For the second time in three weeks, a stock in the Nintai Charitable Trust has been acquired. Analog Devices (NASDAQ:ADI) announced on July 26, that it was acquiring Linear Technology (NASDAQ:LLTC) for $60 per share in a cash/stock deal. The sale price was approximately a 29% premium to the closing price on July 26th. LLTC had been a holding in the Nintai Charitable Trust.
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We first purchased LLTC in August 2015. Since then (and including the rise in price after ADI’s offer), the stock has returned 65% including dividends. We will be selling the entire position over the next few days. With this sale, the Nintai Charitable Trust’s cash position will be roughly 13%.

Because this holding produced a good profit in a relatively short time, I would like to describe my rationale for purchasing it. Linear specializes in high performance analog (HPA) chips. There is simply no other chip maker that generates LLTC’s free cash flow as a percent of revenue, returns of assets/equity/capital and fortress-like balance sheet. As with our discussion about ARM Holdings (NASDAQ:ARMH) (acquired several weeks ago), the acquisition of LLTC is a long-term bet on the Internet of Things (IoT). There was one stark difference, however. LLTC's growth was far slower than ARM. We listened to management and felt growth was about to rise significantly and felt comfortable holding the shares into the future. Also similar to ARM, Linear is the type of company we would have been happy to hold for decades.

he acquisition of Linear Technologies was a bet intended by Analog Devices to broaden its competitive moat in the HPA market. We think ADI overpaid for the company, but see it as part of continuing frenzy in the semiconductor industry to make bets on the IoT bandwagon. As to where the semiconductor industry goes from here, I feel the prices being paid are not necessarily the best use of capital. It’s good to see former Nintai holdings being on the side of overpaid acquisition rather than overpaying suitor.
As mentioned previously, I don’t know where the markets are headed, what logic will be employed for mergers and acquisitions, or whether the Internet of Things will drive double digit growth over the next several decades. At the Nintai Charitable Trust and Dorfman Value Investments, I look for great companies with deep competitive moats generating high returns, generous free cash flow, fortress-like balance sheets, and selling at a significant discount to their estimated fair value. It is my intention to let management compound value over the long term. While I’m somewhat sad to see two holdings be acquired over the past several weeks, if the markets see fit to provide outsized performance in the short term, then I am happy to play along with their tune.
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​Softbank announced on July 18th, 2016 that it was acquiring ARM Holdings (ARMH) for $32B in an all cash deal. The sale price was approximately a 43% premium to the closing price on July 15th.
 
ARMH had been a holding in both the Nintai Charitable Trust and in a Dorfman Value Investments individual account. We first purchased ARMH in the Nintai Charitable Trust in February, 2016 after negative returns in 2014, 2015 and a nearly 15% drop in the first month of 2016. Until then I had never really gotten the valuation required for purchase. I purchased additional shares in June, 2016 in a Dorfman Value Investment individual account.
 
Because this holding produced a good profit in a relatively short time, I’d like to describe my rationale for purchasing it. ARM holds an extensive library of microprocessor intellectual property and has particular expertise in low-power high-performance chip architectures. ARM's IP is the backbone of the vast majority of processors used in mobile devices today, and strong tailwinds from the shift to higher-end smartphones and the proliferation of connected devices as part of the Internet of Things (IoT) should drive growth for ARM in the years ahead.
 
 ARM Holdings is the type of company I love to hold for the long term. As seen below, the company is a cash machine generating high returns and compounding value over the long term. It has no debt and maintains an extraordinarily wide moat in its focused industry.

​The acquisition of ARM Holdings was due as much to macro economic events as the favorable characteristics of the company. In 2016, sterling is down roughly 8% against the Chinese yuan, down 10% against the US dollar, and down a remarkable 21% against the Japanese yen. All of these moves have been predominantly driven by the UK’s recent decision to leave the European Union. So while the company’s stock was up by roughly 17% since the Brexit vote, the company looked like a reasonable deal from Softbank’s Tokyo view.
 
