During an interview, Cus D’Amato (one of boxing’s greatest trainers) once said there were two things about boxing that could make the difference in a fight. One was the technical skill, fitness, and training of the fighter in the ring. This was something he or she has direct control over. The second was the atmosphere outside the ring. The crowd’s fervor, preference for one fighter over the other, venue design, etc. These were things the fighter had no control over, yet still played a role in the final outcome of the bout.

We bring this up because this description isn’t much different than investing. There are things we can certainly control in our process such as selecting companies with certain financial criteria (investment returns), while there are things we simply have no control over such as the P/E ratio of our holdings (speculative return).

 John Bogle had a great formula for describing total investment returns[1] -

 Dividend yield + Investment Returns + Speculative Returns

 He defined investment returns as earnings growth/contraction and speculative returns as the increase/decrease in the respective stock’s P/E ratio. The first two (DY+IR) are direct actions taken or achieved by your investment. The third (SR)  is driven purely by the whims of the market. This combination of all three drive both the short and long term returns of your investment portfolio. To put it in the context of Benjamin Graham’s eponymous phrase, the speculative return is the voting machine while the dividend yield and earnings growth is the weighing machine. Or put in our boxer’s parlance, one happens in the ring and the other outside of it.

 We strongly believe our investment selection process focused on companies with little/no debt, high free cash flow, high capital returns, and deep competitive moats will – over the long term – assure our investment returns. Theoretically, purchasing our investment at a discount to fair value will mitigate risk in the speculative return.

 All of this seems quite reasonable until we recognize that a vast majority of our short-term returns and a substantial part of our long term returns are directly linked to Bogle’s speculative returns. John Maynard Keynes wrote[2], “In one of the greatest investment markets in the world, namely, New York, the influence of speculation is enormous. It is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator.” Things have changed very little since Keynes penned these words in the throes of the great Depression.
 
Investment Return Versus Speculation Return

At Nintai we keep a close watch on both investment returns and speculative returns within our individual holdings and how that impacts the portfolio in total. As seen below, since 2005 over half of our returns have come from speculative returns – meaning over 50% of the returns of the Nintai portfolio have come from P/E expansion rather than dividend rates or earnings growth. 


Much like a state of equilibrium in physics, this simply cannot go on in perpetuity. Over the next decade we would expect to see over all returns decrease in scope as P/E ratios return to a more normalized level. As the Nintai portfolio’s average P/E is roughly 28% below the S&P500, we would expect this correction to affect the portfolio significantly less than the general markets thereby leading to outperformance in the long term. We believe the financial strength of our portfolio holdings – in combination with lower P/E ratios – provides us significant protection in the case of a market correction similar to 2000 or 2008/2009. 

Some Further Thoughts

 This philosophy doesn't extend to just our portfolio. At Nintai we are perpetually on the lookout for stocks that might meet all our investment criteria including trading at a significant discount to fair value. Unfortunately some have never quite met these as the speculative return has vastly outrun the investment return over the past few years. One company – CBOE - is a classic case of this phenomenon.

 Chicago Board of Exchange

 CBOE is engaged in the trading of listed, or exchange-traded, derivatives contracts on four product categories; options on market indexes, futures on the VIX Index and other products, options on stock of individual corporations, options on other exchange-traded products such as exchange-traded funds and exchange traded notes. The Company owns and operates three stand-alone exchanges.

 CBOE has generated an average ROE of 69%, FCF/Revenue of 32%, and net margins of 28% over the past five years. Management has generated a return on capital of 79% over the same period. The company currently has $138M in cash on the balance sheet with no short or long-term debt. CBOE generates roughly $207M in cash annually and pays no dividend.

 So far this is a company we would love to own. The only fly in the ointment is that the P/E of the stock has gone from roughly 16.5 to 27.5 in the past five years while revenue has grown by roughly 10% during this same time. Here the expanding speculative return (the P/E ratio) has driven the price in excess of its investment return (dividend + earnings growth).

The solution here would be a sudden collapse in the speculative return and a significant decrease in the P/E ratio. Given that scenario - and dependent upon the impact on the business itself - we would be highly likely to back up the truck and make CBOE a new holding in the Nintai Portfolio.

