“A customer talking about their experience with you is worth ten times that which you write or say about yourself.” 
                                                                                     -         David J. Greer 

“Investment managers think their professional life centers around beating their respective index. No doubt this has a lot to do with the long-term success of their fund or role with the investment firm. Surprisingly though, that isn’t the most important thing when working with their clients. How they deal with their investors, what level of trust they enjoy, or how much they listen can have twice the impact as to how they perform against their index. Twice as much! That’s something you never hear about from the investment profession.”
                                                                                    -         Alan Hurd   

I’ve often talked about our investment philosophy, our investment process, and our investment returns. I thought I’d share with readers some interesting aspects of being an investment manager beyond those. I wanted to talk about the side of investment management that rarely gets discussed - the client - or as Nintai Investments calls them -  our investment partners.
 
As with any service industry, investment managers focus on outcomes that are the most obvious and measurable - in this case their own portfolio performance versus their respective benchmark such as the S&P 500 or the Russell 2000. I certainly lie awake at night running my fund performances against my benchmark. However, there is a secondary part of being an investment manager that rarely comes up in discussions, but one I think is vital in maintain and growing our assets under management - client support and communication. After reading the latest update to the “Advisor Alpha” report, I was surprised by the level of importance that clients put on their advisor’s client communication and support functions.
 
Poor Returns Don't Always Create Unhappy Clients
 
Each year, Vanguard publishes its annual update to “Vanguard’s Advisor Alpha” report. In creating the original “Adviser’s Alpha” concept and report in 2001 (US-only), the company outlined how advisers could add value - or alpha - through relationship-oriented services such as financial planning and behavioral training (among others) rather than by trying to simply outperform the market. Vanguard believes that implementing their “Adviser’s Alpha” framework may add roughly 3% in net returns for an advisor’s clients. All this while differentiating their soft-skills and their investment practice. For those with greater interest in the Vanguard’s “Advisor Alpha” program, feel free to visit the site here.
 
It’s the 2018 update[1] that I wanted to focus on in this article. In this report was a section that discussed the major reasons why investors terminated their contract with their advisors. Their research divided the reasons into three buckets: personality/service levels, performance/portfolio, and advisor left for new firm. The researchers also broke the respondents into three categories: mass affluent, high net worth, and ultra-high net worth. Reading through the results, several findings really jumped out.
 
Personality/Service Outweighs Performance
64% of mass affluent, 65% of high net worth, and 70% of ultra-high net worth (a blended rate of 65%) clients left their advisor because of personality and/or services. This compares to 38% of mass affluent, 41% of high net worth, and 53% of ultra-high net worth (a blended rate of 39%)[2] who left due to performance or the structure of their portfolio. In general, an advisor’s inability to communicate well and build trust caused more clients - and sometimes nearly double the number - to leave their advisors versus those who left due to performance or the make up of their portfolio. For advisors who think the numbers speak for themselves, they should think again. 
 
The Perception of Bad Investment Choices was Most Painful
Investors were more likely to leave their advisor after perceiving they were poor stock pickers (18%) versus if they felt their advisor had a poor response to a market downturn (12%) or if they were underperforming their peers (10%). In this case, the advisor violated the investors’ first principles (“don’t lose my money”) versus the analogous model of peer-based performance or more general market themes (“well, we’re all losing money in such a down market”).
 
I should note that while it’s surprising how important the relationship is between the advisor and the investor, in no ways should this diminish the importance of achieving adequate results in the eyes of the investor. For instance, for ultra-high net worth investors, 53% stated that performance was a reason for leaving their advisor versus 70% stating it was due to their relationship or level of service. What these numbers show is that an advisor needs to keep an eye on both service and performance for the ultra-high net worth.  
 
What This Means
 
We have frequently taken a (good-natured) ribbing at Nintai Investments for the amount of communication that takes place between our investment partners and our staff. We make a strong commitment - from our Statement of Investment Partnership to our weekly musings on Gurufocus - to communicate with our investment partners on anything that might interest the Nintai team. We love to learn and we love to share our learnings. We try to make an effort to establish great communication and a strong sense of trust before we even sign a contract.
 
Establishing the Relationship
Before we partner with any investor, we think there is knowledge we should convey and a significant of learning we can get back from the prospect. Outgoing knowledge is conveyed in two documents and any number of phone calls. The “Nintai Capabilities” presentation and “Statement of Investment Partnership” convey to any prospective partner our investment strategy, our portfolio theory, and our expectations of how Nintai will communicate and support each investment partner. Equally important is the incoming learning we get from our “Client Profile Form” combined with several lengthy conversations to discuss anything of importance to the partner we may have missed. All these forms can be found on our website.
 
This process hopefully ensures our new investment “partner” feels just that - an equal in the process with the rights to open, clear two-way communication. We want our partners to feel free to call anytime - with questions about their individual goals, their portfolio, or to simply to discuss their thoughts on value investing. It is essential from the beginning that we as the advisor become intimately aware of our partners goals, fears, past experiences, and expectations going forward. We hope to learn as much from them as they learn from us.
 
An Open and Honest Dialogue
When he have a new investment partner, its important we establish an open and honest relationship. This involves developing a deep trust that - as an advisor - we will do everything in our power to meet our fiduciary responsibilities. Not just to the letter of the law, but in the best spirit of it as well. Vanguard Adviser Alpha describes trust in three major buckets - functional (does the advisor do what she says she will), emotional (I sleep better at night), and ethical (she act in my best interest all the time). I have found over time that any advisor who can build such a trust construct with their investment partners will have a great long-term relationship.
 
In support of building such trust, at Nintai we provide our investment partners with a detailed business case and valuation spreadsheet of each prospective holding in their portfolio. This allows our partner to see that we invest in companies that faithfully meet our criteria (functional), that these companies have rock-solid financials, deep competitive moats, and trade at a significant margin of safety (emotional), and will likely purchase the same shares in our personal accounts. Our investment partners get to see we eat our own cooking (ethical). Our quarterly and annual reports discuss our winners and losers with a discussion on what we learned and how we will try to implement this new knowledge.
 
Finally, we treat our investment partners as we would our family. We share food, rare wine, and even rarer whisky with our partners - not because it’s good business - but because it’s what friends do. While we understand our role is to be exceptional allocators of capital, we enjoy celebrating life as much as seeing stocks double in price. Who better to share the fine things in life than with those you trust and respect?
 
Conclusions
 
The latest Vanguard “Advisor Alpha” reinforces the message that trust and service play an equal – if not more important role – than historical portfolio performance. Establishing a personal support process, having respect and trust for your clients, and using each point of contact as a chance to learn more about them can create real value over time. Only an advisor who feels this sincerely will make this work. If there’s anything worse than no service, it’s bad service with fake sincerity. So the next time you think of yourself as the next Seth Klarman of value investing, remember that the ability to create open and trusting relationships will see you through the difficult investing times. It’s something we aspire to every day at Nintai Investing.
 

[1] “The Evolution of Vanguard Advisor’s Alpha”: From Portfolios to People”, Donald G. Bennyhoff, CFA; Francis M. Kinniry Jr., CFA; and Michael A. DiJoseph, CFA January 2018

[2] Some individuals left for multiple reasons thus creating numbers that don’t add up to 100%. 

“When you first start to study a field, it seems like you have to memorize a zillion things. You don’t. What you need is to identify the core principles – generally three to twelve of them – that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles.”
 
                                                                            -       John Reed 

“Trying to figure out whether your core values are relevant in today’s world is a real struggle. We are told we can’t be a stick stuck in the mud, but we also can’t be shackled to out-of-date beliefs due to commitment bias. So which is it? All we can do is continually update our principles with new data, test them, and use a Bayesian approach. It’s not easy, but it’s the only way we know of updating our thinking in a rapidly changing world.”
                                                                           -       Hancock Brower 

Last week I wrote about how we approached our thinking at Nintai Investments by using a first principles approach. We’ve believed for a while - and seen evidence to reinforce this thinking - that this way of looking at the world provides us with a strong framework for analyzing long-term trends.
 
