“Some companies can make millionaires out of their shareholders without a shred of moral character. However, we would argue that few of these shareholders have been long-term value investors. Management without character is like ice cream on a hot afternoon – delicious while it lasts but it always ends up leaving you in an awful sticky mess.”
                                                                                    -     Henry Acton 

"It's a story about the delinquent society—and I use that phrase intentionally—that grew up around the company, and here I'm referring to the collusion of Enron's various advisors and financial intermediaries. And most importantly, Enron is a story about how fraud is often preceded by gross incompetence: where the primary source of that incompetence is inexperience, naiveté, an ends-justify-the-means attitude toward life, and so on. And most importantly, an inability to face reality when painful problems arise."
                                                                                   -     Malcolm Salter on Enron  

****A word of caution up front. This article spends a considerable amount of time discussing the rather complex biopharmaceutical pricing and promotional models as background to Nintai’s purchase and sale of Allergan plc.  For those with little no interest in the esoteric debate of government regulatory power and corporate business ethics, I recommend passing on this article.****
 
On Tuesday, June 25 2019, Abbvie (ABBV) announced it acquiring Allergan plc (AGN) in a $63B deal. Allergan is a former holding in several of Nintai Investments individual portfolios. This article is an attempt to describe how Allergan became a very short-term busted investment for us. I will delve into some level of detail surrounding biopharmaceutical off-label promotional efforts and the current reimbursement model. These was essential components in our decision to eliminate Nintai’s entire position in Allergan.  
 
Allergan: A Brief Investment Case
 
As an investment manager, my fiduciary responsibility is to maximize my clients’ returns within a risk framework best suited to their investment goals. Since we have a tendency to look for companies with great financial strength, a strong competitive moat, selling at a discount to intrinsic value we think the concept of safety is built into our investment selection process.

This focus on safety has held Nintai in good stead over the years. In addition to that, we tend to invest in areas where we feel we have a competitive edge in the nature of the business - its strategy, competitors, marketplace, product development, and regulatory requirements. As a former health consulting firm (with an internal investment fund) we have been quite comfortable investing in the space. Allergan was particularly well-placed. Having served on several life science advisory Boards and 7 of the top 10 biopharmaceuticals as clients, we felt a certain level of comfort investing in the company.
 
Allergan represented a strong investment opportunity. It is one of the largest specialty pharmaceutical manufacturers. It specializes in aesthetics, ophthalmology, women's health, gastrointestinal, and central nervous system products. In 2016, Allergan sold its generics and distribution segments to Teva (TEVA). A series of acquisitions and divestitures hid what we though were some great aspects of the firm. For instance nearly 30% of revenue was converted to free cash over the pasty 5 years. Free cash flow had grown by 13.5% annually over the same period. While the company had roughly $26B in debt, it generated $5B in free cash and had $13B in cash proceeds from the Teva sale. Its major products – regardless of news accounts – had little to no competition for the next several years with one – Botox – looking at label expansion in 9 new therapeutic categories. Last, it was trading at a 9.6 P/E ratio and at a 33% discount to our intrinsic value. What wasn’t to like? Nintai Investments purchased shares of Allergan into some of our clients’ portfolios at roughly $150/share in December 2018.
 
Safety and Ethics or Growth in Sales?
 
Shortly after purchasing our shares in the company, Allergan announced it was under investigation for both off-label promotions and Medicare fraud. Before I go into a description of both of these, let me say up front that I believe good, sound management is essential to long-term corporate growth. This includes outstanding capital allocation skills, deep industry experience, great personnel management, and high ethical standards. Much like a four-legged stool, it is nearly impossible to obtain good balance when missing a leg. Over time, we unfortunately found the company was missing the last leg – high ethical standards.
 
As a steward of my investors’ investments, my primary goal is to not permanently impair their capital. Next in line is to allocate such capital to achieve outperformance of the markets in a manner that meets an investor’s safety requirements. As an investment manager, sometimes these two will be in conflict. In Allergan’s case, it became clear the company’s stock might (and that’s the operative word - might) outperform the general markets. That said, management’s active pursuit of revenue growth and profitability through unethical and potentially illegal means puts such growth at risk. It also put my investors’ capital at risk. For me, there wasn’t much of a debate. If my ultimate goal is to preserve capital, then any activity that puts that at risk requires my direct and immediate action. Accordingly, we sold out of the entire position at roughly $135/share in January 2019. In roughly 30 days we lost 10% (not counting a miniscule dividend payment) on the investment.   
 
As most of you know, it isn’t common for Nintai Investments to own a stock for only 30 days. It’s certainly not our preferred time of ownership. I thought it might be helpful - particularly for those interested in investing in the biopharmaceutical space - to better understand how we see the issues facing Allergan’s management and why such behavior is unacceptable.   
 
