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

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

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

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

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

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

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

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

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

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

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

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

-------------------------------

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

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

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

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

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

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

“To the question, what shall we do to be saved in this world? There is no other answer but this: look to your moat.”
                                                                -        George Savile, 1st Marquess of Halifax 

“Perhaps the greatest flaw in the history of castles was thinking moats were a simple defensive tool. Not true! Moats can be both defensive and offensive weapons. In defense, they could be used to force the enemy to attack in a particular spot such as the castle’s most heavily defended area. But a moat might also allow the castle holder to hold one part of the line with fewer men while allowing a sortie (made larger by less defenders needed) on the besieging forces. A great moat allowed flexibility in defense and offense. Great leaders recognized this.”
 
                                                               -       Andrew Knighton  

Any modern value investor will inevitably use the concept of “competitive moats” in a conversation about a holding in their portfolio. From Graham to Buffett to Klarman, the concept has become a mainstay in the value investing lexicon. I think most value investors would describe a moat as a means of defending existing assets from the inevitable encroachment from competitors. Examples of this might include patents, pricing, or supply chains.
 
Moats May Be Used Both Defensively and Offensively
 
My time at Nintai Partners and now Nintai Investments LLC has taught me to think of moats somewhat differently. We see moats less as a Maginot Line, but rather a strong defensive position as well as a jumping off place for future growth. It seems to me that value investing requires a portfolio holding have both good value (derived from existing assets) and growth opportunities going forward (such as new markets). As examples, I believe a good moat must have strong defensive characteristics (a duopoly/monopoly, pricing advantages, or industry expertise). But it must also allow the company to keep growth perpetually moving forward. Growth strategies are driven by utilizing the defensive strength of the moat to create new opportunities in adjacent markets or new products. Confident in the defensive nature of its core industries, the company can utilize its product and services in industries similar to their core customers. As an example of this, Nintai looks for companies with high return on capital in both existing products and services as well as new initiatives.    
 
A Working Example: Veeva Systems
 
An example of a moat that works both defensively and offensively is Nintai Investments holding Veeva Systems (VEEV). Veeva Systems provides cloud-based software to customers in the life sciences industry for customer relationship, content, and data management. Veeva CRM is a suite of applications that help pharmaceutical and biotechnology companies market and sell products to healthcare providers. Veeva Vault, a product built on proprietary software, is a cloud-based application built to manage content and associated data. Veeva’s first-mover advantage has allowed them to dominate in life sciences with an estimated 65-70% market share.
 
By deeply embedding themselves in most aspects of life sciences drug discovery, development, and promotion/sales, the company has a deep competitive moat that can hold off competitors for at least the next decade or two. Utilizing a Salesforce customer relationship management (CRM) platform, Veeva has become the de facto CRM leader in life science sales and promotional teams. In addition, Veeva has created its own proprietary platform to assist life science companies work with data from drug discovery all the way to Phase IV (label expansion) trials. These products and services can be described as “defensive” in nature through their ability to hold and expend their life sciences customers.
 
Because the company’s systems are cloud based and agnostic to underlying systems, Veeva can use its moat to go on the offensive and seek out similar industries to life sciences (chemicals, food products, industrial manufacturing, etc.). Veeva Nitro – the company’s latest product launch – is a cloud-based data warehouse system that works with their CRM platform and analytics capabilities. These new offerings are meant to explicitly sortie outside their life sciences castle and move into such adjacent industries. As the company defensive moat continues to keep Veeva dominant in life sciences, it funds and creates opportunities to move out offensively in fronts which will drive growth over the next several decades.    
 
Veeva announced earlier this year it had been awarded contracts with two chemical companies and 1 industrial manufacturing facility. These new efforts are considered bridgeheads to the new industries targeted outside life sciences. Veeva’s goal is to create two new industry “castles” with deep competitive moats within the next 5 -10 years. By utilizing the same products and services (customized to meet the needs of these two new industries), Veeva believes it can leverage existing systems quite quickly into dominant positions.    
 
Deep Moats Can Prohibit Growth Too
 
A company with a deep moat can sometimes end being a value trap as management hunkers down and has no inclination to sortie out to seek new markets. An example of this is Value Line (VALU). I’m showing my age when I say I can remember spending days reading the Value Line reports on individual stocks and mutual funds. In its day, it was the Encyclopedia Britannica of investment research. With the onset of the digital age, the company made almost no effort to digitize its data or move to a web-based research model. This is a company Nintai would normally be salivating over. The company generates return on capital of 31%, return on equity of 36% and return on assets of 17%. The company has no debt and yields 3.6%. What’s not like?
 
