Samuel Untermeyer: "Is not commercial credit based primarily upon money or property?"
J.P. Morgan: "No, sir; the first thing is character."
Untermeyer: "Before money or property?"
J.P. Morgan: "Before money or anything else. Money cannot buy it.”
 
From J.P. Morgan’s testimony before the House Committee on Banking and Currency in December 1912[1]. 
 
“It is not so much that too many of our principals, our business leaders, seen less ethical, it is that our principles seem less ethical, somehow diluted. There seem to be far fewer absolute standards in the conduct of our affairs - the things that one just doesn’t do. Rather, we rely too heavily on relative standards - “Everyone else is doing it, so I can do it, too” - a concept that would have appalled the Reverends Makemie, Edwards, and Witherspoon, as well as our founding fathers.”[2]
 
                                                                                      -       John C. Bogle 

As an investment manager I spend an inordinate mount of time reading annual and quarterly reports that tell me quite about the operations of the company, its financial strength, risks, etc. While I can glean some information about management in the way they write, there really isn’t a great process to get a better understanding of the managers themselves. If the first thing is character – as J.P. Morgan believed – then how do you go about understanding a company’s leadership character?
 
What is Management Character?
 
It really doesn’t matter how large margins have expanded, or revenue grown, or costs cut if management lacks character. Without it, management can make decisions adverse to shareholders, enrich themselves from company coffers, be unable to see facts clearly, and develop strategies on completely flawed premises.  When I look for character in management, four major themes guide my evaluation.  
 
A Foundation of Fiduciary Responsibility: The Board of Directors of a company – elected by its shareholders – hire a chief executive officer to carry out a company’s strategy and operations that will maximize shareholder value. At the base of every action is the strong set of values reflecting fiduciary responsibility to his/her shareholders. Without this foundation, companies can be easily led astray. Just ask the shareholders of Enron, Lehman Brothers, Waste Management, or HealthSouth. Warren Buffett has famously said that when he finds one cockroach, there are generally many more. If senior management turns a blind eye to fiduciary responsibility, it won’t be long before it works its way deeper into the organization.   
 
An Ability to Hear, Speak, and Act on the Truth:  An area where my company has substantial knowledge – pharmaceuticals – has a long track record of remarkable failures in ethical leadership. Even large fines seem to make little impact on their behavior. GlaxoSmithKline ($3B), Pfizer ($2.3B), Johnson & Johnson ($2.2B), Abbott ($1.5B) have all been caught promoting drugs when the FDA has not approved them for a specific use. The scope of these illegal operations frequently goes to the top of the organization. If management is unwilling to act on knowledge of such behaviors, then what else will they do to maximize profits? 
 
Their Word is Their Bond: I remember once listening in to an earnings conference call when the management team announced the prudent use of cash on the balance sheet precluded any big M&A deals as they “almost always cost shareholders value”. Less than six months later, this same team announced an acquisition that would use nearly the entire cash balance. Within the first two years of closing, roughly 90% of the deal would be written off as good will. One thing was certain – if their word was their bond, then it was selling at a pretty large discount by year’s end.
 
Treating All With Respect: When I see companies where CEO’s have outrageous compensation packages (including cash, options, warrants, deferred compensation, jet use, private security…..the list goes on and on), I believe this shows complete disrespect to employees (almost always these companies have the largest gap between the highest paid and lowest paid employees) as well as disrespect to shareholders. Respect can be reflected in policies that show fairness to employees no matter the level or position. It can also mean utilizing the annual meeting to genuinely listen to shareholder concerns. Study after study show that companies with satisfied employees and active shareholders are generally the most successful.
 
How to Find It
 
The question of course is how do you find great management? If you focus solely on corporate performance you might end up with a company like Enron and Ken Lay as CEO of the year. If you focus solely on a CEO known as great person you might end up with tech start-up with its own employee barista and swimming pool that flames out in spectacular fashion.  Neither one is likely to lead to outstanding investment returns. So where to look? I suggest the following.
 
Previous Management Performance: The first of course is to see how the individual has performed in the past. If the individual has a history of growing revenue, increasing profitability, and retaining staff then that’s a good start. Reading through 10-Ks and 10Qs can give investors a pretty good idea about this information. A word of caution: those glossy Annual Reports drafted by agencies filled with glitzy graphics don’t hold a candle to a simple report written by the CEO themselves. For a contrast take a look at any Enron Annual Report versus Berkshire Hathaway’s.
 