All that being said, I have found there are times when first principle thinking can lead you astray. The first large area of weakness is when the first principle thinker has little or no knowledge of the subject matter. In these cases it is possible for the person to get the entirely wrong end of the stick. Solid thinkers will realize in these cases that the first principle approach will be more powerful in asking pertinent questions than identifying basic building blocks of the subject matter. For instance, I’ve seen several brilliant first principle thinkers make terrible suggestions for improving the US health care system. In general, this is because the individuals have distilled first principles into facts that might seem as underlying the industry, but are rather far off from reality. As an example, some of the best minds have simply missed the fact that the US healthcare is made up of three distinct parts - federal and state social insurance (Medicare, Medicaid, etc.), for-profit corporations (Merck, Anthem, etc.) and not-for-profit organizations (Catholic Health Initiatives, Blue Cross Blue Shields, etc.). Any first principle has to address this very unique structure and how it might be improved. Ideas such as Medicare For All or a fully deregulated capitalistic health care system fall far from the basic realities of the current system.    
 
The second large area of weakness - and one that matters a great deal to traditional value investors - is when facts begin to emerge that fundamentally alter your first principles developed over time and experience. As an example of this, I have lived in a capitalistic system that has always operated under the principle that higher risk means higher rewards. This means that - in general - longer term bonds yield more than short term bonds (longer term agreements bear the higher risk of inflation than shorter term) or individuals/companies/countries with lower credit quality pay higher interest rates than those with great credit. Yet, we live in a time where the yield curve is not only inverted, but two additional facts are present.

1. As of the end of June 2019, the 10 Year US Treasury yield sat at 2.05% versus the Greek 10 Year at 1.98%. It’s hard to imagine the markets are trying to tell us the Greek government’s credit quality is better than the United States’.
2. As of the end of June 2019, there is $13T of sovereign debt yielding a negative interest rate. Negative interest rates? To this degree, this hasn’t happened in the history of modern finance.    

 
For many value investors (as well as economists and political consultants) first principles such as “higher risk/higher reward” have been falling like dominoes over the past decade. Yet, as I break down these realities down to their basic fundamental assumptions, they still make no sense to me. However, the old ways of doing things (analogies - like when I built out my first company) sometimes simply aren’t around anymore. 
 
To better understand what this means as a value investor, let’s break down the facts related to the $13T in negative interest rates. Utilizing first principle theory, we want to ask questions that will better define the main facts behind the theory - and practice - of central banks utilizing negative interest rates.

1. What is causing governments to issue debt at negative interest rates?
2. What impact does this have on the sovereign debt markets as well as larger overall debt markets?
3. What could cause this policy/market trend to end?

 
Question 1: Negative interest rates (as a government policy) were used by Sweden in 2009 when its Reserve Bank cut its overnight deposit rate to -0.25%. The European Central Bank was next when it lowered its deposit rate to -0.1% in 2014. Since then other countries in Europe and Japan have employed negative interest rates. Countries have employed negative interest rates for two reasons – trying to head off a deflationary cycle and to lower the value of their currency. In the former case, countries hope to stimulate lending (banks would rather lend - even at extremely low rates - than pay the Central Bank to hold their money) thereby heading off deflation. In the latter case, negative interest rates will weaken demand the country’s respective currency. A weaker currency will strengthen export demands and stimulate the economy.
 
Question 2: Certainly the greatest impact for most investors has been the stretch for yield. One of the side effects of that is seeing Greece 10YR yields be less than US 10YR yields. I don’t think anyone would confuse the fact that the United States sovereign debt has less risk than Greek sovereign debt. The second major side effect is that European and Japanese banks have seen their bottom line negatively impacted. Forcing banks to pay for parking their cash at the Central Bank - combined with low lending rates – is a recipe for decreasing earnings. As much as we would sweep these events aside, the bottom line is the $13T in sovereign debt and Greek/US yield abnormality are the reality of the markets as of today. Ugly facts are indeed still facts.
 
Question 3: The question is how this ends or - even more broadly - does this end? Obviously a stronger economy or rising inflationary rates will put an end to the negative rate environment. But what if the economies don’t improve? What if the United States dips into recession and its rates go negative? Then what seems like an anomaly becomes a new standard. The principle of higher risk/higher reward might become - for an extended time - irrelevant.  
 
Have Our First Principles Become Outdated?
 
So what’s a value investor to do? Are we destined to see this become a true “it’s different this time”? Or are we in a New Economy that was promised in 1999-2000? Have first principles – so long accepted in our capitalistic system – gone the way of the dodo? Or will we return to more classic economics that have driven capitalism since the time of the Dutch trading empire and Italian city states in the 15th and 16th centuries?
 
At Nintai Investments, we take a long-term view and see a middle-path going forward. The 2007- 2009 market crash and ensuing Great Recession fundamentally changed the way governments and their institutions see themselves in a capitalistic system. The interdependencies of the markets – along with risk whose depth and width is far broader than just three decades ago requires that sovereign nations find new solutions and roles for themselves going forward. Does this overturn the entire capitalistic/socialistic approaches that have driven US, European, and Asian economies over the last 50 years? We don’t think so.
 
But it does alter some of our first principles that have driven our thinking since getting into the business world all those years ago. We think some of the major assumptions we took for granted such as Keynesian economics (priming the pump), increasing multilateral approaches to the integration of the world economy (lower tariffs and international supply chains), and thoughtful, data-driven decision making will be altered or eliminated going forward. For instance - as an institutional investor - the very act of allocating capital continues to evolve. The long-term view continues to get shorter in length and decisions are increasingly made dependent on information from millisecond-driven social networks. Yet, increasing amounts of investors want nothing to do with high-fee, under performing active management. We see a current active managers have been swimming against only getting stronger. Has our first principles of patient, long-term investing based on valuation and margin of safety disappeared? We don’t think so. But it certainly continues to evolve.
 
Conclusions
 
In these topsy-turvy times, it seems like our guiding first principles have been eliminated as quickly and efficiently as the 1978 one-game playoff Boston Red Sox. However, we think it’s too early to write off some of value investing’s first principles. The bedrock concepts of value investing – valuation, margin of safety, and risk mitigation have not disappeared. But how we achieve these – and the frameworks we use to get there – have certainly changed in the last decade. Being able to adapt and evolve – while maintaining your first principles – has always been the mark of a great value investor. Whether it be Warren Buffett’s move from cigar-butt investing to great companies at fair prices or Nintai’s shift from quality balance sheets to hyper-quality balance sheets, if we don’t adapt then we die. By developing applying first principle thinking, the move along your own investing continuum doesn’t have to be - in John Foster Dulles’ classic phrase - an agonizing reappraisal. A well devised approach - as remarked on by Mr. Reed and Mr. Brower - can make evolution to your first principles as smooth as possible. In today’s raucous world, you can’t ask for anything more.
 
As always, I look forward to your thoughts and comments.
 
DISCLOSURE: None

“The discovery of truth is prevented more effectively, not by the false appearance things present and which mislead into error, not directly by weakness of the reasoning powers, but by preconceived opinion, by prejudice.”
                                                                                           -        Arthur Schopenhauer

“All of our reasoning ends in surrender to feeling.”    
                                                                                           -       Blaise Pascal
 
When I began thinking about starting my own investment firm, I thought back to starting my two previous companies. The first company was designed by committee and we thought the company should have a core set of values and a mission. This was designing by analogy - meaning we designed a firm as we assumed others have done over time. Hence the classic values and mission statement. My second firm (and most certainly my last!) - Nintai Partners - was an entirely different creature. Rather than create it in the form of other consulting firms (or by analogy), we constructed Nintai using the “reasoning from first principles”. For instance, consultant compensation was based on long-term value as calculated by the client, not our company. This was designed around our first principle that any value to a client must be both sustainable in nature and as defined by the client.
 
First Principles Thinking
 
The first principles approach allows you to cutaway the rhetorical fat and get to the most basic truths. In this type of thinking, you can’t simply rely on the traditional way of doing things (or by analogy). You need to break the process or problem down, and rethink it from the ground up. You must return to the most basic assumptions (the first principles) and understand the underlying facts of the model.   
 
I’ll use the design of Nintai Partners as an example and then move the discussion to the investment world. When building out Nintai Partners, we reverse engineered the start-up process and focused on the basic building blocks that make a consulting firm work. When we looked at the basic model, it was based on billable hours. Breaking the model down to its main principles, we found a business that overcharges clients, faces a constant need for new clients, and has no reward system for producing value as measured by the client. By utilizing a design by first principles, we found a business model that was hopelessly mired in overcharging, churn, and poor work quality.    
 
