In this - part three - of a four-part series on fundamental business analysis, I will continue using SEI Investments (SEIC) as a case study taking readers through the three major components of a successful FBA. In this article, I will bring readers through the major steps in analyzing a company’s moat. This will include the major traits of the moat, how the company developed and implemented these components, and steps required to maintain or even broaden its existing moat.
 
It might be good to start by defining what the meaning is of a moat and its major components. I define a competitive moat as the capability of a company to outperform its competitors by achieving high returns on capital, increasing market share, and structural advantages in technology, operational efficiencies, etc. It achieves this moat with a business model that fosters these advantages over a period of 10 to 20 years. Morningstar lists five major sources of moats. These include:
 
Network Effect: Similar to Metcalfe’s law, the more people who use a network, the more powerful a network becomes. A great example of this Uber. The greater the amounts of drivers and riders, the more valuable the Uber network becomes.
Switching Costs: Once a company’s product becomes embedded in the business operations of customers, the harder it becomes to remove the product/system and replace with another. An example of this is electronic health records within the hospital setting. After training, development of order sets, and operational customization, switching to a new system becomes nearly impossible.
Intangible Assets: This can include patents or licenses. This assures customers must use the product or service that is legally or from a regulatory standpoint the only option. FDA approved drugs are a great example of this.
Pricing: Sometime the big guys can simply outprice the smaller guys. Just ask any local store that competes against Wal-Mart.    
 
Sources of SEI Investments’ Moat
 
The company has created its moat through two product lines - TRUST 3000® and the SEI Wealth PlatformSM (the SEI Wealth Platform or the Platform). SEI owns, develops, maintains and operates these software applications and associated information processing infrastructure and facilities. Through their wholly-owned subsidiaries, they also provide business-process outsourcing services including custodial and sub-custodial services and back-office accounting services. Through its fully-integrated suite of technology and services, SEI Investments creates a turn-key offering that can be used by almost any asset management firm including private banks, trust institutions, and mutual fund companies. SEI Investments is perceived as a market leader in its technology, platform integration, breadth of offerings, and return on investment on their product and services.
 
Creating a Barrier to Entry
 
A vital aspect of SEI Investments’ competitive moat is the sheer amount of labor, dollars, and competitive intelligence that has gone into creating both TRUST 3000 and PlatformSM. Over the past 10 years it’s estimated the company has spent over $500M in product and research development. SEI Investments has increased R&D spending from 7.7% of revenue in 2015 to 10.2% in 2017. The ability of a competitor to have access to both the financial and intellectual capital to recreate these two platforms would be an extraordinarily difficult task. Once these products are launched, they are scalable to new customers at nearly no cost to SEI Investments.  This creates a business model remarkably light in assets (other than the intellectual property and proprietary technology) and requires little capital to operate and create growth.
 
Inverting this issue, the ability of SEI Investments to operate such an asset light business allows the company to generate remarkable gross and net margins along with returns on capital. This creates excess cash thst can then be employed in expanding internal capabilities (such as increased R&D) or acquiring outside functionality or snap-on acquisitions. This virtual circle creates a deep and ever-widening moat in its competitive space.
 
Switching Costs and Customer Dependence          
 
SEI Investments’ products and services are deeply embedded in the business operations of their customers. The TRUST 3000 platform is essential for asset managers to successfully manage all their securities processing and investment accounting for both domestic and foreign securities – two of the most important functions in the business. SEI Wealth Platform provides investment processing, infrastructure services, and advanced capabilities to support wealth advisory, asset management, and wealth administration functions. The Platform also provides global wealth management capabilities including a 24/7 operating model, global securities processing, and multi-currency accounting and reporting. Built around a client-centric relationship model, Wealth Platform uses an open architectural approach and supports workflow management and straight-through processing. Both of these platforms are provided in either a Software-as-a-Service or Platform-as-a-Service model.
 
The functionality of these two offerings mean the decision to switch out to a new vendor is neither cost-effective nor knowledge-based effective. As long as SEI Investments can maintain both a quality and functional lead, its moat is substantial from a switching cost or operational integration standpoint. The company manages or administers $920 billion in hedge, private equity, mutual fund and pooled or separately managed assets, including $339 billion in assets under management and $576 billion in client assets under administration. Putting a dime of those assets at risk is not worth it to the 8,900 clients who use SEI Investments’ products and services.
 