Biopharmaceutical Shenanigans
 
The drug industry is highly regulated for good reason. Many treatment therapies can have profound metabolic actions inside the human body. For instance, some inhibitors may inhibit more than originally thought (see COX-2 inhibitor VIOXX) while other treatments may cause side effects that make it impracticable in the clinical setting (see many anti-psychotics and depressants in the teen population). Of course, there is also the possibility of addiction and abuse. For these reasons – and many more – the Food and Drug Administration (FDA) keeps a close eye on the therapeutic approval process, dosage strength, and safety data of each proposed drug.
 
Biopharmaceuticals are no different than any other publicly-traded company.  They face pressure to meet quarterly earnings, show growth in revenue and profits, and assist their shareholders in meeting their financial goals. For these reasons, biopharmaceuticals are tempted to do one of two things (or both) to increase revenues beyond ethical (and sometimes legal) means. The first is off-label marketing. This is when companies promote drugs for treatments of diseases not approved by the FDA. The second is price manipulation whereby the company overcharges state and Federal programs. Not only are both of these against the law, they are also highly unethical. Pushing drugs to be used where no scientific study has demonstrated efficacy and safety can put real lives at risk. Overcharging Medicare means there is less of the pie to go around, meaning there are less drugs available or fewer patients covered.
 
 
Off-Label Drug Promotion
 
There are two major areas of potential ethical violations in the biopharmaceutical industry. The first is promoting drugs “off-label”. This means the company is promoting its drugs to physicians as a therapy for a disease outside of its approved therapeutic guidelines or label. For instance, a drug might have gone though an FDA-approved clinical trial process that shows efficacy in the treatment of rheumatoid arthritis. The FDA then approves a label – found in the drug packaging – that outlines exactly for which disease, at which state of the disease, at what dosage, and at which demographic group the drug has been approved for treatment. This is the legal extent to which the drug can be promoted.
 
However, over time anecdotal evidence may start to suggest this drug is helpful in treating shingles. At this point, the biopharmaceutical is faced with a dilemma. It can spend hundreds of millions of dollars in new studies to confirm the drug is efficacious in shingles, or it can - without FDA approval - promote the drug to physicians “off-label” as a therapy for shingles. In the latter case, the company face up to hundreds of millions of dollars in fines. That said, dependent upon the increase in revenue from off-label sales, some companies might simply build in the fines as a cost of doing business.
 
Abuses of this type range in their level of guilt. Some drugs are promoted and used off-label with common knowledge because we know they work. For instance, colchicine was approved on-label for gout, but was used off-label for years to fight the effects of familial Mediterranean fever. Other efforts have been far shadier in their ethics. For instance, in 2012 GlaxoSmithKline (GSK) faced criminal and civil charges failing to provide safety data (showing much higher risk than disclosed) along with kick-backs, and off-label promotion knowing the drug was highly risky in the off-label target patient group.   
 
Drug Pricing and Reimbursements
 
A second major way of illegally increasing revenue is by overcharging both the Federal government and state governments through manipulation of agreed-to pricing agreements. After receiving FDA approval to begin marketing, promoting, and selling its product, the company develops an average wholesale price (AWP). This is a benchmark used for pricing and reimbursement of prescription drugs for both government and private payers. AWP is not a true representation of actual market prices for either generic or brand drug products. AWP is often been compared to the “list price” or “sticker price”, meaning it is an elevated drug price that is rarely what is actually paid. Pharmaceutical companies then sell their drugs to wholesalers (roughly 90% of drugs are sold this route). The price the wholesaler (companies such as AmerisourceBergen ((ABC)), or Cardinal Health ((CAH))) pays for the drug is called the Wholesale Acquisition Cost (WAC). The final step is getting drugs from the wholesalers to the patients. This is handled through several chain and local retail pharmacies as well as an increasing number of mail and specialty pharmacies. The retail pharmacy market in the US is largely dominated by chain pharmacies;. In 2014 the top three pharmacy chains (Walgreens Boots Alliance ((WBA)), CVS Health ((CVS)) and Rite Aid ((RAD))) accounted for over 75% of the market share.
 
This system might work well if insurers and pharmacy benefits managers (PBMs) weren’t thrown in there as well. Insurers entered the pharmaceutical market to use their market power to reduce the prices they pay for drugs. PBMs (such as ExpressScripts ((ESRX))) work on behalf of their clients to lower the prices paid for pharmaceuticals. They interact in the pharmaceutical market through two primary paths: price negotiation and formulary design. The first part of price negotiation is reducing the prices paid at the pharmacy through discounts. PBMs aggregate the purchasing power of multiple insurers and payers to negotiate better discounts with pharmacies than insurers could achieve on their own. 
 
