- J.P. Morgan in testimony to the Pujo Committee, 1912
"Nobody who has run a business thinks 'Geez, I'd like to run this thing right into the ground, make the business so worthless that some could buy it pennies on the dollar.' No, most managers want to make the most prudent decisions to maximize the value of the company. Being a good manager isn't the best training at being a value manager".
- Joel Alscot
When I first began investing (and this takes me back nearly 40 years ago) in an economics class, I saw stocks simply as a symbol in the financial section of our local newspaper. How quaint. An actual physical newspaper. My understanding of management was absolutely nil. That changed after I graduated from college, and several friends and I started a company together. I knew nothing about running a business or my relationship with shareholders (shareholders?) vis a vis being a senior executive. I got an education very quickly, starting with my first Board meeting. I quickly learned several lessons that were pounded into me by several members.
It's all about allocation of capital: My job - I quickly learned - was to make decisions on allocating capital and achieving the best return I could for the company, and therefore, for our shareholders. Nothing was more essential, and nearly every major decision we made was part of this allocation process – human resources, deal structures, infrastructure spending, etc. By the end of the first year, I was thinking like a capital allocation machine.
Honesty is still the best policy: My Board expected me to report the good and the bad clearly and succinctly without any gobbly-gook or hiding the facts. If we made a mistake, it was best to describe what happened and how we expected to prevent it from happening again. Our Board made it very clear: the worst thing we could do was make a mistake and hide it. When we did this we prevented them from assisting us in finding a solution.
First principles thinking is the best thinking: The Chairman of our Board was a huge proponent of reasoning by first principles. This is a form of reverse-engineering a problem by removing the fuzziness and vagueness of assumptions and focusing on the essentials. Rather than assuming something works because others (our ourselves) have always done it in a particular way, you can go to the most basic level and assemble the building blocks based on facts. Many times you find assumptions can lead you far astray.
After our fourth year in business, our company began an internal fund to invest our retained earnings and increase the book value of our shares. I quickly realized the views I had learned and adopted as an executive were the same values I wanted to see in companies that became our investments. I still think they are the best core values to find companies that will outperform over the long term. Here are a few examples of how I applied my learning in portfolio selection.
Allocation of Capital
When I first had a conversation with the senior management team of FactSet Research (FDS) in the 2000s, I was struck immediately by their focus on capital allocation. One executive said to me:
"We have a lot of choices in what we can do with our capital. We are an asset-light business, meaning it doesn't require a lot of assets to run our business, we are a relatively non-capital intensive business model. It could be easy for us to go out and do a zillion smaller acquisitions or one huge acquisition or buy a new technology for our operating platform. But you know what? We've run the numbers over and over. Frankly, we can achieve the best returns on capital by incrementally spending the money on our business and retaining capital on the balance sheet. Would it be sexy to do a huge deal? Sure! But it wouldn't be our shareholders who win. It would be investment bankers, accountants, and those of us in senior management. We try to remember every day we work for our shareholders. Return on capital means return to shareholders."
From 2006 - 2020, FactSet achieved an average Return in Invested Capital (ROIC) of 34.6% versus an Average Weighted Cost of Capital (WACC) of 8.3% (source: Gurufocus). Over that fifteen-year time frame, WACC never exceeds ROIC in a single year. Now that's discipline in capital allocation.
Honesty and Integrity
You get the feeling watching the news today that not many managers are a paragon of virtue. Stories of embezzlement, failure to pay vendors, gaming the numbers to meet earnings - the list goes on and on. At Nintai, the older we get, the more critical management becomes in the outperformance of our portfolio holdings. Negative things generally happen when good companies are taken over by bad managers (to paraphrase Warren Buffett). Some of the worst things happen when managers turn out to be untruthful or lack integrity. We haven't seen many companies implode when competent and ethical managers run them. Conversely, the investment journey is littered with companies led down the garden path by unscrupulous management.
In 2019, we sold a biotechnology company out of our investment partner portfolios, the Nintai Trust portfolio, and my personal portfolio. The company was accused of overcharging the Center for Medicare/Medicaid Services (CMS) for its products. It's an all too common technique in the industry that provides a quick, highly profitable, (and illegal) manner for juicing revenue at no additional costs. The problem I've always had with this is two-fold. First, these types of issues always start at the top. You simply can't create an entirely
fictional billing process along with a new revenue stream that impacts corporate revenue without senior executives' knowledge. Second, managers who believe these types of lies begin to push the envelope in other ways, such as off-label marketing and even fabricated research results. Executives willing to put patient lives at risk and overcharge those least capable of paying are some of the worst individuals I've been involved with and have happily cut all ties.
First Principle Thinking
Applying first principle thinking isn't always a natural approach to problem-solving. In my case, it took years of note-taking and reminders to make the process a fundamental step in making decisions.