Regulatory Requirements
 
Anybody who has worked in the asset management business knows that state and federal regulators earn their dollars in the extent and detail of their regulatory oversight. Between the SEC, FINRA, and pertinent state regulators you better have your ducks in a row. And that ‘s not even mentioning all the overseas regulators and potential violations that can be achieved in a blink of an eye by some office in Kobe when you’re not looking. That’s where SEI Investments digs its moat even a little deeper and a little wider.  
 
SEI Investment’s customers face an ever-changing regulatory environment. For instance, recent (and continuing) legislative activity in the United States and in other jurisdictions (including the European Union and the United Kingdom) have made and continue to make extensive changes to the laws regulating financial services firms. Recent changes include the effectiveness of the Markets in Financial Instruments Directive (MiFID II) and pending effectiveness of the General Data Protection Regulation in the European Union and the U.S. Department of Labor's Fiduciary Rule. Every one of SEI Investments’ 8.900 clients know that the company’s products and services have to reflect these changes every day. There aren’t any competitors with the intellectual knowledge base, skill sets, regulatory knowledge, and technical abilities to update their product and service offerings on such a regular basis.    
 
Conclusions
 
A solid fundamental business analysis will dig deep into understanding how and why a potential portfolio holding has a competitive advantage. The ability to tie in knowledge about competitors, product and service offerings, customer segmentation business needs, regulatory requirements, and the company’s financial strength to maintain and extend its moat is vital. Without this understanding, it’s difficult to predict how successful this potential investment might be in 10 to 20 years. Is the fundamental business analysis process a perfect predictor? Certainly not. Will it help you understand the potential ability of the company to create long-term value?  Sometimes. But one thing is certain. It is unlikely to hurt in developing your understanding of the company’s business case.  
 
In the last part of this series, I will finish with researching the capabilities of a company to both produce and manage long-term growth. Until then, I look forward to your thoughts and comments.
 
DISCLOSURE: I currently own SEI Investments in individual investment accounts at Nintai Investments LLC as well as the Hayashi Foundation.   
 

​My previous article talked about the role fundamental business analysis (FBA) plays in my style of value investing. I thought I’d use a holding in both the Nintai Investments LLC and Hayashi Foundation’s portfolio - SEI Investments (SEIC) - to focus on how I utilize such analysis to both reduce risk and assess growth potential for each portfolio holding. At the end of each calendar year, I will complete an assessment of each holding as if it is a potential investment I might be interested in purchasing. This fresh start - so to speak - forces me to think through each component with an unjaundiced eye (hopefully!). The next three articles will go into detail about the three major components of an FBA.

1. What Story Do the Financials Tell?
2. How Exactly was the Moat Built and Maintained?
3. What are Characteristics and Capabilities of Growth?

 
My next three articles will delve into each of these three questions utilizing SEI Investments as a business case and walking through each component.
 
Corporate Summary
SEI Investments is a global provider of investment processing, investment management, and investment operations solutions. This includes the back-end operations of any medium to large investment operation. The company provides a platform flexible enough for family offices to large asset manages in both operations (fund administration, regulatory, etc.) and processing (by utilizing a technology platform that services clients’ sales to performance reporting). Recently, the company has moved into the investment management business itself offering financial advice and even managing SEI funds.
 
What Story Do the Financials Tell?
 
As of Q4 2018, in general, the financials of SEI Investments describe a company with compelling financial strength, very high liquidity, no debt, steadily decreasing share count, and a management team with outstanding capital allocation skills. Diving somewhat deeper, the company has high gross (55.6%) and net margins (31.5%), significant free cash flow margins (30.0%), and high returns on invested capital (26.4%). The company has been free cash flow positive since 2003, generated 4.8% average annual revenue growth of the past ten years as well as 10.6% earnings per share growth and 7.8% free cash flow growth over the same time frame. As one would expect, the company’s revenue and profits slumped during the 2008-2010 Great Recession though never achieving negative free cash flow during any of those years. In the period 2008-2018 the company share price increased by a cumulative 223%.  The story describes a steadily growing company (with the exception of the Great Recession) while consistently increasing revenue, earnings, and free cash flow in the high single digits.  
 