Conclusions

 People have been writing to us commenting that our recent musings have been touching a great deal on protection against the downside. Their emails have been asking whether we have any particular knowledge that would predict a future market correction. Our article published on May 27th (found here) touched on our inability to accurately predict almost any macro event including market corrections and/or crashes. That said, we are increasingly sensitive to the risk a downturn could play on our investors’ long-term returns. Any situation that could produce permanent capital impairment is – and must – always be a top concern.  The increasing role of speculative returns in our total investment returns has us concerned about valuations and what is the wisest course of action going forward. By focusing on stocks with great investment characteristics (earnings growth + dividends) and low speculative returns (low P/E ratios) over the past several years, we feel investors are setting themselves up well for a future of dampened total returns.


[1] As I was writing this, Grahamites published a great article entitled “When Total Return Meets Chasing For Yield – A Reality Check On The Consumer Stable Sector”. I highly recommend reading it.


[2] “The General Theory of Employment, Interest, and Money”, John Maynard Keynes, 1936

Over the past several months, we have received many great questions from our readers. Some have been about specific companies, some about valuation processes, and some about general market trends. It's these last that produce the most conversation around the proverbial water cooler. With the market making all-time highs on a near daily basis, we are asked to opine on where we think prices and markets are headed in the future. We think this – along with other areas we categorize as "prognosticating mumbo jumbo" (that's a technical term) – can be highly expensive to investors who rely on our (or anyone else’s) judgments.

False knowledge fields: A definition

George Bernard Shaw once wrote "Beware of false knowledge; it is more dangerous than ignorance." Rather than write about Warren Buffett and Charlie Munger's concept of staying within your circle of competence, we thought we'd change the lens and discuss areas where we might have gobs of data but are simply terrible at correctly estimating trends or outcomes. At Nintai we call these False Knowledge Fields (FKFs) and make sure they play no role in our valuations, investing calculations or investment decisions. We believe FKFs have three major characteristics. These include high amounts of historical data, a proliferation of ever increasingly complex analytical models (with associated acronyms), and an extremely low success rate in predictive calls or recommendations. On Wall Street, there has developed an entire industry around FKFs with trillions of dollars traded on their recommendations and insights. One great example is the use of analyst recommendations in equity selection.

Buy/Sell/Hold recommendations

In a previous article titled “People We Rarely See And Never Meet: Analysts, Research, And Recommendations” (which can be found here) we discussed how actual performance has little to do with analyst pay and perception. It’s probably a good thing. With roughly 5% of all analyst recommendations being a “sell,” you don’t have to be a remarkable statistician to know their overall performance is unlikely to be very stellar. Seen below is a chart of analyst recommendations during the calendar year of 2011 created by Cullen Roche for FactSet Research[1]:


So does the field of analyst recommendations qualify as a false knowledge field? We think the numbers confirm this. First, by utilizing Bloomberg machines and FactSet data alone, there is an extraordinary amount of data available to analysts. Second, each analyst and research organization has a proprietary research and rating system. Last, there is a preponderance of data showing that analyst recommendations woefully underperform the general markets. When less than 5% of stocks are publicly recommended as “sells,” it doesn't take long before your numbers lag. In this instance, analyst recommendations meet each FKF criterion extraordinarily well.

Why this matters

As individual investors (or investment managers in our case), we cannot stress enough the importance of not operating and making decisions in your own false knowledge fields. At Nintai, we have found a considerable amount of our readers’ questions lead us into our own personal FKF danger zones. The challenge is to continually push back and admit we either don't have the ability or the confidence to answer these questions. It’s not easy, but it is most certainly necessary if you intend to carry out your fiduciary responsibility to your clients. As an example, the following two questions should seemingly be easy to answer but are clear examples of FKFs.

Will the market go up (or down) in the next 12-24 months?

There is an extraordinary amount of data that shows us the historical performance of the markets. Combined with thousands of analyst tools ranging from the Schrodinger Equation to the Binary Options Robot, there is no end to the models available to predict whether the markets should be going up or down. The only problem with this is that they are rarely correct. As a bottom-up and individual equity investor, we see no value in these and clearly place this area in a brightly outlined FKF box. We never have and never will be able to make market predictions with any accuracy. An answer to this question given with certainty would be a grave disservice to our investors – and most likely wrong.

How will the world economy impact your portfolio recommendations?

Similar to the last question, there is an enormous amount of data and models that would seemingly help us make informed decisions. Unfortunately, the ability to calculate and estimate world GDP growth and possible recessions is beyond most analysts’ capabilities. The phrase “economists have predicted 9 of the last 5 recessions” is a nifty and succinct way of commenting on the steady failure of individuals to acknowledge their own FKFs. We concede there is both an inordinate amount of data and models out in the real world. We also recognize there are a lot of systems utilizing these data and systems to produce entirely incorrect predictions. Why would we think Nintai could be any different?