While discounts reduce the initial price paid at the pharmacy, rebates earn money back after drugs have been sold and consumed. Drug rebates are negotiated directly with manufacturers on brand medications by PBMs. They often total 10% or more of the price of branded drugs. Manufacturers pay rebates to earn access and to reward volume. Access means that a PBM lists a medication on their formulary as a “preferred” brand drug, meaning it costs less to the consumer and will be more likely to be prescribed by physicians. Volume rebates are additional rebates paid by the manufacturer if a PBM sells more of their brand drug than similar alternatives. A decade ago many PBMs provided their services for a nominal fee and earned most of their money through rebates., Today, most PBMs charge higher upfront fees and pass-thru rebate payments to the insurer.
 
Allergan: An Investment Gone Awry
 
Biopharmaceuticals have increasingly used the complexity and opaque nature of pricing to overcharge state and federal healthcare (particularly Medicare). Along with off-label promotion efforts, the fines have begun to reach breathtaking levels. In the last 10 years, the industry has paid over $15B (that’s with a B) in penalties and fees and signed over 115 consent decrees.
 
Shortly after purchasing the stock, Allergan joined the hallowed halls of biopharmaceuticals stretching the legal limits – until, with a hop and a skip – they crossed the ethical (and perhaps legal lines). At Nintai, we spent the following 3 months interviewing management, wholesalers, pharmacy benefit managers, pharmacists, and managed care formulary committee members surrounding the company’s products and services. After much deliberation and thought, we made the decision to divest the entire position from the portfolio.
 
We didn’t do it lightly. We recognized we were taking a permanent 10% loss on our investors’ capital. But overall we think it was the right thing to do – from both a portfolio management perspective as well as a position of who we like to partner with when it comes to our partners’ hard-earned capital.
 
Conclusions
 
If one were to boycott every biopharmaceutical for a violation related to product promotion and sales, frankly there wouldn’t be that much of population left to research. That said, there are violations where the rot starts at the head. Both off-label marketing and mispricing are two of these. From the CEO down, every major manager knows sales forecasts to the penny. When these numbers begin to either outperform or meet numbers designed with fraud in mind, then senior management has a choice. They can live with knowledge of such activity or they can blow the whistle, take their lumps, and clean up the organization. It is a sad commentary on today’s business ethics that many choose the former course of action.   
 
Do I regret seeing the company being acquired at a 28% premium to its price the day before the announcement? Sure. I hate losing. I equally hate not winning – and Allergan represents both of those in Nintai’s investment experience. But I’m happier knowing that both the Nintai team and our investment partners could sleep well at night – both from an ethical standpoint as well as a risk standpoint.
 

​“There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description that I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”
                                                                       
                                               -     Fred Schwed Jr. “Where Are the Customers’ Yachts?”
 
People often ask me questions such as “why didn’t you buy more of Acme Rubber Band stock when it dropped by 50% then rebounded 300%?”. Conversely, it might be a question about why I didn’t sell a stock that has risen a great deal but then dropped back in price. Many times my immediate response is to shout back - in my best David Mitchell impression[1] - quoting Benjamin Disraeli “it’s much easier to be critical than correct!”. Frankly, that type of response rarely works well. So - in my own tedious and rambling way -  I try to take the time to explain the cause for my actions. My gut feeling is that this type of response garners as little excitement from the questioner as it does me. When I’m taking to an individual investor, it sometimes seems like we are speaking different languages.
 
Professional Money Management: Different Needs, Different Goals   
 
I must concede the stock selection methodology, selection criteria, and emotional responses are usually quite different between a professional money manager and an investor managing their own money. As an investment manager myself, what investments I select, why I select them, and even how I purchase them is very different than if I was choosing my own personal investments. Much like Mr. Schwed’s virgin, there are some things you simply can’t describe in a case study or colorful graphics. There is a very particular feeling when you lose 55% of your client’s investment portfolio on a particularly bold bet on a Rumanian bakery company.  For those who think it’s painful to lose your own personal investment dollars, wait until you start losing other peoples’ money who pay you to fund their retirement or their child’s college education.
 
I was recently talking to an individual who manages his own family’s investment portfolio. It is roughly $50 million dollars with the bulk of it made by the sale of the patriarch’s privately-held construction company. He told me he enjoyed reading my articles and book, but said he couldn’t see much difference between what he does and what I do as an investment manager. One thing that struck me right away was that it certainly feels different managing other peoples’ money versus my own. After giving it more thought, I thought my readers (and my friend) might find it interesting to see how we see the distinction here at Nintai Investments.  
    
