"As the hunter-gatherers began to identify certain species of game easiest to kill, humans began to understand that habitation in the areas where these species abounded was just as important. It wasn't just the roebuck that was important, but the habitat where they lived that meant life or death for their clan".
                                                                                  -     Richard Daly 

For value investors, one of the holy grails has been finding companies with wide competitive moats. These are investments with common characteristics – return on capital higher than the cost of capital, high margins, steady revenue/earnings growth, and dominant market share. These companies can be tremendous long-term investment opportunities. As an investor becomes more experienced in research and identifying such companies, it becomes apparent that such investment opportunities are often clumped in industries with a penchant for individual-wide moat investments. Much like our hunter-gatherer ancestors learned, it isn't just the individual investment but the industry/market that can lead to long-term outperformance. This is an ecosystem that creates an environment which - by its very nature - is conducive to deep competitive advantages. There is, of course, no hard and fast rule, but over time at Nintai, we've identified several critical aspects within specific industries that lead to high percentages of investment opportunities. 
 
Asset Light and Capital Light: Generally, industries and their companies that require high capital infusions, are asset-heavy, and have significant organizational needs (such as unfunded pensions for tens of thousands of former employees) and complex infrastructures (large manufacturing plants). They also have lower gross and net margins, lower free cash flow, and significant capital requirements. An example of this is large legacy manufacturing industries on which the great American middle class was created – steel, automobiles, etc. During the mid-20th century, these companies were able to achieve significant competitive advantages against other global competitors. But much like England in the early-20th century, competition in Asia slowly ate into profits and provided much cheaper labor and operating costs. The steel and automobile industry simply couldn't keep up with the demands for expensive pensions, new capital improvements, or new technologies that increased operating efficiencies. That doesn't mean there aren't some gems in such industries. Companies such as Fastenal (FAST) or Graco (GGG) operate in traditional manufacturing yet achieve outstanding results with high return on capital and equity while maintaining extremely low debt margins. 
 
In the last several decades, new industries have developed in the United States – technology, data & informatics, pharmaceuticals, etc. – that don't require significant capital injections, don't use sizeable unionized labor forces, and don't have many assets on the balance sheet. These companies came about in the early 2000s and became known as "asset-light" companies. Even large businesses like Schering-Plough (now Merck & Co.) were famous for shedding assets, moving employees from pensions to 401(k)s, and outsourcing core functions like research and development. These actions completely changed the business model, driving returns on capital and equity higher, increasing gross and net margins, and making these companies look much less like traditional research and manufacturing companies and more a modern marketing healthcare company. Some examples of industries with asset-light models include technology (software, informatics - meaning the integration and usage of data), health care (contract research organizations - CROs), and financial services (credit card processing, asset management)   
 
Ease of Competitive Dominance: In these asset-light industries, the ability to achieve competitive advantages is easier than others. Please note I didn't say they are easy; they are easier than others. These companies are run by focused, driven management teams that make dominance seem easy. But looks can be curiously deceptive. It can be easier to develop a competitive moat because the market conditions, product/service offerings, and raw materials might be subject to easier dominance. For instance, there are very few areas in the automobile industry where a company might capture significant competitive advantages. There is little need or ability to acquire intellectual property rights to lock out competition. The products are generally the same in concept (a four-wheel gas or electric vehicle with certain unique design features) and built/sold in remarkably the same way (internal design teams, multi-stage manufacturing processes, dealer-based sales). For instance, a company will likely achieve a limited dominance in certain demographic or regional areas through branding efforts or marketing messaging. Nowhere in this process is there a means to map out twenty years of market dominance. 
 
Another industry - informatics - is entirely different. The ability to capture market dominance is easier because nearly every product feature is based on intellectual property. For instance, IMS Health (the company merged with Quintiles and renamed IQVIA in 2017) was known for collecting healthcare data, including de-identified pharmacy data, pharmaceutical sales data, medical claims, and other data. The company had a monopoly on prescribing data that they sold to pharmaceuticals, thereby capturing a market essential to guiding pharmaceuticals to market and promote to in their sales teams. No other could provide this data as IMS had exclusivity in its sources. Thousands of companies have access to proprietary data when you think of it, which they repackage and sell to customers. The informatics market is replete with wide moat, small companies which are outstanding investment opportunities.
 
