In last week’s article about the evolution in my investment theory, I stated that the things I learned from running a firm could be gotten nowhere else. A reader responded by asking a great question about the similarities of running a consulting group and being a value investor. This week I thought I’d describe several broad issues we faced in a service industry-based company and how they relate to becoming a savvier investor.

Thinking differently

At the highest level, running Nintai Partners was similar to value investing because our strategy and operations were set up to be distinctly different than the consulting industry. Just as we know you cannot beat the markets by imitating them, neither could we compete with the McKinseys of the world by being the same. We did this in three broad ways. First, we wanted to make sure our incentives were aligned with our consulting clients. Second, we looked to build the company along the lines of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) where we aimed to grow book value. Last, we decided we would focus on one area where we had real expertise (healthcare informatics).


Incentives

All too often consulting firms are rewarded for project scope creep and billable hours. At Nintai Partners, we turned this on its head when we designed compensation in the following manner: Twenty-five percent of salary was paid on a monthly basis. The remaining 75% was paid out after six-month, one-year, three-year, five-year and 10-year client reviews. In this model our pay was directly tied to the long-term value we added to each client. There was considerable upside for outstandingly consistent reviews. We felt this tied our incentives to what was most important to our clients – making a positive and sustainable impact to the organization.

Similarities

This is similar to the views of a value investor. In the consulting industry we find that companies that align their incentives with their clients are few and far between. On Wall Street, you won’t find many companies – whether they are brokers, mutual fund companies, or financial advisers – that truly align themselves with their clients either. Companies such as Vanguard partner with their clients by keeping costs to a minimum, retaining a true mutual fund structure, and reducing trading to a minimum (particularly in their index funds). Another example is Warren Buffett (Trades, Portfolio)’s partnerships that were designed to specifically align his interests with his partners through performance hurdles and compensation.

Long-term outlook and compound growth

In conjunction with long-term value measures for our clients, Nintai also took a long-term outlook on value creation for our own investors. All retained earnings were invested into our internal fund that invested with a traditional value-based approach (the progenitor of the Nintai Charitable Trust). All employees and consultants were owners in the firm and once a month received an update on their holdings. This model meant we looked to use time, investment growth and compounding to be the value driver for our investors.

Focus on circle of competence

From its inception Nintai Partners focused exclusively on healthcare informatics. We recognized our circle of competence was limited and finite. Any time we thought of expanding our services or taking on a project outside this circle we immediately recognized we were setting up the firm and our clients for disappointing results. It wasn’t easy – we turned away a great deal of projects that could have fattened the portfolio significantly. In the final analysis we decided any short-term gains would be offset by long-term losses in our reputation and quality.

Similarities

It is remarkably easy to wander from your circle of competence when trying to grow a company. It is no different when trying to grow your portfolio. Sticking to your knitting – investing in companies you can understand and value with some certainty – will in the long run serve you in good stead. How many investors have paid the price for investing in BDCs with arcane financials, energy companies with enormous off-balance sheet liabilities or biotechnology firms with incredibly complex scientific barriers to overcome? Recognizing the limits of your circle – and the ability to go no further – is critical in investing and corporate strategy alike.

Conclusions

Whether you are a value investor or CEO of a growing business, the ability to allocate capital will be one of your greatest challenges. By creating some core values – demanding alignment of management with shareholders, keeping a long-term outlook and staying within your circle of competence – you can increase your chances for success. It doesn’t work every time. A vast majority of businesses fail, and most investors underperform the broader markets. But running a business can give you some unique insights into your investment management skills. It certainly made me a better investor, and I wouldn’t have missed it for the world.

In a response to one of my recent articles, a reader sent me a note asking how I define great management in a potential or existing investment.

 There are currently three (3) major buckets in how I measure management’s capabilities, performance, and ethics. These are strategic and operational outcomes, compensation, and intellectual honesty. I will go into further detail in each of these later but for now let me say we evaluate each prospective and existing management team with the following questions:

1.    Does the team have the capability of being great management? In this I look for relevant professional experience, training, and background. It’s unlikely we will invest in a security software business run by a PhD in nuclear engineering and no relevant experience in the field. It doesn't rule it out, but it definitely reduces the chance.

2.    Does performance demonstrate strategic/operational and governance skills? Here I look for data generally outside of Wall Street’s more normal approach. Are the team great allocators of capital? Do they get the highest efficiency from their organization? Is the organization including the Board fully aligned in their mission? I care less about how the stock price has performed than how they’ve increased intrinsic value over the long term.

3.    Are management and shareholders generally aligned? I say generally because a corporation isn’t always about shareholders. Sometimes tough decisions are made (healthcare costs, capital spending) that might effect shareholder returns that are in the best interests of the company and the environment in which it operates. Compensation plays a big part in answering this question.

4.    Is management honest with itself, its corporation, and its key stakeholders? In this I look for recognition of learnings and mistakes in the annual reports, quarterly conference calls and communications with shareholders. Senior management that won’t take responsibility or acknowledge failures are fooling themselves into thinking there is nothing left to learn. Intellectual and emotional stagnation are the death knell for industrial performance and competitive advantages.

