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

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

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

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

                                                                            -        Warren Buffett  

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

“When you start looking at stock buybacks, you begin to realize you are playing a game of Three Card Monty. Nothing is really as it seems and the numbers never really add up. It truly is dealing with the cards stacked against you”.
                                                                            -       Robert G. Warren 

Several years ago I wrote about how many corporate executives buy back company stock at exactly the wrong time. They generally purchase as their share price hits an all-time high then cease all activity when the stock price crashes. I’ve always been cynical when corporate boards announce share buyback plans in the hundreds of millions (or even billions). After M&A activity, in general I can’t think of a worse use of capital.  
 
Buybacks: A Quick History
 
Traditionally stock buybacks were not held in very high regard. In 1932, The New York Times made three specific arguments against buybacks. First, they used up a corporation’s cash balance. Second, they were simply a cash transfer between the corporation and management/directors who were dumping their shares. Last, they focused management on the whims of the market (through stock price movement) and distracted them from the running of the business. The Securities and Exchange Committee made it more difficult in 1934 with the Securities and Exchange Act making stock buybacks (though not mentioned) a potential violation.  
 
The 1970’s provided middle ground by creating conflicting policy of either making buybacks flat out illegal to simply having a corporation disclose their intention to purchase their shares. The SEC never really came up with a good answer, flip flopping back and forth. Things took a big step in a different direction in 1982 with the SEC’s issuance of Rule 10b-18 which made it very difficult (if not impossible) to sue companies for stock buybacks. By removing mandatory disclosure requirements, companies received a green light to start buybacks with relative abandon.
 
Which brings us to today. The Trump tax cuts have brought buybacks into focus again. Indeed, buybacks - which have been increasing over the last decade - jumped about 50 percent last year to nearly $800 billion for the companies in the S&P 500. This is an all new high according to S&P Global. These data seem to contradict the claim that most of the tax cuts have gone towards reinvesting and growing company businesses. (Though to be fair some would argue share buybacks are a form of capital reinvestment). Since 2009 US companies have bought back roughly 80 billion shares, but total shares have increased from 289 billion in 2009 to 294 billion in 2019. It’s hard to argue that shareholders have been the winner in this binge of buying and lack of share reduction. 
​
In fact, much research has been published showing that buybacks add little, none, or even subtracts value from shareholder returns. One of the most interesting – which I encourage readers to download (sorry to say there is a license of $44USD) – is an excellent peer reviewed article[1] outlining that in many countries - whether investors use a dividend model or a total payout model to decompose equity returns - net buybacks explain more than 80% of the cross-sectional dispersion of stock market returns.
 
Another example of repurchases changing in their scope and value for corporations versus shareholders has been the explosion in repurchases. In a study by David
 
Ikenberry  Josef Lakonishok  Theo Vermaelen (“Stock Repurchases in Canada: Performance and Strategic Trading”), the authors state:
 
“In recent years, corporations have dramatically increased the amount of capital devoted to repurchasing their own shares. In the mid-1980s, repurchase program
announcements in the U.S. amounted to roughly $25 billion per year. Between 1996 and 1998 however, more than 4,000 open market repurchase programs were announced which, if fully completed, amount to roughly $550 billion. During the first quarter of 1999 alone, Securities Data Company reports nearly 350 program announcements totaling $40 billion. Interest in corporate repurchase programs is not limited to the U.S. as repurchase activity worldwide has grown in recent years. Countries such as Hong Kong and Japan recently implemented new regulations allowing companies for the first time to repurchase their shares. A recent Goldman Sachs study (March 1999) foresees stock repurchases becoming more common in Europe and discusses the potential impact on European equity values.”
 
Why This Matters
 
With this explosion in repurchases – yet no reduction in share counts – the obvious question is whether these actions have been a wise allocation of capital. If the answer is yes, then shareholders should whole heartedly encourage such behavior. If the answer is no, then shareholders – through their duly elected representatives on the company’s Board of Directors – should actively seek to stop these transactions.
 
Investors should look at share repurchases as no different than their value approach in their own investment process. If shares are bought at a discount to the company’s intrinsic value then this could be perceived as an appropriate allocation of capital. Repurchasing shares at prices higher than intrinsic value would be a poor use of capital.
 
Unfortunately, all evidence would suggest that companies go on repurchasing binges as share prices reach new highs and cease purchases as share prices reach new lows. The most recent example of this has been the example previously cited with new repurchase highs reached in 2019 as shares reached all time highs. Another example was the similar pattern in 2006 – 2009 as share repurchases reached all-time highs (for the time) in 2007 (the height of the mortgage asset bubble) only to see a near 75% drop in repurchases as the markets collapsed in 2008 – 2009 (see graph below). 
 
For any investor in a company that has followed this pattern of “buy high and stop buying when low”, they can safely assume management has a poor understanding of capital allocation. Any value investor should avoid companies run by such individuals.
 
Conclusions
 
The story of stock buybacks has been relatively consistent since the SEC’s policy change in the 1980s. The enormous number of buybacks – mostly purchased when stock prices are at all-time highs – have provided little to no advantage for the value investor. Only when enough shareholders speak up and force management – through Board oversight – to perceive stock buybacks as a means to improve shareholder returns will buybacks become sound capital allocation. As a value investor, I suggest readers find companies that have firm guidelines about buybacks which is tied directly to value versus intrinsic value. Partnering with such management gives an investor the best chance to see long term growth in their portfolio.


[1] “Net Buybacks and the Seven Dwarfs”, Jean-François L’Her , CFA, Tarek Masmoudi & Ram Karthik Krishnamoorthy , CFA, Financial Analysts Journal, December 12, 2018, pages 57 - 85