Examples of Small Wide Moat Markets: Some examples of markets can be found in all parts of the economy. Some include financials, healthcare, technology, and others. Nearly all of these are niche markets with similar characteristics – proprietary technology/data and platforms deeply embedded in client operations. The first is financial data. Examples of this include former Nintai holding FactSet Research (FDS), another former Nintai holding Morningstar (MORN), and Bloomberg (privately held). These three companies have growing opportunities in the financial industry with a focus on stock information, trading data, etc. Their proprietary databases and platforms are essential tools, and their platforms are an intricate part of much of the industry's operations. Many companies simply couldn't run without their services. 
 
Another industry is healthcare informatics. Here there are several sub-markets with powerful competitive moats. The first is pharmaceutical prescription data which I discussed previously using IQVIA as an example. A second is the electronic health record (EHR) market. Nearly every hospital utilizes an EHR to coordinate patient care, manage patient records, oversee drug prescribing, and control imaging such as x-rays or MRIs. EHRs are the platform on which nearly every hospital's operations run these days. Making a decision on which vendor to use is not only a multi-million dollar commitment but a decade-long decision that requires years of planning, training, implementation, and maintenance. Once a health system decides on which EHR vendor to work with, it takes something pretty drastic to force them to replace that vendor. Consequently, the EHR market is replete with highly profitable, wide-moat companies.      
 
High Margin Business Models: There are many business models that generate hefty profits even with small margins. An example of this includes the big box retailers, including both general merchandisers like Walmart (WMT) and Target (TGT) and specialty retailers such as Home Depot (HD), Lowes (LOW), or Best Buy (BBY). These companies can create wide moats but generally don't meet the quality standards we look for at Nintai. Using Walmart as an example, let's compare it versus Nintai Investments' holding Masimo (MASI). Walmart's gross, net, and free cash flow margins were 24.8%, 2.4%, and 4.6% in 2020. During the same period, Masimo generated 65.0%, 21.0%, and 16.3%, respectively. Walmart generated a return on invested capital of 8.3%, while Masimo generated a 39.7% ROIC. Walmart's debt to equity ratio (meaning how much debt does the company have as a percentage of its total equity) is 0.78 (short-term debt and capital lease obligation of $5.3B plus long-term debt and capital lease obligations of $60.0B versus total equity of $81.3B). Masimo's debt to equity ratio is 0.02 (no debt and total capital lease obligations of $34M versus total equity of $1.41B)  
 
While both companies have wide moats, Walmart's financial quality is considerably less than Masimo's (at least using Nintai's criteria). Masimo is more profitable, utilizes capital at a much higher rate, and has a fortress-like balance sheet. I should point out either company could be an outstanding or poor investment candidate given certain conditions. Walmart has been an excellent investment over the past 40 years. But given our druthers at Nintai, we'd prefer a company with high margins in a high margin business model than a low margin business in a moderate profit business model.    
 
Product/Services Create Monopolistic Opportunities: One of the things most overlooked in finding quality investment opportunities is seeking out companies that operate in industries where their product or service inherently creates quality and profitability in both good and bad economies. To do this, a company must have a product that is part of their customers' core business by its very nature. This is different than the EHR model I discussed earlier. There the product was deeply embedded in the business process of their customer. Would it be hard to rip the product out and replace it? Absolutely. Could the hospital operate if the systems went down? Surely. With difficulty, but they could certainly still operate. In this category, we look for companies that as the customer utilizes the product, it becomes nearly impossible to function without it.
 
A great example of this is credit cards. Try to imagine going through an average day having only checks and cash (since most credit card issuer networks also issue debit cards, I count them as the same for this exercise). Think of the daily activities where it takes a credit card to complete the transaction. Everything from purchasing gas to shopping at Amazon, renting a car, or staying at a hotel, many consumers would have to change their daily schedule drastically – or eliminate some tasks – if they lost the ability to use a credit card.  
 
Issues to Think About
 
Identifying industries or markets that have high percentages of quality-driven companies is only part of the research necessary. Whenever you find a niche that allows for highly profitable business models, you will likely find competition close on the leader’s heels. Capital flows to business strategies and markets that generate high returns. It makes sense. Success breeds success. Success breeds envy. Envy breeds greed. And greed breeds competition. So when you find that highly successful business model or market, remember to think about the following issues.  
 
Capital Flows to Success: Name any type of business that successfully grew from a startup to an industry heavyweight, and you will find numberless competitors seeking to break into the same market. A great example of this was office supply big-box stores. After the success of Staples, an astounding 131 companies received venture capital or private equity funding over the next half-decade. A company that creates a market niche with high profits will inevitably face an onslaught of new competitors seeking to steal that company's customers or market share. To see this in action, take any six months and follow the investments of the private equity community. You will likely see many investments in one niche market where managers have focused on outsized profits. One quarter might be drug laboratories and the following real estate informatics. Inevitably, profits in those markets drop after such a massive influx of capital.
 
