“You have got to somehow recognize a good business before it’s recognizable as a good business.”[1]
- Charlie Munger
“The profound point is that the critical link between growth and value creation is the return on incremental capital. Since share prices tend to follow earnings over the long term, the more capital that can be deployed at high rates of return to drive greater earnings growth, the more valuable a company becomes. Warren Buffett summarized the point best: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” The best investments, in other words, combine strong growth with high returns on capital.”[2]
- Lawrence Cunningham
Over the past year or two, we have been asked quite a bit about how we make our stock selections at Nintai Investments. Before I delve into that, distinguishing between finding the right investment and purchasing the right one would be best. Finding a great investment is about identifying the characteristics of a company that you believe will generate better than average value in the long term. Note I mention nothing about price here. It is simply finding a company that meets your investment criteria – nothing more. The second piece of the process is assuring potential qualified investments meet the price-to-value requirements measured by its margin of safety. If a company meets both requirements, we will put significant capital to work since not many meet both.
The quote at the beginning of this article by Charlie Munger sums up the plight succinctly (as usual). Finding a long-term compounding machine at a sufficient discount to your estimated intrinsic value usually means one of two things - you’ve either discovered a hidden gem unrecognized by the general markets, or you’ve found a gem that has already been discovered but discarded by the general markets. This might be due to a poor earnings report or a series of poor decisions by management. In either of these cases, you feel the problems can be solved, and the company’s value has not been permanently impaired.
In today’s article, I will address the first of the two pieces - locating a company that meets our criteria for being a portfolio holding. In next month’s article, I will discuss the fine art of finding the right price to invest in such a company.
Over the years, I’ve discussed some of the specific ratios or numbers-based criteria we look for in an investment. These include high returns on equity, assets, and capital. It also includes high free cash flow margins, little or no debt, and deep competitive moats. Rather than going through these in detail again (I can almost hear the eyes rolling across the internet), I wanted to step back and discuss the conditions that make those numbers possible in much greater detail. For instance, for a company to achieve high returns on invested capital, several things must happen. First, management must be great capital allocators, understanding what drives the highest capital returns and focusing on steps that achieve those conditions. Generally, excellent returns on capital don’t just happen; they are made. In this article, I want to describe what we look for in portfolio holdings that create such numbers.
What We Look for in a Portfolio Holding
Before I start, I wanted to say a few quick words on quality and what that means to Nintai Investments. Within the three major domestic (meaning US-based) stock exchanges (The New Your Stock Exchange, the NASDAQ, and the Over-The-Counter (OTC), roughly 10,000 stocks are being traded. According to Investopedia, at the end of 2023, approximately 55,200 companies were being traded globally. That’s a lot of companies to follow! At Nintai, we generally only follow US, European, UK, and Japanese stocks. This decreases the number by over half, but it’s still a lot. Using our primary screen on Gurufocus.com, which has 12 criteria[3], our complete researchable yield is only 385 companies. That’s a lot more manageable! Of these, roughly 185 are in the United States, and 200 are in the UK, Europe, or Japan.
As we begin to take a look at the remaining companies on our list, there are five major items we look to investigate in each case. These five are:
The five questions and their respective research can help provide specific data that gives us confidence in the company’s potential as a long-term portfolio holding. For instance, to better understand management’s track record in capital allocation (history of acquisitions, organic growth record, etc.), we can better understand the background of the company’s return on invested capital or return on equity ratios.
The Major Areas of Research
Once we have identified a company that broadly meets our investment qualities, we begin the research of the five questions previously listed. Here’s the type of information we are seeking and what we look to find through this research.
Circle of Competence
At Nintai, we have a small circle of competence. In general, we invest in three major areas. First is healthcare and healthcare informatics. These include biotechnology firms, informatics (using data to drive business strategy and operations), and healthcare technology platforms (platforms that capture data across functional areas of a healthcare company). Examples of these include Veeva (VEEV) and Simulations Plus (SLP). Veeva is the global leading supplier of cloud-based software solutions for the life sciences industry. Its two main products are Veeva CRM, a customer relationship management platform for companies with a salesforce, and Veeva Vault, a content management platform that tackles various functions within any life sciences company. The company provides a platform that cuts across nearly every primary function in a life sciences or biotechnology company. Simulations Plus develops and produces software for pharmaceutical research and education and provides consulting and contract research services to the pharmaceutical industry. The company is a leader in utilizing data and advanced research models to increase the speed of drug discovery.