When we began Nintai Investments it was clear we would need to apply the same first principal approach to designing the firm and understanding the core building blocks in an industry undergoing rapid change. After completing the process, we identified four principles that – interestingly enough – were both good for our company and good for our investment strategy. These overlapping qualities gave these principles even more value in our eyes.
 
Principle #1: The value we deliver to our investment partners must be long-term in nature to be of value at all.
 
As a value investor, I strongly believe that finding management that are great capital allocators combined with companies that can produce high returns on capital are a powerful combination. The third component of that formula is time – letting the power of compounding work for the greatest duration possible. Accordingly, any value Nintai adds to our clients must - by its very nature - be long-term in scope. The same goes for any investor/owner of Nintai Investments. There is reason why many wise investors will tell you to avoid the funds, but buy the fund managers.  
 
Principle #2: Growth is finite: A company’s growth will always end – whether by a lack of opportunity or a competitor creating a better mousetrap.
 
In evaluating any possible investment, the ability to grow will be a key driver in the success or failure of that investment. No matter what valuation tool you use, a slowdown (or worse - total absence) will drive down valuations and lead to permanent impairment of capital. therefore, understanding how the investment will grow, understanding the risks to that growth, and successfully prognosticating when that growth will end is vital to the investment process. As a small startup, Nintai understands there are two risks to our growth – an absence of opportunity brought on my market and business model changes (such as the move to indexing) or simply being unable to find new capital to deploy. We believe the former is a much larger risk than the latter.
 
Principle 3: Scale is the Gravity of Business.
 
In almost all businesses (but not all - think Amazon, Microsoft or Google), scale is a weight that will eventually change or dramatically slow down a business. That doesn’t mean it will eliminate growth (though it might). Far from it. But it changes the nature of the growth by creating new organizational needs, capital returns, and market dynamics. The Amazon of 2000 is a very different animal than the Amazon of 2019. The company has dramatically changed in product, organizational, capital structure, and returns standpoint. The same is true for Nintai. As assets grow, the structure of the company will change, our investment opportunities will drop, and history would lead us to predict it will bring with it lower returns.
 
Principle 4: What’s Good for the Client is Good for Us.
 
This principle you would think would a guiding light for most companies, but surprisingly it isn’t. How many times have you had a service company say they will visit between 8AM – 12PM? Generally, for companies in asset management, what’s good for the client is good for the firm. But there are still far too many examples of what’s bad for the client (high fees) is good for the firm. As an asset manager ourselves (with what we perceive to be fair fees), long-term outperformance is good for our clients and good for Nintai.  
 
Conclusions
 
Utilizing a first principal approach is a commodity shared by some the world’s great thinkers. Whether it be Charlie Munger or Richard Feynman, some of the smartest people in the world use first principals to focus on what really makes something tick. Hopefully this article has shown its use is remarkably widespread and can allow you to make connections or see core issues you might never have understood before. Being able to make a direct connection between Nintai as a business and its investment criteria was a remarkable eye opener for all of us. I highly recommend you use it the next time you are looking at a potential investment.
 

“I think a great capital allocator will intuitively understand that there really isn’t anything he or she can do to improve long-term returns. Most of the time they understand the decision to partner with a particular management team is the most fruitful action of the entire relationship.”
 
                                                                                   -         Bill Bishop 
“Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.”
                                                                                   -        Will Rogers 

There’s a lot to be said for both Mr. Bishop’s and Mr. Roger’s thinking - though I think good old Will would have been more successful if he had those seeing eyeglasses. And that’s the problem. Most of us might know a good company when we see one. We just don’t know whether it will be a great stock.  My last article discussed in detail (perhaps too much!) about what type of knowledge is necessary to really grasp the issues facing a modern US-based healthcare company. In that article I used iRadimed (IRMD) - an MRI compliant pump manufacturer – that makes pumps that can safely operate in an MRI setting. In the article, I walked through some of the major knowledge requirements I recommend an investor have as they begin their investment journey into the healthcare markets. 
 
The “Short and Shoddy” Healthcare Investment Process
 
Several readers have reached out to me since that article’s publication to see if it is absolutely essential that investors develop such a skill set.  It’s not unreasonable to see if there is a “short and shoddy” way to quicken the process. Some readers may be surprised to hear me say absolutely yes. There are several ways to do this. First – and the most obvious and easiest – is to find a high quality ETF or focused fund in the industry you look to acquire assets. For instance, the Vanguard Health Care Fund (VGHCX) is an outstanding way to get some healthcare coverage without a lot of real grunt work. Another approach is to find very high quality companies with deep competitive moats and long runways of growth. Of course, you have to wait for the right price, but if you are patient it is possible to find a company that can give you exposure and provide your portfolio with a decades-long anchor that can drive substantial outperformance. 
 
Since my article was on healthcare, I thought I’d use the same industry as an example of finding such a company. Let me start by saying that if there was an industry most suited for the “short and shoddy” approach, it would healthcare. Having made myself a complete hypocrite with this statement, let me explain my thinking. Healthcare - as an industry in the United States – is roughly one-half for profit and one-half not-for-profit. The for-profit part can be heavily regulated producing monopolies and duopolies. This can also create companies with extremely high returns and profitability. In a sense, there is no better market sector to stumble into diamonds without too much effort. There are three reasons for this.
 
First, a large portion of the healthcare industry is regulated by federal and state agencies. A lot of leg work such as product safety and good manufacturing processes (known as cGMP) are already inspected by industry regulators. Second, healthcare provides thousands of companies with exclusive rights to medicines or machines that save lives. This exclusivity can range from 7 - 20 years. Third, the healthcare industry is a steady marketplace. The life cycle of birth, life, sickness, and death is immutable. People need healthcare regardless of market conditions. For these reasons, healthcare can allow value investors to sometimes shorten (dare I say slightly cheat) their research process. This doesn’t take away from the fact that healthcare really is an incredibly complex ecosystem. It just means that if one knows what to look for, sometimes the diamonds are lying in plain sight.
 
So what should an investor look for in their “short and shoddy” investment research process? It isn’t much different than my existing approach, but might be slightly different than most other investors’. The key is looking or smaller companies with high returns on equity and capital along with strong balance sheets. This doesn’t always indicate a company with a wide competitive moat, but I’ve never found such a company without these type of numbers. Another thing to look for is announcements about FDA approvals for their products. Last, it should be in a segment of healthcare with steady revenue and growth. Think along the lines of something like lab testing or saline solution which is constantly used in a clinical setting.
 
An example of this type of company is Nintai Investments’ holding Masimo (MASI). With a market cap of $8.2B, MASI is in the mid-cap range with ample opportunity to grow over the next few decades. Masi is a medical device company focusing on noninvasive patient monitoring. It began by creating a device that nearly any hospital patient will recognize – an oxygen and pulse reader that clamps at the end of your finger tip and allows doctors to see your oxygen and pulse levels. Every emergency department and primary care physician uses these devices on a daily basis.
 
Masimo’s Financial Story
 
We can start by reviewing Masimo’s financials. These should tell a story of high returns based on a deep competitive moat combined with a company product in a steadily growing marketplace. First, the company as a long history of generating above average return on equity, return on invested capital, and return on assets. 

​While fluctuating year by year, on average the company has done an outstanding job over the long term. These types of numbers tell us two things: the company earns considerable profits on generated revenue and management has done a great job in allocating capital.  
 
From another angle, the company has done an outstanding job growing both earnings and revenue. While free cash flow has grown at a slower rate, it has picked up considerably and should continue to increase with Masimo’s recent deal with Phillips as well as leveraging its installed base. 

From a financial standpoint, Masimo’s story is compelling. It has been able to grow earnings and revenue at double digit rates while maintaining outstanding returns on capital and equity. These are all signs of a company with a deep competitive moat and a management team that knows how to take advantage of it.
 
Masimo’s Moat
 
Sometimes being able to ascertain the strength of a moat in healthcare can be difficult. Everything from the microbiology and chemistry behind a biopharmaceutical patent to understanding the technology, professional acceptance, and clinical outcomes of robotic surgery, can demand enormous industry knowledge. But there are some companies like Masimo that don’t require technological, industry, or clinical expertise. For instance, read Morningstar’s description of Masimo’s moat. In two paragraphs, a savvy investor can understand that the company has a strong competitive position.
 