I sold the entire position in ARMH in both the Nintai Charitable Trust and Dorfman Value Investments over the last 24 hours. I’ll be the first to admit I’m simply not smart enough to make investment decisions on merger arbitrage, currency swings, or stock chart patterns. At the Nintai Charitable Trust and Dorfman Value Investments I look for great companies with deep competitive moats generating high returns and free cash flow selling at a significant discount to their estimated fair value. It is my intention to let management compound value over the long term. If other market players can help make our investors favorable returns so much the better. 

​[1] With all due respect to Joseph B. Geoghegan who wrote the original song “Johnny We Hardly Knew Ya” in 1865. 

“Health care is like no other industry. There is seemingly no need for the existence of some functions; you can’t decide whether it’s a profit or not-for-profit system, or whether it’s competitive or not. The regulatory environment is like no other industry. And finally the size and scope of it makes it 25-30 huge industries under one umbrella. It seems to me that the ability to pick a future winner is more an art than science.”  - Adam Wallace

An elderly patient was visiting her primary care physician when she told him she was suffering from silent gas. He listened patiently and then told her he would start with some basic tests and went over to the sink to wash his hands. With his back turned, the woman decided it was the right time to pass some of this aforementioned flatulence. As the doctor was drying his hands, the woman said she just had a case of her silent gas. After a slight pause, the physician said, “Well, perhaps we’ll start by testing your hearing.”*

Much like our elderly patient, investors sometimes get the wrong end of the problem in their health care investing strategy. About every five years, I publish a top three list of the health care companies that I think can produce outstanding long-term results. This list looks to correct some of the problems we commonly see when investors evaluate a potential investment. When looking to invest in today’s health care field, an investor should keep several themes in mind.

Market Durability: Many health care companies provide services or products that work for a defined period or a defined problem. Problems arise when the issue works itself out, and investors are left holding a piece of history rather than an ongoing concern. Look for opportunities that represent a long-term strategic shift in the business model. As an example think of patient outcome data and systems rather than Y2K solutions.

Customer Stickiness/Demand: Real money is made in opportunities where the demand is both sticky and necessary for business success. This includes new patient therapeutic options (such as Gilead’s HCV franchise) or essential operating tools (such as IMS Health Holdings’ pharmaceutical data). Becoming an essential tool to business strategy and execution is the basis of a great investment opportunity.

High Returns: In health care - much like any other industry - success will draw new competitors to the marketplace. The really successful companies are ones that generate high returns on capital and equity for extended periods. They achieve such success through intellectual property rights, FDA approval or data rights (along with others).

The List

A couple of thoughts about this list. First, these are companies I greatly admire and think have a chance to significantly compound value over the next decade or two. This is not a list of buy recommendations. These companies can only provide adequate returns when their share prices offer reasonable discounts to your estimated intrinsic value. I highly recommend you do additional research on your own to decide what valuation you might place on each company.

Second, there is a host of companies that vied to be on this list. It can be argued that some deserve to be on the list while others should be removed. This is simply a list of companies that I think have the management, competitive advantage, financial strength and profitability to produce outstanding long-term value creation.

Novo Nordisk

Novo Nordisk (NYSE:NVO) is the leading provider of diabetes-care products in the world. Based in Denmark, the company manufactures and markets a variety of human and modern insulin products as well as oral anti-diabetic agents. Novo also has a biopharmaceutical segment (constituting roughly 20% of revenue) that specializes in protein-related therapies for hemophilia and other disorders.

Novo has roughly 28% market share of the $45 billion global insulin market. Demographic changes - with remarkable growth rates in obesity and an aging population -  will drive the need for increased quantity and quality of treatment options. There is also a growing adoption of longer-acting insulin (such as Novo’s Levemir) versus the more traditional short-acting insulin (such as Novo’s Novolog). The introduction of GLP-1 analogs means the transition between oral treatment (for those with less serious type 2 diabetes) and insulin therapy is an entirely new market for Novo. In addition, the Centers for Medicare and Medicaid (CMS) along with Accountable Care Organizations (ACOs) are focusing on patient outcomes to a greater extent than ever before. This means primary care physicians - along with specialists - will be incentivized to proactively push patients to comply with their diabetes treatment regimen.