Regulatory is a Whole New World
 
The first difference – and certainly the most profound – is the amount of regulatory requirements necessary to create and run an investment advisory business. It boggles the mind to see the sheer volume of state and federal regulations that dictate everything - from how you market your services to how information you are allowed to disclose to different people. There is no amount of discussion or graphic demonstrations that can prepare a fresh college graduate who thinks they can quickly open up their own investment house.
 
Your Fiduciary Responsibilities Lie With Your Client
The Investment Company Act of 1940 along with the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940, are make up the rules-based regulatory backbone issued by the Securities and Exchange Commission. In addition, each state has its own Securities Division – usually residing in the Secretary of State’s office. Both Federal and State rules and agencies are designed to protect the general investing public. For the individual investor, you will likely see all of these efforts is in a mound of paperwork you (if you are the average investor) will never read. As an investment manager, these regulations are there to modify your thinking from an internal perspective (you as a money manager) to looking outwards (for your client). You can never lose sight of the fact that you are a fiduciary steward for your clients.   
 
Even Though the Fiduciary Rule is Dead, Its Ghost Lives On
During the Obama administration, the Department of Labor proposed that investment advisors act in their investors’ best interests in managing their retirement accounts. It became known as the Conflict of Interest Rule. The proposed rule would have meant shifting away from commissions on various investment products and becoming completely transparent on what advisers did and the advice they would provide. Inexplicably (or maybe not), there was a great deal of hostility towards the proposed rule leading to multiple law suits, congressional hearings, and bombastic op-eds. Apparently, the horror of putting your clients fiduciary needs ahead of your second vacation home was simply too much for the industry and it was quietly put to sleep in June 2018.
 
It Doesn’t Meet Our Investment Partner’s Needs
As a registered investment advisor, I have a fiduciary responsibility to purchase investments that best meet my investment partners needs and style. For instance, they may state they want no tobacco or gun companies in the portfolio. As a 70-year old retiree it is likely (but not certain) to be a bad investment choice to allocate 25% of all assets under management (AUM) in high-tech stocks with no earnings, no free cash flow, and a rapidly evolving product space. The simple case may be that – while Acme Rubber Band Company makes sense in my 12 year old nephew’s IRA – it has no place in my client’s portfolio.  
 
It isn’t just process that separates investment managers from individual investors. Many times individual stocks are not in portfolio because of specific market conditions, the amount publicly floated shares, or trading volume. For instance, in my investment search criteria, there are only 125 – 150 stocks that meet my investment criteria. As my assets under management continue to grow, it becomes increasingly hard to obtain adequate shares. Two issues can become problematic in these cases.
 
The Position is Too Big as a Percent of Total AUM
As an individual investor, I didn’t get overly concerned when a portfolio might represent more than 40% of my total investments. This is certainly different than my role as an investment manager. Currently we have a rule that when a holding exceeds 10% of total AUM we notify our affected investment partners. At 20% a second letter goes with a detail risk analysis. We have a hard cap at 30%. Does this decrease my chances at watching a stock become a ten-bagger like FactSet Research (FDS) became earlier in my career? You bet. But does it allow our investment partners a greater level of comfort? Indeed it does. I’ve always held true to the idea that if I lose a point or two to achieve a good night’s sleep then I will unhesitatingly do so for myself and my clients.   
 
It Takes Too Long to Acquire/Sell the Total Position
We have a holding in all the portfolios we currently manage – Biosyent (OTC: BIOYF). It is Canadian company traded on the Toronto Exchange under the ticker RX. We own shares purchased in the over-the-counter market. On any given day, it might trade 7,500 shares on average. In our current positions, we own roughly 13 days of trading, meaning it would take 13 days of average activity to fully liquidate our total holdings. As stewards of our investors’ capital, this is a risk we take quite seriously. With roughly 20% of each portfolio in cash and long-term buy and hold investors, we are comfortable with this type of situation. But one doesn’t have to think very hard about risk if we levered up on this position by purchasing an additional 50% on margin.  
 
You Actually Need a Great Return History
Everyone talks a good game on internet chat boards or in the comments section of some Seeking Alpha article. When you become a money manager, you lay everything out there for your clients to see. Everything from your management costs to sales agreements to your actual returns. There are no mulligans and there is no selective grooming of the portfolio to scrub out the occasional bone-headed investment decision. In essence, managing other people’s money means you open your kimono and compete every day against your appropriate benchmark and other investors who are likely a lot smarter than yourself. After all that, you have to create a compelling record - either through your own investment methodology, a particular niche that you know better than others, or simply pick great stocks that outperform over the long-term. Having that record - and having it audited and confirmed by third parties -  is far more difficult than most people think.
 