The second major circle of competence is technology platform providers. These companies create fully integrated systems that allow organizations to better use data and informatics from across the organizations. This can increase product speed to market, achieve cost savings, or obtain strategic insights to grow the business. An example of this includes SEI Investments (SEIC). SEI Investments 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. By providing a fully integrated platform, SEI allows investment managers to better market and cross-sell their products and services, meet regulatory requirements, and manage diverse financial accounts.
The last are companies that have built wide-moat businesses in selective niche markets. Examples include Expeditors International (EXPD) and MarketAxess (MKTX). Expeditors International is a non-asset-based third-party logistics provider focused on international freight forwarding. It offers freight consolidation and forwarding, customs brokerage, warehousing and distribution, purchase order management, vendor consolidation, and numerous other value-added logistics services. It employs sophisticated IT systems and contracts with airlines and ocean carriers to move customers' freight globally. MarketAxess is a leading electronic fixed-income trading platform that connects broker/dealers and institutional investors. The company primarily focuses on credit-based fixed-income securities, with its main trading products being U.S. investment-grade and high-yield bonds, Eurobonds, and Emerging Market corporate debt. Both of these companies have built a wide-moat company providing a particular offering that is very difficult to replicate. In addition, they overlap with our circle of competence within platform companies.
Capital Allocation
One of the most essential skills for a senior manager is the ability to allocate capital successfully. To work successfully for their shareholders, management faces three significant options – return capital excess capital to shareholders through dividends or stock buybacks, allocate capital to internal/organic growth opportunities, or utilize capital for acquisitions. The ability to decide the best use of the company’s capital essentially decides whether their stewardship will be successful over the long term. The first decision is to decide whether there is any opportunity to utilize capital for internal or external growth opportunities. Share buybacks or a dividend announcement might be the best action if not. Why are there no such opportunities? Has the business reached a dead end of sorts in its growth? If so, why? At Nintai, we look for long-term value compounders. If the company pays out a special dividend because there is little opportunity to allocate capital to the business, we will likely pass. The next thing to look at is management’s track record at acquisitions. The data suggest that most acquisitions are capital destroyers, not capital compounders. The exception is minor “tuck-in” deals that might help solidify a company’s moat or add a new product offering that customers have frequently sought. But for most managers with a history of capital allocation centered on acquisitions, we generally see empire builders seeking personal aggrandizement, not shareholder value creation. Good capital allocators will find uses of capital that achieve high returns. And frankly, there aren’t many of those out there.
Growth Opportunities
Management capital allocation skills generally go hand-in-hand with growth opportunities available to the company. We see companies having three primary ways to grow - expanding the business within its current customer base, capturing increased market share in its current space, or building out its base in adjacent markets with similar characteristics to its existing market. As we pointed out in the previous section, jumping into entirely new markets is usually achieved by acquisitions, which are extremely difficult to pull off successfully. We see the best opportunities as a mix of all three, maximizing capital returns, not reinventing the wheel, and sticking to their core knitting. Nintai holding Guidewire Software (GWRE) is an excellent example of this. The company focuses on converting the P&C (Property & Casualty) Insurance sector into the digital age. The company started by literally converting paper-based models into a digitized format. They are now expanding that into a SaaS (software-as-a-service) model by moving the product (and customers) into the “cloud.” The company looks to dominate the P&C space and gradually move into adjacent insurance spaces, leveraging its core product and experience without recreating the wheel. This has provided the company with a long runway of high-return growth while smartly focusing on wise capital allocation.
Depth of Customer Integration
Our type of dream company has created a series of products and services that rely on a platform fully integrated into its customers’ operations. By getting embedded into the core operations of a business, it becomes tough to replace the company after installation, training, and efficiency costs are considered. In creating such a business, we believe the holding has a very deep moat that can provide highly profitable growth over a long period. An example of this is iRadimed (IRMD). iRadimed develops, manufactures, and sells a Magnetic Resonance Imaging (MRI) compatible intravenous (IV) infusion pump system and MRI-compatible patient vital signs monitoring system. They also sell accessories and services relating to them. The company has a monopoly on providing a non-magnetic IV infusion pump system designed to be safe for use during MRI procedures. Once iRadimed’s products are installed in a hospital or acute care facility, it is nearly impossible to have them replaced, and they become an integral part of the organization’s imaging capital budget.