Novo isn’t about only diabetes though. Novo's biopharmaceutical group is more profitable than its diabetes franchise. It also dominates in several niche markets such as the treatment of hemophilia. While only 20% of current total revenue, I would expect this group to grow faster than the diabetes franchise. Both its biologic drugs – NovoSeven and Norditropin – are market leaders in their respective therapeutic class.

Novo has generated an average ROE of 61%, FCF/Revenue of 28% and net margins of 29% over the past five years. Management has generated a return on capital of 56% over the same period. The company currently has $3 billion in cash/marketable securities on the balance sheet with no short- or long-term debt. Novo generates roughly $5.2 billion in free cash annually and has a dividend yield of 0.85%.

Intuitive Surgical

Intuitive Surgical (NASDAQ:ISRG) designs, manufactures and markets da Vinci Surgical Systems and related instruments and accessories. A da Vinci Surgical System consists of a surgeon's console, a patient-side cart and a high-performance vision system. Da Vinci Surgery utilizes computational, robotic and imaging technologies to enable improved patient outcomes compared to other surgical and nonsurgical therapies.

Intuitive Surgical’s traditional market – da Vinci Prostatectomy (dVP) andda Vinci Hysterectomy (dVH) – is pretty well saturated. The future growth in these two fields is likely to decrease slightly over the next decade after nearly 30% annual increases over the past 10 years. Growth in new procedures will drive revenue going forward. The market for robotic surgery is nearly endless. There are current therapeutic opportunities in colorectal, urology, cardiothoracic and gynecology. In addition, new international markets such as Japan and Eastern Europe have little to no penetration to date.

Intuitive Surgical has a growing base of users who are trained specifically on the da Vinci system. Beating Intuitive Surgical with its current clients will be a difficult task for any competitor in the future. Achieving FDA approval for both the machine and the procedure creates a significant regulatory burden for those looking to enter the market.

Intuitive Surgical has generated an average ROE of 19%, FCF/Revenue of 31% and net margins of 27% over the past five years. Management has generated a return on capital of 63% over the same period. The company currently has $1 billion in cash on the balance sheet with no short- or long-term debt. Intuitive Surgical generates roughly $506 million in free cash annually and does not pay a dividend.

Waters

Waters (NYSE:WAT) makes instruments for applications that range from biopharma drug discovery/development to academic lab research and industrial quality control. The core of Waters' business is chromatography (separation of a mixture by passing it in solution or suspension or as a vapor through a medium in which the components move at different rates). In the space, Waters has significant market share and is perceived as a thought leader with new product development and launches. Waters is also a leader in biopharma mass spectrometry (a mass spectrum measures the masses of ions within a sample). The company is considered the industry standard with its high-end suite platform.

Management has been an excellent allocator of capital. The company refuses to do large deals that destroy shareholder value. Almost all capital is deployed in smaller snap-on acquisitions or internal development of new products. The company is currently focused on seeking market adjacent opportunities such as industrial quality control, production, and applied markets. Though margins will be squeezed somewhat in these markets, the opportunities are roughly four to five times greater than the more traditional biopharma and academic space.

Waters has generated an average ROE of 29%, FCF/Revenue of 21% and net margins of 23% over the past five years. Management has generated a return on capital of 48% over the same period. The company currently has $2.5 billion in cash on the balance sheet with $1.6 billion in long-term debt. Waters generates roughly $460 million in free cash annually and does not pay a dividend.

Conclusions

Health care can provide investors with adequate long-term returns when investors spend the time necessary to identify opportunities. Unless individuals are willing to put a great deal of effort into understanding the business strategies/structures, drug/clinical science and public policy, we suggest investors choose a solid manager (such as Vanguard Health Care ETF [VHT]) rather than direct investing.