Cash Flow Statement
When I look at the statement of cash flows, my top priority is looking at the overall strength of liquidity of the company. In short, what areas of distress could cause significant damage to my business case. Several modern formulas such as the H-Score and Z-Score can help test the company’s overall financial strength. At a high level, these scores tell the investor what areas of weakness exist in the financial model of the company. The next area of priority is seeing a steady rise in free cash flow over a decade or two. As mentioned, SEIC achieved 7.8% annual growth in free cash when even including numbers during the Great Recession. The third area of interest is the quality and clarity of the numbers themselves. For instance, is there detailed information on the relationship between free cash flow and earnings? Do the earnings growth numbers generally move in a proportional manner with free cash? Last is the cost of stock-based compensation. Every share given out to management dilutes you as a shareholder. I cringe every time I see numbers stock compensation in the millions and dilution by 1-2% annually. SEIC has reduced share count from 216.6M in 2003 to 160.5M in 2018. Clearly management has not utilized stock options to the detriment of shareholders.
 
When I’m completed with my evaluation of the cash flow statement, I should have a very solid understanding of how well the company manages its cash flows, whether management are compensated in a shareholder-friendly manner, and whether management is trying to fudge the earnings numbers that simply don’t map to cash flows. Dishonest managers will seek to fool shareholders. The cash flow statement will give away whether they are trying to fool themselves. Finally, I should feel a level of comfort that even the worst-case scenarios can be handled with both free cash generated from operations and the availability of debt financing if needed.     
 
Balance Sheet
The balance sheet is very different from either cash flow statements or income statements because they show the financial condition of the company at a particular moment in time rather than a set period (such as a quarter or year). Generally, this is year-end (either fiscal or calendar). The balance sheet ties into the cash flow statement in that it gives you another look at the liquidity of the company. You have both assets (what the company owns) and liabilities (what the company owes) listed on the balance sheet. The most critical aspect I look for is that the company has no (or almost no) debt. As I’ve said many times before, no company has gone bankrupt without any debt. The great news is that SEIC has no short or long-term debt. The second area of interest I look to evaluate is goodwill. Goodwill is the excess of purchase price over the fair market value of a company's identifiable assets. In plain English, how much did you overpay for assets that you acquired? Seeing numbers where goodwill makes up 25-30% of total assets can make me queasy pretty quick. Essentially that large amount of book value can evaporate over night if an auditor decides the asset has simply been inflated in price or has become impaired. The biggest loser when this happens? You – the shareholder. Currently, goodwill makes up 3.3% of SEI Investment’s total assets. That’s a great number to see as an investor.  
 
Income Statement
In the past 25-30 years, the income statement has become the most vital financial document for financial analysts. This is because it tells Wall Street whether the company will meet its expected quarterly earnings and whether future guidance will be in-line with analysts’ estimates. If you really want to play along with Wall Street’s earnings game, then this document is for you. For those more old-fashioned value investors, this document holds far less appeal. My first priority in this document is to make sure earnings growth/decreases generally match the free cash flow statement. The number of companies who manipulate earnings on a regular basis is truly shocking. Companies can do this in almost any conceivable manner. One is to report non-Generally Accepted Accounting Rules (GAAP) numbers such as claiming payroll really isn’t a cost. Others might claim revenues before payment is received. Another popular option is claim certain liabilities are “off-budget” and removed from the balance sheet. All sorts of techniques are used to manipulate earnings. Second, even with all these opportunities to cheat (for that is what it really is), it’s good to see earnings increasing steadily over time (sometimes this can be lumpy but that’s OK). Again, matching these numbers to free cash flow growth/decreases can make a big difference in your confidence of the numbers. SEIC grew earnings at roughly 10.6% annually from 2008-2018. The second area of interest are margins (gross, net, and free cash). These should show a steady pattern of solid performance if not slight improvement over time. Last – and most important – are the returns generated by the business: return on equity, return on assets, and return on invested capital. In general, these tell you whether management are adequate, good, or outstanding allocators of capital. In essence, are they are putting the company’s capital to work in a profitable manner that increases profits and grows the value of the business.   

Conclusions
 
As a value investor, understanding the financial reports of your portfolio holdings is essential to achieving long-term outperformance. Basic math skills and accounting are the language of business. If you can’t speak the language, you will be blind in areas of tremendous importance to assessing value and allocating capital. One doesn’t need to be a genius in algebra or advanced mathematics to succeed. I was a straight C and even D student in math right through college. But finding a mentor and several books that work through the issues and formulas I discussed here will be essential in your growth as a value investor.
 