A Run of Success
At Nintai, we frequently joke (half joke?) that we like to find great companies led by extraordinary leaders, purchase them at the right price, and then sit back and let the managers do the heavy lifting. We firmly believe that Charlie Munger was right when he said the only natural way of getting rich was getting rich slowly. Unless you were smart enough (or lucky enough) to pick the Powerball numbers or purchase a Reubens at a yard sale, then you are a person who needs to let compounding do its magic patiently. That’s why we look for companies to invest in that have a long(ish) story of success with steady management changes, increasing free cash flow year after year, and a long runway of potential growth (see “Growth Opportunities”). We think quality small and mid-cap stocks are the best candidates for this type of compounding value. The secret to bringing this full circle is what Charlie Munger said at the beginning of this article – “You have got to somehow recognize a good business before it’s recognizable as a good business.” It isn’t just our smaller holdings that generate outstanding returns. We acquired shares in Novo Nordisk (NVO) over five years ago, and we think the company can run for another decade, though its share price has tripled since we purchased it.
Conclusions
Having a set criteria to identify the kind of company in your portfolio is the first step in building a quality portfolio built for compounding value. The second part, which we will go into in detail next month, is figuring out the best way to calculate its value and how much margin of safety is required to purchase it. Following the process discussed in today’s article doesn’t guarantee future returns. Nothing can do that. However, building a quality-based portfolio of highly profitable companies run by intelligent managers with deep moats can improve the odds of avoiding occasional blowouts.
As usual, I look forward to your thoughts and comments.
DISCLOSURE: Nintai Investments and my personal portfolio have holdings in the following companies discussed in this article: Veeva (VEEV), Simulations Plus (SLP), SEI Investments (SEIC), Expeditors International of Washington (EXPD), MarketAxess (MKTX), Guidewire Software (GWRE), iRadimed (IRMD), and Novo Nordisk (NVO)
[1] Daily Journal Corporation Annual Shareholders Meeting, February 15th, 2023
[2] “Quality Investing: Owning the Best Companies for the Long Term,” Lawrence A. Cunningham, Harriman House, January 2016
[3] Most of these are what I’ve discussed previously, such as return on equity 10-year average > 15%, short and long-term debt = $0, etc.
- Charlie Munger
“The profound point is that the critical link between growth and value creation is the return on incremental capital. Since share prices tend to follow earnings over the long term, the more capital that can be deployed at high rates of return to drive greater earnings growth, the more valuable a company becomes. Warren Buffett summarized the point best: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” The best investments, in other words, combine strong growth with high returns on capital.”[2]
- Lawrence Cunningham
Over the past year or two, we have been asked quite a bit about how we make our stock selections at Nintai Investments. Before I delve into that, distinguishing between finding the right investment and purchasing the right one would be best. Finding a great investment is about identifying the characteristics of a company that you believe will generate better than average value in the long term. Note I mention nothing about price here. It is simply finding a company that meets your investment criteria – nothing more. The second piece of the process is assuring potential qualified investments meet the price-to-value requirements measured by its margin of safety. If a company meets both requirements, we will put significant capital to work since not many meet both.
The quote at the beginning of this article by Charlie Munger sums up the plight succinctly (as usual). Finding a long-term compounding machine at a sufficient discount to your estimated intrinsic value usually means one of two things - you’ve either discovered a hidden gem unrecognized by the general markets, or you’ve found a gem that has already been discovered but discarded by the general markets. This might be due to a poor earnings report or a series of poor decisions by management. In either of these cases, you feel the problems can be solved, and the company’s value has not been permanently impaired.
In today’s article, I will address the first of the two pieces - locating a company that meets our criteria for being a portfolio holding. In next month’s article, I will discuss the fine art of finding the right price to invest in such a company.
Over the years, I’ve discussed some of the specific ratios or numbers-based criteria we look for in an investment. These include high returns on equity, assets, and capital. It also includes high free cash flow margins, little or no debt, and deep competitive moats. Rather than going through these in detail again (I can almost hear the eyes rolling across the internet), I wanted to step back and discuss the conditions that make those numbers possible in much greater detail. For instance, for a company to achieve high returns on invested capital, several things must happen. First, management must be great capital allocators, understanding what drives the highest capital returns and focusing on steps that achieve those conditions. Generally, excellent returns on capital don’t just happen; they are made. In this article, I want to describe what we look for in portfolio holdings that create such numbers.