Direct Conversation: If the company is small enough, then you might be fortunate enough to talk directly to the CEO. Sometimes you can speak to other senior executives. Either way, be prepared to have a list of questions that you can run through without hesitation. (For some thoughts on this see my article “Interviewing Management: Core Concepts”, June 2016) No senior executive likes to waste their time. 
 
Scuttlebutt: Another great source is Phil Fisher’s classic scuttlebutt. There are a host of websites (examples include “Glass Ceiling” for equal pay, “Fierce Biotech” for Biotechnology business news, and CafePharma for all kinds of business and personnel scuttlebutt) for each industry that generally dish everything from potential deals to reports on individuals (it was actually posted on one site that I had died until I confirmed I was quite alive!). Some sites have far greater credibility than others so use your discretion and try to multi-source any stories.  
 
Conclusions
 
Partnering with outstanding management is a multi-pronged approach. You are looking for great allocators of capital, individuals with sound judgement, great business acumen, outstanding intrapersonal skills, and a strong strategic vision of the business and industry. Is it possible to find any one person with all these skills? It’s unlikely, but possible. Over time, you will have to create a hierarchy of importance. For me, capital allocation comes first combined with a strong strategic vision. Yours may be strong personnel skills and outstanding business acumen. One thing is certain though: picking a bad manager outweighs almost any positive characteristics of the company.  As J.P. Morgan said, money and assets cannot trump character. And it’s hard to find fault in his results.
 
As always, I look forward to your thoughts and comments. 
 
------------------------------------------------------------
[1] Money Trust Investigation : Investigation of Financial and Monetary Conditions in the United States Under House Resolutions Nos. 429 and 504 Before a Subcommittee of the Committee on Banking and Currency, House of Representatives, (1912-1913)

[2] John C. Bogle, “Don’t Count On It!”, John Wiley & Sons, 2011

“I don’na mind I ain’t rich. And I don’na mind he ain’t poor. I just canna stand it ain’t ever gonna change, that’s all.”
                                                                -        Jock Druery (Fictional Character, 1857) 

“The greatest threat to capitalism is capitalists. When these individuals lose sight of the fact that capitalism is as much a hope-based system as a capitalist system, then the whole structure is threatened. Recently we’ve heard capitalist thinkers tell us that socialism is about shrinking the pie and that capitalism is about growing the pie. I wouldn’t question that thesis. But I would question whether growing the pie - and having a very select group of people eat greater and greater amounts of this growing pie is any different than their fears of socialism and a shrinking pie. Whether you go hungry because the system doesn’t manufacture enough bread or because an increasing amount of bread was made, and a few lucky individuals got to eat even more than ever, is irrelevant. You’re still hungry, and you still feel screwed. The latter is the threat to western capitalism, not the former. Anyone arguing the former simply has an insatiable hunger for bread”.

                                                              -         Sandra W. Hall 

I was recently reading Howard Marks’ latest memo in which he took issue with socialism and some of the ideas and recommendations from those in the “Democratic Socialist” wing of the Democratic Party. It’s not my intention to take a stand on any of the issues he brings up or the current political debate, but rather address the issue he never really fleshed out - the meaning of “responsible capitalism”[1].
 
Capitalism works best when capital is wisely allocated. The purpose of a group of businessmen gathering under a New York City buttonwood tree in May 1792 was to create an environment where companies could access capital and shareholders could enjoy the benefits of putting this capital to work. Successful capitalism requires a system where stakeholders – small businesses, vendors, local and state governments, etc. see direct - and indirect - benefits from having companies reside within their greater community. When all these individuals and institutions - the company, its employees, its shareholders, its vendors, the communities and people in which excess profits are spent - see the benefits of well-deployed capital, then that (at least to me) is the definition of “responsible capitalism”.
 
I thought I’d use Mr. Marks’ (along with my) industry - investment management - as a test to see how responsible capitalism has been over the past several decades. One of the roles of the financial investment industry is to allow the American worker to put their hard-earned capital to work and allow the strength of the US and international markets to grow this capital and generate adequate returns to meet their goals – whether it be their child’s education or their future retirement. For generations, workers have expected the financial industry – either through their pension plans or more recently 401k plans – to generate wealth and carry their half of the capitalist bargain – the worker toils to earn their wages and the financial community assists in meeting their long-term goals.
 