 Unfortunately, the Bernhard family (Arnold Bernhard started the company in 1973. His daughter Jean Bernhard Buttner ran the company as well) through its family trust never saw any reason to take competition seriously from such companies as FactSet Research (FDS) or Morningstar (MORN). Hunkered down in their castle, company management saw revenue drop from $85.3M in 2004 to $35.9M in 2018. Even with a major restructuring in 2010, investors have seen a cumulative -4% return over the last 10 years (not including dividend reinvestment).
 
Value Line’s management has squandered an extraordinary asset in its Value Line reports by allowing a deep competitive moat to trap them within their own lines. Eventually, any moat can be filled. Without the ability to see outside the walls of their castle, sometimes the best companies play defense for far too long. Without any plan for growth, Value Line has become the walking embodiment of a value trap.
 
Conclusions
 
Without a doubt, I would rather invest in a company with a moat against one that has none. As a value investor though, that only tells half the story. A moat is only part of a fixed defense that allow for companies to continue building the moat or simply expand and build a new castle. Sitting in their fortifications, sometimes management can get overconfident and live off the safety of their moat for too long. Remaining in leadership means constant evolution in your business model so that as one moat may be filling, you might be thinking how to build an entirely new one. As the Marquess of Halifax said: look to your moat. But also look for growth.
 
As always I look forward to your thoughts and comments.    
​
DISCLOSURE: I currently own Veeva in individual and institutional accounts. Morningstar (MORN) and FactSet Research (FDS) are former holdings of Nintai Partners.

“There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can't reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation. Anyone owning such numbers of securities after presumably studying their investment merit (and I don't care how prestigious their labels) is following what I call the Noah School of Investing - two of everything. Such investors should be piloting arks. While Noah may have been acting in accord with certain time-tested biological principles, the investors have left the track regarding mathematical principles.”
 
                                                             -      Warren Buffett, 1965 Partnership Letter   

Anybody who has read Patrick O’Brian’s Aubrey and Maturin canon are quite familiar with concept of carrying too much sail. In the days before steam, all navies were dependent on the vagaries of the wind. Whether it be triple reefed topsails in a gale (meaning sails were made smaller through a series of “reefs”) or becalmed in the doldrums in the Sargasso Sea, ships’ schedules were dependent upon the amount of wind and the amount of sails the ship could carry. It was common for younger officers to over-press or over-canvass the ship. This meant that - counterintuitively - the ship could go faster if the masts carried less sail. Sometimes too much canvas could push the head of the ship downwards thereby creating more drag and slowing the ship down. Great sailors knew when less sails meant more speed. As the traditional saying goes, any damn fool can shake out a sail, but it takes a sailor to reef it.    
 
I bring this up not to simply mention the writings of Patrick O’Brian (though his works rank as some the best literature of the past century), but to point out the concept that less is more is as easily utilized in value investing as it is in an Atlantic gale in the Bay of Biscay. The idea of reducing the number of holdings in your portfolio goes against most major investment theses centered on risk. Many of these state that a greater number of holdings can reduce risk over time. In the next section, I will discuss why that overall negative view is well justified.
 
For now, I wanted to discuss why my firm takes a different approach than most of Wall Street. At Nintai Investments, we are quite aggressive in limiting the number of holdings in our personal and institutional portfolios. We achieve this by focusing on a very small segment of the total market. This segmentation can be made by any number of criteria: corporate strategy, financial strength, Nintai’s knowledge of the business market and competition, etc.[1] We run a very focused portfolio consisting of roughly 20 - 25 stocks. We do this for several reasons.
 
The Market is So Big, and My Mind is So Small
As of 2016, there are roughly 109,000 publicly traded stocks in all of the global markets (there are roughly 200 stock exchanges in the world). Nearly 4,000 of these are traded on a regular basis on the two major US exchanges – the New York Stock Exchange and the NASDAQ. Another 15,000 trade over-the-counter (or on the so-called pink sheets). That’s a lot of companies! To truly understand all the aspects of an investment (its strategy, operations, financials, markets, competitors, etc.) we’ve found we can own no more than 25 stocks and have a level of comfort that we completely understand each of our holdings.
 