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

Below are my selections in 2006 and 2011. Numbers are cumulative returns for five and 10 years.

2011: ISRG (+85%), NVO (+114%), WAT (+45%).
2006: ISRG (+471%), NVO (+753%), Computer Programs and Systems (NASDAQ:CPSI) (+1%).

Disclosure: The Nintai Charitable Trust is long NVO, ISRG, WAT, CPSI.

*A special note of thanks to my friend Robert B. Runnells who always had a joke at the ready no matter the situation. I’m sure he has a group of angels currently rolling on the ground begging him to stop.

​Portfolio Returns
 
The second quarter saw some dramatic movement at the end of June as Britain voted to exit the European Union. The reaction to this left the markets down during the quarter. The S&P 500TR was down by (0.38%), the Morningstar Total US Equity Index was down (0.8%) and the Nintai Proxy (70% Vanguard US Equities Total Market Index, 15% Vanguard Global Equities Total Market Index, and 15% Cash) was down (1.3%).  The Nintai Charitable Trust Portfolio was down (2.1%) net fees. For this year through June 30th, 2016, (YTD) the S&P 500TR is up 3.8%, the Morningstar Total US Equity Index is up 2.6%, and the Nintai Proxy is down (0.6%). The Nintai Charitable Trust Portfolio is up 7.4% YTD net all fees.
 
Several stocks have driven outperformance YTD. Collectors Universe (CLCT) is up 33%, Dolby Labs (DLB) is up 43%, and SEI Investments (SEIC) is up 30%. Several companies have produced significant drag YTD including Computer Programs and Systems (CPSI) down (-18%), Novo Nordisk (NVO) down (-6%), and Mastercard (MA) down (-9%).
 
The following is the breakdown of annualized returns by 1YR, 3YR, 5YR, 10YR and since inception. 

​Portfolio Changes
 
I made only one (1) change in the portfolio during the quarter. The Trust purchased Hargreaves Lansdown PLC (LSE: HL.). The purchase was made at the end of the quarter when UK financial stocks dropped significantly after the Brexit vote. Hargreaves Lansdown is one of the UK’s larger investment management services firms. It acts as a fund supermarket, a fund manager, a discount broker, a stockbroker, a pension specialist, an annuity specialist, a wealth manager and a financial adviser. It offers investment products, investment services, financial planning and advice to private investors and advisory services to companies in respect of group pension plans. The stock price dropped roughly 35% in two days and I purchased shares at a roughly 30% discount to my estimated intrinsic value. 
 
Portfolio Positioning
 
The current P/E ratio of the portfolio is 21 or roughly 16% above the current S&P 500 ratio. Projected earnings growth over the next 5 years is 12.4%, or roughly 40% greater than the S&P 500. Additional measures can be seen here on the Nintai Abacus report:

​Thoughts On The Quarter
 
While disappointed with the portfolio performance on a three (3) and five (5) year basis, I am pleased with YTD results (beating the S&P 500 TR by roughly 3%) and its long-term ten (10) and since inception performance. The fact that we made only one transaction during the quarter shows that we view the opportunities in the market as limited right now. The benefits of holding cash became evident when we saw the UK markets swoon in in late June and we were able to put some capital to work purchasing outstanding assets at fair prices.
 
Notice I say fair prices. While the market has pretty much tread water in 2016, the vast majority of equities are trading at fair – or slightly above fair - values. There simply aren’t many opportunities out there right now. That said the Charitable Trust has partial ownership in a selection of outstanding companies I would love to own for an extended period of time. Management that wisely allocates capital combined with such a long time horizon should provide the Trust with more than adequate compounding investment returns.
 
As the investment manager of a charitable trust, the Board has charged me with making the trust grow so that it can better fund the Trust’s charitable activities. I am cognizant of the responsibility that places on me. I will continue to invest with that future in mind – keeping one eye on risk and the other on opportunity. I hope everyone has a happy and safe summer.