fewer who can choose the highs and lows of markets (definitely not Nintai!), nor do we have a business divining rod that identifies the next hot "it" thing in the markets (we are so far from what's hot in business, I'm not sure we would know "hot" if it hit us in the nose). At Nintai, we think the more active we are, the less effective we will be in the long term. Unfortunately, our circles of competence are limited, and our crystal balls are pretty fuzzy. So instead, I told this group of analysts that our success had been driven by finding several compounding machines throughout my investing career and riding them for as long as possible.
 
What exactly is a "Compounding Machine"?
 
Compounding machines are simply companies that consistently grow free cash flow at substantial rates over a decade or two creating long-term value. This can be achieved through competitive advantages gained through internal and externally-facing moats. Additionally, these companies often generate high returns on capital and maintain fortress-like balance sheets. These attributes drive steady growth in the intrinsic value of the business. When I describe it like that, it seems like a pretty straightforward process. You simply have to find these types of companies, back up the truck, purchase a significant number of shares, and merely wait ten to twenty years as management and the company work their magic. What an easy world value investing would be if it was so simple. But, of course, we all know it doesn't work quite like that.  
 
Finding compounding machines requires several major buckets of data. Some are easier to find, while others are more difficult. Overall, it requires a significant effort to create a process, identify opportunities, research candidates, and track holdings. The primary information and process requirements can include the following. 
 
Quantifiable Data
 
In some ways, this is the easiest part of the process. A single search query can identify some (but certainly not all!) compounding machines on a search platform such as Gurufocus' All-in-One Screener. Search criteria might include the following.
 
Return on Equity (10 Year Average) > 15%
Return on Assets (10 Year Average) > 15%
Return on Capital (10 Year Average) > 15%
Free Cash Flow Margins (10 Year Average) > 25%
Free Cash Flow Growth (10 Year Average) > 10%
Debt/Equity Ratio (1, 3, 5, and 10 Year) < or = 0
 
This search on Gurufocus will likely generate less than 100 companies, and we haven't even begun to screen on valuation. An investor could probably do fine simply by investing in a broad bucket of such companies trading near their 52-week lows.
 
Non-Quantifiable Data
 
A simple query in a database can't discover some characteristics. While such searches can sometimes be good starting places, many compounding machines can only be found through the hard work achieved by rolling up the sleeves and better understanding specific industries or verticals. This includes a lot of time researching individual companies, their operations, competitors, product development, regulatory challenges, etc. In the course of this research, an investor should be looking for four broad themes.

Outstanding Capital Allocation
This is a multi-faceted attribute. It includes management that can identify great capital investment opportunities. It also requires management to say no to opportunities that might not reflect their core competence or provide adequate margins. Finally, it includes creating a business that operates in an environment where opportunities exist for allocating capital in existing business lines that can generate long-term runways for growth. 

Deep and Wide Inward/Outward-Looking Moats
In last month's presentation to the Gurufocus's "Value Investing Live" series, I discussed in depth the idea of inward and outward-looking moats. In summary, outward-facing moats keep competitors at bay through a series of strategic and operational advantages.  Inward-facing moats keep customers locked in by having products or services essential to their customer's business model, strategy, and operations. Capital compounders must have strengths in both of these, not just one.  

Expanding Market Opportunities   
This, too, is multi-faceted in that opportunities must be both in existing customers (by selling deeper into the organization) and new customers in either existing markets or new markets (this can be demographically and functionally). Compounding machines are generally strong in both of these but lean towards the former (broadening existing bases) and aim for the latter. Most avoid costly acquisitions as a means to growing market share or revenue. 

Self-Fund Growth with Existing Internal Capital
​Compounding machines tend to require very little capital to achieve growth. Because of this, nearly all new opportunities can be funded with either free cash flow or cash on the balance sheet. Most of these companies have extremely strong balance sheets with little or no debt and very high free cash flow margins (meaning the percentage of revenue converted into free cash). With extremely low weighted average cost of capital (WACC), compounding machines can achieve high returns on even lower margin growth. 
 
An Example: Veeva (VEEV)
I have written about Veeva extensively over the last two years (including a recent presentation on Gurufocus' Value Investing Live), so I won't spend a lot of time rehashing previous content. Instead, I wanted to show a graphic that demonstrates the compounding nature of the company. Seen below is a quick overview of the growth in the company's free cash flow, earnings, returns, and valuation. The reader can see strong growth combined with consistent profitability and high returns. In combination, these drive an ever-increasing estimated intrinsic value. 

Nintai estimates growth and returns will be very similar over the next decade or two (with slowing growth rates due to size). Veeva is the very image of a compounding machine. 
 
Conclusions
 
The goal of every value investor - indeed every investor - is to create value over the long term that outperforms the general markets. Compounding machines can play a huge role in achieving those results. Finding companies with wide moats run by great capital allocators in growing markets is the holy grail at Nintai Investments. When we can find a company with these attributes (and the price is right), we will generally invest a substantial portion of our capital in the stock. We will then try to sit quietly and let management do the heavy lifting and perform their wonders. A successful investor once said that it isn't the investment manager that produces excellent returns but rather the management and companies in the portfolio. That individual understood the concept of compounding machines. It would behoove all investors to follow her lead.    

Tom Macpherson presented on Gurufocus' Value Investing Live, a series of presentations and interviews of today's leading value investors. Thank you to the Gurufocus team and members for such a great experience!

"As the hunter-gatherers began to identify certain species of game easiest to kill, humans began to understand that habitation in the areas where these species abounded was just as important. It wasn't just the roebuck that was important, but the habitat where they lived that meant life or death for their clan".
                                                                                  -     Richard Daly 

For value investors, one of the holy grails has been finding companies with wide competitive moats. These are investments with common characteristics – return on capital higher than the cost of capital, high margins, steady revenue/earnings growth, and dominant market share. These companies can be tremendous long-term investment opportunities. As an investor becomes more experienced in research and identifying such companies, it becomes apparent that such investment opportunities are often clumped in industries with a penchant for individual-wide moat investments. Much like our hunter-gatherer ancestors learned, it isn't just the individual investment but the industry/market that can lead to long-term outperformance. This is an ecosystem that creates an environment which - by its very nature - is conducive to deep competitive advantages. There is, of course, no hard and fast rule, but over time at Nintai, we've identified several critical aspects within specific industries that lead to high percentages of investment opportunities. 
 
Asset Light and Capital Light: Generally, industries and their companies that require high capital infusions, are asset-heavy, and have significant organizational needs (such as unfunded pensions for tens of thousands of former employees) and complex infrastructures (large manufacturing plants). They also have lower gross and net margins, lower free cash flow, and significant capital requirements. An example of this is large legacy manufacturing industries on which the great American middle class was created – steel, automobiles, etc. During the mid-20th century, these companies were able to achieve significant competitive advantages against other global competitors. But much like England in the early-20th century, competition in Asia slowly ate into profits and provided much cheaper labor and operating costs. The steel and automobile industry simply couldn't keep up with the demands for expensive pensions, new capital improvements, or new technologies that increased operating efficiencies. That doesn't mean there aren't some gems in such industries. Companies such as Fastenal (FAST) or Graco (GGG) operate in traditional manufacturing yet achieve outstanding results with high return on capital and equity while maintaining extremely low debt margins. 
 
In the last several decades, new industries have developed in the United States – technology, data & informatics, pharmaceuticals, etc. – that don't require significant capital injections, don't use sizeable unionized labor forces, and don't have many assets on the balance sheet. These companies came about in the early 2000s and became known as "asset-light" companies. Even large businesses like Schering-Plough (now Merck & Co.) were famous for shedding assets, moving employees from pensions to 401(k)s, and outsourcing core functions like research and development. These actions completely changed the business model, driving returns on capital and equity higher, increasing gross and net margins, and making these companies look much less like traditional research and manufacturing companies and more a modern marketing healthcare company. Some examples of industries with asset-light models include technology (software, informatics - meaning the integration and usage of data), health care (contract research organizations - CROs), and financial services (credit card processing, asset management)   
 
Ease of Competitive Dominance: In these asset-light industries, the ability to achieve competitive advantages is easier than others. Please note I didn't say they are easy; they are easier than others. These companies are run by focused, driven management teams that make dominance seem easy. But looks can be curiously deceptive. It can be easier to develop a competitive moat because the market conditions, product/service offerings, and raw materials might be subject to easier dominance. For instance, there are very few areas in the automobile industry where a company might capture significant competitive advantages. There is little need or ability to acquire intellectual property rights to lock out competition. The products are generally the same in concept (a four-wheel gas or electric vehicle with certain unique design features) and built/sold in remarkably the same way (internal design teams, multi-stage manufacturing processes, dealer-based sales). For instance, a company will likely achieve a limited dominance in certain demographic or regional areas through branding efforts or marketing messaging. Nowhere in this process is there a means to map out twenty years of market dominance. 
 