“The pulse oximetry market is an effective duopoly between Masimo and Covidien (now Medtronic), with Philips and GE Healthcare representing a minority 10%-15% share. Masimo’s share of shipped units has grown from 30% at the beginning of the decade to nearly 50% today thanks to superior products that are more accurate and reliable than the competition. The company is agnostic about how its units get to market, whether directly in Masimo-branded monitors or through OEM devices using Masimo SET. Of the company’s approximately 1.5 million installed units, only a fourth are Masimo devices; the remaining three fourths are OEM multiparameter monitors containing a Masimo circuit board. This strategy has driven returns on capital substantially ahead of our estimate of WACC each year since the company’s 2007 IPO, which to us signals the existence of a moat.
 
Masimo has left the lumpy and sales-intensive capital equipment business largely to its OEM partners, while retaining the asset-light, high-margin sensor sales business. The company relies on razor-and-blade effects to establish the installed base from which it can drive repeat sales of its disposable and reusable sensors, generally under five- to six-year purchase contracts. Masimo sensors can be used across competing systems through universal adapters, but Masimo oximetry units use a closed architecture, creating a captive sales base. Further, the company has demonstrated its ability to successfully retain customers after an initial contract win; renewal rates have remained near 98% over time, which we believe illustrates the company’s superior value proposition.”
  
By now, we’ve learned relatively quickly that Masimo is a medical device company that achieves outstanding financial results driven by a duopoly in a healthcare market that has shown steady growth rates with predictions of more of the same over the next decade or two. All of this without going into the technology behind it, the science for which it is employed, and without knowing much about the end-customer, its competition, or its supply chain.
 
We’ve reached this conclusion by coming from the nearly opposite direction that Nintai Investments employs. In healthcare, we utilize deep industry knowledge to look for players that might be overlooked due to size, complexity, or flat-out “unsexiness”. We do this – as I discussed in “Industry Knowledge” – by looking at connections or business processes missed by many with less experience in the industry. But as I’ve often said, in value investing there are many ways to skin a cat.
 
Some Takeaways
 
I believe that deep industry knowledge can give investors a leg up in finding investment opportunities. Some of the most successful investments over my investing career have been found that way. But not all. Sometimes you can find a diamond in the rough - not by knowing where to dig - but simply by knowing what a diamond looks like. Many investment diamonds - meaning companies that you can hold for decades - have common characteristics that can help you create a shortcut in your investment research. Here are a few that I’ve found over the years that can help them shine brightly as you sift through investment dirt.
 
Duopolies:  Most companies that are monopolies are well known and hard to find at the right price. Duopolies have many advantages of a monopoly but often fly below the radar. A company like FactSet Research (FDS) is a great example. Remember: It doesn’t matter whether your holding is #1 or #2 position. Just make sure there is only two.
 
ROIC Far Exceeds WACC: Companies with strong competitive moats have their return on invested capital always exceed their weighted average cost of capital. Simply looking on GuruFocus’ 30 Year Financial tab under “Ratios” can give you both numbers.
 
Their Advantage is Locked In: You are looking for a company where their advantage is secure – whether by patent (like Masimo) or by switching costs combined with technological excellence (also Masimo). Their competitive advantage should be secure for the next 10 -20 years. There aren’t many companies that can say that. Whether it be Coke or Wrigley or Masimo, as an investor you shouldn’t be able to find any major reason why the moat could be filled in or outflanked.
 
The Balance Sheet Should Be Rock Solid: If a company has a strong competitive advantage, it shouldn’t be loading up on debt or issuing convertible debt. You want management to reinvest capital back into operations when ROIC exceeds WACC. Any profits they don’t need can be retained as cash on the balance sheet, used to repurchase shares (hopefully not overpaying), or sent back to investors in the form of dividends. Running an outstanding company should not be financial rocket science.
 
Finding a company with these types of attributes isn’t that hard. In today’s world, investors can create screens on GuruFocus or Morningstar in a matter of seconds.
 
One Last Thing
 
One thing I haven’t touched on in this article has been price. In the past few pages, I’ve shown you how to create a “short and shoddy” investment approach. It can help you find diamonds in any type of industry. But it doesn’t tell you what to pay for that diamond. At Nintai Investments we use a discounted free cash flow model to ascertain value. What approach you use is entirely up to you. I should warn you up front - the lack of industry knowledge abandoned in the “short and shoddy” approach will hurt in calculating valuation. A lot of assumptions that are used in calculating value come from deep industry expertise. But if you are committed to the “short and shoddy” method, then attempt whatever is your preferred way to calculate value and come up with a number. If the price is right, then congratulate yourself for find a truly affordable diamond in the rough.
 
Conclusions
 
It’s unlikely you will find us employing the “short and shoddy” approach to finding investment opportunities in Nintai portfolios. As a professional investment manager I will use every piece of data and run as many spreadsheets as possible to increase my chances at outperforming the markets. I employ researchers or buy industry research to try to make the most informed and knowledgeable decision I can. If pressed, I would probably still rank an industry focused index fund over the “short and shoddy” approach. That said, I encourage investors to create a few search screens and find out what shows up. This isn’t an investment recommendation in any way, but more a research recommendation. It may not be exactly to Will Roger’s methodology, but I can’t help but think you wouldn’t get a nod or a wink when you told him you invested in the “short and shoddy” way.
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: Masimo (MASI) is a holding in some of our personal and institutional accounts.  

“An expert knows more and more about less and less until he or she knows everything about nothing.”

                                                                                                   -        William Mayo 

I was recently reading a great piece by Grahamites on Gurufocus (“Blind Spots in Investing”. It can be found here) and his cautionary tale about his research process related to DeVita (DVA). One of the real challenges I’ve found to exist in investing is the breadth and depth of research/knowledge that is required to have an advantage in portfolio selection. Grahamites faces the same dilemma all of us face – acquiring valuable knowledge. Let’s face it. In today’s content driven world knowledge is a pretty cheap commodity. In fact, there is far more knowledge than required out there today. But is it the knowledge we need? 
 
Before you get started, I should warn you this article turned out far larger than I originally intended. My initial thought was to scrap it, but it suddenly occurred to me that researching a company and acquiring knowledge really is this involved, complex, and timely. So if you pressed for time, the short and shoddy can be found in the conclusions section.
 
Industry and Company Knowledge: What Am I Getting In To?
 
Successful value investors find a way to ask the right questions and sift through the data to acquire truly valuable knowledge. I break such knowledge in to three buckets – breadth, depth and accuracy. If an investor can capture knowledge with these three criteria then they are 90% to the way in finding a great investment opportunity. Equally important to broadly capturing the right strategic knowledge, is getting company specific data - along with market and competitive data - which puts you in the position to know a company as well as the CEO herself. This type of knowledge takes more time and more grunt work than the first. It’s where I’ve found most investment managers fail. They find the concept of investing in a company exciting, but are often bored by the specifics that make it tick and -in the long run - succeed. Knowing that a company has a high return on capital is helpful, but knowing how it achieves those numbers is essential.                                                          
 
Before getting into the nitty-gritty about knowledge, I thought for the sake of today’s discussion, I’d use Nintai Investments’ holding iRadimed (IRMD) as a working example. The company is a wonderful healthcare technology company focused on manufacturing magnetic resonance imaging (MRI) infusion pumps and patient monitors. Since MRIs are huge magnets, it is essential that anything with metal be excluded from the imaging room. iRadimed manufactures both pumps and monitors that meet those safety standards. As we discuss how knowledge is critical for investors to acquire, gather, and synthesize, I will discuss the company, its products, its customers, and its competition in greater detail.     
 
The company is in an industry – health care - that requires an insatiable desire to learn and the capacity to synthesize knowledge. After being able to locate great data, an investor will need to know the breadth, depth, and accuracy of knowledge specific to all the moving parts of the ecosystem that iRadimed thrives in. The essential components of knowledge required - clinical care players, clinical care process, technology requirements, research and development, regulatory review and approval, competitive landscape, pricing and reimbursement models (we will get to all of these in detail later) – means that investors need both a strong structural research process (how to define and get the breadth, depth, and accuracy of research) along with tremendous applied knowledge and industry expertise.
 