Conclusions

Just as it is critical to identify your own circle of competence (“know what you know”), it is equally vital to identify what is clearly outside your knowledge even when it seems the numbers and processes can get you to a well reasoned answer. The abundance of data and the definitive quality of multiple models gives us an entirely false sense of security that we are operating well within our competency. Nothing could be further from the truth. By answering our three questions it is possible to ascertain whether we should move forward or simply walk away from the problem and admit our ignorance. At Nintai, we believe the identification of our personal and professional False Knowledge Fields is as important as identifying our Circle of Competence. When put together we believe investors and money managers will have a significant advantage over Wall Street.

As always we look forward to your thoughts and comments.

[1] “Buy or Hold, But Never Sell!”, Pragmatic Capitalism, February 14th, 2012

In 16th-century China two businessmen walked to the daily opening of their village marketplace. One of the businessmen carried a bag of silver coins that he brought to his place of business each and every day. The second businessman carried nothing and laughed at his traveling companion asking him why he insisted on carrying around all his working capital in cash. He pointed out his investments – spread across three lower class retailers – allowed him to make additional money by purchasing parts of each business and collecting his due each month. The first businessman stopped and remained thoughtful for a moment. He finally replied, "My claim to what is owed me is based on the hard truth of this silver. What is owed is in my hand. Yours is based on conjecture. I will eat every day for the rest of my life because my assets are very real. You might eat very well this month but not so much after because you understand what is owed you, but not what your people can payyou".

Being a business owner: Ownership of what?

As the markets seem to reach a new all-time high nearly every month, an enormous amount our time at Nintai has been spent thinking of risk and financial claims of our portfolio positions. What we mean by this is the fact that each of our 20 stock positions gives us a legal claim to a portion of current and future assets/earnings of our portfolio holdings. As equity holders we stand at the bottom of the totem pole – behind holders of debt and preferred stock. Most investors don't think much about this issue on a regular basis. During the crash of 2008/2009 it became something far more real and visceral as many shareholders found their stock worth as much as the paper covering their basement den walls. Much like our second eponymous businessman, investors knew what they were owed, but had little understanding of what could be paid.

We've been giving this a great deal of thought because we think the strength of our portfolio assets and earnings are vital in assessing risk. We think some of the really disastrous losses over the past 15 years have been caused by investors losing sight of their position on claims to assets and earnings combined with a fundamental ignorance of their make up. Put more succinctly, investors weren't sure what rights they own and what assets backed up these claims.

A quote we have on our wall at Nintai is one of the lesser known from Benjamin Graham that states, “The really dreadful losses of the past few years were realized in those common-stock issues where the buyer forgot to ask ‘How much?’” We think there is a corollary to this. “Dreadful losses were also brought about by not understanding what the investor bought and what the investment could pay.”

A great example of this is a corporation’s level of debt and the potential risk that implies on your portfolio holdings. Ownership cuts both ways – while assuring you a percent of future cash flow, it also means that claim is offset by debt holders. Where you sit on future payment rights as well as understanding what your assets can pay you in the future is greatly impacted by levels of indebtedness.

We’ve Seen This Movie Too

All too often we hear individuals in the finance world say we’ve learned our lesson since the Great Recession. Companies – indebted to levels beyond reason – are features of a long distant past. The data tell us differently. In a recent study by McKinsey[1], the growth of debt on corporate balance sheets has grown slightly faster from 2007 – 2014 than the run up period (2000 – 2007) before the Great Crash in 2008-2009 (see graphic below).

We recognize there are various compelling reasons to see such increase in debt including historically low interest rates, significant capital spending that had been delayed during the Great Recession, and an equal surge in cash on the balance sheets[2].

These are all well and good. But it is as vital today as it was in 2007 to make sure your ownership is in a company where – for various reasons – management is prepared to survive limited or no access to the capital markets. Another equally daunting risk is that interest rates spike upwards and companies find themselves unwilling or unable to refinance existing debt. Your long-term investment returns will be starkly impacted on where you place your bets, what ownership guarantees you as a shareholder, and how the markets perceive the financial strength of the company.

As a working example of this thesis, I would offer a comparison between a holding in the Nintai portfolio and another entity with very different ownership and financial structure.