A Lesson in Debt: While running my business (which I still do at Nintai Investments with only three shareholders), I quickly learned that debt could be a double-edged sword for the business. While it can provide opportunities to invest in growth, all too often, debt can be an albatross around the neck when times get hard. We've all heard the phrase "you can't go bankrupt without debt." First principle thinking allows us to break this down into different pieces. First, without debt, you can't go bankrupt. Second, debt can’t be serviced at the worst time. Third, companies often generate low returns on debt financing. Ergo, it's hard to get in trouble without debt. Consequently, in my history as a money manager, roughly 75-80% of my portfolio holdings have (or had) zero short- or long-term debt.
A Lesson in Costs: When I talked to the former CEO of Fastenal (FAST) – a past holding in the Nintai portfolios – he frequently would tell me about how excited he was to obtain low costs, not just in his business, but even his personal life. Low costs were a passion for him and a sign of personal integrity. For example, he said to me once:
"What most people fail to understand is that to have low prices, you have to have low costs. I know that sounds crazy, but you'd be amazed by the examples I've seen where management thinks the company should have low costs, but management shouldn’t. Take a look at their corporate offices, their expense accounts, the flashy clothes. Rot starts at the head of the fish. If you want low prices, then low costs start at the very top – with the Board and the executives."
His application of first principles came intuitively to him. Query: how do you achieve low costs and high returns to shareholders and customers? Answer: Have the lowest costs. It might not seem like rocket science, but frankly, I haven't found many other executives like him nor holdings as successful as Fastenal.
What This All Means
So what does all this mean? Focusing on the lessons I learned from running my own business (both in the past and present) helped me to understand the type of company I'm looking to create and run is the type of company I would like to add to my portfolio. Several themes emerge from that.
They're human beings, not robots
We often hear the comment that when you invest, you buy a piece of a business, not a stock share. That rule is equally valid when it comes to an investment's management. You are purchasing the qualities of a set of human beings, not a computer named Hal that runs the ship. First and foremost, managers are people just like you and me, filled with emotions like fear and joy or uncertainty and egoism. They have good days and bad days. What is necessary before anything else is that we are aware we are purchasing the rights to a human management team that reflects their emotions, skills, and values. These values will hopefully provide shareholders with adequate returns over the long term. Of course, as an investor, we expect management will make mistakes. That's part of being human. We just need to be made aware of them – quickly and openly – and plan accordingly.
Values still matter
No matter what you may hear on the TV or read on the internet, at Nintai, we like to think that values still matter and good guys (and women) still finish first most of the time. Those that cut corners, fudge numbers to meet aggressive quarterly earnings, or create neat little off-balance sheet SIVs will eventually be hung up by their own petard. None of those scenarios are good for shareholders. Equally important is the way management communicates with shareholders. At Nintai, we like to invest in management who see us as business partners. Therefore, we want management to communicate with us in an honest and open approach helping to make the best investment decisions. When mistakes are made (see the previous point), we like our portfolio holdings' management to own up to them, explain what went wrong, and hear how they intend to prevent a repeat in the future. Bottom line: integrity still matters a lot.
It's easy to forget what matters
I've noticed over the years our willingness to let unacceptable cases slide in some cases and not in others. It's important to realize that "it's OK because everybody does it" is just as dangerous as a case of apparent specific personal misconduct. Let me give you an example of what I mean.
Case 1: You read an article about a Wall Street financier who knowingly bundled together bad debt (voila! Let there be good debt) and created fictional debt instruments to be sold to unknowing investors. These instruments lead to the creation of a financial bubble that costs thousands of jobs and billions in dollars of losses.
Case 2: A co-worker comes to you and asks for money to help fund a family member fighting cancer. After writing a check for $500, you find out the story was a lie, and there was no family member and no cancer. Instead, they used that money to finance a vacation to Bali.
Now answer these questions as quickly and honestly as possible.
- Which case made you angrier at a purely emotional level?
- Which individual would you least likely do business with in the future?
If we are being honest, just about everybody has a far more visceral reaction to the second case versus the first case. But as an investor, it's vitally important to see both as clear-cut cases to reject both individuals in a potential investment. Just because everybody is doing it (think about how widespread the problem was in the first case) doesn't make it right. On the other hand, the lack of individualized anger (such as case 2) also doesn't mean it's OK to ignore it. Have your standards and stick by them no matter the scope or size.
Another J.P. Morgan story relates that he thought someone failing to pay back five dollars told him more about somebody than not paying back five million dollars. Over time I've realized that genuinely great managers who produce outstanding long-term results have ethics that consider the small ($5) or very personal (the cancer scam) value just as much as driving overall corporate values. They all matter equally. Look for managers who, through their values, create value in your investments. It isn't easy. Doing the right thing isn't always the easiest path. But it is one we admire greatly at Nintai.
As always, I look forward to your thoughts and comments.
DISCLOSURE: Nintai has no positions in the companies mentioned within this article.