My Business Knowledge is Wide….But Incredibly Shallow
To understand a company, an investor has to have considerable knowledge about their business and markets. Through my investing career I’ve found two areas where I’ve developed deep industry knowledge – health care and informatics. Most of the holdings in our portfolios will be in one of those two areas. You may have considerable knowledge about certain industries because of your line of work. Great returns can be made by investing in what you know about. Conversely bad returns can be generated by investing in something you know nothing about. As Thomas Watson Sr. (founder of IBM) said, “I'm no genius. I'm smart in spots — but I stay around those spots.”
 
My Criteria Rejects Roughly 99.99% of Publicly Traded Companies
I’ve discussed in great detail Nintai’s criteria for selecting portfolio holdings. It focuses on businesses with high returns, little/no debt, deep competitive moats, and trading at a reasonable discount to our intrinsic value. After running a screen with our investment criteria, we are left with roughly 140 - 180 publicly traded stocks around the world. It’s a pretty small pond! We believe the criteria create a portfolio with sound downside protection (owe very little money and are deeply embedded in client operations) as well as upside potential (platform-based with multiple new market opportunities).     
 
It Works For Us
A final reason (without trying to boast) is that it has worked - as configured by Nintai - for over 20 years. Our employees and investors have done quite well against the major indices. (remember: past returns are no assurance of future performance!)  
 
Is Less Really More?
 
As you read this article, you might think I’m now going to demonstrate that good, old-fashioned, intellectual sleeve rolling helps most focused portfolios generate better returns than the general markets. That would be a misplaced assumption. In fact, the exact opposite is true. Nintai is in a very distinct minority of focused portfolios that has outperformed the general markets over extended periods of time (see the previous warning that past performance is no assurance of great future returns!). As seen from the previous section, we’ve never run a focused portfolio because we think focus - by its very nature - outperforms the broader markets. Far from it. We run a focused portfolio out of necessity, not choice.
 
It turns out, running a focused portfolio - in general - isn’t an assurance you will outperform the markets. In fact, recent research by Morningstar demonstrates focused portfolios are no better (performance-wise) than broader index funds. However, they are more expensive by far. In Morningstar’s[2] “Portfolio Concentration Doesn't Have Much Sway on Returns”, Alex Bryan writes that their research finds there is no significant relationship between portfolio concentration and gross returns among U.S. equity mutual funds. The idea that allowing an investment manager to focus on his top picks will lead to market outperformance is really just all hogwash. This of course comes as a great surprise to focused investment managers (like me!), investment management companies that market such funds, and investors who put money in such funds.   
  
Performance is Similar to Non-Focused Portfolios
Focused portfolios (as measured by the percent of assets invested in the manger’s top 10 picks) had little effect on gross return when compared to non-focused funds within their respective Morningstar category. Accordingly, the odds of choosing a focused fund that will outperform the Morningstar category average return is very low. In Large (Growth, Core, and Value), Mid and Small-Cap, performance during 2004 - 2018 between the lest-focused quartile and the most-focused quartile was quite similar. In fact, in the total 9 domestic stock categories, only 2 saw the focused portfolios exceed the least focused by more than 1%. When fees are taken into account, most outperformance is washed out.   
 
Focused Funds Can Deliver Great Outperformance….and Great Under-Performance
As a portfolio becomes increasingly focused, the risk of wider swings in performance becomes much larger. For instance, a 100-stock portfolio had drawdowns of over 5% just once every 157 days from 2010 – 2017. A 20-stock portfolio had a similar drawdown every 34 days. Such swings happening at a far greater frequency can play old Harry on an investor’s nervous system. So remember: concentrated funds can deliver greater outperformance, but also greater underperformance. One other important reminder: since the majority of all funds never outperform the general markets, it stands to reason neither do focused funds.
 
Focused Funds are More Expensive
The average focused fund charged between 25 to 50 basis points more than a traditional non-focused fund. The largest difference was in small-caps - with focused funds charging roughly 39 basis points more. Large-caps had the smallest gap, with focused funds charging roughly 21 basis points more. Looking at performance, it’s not clear paying such a greater amount in management fees is worth it in the long run.   
 