We first purchased the stock in September of 2016. It peaked earlier in 2019 rising nearly 200% from our purchase price before dropping by nearly 50% since then. As of July 2019, we’ve roughly doubled our share price. Was all of that gain due to our research? Certainly not. Did all the knowledge we acquired position us to better understand the investment opportunity? You bet.
 
The Three Characteristics of Strategic Knowledge
 
Let’s start with the three dimensional approach that I mentioned about higher knowledge. First is breadth. What I mean by this is defining the limits of the company’s strategy and tactics. Is the knowledge in well-defined siloes or does it bleed into other company functional units or market segments? For instance, a technology company may focus on laser measurement tools but find its markets ranging from home-improvement to general contractors to national defense spending. In the case of iRadimed, the company’s technology and market is completely focused on facility-based MRI machines. Even this itself is quite broad and can include privately held imaging centers, mobile MRI providers, hospital-based imaging units, and research institutions. It does not include other types of imaging (CT-scan, X-ray), new technology requirements (such as prone-based units versus raised or fMRI versus traditional MRI). By placing a firm barrier around your product segmentation (meaning a defined “breadth”), technology requirements, or functional area, an investor can develop a deep expertise for a specific part of the organization or market.   
 
In depth, I am talking about understanding the limited reach within either the customer’s organization or marketplace. For iRadimed, it deals solely with imaging groups. It doesn’t sell into other parts of the hospital, it doesn’t deal with other parts of the healthcare industry other than MRIs. It’s sales force can focus on certain individuals with a specific expertise (such as VP of Imaging) with a very focused financial model and a specific focus on technology components that reside in a specific part of the organization. For instance MRI compliant IV pump parts (sold only to the Imaging Center) are not like light bulbs (sold to general purchasing with customers throughout the organization with hundreds of specific requirements (wattage, dimming, white vs. natural, etc.). As a value investor, this allows me to develop a very deep knowledge of the imaging segment of the healthcare industry.
 
Finally is the accuracy of the research. Being sharply focused allows an investor to have timely data (pricing, market share, sales growth, gross/net margins, competitive sales data, research and development costs, etc.). An awful lot or time is spent in our field calculating “value”. Bad or stale data can play old Harry with your estimates and lead you far astray from a real versus imagined value opportunity. The smaller the segment that needs to be researched, the less the chance for being far off in your calculations. Additionally, valuable data (whether because its timely or because its accurate or even rarer – both of these) can be an extraordinary competitive advantage in the investment management business. When running a focused portfolio, one great investment can make or break your performance record over the long term.
 
These three characteristics define the scope of knowledge required to best understand major segments of the business. The will allow you as an investor to then roll up your sleeves and begin capturing data that drives your investment case. Without the first group, the second group of detailed research questions will be muddled, misguided, and provide no value in developing your business case.
 
Company and Industry Knowledge: The Nitty Gritty
 
After gathering the strategic knowledge I just discussed, hopefully you found a market and a company that look like something for further evaluation. You now need data - and ultimately knowledge - on every major aspect of what makes a company successful and how it works within a specific industry. Your major concerns at this point are:
 

1. Who do I talk to and what do I read to collect all the information necessary to acquire adequate knowledge required to make an informed investment decision?
2. What do I need to know about the company that can inform me about where it will be 10 - 20 years from now – from product and service, profitability, financial, management, and technology aspects?
3. What do I need to know about the market/industry that can make my investment case close enough to be helpful in developing long-term investment assumptions?   

   
Let’s start with the company continuing to use iRadimed as an example. What are the key knowledge components of the business we must understand to inform us about long-term value? The first bucket is related to their product. The following questions will allow us to better understand how it works, how long can we expect it to work, and what progress is necessary for it to still be a market leader in 2039?
 
Product Development
 

1. What is the development history of the product?
2. Are members of the iRadimed team part of that development history? If so, for how long? In what role/capacity?
3. Does the team have experience with the end-user community (meaning the healthcare imaging community)?
4. Does the product work in both an industrial as well as academic/research setting?
5. What is the development time line for next generation development?

 
Overall, iRadimed’s team was in on the ground floor in the development of MRI compliant pump technology. Roger Susi, founder of iRadimed was also the founder of Invivo Research - the first MRI compliant pump. After selling the company and watching competitors implode, Roger founded iRadimed to drive the technology into the 21st century. The team had deep ties into the imaging community as well as strong relationships with FDA regulators vital for future product approvals. iRadimed’s product works in any MRI facility – whether commercial or academic. In the last several years, iRadimed has broadened its work into the adjacent field of MRI-compliant monitoring systems that work hand and glove with their IV pump systems.
 
Regulatory
In healthcare, regulatory can be all-encompassing (such as biopharmaceuticals) or not relevant at all (selling over the counter cherry throat lozenges). In this case, iRadimad operates in a highly regulated part of healthcare.
 

1. What products currently have FDA approval and what is the length of their patent protection?
2. What has been iRadimed’s history when it comes to FDA submissions and approval rates?
3. For instances such as complete response letters, how has the company dealt with these? Have they been successful in overcoming them?  
4. What new products are under review currently and what does the submission pipeline look like?
5. As the company looks at overseas expansion, what is the status of IRMD’s filings in the EU, and Japan markets.

 
The MRidium pump, the iRadimed 3880 monitor, and the iMagox pulse oximeter are fully approved by the FDA and are being use in the clinical setting today. As of the end of Q1 2019, the company still operates under an Open Warning Letter first received in 2014 related to the MRidium 3860 and 3850 software upgrades. While still open, the FDA gave 510(k) clearance in 2016. In addition, in January 2019, iRadimed received notification that the Agency’s review of their 3880 MRI compatible patient vital signs monitoring system could not be completed as aspects of clinical evaluation reporting, as required by newly issued guidance from the European Union. IRMD immediately suspended shipments of their 3880 patient vital signs monitor to all markets requiring a CE Mark. They are addressing the technical non-conformity, though temporary EC Certificate extends through July 27, 2019.
 
Competition
Competition can be the key driver in how long your investment’s moat maintains its depth or generates high returns on capital. In iRadimed’s case we are lucky in that the company has a true monopoly protected by FDA approvals. That said, it is still critical to understand where competition may be coming from.  
 

1. What companies (if any) provide MRI-compliant IV pumps, monitors, or pulse oximeter? If any, what is their regulatory status in US or overseas markets?
2. Are there any current filings with the FDA seeking approval for any of the three IRMD products?
3. Since Bayer’s departure from the MRI-compliance space, has any other healthcare or technology player discussing the space?
4. Has there been any discussion of mergers or acquisitions to try to merge technologies or products?

 
Competition in the MRI-compliant market has been nearly non-existent since the FDA granted IRMD their 501(k) FDA Premarket license. Bayer’s departure from the market has only tightened IRMD’s monopoly position.
 
Market Size and Growth
Finding a compounding machine means finding a company in a large and growing market. Understanding healthcare markets can be a little tricky with patents and FDA approvals.
 

1. What is the number of existing MRI machines in the US and globally?
2. Where are these machines located as a % of total? Private imaging center? Ambulatory hospital, in-patient hospital, for-profit hospital (Morristown) versus not-for-profit (VA hospital system) research facilities?
3. How many MRI’s are retired versus new purchases? Leases?
4. What is the average daily use of each machine? Imaging for what therapeutic area? (Oncology, gastro, neuro, etc.)?
5. What is the reimbursement ratio public versus private insurance?

 
Infusion Pump Market
 
Combining Nintai Investments’ research with iRadimed’s, we think there are roughly 12,000 MRI scanners installed around the globe. iRadimed has a set of safety standards required within the MRI facility, so not all facilities can be identified as a possible client. Many sites purchase multiple pump systems for each MRI screener installed. Based on historical sales and customer pump purchases, IRMD estimates the current global market opportunity represents approximately 18,000 MRI compatible IV infusion pump systems, of which approximately 55% are located in the U.S.
 
Monitor Market
 
Nintai Investments’ research shows that multi-parameter monitors is a market where mot adoption has taken place. Much like MS Office, IRMD’s focus is on next-gen functionality and hardware replacement. Global sales is estimated by iRadimed to be roughly 1200 units with over three-quarters of sales in the domestic US market. Growth is estimated to be 6-7% annually on a base of $70-$80M in revenue. iRadimed is hoping to get customers to move to a multiple unit purchase model similar to the pump systems.  
 