Another industry - informatics - is entirely different. The ability to capture market dominance is easier because nearly every product feature is based on intellectual property. For instance, IMS Health (the company merged with Quintiles and renamed IQVIA in 2017) was known for collecting healthcare data, including de-identified pharmacy data, pharmaceutical sales data, medical claims, and other data. The company had a monopoly on prescribing data that they sold to pharmaceuticals, thereby capturing a market essential to guiding pharmaceuticals to market and promote to in their sales teams. No other could provide this data as IMS had exclusivity in its sources. Thousands of companies have access to proprietary data when you think of it, which they repackage and sell to customers. The informatics market is replete with wide moat, small companies which are outstanding investment opportunities.
 
Examples of Small Wide Moat Markets: Some examples of markets can be found in all parts of the economy. Some include financials, healthcare, technology, and others. Nearly all of these are niche markets with similar characteristics – proprietary technology/data and platforms deeply embedded in client operations. The first is financial data. Examples of this include former Nintai holding FactSet Research (FDS), another former Nintai holding Morningstar (MORN), and Bloomberg (privately held). These three companies have growing opportunities in the financial industry with a focus on stock information, trading data, etc. Their proprietary databases and platforms are essential tools, and their platforms are an intricate part of much of the industry's operations. Many companies simply couldn't run without their services. 
 
Another industry is healthcare informatics. Here there are several sub-markets with powerful competitive moats. The first is pharmaceutical prescription data which I discussed previously using IQVIA as an example. A second is the electronic health record (EHR) market. Nearly every hospital utilizes an EHR to coordinate patient care, manage patient records, oversee drug prescribing, and control imaging such as x-rays or MRIs. EHRs are the platform on which nearly every hospital's operations run these days. Making a decision on which vendor to use is not only a multi-million dollar commitment but a decade-long decision that requires years of planning, training, implementation, and maintenance. Once a health system decides on which EHR vendor to work with, it takes something pretty drastic to force them to replace that vendor. Consequently, the EHR market is replete with highly profitable, wide-moat companies.      
 
High Margin Business Models: There are many business models that generate hefty profits even with small margins. An example of this includes the big box retailers, including both general merchandisers like Walmart (WMT) and Target (TGT) and specialty retailers such as Home Depot (HD), Lowes (LOW), or Best Buy (BBY). These companies can create wide moats but generally don't meet the quality standards we look for at Nintai. Using Walmart as an example, let's compare it versus Nintai Investments' holding Masimo (MASI). Walmart's gross, net, and free cash flow margins were 24.8%, 2.4%, and 4.6% in 2020. During the same period, Masimo generated 65.0%, 21.0%, and 16.3%, respectively. Walmart generated a return on invested capital of 8.3%, while Masimo generated a 39.7% ROIC. Walmart's debt to equity ratio (meaning how much debt does the company have as a percentage of its total equity) is 0.78 (short-term debt and capital lease obligation of $5.3B plus long-term debt and capital lease obligations of $60.0B versus total equity of $81.3B). Masimo's debt to equity ratio is 0.02 (no debt and total capital lease obligations of $34M versus total equity of $1.41B)  
 
While both companies have wide moats, Walmart's financial quality is considerably less than Masimo's (at least using Nintai's criteria). Masimo is more profitable, utilizes capital at a much higher rate, and has a fortress-like balance sheet. I should point out either company could be an outstanding or poor investment candidate given certain conditions. Walmart has been an excellent investment over the past 40 years. But given our druthers at Nintai, we'd prefer a company with high margins in a high margin business model than a low margin business in a moderate profit business model.    
 
Product/Services Create Monopolistic Opportunities: One of the things most overlooked in finding quality investment opportunities is seeking out companies that operate in industries where their product or service inherently creates quality and profitability in both good and bad economies. To do this, a company must have a product that is part of their customers' core business by its very nature. This is different than the EHR model I discussed earlier. There the product was deeply embedded in the business process of their customer. Would it be hard to rip the product out and replace it? Absolutely. Could the hospital operate if the systems went down? Surely. With difficulty, but they could certainly still operate. In this category, we look for companies that as the customer utilizes the product, it becomes nearly impossible to function without it.
 
A great example of this is credit cards. Try to imagine going through an average day having only checks and cash (since most credit card issuer networks also issue debit cards, I count them as the same for this exercise). Think of the daily activities where it takes a credit card to complete the transaction. Everything from purchasing gas to shopping at Amazon, renting a car, or staying at a hotel, many consumers would have to change their daily schedule drastically – or eliminate some tasks – if they lost the ability to use a credit card.  
 
Issues to Think About
 
Identifying industries or markets that have high percentages of quality-driven companies is only part of the research necessary. Whenever you find a niche that allows for highly profitable business models, you will likely find competition close on the leader’s heels. Capital flows to business strategies and markets that generate high returns. It makes sense. Success breeds success. Success breeds envy. Envy breeds greed. And greed breeds competition. So when you find that highly successful business model or market, remember to think about the following issues.  
 
Capital Flows to Success: Name any type of business that successfully grew from a startup to an industry heavyweight, and you will find numberless competitors seeking to break into the same market. A great example of this was office supply big-box stores. After the success of Staples, an astounding 131 companies received venture capital or private equity funding over the next half-decade. A company that creates a market niche with high profits will inevitably face an onslaught of new competitors seeking to steal that company's customers or market share. To see this in action, take any six months and follow the investments of the private equity community. You will likely see many investments in one niche market where managers have focused on outsized profits. One quarter might be drug laboratories and the following real estate informatics. Inevitably, profits in those markets drop after such a massive influx of capital.
 
Speed of Innovation/Product Development: Some industries see innovation take place much faster than others. For instance, the automobile industry has been notoriously slow in adopting innovation. The combustion engine has reigned supreme for nearly one hundred years regardless of new technologies that would be far energy efficient. On the other hand, the semiconductor industry has been a continuous struggle to keep up with innovation. Here moats are dug and filled in no time. Finding an industry where innovation widens moats over time is a prescription for long-term outperformance. 
 
Customer Fads: Some industries are prone to customer fads that come and go with remarkable speed. We've all heard of them – Ouija Boards, Game Boys, Beanie Babies, and Rubik's Cubes. These times may temporarily cause stock prices to suddenly soar but are just as likely to drop like a…..pet rock. Certain industries – like consumer electronics – come to mind when you think of industries that suffer from such market fads. If you choose to dip your toes in these waters, just be aware of the strength and depth of the moat. There's a big difference between a game whose name becomes part of our lexicon like Monopoly ("you're spending like it's monopoly money") versus Tickle Me Elmo. 
 
Conclusions
 
The adage goes, "fish where the fish are." No doubt, sound advice if your survival depends on successfully catching fish. Investing is no different. When looking for value-priced quality companies, start looking in industries with a penchant for wide-moat businesses. These markets may be hard to locate initially. Some industries take a great deal of research to find the underlying reasons for their wide moat (pharmaceutical informatics) versus those staring us in the face (pipelines). But once you've found such a sweet spot, spend a good deal of time understanding the industry dynamics and the sources of its moats. Like the hunter-gatherers of old, you might be fishing there for quite a while. 

"Don't worry. We might be losing a penny on each sale, but we can make it up on volume."  
 
                                                                                         -       Anonymous 
 "The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine."
 
                                                                                         -      Warren Buffett 

Revisiting Weighted Average Cost of Capital
 
One of the most interesting stories in the past 18 months has been the lack of discussion about the rapid fall and rise in the US 10-year Treasury yield. It isn't my intention to discuss the reasons for the changes or their meaning for the economy, but rather its simple impact on stock valuation. Such increases and decreases mean that any borrower will see a dramatic effect on their average cost of capital. With rates peaking at roughly 3.1% in October 2018, companies saw the rate drop by approximately 80% over the next 18 months. In less than six months, the 10-year US Treasury rate rose from 0.53% in October 2020 to 1.63% in March 2021. 
 
It's hard to overstate the impact these swings should have on the valuations of publicly traded equities. For those who use a discounted cash flow model (which we do at Nintai investments), a vital component in getting to an estimated intrinsic share value is calculating a company's average cost of capital. In our models, the most significant impact on that calculation is the 10-year Treasury yield. 
 
Before I get into that, a quick overview of United States Treasury note yields, how they are calculated, and their role in our financial markets. The Treasury note yield is the current interest rate paid on the 10-year United States Government Treasury note. The government pays the yields as interest for borrowing money through debt sales at monthly auctions. When the auctions take place, the government sells a specific dollar amount of bills (duration less than one year), notes (sold in 2, 3, 5, 7, and 10-year maturities), and bonds (30 years, reintroduced in February 2006).  For the sake of this discussion, we are only interested in the 10-year note.   
 