This model worked well for nearly all of the twentieth century. It made the American middle class the envy of the world. It’s what brought my family to this country. But somewhere in the latter part of the twentieth century capitalism and the functions the markets play in capital allocation changed. These changes can be summed up in the following ways.
 

1. The financial markets went from being a facilitator of corporate ownership (long-term investments) to corporate rentals (day trading and excessive portfolio turnover). The idea of owning a piece of a business went to the idea of trading pieces of paper or clicking on buy and sell keys.
2. The traditional risk/reward (an American worker invested in the economy through the stock market and was rewarded over time) was replaced by an agency model of heads I win, tails I win more. Over time, more and more individual investors have taken the risk but seen less rewards.
3. Frictional costs created by agency action (rapid trading, management fees, marketing fees, 2/20 agreements, etc.) are subtracting far more value than adding it to investor returns.       

 
Let’s take a look at these friction-related costs that no one seems to want to discuss yet play a devastating role in reducing the size of the pie. In 2004[2], investment bankers and brokers generated $220 billion, mutual fund fees were roughly $70 billion, pension management fees were $15 billion, hedge fund fees came in around $25 billion, and personal advisor fees around $5 billion. Note that these numbers don’t include investment services fees generated by banks and insurance companies (like the 1% fee layered on by many bank in-house investment management groups). Just these numbers alone come to roughly $350 billion directly deducted from investor returns. Adjusted to 2019 dollars, these numbers are estimated to be nearly $680 billion dollars. That’s nearly two-thirds of a trillion dollars in one year.
 
As I said earlier, capitalism works best when capital is allocated wisely. In the case of the investment management business -for all of these hundreds of billions paid - you would think that capital has flowed to agencies because they provide additional returns to investors. That assumption couldn’t be more wrong. Going through each category we find that each agency has deducted from investor returns and simply made profits for their respective function.
 
Investment bankers and brokers work to bring companies together to conduct mergers and acquisitions. Yet, according to the Harvard Business Review, 70-90% of those mergers and acquisitions are value destroyers for investors[3]. In 2018 alone, the total global value of mergers and acquisitions came to $3.8 trillion dollars[4]. Assuming the HBR failure rate, that’s an extraordinary amount of capital destruction. Who pays for this? Shareholders as good will is slashed from the balance sheet over time. 
 
Actively managed mutual funds have an abysmal record in outperforming index funds. In my article “Mutual Fund Survivorship: The Revenge of Abraham Wald” of January 2 2015, between 1997 – 2011, roughly nine out of ten actively managed funds underperformed their index fund proxy. 46% of the fund were simply closed or merged away they were doing so poorly. Additionally, funds are simply charging too much to compete with index funds. In another article, “Are Management Fees Coming Down? Yes, Sort Of…..”, April 28 2015, I write that fees are not coming down proportional to the growth of assets under management (i.e. no economy of scale).
 
As of September 2018, local and state government pension funds have $4.41 trillion in assets under management. Putting aside the accuracy of pension actuarial assumptions, pension funds have a long history of underperforming due to several reasons. First, their expenses - after layering on for fees charged by their holdings such as mutual funds or hedge funds - make it nearly impossible to outperform the general markers. Second, pension fund investments in hedge funds have proven to be an expensive experiment in poor returns (see hedge funds section). The Center for Retirement Research at Boston College (CRR) took a look into the variation of returns to investigate why some plans perform better or worse than others. The study examined the period from 2001 to 2016, during which public plans earned an annualized return of 5.5 percent, well below the average return assumption of about 7.6 percent. Who receives either a lower pension payment or increases in deductions? Pension plan participants (i.e. the common worker).
 
Why This Matters
 
When Howard Marks talks about socialism and the danger of a shrinking pie, I think he (and all of us who are professional capitalists) have to take a long hard look at how well we’ve done in both growing the pie and sharing that pie with individual investors. From the college student or blue-collar worker who puts their hard earned $50 into their IRA or 401k, to the retiree who relies on their pension plan to enjoy their retirement, these individuals deserve their share as much as any hedge fund manager making $5 billion a year in New York City. True parity and fairness would require “responsible capitalism”.
 
