"The huge volatility of the market broke down all but the most fundamental relationships between markets and securities.  The usual day-to-day world where investors cared about subtleties like corporate earnings or analysts’ forecasts dissolved as the energy of the market was turned up.  All stocks moved together; if it was a stock, it was sold like it was plasma physics: as matter becomes hotter, it becomes less differentiated.  The forces that bond atoms together in the form of molecules are overwhelmed, so that rather than having a myriad of different substances, we have the elemental building blocks of the atoms.  Turn up the heat even more and the atoms themselves are melded into plasma, positively charged ions and negatively charged free electrons; matter in its most uniform and non-differentiated state, no longer hydrogen atoms and oxygen atoms, just a seething white-hot blur of matter.”
                                         -          Richard Bookstaber, “A Demon of Our Own Design”
​
During times of crisis, it’s often said that multiple correlations all converge at 1 as panic settles in – REIT owners, preferred stock owners, and even bond owners all look at their assets through identical lenses. As fear grows increasingly into panic, investors begin to see the heat rise even further into that “seething white-hot blur of matter” that Bookstaber discusses. Soon all assets – bonds, stocks, even derivatives – begin to narrow their correlation until it that trade near 1.

Morningstar just published a great article on why correlations tighten until they hit 1 during market corrections[1].  It’s important to remember that not every downturn in the markets drives correlations to near equal status. During the 1998 Asian currency crisis, all the categories of US diversified stock funds losses ranged from 1.7% to 22.6%. Not even close to a tight correlation. However, the coronavirus has induced a level of panic in the markets that selling (and buying) have pushed correlations the closest to 1 since the great recession.

So what makes this latest crash so intriguing? First, when Morningstar looked at all nine categories of UD diversified stock funds, the range in average losses was incredibly narrow and small – ranging from 10.8% and 11.6% starting from Feb. 19 - the S&P 500 high - and Feb. 27. Historically, this is a remarkably small range. What makes the small range so interesting, is the data show it to exist in nearly every respective type of fund. The most interesting to us at Nintai - and likely everyone at GuruFocus - is the difference between growth and value. It’s been a near given mantra that value will outperform growth during downdrafts in the market. So how did value do against the market in the initial period of collapse from February 19 -  February 27?
It turns out during the virus-induced crash, there was very little difference between value and growth performance. During the period, value funds on average posted losses of 11.25% versus an 11.11% average drop for growth funds. The second category that Morningstar looked at was the difference between small-caps and large-caps. Again the difference was minimal between the two – small-caps posted a negative return of 10.94% versus a large-cap return of a negative 11.30%.    
      
Of course, the S&P 5000 has dropped roughly 32% since its peak in February. Have the numbers changed any as the losses have increased? The initial review of the data suggest not. Value funds have lost roughly 31.6% since market highs while growth funds have lost roughly 33.2% during the same time. At its most basic, this market crash - driven by a virus of unknown nature, pathology, and treatment - has driven correlations to 1 from the onset of the disease/crash to its current state.     

What Does All This Mean?
All of this has left us with some heady questions between the cause of the crash, the impact of the disease, and potential length and depth of the market crash. Here are some of the theories we are working on to think ahead for the next emergency similar to this one.

1. Stock Prices Were Inflated
I’m not sure of many on Wall Street that wouldn’t have argued that stocks were due for a tumble some point. Record high P/E ratios, a 10 year bull market, and slowing growth all gave off the feeling that the bull market was nearing its end. At Nintai we had reached nearly 30% cash in some portfolios being unable to find anything that met our criteria or margin of safety. With the rebound in prices over the past few days, most buying opportunities have passed by already.   

Greater Fear (As per VIX) Leads to More 1-Based Correlation
During the crash of February and March 2019, the VIX reached its highest level since the Great Recession. When the VIX reaches such stratospheric levels (66.2 in December 2008 and 65.65 on March 27 2020) nearly every asset is correlated. In other words, there are very few places to hide when the vast majority of investors are convinced the markets will drop.