Conclusions
 
Since founding the Nintai Partners Investment Fund in 2004, I have always run a relatively focused portfolio. Nintai Investments LLC continues that investment strategy. That said, as you look for investment managers it’s perfectly fine to invest with one who maintains a portfolio of 300 stocks versus one who focuses on only 25 individual positions. The key is understanding why the manager believes a focused approach works better and what their record has been in using such an approach. Sometimes spreading a little canvas can be just as effective as shortening sail. It simply depends on the sailor and the conditions.
 
DISCLOSURES: None, with the exception that I’ve read the Aubrey and Maturin canon (21 books) 8 times over.
 
​--------------------------------------

[1] For a far more detailed discussion on how we select holdings – and what criteria we use – please see my article “Our Investment Strategy and Portfolio Selection” which can be found here.
 

[2] “Portfolio Concentration Doesn't Have Much Sway on Returns”, Alex Bryan CFA, Director of Passive Strategies Research, North America, Morningstar Manager Research, May 1 2019

“I remember watching cartoons as a kid where each character had a super power. Some could fly, some could see through walls, some shot sticky crap to catch the bad guys. They all had something that innately made them better than both the bad guys and the good guys. When I’m looking at a potential investment, I want my managers to have capital allocation super powers. I want the Superman of return on capital”.
                                                                        -       Allard Ross 

“It’s interesting. I’ve never found a single test that can help you find a manager that - over the long-term - has the uncanny ability to be an outstanding allocator of capital. Perhaps the one and only corelative factor I’ve ever seen (and I mean this quite seriously) is whether the individual does their shopping at discount or second-hand stores. That nearly always guarantees you’ve got someone at the helm that takes shareholder capital very, very seriously.”    

                                                                     -      Pierre Pontet-Canet 

There was a story about Bob Kierlin, the former CEO of Fastenal (FAST) who used to buy his suits not a mark-down suit store, but suits already used by the manager at the mark-down suit store. He said, “Luckily, we're the same size. I picked up six of those suits for 60 bucks each." Another time, Bob and current CEO Dan Florness had to get to Chicago for a meeting. Since the meeting wasn’t until the next day, they decided to scrap the one-hour flight and drive instead – saving the company 78% in costs and eating at A&W because they had the cheapest hamburger on the route. But it wasn’t just frugality that Kierlin built into corporate DNA. Fairness was another. When a recession hurt Fastenal growth in 2001, management were the first to cut their pay. Variable pay for management declined 30%. Bob’s salary was hit the hardest. His $121,000 salary was cut almost in half to $63,500. For other employees, variable pay increased 4%.
 
Cheap Management Generate High Returns
 
In 2014, Nintai Partners did an analysis comparing corporate return on capital of companies with management compensation in the highest decile versus companies with management compensation in the lowest decile. We were interested in seeing whether there was a correlation between how much management was compensated and their respective company’s return on capital. We chose 36 companies from the top decile of the S&P 500 and 49 companies from the top decile of the Russell 3000 and calculated return on capital for the years 2009 - 2013. We chose the same amount for the lowest decile. In addition, we wanted to see if individuals who are compensated either dramatically more or less had a different tenure within their respective companies. Last, we were interested to see what happened to the company’s ROC after that management team had left. (The pool of candidates was smaller here simply because not everyone has left yet).
 
It turns out there was a strong correlation. The numbers seen below show that management who are compensated the least have a dramatic - and positive - impact on ROC. I should note this applied in every industry sector listed (in the Corporate Sector Make Up). The lowest 10% in compensation achieved an average ROC from 2009 – 2013 of 17.3%. The highest 10% compensated managers achieved a ROC of only 11.4%. Additionally, the lowest paid managers stayed on in their CEO position nearly 10 years longer. As an investor, not only does your holding managed by the lowest compensated managers generate a higher ROC, but it achieves it for a longer period of time. Last, the departure of the lowest paid CEOs had a slight greater negative impact than the departure of the highest paid (this is to be expected since the gap was so large to begin with). 
​

Why This Matters
 
Anecdotally, I’ve often heard that if someone manages your money like their own then you’ve found a good manager. It turns out the data show that managers who are frugally compensated have a tendency to generate much higher return on capital than those who are lavishly compensated. I believe Nintai’s research can teach investors several lessons.
 
Frugality is a Lifestyle
It turns out frugality runs through many managers’ personal and professional lives. Whether it be Bob Kierlin at Fastenal or Ken Iverson at Nucor (NUE), some individuals run a tight financial ship throughout their lives. This type of tight-fisted approach to spending can run through an entire business creating extraordinary internal returns (such as return on capital, return on equity, and return on assets) as well as investor returns.
 