Sales Outside the Imaging Room
 
iRadimed is looking to pilot sales forces in both the Emergency Departments (EDs) and Intensive Care Units (ICUS) as many patients in these settings are at high risk of needing MRIs for clinical assessment.
 
Evolving Commercial Strategy
 
After extensive conversations with management, channel distributors, customers, though leaders, regulatory officials, etc. we think iRadimed’s two pronged commercialization approach is spot on. Two key conditions drive this: currently IRMD is the only approved MRI compliant solution in the marketplace. This truly is a monopoly. Second, iRadimed for the first time in its history has an MRI-compliant platform with IV pump combined with a multi-parameter monitor. Focusing on these two messages, IRMD is building out a sales force that will look to grow the business in the high single digits for the next 15 – 20 years.   
 
Research Components
 
Researching all this data, synthesizing it into actionable data, and then deriving real knowledge isn’t easy. It takes a lot of people to help you understand all of these moving parts. For Nintai Investments, it took approximately 400 hours to talk to a host of individuals and gather any follow up research including trade journals and professional studies, conferences, and peer reviewed papers. Here’s a small selection of that research.  
 

1. IRMD Management
2. Former competitors: such as Baxter product Associate Vice-President, Executive Director, Sales Directors, Technology Leads, Business Managers, Research and Development, Market Access, etc.
3. Hospital Administrators: VP Imaging, Data VP, MRI Ops Team, Safety Council
4. Ambulatory MRI Private Center: Executive Director, Technical Lead, Ops Manager, Technicians, Safety Coordinator
5. Regulatory: FDA Imaging Lead, Research Coordinator, Consulting MDs
6. Managed Care: SVP Imaging Strategies, Executive Director, Reimbursement, Director, Image Resources and Clinical Outcomes
7. Medical Research Facility: Executive Director, SVP Technology, Senior Director, Image Services
8. GE Health: VP, Research, Director, Image Services
9. Canon Health, SVP, Market Strategies and Product Development, AVP, New Technologies.   
10. Thought Leaders: Harvard Medical School, “The Whole Brain Atlas”, Keith A. Johnson, MD, Professor, Harvard Medical School
11. Thought Leaders: Greg Freiherr, The Freiherr Group
12. Thought Leaders: Eliot Siegel, MD, Professor of Diagnostic Radiology and Nuclear Medicine, University of Maryland School of Medicine
13. Thought Leader: Ezequiel Silva, MD, FACR, Chair, American College of Radiology Commission on Economics

 
Trade Journals
 
Imaging Technology News
Diagnostic Imaging
Radiology (Journal of the Radiology Society of North America
 
Conclusions
 
As you can see, Nintai Investment’s research methodology is a robust process in trying to acquire knowledge that will best inform us about a potential investment. I should note that roughly 1 out 50 of these processes will lead to an actual investment. That doesn’t really bother us though. Acquiring knowledge on MRI imaging might help us when we look at a potential investment in a physician group in southern California or a patient outcomes informatics firm on the inner Beltway of Boston. Nearly no knowledge in these processes goes to waste. Much like Charlie Munger’s view of lattice work, research like this layers another piece on to our knowledge lattice work. A word of caution. Nearly every successful value investor I’ve met loves this process. They’d rather read the latest peer reviewed study on how demographic changes in Ithaca drove a cancer blossom in De Moines than attend the latest Avengers-franchise film. But if you have a strange passion like some of us – or want someone like that managing your funds – you might be hard pressed to find a better fit.
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: iRadimed (IRMD) is a holding in some of out personal and institutional accounts.   
 

"Today, the stock market has become a device to offload risk to the public market and cashing in -- it is an "exit" not a growth vehicle."
                                                                                   -     Hedgephone
 
“Capital markets are the essential tool to make capitalism work, and most importantly, work well. Keynes said that when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. Has anyone noticed that asset bubbles are coming more frequently with greater impact? Who would have thought we could have a technology bubble and crash followed by a real estate bubble and crash only seven years later? My greatest fear is that speculators are using the markets to offload their risk to an increasingly complacent public market.”
 
                                                                                   -     Richard Addison    

Recently I wrote about the concept of “responsible capitalism” in a reply to Howard Marks’ memo “Growing The Pie” (the article can be found here). One of the subjects I discussed was the changing role of capital allocation in the public markets. More specifically, I discussed the role of increasing complexity and financial engineering that assures that hedge funds and large institutional investors make a great deal of money while putting a great deal of risk on the individual investor and reducing their share of the pie.
 
It made me think of the story of two tourists who had purchased tickets to participate on a safari. The first tourist smirked at the second when he noticed his seat was the closest to the ground. He said to his companion, “I may have paid more, but I’ve got the best seat to see the animals”. His companion smiled, took his friend’s ticket and turned it over. It read “This seat - while having the greatest views also carries the greatest risk. Please be advised you may need to vacate your seat in the case of an animal attack”. After reading this, the second tourist smiled and said, “It isn’t always the price and the view. Sometimes it’s where you sit that does you in”.  
 
The Changing Role of the Capital Markets
 
If Wall Street’s job is to allocate capital “for the singular purpose of maximizing shareholder returns”, sometimes I’m confused by the transactions I see announced on the financial news. In a well-functioning market, capital should flow to companies and concepts that have the greatest potential return to investors. As an example, take two fictional companies that have filed S-1s with an intention to go public over the next 90-120 days. The first company - Acme Rubber Band (DOINK) – generates $15 of earnings on $150 of revenue (a P/E ratio of 10), earns 15% return on equity, and has been growing revenue at roughly 11% annually over the past 10 years. The second company - Shmaltz Quick Fix Solutions (STEAL) has not produced positive earnings in its history, has negative return on equity, and burns through roughly 33% of its cash balance each year. All things being equal, one would think that Acme should have an easier time underwriting its initial public offering (IPO) than Shmaltz. In Acme Rubber Band’s case, we have a company that has generated significant returns for its initial (private) investors. The company is now seeking to access capital to help ramp up sales, marketing, staffing, or production. Additionally, it may use IPO proceeds to pay off short or long-term debt. Finally, they may use some of the proceeds to pay off earlier investors should they seek to exit their current position. In essence, Acme has gone to the markets to continue their growth story and seek new investors and capital in the continuation of that journey.
 
Schmaltz Quick Fix is really quite a different story. In this instance, the company may try to pass this off as looking for investors in their growth story, but they really don’t have one. Their finances are a wreck, their growth is not profitable, and there is a fair chance that any new capital will be used to pay off previous investors and keep the doors open. In the words of Hedgephone, this IPO is an exit strategy for previous investors, not a growth strategy for new investors.
 
Investors - who by their very nature must be allocators of capital - should seek two things when making a decision to invest in an IPO. First, which company has the best chance of achieving above average returns on capital in its operations and strategy? The answer to this question is vital to value creation and investment returns in the long term. The choice between Acme and Schmaltz couldn’t be starker. Second, how is the deal structured, how will the capital raised be employed, and how will it drive returns for investors? This question tells us which investors will see a return and which that won’t. In other words, where are they in the safari seating plan? Without knowing the exact deal structure it’s hard to make a fully documented choice. However, with the historic data we have, I’d say the circumstances certainly lean in Acme’s favor.
 
This type of discussion isn’t entirely academic in nature. Over the past twenty to thirty years, the idea of Schmaltz being taken public – on a major exchange - has gone from being laughable to entirely plausible. What might have been seen as a lark on the Pacific Stock Exchange in 1980 is an almost everyday occurrence on either the NYSE or NASDAQ today.   
 
A Working Example: Chuck E. Cheese
 
We can move the discussion from the hypothetical to the real world by using an example of a recent IPO announcement for a company known by many readers with young children – Chuck E. Cheese. The company was started in 1977 with its first Chuck E. Cheese Pizza Time Theater in San Jose, CA. After filing for bankruptcy in 1984, it was acquired by ShowBiz Pizza Place, In 1998 it became CEC Entertainment. In 2014, the company was acquired and taken private by Apollo Global Management. Apollo paid roughly $1.3B for CEC’s restaurants in 47 states and 14 countries. The company also has 144 Peter Piper Pizza units in six states and Mexico.
 