Non-Controllable Events Lead to More 1-Based Correlation
Fear can be generated by fear or uncertainty or both. In some economic situations fear can be driven by poor earnings results or missed expectations. Uncertainty can be caused by a simply non-measurable event – meaning there is no way to quantify both the odds of it happening and the scope of the event. Fear and uncertainty can be a deadly mix on wall street. When they say “Wall Street has to climb the wall of worry”, they aren’t kidding.    
​
Conclusions
Over the course of the last month, several key learnings have come back to haunt investors. The first is that fear - real gut wrenching, visceral fear - forces a wide range of investors to act in a similar way. This can be value versus growth, small-cap versus large-cap, low-yield versus high-yield. When investors panic, the phrase “no place to hide” really means that many seemingly different asset classes suddenly all begin correlate to each other. Stocks, bonds, energy, utilities, REITs, etc. all begin to drop in similar ways and in similar amounts. In other words - the dreadful 1-factor correlation. The second learning is that crashes like we’ve seen over the past month are by far easiest ways to differentiate your returns (for both good and bad) against the general markets and individual investors. At Nintai Investments, we’ve seen our outperformance with the Russell 2000 jump from roughly 2 - 5% at the beginning of February to 20 – 25% by the end of March 2020[2]. Which brings us to the third finding. To give yourself a chance at outperformance, you really need to invest differently than the indexes and other investors. Whether it be 30% cash, 20% in microcaps, or investments in only 4 of the 11 S&P 500 industry categories (all characteristics of Nintai Investment portfolios), investors should find their niche and make it their own. Great value investors find their niche - purchase shares at a considerable discount to fair value – and hang on for the journey. The ability to differentiate your investment from the dreaded bear market 1 correlation will in the end decide how successful you are in the long term.      
As always I look forward to your thoughts and comments.
DISCLOSURES: None

[1] “Correlations Going to 1: Amid Market Collapse, U.S. Stock Fund Fs Show Little Differentiation”, David Carey, Tom Lauricella, Mar 6, 2020
[2] Past investment performance does not ensure future returns

It isn’t often we see market actions like we’ve seen over the past few weeks. This is the kind of market where you see almost no correlation with corporate-specific data and individual stock prices. A company like Veeva (VEEV) - down from $165/share on February 20 2019 is trading at $135/share on March 12 2019 after announcing an outstanding quarter on March 4 (revenue up 34% Y/Y, earnings beat by $0.02, etc.). What is one to make from such markets? What protection is there in these conditions?
 
First, we recommend having confidence in the companies and managements that make up your portfolio. At Nintai, we seek out companies with high returns on capital, equity, assets, high free cash flow margins, deep competitive moats, and management who know how to create long term investor value. We can assure you that corporate operations, strategies, or management skill sets have not collapsed because the markets have entered bear market territory or the coronavirus has reached pandemic scale.
 
Equally, we are confident our investment partners are aware they still own a set of outstanding companies in their portfolios. Each of our portfolios have generous cash positions which provide both downside protection and the ability to add to existing positions as prices become increasingly compelling. Equally, companies in their portfolios have no debt that forces them to make desperate - and likely poor capital allocation - decisions. Occasionally you here about investors who became rich by selling at the top (like Joe Kennedy selling after his shoe shine boy recommended Hindenburg - “the moment a shoe shine boy gives you stock recommendations it’s time to get out of the markets”)  
 
But the vast majority of investors who outperform the general markets build up cash as the markets reach rarified levels, take their profits, build up cash, and await the inevitable crash. Yes, it’s the buy low, sell high concept. It doesn’t take a lot of intellectual quotient (IQ), but it takes a heck of a lot of emotional quotient (EQ) to successfully achieve this model. Here at Nintai Investments, we might not be the brightest lights on the block, but we firmly understand the concept of holding cash, buying low, and selling high. As I’ve mentioned before, we have a tendency to not make our money in bull markets, but rather preventing permanent capital losses in bear markets.
 
As for Veeva (VEEV) which I first discussed in this article, the company has no debt, roughly $1.1B USD cash on the balance sheet, grew revenue 25.8%, earnings by 50.3% and free cash flow by 60.4% over the past 5 years. Management has a clear view on where growth is coming from over the next 5 – 10 years, and are outstanding capital allocators. The fact the price has dropped by 18% in three weeks would suggest this rapid decrease represents increased value rather than increased risk.
 
As value investors - regardless of the knot in your stomach and that feeling of flight over fight - we live for moments like this. These are the days that test an investor’s ability to live by value-based credo – buy low, sell high, look for quality and value at a discount to your estimated intrinsic value, be patient and keep your emotions in check.
 
Our markets have survived a Civil War, the crashes of 1896, 1901, 1907, 1929, the Great Depression, two World Wars, the Cuban Missile Crisis, the 1973-1974 crash, the technology bubble, and the real estate bubble (just to name some!). At Nintai we believe that as prices continue their drop, opportunities at acquiring outstanding companies at a discount to their intrinsic value will provide some great opportunities going forward.        
 
By remaining calm and seeking out investment opportunities, we believe we can provide our investment partners with their best chance at long term market outperformance. As value investors, it’s what we do best. 

“We make money the old fashioned way. We earn it.”
 
                                                     -      John Houseman for Smith Barney 

If you are old enough you can remember those commercials in the early eighties with John Houseman sitting in front of a burning fire in some gentleman’s club telling viewers that Smith Barney makes money the old fashioned way - they earn it.  I was never quite sure what they meant by that, but it certainly was a great line delivered by a great actor.
 