In my next article, I will walk through how SEI Investments created, maintains, and hopefully increases its competitive moat going forward. Until then, I look forward to your thoughts and comments.
 
DISCLOSURE: I currently own SEI Investments in individual investment accounts at Nintai Investments LLC as well as the Hayashi Foundation.   
 

“Getting inside the guts of a business and understanding how it works really isn’t that interesting or sexy. I remember sitting on an assembly line and watching three people add a small piece of felt on to a rubber ducky. I must have spent three hours watching this process. The workers did these thousands of time each week. When I asked about it, management told me they had recently fired the entire team and hired outside temporary laborers to complete the work. We ended up not investing in the company but I did notice about 6 months later they were engaged in a huge product recall dispute because the felt pieces weren’t applied correctly and several children had choked on them. Now I didn’t KNOW this was going to happen, but in our deep dive research of the business, I’d seen dozens of areas where new management were cutting corners and I thought it was only a matter of time before something blew up. That’s why we conduct fundamental business analysis.”   
 
                                                                                                -      Wes Leason, Jr. 

Fundamental business analysis can either be the most exciting or most boring part of the investment process. As a former consultant, it is second nature for me to break down the major components of a company, create a business operations map, and then tie that to the broader markets, company financials, and direct competition. It’s a lot of work and I don’t know many other investors who complete a full business analysis. Some of this is due to the sheer number of stocks in the portfolio, others prefer to spend time focusing on ratios (price to earnings, price to book, price to sales) and some are focused on things like stock price momentum or macro-economic numbers.
 
Why Do It?
 
I’ve found that fundamental business analysis gives me a huge leg up on my competitors because it allows me to see my investment through the eyes of the business owner. I want to understand what the major drivers are of margins and free cash flow and what management can do to improve operations to maximize these. I’d like to understand what restrictions have been imposed on management’s capital allocation choices because of debt levels.  Essentially I want to understand the operations and key drivers of what makes this company successful and profitable. Equally – if not more important – I want to know what types of events would impact or impair my business case. Through fundamental business analysis, I look to get three key insights into the business.
 
What Story Do the Financials Tell?
 
As a value investor, I have a tendency to look at corporate financials a little bit differently than most. I start with the Statement of Cash Flows, move to the Balance Sheet, then finish with the Income Statement. I place very little emphasis on earnings. I’ve found over time they are the easiest numbers to manipulate. I try to stay focused on free cash. On the balance sheet I look for no short or long-term debt. I also look for high amounts of goodwill. Don’t get me wrong, some goodwill is valuable – like Coca Cola’s brand. Others, not so much. After purchasing aQuantive for $6.3B in July 2012, Microsoft was forced to take a $6.2B write off less than 6 months later. That type of unforced error drives me crazy. I like to see goodwill represent less than 5% of total market cap. Finally, I love to find companies where cash and cash equivalents can pay off all liabilities without even touching operating income. On the statement of cash flows I look for companies that convert roughly 25% of every dollar into free cash. 
 
In essence, the financials should show s company with strong competitive advantages achieved through high returns on capital, financial flexibility through no debt, and outstanding capital allocators in management. Inversely, the should tell you the areas of concern that might lead to real distress down the road.
 
How Exactly Was the Moat Built?
 
This question can only be answered by an extraordinary level of research where an investor really needs to roll up their sleeves and dig into the company, its markets, and its competition. Evaluating a moat is similar to 3-D chess. First, you must understand the dynamics of the moat (meaning its source: customer demand versus need, switching costs, brand strength, pricing power with vendors, etc.). Second, you must understand the market dynamics (key players and their relationships, product/service development, competitive players and their strategies, market niches, etc.). Last, you must be able to map out what you believe are the major trends and their outcomes for both your potential investment as well as the industry. This includes assigning a range of probabilities of these events happening. 
 
A great measure of how well you have succeeded in this endeavor is not only the level of comfort you have talking with management of your potential investment but also a wide range of players including vendors, competitors, and industry knowledge thought leaders. If you find yourself comfortable asking and answering questions to this range of players you’ve accomplished your goal. As an example, I remember the first time talking to a pharmaceutical company and they kept discussing ambulatory versus hospitalists. The fact I had to look it up meant I wasn’t nearly ready to invest.
 
What are the Characteristics and Capabilities of Growth?
 