Frugal Managers are Long-Lived Managers
During their research, Nintai Partners wasn’t able to measure the happiness or contentment of low-compensated versus high-compensated managers. But one thing was for certain - managers who faithfully showed up on the lowest compensated list year after year remained at their post far longer than those who were the highest compensated.   
 
Frugal DNA Remains Within the Organization
While return on capital decreased slightly after the departure of a lowest compensated manager, generally the company continued to outperform companies with the highest compensated managers. This persisted over the next 5 - 10 years in nearly every case. The values of the cheap-skate CEO had a lasting effect.
 
Conclusions
 
Over my investing career, I’ve always looked for companies with high return on capital because I believe these are organizations with the best chance at becoming (or already being) compounding machines. Partnering with managers whose personal and professional characteristics help drive high return on capital and receive low compensation can increase your chances in investing in one of these compounding machines. For instance - from 1987 to the 2019 - the S&P 500 has grown 989% while Fastenal’s stock has grown 49,000%. As an investor, you can’t ask for more than that. If you were Bob Kierlin, you simply didn’t.
  
DISCLOSURE: I own Fastenal in several accounts I personally manage. 

“Being an investment manager doesn’t require just our fiduciary stewardship of your assets invested with us. It also requires we provide you with the most relevant, timely, and useful information to understanding our methodology, purchases, sales, and performance. As an investment partner, we look to provide you with the same service we would look for if we were a customer. Partnership requires honest and fair dealing – with both the investment of your money and with information about your investments.”
                                    -   Nintai Investment “Statement of Investment Partnership”   

When one considers performance of active versus passive (index) investing, many times you will hear about how some markets are great for indexing - like the last 10-year bull market[1]. Of course, those arguing that bull markets are great for indexing and make it difficult for active investors to outperform are - wait for it - active investment managers. Indeed, the last 10 years (through 2018) have been cruel years for both value and growth investors[2]. For Large Cap (Growth, Blend, and Value) investors, only 9.6% of funds survived and beat their respective index. It was slightly better for Mid-Cap investors (18.2%), and for Small-Cap investors (19.5%). The disparity between the highest and lowest funds was shocking. For instance, in the Large-Cap category 15.7% of the least expensive funds beat their proxy while only 5.3% of the most expensive funds beat the same proxy. For Mid-Caps, 24.1% of the least expensive funds outperformed their proxy while only 10.2% of the most expensive compiled such a record. For Small-Caps, 23.9% of the cheapest funds outperformed versus 12.6% for the most expensive.

No matter how you slice it, those are difficult numbers to absorb as an investor looking to fund their retirement or child’s college education. It’s not difficult to see why the last decade has seen a massive influx into index funds. Yet, even with these numbers over half of total investments in the United States are still in actively managed funds (roughly 52% active versus 48% passive in 2019 according to Morningstar).     

It Isn’t Just Underperformance, But Also Under-Reporting

None of this information should be a great shock to investors (or fund managers), but sadly it is. As an active investment manager myself, I find not only outperformance is required to grow my asset base, but providing my investment partners with accurate, relevant data is essential as well. After considering this - along with the aforementioned performance data - I decided to investigate what type of information is provided to fund owners with a particular focus on the distinction between high- expense funds versus low-expense funds. After all, with such a larger group of high-expense funds underperforming, you would think they would have considerably more explaining to do.

I couldn’t have been more wrong. I divided quarterly reports into several major areas to see how each group does in terms of level of disclosure or discussion. These include investment strategy, portfolio holdings discussion, investment buy/sell criteria, and valuation of a holding at the time of purchase or sale. For the most expensive funds, a sample of 37 funds showed roughly 55% discussed their investment strategy while 45% did not. Roughly 35% did a cursory overview of portfolio holdings while 65% did not. Only 18% specifically discussed the business case for specific additions or sales to the portfolio. 82% made no mention. Finally, only 27% discussed valuations related to specific purchases or sales. The least expensive were considerably more forthcoming with data and discussions. A sample of 32 funds showed that 78% discussed their investment strategy. Nearly 60% discussed a percentage of their holdings (usually the top 10). A whopping 71% discussed specific purchases or sales (versus just 18%!). Only in the discussion of valuations related to purchase or sales were the two groups similar in percentage, with 34% of least-expensive funds discussing this subject.