At Nintai we like to think we make many the old fashioned was as well - by simply outperforming the markets. This too is also a great line, though we have no John Houseman to deliver it. Rather than a great marketing line, the only way we know of backing up our claim is through performance. During my time at Nintai Partners - and subsequently at Nintai Investments - there have been two salient facts that have driven our outperformance (of course past performance is no assurance of future returns).
First, the value of cash becomes outsized in that its value does not drop and its ability to purchase downtrodden stocks becomes vital. Having dry powder to take advantage of mispricing in the markets becomes essential for long-term outperformance. Second, during genuine market corrections (drops by at least 20%), correlative values (meaning the difference in returns between value and growth, small and large, etc.)  generally merge to roughly 1. This means everybody does equally poorly. If value stocks drop by 20%, then growth stocks drop by roughly 20%. Having the ability to remain calm and sticking to your core valuations - and buying when stock prices hit the required margin of safety - are two emotional and intellectual prerequisites to being a great value investor. In my next two articles I want to discuss these two factors – the strength of the cold hard cash and the drop to mutual correlative values in market corrections. In the final analysis, most of the value we add at Nintai Investments does not come in bull market, but rather our defensive nature and positioning when bear markets come about over time.  
 
In part 1, I thought I’d use three individual Nintai Investments to discuss the value (and cost) of holding large cash positions over the past year. Over the past several years,
 
 I‘ve written extensively about the underlying power of cash. I have described its strength in the terms of what the armed services refers to optionality. This means that
cash gives you the ability to play defensively and offensively when certain assets reach an adequate margin of safety.
 
Below, you will see 3 Nintai Investment individualized accounts breaking out cash as a percent of AUM, US equities and foreign equities as a percent of AUM, and the average portfolio equity market cap. The 3 portfolios’ cash positions range from 14% of total AUM to 33%. I should point out that Nintai Investments generally holds cash – not bonds – as we believe bond prices are as distorted as equity prices. 

​As seen below, looking at the difference between market highs (achieved February 20 2019) and the lows (achieved – so far – through March 6 2019), readers can see that cash positions provided an enormous brake on market losses compared to those achieved by the general markets.

Note: Some may be asking why the portfolio with the largest percent in cash lost the greatest percentage. The answer is quite simple – shares in this portfolio were bought closer to the market highs in February than the other two portfolios. 

I’ve often said that I made my record at Nintai Partners Fund by losing only 18% in 2008 and making 71% in 2009. Every other year was actually not that different thanthe general markets between 2002 - 2015. Indeed, some of these years (particularly 2013, 2014, and 2015 I really underperformed).   
 
What To Learn from Severe Drawdowns
When markets drop 2-3% every day for 2 straight weeks, even the most sanguine investor can get sweaty palms and feel the first pangs of fear in the gut. But I’ve never been involved in severe drawdowns when there hasn’t been – beforehand - a run up of truly magnificent proportions. Whether it was the technology bubble in 1999 - 2000, the real estate/CDO/MBS bubble in 2006 – 2007, or the ten year bull market from 2009 - 2020, prices have generally reached nose-bleed levels before the inevitable sucking sound of the drawdown. During the end of those run ups, successful value investors will be arguing with other market participants that 30 - 40% cash positions aren’t that unreasonable.     
 
By the end of December, I found my investment partner portfolios were ranging from 15 - 30% cash. Any buys I might be adding to accounts were additions to existing positions. Nearly every report update had a section on cash - explaining why percentages were so high and its impact on returns. While slightly outperforming the markets, it was touch and go as the large cash positions were taking a toll on the continuous upward pressure of the bull market.
 
Then came the last two weeks at the end of February 2020 to the beginning of March 2020. During this time, the markets went on a roller coaster ride down 1,000 points one day and up 800 the next. However, the over trajectory was down - with the S&P 500 losing 14% over the roughly 2 week period. As I discussed earlier, the large cash positions helped each portfolio outperform the general markets.    
 
What Can Be Learned?
Most professional money managers don’t have the luxury of holding large percentages of their assets under management in cash. Many feel they must be “all in” when it comes to their clients funds as inaction represents lack of effort.
 
Cash Acts Like a Portfolio Anchor
At Nintai we feel very different than most players on Wall Street. Our actions – in this case represented by the holding of cash – represents wisdom in not overpaying for an asset and awaiting the right opportunity to come along to deploy capital. In these cases, cash acts as an anchor against permanently impairing capital in down markets. After a stock has dropped by 55% in 30 days, it’s pretty hard to see a recovery over the short - or even long - term, while cash hasn’t dropped an iota in the same scenario.     
 