The IPO Announcement
 
After 5 years of ownership, Apollo is looking to cash out and make a return on its initial investment. CEC announced that its parent company would merge with Leo Holdings, a special-purpose acquisition company. The new company will be known as Chuck E. Cheese brands, and it will trade on the NYSE under the ticker CEC after the deal closes sometime late in the second quarter. In their announcement, the companies stated the new organization will have an enterprise value (market cap + debt – cash) of $1.4B. After all of the accounting and corporate engineering shenanigans, Apollo will retain 51% of the new corporate entity.
 
The IPO announcement reads as follows:
 
CEC Entertainment, which owns the Chuck E. Cheese pizza/entertainment chain expects to start trading with an anticipated initial enterprise value of ~$1.4B or 7.5x the company's estimated 2019 adjusted EBITDA of ~$187M. CEC and Leo Holdings (NYSE:LEO) a publicly traded special-purpose acquisition vehicle, along with CEC parent Queso Holdings, agree to combine. Queso's controlling stockholder is an entity owned by funds managed by affiliates of Apollo Global Management (NYSE:APO).
Immediately following the closing of the proposed transaction, Leo intends to change its name to Chuck E. Cheese Brands and trade under the ticker symbol CEC. Apollo funds won't be selling any shares in the transaction and will continue to be CEC's largest shareholder with about ~51% ownership. Concurrent with the consummation of the deal, additional investors will buy $100M of common stock of Leo in a private placement. After any redemptions by the public shareholders of Leo, the balance of the ~$200M in cash held in Leo Holdings' trust account, together with the $100M in private placement proceeds, will be used to pay transaction costs and de-leverage the CEC's existing capital structure.
 
For those having a hard time following the financial engineering, I’ve enclosed a chart that graphically demonstrates the organizational transactions that gets us to the new/old Chuck E. Cheese.   

​Now at this point, you may be leafing back through this article thinking “that valuation is pretty close to what Apollo paid back in 2014”. Indeed, the new company’s enterprise value of $1.4B is only slightly higher than Apollo’s original purchase price of $1.3B 5 years ago. It certainly doesn’t seem like much of a return. But here the hypothetical examples of Schmaltz and Acme become frighteningly relevant. CEC Entertainment is going public as a means for Apollo to exit with its gains locked in. The source of Apollo’s profits - $1B in debt taken on by CEC – will be partially paid off by investors in LEO. The remaining will be paid off from the promised “high growth” coming from the new entities sales and operations. Those numbers – which will become the issue for CEC’s new 49% owners. In the words of Hedgephone, CEC’s IPO is a device to offload risk to the public market and cashing in -- it is an "exit" not a growth vehicle (strategy).”
 
Over the last four quarters, comparable sales have improved sequentially, rising from 1% in second-quarter 2018 to 7.7% in first-quarter 2019. However, overall revenue increased just 1% last year to $896.1 million as its store count fell from 754 to 750. CEC reported operating income of $50.8 million last year which seems adequate until you realize the company had $76.3 million in interest expense. Suddenly CEC moved to a net loss of $20.5 million. CEC has nearly $1 billion in debt on its balance sheet, which explains its crushing interest expense and its inability to make a non-EBITDA profit.
 
A Lesson to Be Learned
 
If one to were to take an old-fashioned view of the capital markets, capital should flow to companies and their investors that will provide the best opportunity of achieving outstanding returns over the long-term. That’s certainly the way I look at the role of the markets. With that said, I find very few opportunities in the IPO market. I think there are far too many “exit” vehicles rather than “growth vehicles”. Far too many deals are structured to make money for past investors, not future investors. That doesn’t mean I don’t think there is a role for the public markets or the IPO process. Far from it. They provide a vital role in capital liquidity and access to the capital for small and upcoming ventures. But as an older – more prudent – investor, I look to invest with management where both internal and external shareholders have the opportunity to compound their returns over an extended period of time.
 
Value investors should never lose focus on the two words that make up their occupation. “Value” means purchasing an asset at a discount to its estimated intrinsic value. “Investor” means utilizing time and the power of compounding to achieve adequate returns over the long term. When a company comes to the public markets as a result of financial engineering and accounting gimmickry – to paraphrase the words of John Maynard Keynes - the job is likely to be ill-done. To put in the context of our big game safari tourists, always make sure you purchase the ticket with the best seating – not from the lion’s standpoint, but from a survival standpoint.
 

Q2 2019 Returns
 
The past 6 months have been an indexer’s dream. You simply couldn’t choose a bad asset class. It's difficult to imagine that the second half of 2019 could be kinder to multi-asset investors than the first half. 1H2019 was the best first half to a year for the S&P since 1997. At the same time, the iShares Core U.S. Aggregate Bond ETF had what looks like its best half on record. In a true testament to just how over-the-top the bond rally was, the German 30-year bond logged a total return of some 15%. That would be the second-best 6-month return in a quarter century and very nearly better than the S&P's first-half gain.
 
I concede that Nintai’s investment philosophy doesn’t excel in this type of market conditions. Our focus on companies with no debt, high returns on capital, deep competitive moats trading at a discount from our estimated intrinsic value go from being rare to non-existent. By the height of a cycle we might be as high as 30-35% in cash as a total percent of AUM. Nintai’s type of investment has also been penalized over the past 6 months. The rate of returns and the assets that have been achieving such outstanding results are outside our value-based thinking. Frankly, we have a hard time understanding markets like the ones we are seeing today. However, that doesn’t make it any easier for you or me. I’m not a big fan of losing and underperformance eats at me every night. I am as competitive as the next man, and it drives me harder to figure out a solution for the last 6 months’ underperformance.
 
The one thing Nintai will not do is panic and suddenly start purchasing block chain companies or Chinese pharmaceuticals. We are comfortable with our process over the long-term and don’t think the current market conditions can continue forever. In the final analysis, we’d rather not make as much in this type of market than to permanently impair our investment partners’ capital in a down market.   
 
We’ve been particularly disappointed with portfolio returns since Q42018. I’ve been most surprised by the fact that even when holding 20% in cash, the portfolio had drawdowns that match (and sometimes even exceed) the general markets. This type of performance tells us that our portfolio picks are underperforming but losses have been somewhat offset by a significant cash position. Over the past six months, the companies with the largest losses have no debt, high returns on capital and equity, and great free cash flow margins. Some of the disappointment has been environmental in nature (such as a holding’s double whammy of a potential China trade war and the threat of Mexican tariffs), but overall most have been large drops in stock prices matching more general market trading. This can mean one of two things - either we mispriced the valuation/risk of the holding or the markets are mispricing the valuation/risk related to the holding. We are spending an enormous amount of time trying to better understand who is wrong in their judgment.
 
We are clearly not pleased with our returns YTD. As mentioned previously, since January 2019, our portfolios have held roughly 15 - 20% in cash as a percent of total assets under management. This cash position has been both a drag during up markets (bad) and acted as a sheet anchor during down markets (good). The last two quarters have been extremely disappointing with the portfolio equities underperforming the general markets by a considerable amount. That type of performance – though short-term in nature – is a huge disappointment for this firm. 
 
If there is a silver lining in this type of underperformance, it is that it has created a value gap between the general markets and our client portfolios. As of June 30 2019 Morningstar has the total stock market valued at a 1% premium. Our average Nintai portfolio was valued at an estimated 9% - 11% discount to the S&P 500 as of June 30 2019. Total returns (less fees) year-to-date (2019), 1 year (July 1 2018 - June 30 2019) and since inception (September 2016) are seen below: 

A Note on Measuring Performance
 
One of things that I find particularly egregious is when investment managers cherry pick data or their respective benchmark to improve their (perceived) performance. Some try by comparing their large-cap US growth fund performance to the MSCI ACWI Index. Others might try to use a balanced fund benchmark to measure against their small-cap growth fund.  Recently Neuberger Berman published an article called “The Overlooked Persistence of Active Outperformance”[1] where they argue returns would be much better if you simply removed the lowest quarter of (under)performing funds (You can almost hear them sitting around their conference room saying “everyone deserves a mulligan”). I’d like to think how well Nintai has done if I could simply take back those nasty picks that represent the lowest 25% performers in the portfolio. With arguments like this, who needs attacks from index investor supporters?
                               