Perhaps the greatest problem for management is the ability to handle growth. We’ve all seen those UPS or FEDEX commercials telling companies to “let us handle the growth in your shipping needs”. They run these ads for the simple reason it’s true. Most companies can’t handle growth, and growth is the only way you are going to achieve long-term outperformance in your investment portfolio.
 
In a McKinsey article[1], the authors point out some great reasons why companies hit a wall and can’t grow anymore. They range from growing market share until there are no additional opportunities, management becomes complacent as they’ve reached a level of performance that assures high profits and steady revenue for the company, or organic growth is no longer an option and they begin to look at M&A as an option (I’ve written about the generally horrible returns from M&A before so watch this carefully). A great example of dealing with these issues was a company I owned from 2000 – 2015, Fastenal (FAST). As a company that sold replacement parts it seemed the company has tapped out its market by saturating areas with distribution centers. The company came up with the idea of micro-centers provided through on-site vending machines. Customers can purchase the highest requested product right on site with no delivery wait time. Fastenal achieved another decade of growth through this strategy. Now if only I was smart enough to see that coming.    
 
Conclusions
 
Fundamental business analysis isn’t fun (unless you are odd like me) or sexy. The knowledge you gain from such research will pay you back in multiple ways going forward. Every time you begin the journey of learning about a potential investment and its industry, this knowledge builds on other companies and markets until you can weave that infamous “mental models” discussed by Charlie Munger. Understanding what happens in drug development can help you better understand the development of a software application. The more you learn the stronger the investor you will be. You can’t be unhappy about that.

DISCLOSURE: I do not own Fastenal in any of Nintai Investments LLC individual accounts or in the Hayashi Foundation portfolio. 
 

[1] “Why The Biggest and Best Struggle to Grow”, Nicholas F. Lawler, Robert S. McNish, and Jean-Hugues J. Monier, McKinsey, Commentary, January 2004   https://mck.co/2ChUvpw
 

Looking back over the year, I noticed the site passed over 150,000 viewers this year. First, I am deeply humbled that so many people would find my writing of interest. I try to write about things that both interest my readers as well as educate them. Over time, I've found one can't do one without the other. 

Having opened a new investment firm at the end of 2018, my responsibilities lie with all the effort that goes into growing a business - from doing the accounting to sweeping the floor. Ultimately, my true (and fiduciary responsibilities) lie with my investors. To them will go the vast majority of my time. Managing money is a full time job that bears enormous responsibility. I feel incredibly grateful that my job allows (and demands) that I cogently and effectively explain my thoughts and processes to both my investors and readers.

So thank you for taking the time reading my articles, giving sound and reasonable advice, and offering general support to keep writing. As any writer knows, those late night edits or writers' block are achieved and overcome by such support.  I wish everyone a happy, healthy, and prosperous New Year. 

​Tom

​The following is an update on the 2018 performance of individual accounts I run along with the returns of the Hayashi Foundation – a not-for-profit fund based in Japan of which I am currently Chief Investment Officer.
 
Getting these numbers to accurately reflect returns has been quite an adventure. As many of you know, I left Dorfman Value Investments and opened my own investment firm -  Nintai Investments LLC - on October 1 2018. The numbers in this report reflect a composite of fees from both Dorfman Value Investments and Nintai Investments LLC. The Hayashi Foundation charges a set 0.25% management frees and calculations were made on the yen/dollar conversion as of December 31 2018.
 
While I was pleased with the both the individual portfolio’s and Hayashi Trust’s relative performance for the year (beating the S&P 500 by roughly 5.5% for 2018), absolute returns were disappointing across the board. Even with cash at nearly 25% of total AUM for the most of the quarter (and year), the composite portfolio lost -14.1% in the 4th quarter. This is extremely disappointing. 2018 4th quarter’s underperformance was caused by a widespread drop in multiple portfolio holdings. I deliberately invest in companies with pristine balance sheets, deep economic moats, and growing free cash flow to offset losses to the downside. With double-digit drops in 17 of the 21 portfolio holdings during Q4, I added to positions aggressively over the second half of 2018. 
 
For the year, the Nintai Investment’s (and previous DVI) portfolios plus Hayashi Foundation outperformed the S&P500 1.71% (net of fees) to -4.38%.  Last year, my significant cash position was a drag on returns. In 2018, the case was altered. Here are the Nintai Investment and Hayashi Trust account returns for periods ended December 31, 2018. 