Cash Has Immediate Use
One of the most powerful aspects of cash is the fact is you never have to think to act when action is necessary. If one owns bonds, then you have to calculate the bid/ask or the current price per share if you own them in a fund and calculate if you want to take the loss or pay the tax to cash out and use the proceeds in purchasing another asset. Not so with cash. You can purchase the asset in seconds and not give a thought to price conversions, long or short term capital gains, or whether the price is equal to the amount of shares you are looking to purchase. Cash has immediate purchasing power – which is a huge advantage in crazily volatile markets.     
 
Cash Can Go From Defensive to Offensive Instantly
Nothing beats cash when it comes to optionality. If you think a stock has reached its bottom, or even has just passed its point of an adequate margin of safety, then cash goes from an immediate defensive tool to an offensive tool. It no longer protects to the downside but rather covers the opportunity of the upside. There is simply no tool in the financial markets that can provide such a change in strategy so quickly.
 
Conclusions
 
In this time of financial volatility - when not every investor is asking “how much many will I make today” but rather cowering in their home unwilling to open their statements or go on the computer to check their balances - the ability to have an anchor to windward that protects against the downside and offers instant opportunity to take advantage of new opportunities is a powerful tool. The ability to sleep better at night because you know you’ve made provisions against the downside is vastly underrated as an investment position. If you have positions that are 20 - 30% above your estimated intrinsic value, don’t hesitate to pay the taxes, lock in the profit, and have some cash ready to purchase some potential long term bargains as the markets fluctuate as severely as they have in the past few weeks. My guess is you won’t regret it and you might it find yourself more relaxed and salivating at some potential stock you’ve had your eye on for several years but was never in your price range.       
 
As always, I look forward to your thoughts and comments. 

“The investment management business (it should be a profession but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.”

"Don't do anything because when you try to do something, it is on average a mistake." - Charles Ellis

Sittin’ on top of the world
Since the 2009 bottom of the credit crash, we’ve had an over decade-long market expansion which has provided investors with the longest bull market in recent history. For those at the end of their investing career, this has been a huge tailwind, allowing for far more generous performance any would have thought possible.

Better quality, cheaper prices

At Nintai, we believe in a fundamental investment concept. If we invest in a bucket of companies with significant advantages in quality (higher returns on capital, equity, assets, free cash flow margins, no debt, etc.) combined with valuations (a blend of cheaper attributes, including estimated intrinsic value from our discounted cash flow models and cheaper price-earnings ratios), we can expect to outperform the broader markets over the long term.The concept of purchasing higher-quality companies or looking to purchase shares at a discount to estimated intrinsic value isn’t anything new to the value investment community. I have found it is rarer to combine the two as a foundation for your investment strategy. When I utilize Morningstar’s portfolio manager research tools to find funds with a high portfolio match, I’ve found only two with a greater than 25% overlap of our holdings. About 45% had no stock in common at all. With numbers like this, the reader can see it’s pretty rare to find the concept carried out on a regular basis. What’s equally rare (as far as I can see) is articulating the idea that the highest-quality companies purchased at good prices can provide significant downside protection during a bear market. In general, I’ve found that companies and management that generate great returns on capital and have little or no debt are businesses that thrive in bull or bear markets, in expanding or recessionary economic times. Combined with holding significant cash, I feel comfortable that when the inevitable market tumble comes along, I’ve reduced the risk of capital impairment as best as I can in today’s markets.

Nintai’s Abacus reports give a quick graphic overview in how we are doing in meeting the goals of a portfolio consisting of outstanding quality at value prices. Later on, I will walk readers through the summary report and take a look at how we are doing in meeting Nintai’s investment strategy and check in on performance.

It all starts by finding corporate excellence

Any research we do at Nintai starts with locating companies with outstanding business characteristics. We locate these in multiple ways – GuruFocus’ All-in-One Screener, conversations with thought leaders, meetings with corporate executives and so on. Once we’ve found a company that meets our criteria, we will begin the in-depth process of really understanding the company’s strategy, products, markets and competitors. If we’ve done our job, we can run a summary “quality” report on Nintai Abacus and make sure the portfolio is meeting our strategy.
​
Let’s use a blend of our investment partner portfolios to demonstrate what I mean by a “quality” summary report. In November 2019 on average, the Nintai Investment portfolios shared the following attributes: return on capital (42.8%), return on equity (31.7%) and return on assets (19.2%). This compares to the same numbers for the S&P500 (source: Morningstar’s “Portfolio X-Ray” reporting function): return on capital (3.28%[1]), return on equity (1.21%), and return on assets (2.11%). These numbers show that - in general - Nintai’s portfolios have created a basket of holdings far more profitable than the S&P 500. Additionally, the debt-to-equity ratio of the S&P 500 (as of August 2019) stood at 0.89 (source: Haver Analytics and Standard & Poor’s) versus 0.023 for the Nintai portfolios.
Why are all the numbers important? First, a basic tenant at Nintai Investments is to prevent permanent impairment of our investment partners’ hard-earned capital. We’ve found over time that companies with little or no debt[2] and who are also highly profitable (both from a free cash flow perspective as well as capital returns) minimize that risk. Second, we’ve found that management teams who act prudently with their investors’ capital are great stewards to partner with over a decade or two. Last, companies with these characteristics are generally outstanding businesses with outstanding fundamentals and deep competitive moats. All three of these play a vital role in having a blow up in the portfolio that can lead to truly horrendous losses. At Nintai, everything begins by investing in outstanding quality.