Playing With Your Money or Someone Else’s Money
 
A final note on managing your own money versus someone else’s. If you think the latter gives a greater level of risk, or it gives you a chance to stretch returns and make you look real smart, you are in the wrong business. Fiduciary responsibility is a remarkable honor to have bestowed on you, but it comes with great responsibility. From both an ethical and legal perspective you have the responsibility to do what’s best for your client. In many cases, this might be at odds with what’s good for you. Much like Mr. Schwed’s virgin and investor, you can’t teach someone how it feels to lose a substantial amount of money in the markets. It certainly can’t teach you what it feels like when it’s your clients’ hard earned savings. Generally, great investors are also great financial stewards. They weren’t taught that. It’s likely the next generation of great investors won’t be either.    
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: I own Biosyent in several personal and institutional accounts that I personally manage.

[1] A compilation of classic David Mitchell rants, ravings, and general outbursts can be found here. 

“If you do not change direction, you may end up where you are heading.”   -  Lao Tzu
 
“There is the great line that to finish first you must first finish. To do that, you have to stay on the road. You have to have guardrails that prevent you from driving into the woods. Another phrase is you can’t see the forest through the trees. To confuse the hell out of you all, I’m going to mix metaphors. You won’t finish first if you drive off the road into a bunch of trees. That’s bad. Really bad. So make sure you stay on the road and make sure you don’t mix metaphors. Screwing up either of these never ends well.”
                                                                                         -      Steven Harcourt   
  
One of the things I think most underestimated is that successful investors have strict value-based guidelines. That doesn’t mean their investment criteria is necessarily strict (though it might be). It means the tools they use to help structure their strategy are strict. An analogy might be driving on the highway. The guardrails play a vital role of keeping you on the road and headed for your destination. These guardrails are immovable. How fast you drive, whether you pass someone or not, or what type of gasoline you use is entirely up to you and dependent upon your time to destination, the weather, or even how you are feeling that day.
 
Many great value investors have their own guardrails. Some of these include margin of safety, or staying within your circle of competence. Whatever it might be, most investors will find that a similar structural framework will help guide them in reaching their investment destination. At a recent conference, I struck up a conversation with a very successful value investor who has outperformed the markets for roughly three quarters of any 5-year rolling period between 1980 - 2016. When I asked him the secret to his success he said there are two things to always bear in mind.
 
Never Stray From Your Framework
This individual has four key theses that he says guides him and his firm in everything from asset allocation to investment selection to business operations. He says he developed these over time to reflect his strengths and weaknesses. These four values are non-negotiable from his and his organization’s standpoint. He refers to them as his foundational guide posts. In the conversation he went on to say:

“These four guide posts corral our thinking, our operations, and our decision making. Having something that maps out your path and gently reminds you (and sometimes NOT so gently) to stay on the straight and narrow has been a big part of our success. We have a lot of flexibility at our firm – from our investment style mandate to our work-from-home-policy. But every one of those flexible policies can be traced back to the four values. Those never change and are never negotiable. They are our guiding light”.
 
Trace All Your Decisions Back to Your Guidelines   
The second item for this investor was the fact that all of his company’s strategy, operations, and decision processes flow from his four theses. As a professional money manager, I’ve tried to build everything about Nintai Investments LLC around my own guidelines. When I started the firm, the Board and I decided there were two sets of theses (or guardrails) that would drive the business. The first set centered around the type of company I wanted to work for and offer to my employees, investment partners, Board of Directors, and greater community where we live and work. I’ve touched on those previously, so I will pass on any discussion specific to these. The second group of guidelines helps create a structure around our investment philosophy, portfolio selection, and capital deployment. Everything we do in portfolio management can be traced back to these guidelines – our stress on high returns on capital, low or no debt, deep competitive moat, and purchasing with a considerable margin of safety.                                                       

Nintai’s Guidelines: GPS (More than Roadside Assistance)
 
After our first Board meeting, it was brought up that it might be helpful to create an acronym for our investment guidelines - something pithy that could make it easy to remember. After considerable time (and a not so inconsiderable amount of libations) we developed the acronym GPS. Not only does it automatically make one think of guidance and direction, the letters also happened to represent the three guiding values in our investment policies.
 
To most GPS means Global Positioning Service. It is a satellite-based system created by the United States government (and now greatly enhanced by both private and international government efforts) to assist in defining one’s location speedily and accurately. At Nintai Investments, GPS is an acronym for the three major pillars in our investment process. First, we seek companies with a systems or platform-based approach to their customer. We look for companies that seek to embed themselves within their customers operations and/or marketplace. We like to see the company have an agnostic approach to technology. This allows for sales in new product niches or adjacent markets regardless of the legacy technology applications or systems. This assures (G)rowth. Next, we try to find companies that earn high returns on capital - considerably higher than their weighted average cost of capital - and then hold on to them for extended periods. When we can find managers who are outstanding allocators of capital – and give them a long stretch of time to produce – this gives us our best chance at long-term (P)rofitability. Finally we look for companies with a high conversion of revenue into free cash and no debt. Companies with such strength on their balance sheet and statement of cash flows have great strategic flexibility (particularly in down markets). They are rarely forced to make poor capital allocation decisions that can permanently impair our customers’ capital. This assures (S)afety.
 