Dolby Labs

Dolby (DLB) is a leader in the auto, entertainment, and mobile audio space. Through its licensing model (which produces more than 90% of its revenue) the company generates nearly $1B in sales with 92% gross margins and net margins of roughly 20%. The company has no short- or long-term debt, and returns on equity, assets and capital of 16.2%, 15.2%, and 38% respectively. Finally the company has turned roughly 30% of revenue into free cash flow over the past five years. A compounding cash machine indeed. We purchased stock in the company in 2004 at a significant discount to fair value and believe the stock currently trades below its intrinsic value. In this instance we have purchased the rights of a company that produces growing free cash flow based on legally binding patents that management turns into high return research and capital allocation. What danger do we see in the case of an inevitable downturn? Is our ownership percentage at risk because of higher positioned stakeholders? As an organization with no debt and no preferred shares, we feel extremely comfortable knowing the risk of permanent capital impairment is relatively low.

Xerium Technologies

Xerium (XRM) went public in 2006 and manufactures and supplies materials used in the production of roll covers and paper-based clothes. The stock is up 45% over the past 12 months though it is down nearly 92% since it’s IPO. People often conflate high investment returns such as the past year in XRM's case with financial strength. In the case of Xerium nothing could be further from the truth. Saddled with enormous debt, investors have purchased rights in a company with no growth and a large group of stakeholders with preeminent claims ahead of them.

The company currently has $465M of long-term debt, pension liabilities of $75M, and $9M in cash on the balance sheet. Shareholders have been diluted nearly every year since 2006 with outstanding shares going from 2.2M in 2006 to 16.5M in 2014. The company has produced FCF only twice in the past 6 years with 2014 generating $-39M. Revenue is actually lower in 2014 than in 2005 going from $582M to $531M. On average the company has never produced a positive annual return on equity, assets, or capital.

For those investors who have purchased the stock and seen it increase 45% in the last 12 months, we would ask the same questions we posed in regards to Nintai’s ownership stake in Dolby. What danger do we see in the case of an inevitable downturn? Is our ownership percentage at risk because of higher positioned stakeholders? Is there a chance for permanent capital impairment? We believe the answers are very, very different in Xerium’s case. The fact the stock has risen so far in 2014-2015 tells us investors are losing sight of what they own and what Xerium can pay. To Nintai, this represents yet another example of why 2015 feels so much like 2007.

Conclusions

We are approaching levels in valuations where we believe investor returns will be based on three key components – their holdings were purchased at a significant discount to fair value, they have pristine financials, and they have highly sticky free cash flow. This doesn't put us very far from our everyday strategy of investing. But it does mean we spend a far greater time focusing on these three factors than at any other moment of our investing careers since 2007. Our recent sales of FactSet Research (FDS) and Manhattan Associates (MANH) reflect the fact that both companies easily pass the latter two criteria but miserably failed the first. When market valuations are at this level, a failure in any of these (both individually or in combination) can prove to be fatal to long-term investment returns. In sailing terms it’s time to batten down the hatches and prepare to scud if necessary. Those investors who fail to understand what they own – and even more importantly what their holdings can pay – will find themselves on a lee shore with little to no room to maneuver.

As always we look forward to your thoughts and comments.

[1] “Debt and (Not Much) Deleveraging”, McKinsey Global Institute, February, 2015

[2] It’s not all bad news. Two areas showed true deleveraging – consumers/families and the financial industry. There is more to the financial industry numbers than shown. It mostly reflects the real hit in the shadow banking field but we should celebrate when and where we can.

In 1955, Senator Estes Kefauver of Tennessee was considering running for president. After a particularly warm reception at an event in New York City, he turned to his campaign strategist and remarked how much support he had in the room. His aide – a laconic, tall, bald, and battle hardened warrior said, “People with the biggest smiles are usually the first to cut you out. Remember Jesus was betrayed with a kiss. Never, ever mistake friendly with supportive.”

We bring this story up because you often hear about finding investments with shareholder friendly management. At Nintai, we certainly count ourselves in the camp searching for companies meeting that criteria. However, we think it would be wise to follow our political aide’s advice that investor friendly management isn’t always supportiveof investors.

Before we get into that discussion, a definition of shareholder friendly might be helpful. For some, shareholder friendly management is a team that produces a steady increase in share price. In 1999 alone, Jack Welch, former CEO of General Electric had the phrase "shareholder friendly" matched to his name over 1.4 million times[1]. We can't say we agree with this definition. We think individuals are putting the cart before the horse when they link share price to shareholder friendliness - or for those of Wall Street lexicon - shareholder value. Nintai believes there are certain attributes that when implemented and made part of the corporate DNA will eventually drive share price. The operative word here is “eventually”. Actions taken to drive share price alone are not shareholder friendly. They are options holder - generally meaning senior management - friendly. What we look for are traits that generally don't move the stock price on their own but rather by their cumulative effect. In fact, some of these qualities can actually decrease share price when Wall Street panics about the next quarterly earnings call. In search for new investment opportunities, we think there are four (4) attributes that reflect friendly and supportive corporate management.