Finding value in a value investment strategy

Finding outstanding, profitable and prudent companies is, of course, only half the battle. Buying them at a discount to my estimated intrinsic value is the second piece of equally important halves. In finding value, we use two different and distinct methods. The first is company specific. We utilize a discounted free cash flow model to ascertain the value of each individual holding (or potential holding). As this information is proprietary, I will simply say the aggregate price-value ratio for the Nintai portfolios is 0.91. This is to say our portfolios currently trade at a 9% discount to our estimated intrinsic value. Value ranges from 137% (overvalued) of our estimated value to 72% (undervalued). As a portfolio of individual stocks, we see some investment opportunities in several holdings trading at significant discounts to their estimated intrinsic values.

The second approach we take to value is comparing the total portfolio to the S&P 500. This gives us an idea as to how the portfolio’s value is to the general markets. While we put a great deal of effort into the DCF model, we think looking at the broader markets is equally valuable. There are two numbers we look for in the broader markets review. First is how our portfolio price-earnings ratio looks against the S&P 500’s ratio. This tells us how expensive the portfolio is against the broader markets. The second is analyzing the portfolio’s five-year earnings growth projections against the S&P 500. This gives us a look at whether we are paying more or less for future growth versus the general markets.
The S&P 500’s price-earnings ratio - as of November 2019 - stood at 22.95. The Nintai portfolios average price-earnings ratio was 18.8 at the same time - an 18.1% discount to the S&P 500's price-earnings ratio. This tells us the Nintai portfolios are currently trading significantly cheaper than the S&P 500. Great news. In addition, the Nintai portfolios have a five-year estimated earnings growth rate of 11.1%. This is roughly 17% greater rate than the estimated S&P 500 rate. We now know the portfolios are cheaper than the S&P 500 as well as estimated to grow much faster. What’s not to like about those statistics?

Putting it all together

All of these numbers can certainly make your head spin and do nothing but sow confusion among our investment partners. Because of this we created the Abacus reporting system, which can show these numbers in an easy-to-read graphic. Seen below is the past few pages of content in a format that is much easier to understand.

Our investment partners have a tendency to look at the rating arrows (all green is what they are looking for here) and ask any questions related to those. At the core, the graphic quickly encapsulates

• Does the portfolio meet our quality criteria in general and against the S&P 500?
• How does the portfolio compare in value against the S&P 500?

A number we look at carefully is the combination of the S&P 500 price-earnings relative number as well as the S&P 500 projected earnings per share growth relative number. Here we combine the fact that the portfolio is 18% cheaper than the S&P 500 and is estimated to grow 17% faster, giving us a 35% “combined value rate (CVR).” We are satisfied with a CVR over 25%. We have nearly always outperformed over the next three to five years if the number exceeds that amount. Equally important is adding up the S&P 500 relative number for return on capital, return on equity and return on assets. Here we look for a sum called the “combined quality value (CQV)” greater than 5. The current portfolio CQV is 6.6.

Conclusions

I’ve written about the Abacus tool we use several times before. The reason for its importance is that it provides a quick way to ascertain how your portfolio stacks up against the S&P 500 from a quality and value standpoint. At Nintai, we think a combination of buying a set of stocks that are qualitatively better and provide greater value provides an investor with a better chance at outperformance - in the long term - than any other investment approach.

As always, I would love to hear your thoughts and comments.

[1] Meaning the Nintai Portfolio return on capital is 3.21 x the S&P 500’s return on capital
[2] Out of roughly 20 – 25 Nintai holdings, at least 15 holdings will generally have no short or long-term debt.

When you have to make a choice and don’t make it, that is in itself a choice.”
 