Once the debt has been sold, bills, notes, and bonds are traded on public markets, with investors buying and selling this debt and creating a market-driven interest rate. The rates generated in these markets for the 10-year note are vital in the financial markets. For instance, it is the proxy for many financial services such as mortgage rates. It is also used in determining interest rates on credit card debt. Trillions of dollars of financial instruments are affected by changes in these rates. 
 
The 10 Year Treasury Yield and Stock Valuation
 
For value investors, the 10-year note's yield has (or should have) an enormous impact on the valuation of publicly traded equities. When an investor looks to value a business, there are two calculations that play a tremendous role in estimating its long-term intrinsic value. The first is the company's return on capital (ROC). The second is its average weighted cost of capital (WACC). One of the most critical aspects of finding quality in a potential investment opportunity is a having a high return on capital. At Nintai, we look for companies that achieve 15% or greater ROC over the past decade. ROC is an excellent tool for getting a grasp on how well management teams allocate capital. But it's only half the equation (literally and figuratively!). Equally important is the company's weighted average cost of capital. A company always wants ROC to be significantly greater than WACC. It doesn't matter if they can generate an ROIC of 15% if their cost of capital is 18%. (Hence the opening quote about losing a small amount on each transaction, but making up for it in volume)
 
The weighted average cost of capital is one of those topics that inevitably leave peoples’ eyes glazed over when you bring it up. It's like discussing the interest rate you will be paying on that brand new sports car in the driveway. Not many people insist on diligently reading the term sheet. Instead, most dream of taking those sharp turns or doing racing changes on the interstate before trying to measure how the cost of capital might impact the long-term value of that new sports car. 
 
Return on Capital versus Cost of Capital: A Simple Example  
 
Let's use an example of an investor choosing to use cash obtained from a credit card advance to invest in stocks. It sounds crazy, but I've seen things more insane in my investing career. For example, let's start with the cost of capital. A cash advance can be obtained for the average credit card owner with two main items driving calculating the cost of that capital.
 
First, the card company will charge a fee which is generally based on the percentage of the transaction. For the sake of this exercise, let's assume the cash advance is $25,000. According to CNBC, the average transaction charge usually is between 3 – 5% of the advance amount. For this case, let's cut it down the middle and call it 4%. In this example, the individual will pay $1000 for the advance (25,000 x 4%). Second, the credit card company charges an annual interest rate fee on the balance. Let's assume the individual is not planning on paying off the balance for the first year but pay any fees and interest charges. According to the website creditcard.com, the average interest rate charged by the credit card company is 16.15%. For the first year, the individual will pay $4,037.50 (25,000 x 16.15%).
 
In this instance, cost of capital would be $1,000 + $4,037.50 or a total of $5,037.50. Put in the Wall Street terms, the cost of capital would be 4% + 16.15% or 20.15%. Of course, this number means nothing until we calculate the return on capital and see how the two numbers compare. 
 
To calculate return on capital, let's assume the individual wants to invest in a hot-shot stock growth fund that she's been assured is a real winner. We'll call this the "UltraHype Growth Fund" (which goes by the ticker BLECH). Over the past ten years, the BLECH fund has returned 11.2% annually. This is the starting point on the return on capital, but sadly not the final figure. The fund charges are very high – a 1.8% management fee. This is subtracted from returns, reducing the returns to 9.4% annually. Let's be generous and assume there are no additional costs like a load fee of 5.5% or 12b-1 fees or redemption fees. 
 
The return on capital number will be 11.2% of $25,000 or a return of $2,800. From that, we subtract the 1.8% management fee or $450. This leaves the individual with a net return of $2,350. Another way to calculate it is 11.2% - 1.8%, which generates a return on capital of 9.4%. 
 
It should be pointed out here, calculating the weighted average cost of capital and return on capital can be - and usually is - far more complex. It helps to have a calculator or Excel spreadsheet handy. For instance, the actual formula looks like this.

Suffice it to say our calculation in getting a cost of capital in this example is conceptually the same, but woefully deficient in terms of completeness. This is an article for investors, not a graduate accounting class!
 
So, where does this leave our individual? Did their move of taking a cash advance on their credit card pay off by investing in their expensive, hot-shot growth fund? The answer is a clear no. Their return on capital of 9.4% was swamped by their cost of capital of 20.15%. While it may seem obvious to any investor, it's important to point out this is a terrible use of capital. 
 
Cost of Capital and Stock Valuations
 
Having your return on capital exceed your cost of capital really shouldn't be that profound of a concept for individual investors, professional money managers, or senior corporate executives. Is should also be pretty clear that rising input costs in calculating your cost of capital will lead to higher cost of capital. The dramatic movement in treasury yields cited earlier will dramatically impact a company’s cost of capital. With rising Treasury yields, many company’s suddenly began to see WACC exceeding ROC in their returns. These changes should have been seen in valuations if investors were taking these changes into account. The exact opposite has happened. Except for the sharp drop in valuation in the spring of 2020 and their subsequent - and relatively rapid - recovery, the trend in stock prices has been nearly always upward. 
 
To apply this concept and see this disconnect in real terms, I want to use a holding in many of Nintai Investments’ individual portfolios - SEI Investments (SEIC). In December 2019, we estimated the company's weighted average cost of capital was roughly 9.4%. In that calculation, we included the federal funds rate of 1.87%. At that time, we estimated the intrinsic value of the company's stock was $55.20 per share. It was trading at roughly $66.00 per share or approximately 20% above fair value. By any standards, the stock was not a compelling buy. By December 2020, we estimated the company's weighted average cost of capital at roughly 7.9%. Nearly all the decrease in the WACC was the drop in the 10-year note yield. In our calculation, not much else changed. Revenue was flat, free cash flow was down slightly, and publicly traded shares were down slightly. There wasn't much to change valuation except the drop in the funds rate. But, boy, did that change our valuation. The $66 per share in December 2019 had jumped to $73 per share in December 2020. With the stock trading at $56 per share, the company was now trading at 23% below fair value - an enormous change in roughly one year. What had been a moderately overvalue company was now trading moderately below intrinsic value. On these numbers, we purchased shares in our portfolios. What a difference a year makes. 
 
But our example doesn't end there. The exact opposite happened from October 2020 to March 2021. The 10-year note rate jumped 0.53% in October to 1.63% just six months later. The example we just showed went in the exact opposite direction. With such a massive jump in the 10-year rate, companies' valuations took a whopper of a hit. SEIC's valuation dropped from $73/share back to $61 per share. With shares trading at $60 per share, they were now at fair value instead of 23% below intrinsic value.
 
Talk about a whipsaw! In a little over 16 months, SEIC went from moderately overpriced to moderately underpriced to roughly fair value, all due mainly to changes in the 10-year Treasury note yield which then impacted the company's weighted average cost of capital.  SEI Investments wasn't the only company that saw its valuations affected by its drop in the weighted average cost of capital. Every company in the public markets was impacted – some more than SEI, some less. Throughout all of this, overall yields didn't move much. The 10 Year US Treasury note yield was 1.73% on December 3, 2019, 0.92% on December 1, 2020, and 1.45% on March 1, 2021. But there was quite a gap between highs and lows. In August 2020, rates hit their low  0.52% and hit their high in December 2019 at 1.93%.
 
It's important to note that the markets overall were minimally impacted by these changes. From December 2019 to March 2021, the S&P 500 gained 25.4% rising from roughly 3150 to 3850. This even includes the massive drop in the spring of 2020 when the S&P dropped nearly 30%. 
 
What This Means
 
For all this data and heavy reading, you might be asking yourself at this point what this all means. It's a good question and an important one to answer. The most important lesson to understand is that having cost of capital exceed return on capital is not a recipe for outstanding long-term stock returns. It should be common sense to any investor, but roughly one-third of all publicly traded companies currently have WACC exceed ROC. Somebody is investing in these companies, so not everybody has learned this lesson.  Here are some other learnings to think about. 
 
WACC and ROC Must Be Measured Together: I have to concede that I searched for companies with extremely high ROC at the beginning of my investing career but never screened them for WACC. There is a particular bias that a company with high ROC couldn't possibly have even higher WACC. It happens, though. And like any other company with a negative ratio, it's a company that doesn't generate value. Always remember to look at both ratios, not just one. 
 
The 10 Year Treasury Yield Has a Big Impact: I used to denigrate investors who took a lot of time looking at macroeconomic issues because I felt they play a minor role in the business. I was right about that. What I was wrong about is that it plays a massive role in the stock. Remember: sometimes, a company's stock (and its price) has little to do with the company. This type of disconnect happens all the time. A significant rise in the 10-year note rate can drive up the cost of capital, making a dollar in the future worth a lot less. While the company might remain the same, its intrinsic value might decrease significantly. Never lose sight of the role of interest rates in valuation. 
 