Please note the returns reflect a 1.5% management fee through October 31 2018 (utilizing Dorfman Value charges) and a 0.75% management fee for November 1 2018 – December 31 2018 (utilizing Nintai Investments management fee charges). The Hayashi Trust charges a 0.25% management fee.
 
There weren’t many areas to hide from the losses in 2018. The only two major sectors to show positive returns were utilities (+0.5%) and healthcare (+4.7%). Others showed medium losses such as consumer discretionary (-0.5%), information technology (-1.6%) and real estate (-5.6%). Others showed substantial losses including consumer staples (-11.2%), financials (-14.7%), industrials (-15.0%), communication services (-16.4%), materials (-16.4%), and energy (-20.5%)
 
2018 was the year the bull market ended in a series of spectacular drops and rises rarely seen in the past decade. The Trump Administration’s announcements to impose tariffs on China, negotiations on a new NAFTA treaty, criticism of the Federal Reserve Board on its rate policy all added to a profound sense of uncertainty in both the economy and the markets. At Nintai Investments LLC and the Hayashi Trust, for most of the year I found the risk/reward of market highs combined with these aforementioned macroeconomic issues quite poor for value investing. Our large cash position allowed me the opportunity to take advantage of mispricing late in the 4th quarter of 2018.    
 
Last year I discussed with my investors my role as an allocator of capital seeking to maximize returns while simultaneously minimizing risk. As a value investor, the opportune moment of low risk and achieving potentially high long-term returns is a rare moment in time. Mispriced value – combined with the high quality I look for in portfolio holdings – might come along every 6-8 years. I’ve written previously these opportunities at mispriced value can happen in one of two ways (or both). First, the markets suffer a collapse of confidence and the general indices head towards (or enter) bear market territory. The second is when a great company misses Wall Street’s expectations and the stock price drops below my estimated intrinsic value. The latter part of 2018 has seen both of these. As I write at year end, many major indices are close – or already in – bear market territory.
 
Additionally, 12 of the 26 holdings in the individual portfolios and Hayashi Trust dropped at least 10% since purchase. In nearly every case, I added substantially to my existing position.
 
The Losers
 
Going hand in hand with holding cash during a downturn, the ability to not permanently impair capital is the second-best way to assure adequate long-term returns. Each of the companies listed as losers this year saw me double or triple my positions over the course of the year. I am confident that none of these companies will come remotely close to creating a permanent loss to my investments.  
 
Loser: Computer Modelling Group (CMDXF)
 
Computer Modelling Group is a Canadian software company that specializes in integrated analysis and optimization, black oil and unconventional simulation, reservoir and production system modelling for the petroleum industry.
 
The decision to purchase CMDXF has been proven to be a net negative in nearly every possible way. Oil prices continue to drop, licensing fees continue to drop, and revenue continues to slightly contract. The upside? Free cash flow grew slightly in 2018 and the company continues its generous dividend policy with a C$0.10 dividend creating a yield of 6.90%. That said, we have been steadily adding to the CMDXF portfolio with 5 additional purchases in Q42018.
 
I continue to be impressed with Computer Modelling Group’s management and am impressed with the Board’s decision to hire Ryan Schneider, formally COO, as the new CEO. I believe Ryan understands the necessary steps required to get CMDXF back onto a growth trajectory.  Oil reserves are increasingly in areas where extraction costs are nearly cost prohibitive. The ability to calculate potential reserves without drilling will become increasingly important. Computer Modelling Group’s platform and strength of their IP leads me to be confident demand will remain strong over the next decade.
 
Loser: Cognex (CGNX)
 
Cognex (CGNX) provides machine vision products that help automate manufacturing processes. The firm’s products include vision software, vision systems, vision sensors, and ID products. Vision sensors deliver simple, low-cost solutions for common vision applications, such as checking the size of parts. ID products read codes that have been applied to items during the manufacturing process. Cognex generates the largest proportion of its sales in the United States and Europe. Cognex is a gem of a business. In July 2015, CGNX completed the sale of its Surface Inspection Systems Division (SISD) to AMETEK for $156 million in cash. With the sale, Cognex is focusing their efforts on discrete manufacturing where they see the greatest growth potential (11-13%) in discrete vs. slower growth (5-7%) in surface inspection.
 