                                                                            -       William James 

One evening a Cherokee elder told his grandson about a battle that goes on inside people.
He said, “My son, the battle is between two “wolves” inside us all. One is Evil. It is anger, envy, jealousy, sorrow, regret, greed, arrogance, self-pity, guilt, resentment, inferiority, lies, false pride, superiority, and ego. The other is Good. It is joy, peace, love, hope, serenity, humility, kindness, benevolence, empathy, generosity, truth, compassion, and faith.” The grandson thought about it for a minute and then asked his grandfather, “Which wolf wins?” The old Cherokee simply replied, “The one you feed.”
                                                                          -       Ancient American Indian Parable
 
Over the years, I’ve been asked many times what is the one major question I ask when looking to invest in a stock. It’s pretty difficult to pick just one thing. For instance, in most cases it is critical that the company has a management team focused on costs and capital returns. In some industries where margins are tight, the ability to focus on costs, production methods, and distribution costs is vital. In some industries the ability to navigate research and development and meet regulatory requirements is vital.
 
It’s pretty hard to nail down one specific thing that would make Nintai Investments say “Aha! That’s the perfect investment. We MUST have it in the portfolio”. There are a lot of moving parts that make for a great company.  So how do you rate each component? Which piece is the keystone block that holds it all together?
 
Invest In What Got You There: Your Competitive Moat
 
Of all the statistics and the ratios that drive my interest in a company, the cap or keystone is the company’s competitive moat. A great moat drives high return on capital, high return on equity, high free cash flow ratios, and other sustained high margins. Great management will focus on how to always widen and strengthen their moat. They realize they need to dance with the one who brought them there.
 
Morningstar has the view there are five sources of a competitive moat - the network effect, customer switching costs, intangible assets, efficiency scale, and cost advantage. Most companies with a wide competitive moat will have at least one of these competitive advantages - and likely - have more than one. Every company I own in a Nintai portfolio has a laser like focus on one of these advantages. Everyday when they head to the office they think of how to maximize their strategy and operations to widen any one of these advantages.
 
The Network Effect 
Every day, leaders of Nintai holding Mastercard (MA) look for ways to strengthen their company’s network advantage. Whether it be against fellow duopoly member Visa (V) or a smaller up and comer like Discover Cards (DFS), Mastercard’s network - who uses their cards and who accepts their cards  - constantly strives to find new tools, advantages, discounts, etc. as a tool to bring in new customers and maintain existing ones. This competitive strength will continue to drive Mastercard’s competitive advantage for decades to come. As a shareholder we look to see revenue growth and higher returns on equity as some the statistics showing the continued strength of the company’s moat.
 
Customer Switching Costs
SEI Investments (SEIC) provides investment processing, management, and operations services to financial institutions, asset managers, asset owners, and financial advisors in four material segments: private banks, investment advisors, institutional investors, and investment managers. It’s services are deeply embedded in all of their customers’ operations. The cost and time requirements to switch their systems to a new vendor is staggering. The potential for errors in the transfer of data, downtime in the course of switching vendors, and amount of time teaching a new internal system are all deeply complex and involve high risk.  Combine this with the risk placed on the core functions of the customers’ systems – daily fund accounting, SEC filings, etc. and one can see how difficult it is to make the decision to pull the plug on SEI Investment’s product and suddenly move to a new vendor.
 
Intangible Assets
Novo Nordisk (NVO) has been a leader in the treatment of diabetes for almost a hundred years. Armed with intangible assets such as FDA (US-based) and EMA (European-based) regulatory approvals, patents for drug levers of action, and intensely deep organizational knowledge about diabetes (the disease) and diabetes (the treatment history), it’s hard to see a new competitor come along and suddenly start competing with Novo Nordisk’s competitive advantage in these intangible assets. Combined with a network effect of prescribing physicians who implicitly trust Novo Nordisk’s knowledge with the disease along with billions of dollars sitting on the balance sheet while producing billions more in free cash flow and what you’ve got is a company with a wonderfully deep moat.
 
Efficiency Scale
Veeva Systems (VEEV) has the most in-depth customer relationship management (CRM) vertically focused on life sciences (pharmaceuticals). The efficiency that Veeva brings to their space has driven out nearly every home-grown model and small boutique player. There simply isn’t room for another player than Veeva within the space. The company is now taking that industrial dominance and looking to add new verticals to its expertise such as consumer goods, chemicals, and cosmetics (all industries with similar CRM and regulatory needs). Veeva’s extraordinary depth of knowledge drives out a need for other competitors. By constantly focusing on adding new functionality, new applications, and new knowledge, the company continues to widen its moat.
 
Cost Advantage
By far, this is Nintai’s smallest source of competitive advantage or moat. As Amazon (AMZN) has always said “your margin is my opportunity”.  Even Walmart (WMT) - the king of margins - for decades found itself unprepared for Amazon’s pricing revolution. At Nintai, we believe this is the weakest of all moat characteristics. The closest we’ve come to owning a company that made price a key component of its competitive offering was Fastenal (FAST - we sold the position in 2015). Management for the longest time utilized cost structure as a means for driving business to Fastenal distribution centers. They focused this along with the ability to carry nearly every part (in a just-in-time model) and the company dominated the industry parts business. This has changed somewhat as they have focused more on a network effect with vending machines on site allowing customers to not even have to wait for delivery. 
 