Don’t get me wrong. My family came to this country because it was the capitalist engine (combined with a democratic republic) that drove world growth. I couldn’t have been more proud then - or now  - to be an American and taking part in a capitalistic system that rewards (generally) hard work, diligence, and acquired education. As a professional capitalist I think it’s the best system in the world. But there are improvements that could improve the system to make it a more “responsible” in Mr. Marks’ words. Here are a few ideas I humbly suggest.
 
Too Many Fees, Not Enough Value: The amount of value extracted from our capitalistic system by the financial industry far exceeds the value it brings to the table. Ranging from ridiculously high management fees to sky high turnover to even bank ATM fees, individual investors and consumers are increasingly demanding cheap and effective financial solutions. As an active investment manager, I see the warning signs everyday - the growth of passive/index investing, fund withdrawals, continued underperformance. This list goes on and on. If our industry wants to keep extracting so much capital from the markets, then it needs to either find a way to increase value or decrease costs.
 
To Much Selling, Not Enough Thinking: In many ways, the investment management business has become like the pharmaceutical business – to much focus of sales and promotion and not enough on R&D and science. It seems every major investment house has become a marketing machine – touting short term Morningstar star ratings and turning over entire portfolios in 6-12 months. Not enough time is spent on thinking about long-term value, customer needs, simply being patient, and letting the magic of compounding do its work.
 
Too Much Pie Subtraction, Not Enough Pie Sharing: All too often Wall Street spends its time thinking about new (and of course expensive) ways to convince investors to spend their hard-earned dollars on products that have little chance to deliver outperformance - or even adequate performance. How many individual investors really need a triple leveraged short-based ETF on oil futures? When I was growing up, I had a paper route where I delivered 127 newspapers daily. It took three runs on my bicycle but I realized that if I did my job, delivered the papers on time, in good condition, and treated my customers with respect, then I would do pretty well when it came to payday on Saturday mornings. The editor of the paper said to me once, ‘the more complicated you make the product or the services, the more the customer pays and the less value they get. And most people aren’t stupid. They’ll find another way to get the news when they realize they’re getting screwed’. I tell my clients my services are pretty simple - I allocate their money and charge them a modest rate with the goal of meeting their financial needs. That’s about pie sharing, not about pie consumption.
 
Conclusions
 
It wasn’t my intention to write an article on the issues of improving capitalism, nor making it the longest article I’ve ever written. But as a professional money manager with clients seeking to achieve their financial goals, I think it’s important that as professionals we take a long hard look at the issues which are causing tectonic shifts in our industry. We can only succeed when our clients succeed. That means getting back to the basics which made capitalism great - getting the largest amount of individuals to share in the risk and rewards of a growing economy and making sure as many feel and see these rewards as possible. In the end, it might just mean eating some humble pie.
 
----------------------------------------------------

[1] Ray Dalio had a slightly different take than Howard Marks in his rather contentious discussion about why capitalism needs to be reformed in an appearance on CNBC April 9 2019. Video can be seen here: https://www.marketwatch.com/story/watch-cnbc-host-get-into-heated-exchange-with-ray-dalio-over-capitalism-2019-04-08

[2] These numbers come from Jack Bogle’s research at the Bogle Financial Markets Research Center at Vanguard Corporation in Valley Forge, PA.

[3] Harvard Business Review, June, 2016. “M&A: The One Thing You Need To Get Right”. In 2015 Microsoft wrote off 96% of the value of the handset business it had acquired from Nokia for $7.9 billion the previous year. HP wrote off $8.8 billion of its $11.1 billion Autonomy acquisition. Finally, in 2011 News Corporation sold MySpace for $35 million after acquiring it for $580 million just six years earlier.

[4] Wall Street Journal, Money Beat http://graphics.wsj.com/investment-banking-scorecard/
 

With the opening of Nintai Investments LLC, I thought I’d go back to my previous method of reporting quarterly returns to the Gurufocus community and readers of my website’s blog. Before I get into the specifics, a few ground rules are in order.

