- Warren Buffett, 2016 Berkshire Annual Report
For decades there has been a raging debate about the index fund versus the actively managed model. Which model achieves best returns? Which model achieves the best risk/reward? Does low cost and low turnover beat out the efficient market theory? This debate will likely rage for another century with no consensus being reached.
I’ve found the debate to be a waste of time and print. I think the answer - like most of life’s thorny issues - is a hybrid solution. Value investing is no different. I firmly believe that successful investing requires purchasing an asset for an adequate discount to its estimated fair value. I also think that discount must contain an adequate margin of safety. But I also demand that companies be of the highest quality - no short/long term debt, high return on equity, return on assets, and return on equity (meaning greater that 15-20%). I also look for free cash margins of 25% or greater. Finally, I look for - what my business partner once called “the tapeworm effect” - where the portfolio company’s products and services are deeply embedded in the infrastructure making it nearly impossible to swap out to a competitor. This blend of depressed prices merged with high quality has worked well for me. My investment partners have seen significant outperformance – particularly since the Covid-19 crash.
The Returns Speak for Themselves
This crash has reopened the debate about active versus indexing. In the last 60 days alone there have been over 100 articles in major print financial journals about the war between active and indexing. As I mentioned, we think this is a rather stale argument. Seen below is a graphic representing the average return for Nintai Investment’s customers versus several key bogies. Note that all of these represent indexed funds. Losses would be greater for actively managed funds.
In the same period, you can see Nintai Investment’s average portfolio return was
–9.20%. While not anything to write home about, it’s roughly half of the S&P 500 and nearly 60% better than the Russell 2000 (Nintai’s preferred proxy due to portfolio size). This isn’t to boast about Nintai’s portfolio (though we are very pleased for our investment partners). Rather we think this demonstrates the thin gruel passed off in the argument about value versus growth. As Warren Buffett said “you can’t separate them”.
Growth, Value, and Price: Why Limit Yourself
We think outperformance in both Nintai Partner’s internal fund as well as Nintai Investment’s short-term record demonstrate that growth, valuation, and quality are the most potent combination. (We love to joke about being G-VaP ((pronounced gee-vap)) investors) We think G-VaP gives investors the best chance at long-term outperformance of both active and value indexing. Here’s why.
An asset can’t grow in price long-term without…..growth. It may increase due to inflation or investor passions, but nearly always tumbles back. Gold is an example of this. There is a limited amount of gold in the world with a certain amount of small additions extracted from mines around the world. But it has no earnings, no free cash flow, essentially……no growth. Compared to a Cognex (CGNX) which has grown free cash flow 25% annually over the last 10 years, gold has a long way to go.
When an investor overpays for an asset, it becomes increasingly hard to see outperformance in the long-term. One only has to think of buying technology stocks in late-1999, funds invested in triple leveraged mortgage-backed securities in 2007, or Bitcoin in December 2017. Timing isn’t everything, but pricing means an awful lot. Developing a valuation model (or stealing one) is an essential tool to identify when to buy and how much you should pay.
On Wall Street there is a hundred ways to skin a cat. But the real money isn’t made in upcycles, it’s made in the down cycles. Let’s assume you were unfortunately gullible (and greedy) in December 2019 and you bought Acme Rubber Band Company at $100 per share. During Q1 the stock dropped 80% to $20 per share. Bad luck! But there is even worse mathematics at play. You will now need a 500% increase to get back to even. These types of losses rarely happen to companies of extremely high quality (like those defined earlier - no debt, high free cash flow, and customer-based tapeworm relationships with their customers. Those 80% losses can permanently impair your (or your investment partner’s) hard earned dollars.
Many value investors practice one or two the value triangle (growth, valuation, and quality) I’ve outlined in this article. For instance, traditional value investors might seek low growth and low valuation, but unfortunately also get poor quality. Building a
portfolio of companies with all three attributes is difficult, but possible. Just take a look at this latest crash in Q1 2020. A company like Abiomed (ABMD) dropped from $450 per share to a low of roughly $130 per share on March 20 2020. Has the company’s value dropped by roughly 65% in a little over one year? In the last 12 months free cash flow has grown 35%, earnings have grown 12%, and revenue has grown 14.7%. Compared to ten year numbers, nearly every category has decreased. It is still a company that has no debt, $492M in cash/short-term instruments, 25% ROE, 22.5% ROA, 39.5% ROIC, and 30.5% FCF margins. It has 97% retention with customers over the past 5 years. Does such a company merit such a drop in share price? We don’t think so.
Companies – with all three attributes present at one time – comes along rarely – but more often than you think. Particularly after such a market crackup, it worth rummaging around and seeing what’s out there (hint: 7 of Nintai’s core holdings trade below 70% of their estimated intrinsic value as of April 27, 2020). You might be surprised how quickly you can start building your own G-VaP portfolio.
As always I look forward to your thoughts and comments.
DISCLOSURE: Nintai Investments LLC owns Cognex in both investment partner portfolios and Nintai Investment’s own portfolio. Nintai Investments LLC holds Abiomed in some investment partner portfolios.