Conclusions
 
Nintai focuses on companies with high returns on capital, equity, and assets, high free cash flow margins, growing businesses, and management focused on maintaining - if not increasing - those previously mentioned measures. The ways to get there is to identify your core competitive advantage and focus on making it better every day. That’s why you don’t see Novo Nordisk suddenly purchasing an oncology immunotherapy firm. Or you don’t SEI Investments purchasing a publishing company on investment management. The Nintai portfolios are made up of companies that know what they do best and they stick with it. With a portfolio run by such management – with companies with such attributes – you really need to sit back and make sure management has its eye on the ball and generates numbers that demonstrate their excellence in making the company grow. After that, let time do its magic and you’ll be surprised how well your portfolio will do over time[1].
 
As always, I look forward to your thoughts and comments.
 
DISCLOSURE: Nintai maintains positions in MA, SEIC, NVO, and VEEV  
 
[1] Of course past performance is no assurance of future returns.

​“The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions”
                                                                              -       Benjamin Graham  

“You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting - how to read and interpret financial statements - you really shouldn’t select stocks yourself” 

                                                                            -        Warren Buffett  

There are so many ways to approach value investing that sometimes one wonders there is a single description that works for them all. I’ve tended to focus on a proposed definition by one of my first investment mentors (paraphrasing Benjamin Graham).
 
“Value investment is purchasing an asset at a discount to its estimated intrinsic value. Nothing more and nothing less. Anything else is the same as gambling without knowing the odds and will likely make you look like a damn fool”.
 
At Nintai that means calculating value before anything else. Yes, we do use screens to help identify companies that meet our investment criteria. But it’s important to understand these screens give us an idea of a company - not its industry, its SIC code, its competition or management team. These screens simply give us a list of companies that have characteristics of high-quality securities trading at a reasonable price. Only after we’ve run a high level valuation spreadsheet tab do we begin to ascertain the specifics of the potential target. Sometimes identifying this information is enough to rule out any further research. For instance, one time after finding a target turned out to be in the grocery business, we removed it right away from the watch list.
 
There are three major areas which I believe drive long-term competitive advantages. These include structural cash advantages, long-term cash generation, and long-term value generation.
 
Structural Cash Advantages
 
The first - structural cash advantages - is the type of opportunities where the company generates excess cash and has opportunities to deploy this capital generating returns on capital far in excess if its cost of capital. These are companies that can provide decades of profitable growth for equally patient investors. Examples of this type of business include Fastenal (FAST) and Expeditors International (EXPD). Both companies generated ROCs in the high 20s versus a weighted average cost of capital in the mid-single digits. These are companies with opportunities to seek growth in their existing markets without having to overpay or take risks in the M&A marketplace. Deployment of capital is done with a clear focus in return on capital exceeding cost of capital.
 
Cash Flow and Balance Sheet Strength
 
The second category are companies with a long history of free cash flow generation and pristine balance sheets. These are companies with deep and wide competitive moats allowing for pricing strength and the free cash flow growth over generations. This can be achieved though brand strength, product monopoly or duopoly, or the strength of its competitive position. Companies with these traits include Computer Modelling Group (CMDXF) or Fanuc (FANUY) which use their competitive advantages to generate positive free cash. In addition, these companies are wide enough to know how and when to use their capital for snap on acquisitions that generate positive value for their shareholders.     
 
Retain Earnings and Intrinsic Value Growth     
 
The last type of company that Nintai looks for is one that has long history of retained earnings used to adding additional companies (along with their retained earnings) to build value over the long term. In these companies, management makes the decision that M&A (generally through smaller M&A) can substantially increase the book value of their firms – and hence reward their long term shareholders. Companies in this category consist of firms like Berkshire Hathaway (BRK-B) or Cognex (CGNX). In the case of Cognex the company has increased retained earnings from $284M USD in 2004 to $682M USD in 2019.
 
Why This Matters
 
In general, great wealth has been made in the “slow-is-steady” routine. For nearly ever great value investor, there is one who made a killing on one major bet. Many times, hedge funds are held out as the poster child for slow and steady returns. In fact, when one looks at hedge fund returns, we frequently find a good bet locked in solid returns over the next few years followed by substantial underperformance. An example of the hit-it-big then mostly lose it all is Paulson & Co’s bet against the credit markets. This single bet brought the company’s AUM up to $36B USD in 2011. By 2019 this number had dwindled to just $8.7B of which nearly 80-85% was Paulson’s own personal funds. The Financial Times reported on January 22 2019 that Paulson was considering closing the fund and converting it to a family office.
 