They Act Wisely in Allocating Capital 

One of the clear indicators of shareholder friendly management is wise allocation of capital. This includes funding initiatives that can produce returns in excess of the cost of capital either in the short or long term. This also includes buying back shares when company stock trades below intrinsic value. If neither case exists then it includes returning capital in the form of dividends to shareholders. These – in any combination – are real measures of a shareholder friendly management. Expeditors International (EXPD), a long time holding of the Nintai portfolio, is a great example of these values. Senior executives are encouraged to evaluate each strategic initiative through the lens of return on capital, lost opportunity costs, and a brief description why this will add value to shareholders. In the absence of long term value creation, management is committed to returning capital to shareholders through quarterly or special dividends.

They Eat Their Own Cooking

We greatly prefer managers who have a large stake (proportional to their financial situation) that was acquired in the general markets. We don’t believe senior managers who have acquired 5% of the company through stock options are the ideal shareholder friendly management. Nothing pleases us more than seeing senior managers purchasing shares on the open market as the share price drops. Fastenal (FAST) - a long time holding in the Nintai portfolio - is a great example of this. Since the stock has dropped roughly 15% since April, 2014, senior managers and Board Directors have been purchasing the stock hand over fist. Stock sales during this time have all been planned distributions. Nothing shows more commitment than these types of actions.

They Treat Corporate Money Like Shareholder Money

We admire senior executives who are as frugal in their private corporate spending as they are in utilizing capital in strategy. A great example of this is Fastenal’s recently retired CEO/Chairman Bob Kierlin. He was a fanatic about cost savings. In an interview he stated “Being careful about your expenditures, whether large or small, requires a total commitment. Either you do a good job of cost control in all aspects of your business, or you start losing it….Frugality is an attitude you develop. Once you have it, it sticks with you in everything in life. You don't have to think about it." Inc. Magazine[2] said it best when it described Kierlin in the following manner:

“Frugality touches all aspects of his life. Kierlin, 58, eschews all small talk, speaking only when he has something to say. He drives an Oldsmobile and has taken home the same $120,000 yearly paycheck for the past decade, even though the Fastenal board has repeatedly authorized an increase for him. His office reflects his unpretentiousness: used furniture, a few photos of loved ones, and a PC, which he uses to type his own correspondence. He has no personal secretary. And then there are his suits. At a discount store, they'd probably go for $200 apiece. But Kierlin didn't buy them there. He got them from the manager of a men's clothing store. Not from the manager's store. From the manager. The suits are used. "Luckily, we're the same size," says Kierlin, a triumphant smile crossing his face. "I picked up six of those suits for 60 bucks each."

Being cheap alone doesn’t make us happy. Being cheap in the areas that matter (cost controls) and wise in allocating capital make for very shareholder friendly management. And they generally lead fantastic investment opportunities. .

Open and Frank Communications 

Over our lifetime we’ve found the more someone talks about how honest they are (“I want to be utterly honest with you….”) the less they tell the truth. We greatly admire management that both tells the truth and communicates directly with investors. This includes writing their own CEO sections of an annual report, answering questions from shareholders on a regular basis such as Morningstar (MORN) and Expeditors International (EXPD) (both Nintai holdings), and clearly explaining their actions and mistakes.

Conclusions

When you hear about shareholder friendly management, we think it’s vital investors discern between those interested solely in “shareholder value” or stock appreciation and those who build a company designed to see investors as partners on the long journey to success. Being “friendly” doesn't always mean saying things shareholders want to hear. The best partners provide a dynamic, give-and-take relationship structured to survive the inevitable ups and downs of the stock market. Senator Kefauver learned not to mistake friendly for supportive when 15 of the 20 individuals at that event in 1955 voted against him at the 1956 convention. At Nintai we seek both friendly – and supportive – management in our investments. It has served us well over the years and we think it will do so for you as well.

As always, we look forward to your thoughts and comments.

[1] That is until his comments in an FT article, “Welch Denounces Corporate Obsessions”, Financial Times, March 12th, 2009. His retirement package and benefits didn’t help much either.

[2] “The Cheapest CEO in America”, Mark Ballon, Inc Magazine