In the Short Term Voting Machines, In the Long Term Weighing Machines: Having said that interest rates could affect valuation, it's important to remember the longer the holding and the greater the business's success (through quality and value) the less the impact of interest rates will be. This is a convoluted way to say that time and business excellence overrides the shorter-term impact of interest rates. Being patient and allowing time to work its magic can dramatically reduce some of the risks (but not all!) associated with cost of capital. 
 
Conclusions
 
For any long-term value investor (and what other kind is there? “Short-term value investor” is undoubtedly a contradiction in terms), the ability to find a business and management team that can produce value over a decade or two is the means to creating investment gains. The underlying foundation of this value creation is the ability to have the return on capital far exceed the cost of capital.  Given time and allowing for the weighing machine of the markets to work their magic, companies can become compounding machines for their shareholders. 
 
Understanding the dynamics of what constitutes the cost of capital and its relationship to return on capital is one of the most powerful concepts to a value investor. Looking at both and understanding the drivers of each, an investor has the tools necessary for making the best investment decisions possible. Will the markets always agree with you? Absolutely not. But an investor can go to bed each night fully understanding their investment has created value that day, that week, that month, that year, and hopefully the next decade or two. 
 
I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai Investments has no positions in any stock mentioned.

Yesterday, we learned about the death of Charles de Vaulx by suicide at his offices in New York City. Before anything else, this is a human tragedy. By every measure, Charles was a diligent, hardworking, and incredibly thoughtful value manager. He leaves behind a wife and two children. Everyone at Nintai sends our condolences to his family at this very difficult time. 
 
Charles was a value investor who represented the best of the Old Guard. By that, I mean in thinking, not in age. He was only 59 and still had much to offer the investment community. I refer to his investment thesis, portfolio management theory, and investment practices. First and most important, he always insisted on a reasonable margin of safety. He was willing to go to what is considered today heretical, extraordinarily high percentages of cash, reaching 40% of total AUM sometimes. He insisted, much like his mentor Jean-Marie Eveillard, in holding actual gold in portfolios as a means to offset risk. Last, he saw his job’s role as a means to retain wealth, not just createwealth. His passion for reducing risk for his clients’ assets was legendary. 
 
All of that was, of course, profoundly out of step in today’s investment world. Nearly every core concept Charles held dearly has been tossed topsy-turvy over the last decade. Interest rates continued their downward trend that had started in the 1980s, finally turning negative (!) in many countries around the world over the past few years. His remarkably high cash position was a terrible drag over the past decade. Interestingly, even that didn’t help when the market suffered its collapse in the spring of 2020 with the onset of COVID. Even with so much cash, IVA funds saw share price drops of over 25%.  
 
The last year had been difficult for IVA and Charles. Total assets had dropped from a peak of nearly $20B to less than $1B this year. In July last year, Charles’ co-investment manager Chuck de Lardemelle left the firm. In December, another founding partner, Michael Malafronte, left the firm for health reasons. The final blow was a dreadful 2020, with both funds underperforming their index by nearly 15 percentage points. The end came on March 10, 2021, when IVA filed with the SEC that it intended to liquidate its two mutual funds – IVA Worldwide and IVA Global and shutter the firm altogether.
 
The Weight of Professional Asset Management
 
There is a vast distinction between managing your own money and doing it professionally. It’s hard to describe the pressure one feels as underperformance piles up. The markets are famously unfeeling. You wake up every morning, and you compete against a faceless index. There is no emotion or subjectivity to what a professional investment manager does. You either outperform the market, or you don’t. You can come up with many reasons why your picks have performed poorly, but there is simply no hiding from the numbers.
 
For many value managers, the past decade or more have been a grueling experience having to report -  year after year - underperformance to their investors. After the first few years, it becomes increasingly difficult not to question your methodology. After a decade, it becomes hard not to question your entire investing career. Was initial success just luck? Is it possible to add value to your clients? Is it even worth continuing?
 
When I listened to Charles on Morningstar’s “The Long View” in November 2019, it was clear IVA and the investment management team still felt their underperformance would turn around. The markets would return to some form of sanity after nearly a decade of seeming craziness. Somewhere between then and March of this year, their view fundamentally changed.   
 
I can only speak from my perspective of having an abysmal 12 month run over the past year. I find I don’t sleep as well. I spend days evaluating current holdings, re-running our investment thesis, tweaking the numbers until there isn’t much else to do. I find it takes about six months of straight underperformance before I question not only the investment thesis but whether Nintai’s strategy is flawed. In this business, I think three major themes can significantly (and negatively) impact a professional value manager these days. 
 
Some Important Themes
 
Competition is Brutal
I’m not sure you will find an industry with such widespread competition as investment management. At the strategic level, competition takes place against other active managers and against index (or passive) funds. With fellow active investors, a manager competes on her stock-picking abilities and his management fee. Against index funds, the battles rest more on price (it’s hard to compete when you give away 1.5% at the top every year) and secondarily on stock picking. At the tactical level, competition is intense as data and content have become democratized. The days of finding net/nets by reviewing individual annual reports or Value Line surveys has been replaced by utilizing a search query of GuruFocus that takes roughly 25 seconds to run. Nearly every competitive advantage a value investor brought to the table 25-30 years ago is gone in today’s investment world. 
 
Generally, Your Behavior is Your Enemy
Value investors operate in a field where nearly every genetically programmed behavior is contrary to what it takes to be successful. Everything from confirmation bias to loss aversion pushes an active manager to behave against their investors’ best interests. The ability to control your emotions and focus on what works – regardless of your native impulses – is vital to success. As almost anybody who has invested for more than a decade can tell you, that sure as hell isn’t easy. 
 
Time Should Be Your Friends, But Sometimes Isn’t
The past decade has added an enemy to many value investors that have always been one of their greatest allies. Warren Buffett said that a key to investment success is to find wet snow and a very long hill. For nearly every decade since the 1920s, it was assumed the long hill ran downwards. The past 12 years have been a long uphill climb for value investors. Nearly every investment thesis and process has been challenged or simply not worked since 2009. That’s a long uphill climb. 
 
Conclusions
 
I can’t say Charles de Vaulx was an acquaintance, let alone a friend. I met him several times, and I treasured our conversations. I first knew of him because I admired his investment record over the long term, the brilliance and clarity of his intellectual frameworks, and his ability to stick to his core convictions. (I highly recommend the aforementioned “The Long View” interview on Morningstar. It can be found here.) It’s unlikely we will ever be sure what happened over the last few months of his life. Still, we can be pretty sure he looked out over the previous decade as every value investor has and saw a challenging period that posed a risk to his very professional being. He isn’t alone. But it’s important to realize that at its most fundamental, value investing is about human beings making judgment calls on the long-term future of a possible investment. Charles was human, and he also happened to be a good human being. I’m glad I met him, and I’m even more glad I got to understand his skills better, thinking, and convictions. He will be missed.  

We are pleased to announce that Tom's book "Seeking Wisdom: Thoughts on Value Investing" is now available on Audible. A compilation of Tom's articles written for the website Gurufocus, the book has a great deal of original content as well. For those looking to listen and learn about value investing from diverse angles, "Seeking Wisdom" is sure to get you thinking differently about investing. You can find it here: https://tinyurl.com/yt7ac3uv

"When you combine ignorance and leverage, you get some pretty interesting results." 
 
                                                                                 - Warren Buffett
 
Margin Debt: A Brief History
 
Margin debt is when an investor uses assets provided by a third party - in many cases, the investor's brokerage house - to purchase more shares than they usually could using just the cash assets available to them at the time of purchase. This means opening a margin account and utilizing the credit line on the account to make such a purchase. For instance, assume an investor has $1,000,000 in cash in their brokerage sweep account to make purchases. Also, they have a margin account with a credit limit of $500,000. The investor wants to purchase $1,000,000 worth of a particular stock. They can use the $750,000 available in their sweep account, and they borrow $250,000 on their margin account and make the purchase. This means the investor has $250,000 in cash as collateral for the $250,000 balance on their margin account. This has allowed the investor to boost their share purchase by $250,000 while still leaving cash in their sweep account.  
 
It's important to note a few things. The Federal Reserve Board's Regulation T limits the broker to lending up to 50% of the initial investment. This puts a hard cap on how much margin the investor can borrow. Second, many brokerage houses have their own regulations that may be more stringent than Regulation T. 
 
This, of course, is all fine and good if the stock goes up. Using leverage (or gearing as they call it in the UK and Australia), investors can make more profits than they could have if they only used their own cash. But what if the stock goes down? If that's the case, then the investor's losses would be much more significant than if they only used their own cash. One of the worst possible scenarios is when the stock price drops so low, the brokerage company makes a "margin call," essentially demanding the investor pay back some - or all - of the total amount of margin borrowed. Margin calls can force investors to sell other assets to raise cash at precisely the wrong time, wiping out gains or even bankrupting them. As usual, there is no free lunch, and increased returns always come with higher risk. At Nintai, we have an official policy that bans the use of leverage - or margin - in both individually managed as well as our internal fund.   
 