I’ve struggled at Nintai ever since we began as investment managers trying to find the best comparison to measure our performance. With an all-cap, all markets mandate, Nintai’s
portfolios tend not to be a perfect fit with the S&P 500 or a US-only index. For instance, our median portfolio holding market cap is 8% the size of the median S&P500 company. Roughly 20-25% of our holdings are non-US based companies. We also are very focused by industry – holding companies in only 5 of the 11 S&P industry categories.
 
In light of this, we try to give our investors a wide set of benchmarks for use in comparing Nintai performance. I start with the S&P 500 simply because this is de facto benchmark nearly every manager is compared against. I also include the Russell 2000 since this is the closest match by market cap. (The Russell 2000 median market cap is $900M versus the average Nintai portfolio’s median market cap of $721M). Fidelity also allows me to create an 80% - 85% equities and 15-20% cash benchmark. I include this because the Nintai portfolio usually holds 15 -20% of AUM in cash. (as of the end of Q2 2019 the average Nintai cash position was 26% of total AUM). Finally I include the MSCI ACWI ex-US index because of the substantial holdings in international stocks (as of the end of Q2 2019, the average Nintai portfolio had roughly 24% of AUM in international stocks).   
 
Nintai’s portfolios have generally outperformed the S&P 500 after fees. They have performed better against the other benchmarks. Which benchmark investors choose to use in measuring Nintai’s performance is entirely up to them. I think the best approach is to review performance against all and see – in totality – how the portfolio has performed. I haven’t found a reasonable way to create a summary of all the benchmarks and generate an average rate of return. Until we do, we will continue to provide investors with a relatively large portfolio/benchmark return chart.
 
One thing I can assure you. Whether our returns outperform or underperform the markets, Nintai will report results in a direct and forthright manner. We look to give investors information on their returns in the manner we’d like to have given to us. If our performance lags, you will hear about it.   
 
Winners and Losers
 
Two stocks led the way in Q2 – Veeva Systems (VEEV) and Manhattan Associates (MANH).  Veeva was up 27% in the quarter while Manhattan increased by 23%. Veeva’s May quarterly earnings exceeded both top and bottom lines. Management upped guidance (again) as well. Over the last year, VEEV has increased free cash flow by 37%, EPS by 71%, and revenue by 28%. We increased Veeva’s estimated intrinsic value by roughly 13% in February 2019 after the company raised guidance. We increased it by an additional 16% in May. The position gained roughly 185% since I purchased it in February 2018. ***Note: We eliminated the position entirely in early July 2019 based on valuation ***
 
Manhattan Associates continues its run as the acknowledged leader in warehouse management systems (WMS). In Q2 the company received the leadership award in Gartner’s WMS magic quadrant for the 11th consecutive year. In addition, Dennis Story was named CFO of the year. The company has ramped up R&D by nearly 40% to begin its push into AI-driven fulfillment workflow capabilities. While pushing down free cash margins from the mid-20s to low-20s, these efforts will likely prove to be the growth drivers over the next 10 – 20 years. Return on equity has jumped from 26% on 2012 to 73% in 2019. Return on invested capital has also jumped from 68% in 2012 to 247% in 2019. Shares outstanding has dropped from 124M in 2004 to 65M in 2019. Free cash flow margins remain in the low-20% range. The company has no debt and roughly $100M cash on the balance sheet.
 
Our biggest loser by far was PetMed Express (PETS). Nothing is as frustrating as spending 3 – 4 months completing intense research on a company, make a decision to add it to the portfolio, and then promptly see the share price drop by 35%. As a positive spin to all this, it gave us the opportunity to keep loading up on the stock as it continued to drop.
 
The markets seem to be spooked by the IPO of Chewy (the markets valued the company at $9B versus PETS market cap of $312M). There is of course the talk of Amazon driving out all competition, but it should be noted that PetMed Express is a licensed pharmacy in all 50 states, dispensing FDA approved medications not just OTC products. This requires registration with both State Boards of Pharmacy as well as federal registration required for Schedule V medication fulfillment. While growth slowed in 2019, I haven’t seen anything after talking to management, customers, veterinarians, and state Board members that suggests the business model is broken or impaired in any way.    
 
Portfolio Characteristics
 
The current Abacus view as of June 30 2019 shows that the Nintai Portfolio holdings are roughly 10% cheaper than the S&P500 and projected to grow earnings at a substantially greater rate than the S&P500 over the next five years. Combining these two gives us an Abacus Comparative Value (ACV) of +23. The ACV is a simple tool which tells us how the portfolio stacks up against the S&P 500 from both a valuation and an estimated earnings growth stand point. We like to see the portfolio below the valuation of the S&P 500 but with a higher 5 year estimated earnings growth rate. Like an increasingly compressed spring, these two numbers – combined with higher rates of return on equity and capital – should lead to long-term outperformance. An ACV of >15 has led to outperformance over 90% of the last twenty 5 year rolling periods.   

​If opportunities arise we will add or reduce position size. We might also swap out an entire position for a chance to invest in a situation with a better risk/reward profile. We will be actively looking to take profits or find cheaper prospects over the next 6-9 months.
 
We remain highly focused in industry and sector weightings. We currently have holdings in only 5 of the S&P500’s 11 categories - financial services, technology, industrials, consumer defensive, and healthcare. Industrials and consumer defensive are both extremely small holdings with roughly 90% of holdings in just three categories – financial services, technology, and healthcare. However, I should point out we see the categorization of the portfolio slightly differently. For instance, Computer Modelling Group is categorized as a technology company by the index. However, with 100% of its revenue derived in the oil and gas discovery process, I consider the company a way to gain exposure in the energy industry. 

​Turnover and Cash
 
Turnover for the quarter was roughly 13%. I expect this to drop as assets under management increase. I try to look for turnover of roughly 5-10% annually. This is dependent of course on factors such as overall market performance (steady increases over the past few years have forced us to take profits thereby increasing turnover) or individual stock performance (a sudden price drop of 20% might make for a compelling buy scenario). I have reached the upper end of stocks I look to own in the portfolio. It’s likely that most trading going forward will be additions or subtractions from existing positions. Occasionally opportunities may arise where I swap out an entire position for one that is either trading at a steeper discount to my intrinsic value and represents a step up in quality and potential long-term gains.
 
Cash as a percent of assets under management remains high at roughly 25%. This number is a reflection of the lack of opportunities to invest in the current markets. It is also a statement on the valuations of current holdings (meaning that individual portfolio holding valuations are at record highs) which forces us to take profits and reduce our holdings’ size.    
 
A Note on the Markets
 
If markets continue to push onwards to new highs it is likely this number will go higher. Gurufocus does a great job of providing investors with Warren Buffett’s market valuation indicator.  Buffett said the ratio between the Wilshire 5000 to the US gross domestic is “probably the best single measure of where valuations stand at any given moment.” As of June 30 2019 the ratio stands at approximately 1.44. Utilizing Mr. Buffett’s calculation, the ratio implies an annual return of -2.1% over the next decade. Additionally, Jack Bogle’s market return formula (dividend yield + earnings growth + speculative return) isn’t looking to knock it out of the park either. Current dividend yields are roughly 1.8%. I project earnings growth to be roughly 2 - 3% annually over the next decade. Let’s split that and say 2.5%. So far that gets us an investment return of 4.3% (1.8% + 2.5%). I’m assuming the speculative return (defined as the growth or shrinkage of the P/E ratio) will drive the P/E ratio closer to its long-term average of roughly 15. It currently stands at roughly 22. To regress to the median, the speculative return would be rough -4% annually over the next decade. This would give us a decade of roughly flat returns.
 
Both of these calculations would suggest there is considerable risk in the equity markets at these prices.  It is for this reason I have been taking profits – or eliminating entire positions – to protect against the downside. Until prices come down (or earnings show far greater growth estimates), then cash represents a safe holding to prevent a permanent impairment of your capital.
 
As Nintai Investments LLC, I take my responsibility seriously to wisely allocate capital, prudently manage risk, and attempt to generate adequate returns. Helping individuals and organizations achieve their life goals, support their corporate giving, or meet their retirement needs is a remarkable honor and mark of great trust. Every day we look to continue earning tour investment partners’ trust. Should you have any questions, please do not hesitate to contact me by phone or email. 
 
Thomas Macpherson
tom@nintaiinvestments.net
603.512.5358
 
My best wishes for a wonderful summer season.