• As a professional investment manager, I will not be providing a full list of portfolio holdings. My customers pay me to allocate their dollars in a specifically chosen portfolio – not announce their portfolio to website readers.
• Returns are a composite of the Hayashi Trust and individual investor portfolios.
• Inception date is October 15 2018 for the Hayashi Trust and January 1 2019 for individual portfolios.
• In my previous life, I was happy to discuss individual holdings and my rationale for their being in the portfolio. As a paid investment manager, I must necessarily be far more discreet in my answers to readers’ questions. 
• Of course, past performance does not promise future returns. Any company discussed will be identified as a portfolio holding if in either an individual investment account, the Hayashi Trust, or in my personal brokerage account.

 
As many of you know, I ran the Nintai Partners Portfolio – and then the Charitable Trust – from 2002 - 2015. In addition, I was a portfolio manager from 2015 - 2018 at Dorfman Value Investments. While very proud of those returns, I believe the results of Nintai Investments LLC must stand on their own and develop their own unique history. Going forward, when I discuss the Nintai Investments LLC portfolio, I will be referring to a composite of individual portfolios managed by Nintai Investments LLC and the Hayashi Trust portfolio managed by Nintai Investments LLC.
 
I was pleased with Q1 performance of the composite portfolio outperforming its benchmark, the S&P 500. I have also been very pleased with performance since inception. Seen below are the numbers for periods ended March 31 2019.
 
Total Returns Net of Fees

We added two new positions in Quarter 1. Making a return to the portfolio is F5 Networks (FFIV). I sold out of the entire position in 2018 when the company’s stock price hit 155% of my estimated intrinsic value. Total profit was 44% on the position which I held in the portfolio for roughly 19 months.  Year-to-date the stock has dropped roughly 8% while after reviewing the company I increased my estimated intrinsic value by 35%. The second purchase was PetMed Express (PETS). The company had been on my watchlist for 4 years. Over the past 1 year the company stock price has been cut by 50%. Free cash flow has grown by 14% annually over the past 5 years while earnings have grown by 18% over the same period. The stock yields 5.2%. There have been questions as to whether company has been selling Tramadol (a synthetic opioid pain medicine) to animal veterinarians to be sold or prescribed illegally for human use. To date, there has been no announcement of any investigations to support such an allegation.
 
This quarter I sold the entire stake in Allergan (AGN) after it was announced the company was charged with systematically overcharging the Centers for Medicare and Medicaid (CMS) by utilizing false data on average wholesale pricing (AWP). As I wrote at the time, this is a particularly egregious crime that steals money from the patients who can afford it the least and reduces government funding available for other treatments.  I simply will not tolerate such behavior by a holding’s management.
 
During the quarter I also added to 4 existing positions. Each holding was trading at a significant discount to my estimated intrinsic value at the time I added to the position.  
 
Winners and Losers
 
Two stocks led the way in Q1 - Veeva Systems (VEEV) and NIC (EGOV).  Veeva was up 38% in the quarter while NIC increased by 34%. Veeva’s February quarterly earnings exceeded both top and bottom lines. Management upped guidance as well. Over the last year, VEEV has increased free cash flow by 33%, EPS by 60%, and revenue by 24%. I increased Veeva’s estimated intrinsic value by roughly 13% in February 2019 after the company raised guidance. The position is currently up 115% since it was purchased in February 2018.
 
NIC recovered nicely after the markets recognized the loss of part of the company’s Texas website contract was not going to have a significantly adverse effect on the firm. Free cash flow actually grew by 1% after analysts estimated a 15-20% drop in 2018. While the quarter’s results were gratifying, the position is currently only breaking even. While Veeva and NIC had great quarters, I should point out that roughly half the portfolio holdings were up 20% or greater during the quarter.
 
It wouldn’t be value investing if you didn’t have to report on stocks that were the inverse to those winners. The ones that get you all puffed up and make you feel like the smartest person in the room. For the second quarter in a row, the largest drag on the portfolio was Biosyent (BIOYF) down -5.2%.  The company was a having a decent year until in the last days of Q1. Management announced they received two notice of deficiencies from Health Canada for their two new cardiovascular products.  The company has exclusive distribution rights to these drugs in the Canadian markets. At the time of this report, I’m still in discussions with Biosyent management, Health Canada clinical reviewers, and market analysts to judge the impact on my estimated intrinsic value.
 