Speed of Innovation/Product Development: Some industries see innovation take place much faster than others. For instance, the automobile industry has been notoriously slow in adopting innovation. The combustion engine has reigned supreme for nearly one hundred years regardless of new technologies that would be far energy efficient. On the other hand, the semiconductor industry has been a continuous struggle to keep up with innovation. Here moats are dug and filled in no time. Finding an industry where innovation widens moats over time is a prescription for long-term outperformance. 
 
Customer Fads: Some industries are prone to customer fads that come and go with remarkable speed. We've all heard of them – Ouija Boards, Game Boys, Beanie Babies, and Rubik's Cubes. These times may temporarily cause stock prices to suddenly soar but are just as likely to drop like a…..pet rock. Certain industries – like consumer electronics – come to mind when you think of industries that suffer from such market fads. If you choose to dip your toes in these waters, just be aware of the strength and depth of the moat. There's a big difference between a game whose name becomes part of our lexicon like Monopoly ("you're spending like it's monopoly money") versus Tickle Me Elmo. 
 
Conclusions
 
The adage goes, "fish where the fish are." No doubt, sound advice if your survival depends on successfully catching fish. Investing is no different. When looking for value-priced quality companies, start looking in industries with a penchant for wide-moat businesses. These markets may be hard to locate initially. Some industries take a great deal of research to find the underlying reasons for their wide moat (pharmaceutical informatics) versus those staring us in the face (pipelines). But once you've found such a sweet spot, spend a good deal of time understanding the industry dynamics and the sources of its moats. Like the hunter-gatherers of old, you might be fishing there for quite a while. 

"Don't worry. We might be losing a penny on each sale, but we can make it up on volume."  
 
                                                                                         -       Anonymous 
 "The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine."
 
                                                                                         -      Warren Buffett 

Revisiting Weighted Average Cost of Capital
 
One of the most interesting stories in the past 18 months has been the lack of discussion about the rapid fall and rise in the US 10-year Treasury yield. It isn't my intention to discuss the reasons for the changes or their meaning for the economy, but rather its simple impact on stock valuation. Such increases and decreases mean that any borrower will see a dramatic effect on their average cost of capital. With rates peaking at roughly 3.1% in October 2018, companies saw the rate drop by approximately 80% over the next 18 months. In less than six months, the 10-year US Treasury rate rose from 0.53% in October 2020 to 1.63% in March 2021. 
 
It's hard to overstate the impact these swings should have on the valuations of publicly traded equities. For those who use a discounted cash flow model (which we do at Nintai investments), a vital component in getting to an estimated intrinsic share value is calculating a company's average cost of capital. In our models, the most significant impact on that calculation is the 10-year Treasury yield. 
 
Before I get into that, a quick overview of United States Treasury note yields, how they are calculated, and their role in our financial markets. The Treasury note yield is the current interest rate paid on the 10-year United States Government Treasury note. The government pays the yields as interest for borrowing money through debt sales at monthly auctions. When the auctions take place, the government sells a specific dollar amount of bills (duration less than one year), notes (sold in 2, 3, 5, 7, and 10-year maturities), and bonds (30 years, reintroduced in February 2006).  For the sake of this discussion, we are only interested in the 10-year note.   
 
Once the debt has been sold, bills, notes, and bonds are traded on public markets, with investors buying and selling this debt and creating a market-driven interest rate. The rates generated in these markets for the 10-year note are vital in the financial markets. For instance, it is the proxy for many financial services such as mortgage rates. It is also used in determining interest rates on credit card debt. Trillions of dollars of financial instruments are affected by changes in these rates. 
 
The 10 Year Treasury Yield and Stock Valuation
 
For value investors, the 10-year note's yield has (or should have) an enormous impact on the valuation of publicly traded equities. When an investor looks to value a business, there are two calculations that play a tremendous role in estimating its long-term intrinsic value. The first is the company's return on capital (ROC). The second is its average weighted cost of capital (WACC). One of the most critical aspects of finding quality in a potential investment opportunity is a having a high return on capital. At Nintai, we look for companies that achieve 15% or greater ROC over the past decade. ROC is an excellent tool for getting a grasp on how well management teams allocate capital. But it's only half the equation (literally and figuratively!). Equally important is the company's weighted average cost of capital. A company always wants ROC to be significantly greater than WACC. It doesn't matter if they can generate an ROIC of 15% if their cost of capital is 18%. (Hence the opening quote about losing a small amount on each transaction, but making up for it in volume)
 
The weighted average cost of capital is one of those topics that inevitably leave peoples’ eyes glazed over when you bring it up. It's like discussing the interest rate you will be paying on that brand new sports car in the driveway. Not many people insist on diligently reading the term sheet. Instead, most dream of taking those sharp turns or doing racing changes on the interstate before trying to measure how the cost of capital might impact the long-term value of that new sports car. 
 