So why bring up margin loans/debt at this point in the market cycle? The major indexes are near all-time highs, and the economy is slowly recovering from the COVID crisis. What's to worry about?        
 
A Remarkable Twenty Year Run: 2000 - 2020
 
Below you will find a chart mapping two trends – the returns of the S&P 500 (the blue line centered on the right axis in terms of trading price) and the amount of margin debt (the red line centered on the left axis in billions of US dollars). The chart begins in 1997 because this was the year of the margin debt reporting changed dramatically. Before 1997, margin debt data was available for only the New York Stock Exchange (NYSE) members. Post-1997, the NYSE closed down its data collection and allowed the Financial Industry Regulatory Authority (FINRA) to capture data from all major exchanges such as NASDAQ and NYSE.   
 
As you can see, 1997 represents the nearly three-quarter point in the 1982 - 2000 bull market that culminated in the great technology bubble. Margin debt peaked in 2000 before reaching its nadir in 2003. It wasn't long after getting this bottom that investors forgot any lessons related to the risk of margin and market bubbles by pumping up margin debt to all-new high highs in July 2007 - just in time for the collapse of the next market bubble (the Great Credit Crash) leading to stunning losses in individual brokerage accounts accelerated by this considerable margin debt. But like Sisyphus (who really should be Wall Street's patron saint), investors started the cycle all over again (the third time in just ten years!). With the new bull market beginning sometime in 2009, margin debt has grown hand in hand with growth in the S&P 500 average, with total margin debt rising from roughly $250B in 2009 to nearly $800B in 2020. After the market correction in early 2020, margin debt fell from $600B at the beginning of 2019 to $475B after the correction. After such a reduction, any pessimistic feelings were immediately forgotten when debt rose from $475B in early 2020 to nearly $800B (!) by the end of the year – a staggering 68% increase in just nine months.  

Source: "Margin Debt and the Market: Up 2.6% in January, Continues Record Trend", Jill Mislinski, February 18, 2021

If we zoom in further and look at the tail end of the chart data, you can see the remarkable increase in margin debt. FINRA (through Investopedia) stated[1]:
 
"Margin debt has reached the highest point in two years as investors borrowed a record $722.1 billion against their investment portfolios through November, topping the previous high of $668.9 billion from May 2018, according to the Financial Industry Regulatory Authority (FINRA). This amount is a 28% increase since the same time last year and is up nearly 10% from $659.3 billion in Oct. 2020".
 
This massive increase was likely driven by the markets' assumptions that vaccines would bring an end to COVID-19 as an economic story. 

Source: FINRA, "Margin Statistics," January 2021

Why This Matters
 
Many readers may ask, "So what? The markets are going up. What's the big deal?". If markets continued to rise indefinitely, then the short answer would be there isn't much to worry about. But we all know markets don't go up indefinitely. An 11-year-old bull market will end. The question isn't if. The question is when? 
 
Margin debt is no different from corporate debt, except that margin debt would be considered short-term debt at all times. The reason why Nintai Investments is so averse to debt is that it seems to come due at the most inopportune time. Most companies borrow money when they need it but have to pay it back when they need it even more. This doesn't make for the best capital allocation decisions. 
 
Individual investors are no different than corporations when it comes to margin debt. Investors tap their margin credit lines when they want to purchase more shares and leverage their current assets. They need that credit even more, when markets crash and margin calls come flooding in. Much like the corporation, this doesn't lead to rational capital allocation decisions. 
 
A Useful Example
 
Let's assume Bob is an investor who considers his stock-picking abilities above average and is tired of just barely meeting the index's returns (which, when you think of it, makes him just average, but will let that go for the sake of our case). Bob has $600,000 of equities in his taxable brokerage account and $200,000 in cash in the brokerage account's sweep account. He has decided to leverage these assets and begin trading on margin. A quick reminder: in Bob's brokerage account (or cash account), all transactions must be made with the cash on hand in the account. A margin account allows the investor to borrow against the total value of assets in the cash account. In Bob's case, his cash account would be worth $800,000 ($600,000 in equities and $200,000 in cash). According to Regulation T, Bob's brokerage house can loan him up to 50% of the total purchase price. 
 
After considerable research, Bob has decided to purchase $250,000 of "Ted's Adventure Company" (note: this is a fictional corporation). When Bob purchases these shares on his margin account, he has one "payment period" (his brokerage account names this as five business days) to meet the Regulation T 50% margin requirement. Bob utilizes his cash and equities as collateral. He feels very comfortable knowing he has $800,000 in his cash account to post versus the $250,000 margin balance. Regulation T requires 50%, so Bob is required to cover $125,000 (which is 50% of 250,000 on margin). 
 
So far, so good. Bob is in fine shape unless one of three things happen. First, a general market decline decreases the value of both the stocks he borrowed against (Ted's) to buy (remember: the $200,000 balance remains the same). If the stock drops by 25%, then Bob now needs to have enough capital to cover the $250,000 initial loan plus the 20% decrease in the value of his shares bought with the loan ($250,000 x 20% = $50,000) In this case his margin balance increases from $250,000 to $300,000. The second action that impacts his margin status is if the value of the stocks he holds in collateral decreases. For instance should Bob’s equities also decrease by 20%, then his balance available as collateral drops from $600,000 to $480,000 ($600,000 - 20% = $480,000). If Bob is near the 50% required collateral level, he may be required to post additional assets to keep below the 50% mark. This is known as a margin call. I'll get into more detail about that shortly. The third action that would affect Bob's margin status is if he finds himself in need of cash and has to tap the $200,000 in his sweep account. Again, this might bring him below the required 50% margin coverage.
 
Unfortunately, rarely does one of these things happen alone. During a market crash, the stock price (Ted's) is likely to drop in addition to the value of the equities in Bob's brokerage account. Additionally, he may need cash from the sweep account because the market crash has accompanied an economic downturn and Bob's planned bonus never appeared. This would be known (and I hate the term) as "the perfect storm" for Bob's portfolio.      
 
The Margin Call
 
Now that we've walked through the logistics of using margin, let's look at the worst-case scenario when things go wrong – the dreaded margin call. A margin call happens when the amount of assets in the investor's margin account falls below the required amount. For instance, let's use the case of purchasing $250,000 of Ted's Adventure Co. Assuming our investor used $125,000 from their cash account and $125,000 from their margin account, they have barely met Regulation T that requires the amount of the margin purchase not to be more than 50% of the total price paid (Since the purchase was $250,000 in stock and the investor used $125,000 of their margin account, then just met Regulation T's 50% rule). Should the stock price start dropping, the brokerage house will begin the process of a margin call when the asset price falls below $125,000. For instance, should the stock drop 20%, then the stock's total value purchased on margin drops from $125,000 to $100,000. In this instance, the brokerage house would place a margin call for $25,000. This means the investor would need to place an additional $25,000 into the margin account. Since this event rarely happens in a vacuum, a margin call can put enormous strain on an investor. If the brokerage company doesn't receive its $25,000, it can liquidate other stocks - no matter the price - to meet the margin call. As I said, these events rarely happen in a vacuum, and the forced selling of additional prices likely will take place as those share prices are dropping as well. It's never good when you are forced to sell at any price. Particularly when the proceeds of any sale are needed to fill a gap caused by a margin call. When a margin call forces a sale, you can expect the prices your assets are sold will be to your disadvantage.
 
Final Thoughts on Margin Trading
 
As major indexes trade and margin debt both reach near all-time highs, any investor utilizing high amounts of leverage (margin debt) should consider the potential implications of a severe market drawdown. As I've explained earlier, generally, margin calls are part of an investor's perfect storm with the potential of causing catastrophic losses in their portfolios. Here are some thoughts I offer investors employing leverage in today's markets. 
 
Leverage Goes Both Ways
For every person who uses margin to increase their profits, some investors increased their losses by utilizing leverage. After such a long period of market gains, it's easy to lose sight of the fact that markets can drop - and drop fast. Just ask anybody who was highly leveraged in the spring of 2020. With valuations as tight as they are, it shouldn't surprise anyone to see a 25 - 30% correction at any time. If you are using a model that uses a significant increase in market prices, build in such a loss. Then double it again. You might be surprised by the results. 
 
Just Because You Can Doesn't Mean You Should
The recent events with RobinHood and GameStop (GME) trading have shown that not everybody should be trading on margin or shorting stocks. Just because an investor has access to margin accounts and trading doesn't mean they should employ such a strategy. Unless an investor has given considerable thought about the potential impact (and modeled possible results) of utilizing leverage, they should stay clear of any such market operations. Just because you have access to a margin account doesn't mean you should use it. 
 