We see this three-legged guideline approach to our investment process as a means to sleep well at night regardless of market conditions. Additionally, the broader role of the GPS acronym gives our investment partners a simple - yet effective - tool to remember how Nintai structures its investment decisions.
 
Conclusions
 
No matter how long you’ve been in the investment management business, times of market highs or severe drawdowns can distract you very quickly from your investment strategy and processes. Knowing your guidelines and building your investment processes around them can help you stay focused in times of real market stress. The ability to go back and draw on your core values and apply them quickly and easily can make or break your investment returns over the long term. Spending some time drafting up your investment guidelines then mapping your investment processes against them can be a great tool to better understand how you might react in times of crisis. In these days of Twitter announced (and canceled) tariffs, Federal Reserve policy reversals, and potential economic conflicts, it can’t hurt to have something that anchors your emotions and investment decisions. 

During the first weeks of the First World War, many German commanders were reporting back to General Headquarters about the successful attacks on French lines. Many boasted about encircling French forces and how they were retreating in disarray. Helmuth von Moltke (the Younger), who was Chief of the German General Staff - on the receiving end of these reports - had severe doubts. He kept asking the same question: “But where are the prisoners?” Moltke understood that claims of the French Army collapse must coincide with the capturing of vast amounts of prisoners. Since there were very few troops captured, he realized the French Army was not routed, but instead carrying out a rather deliberate retreat, leaving the chance of a great counteroffensive possible. Moltke’s understanding came too late. In early September, the French and British launched a crushing counteroffensive that stopped the German advance cold and ushered in 4 years of grinding trench warfare.   
 
I bring up this short history lesson after listening to Stanley Druckenmiller’s interview that took place at the Economic Club of New York and a follow up interview on CNBC on June 7 2019. In both events, Druckenmiller discusses the fact that corporate debt has risen from $6T in 2010 to $10T in 2018 (a 65% increase). At the same time corporate profits rose from $1.7T to $2.2T. (a 29% increase). He points out that for a 65% increase in debt total profits grew at roughly 3% annual growth rate. To paraphrase Von Moltke - where are all the profits?
 
It isn’t just the lack of profits where Druckenmiller has a problem. During the same period, companies spent $5.7T in buybacks versus $2.2T in CapEx. This is a complete reversal from the numbers in 2010. At that time, buybacks represented 20% and CapEx 65%. His concern is that companies haven’t invested in making their companies more productive or more competitive. Rather, cheap debt has allowed an enormous amount of companies that would - in more normal times - have faced bankruptcy put in place a systemic process to transfer wealth from the company to its largest shareholders and management. Again - to paraphrase von Moltke - where are all the bankruptcies?  
 
A Rather False Narrative: The Russell 2000 and Corporate Debt
 
The narrative concerning the strength of the US economy is based on two pillars - the strength of the US equities markets and the burst in GDP growth after the tax cuts of 2017. While some may argue the markets have been rather flat for the past year (the S&P 500 is up roughly 3.8%), there is no doubt the tax cuts boosted GDP growth in the short term. But over time, I think the numbers tell a false narrative that puts value investors at grave risk. In this article, I thought I’d take a look at a segment of the market and apply Mr. Druckenmiller’s concerns.
 
The Russell 2000 represents the smallest 2000 small-cap stocks of the Russell 3000. It is considered the best representation of US-based small-cap businesses. As you look at the companies in the index, several statistics stand out that should cause serious reflection in all value investors[1].

1. In 2018, 38% of the Russell 2000 had no net income, whereas only 1.4% of S&P 500 companies have no net income.
2. In 2012 the Russell 2000’s total debt to capital was 19%. Prior to the Great Recession, the average total debt to capital was 29% at year-end of 2007. As of May 2019 that number sits at 34%.
3. In the Q4 2018 swoon, the Russell 2000 companies whose shares were in the highest quartile of percentage declines had a median debt-to-equity ratio of 41%. Russell 2000 companies whose shares were in the lowest quartile of percentage declines had a median debt-to-equity ratio of 32%.
4. In the Q1 2019 surge, the highest leverage Russell 2000 companies gained 17% on average, while the least leveraged gained just 5%.

This data can tell us some very interesting points about the investment markets.
 