Return on Capital versus Cost of Capital: A Simple Example  
 
Let's use an example of an investor choosing to use cash obtained from a credit card advance to invest in stocks. It sounds crazy, but I've seen things more insane in my investing career. For example, let's start with the cost of capital. A cash advance can be obtained for the average credit card owner with two main items driving calculating the cost of that capital.
 
First, the card company will charge a fee which is generally based on the percentage of the transaction. For the sake of this exercise, let's assume the cash advance is $25,000. According to CNBC, the average transaction charge usually is between 3 – 5% of the advance amount. For this case, let's cut it down the middle and call it 4%. In this example, the individual will pay $1000 for the advance (25,000 x 4%). Second, the credit card company charges an annual interest rate fee on the balance. Let's assume the individual is not planning on paying off the balance for the first year but pay any fees and interest charges. According to the website creditcard.com, the average interest rate charged by the credit card company is 16.15%. For the first year, the individual will pay $4,037.50 (25,000 x 16.15%).
 
In this instance, cost of capital would be $1,000 + $4,037.50 or a total of $5,037.50. Put in the Wall Street terms, the cost of capital would be 4% + 16.15% or 20.15%. Of course, this number means nothing until we calculate the return on capital and see how the two numbers compare. 
 
To calculate return on capital, let's assume the individual wants to invest in a hot-shot stock growth fund that she's been assured is a real winner. We'll call this the "UltraHype Growth Fund" (which goes by the ticker BLECH). Over the past ten years, the BLECH fund has returned 11.2% annually. This is the starting point on the return on capital, but sadly not the final figure. The fund charges are very high – a 1.8% management fee. This is subtracted from returns, reducing the returns to 9.4% annually. Let's be generous and assume there are no additional costs like a load fee of 5.5% or 12b-1 fees or redemption fees. 
 
The return on capital number will be 11.2% of $25,000 or a return of $2,800. From that, we subtract the 1.8% management fee or $450. This leaves the individual with a net return of $2,350. Another way to calculate it is 11.2% - 1.8%, which generates a return on capital of 9.4%. 
 
It should be pointed out here, calculating the weighted average cost of capital and return on capital can be - and usually is - far more complex. It helps to have a calculator or Excel spreadsheet handy. For instance, the actual formula looks like this.

Suffice it to say our calculation in getting a cost of capital in this example is conceptually the same, but woefully deficient in terms of completeness. This is an article for investors, not a graduate accounting class!
 
So, where does this leave our individual? Did their move of taking a cash advance on their credit card pay off by investing in their expensive, hot-shot growth fund? The answer is a clear no. Their return on capital of 9.4% was swamped by their cost of capital of 20.15%. While it may seem obvious to any investor, it's important to point out this is a terrible use of capital. 
 
Cost of Capital and Stock Valuations
 
Having your return on capital exceed your cost of capital really shouldn't be that profound of a concept for individual investors, professional money managers, or senior corporate executives. Is should also be pretty clear that rising input costs in calculating your cost of capital will lead to higher cost of capital. The dramatic movement in treasury yields cited earlier will dramatically impact a company’s cost of capital. With rising Treasury yields, many company’s suddenly began to see WACC exceeding ROC in their returns. These changes should have been seen in valuations if investors were taking these changes into account. The exact opposite has happened. Except for the sharp drop in valuation in the spring of 2020 and their subsequent - and relatively rapid - recovery, the trend in stock prices has been nearly always upward. 
 
To apply this concept and see this disconnect in real terms, I want to use a holding in many of Nintai Investments’ individual portfolios - SEI Investments (SEIC). In December 2019, we estimated the company's weighted average cost of capital was roughly 9.4%. In that calculation, we included the federal funds rate of 1.87%. At that time, we estimated the intrinsic value of the company's stock was $55.20 per share. It was trading at roughly $66.00 per share or approximately 20% above fair value. By any standards, the stock was not a compelling buy. By December 2020, we estimated the company's weighted average cost of capital at roughly 7.9%. Nearly all the decrease in the WACC was the drop in the 10-year note yield. In our calculation, not much else changed. Revenue was flat, free cash flow was down slightly, and publicly traded shares were down slightly. There wasn't much to change valuation except the drop in the funds rate. But, boy, did that change our valuation. The $66 per share in December 2019 had jumped to $73 per share in December 2020. With the stock trading at $56 per share, the company was now trading at 23% below fair value - an enormous change in roughly one year. What had been a moderately overvalue company was now trading moderately below intrinsic value. On these numbers, we purchased shares in our portfolios. What a difference a year makes. 
 