Enough Can Truly Be Enough
After a twelve-year bull market, if - as an investor - you don't feel you've squeezed out every possible profit from your investments, then margin isn't the way to go. It seems the odds (though I have no real way to predict) predict a much lower growth rate or even net negative returns over the next decade. If this proves to be accurate, then margin isn't going to help squeeze any extra returns out of the market at this point. We highly recommend investors recognize they've gotten as much as possible from this bull market and head for safer investment waters. 
 
Conclusions
 
Just a few days ago, Charlie Munger commented on special purpose acquisition companies (SPACs), 
 
"This kind of crazy speculation, in enterprises not even found or picked out yet, is a sign of an irritating bubble. The investment-banking profession will sell shit as long as shit can be sold."
 
We think the use of margin accounts and leverage are similar for individual investors. Wall Street sells margin accounts because they can. In most cases, they are inappropriate for investors and allow them to take on terrible risks while only thinking about possible rewards. There are many safer ways for investors to increase returns. These include cutting down on management fees and reducing trading costs. The actions minimize the risk while generally increasing returns. As an individual investor, at Nintai, we suggest investors look for the low-hanging fruit and safest ways to juice (no pun intended!) returns. We think this is the smartest move available to individual investors by a wide margin (pun intended).   
 
 -----------------------------------
[1] https://www.finra.org/investors/learn-to-invest/advanced-investing/margin-statistics

"A prudent mind can see room for misgiving, lest he who prospers should one day suffer a reverse."
                                           
                                                                                              -      Sophocles 

"It's amazing what you see in disclosures. People will go to all extremes to make their performance look better. Comparisons are crazy – you might see something like a  comparison of funds returns versus the amount of vanilla bean grown in Tahiti divided by metric tons of iron ore deposits in Western Australia. Voila! We outperformed that number by 3% annually. I'm kidding…..but not by much!"
                                                                        
                                                                                             -     "Sonny" Mendez 

Value Investing: "A Hell of a Beating"[1]
 
At the end of each year, the investment management world's conversation inevitably focuses on performance and how well a manager did against their respective competition (the S&P 500, MSCI International Stocks, Bloomberg Barclays Aggregate Index, etc.). This year's discussion has centered on one topic that seems to always be near the top of everybody's list - growth versus value performance. It seems an eternity since value has outperformed growth over a substantial period. Last year was no exception. 2020 was one of the worst years ever when it comes to value strategy versus growth strategy performance. Morningstar reports[2] that:
 
"Large-growth stock funds--which generally invest in companies with strong earnings growth profiles--returned an average of 34.8% in 2020. That was 32 percentage points ahead of the average large-value fund, which has portfolios of companies deemed cheap compared with their potential or are seen as turnaround stories. That exceeded the gap registered in 1999 when growth beat value by 30.7 percentage points. While the value versus growth performance gap wasn't a record for small- and mid-cap stock funds, those groups' average margins were the widest since 1999. And the woeful relative performance for value significantly widened the longer-term return gaps across the board."
 
The long-term record isn't much better. Over the past one, three, five, and ten year periods, large value, mid-cap value, and small-cap value have underperformed their growth cousins every time. That's right. Not a single time period of outperformance in any market segment in any time period. Here's the very ugly looking chart. 

I bring this data up because Nintai just released its 2020 Annual Report. I was asked several times how we decide what to disclose, how we discuss results and our methodology in comparing results against other funds or indexes. Most of the questioners were trying to ask politely - do you provide information that shows me what the hell happened this year. 
 
Discussing Failure: Avoid and Abdicate
 
With value investing performing so poorly, I've been intrigued about how investment managers have been disclosing their results and explaining the reasons for their underperformance. After reviewing about 250 annual reports, investment updates, and articles, the short answer is - most managers don't do anything of the kind. I've found many annual reports discuss everything BUT their returns – discussions that include long term energy policy, the role of climate change in fishing rights, the history of pandemics, the rise and fall of the serf-based economy, etc. Many discuss folksy wisdom like looking at investing as farming - sowing seeds, tending the weeds, and harvesting the profits. Of course, the problem with this is that it might be better to discuss the effects of a ten-year drought filled with biblical hordes of locusts.   
 
At Nintai, we always try to stick to some basic rules in our disclosure policy. First, we seek to be open and honest in our communications with our investment partners. This includes our methodology and our performance. Second, we acknowledge mistakes in a free manner. We discuss the core issues, what went wrong, what we learned, and how we will try not to make the same mistake again. It goes against nearly every business rule, but I enjoy writing about my mistakes. It helps clarify my thinking, and it tells me how my partners view my mistakes. Don't get me wrong. I hate underperformance. I'm as competitive as any manager in the investment industry. That doesn't mean that I can't be honest with myself and truthful with my investment partners.   
 
We recently released Nintai Investments' latest annual performance report. The report discusses 2020 results as well as three years and since inception returns. We compare our return against the performance of the S&P 500 TR index, the Russell 2000 index, and the MSCI ACWI ex-US index. We cite the S&P 500 for the simple reason this is the index most used by the investment world for comparison. We include the Russell 2000 because it is the closest fit to our portfolios' market cap average. Finally, we have the ACWI ex-US because our portfolios hold a considerable portion of foreign stock management assets. We encourage our investors to think of their returns as a blend of these three indexes. We also discuss what investments did best, which did the most poorly, and explain – in detail – why these companies performed the way they did. 
 
We like to think our Annual Reports - along with our Investment Cases and Valuation Spreadsheets - give our investment partners all the information they need to judge our performance and how we communicate with them. We think this type of clarity is critical to maintaining well-functioning financial markets and helps individual investors make well-reasoned decisions to allocate their hard-earned dollars. Later in this document, I will discuss what components are essential in communicating with investors. I will also explain why investment documents are vital in assisting investors in choosing, evaluating, and making decisions. 
 
Disclosure and Discussion: A Working Example
 
Before I get into those things that I think are important, I thought I'd discuss an instance of financial reports that caught my attention last month. They did so for many reasons, but several stood out. First, the returns for the investment company were abysmal. Second, the reports themselves seem to reflect nothing but good news and the seemingly endless bragging of the fund's managers' investment wisdom. Finally, the report seems to go out of its way to obfuscate and create an intellectual fog about their investment performance relative to the general markets. Before I disclose the company, I should say, in all fairness, this could be many of the funds out in the marketplace. The poor performance, the folksy talk, and the incomprehensible reporting format of performance are all too familiar. I have chosen this investment company simply because its report happened to float across my desk. I have no particular bone to pick with the managers of the investment team. 
 
In this case, the company is Muhlenkamp and Company, based out of Wexford, Pennsylvania. The company was founded in 1977 by Ron Muhlenkamp. In 1988, the company launched a no-load mutual fund (MUHLX). Ron handed the reigns to his son Jeff in 2019. 
 
First, some statistics on the fund. According to Morningstar, assets under management have dropped from $3.47B in 2005 to $181.4M in 2020 (a 94.8% decrease in AUM). Muhlenkamp reports the company's total number of accounts dropped from 289 in 2005 to 48 in 2019 (an 83.4% decrease in accounts). 
 
These decreases have likely been driven by performance, which has been pretty hard to read about from 2005 through 2019. When measured against the S&P 500 TR, the fund's record is the following:

According to Gurufocus.com, the Muhlenkamp fund has underperformed the S&P 500 by -7.31% annually over the past three years, -8.13% annually over the past five, -6.13% annually over the past ten, and -4.97% annually over the past fifteen. The fund has a one-star Morningstar rating for its 3, 5, and 10-year record. Its qualitative rating is negative, People rating below average, Process rating low, and Parent rating low. Overall, the statistics paint a pretty grim picture. 
 
With these numbers in mind, I thought it might help look at what and how Muhlenkamp reports this information to its investors. On its website, there are 8 page tabs including Home, Individuals, Business, Fund, Separately Managed Accounts, Blog, About Us, and Contact.  Performance information can be found both in the Fund tab underperformance and can also be found at the end of each "Muhlenkamp Memorandum." A few things jump after reading nearly ten years of reports and memorandums.  

1. I couldn't find any explanation in any document why returns were so poor. Memorandums were filled with information on the economy, politics, and broader societal issues (like COVID). Yet nowhere could I find an explanation for such overall underperformance (was it due to poor stock selection, lousy market timing, value as a class underperforming growth?). If my fund underperformed (by a lot) on a 3, 5,10, and 15-year basis, I'd feel a deep obligation to explain to my investors how and why performance was so poor. 
2. Some of the performance data seemed (and this my impression – I have no facts to back this up) to be in the charts to make the funds returns better. For instance, what in the world does the consumer price index have to do in comparing the fund return versus the S&P 500? – other than the CPI number looks a lot smaller than the fund returns.[3] Second, there were columns in the return analysis that I had no idea what they meant or why they were important. For instance, one column was the Composite Dispersion, which is "a measure of the similarity of returns among accounts of the Composite.  It is the standard deviation of the annual returns for all accounts which were in the Composite for the entire year." Would an average retiree understand the meaning of any of that and how it impacts their retirement portfolio?
3. There is the usual discussion in one of their reports of the sowing and reaping and having a farmer's fortitude and patience. If I had a nickel for every time an investment manager talked about farming, I wouldn't need to be an investment manager. With active value management's performance as it is over the past decade and a half, I'm not sure discussing sowing and reaping is the best approach. 