Cognex has an outstanding balance sheet and set of financials. It has no short or long-term debt, $405M in cash on the balance sheet, and generates $196M in free cash flow. The company’s 86.9% return on capital far outweighs its 14.04% WACC. Cognex converts 26% of revenue into free cash and generates mid-teens ROE. The stock trades at an 19% discount to my estimated intrinsic value and yields 0.48%.
 
Sine my initial purchase, I’ve made 3 additional purchases, and with its value as it is wil likely be buying more.
 
Loser: Biosyent (BIOYF)
 
Biosyent is a specialty pharmaceutical company focused on in-licensing or acquiring innovative pharmaceutical and healthcare products. The company markets these pharmaceutical products in Canada and in other international markets. Biosyent seeks out products that have underperformed (through lack of marketing dollars, lack of product fit, etc.) and in-license them to fully support an integrated sales and promotional strategy.
 
I wrote about Biosyent’s strategy in much greater detail in an article entitled, “Valeant and Biosyent: Opposites Don’t Attract”. In it, I discussed the difference between Valeant’s strategy of purchasing drugs with dubious track records, assuming huge amounts of debt, and raising drug prices by up to 4,000%. Compare this to Biosyent’s strategy of purchasing quality drugs that simply don’t have the marketing budget to get promoted or acquiring molecules in late stage development and you have two very different companies.  
 
Biosyent has a strong balance sheet. It has no short or long-term debt, $17.3M in cash on the balance sheet, and generates $4.7M in free cash flow. The company’s 58% return on capital far outweighs its 6.4% WACC. Biosyent converts 28% of revenue into free cash and generates mid-30s ROE. The stock trades at an 15% discount to my estimated intrinsic value. As the stock price has dropped, we added significantly to our position with purchases in October and November 2018.
 
The Winners
 
Winner: Cash
For most of the year cash looked like it was going to be a drag on returns as it had been since 2011. The last three months of 2018 it completely redeemed itself. I’ve often mentioned that real value investors make their names in market downturns, not bull runs. This adage has served me well in the past and will likely continue into the future. At its peak, cash represented roughly 42% of my total portfolios.
 
Winner: iRadimed (IRMD)
iRadimed was up roughly 61% for the year. iRadimed engages in developing, manufacturing, marketing, and distributing magnetic resonance imaging (MRI) compatible products such as IV pumps and other electronic equipment.
 
iRadimed is one of those stocks that you purchase and then it immediately drops by 30%. At times like this, it is essential you know the business inside and out. If the business case is broken, you are faced with a difficult choice. If the business case remains valid, then it is time to make additional – and significant additions - to the position. In IRMD’s case, the latter represented the case and I took the opportunity over the next 6 months to nearly triple the size of the original purchase. The 35% run up during the latter part of 2017 and then 61% in 2018 was driven by excellent management execution, strategic capital allocation, and FDA approvals that brought the stock to record highs.
 
Winner: Novo Nordisk (NVO)
Novo Nordisk is a Danish healthcare company. It is engaged in the discovery, development, manufacturing and marketing of pharmaceutical products. The company’s business segments include, diabetes and obesity care, and biopharmaceuticals. As a pioneer in diabetes care, Novo Nordisk has been developing diabetes care products since early 20th century. It currently garners slight over one-quarter of the $45 billion branded diabetes treatment market. The next two decades will see enormous growth in the diabetes market. As obesity and age take their toll, the diagnosis and treatment of the disease with markedly increase until 2037.
 
As a leader in modern insulin analogs, NVO leads in long-term (Levemir) and short-term (Novolog) as well as oral-to-injection transition (Victoza). The company just a significant boost in clinical trial data showing its ultra-long insulin is more effective, has greater dosing variables, and less risk of hypoglycemia. All of these led to solid 2018 gains.
 
 
Conclusions
 
2018 was one of the more interesting years I’ve had in my investing career. The end of a bull run is never a pretty picture unless you have loads of cash you are looking to put to work and can find those price to valuation disconnects that get every value investor’s heat pumping. I’m proud of the work of the many researchers who helped me identify, rep art, and make assessments on companies barely in my circle of competence. I am grateful for clients who have had the confidence that their investment manager needs the freedom to wait for the right moment. But I am most grateful for friends, family, and co-workers who helped me through the course of the year as I dealt with professional changes and medical treatments that saved my life. I wish everyone a happy and prosperous New Year.