Portfolio Characteristics
 
The current Abacus view as of March 31 2019 shows that the Nintai Portfolio holdings are slightly more expensive than the S&P500 and projected to grow earnings at a significantly greater rate than the S&P500 over the next five years. 

The additions of F5 Networks and PetMed Express along with the sale of Allergan brought the portfolio to 21 positions in total. If opportunities arise I will add or reduce position size. I might also swap out an entire position for a chance to invest in a situation with a better risk/reward profile. I am uncomfortable having the valuation of the portfolio be slightly higher than the S&P500. This explains the build-up in cash to roughly 20-25% over the quarter. I will be actively looking to take profits or find cheaper prospects over the next 6-9 months.
 
I remain highly focused in my industry and sector weightings.  I currently have holdings in only 5 of the S&P500’s 11 categories - financial services, technology, industrials, consumer defensive, and healthcare. Industrials and consumer defensive are both extremely small holdings with roughly 90% of holdings in just three categories – financial services, technology, and healthcare. However, I should point out I see the categorization of the portfolio slightly differently. For instance, Computer Modelling Group (CMDXF) is categorized as a technology company by the index. However, with 100% of its revenue derived in the oil and gas discovery process, I consider the company a way to gain exposure in the energy industry. 

​ Thoughts on Turnover and Cash
 
Turnover for the quarter was roughly 14%. I expect this to drop as assets under management increase. I try to look for turnover of roughly 5-10% annually. This is dependent of course on factors such as overall market performance (steady increases over the past few years have allowed me to take profits but also increase turnover) or individual stock performance (a sudden price drop of 20% might make for a compelling buy scenario). I have reached the upper end of stocks I look to own in the portfolio. It’s likely that most trading going forward will be additions or subtractions from existing positions. Occasionally opportunities may arise where I swap out an entire position for one that is either trading at a steeper discount to my intrinsic value and represents a step up in quality and potential long-term gains.
 
In regards to cash, the portfolio currently maintains roughly 20% of its assets in cash. I have been fortunate that 80% of the portfolio has easily outperformed 100% of the S&P500. How long that can continue is anybody’s guess. With the Abacus report showing the portfolio’s estimated 5-year earnings growth at 18% greater than the S&P500 while being equally valued, the data suggest there is at least a moderate chance this could continue. But as always, I want to point out that past performance does not ensure future returns.
 
Eating Our Own Cooking
 
As many of my readers may remember from my GuruFocus presentation in April 2016, I have the “honor” of having an extremely rare genetic mutation (the TRNT1 gene for those keeping track). This disease – known by its acronym SIFD – is found in only 18 individuals in the world. While my parents always told me to be different, I’m not sure this is what they meant! I bring this up because over the past 8 years of treatments I spent my entire life’s savings seeking care that would keep me alive (the US is both a great place and a terrible place to have a rare disease). Now that we’ve isolated the disease through modern genetic clinical research, I’m in the position to begin rebuilding my individual investment portfolio. I want to assure my readers and investors that every dollar invested will be in the same stocks I own in the Nintai Investments portfolio. It is my intention that I will most certainly be eating my own cooking.  
 
Making A Difference
 
At Nintai Investments, I take our social responsibility seriously. We (meaning myself and my shareholders) currently give 10% of net income to charitable causes that are making a difference in our communities. Each annual report I will highlight an organization that Nintai Investments has supported that year. As a corporate citizen, Nintai Investments has an equal – if not greater – responsibility to make a difference in our society. Having lived an immigrant life here in the United States, I have seen that capitalism produces enormous opportunities for all our citizens. But sometimes that isn’t enough - sometimes people need a helping hand. Having been blessed with a wonderful family, a great education, and a successful professional career, I feel Nintai Investments has a special responsibility to help provide that helping hand.  
 
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As Nintai Investments LLC begins its corporate journey, I take my responsibility seriously to wisely allocate capital, prudently manage risk, and attempt to generate adequate returns. Helping individuals and organizations achieve their life goals, support their corporate giving, or meet their retirement needs is a remarkable honor and mark of great trust. Every day we look to continue earning that trust. Should you have any questions, please do not hesitate to contact me by phone or email. 
 
Thomas Macpherson
tom@nintaiinvestments.net
603.512.5358
 
My best wishes for a wonderful spring season.