 
Muhlenkamp's slogan is "Goal-setting, dream-building, future-conquering, financial freedom starts here." They go on to say, "WE'RE NOT YOUR AVERAGE MONEY MANAGERS. We're a scrappy pack of financial nerds and outliers, passionate folks who believe in redefining the industry with data-driven, intelligent investing. We love to smash through the smoke and mirrors that so often mystifies wealth building as we eagerly share our knowledge and decades of expertise with people just like you. We're Your Hometown Team, Forging A Better Way."
 
Looking at Muhlenkamp's performance over the past fifteen years would suggest they look an awful lot like your average money manager. More importantly, it is unclear what gains have been obtained - from all this smoke and mirror smashing - in both returns and investor knowledge. 
 
As I said previously, I don't have any particular bone to pick with Muhlenkamp and Company. They are pretty standard for a Wall Street investment house (though based in PA). Whether it is caused by the long-term underperformance of value investments in general or something specific to the Muhlenkamp strategy or team, what is evident is that performance is lagging, and disclosure does very little to explain why. It's bad enough their investors have taken their lumps when it comes to a truly horrific case of returns. It seems far worse when these investors are seemingly left in the dark. 
 
So What Can Be Done?
 
If this type of situation is typical (and value underperformance combined with poor communication is pretty consistent across the investing world spectrum), what can investors do to avoid it? Are there specific items that managers can include in their reports which better educate investors? I suggest there are five particular areas where individuals can look for receiving more pertinent and relevant data.
 
Does Fund Management Use Fair Comparisons?
One of the first things an investor should look for is fair comparisons when measuring performance. For instance, if a fund invests in small or micro-cap stocks, it's probably not a great idea to measure itself against the S&P 500 index (representing the largest 500 companies). When you see comparisons against indexes with very little in common with the fund, management would seemingly have very little knowledge of market indexes or a willful denial in seeing relevant comparisons. You see this a lot when fund managers are desperately looking for a way to make their returns look better than they really are. 
 
Does Management Openly Disclose and Discuss Mistakes?
Nearly every manager I've ever worked or consulted with has told me discussing mistakes is a form of weakness. I couldn't disagree more strongly. That statement is one of the more egregious I've heard over my years in business. If someone can't confess to errors to themselves and their clients, to whom can they confess? Once an investment manager deceives himself, it isn't long before they start deceiving their clients. Granted, I don't want someone writing me a mea culpa once a month, but the occasional explanation of an error – and description of what they learned – is quite refreshing and assuring.  
 
Does Management Clearly Show Impact of Fees?
This is an area where Nintai Investments needs to do a better job. We charge a rate slightly lower than most actively managed investment services (0.75% annually) but don't describe how much this rate eats into long-term results. I think it would be beneficial to show the difference between an active fund's returns versus their respective index and show the impact on returns by management fee, trading costs, etc. It is certainly possible to show cumulative annual trading costs in an annual report. This is information that could be very helpful to individual investors. It is a goal at Nintai Investments to include this data in 2021 and going forward.  
 
Does Management Discuss Individual Portfolio Holdings?
We think it's constructive for investors to see the investment cases for individual portfolio holdings and an estimated intrinsic value when the stock is purchased/sold in or out of the portfolio. At Nintai, we do this for every stock in every investment partner portfolio. Some have told us they find the information quite helpful and interesting, while others have asked us to stop sending it. Either way, we want to give partners a choice in how much knowledge they have of their investments. After all, it is their hard-earned dollars. We are just fiduciary custodians. 
 
Does Management Clearly Articulate Their Investment Process?
Whenever an investor receives a document from an investment manager, it should assist (in some way) in better understanding that manager's style, approach, and process. We often read reports (much like the infamous "farming sowing and reaping") that tell us nothing about the manager's thinking. This type of writing can help investors better see why a manager made individual decisions and how they feel about their outcomes.   
 
Conclusions
 
As we head into the twelfth year of value investing underperformance against growth, managers must be able to articulate why their value investment process is still relevant. More importantly, investors want to hear why they should hold tight with managers who have performed poorly over both the short and long term. I've written several times before that underperformance is necessary sometimes to achieve overperformance in the future. If value investing is to avoid the dodo's life path, managers better start explaining how such a theory works and how they expect it to 
 
improve performance going forward. Underperforming on a one, three, five, ten, and even fifteen year time period ask an awful lot of investors' patience. Managers have two choices - increase performance or sharpen their explanations on their investment process and outcomes. Otherwise, as Sophocles pointed out, prudent minds will have had enough of suffering reverses and simply walk away. With losses in AUM like we've seen over the past fifteen years, that might simply be the final straw for many value investment managers.  
 
As always, I look forward to your thoughts and comments. 
 
Disclosures: None

------------------------------------

[1] The quote comes from General “Vinegar” Joe Stillwell of US forces in Burma in World War II. When asked what happened to the allies after the long retreat from Burma he was quoted as saying “I claim we got a hell of a beating. We got run out of Burma and it is as humiliating as hell. I think we ought to find out what caused it, go back and retake it.” 
[2] “Value vs. Growth: Widest Performance Gap on Record”, Katherine Lynch, January 11, 2021 https://www.morningstar.com/articles/1017342/value-vs-growth-widest-performance-gap-on-record
[3] Granted, the CPI impacts the purchasing power of the consumer and cuts into returns. However, utilizing this number is similar to comparing the amount of 8 inch turkey subs versus 12 inch turkey subs sold because it reflects the overall strength of consumer spending.

We spend a vast amount of time at Nintai thinking about quality and value. It’s the two measures that we believe give us our leg up on Wall Street. If we can find a hidden gem of a company - built on a solid foundation of quality measures in an industry we understand and priced with value in mind - we will likely back up the truck and happily put anywhere from 5 - 10% of our assets into the company. Because of that focus and such a large percentage of our assets, it’s vital we spend time understanding the characteristics of the company’s quality. It’s equally vital we spend time on what could impair its quality and create tools and processes to help us avoid such mistakes.   
 
At the highest level, at Nintai we think the following characteristics make up quality. 

• Run by management who allocate capital like it is their own money. Nothing turns us off as much as individuals who think of the company purse as their own personal piggy bank. We also want individuals who see themselves as stewards of their shareholders. Every action should be about building value for them. Building empires or funding pet projects simply don’t wash. 
• The company generates extremely high return on capital, return on equity, and return on assets. What we mean by this is when the company spends money it achieves good profits from the effort. If management spends a dollar to build a new product, we like to see five dollars in return. Much like a person who doesn’t want to spend good money for a dishwasher only to have to spend hundreds more in repairs, we like to see good money spent on even better returns. 
• The company has a competitive moat generated by internal competencies (very high quality control, streamlined/efficient manufacturing, great personnel policies, etc.) and external advantages (product/services deeply embedded in client strategy or operations, product hard to replicate due to intellectual property rights or patents, etc.) Both of these show up in the company’s returns on capital and equity.
• A fortress-like balance sheet and cash flows. Nintai looks for companies with no or very little debt. If the company holds debt, we look for the ability to pay off such debt within 12 months through ether cash on the balance sheet or free cash flow. We look for free cash flow (meaning all cash remaining after paying all its bills) to be at least 25% of total revenue. As we’ve said many times before, it’s very rare for a company with no debt to go bankrupt.   
• We like to purchase a company’s shares for a substantial discount to our estimated intrinsic value. As much as shoppers don’t want to overpay for the groceries, their car, or their home, we like to have what Ben Graham called a “margin of safety” in case we get our estimates wrong. 

 
In the final analysis, we want to purchase a company that will provide Nintai with the ability to compound its capital at a rate greater than its competitive index. More importantly, we want to purchase companies at a value and a quality that will minimize our chances of permanently impairing our investors’ capital. That’s a fancy way of saying we hate losing our investors’ money. 
 
Because of this, most days you will find us hard at work taking apart business cases, looking at the competitive markets, diving into new products and services, and completing a very 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 they’ve increased), and the share price has not gotten too far ahead of our estimated intrinsic value. When these reviews are complete, we share our findings and recommendations with our investment partners in the form of investment cases and valuation spreadsheets.
 