 So how do you go about and measure whether management is someone you want to partner with? At the Nintai Charitable Trust (NCT) we use the following criteria to answer the four (4) questions above.

 Strategic and Operational Outcomes

In this category we want to see specific data that management are utilizing a smart strategy and have a great handle on operations. Several items fall under this.

 M&A Activity: Most of the data suggests that M&A activity is a long-term detriment to a corporation’s intrinsic value. Any activity on this front I like to be supported by measured milestones and investment metrics. In my career, I’ve generally found great management is far more successful in bolt-on acquisitions than industry/corporate changing events.  A holding in the Nintai Charitable Trust – T Rowe Price (TROW) – has done a great job ignoring the demands of investment bankers and steering clear of large M&A deals and taking on large amounts of debt.

 Operational Measures: Here I look for long-term management performance with an emphasis on ten (10) year returns. These include Return on Equity, Return on Capital, and Return on Capital vs. Return of Capital. The latter represents management’s view on whether capital can be allocated internally for projects that will generate excellent returns or return the capital to shareholders in the form of dividends or stock buybacks. As Science of Hitting pointed out earlier this week, he looks for buybacks to take place at a discount to intrinsic value. We concur. NCT’s holding Fastenal (FAST) has done a great job focusing on operational returns with an eagle eye. With a 5 year ROE of 26% and 5 year ROC of 25%, management has generated great long term returns for its investors. 

Compensation: The last ten years has proven how difficult it is to align management’s needs with shareholder needs when it comes to compensation. Everything from the stock options backdating scandal[1] to the growth of CEO pay has created a rather dismal picture of corporate governance. I’m not locked into any specific policy related to compensation but I do have several criteria I think are important. First, management should not be rewarded for failure. It seems nearly every failed CEO leaves these days with a shocking golden parachute that would make the golden calf itself blush. Second, success should be defined by long-term value creation. Whether it is book value or some other measure, one thing it shouldn't be is tied to the company’s stock price. Long time NCT holding Expeditors International (EXPD) has utilized incentive pay as well as operational margins to give bonuses to all staff. From top to bottom, staff is incentivized to create long-term value to the company.  

 Intellectual Honesty

Perhaps the hardest thing to measure is management’s intellectual honesty. What I mean by this is the acknowledgement of intellectual and emotional learnings gleaned through successes and failures. I look for this in public disclosures such as 10-Qs, 10-Ks, Annual Report commentary, and quarterly conference calls. Second, I look for clear explanations in plain English which lay out the issues faced, options presented, decisions made, and outcomes generated. Third, unequivocal acknowledgements of failure go a long way to building confidence in our investments. Last, it’s great to hear from management learnings they’ve gleaned and how it’s impacted their strategy and management. An example of this is NCT’s Fastenal (FAST) that addresses specific questions about financials in both their quarterly calls and investor meetings. They are open about mistakes they have made and what they’ve learned from these.

 Conclusions

When you purchase a piece of a company, you are going into business with a management team chosen by your duly elected representatives (the Board of Directors). We think it’s vital that as an owner you fully understand their abilities, skills, ethics, and goals. More importantly, it is vital you have set criteria on which you can measure their performance. While there is no perfect process that can protect investors against poor management decisions, as investors we can at least choose who we do business with in our portfolio.


[1] The Wall Street Journal was a leader in coverage of this story. In the end nearly 340 publicly traded companies were investigated. An example was Jeffrey Rich of Affiliated Computer Services (ACS is now part of Xerox). In a total of six grants, Mr. Rich had a 1 in 300 billion chance of receiving grants on the exact dates of corporate stock lows. ACS’ options program was –like many others - a disgrace to its shareholders and the industry in general.

“There is a certain relief in change, even though it be from bad to worse. As I have often found in traveling in a stagecoach, that it is often a comfort to shift one’s position, and be bruised in a new place”.      -   Washington Irving

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 A reporter interviewing A.J. Muste, who during the Vietnam War stood in front of the White House night after night with a candle, one rainy night asked,"Mr. Muste, do you really think you are going to change the policies of this country by standing out here alone at night with a candle?" Muste replied, "Oh, I don't do it to change the country, I do it so the country won't change me”.
 
I was recently speaking with my co-worker John Dorfman at Dorfman Value Investments and we were discussing changes in our investment philosophy and stock picking criteria over our investing career. It occurred to me that not only had I proactively changed in a positive manner (meaning I chose to adopt new thinking) but I have changed in a negative manner (meaning I chose to reject certain thinking) as well. Looking back, I believe the ideas I have rejected have an equally important role in making me a better investor as those I’ve adopted. In the words of Mr. Muste, not allowing Wall Street to change me has been just as vital in my investment success.