What We Look for in a Portfolio Holding
Before I start, I wanted to say a few quick words on quality and what that means to Nintai Investments. Within the three major domestic (meaning US-based) stock exchanges (The New Your Stock Exchange, the NASDAQ, and the Over-The-Counter (OTC), roughly 10,000 stocks are being traded. According to Investopedia, at the end of 2023, approximately 55,200 companies were being traded globally. That’s a lot of companies to follow! At Nintai, we generally only follow US, European, UK, and Japanese stocks. This decreases the number by over half, but it’s still a lot. Using our primary screen on Gurufocus.com, which has 12 criteria[3], our complete researchable yield is only 385 companies. That’s a lot more manageable! Of these, roughly 185 are in the United States, and 200 are in the UK, Europe, or Japan.
As we begin to take a look at the remaining companies on our list, there are five major items we look to investigate in each case. These five are:
- Does the company operate in Nintai’s circle of competence?
- Does management show skill in capital allocation?
- How sizable are the opportunities for growth within their current customers, markets, and adjacent markets?
- How deeply embedded is the company with its customers’ operations?
- Does the company have a history of long-term success?
The five questions and their respective research can help provide specific data that gives us confidence in the company’s potential as a long-term portfolio holding. For instance, to better understand management’s track record in capital allocation (history of acquisitions, organic growth record, etc.), we can better understand the background of the company’s return on invested capital or return on equity ratios.
The Major Areas of Research
Once we have identified a company that broadly meets our investment qualities, we begin the research of the five questions previously listed. Here’s the type of information we are seeking and what we look to find through this research.
Circle of Competence
At Nintai, we have a small circle of competence. In general, we invest in three major areas. First is healthcare and healthcare informatics. These include biotechnology firms, informatics (using data to drive business strategy and operations), and healthcare technology platforms (platforms that capture data across functional areas of a healthcare company). Examples of these include Veeva (VEEV) and Simulations Plus (SLP). Veeva is the global leading supplier of cloud-based software solutions for the life sciences industry. Its two main products are Veeva CRM, a customer relationship management platform for companies with a salesforce, and Veeva Vault, a content management platform that tackles various functions within any life sciences company. The company provides a platform that cuts across nearly every primary function in a life sciences or biotechnology company. Simulations Plus develops and produces software for pharmaceutical research and education and provides consulting and contract research services to the pharmaceutical industry. The company is a leader in utilizing data and advanced research models to increase the speed of drug discovery.
The second major circle of competence is technology platform providers. These companies create fully integrated systems that allow organizations to better use data and informatics from across the organizations. This can increase product speed to market, achieve cost savings, or obtain strategic insights to grow the business. An example of this includes SEI Investments (SEIC). SEI Investments 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. By providing a fully integrated platform, SEI allows investment managers to better market and cross-sell their products and services, meet regulatory requirements, and manage diverse financial accounts.
The last are companies that have built wide-moat businesses in selective niche markets. Examples include Expeditors International (EXPD) and MarketAxess (MKTX). Expeditors International is a non-asset-based third-party logistics provider focused on international freight forwarding. It offers freight consolidation and forwarding, customs brokerage, warehousing and distribution, purchase order management, vendor consolidation, and numerous other value-added logistics services. It employs sophisticated IT systems and contracts with airlines and ocean carriers to move customers' freight globally. MarketAxess is a leading electronic fixed-income trading platform that connects broker/dealers and institutional investors. The company primarily focuses on credit-based fixed-income securities, with its main trading products being U.S. investment-grade and high-yield bonds, Eurobonds, and Emerging Market corporate debt. Both of these companies have built a wide-moat company providing a particular offering that is very difficult to replicate. In addition, they overlap with our circle of competence within platform companies.
Capital Allocation
One of the most essential skills for a senior manager is the ability to allocate capital successfully. To work successfully for their shareholders, management faces three significant options – return capital excess capital to shareholders through dividends or stock buybacks, allocate capital to internal/organic growth opportunities, or utilize capital for acquisitions. The ability to decide the best use of the company’s capital essentially decides whether their stewardship will be successful over the long term. The first decision is to decide whether there is any opportunity to utilize capital for internal or external growth opportunities. Share buybacks or a dividend announcement might be the best action if not. Why are there no such opportunities? Has the business reached a dead end of sorts in its growth? If so, why? At Nintai, we look for long-term value compounders. If the company pays out a special dividend because there is little opportunity to allocate capital to the business, we will likely pass. The next thing to look at is management’s track record at acquisitions. The data suggest that most acquisitions are capital destroyers, not capital compounders. The exception is minor “tuck-in” deals that might help solidify a company’s moat or add a new product offering that customers have frequently sought. But for most managers with a history of capital allocation centered on acquisitions, we generally see empire builders seeking personal aggrandizement, not shareholder value creation. Good capital allocators will find uses of capital that achieve high returns. And frankly, there aren’t many of those out there.