So what should we make of this? Not only do funds with higher expenses underperform at an alarmingly higher rate than the least expensive funds, they also disclose far less in terms of portfolio specifics. Only in one area do high-expense funds out do low-expense funds – discussion of macro-economic issues. Presumably this is because they have less incentives to discuss performance and more to convince their investors why they are relevant.   
 
What Needs To Be Discussed

In my mind, the more information I share with my investment partners the better. That doesn’t mean every one of my investors reads everything I provide. But overall, I think it should be the investor’s decision - not mine - to decide what is too much and what is enough. Over time, I’ve found the following four items give my investors the best chance at fully understanding my investment strategy and decisions surrounding their portfolio holdings.

Explanation of Investment Philosophy
Whether it is Berkshire Hathaway’s “Owner’s Manual” or Nintai Investment’s “Statement of Investment Partnership”, every quarterly and annual report should include a summary of the investment manager’s methodology. Even better, examples of this including recent purchases and sales in the portfolio should leave investors with a clear understanding of what and how the manager is looking to achieve long-term outperformance versus their respective proxy. I include Nintai’s “Statement” at the beginning of each annual report and include an example of a portfolio holding’s purchase or sale with an explanation of its relevance to my core strategy.  

Investment Cases for New Investments
Each time I make a purchase or sale in any Nintai portfolio, I send each impacted investor (I may not necessarily purchase or sell a holding in all accounts) a detailed business case about the holding including a numbers-based summary (returns, free cash flow, debt, etc.), investment thesis, business overview, market characteristics, competitive analysis, business case risks, and valuation summary. In general this is 3-4 pages in length.  

Valuation Methodology and Estimated Intrinsic Value
I also send a summary valuation spreadsheet that includes a free cash flow valuation worksheet and multiple tabs that include return on capital calculations, balance sheet strength, allocation of capital, cash return, rate of return, etc. This gives the investor a chance to roll up their sleeves (if they so choose) and better understand why I think the price of the asset offers an adequate margin of safety and how I derived an estimated intrinsic value.   

Evaluation of Performance
The performance of Nintai Investment’s portfolio is front and center in each of my quarterly and annual reports. This includes both good and bad data (thankfully the good has far outweighed the bad, though past performance is no assurance of future returns!). I like to discuss those companies that added the most to returns and those that detracted the most. In the latter case, I find it helpful to outline how and where I got the investment case wrong and what steps can be taken to turn things around. This includes a frank discussion on what data points or results might require taking losses and moving on. I measure performance against both the S&P 500 TR (whch many see as a proxy for the market) as well as a individualized portfolio that best matches the portfolio but based on a collection of index funds and cash such as 15% Vanguard US Small Cap Index, 35% Vanguard Mid Cap Index, 35% Vanguard S&P 500 Index, and 15% Vanguard Short Term Government Bond Index.
Not every fund manager is going to be able to provide this to their investors. Funds with 1,200 holdings or 350% turnover are unlikely to be able to (or be financially capable of) providing such information on a quarterly basis. But when asked, they should be able to provide such data. It is their investors’ money after all for heaven’s sake.  

Conclusions

Active investment managers haven’t done a very good job of demonstrating an ability to outperform their respective index. They’ve done an even greater disservice to their investment partners at reporting and discussing as little as possible about their methodology, process - and most importantly - their performance. If we are - as a collection of investment professionals - going to change the trend of investors moving to passive investments versus active management, then we not only need to better our performance, but do a better job communicating with our investment partners. Underperformance requires more communication, not less. While it doesn’t make underperformance any easier to take for investors, they will at least better understand how and why such underperformance is taking place and how managers intend to turn things around. It’s the least active manages can do to allay the fears of a rightfully frustrated investor base.  

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[1] This is true in some ways but doesn’t tell the whole story. Many stock segments are performing quite poorly when compared to the S&P500 (the largest 500 companies publicly traded). For instance, Morningstar reports that nearly 25% of all publicly traded stocks are currently (as of April, 2019) trading in bear market territory. But overall, the last 10 years have been on average a tremendous bull market that has lifted the majority of all boats.  
[2] Data for this section comes from Morningstar’s Active/Passive Barometer. Information is from the 2018 report published in March 2018. The authors are Ben Johnson CFA and Alex Bryan.