There have been several major issues that have evolved in my thinking where I have worked hard at adopting them into my investment methodology. Some have been by commission (where I have actively cultivated an approach or strategy) and some have been through osmosis (a more gradual and less conscious adoption). The following I would put in this adoptive bucket:

 Think Like A Business Owner

When I first started investing I really had no idea about how to run a successful business. More importantly I didn't know some of the measures that define long-term success and value creation. Overtime, running a successful management consulting firm has made me a better investor. Conversely, being a value investor has made a tremendous impact on how I think about managing and overseeing my business. None of this was a light bulb going off but a gradual understanding of the symbiotic relationship between corporate management and value investing. When Mark Twain commented about cats, (“A man who carries a cat by the tail learns something he can learn in no other way”), he could have been talking about a someone who owns and manages a business -  you can learn some things in no other way.

Quality Creep

 As Warren Buffett learned from Charlie Munger, quality matters in investing. Overtime I have evolved my investment criteria to reflect what I consider extraordinary businesses with high ROE, ROC, no/little debt, high FCF/revenue, and significant competitive moats. This learning hasn't been as linear as some of my other education. The Market Crashes of 2000-2002 and 2008-2009 have greatly affected my thinking in this area. The “creep to quality” - as my friends refer to it – has been a by-product of my next learning – investing not to lose.

It’s Not About Winning, But About Not Losing

 When I began in this industry, my eyes were always on the Peter Lynch ten-bagger and looking to achieve extraordinary returns. Overtime my thinking has inverted on this subject. I recognize now the odds of finding and selecting a company that will return 1,000% is infinitesimally small. Rather, by focusing on certain things in my control (trading costs, turnover, stock selection) I’ve found the returns will take care of themselves. I have been extraordinarily lucky (and let’s call it for what it is – luck) in having several companies in the portfolio (FDS and MANH come to mind) that have allowed for significant outperformance. But equally important has been sticking with the simple block and tackling that has prevented truly egregious losses. By not swinging for the fences I’ve always allowed myself to stay in the game.  

 It’s Not About IQ, But About EQ

 Graduating from a prestigious schools, belonging to all the right clubs, and joining all the right firms has always been perceived as a leg up on Wall Street. I don’t discount this entirely. But I’ve found some of the best investors aren’t extraordinary geniuses. They are smart – no doubt about it. But overtime I’ve realized my worst enemy is not a normal IQ, but a poor EQ. The ability to control your emotions, be dispassionate in your actions, and be driven by the data is equally – if not more important – than having a considerable intellect. Each market crash and genius hedge fund failure has solidified my thinking in this area.

 As I mentioned earlier it hasn't been proactive choices alone that have changed over the years. There has been an equal amount of rejection of theories on my part. This negative response to common wisdom (if you can call it that) has stood me well over the years by avoiding hot trends (tech stocks, RFID companies, nanoanything, etc.) and general sheep-like behavior. Some of these include:

 Short-Term Thinking

Boy did I learn at a young age how short term thinking can kill you. I remember purchasing a stock in high school (now long since gone – a shoe manufacturer if I remember correctly) that I purchased on a Friday and sold the following Tuesday for a 7% gain. So excited at this I bought it again on the following Thursday and promptly lost 27% in three days. And I sold it the next week to only see it go up 18% the next week. It dawned on me I was playing a fool’s game and clapped a stopper on this behavior going forward. As much as Wall Street will try to convince us that EVERYDAY there is some extraordinary gain to be made by acting NOW (kind of like those Ronco potato peelers), I’ve learned that short term thinking is the grave yard of so many unhappy – and poor – investors.

 Value Doesn’t Matter

 There are so many ways to ascertain value for value investors – whether it’s using low P/E like my friend John Dorfman to conservative DCF calculations like the Nintai Charitable Trust. Many successful long-term investors use a means to calculate value and then buy at a discount to that assessment. I haven’t seen many long-term wealthy investors who trade on momentum, market trends, or individual stock technicals. As much as Wall Street wants us to believe the house casino can be beat by letting the dice fly high, the bottom line is you are purchasing a piece of a business that is worth something. The simple trick is knowing that value and waiting for your opportunity to buy at a discount.

 The Trend is Your Friend

 No. The trend is never your friend. If you expect to beat the markets then you have to be different. Putting all your money into tech stocks in 2000 or financials in 2007 might have been the trend, but they sure didn’t make you rich. Over time I have become far more adamant in my opposition to following the herd and seeking gratification from the overall market. Being contrarian may not make you the talk of the cocktail circuit, but it will most assuredly give you a better shot at outperforming the general markets.

Conclusions

 Most of the great investors I’ve had the pleasure to meet or read about have been knowledge compounding machines. Their ability to identify, sift, and accept/reject potential learnings is a vital development in their investment success. Much like good value investing, it is vital to prevent poor intellectual theories to infect your thinking. Knowing what to accept – and reject – can make or break your short and long-term investment returns. In any event, change is important - if for nothing else – than to refresh the mind and provide new tests for our intellectual and emotional frameworks. Develop your own thinking, rigorously test your ideas, and constantly assess your current models. Doing this will make your chances to outperform all that much stronger. Otherwise, much like Washington Irving’s coach passenger, your largest pain may be in your posterior.