Growth Opportunities
Management capital allocation skills generally go hand-in-hand with growth opportunities available to the company. We see companies having three primary ways to grow - expanding the business within its current customer base, capturing increased market share in its current space, or building out its base in adjacent markets with similar characteristics to its existing market. As we pointed out in the previous section, jumping into entirely new markets is usually achieved by acquisitions, which are extremely difficult to pull off successfully. We see the best opportunities as a mix of all three, maximizing capital returns, not reinventing the wheel, and sticking to their core knitting. Nintai holding Guidewire Software (GWRE) is an excellent example of this. The company focuses on converting the P&C (Property & Casualty) Insurance sector into the digital age. The company started by literally converting paper-based models into a digitized format. They are now expanding that into a SaaS (software-as-a-service) model by moving the product (and customers) into the “cloud.” The company looks to dominate the P&C space and gradually move into adjacent insurance spaces, leveraging its core product and experience without recreating the wheel. This has provided the company with a long runway of high-return growth while smartly focusing on wise capital allocation.
Depth of Customer Integration
Our type of dream company has created a series of products and services that rely on a platform fully integrated into its customers’ operations. By getting embedded into the core operations of a business, it becomes tough to replace the company after installation, training, and efficiency costs are considered. In creating such a business, we believe the holding has a very deep moat that can provide highly profitable growth over a long period. An example of this is iRadimed (IRMD). iRadimed develops, manufactures, and sells a Magnetic Resonance Imaging (MRI) compatible intravenous (IV) infusion pump system and MRI-compatible patient vital signs monitoring system. They also sell accessories and services relating to them. The company has a monopoly on providing a non-magnetic IV infusion pump system designed to be safe for use during MRI procedures. Once iRadimed’s products are installed in a hospital or acute care facility, it is nearly impossible to have them replaced, and they become an integral part of the organization’s imaging capital budget.
A Run of Success
At Nintai, we frequently joke (half joke?) that we like to find great companies led by extraordinary leaders, purchase them at the right price, and then sit back and let the managers do the heavy lifting. We firmly believe that Charlie Munger was right when he said the only natural way of getting rich was getting rich slowly. Unless you were smart enough (or lucky enough) to pick the Powerball numbers or purchase a Reubens at a yard sale, then you are a person who needs to let compounding do its magic patiently. That’s why we look for companies to invest in that have a long(ish) story of success with steady management changes, increasing free cash flow year after year, and a long runway of potential growth (see “Growth Opportunities”). We think quality small and mid-cap stocks are the best candidates for this type of compounding value. The secret to bringing this full circle is what Charlie Munger said at the beginning of this article – “You have got to somehow recognize a good business before it’s recognizable as a good business.” It isn’t just our smaller holdings that generate outstanding returns. We acquired shares in Novo Nordisk (NVO) over five years ago, and we think the company can run for another decade, though its share price has tripled since we purchased it.
Conclusions
Having a set criteria to identify the kind of company in your portfolio is the first step in building a quality portfolio built for compounding value. The second part, which we will go into in detail next month, is figuring out the best way to calculate its value and how much margin of safety is required to purchase it. Following the process discussed in today’s article doesn’t guarantee future returns. Nothing can do that. However, building a quality-based portfolio of highly profitable companies run by intelligent managers with deep moats can improve the odds of avoiding occasional blowouts.
As usual, I look forward to your thoughts and comments.
DISCLOSURE: Nintai Investments and my personal portfolio have holdings in the following companies discussed in this article: Veeva (VEEV), Simulations Plus (SLP), SEI Investments (SEIC), Expeditors International of Washington (EXPD), MarketAxess (MKTX), Guidewire Software (GWRE), iRadimed (IRMD), and Novo Nordisk (NVO)
[1] Daily Journal Corporation Annual Shareholders Meeting, February 15th, 2023
[2] “Quality Investing: Owning the Best Companies for the Long Term,” Lawrence A. Cunningham, Harriman House, January 2016
[3] Most of these are what I’ve discussed previously, such as return on equity 10-year average > 15%, short and long-term debt = $0, etc.
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