But our example doesn't end there. The exact opposite happened from October 2020 to March 2021. The 10-year note rate jumped 0.53% in October to 1.63% just six months later. The example we just showed went in the exact opposite direction. With such a massive jump in the 10-year rate, companies' valuations took a whopper of a hit. SEIC's valuation dropped from $73/share back to $61 per share. With shares trading at $60 per share, they were now at fair value instead of 23% below intrinsic value.
 
Talk about a whipsaw! In a little over 16 months, SEIC went from moderately overpriced to moderately underpriced to roughly fair value, all due mainly to changes in the 10-year Treasury note yield which then impacted the company's weighted average cost of capital.  SEI Investments wasn't the only company that saw its valuations affected by its drop in the weighted average cost of capital. Every company in the public markets was impacted – some more than SEI, some less. Throughout all of this, overall yields didn't move much. The 10 Year US Treasury note yield was 1.73% on December 3, 2019, 0.92% on December 1, 2020, and 1.45% on March 1, 2021. But there was quite a gap between highs and lows. In August 2020, rates hit their low  0.52% and hit their high in December 2019 at 1.93%.
 
It's important to note that the markets overall were minimally impacted by these changes. From December 2019 to March 2021, the S&P 500 gained 25.4% rising from roughly 3150 to 3850. This even includes the massive drop in the spring of 2020 when the S&P dropped nearly 30%. 
 
What This Means
 
For all this data and heavy reading, you might be asking yourself at this point what this all means. It's a good question and an important one to answer. The most important lesson to understand is that having cost of capital exceed return on capital is not a recipe for outstanding long-term stock returns. It should be common sense to any investor, but roughly one-third of all publicly traded companies currently have WACC exceed ROC. Somebody is investing in these companies, so not everybody has learned this lesson.  Here are some other learnings to think about. 
 
WACC and ROC Must Be Measured Together: I have to concede that I searched for companies with extremely high ROC at the beginning of my investing career but never screened them for WACC. There is a particular bias that a company with high ROC couldn't possibly have even higher WACC. It happens, though. And like any other company with a negative ratio, it's a company that doesn't generate value. Always remember to look at both ratios, not just one. 
 
The 10 Year Treasury Yield Has a Big Impact: I used to denigrate investors who took a lot of time looking at macroeconomic issues because I felt they play a minor role in the business. I was right about that. What I was wrong about is that it plays a massive role in the stock. Remember: sometimes, a company's stock (and its price) has little to do with the company. This type of disconnect happens all the time. A significant rise in the 10-year note rate can drive up the cost of capital, making a dollar in the future worth a lot less. While the company might remain the same, its intrinsic value might decrease significantly. Never lose sight of the role of interest rates in valuation. 
 
In the Short Term Voting Machines, In the Long Term Weighing Machines: Having said that interest rates could affect valuation, it's important to remember the longer the holding and the greater the business's success (through quality and value) the less the impact of interest rates will be. This is a convoluted way to say that time and business excellence overrides the shorter-term impact of interest rates. Being patient and allowing time to work its magic can dramatically reduce some of the risks (but not all!) associated with cost of capital. 
 
Conclusions
 
For any long-term value investor (and what other kind is there? “Short-term value investor” is undoubtedly a contradiction in terms), the ability to find a business and management team that can produce value over a decade or two is the means to creating investment gains. The underlying foundation of this value creation is the ability to have the return on capital far exceed the cost of capital.  Given time and allowing for the weighing machine of the markets to work their magic, companies can become compounding machines for their shareholders. 
 
Understanding the dynamics of what constitutes the cost of capital and its relationship to return on capital is one of the most powerful concepts to a value investor. Looking at both and understanding the drivers of each, an investor has the tools necessary for making the best investment decisions possible. Will the markets always agree with you? Absolutely not. But an investor can go to bed each night fully understanding their investment has created value that day, that week, that month, that year, and hopefully the next decade or two. 
 
I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai Investments has no positions in any stock mentioned.