Debt as a Percent of Equity Has Never Been Higher
The amount of debt taken on by the Russell 2000 constituent companies has not been this high since the 2008-2008 market crash. Indeed, debt as a percent of equity is far higher than previous to the crash. The vast majority of this debt consists of Cov-lite loans (as discussed in my recent article “Fata Morgana and the Illusion of Safety” which can be found here) which are very sensitive to interest rate volatility.
 
Debt as a Form of Capital Has Generated Awful Returns
The debt taken on by companies has provided little to no increase in productivity or profitability. Indeed, a quick review of 100 companies in the Russell 2000 by Nintai Investments shows that return on capital has decreased from an average 14.1% in 2012 to just 9.3% in 2018. Additionally, companies with no net income has risen from 26% in 2012 to 38% in 2018.      
 
Investors Have Lost Sight of Risk
The returns generated by the highest leveraged small-cap stocks in Q1 of 2019 shows that investors have lost sight of risk associated with high levels of indebtedness. Combined with the fact that a large percentage of these companies have no net income, I would suggest value investors proceed with extreme caution in this market environment.
 
Conclusions
 
The last six to nine months have been a whipsaw for investors and business owners alike. The possibility of trade wars - being announced and rescinded by random tweets by the President - leave many of us without a clue as to where and what protections are afforded by business fundamentals[1]. Combined with the 180 degree change in the Feds approach to raising rates (now even discussing lowering rates), the ability to look out and assess risk has gotten extremely difficult. With all of this happening, it would seem to me value investors must be extremely risk averse when it comes to highly leveraged Russell 2000 (or for that matter any) companies. That doesn’t mean I haven’t been wrong before. Nintai Investments’ returns have beaten both the S&P 500 and Russell 2000 indices - barely - over the past 2 years as investors have clearly decided that risk is not a prime concern. My extreme aversion to debt and requirement of fortress-like balance sheets has afforded me little advantage against the general markets. That said, I would still advise value investors focus on one question – to paraphrase von Moltke: where is the risk? Once you’ve assessed and answered that question, then act accordingly.

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[1] I should point out I wrote about debt and the Russell 2000 in an article “Leverage and the Stock Market” in May 2018. The article can be found here.  

[2] As an aside, Skyworks Solution (a holding in both personal and institutional investors’accounts at Nintai Investments) is a supplier to both Huawei (in January 2019 the US Justice Department unsealed 23 counts including IP theft, obstruction, etc.) and has 39% of its assets in Mexico (the President threatened and then backed off imposing between 5 - 25% tariffs on Mexican imports). As a holding in our portfolio, it is nearly impossible to generate a business case with any confidence going forward.  

For centuries, the Fata Morgana - a mirage created by refracted light - caused varying amounts of fear, panic, and wonder to sailors around the world. Named after King Arthur’s sister Morgana (who lived in a crystal city under the sea that would occasionally surface), sailors would record seeing everything from armies fighting battles to huge fleets crossing the ocean. The fata morgana - of course - would eventually be explained by understanding how light is refracted through different temperature layers. What sailors saw was a combination of such refraction with a (un)healthy dose of creative imagination.
 
I bring up the Fata Morgana because it isn’t just sailors who see mirages in the distance. Investors can as well. For instance, the vast majority of income investors see most business loans as refracted through 20th century lenses. They see loans backed up by collateral with credit ratings providing a certain guidance on risk. Much like the mortgage-backed securities (MBS) market of 2005-2007, this couldn’t be a larger mirage. Since 2011, there has been an explosion of Cov-lite loans in both dollars and as a total percentage of leveraged loans. 
 
Covenant Light (Cov-lite) loans are loans that don’t contain the more traditional covenants that protect a lender against potential loss. In earlier times, banks would require certain collateral (such as your house against a mortgage) that would allow them to seize control of assets or intervene in operations if the underlying assets lose enough value. The key here is the bank could see a developing situation and take corrective action before things got too far out of control. Generally these covenants fit into three buckets. The first is leverage. This is generally calculated as a multiple of either income statement or balance sheet line items. Second is loan-to-value. This is the ratio of a loan to the value of an asset purchased. The last is an EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio. This covenant might be expressed as EBITDA as a percent of total revenue.
 
Cov-lite loans dispense with all of this. These loans are generally made by a syndicate of banks with little to no covenants attached to the loan. The lender has little protection against loss. The market for Cov-lite loans has been driven by private equity and their use of such loans. As these firms have played an ever increasing role in corporate debt financing, lower credit quality companies have used this to force banks to give way on the more traditional loans guarded by the series of covenants previously discussed. Cov-lite loans are considered leveraged loans or loans provided to companies/individuals with significant debt already or poor credit quality. Many leveraged loans are utilized for leveraged buy outs (LBOs) mergers and acquisitions, or restructuring the balance sheet.   