When we begin the evaluation process of a potential investment, I think it’s critical that at completion you have a clear understanding of what parts of the company demonstrate outstanding quality characteristics, what do not, and what actions could lead to the degradation of such quality. We feel it’s equally important to understand the same characteristics about the company’s value. Whether you are a sophisticated, professional asset manager or an individual investor just starting in investing, the ability to identify quality and value, understand their resilience, and how those characteristics convert to competitive and financial strength is the most essential arrow in your investment quiver. If you don’t understand what makes up quality, then you don’t understand what creates value. 
 
As we begin the process of thinking about what makes up quality, I thought it might be helpful to discuss not only what it is and what it is not. It’s important to get these two lists firmly in your head. Nearly every decision you make in your investment career, will center on what is and what is not to be considered quality. One mistake - and rest assured you will make more than one mistake in your investment lifetime - can cause considerable havoc in your long term results and in meeting your investment goals. At my mentioning of the word quality, some of my readers will say “Oh God. I’ve heard all this before”. And 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 quality and its relationship to value. Looking through my writings since June 2018, the second most common word was “quality” – coming up a total of 232 times. (“Value” was the number one word cited 431 times).  
 
So Just What Does Quality Mean?
 
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. These criteria generally leave us with about 40 of 3,671 (1.1%) total United States publicly traded companies, 300 of 17,602 (0.23%) total Asian publicly traded companies, and 90 of 8300 (0.50%) total European publicly traded companies. This leaves us with roughly 400 - 450 companies globally that meet our statistical measures of quality. If you add the criteria of value (meaning trading at a discount to our estimated intrinsic value) the number drops to less than roughly 10 - 15 at any one time. That’s a pretty small investment universe! 
 
Earlier I outlined some the characteristics we look for when it comes to identifying a quality company. 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”. To supplement the list I cited a few pages back, here are some the very high level components that Nintai thinks makes up a truly quality company. 
 
Excellence in Management: We look for management that have a vested interest in how the company performs (such as by purchasing shares in the open market, not stock option grants), has a history of outstanding management candidates usually found within the company’s ranks, deeply understands they work for both shareholders and their respective greater corporate community, and finally achieve outstanding results in both operational measures (return on equity, return on assets, etc.) and strategic measures (market share percentages, industry respect, product innovation, etc.). Most important than all of these, we look for management with a clear moral compass. This presents itself in such ways as forbidding financial transactions that profit management (such as renting a building they own directly or through corporate ownership), banning use of 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.  
 
An example of a management team that drives quality O’Reilly Automotive (ORLY). First, management compensation scheme keeps executives’ thoughts and actions on creating long term value for shareholders. Roughly one-third of compensation is calculated on a base salary. The remaining two-thirds is a combination of cash awards and stock grants based on return on invested capital, growth in free cash flow (not earnings), increase in operating income, and growth on store sales. Second, management has done an outstanding job at allocating capital. As I mentioned earlier, as an investor you always want to see management obtain a better return on capital than its cost of capital (meaning they make more money on the capital than it does to borrow it). In O’Reilly’s case, the company has averaged a 19% return on invested capital against Morningstar’s estimated weighted average cost of capital of 8% over the past ten years. While achieving such results, management has greatly expanded O’Reilly’s footprint though small “tuck-in” (meaning smaller, adjacent opportunities) acquisitions, never overpaying for new investment opportunities. Finally, the company has a long history of focusing on corporate governance including diversity, health & safety, training/promotion within, and corporate giving. Morningstar rates corporate governance as Excellent.   
 
Create Deep Externally Facing and Inwardly Looking Moats: In both good times and bad, we look for managers who can create exceptional defensively and offensively balanced moats. By defensive moat, we mean management keeps competitors, the general business environment, and time from attacking its position of strength. Defensive moats consist of maintaining market share, achieving steady and high pricing power. Defensive moats prove their worth as competitors seek ways to chip away at high gross or net margins or high return on capital. However, managers can sometimes excessive spend blood and capital digging a defensive moat and trying too hard at maintaining the status quo. 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 or offensive 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, increased scope of offerings, better quality, and new products/services on a remarkably frequent basis. An offensive moat is designed to find ever increasing opportunities (both in depth and breadth) with existing customers. 
 
An example of a company working diligently at both defensive and offensive moats is Veeva (VEEV), a Nintai Investments holding as of January 2021. Starting out as a customer relationship manager spinoff from Salesforce.com, the company has initially focused on achieving market dominance in the pharmaceutical/biotechnology industry. As of 2020, the company contracts with 19 of the 20 largest industry companies. Its numbers tell the story of an incredibly strong defensive moat – 21% return on equity, return on invested capital of 49%, free cash flow margins of 38%. The company has grown revenue at 26% for the past five years and free cash flow by an astounding 60% over the same time frame.  
 
But the company doesn’t just create a defensive moat. It has worked incredibly hard to keep expanding its moat within its customers. Average contract value per customer has increased by 167 times since 2006. Average product per client has increased from 31 in 2008 to 431 in 2020. Talk about embedding yourself with your clients. Veeva is a moat building domino.  
 
Create 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 it’s 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. 
 
An example of such a company is SEI Investments (SEIC), a Nintai Investments holding as of 2020. SEI  provides investment processing, management, and operations services (what often referred to as “back office” operations to financial institutions, asset managers, asset owners, and financial advisors in four material segments: private banks, investment advisors, institutional investors, and investment managers. 
 
As a company reliant upon the financial markets for 100% of its revenue, an investor can imagine the impact of the credit crisis of 2007 - 2009 and the ensuing market crash would have a powerful impact on the company’s operations and finances. It most certainly did. Revenue dropped from $1.37B in 2007 to $901M in 2010 - an extraordinary 34% drop. Free cash flow dropped from $282M to $177M in the same time - a 37% drop. For many companies a drop like this could cause management to hit the panic button. Such a huge decrease in free cash could put pressure on capital spending and debt servicing. Any hint of this - such the rumors swirling around Bear Stearns or Lehman Brothers could put the stock price into a death spiral. 
 
SEI stock did drop horrifically like the rest of the markets but in time recovered. Most importantly there was no rumors of insolvency or inability to meet its obligations. Why was that? Certain part of that was the company had zero debt. No short term and no long term debt. It had roughly $400M in cash on the balance sheet and the previously mentioned $177M in free cash flow. For a company in the hardest hit industry in one of the worst crisis in Wall Street history, the company’s fortress-like balance sheet held the walls against all issues. This was a castle we were happy to hold.     
 
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. Amazingly, companies with these attributes can be frequently found in the course of the markets’ daily trading. Generally monopolies and duopolies have intense competition as other companies’ leadership see the opportunity to get in on a profitable business segment. 
 
But many duopolies and monopolies are founded by legal or regulatory rulings that are difficult to break through. Others are created through the ability of a company or a couple of companies to capture such a significant market share there simply isn’t room for any new competitors. A classic case of a duopoly is Visa (V) and Mastercard (MA). The latter is a Nintai Investments portfolio holding. While there are other companies - such as Discover (DFS) or American Express (AXP) - that offer card services, these two behemoths have essentially split the market between themselves. 
 
What we look for the most at Nintai are companies with domination provided by legal means such as patents, regulatory approvals, etc. An example of this is iRadimed (IRMD) a Nintai investments portfolio holding. The company is the maker of non-magnetic MRI pumps and oximeters. This allows patients to have their IV pumps be brought directly into the MRI (magnetic resonance imaging) room without having to run long extension tubing outside vastly increasing the chances of a medical adverse event. This monopoly was created by FDA when IRMD received its FDA approval thereby winning a more-than-decade long prohibition of patent infringement. This type of monopoly will allow iRadimed to expand its markets, develop new products, and embed its in every ambulatory or hospital-based MRI imaging centers in the US. Now that’s what we like to own.   
 
The Share Price Doesn’t Reflect its Value: One vital piece remains in finding a quality company. I will discuss it in much greater detail in “Chapter 2: Defining Value”, but let me summarize by saying quality must be linked to value to make it a compelling investment opportunity. There have been many examples in Nintai’s research where we have found a stock with every possible quality measure – except this one. For instance, in 2020 we continued to look longingly as Factset Research (FDS) a former Nintai holding which we sold out of because of price appreciation. It hasn’t come down since we sold it. To the contrary, the price has continued to reach new highs, sometimes trading at nearly double our estimated intrinsic value. No matter how impressed we were with the financials, management’s focus on profitable growth, and its near duopoly with Bloomberg (privately-held), we simply couldn’t justify paying such a price for quality. 
 
This happens a lot. It is perhaps the hardest part of being a successful quality value investor. The desire is so strong to pull the trigger and become the proud owner of such a business. But there is perhaps no easier way to permanently impair your - or your investors’ hard earned investment dollars - than overpaying for a stock. Never forget that price and value change every day. It might be that you can purchase the stock next week, next month, or next year. Or you may never be able justify purchasing it. Either way, always keep the connection between quality and value.