Cov-lite loans peaked just before the Lehman crash in 2007 at roughly $94B. After that, the loans essentially dried up with only $2B in 2008, $4B in 2009, and $8B in 2010 before roaring back to $58B in 2011. Fast forward to 2018 when nearly 75% of the $970B leveraged loan market is made up of Cov-lite loans or roughly $728B in corporate debt. (See chart below) Compare this to the $94B before the Lehman crash and one begins to feel the palms sweat a little bit. 

This growth - in both dollars and percentage - of total leveraged loans have several effects on the corporate debt markets.
 
Hard to See the Incoming Train with Cov-lite
Traditionally, covenant loans provided lenders with warnings to potential impairment or losses. When a company began to close in on an EBITDA ratio cap, the bank would be notified and prepare itself to either renegotiate the loan or take steps to protect its capital. Cov-lite loans rob banks (no pun intended) of the ability to get ahead of the curve and protect their capital. Should there be a slowdown in the general economy, many syndicates could be blind-sided by wide-spread defaults.
 
A Majority of Cov-lite are B3 Companies
In 2018, nearly half (or roughly $360B) of all Cov-lite loans were made to companies with credit ratings of B3. This means that a drop of one notch in credit quality will bring these loans into junk status. This kind of mass movement can play old Harry with bond funds whose covenants may require these loans be removed from their portfolios. For individual investors, this could lead to significant drops in the NAV of their corporate debt funds.   
 
Cov-lite Can Be Good and Bad for Equity Investors
For investors in companies with lower credit quality, Cov-lite loans might actually be a net positive since the lender has little or no protection should there be slow down. Rather than face dramatic steps such as corporate restructuring or asset seizure, the company may be able to face little action. That said, it should be pointed out that if the company has a.) poor credit quality and b.) slowing or failing business fundamentals then it is unlikely a Cov-lite loan versus a covenant-based loan will save their investment.
 
Why This Matters
 
As a value investor, I see my top priority as avoiding the permanent impairment of my investors’ capital. Growth is necessary as well, but certainly not my top priority. The leveraged loan market – frequently mixed with the High-Yield or Junk Bond markets – can tantalize investors with generous dividend yields. As a value investor with very strict balance sheet requirements, Cov-lite supported companies play no role in my portfolio selection. For those who do invest in such companies, they should go into the investment with their eyes wide open and aware of several risks.
 
Things Can Go From Fine to Very Bad Quite Quickly
Much like recessions - when you don’t know it’s coming until you are in one - the Cov-lite loan market can head south quite quickly. For instance, S&P Global Market Intelligence reports that earnings-per-share growth across the Cov-lite market in the first quarter 2019 dropped to 0.5%, from 14% in the fourth quarter of 2018, and from growth rates of 20%–25% over the first three quarters of 2018. Default rates of Cov-lite rates went from 0.2% in June 2007 to 10% in December 2007 - a grand total of 6 months.  
 
Cov-Lite Market Liquidity can Disappear Quickly
During the height of the credit crisis in 2008, there was simply no market for Cov-lite paper. It seemed that in a matter of moments the trading market was fine and then closed to investors. For those who didn’t need the cash thrown off from these investments, a year later the market (though much smaller) was working efficiently. However, open-ended funds that had significant withdrawals saw their investors suffer horrendous losses. In addition, companies that survived on Cov-lite loans saw their financing dry up and frequently sought bankruptcy protection.  

Risk is Often Mis-Priced and Difficult to Value
It seems to me the lower credit quality markets either trade at exuberant rates or severely depressed rates. Much like Goldilocks of yore, the temperature never seems to be just right. Additionally, delving into the actual loan agreements and understanding the legal obligations of both parties takes a mind far smarter than I and trained in corporate law. It’s extremely easy for a layman to misprice risk in these markets.
 
Conclusions
 
Whenever markets reach highs and valuations are stretched, the first thing I look for are opportunities where I might be mispricing and/or misunderstanding risk in my portfolios. This type of risk can be direct (owning an individual company dependent on short-term paper to fund operations) or indirect (owning an individual company with widespread exposure to such companies) dependent upon the company. Because Nintai Investments steers clear of lower credit quality holdings and does not invest in debt instruments of any sort, we remain comfortable the explosion in leveraged loans will have minimum direct impact on our portfolio performance. Indirect impact - such as when the credit markets seize up and stock prices across the board collapse - is a whole other issue. For those investors who are invested  - in either direct or indirect ways - in the leverage loan markets or individual companies dependent on such loans, we advise caution. Sometimes the illusion created by fata morgana creates castles where none exist and that’s not a proper defense for anybody’s investments.