Another example has been value investors who have generally performed poorly since their doors opened. Examples of these include Ronald Muhlenkamp (underperformed S&P 3 Year: -9.4%, 5 Year: -9.7%, 10 Year: -6.5%, 15 Year: -5.3%, and 20 Year: -0.7%), who record is a truly abysmal performance versus the S&P 500. David Winters is another example of long-term underperformance withdrawals. Wintergreen Fund saw total assets under management (AUM) drop by roughly 90% between October 2005 – January 2019 before shutting down the fund.
 
One of the common themes one sees in these guru performances is a remarkable hubris that since their initial big-win. Many great value gurus think the previous victories can be replicated over and over again. But much like Tolstoy’s unhappy families, "Happy families are all alike; every unhappy family is unhappy in its own way." So goes value investing - every bear market is unhappy to its shareholders in its own unique way. Whether it be Paulson’s short on the mortgage asset business or Ronald Muhlenkamp’s description of his business as “intelligent investment management to emphasize that we remove the emotion from investing. We might also be described as “common sense” or “no BS” investment managers...” value investors can get caught in the same confirmation feedback loop as any investor.
 
Conclusions
 
Value investing is about having a core set of values flexible enough to change with the times. I remember reading how Warren Buffett (BRK-B) had first invested in the Washington Post in 1973 at $11M USD. When Buffett was planning on the transaction to spin off hid 23.4% holdings in the Post to Graham Holdings (GHC), his stake in the Post was now worth $1.1B USD. Perhaps one of Buffett’s greatest attributes has been his ability to evolve with the investment times. Perhaps his greatest - and most profitable - shift has been from the cigar butt model to purchasing great companies at fair prices.  In my investing career I’ve certainly exchanged some expansively acquired theories for those with more modern trends. By focusing on higher quality (defined by structural cash advantages, cash flow/balance sheet strength, and intrinsic value growth) my ability to add vale to investor portfolios has increased dramatically. By finding great companies at fair prices, I’ve found ways to decrease turnover, reduce long-term tax liabilities, and let management do the heavy lifting. You can do the same by evolving your own standards.      
 
As always, I look forward to your thoughts and comments,
 
DISCLOSURES: Nintai retains positions in CMDXF, FANUY, CGNX, 

“When you start looking at stock buybacks, you begin to realize you are playing a game of Three Card Monty. Nothing is really as it seems and the numbers never really add up. It truly is dealing with the cards stacked against you”.
                                                                            -       Robert G. Warren 

Several years ago I wrote about how many corporate executives buy back company stock at exactly the wrong time. They generally purchase as their share price hits an all-time high then cease all activity when the stock price crashes. I’ve always been cynical when corporate boards announce share buyback plans in the hundreds of millions (or even billions). After M&A activity, in general I can’t think of a worse use of capital.  
 
Buybacks: A Quick History
 
Traditionally stock buybacks were not held in very high regard. In 1932, The New York Times made three specific arguments against buybacks. First, they used up a corporation’s cash balance. Second, they were simply a cash transfer between the corporation and management/directors who were dumping their shares. Last, they focused management on the whims of the market (through stock price movement) and distracted them from the running of the business. The Securities and Exchange Committee made it more difficult in 1934 with the Securities and Exchange Act making stock buybacks (though not mentioned) a potential violation.  
 
The 1970’s provided middle ground by creating conflicting policy of either making buybacks flat out illegal to simply having a corporation disclose their intention to purchase their shares. The SEC never really came up with a good answer, flip flopping back and forth. Things took a big step in a different direction in 1982 with the SEC’s issuance of Rule 10b-18 which made it very difficult (if not impossible) to sue companies for stock buybacks. By removing mandatory disclosure requirements, companies received a green light to start buybacks with relative abandon.
 
Which brings us to today. The Trump tax cuts have brought buybacks into focus again. Indeed, buybacks - which have been increasing over the last decade - jumped about 50 percent last year to nearly $800 billion for the companies in the S&P 500. This is an all new high according to S&P Global. These data seem to contradict the claim that most of the tax cuts have gone towards reinvesting and growing company businesses. (Though to be fair some would argue share buybacks are a form of capital reinvestment). Since 2009 US companies have bought back roughly 80 billion shares, but total shares have increased from 289 billion in 2009 to 294 billion in 2019. It’s hard to argue that shareholders have been the winner in this binge of buying and lack of share reduction. 
​
In fact, much research has been published showing that buybacks add little, none, or even subtracts value from shareholder returns. One of the most interesting – which I encourage readers to download (sorry to say there is a license of $44USD) – is an excellent peer reviewed article[1] outlining that in many countries - whether investors use a dividend model or a total payout model to decompose equity returns - net buybacks explain more than 80% of the cross-sectional dispersion of stock market returns.
 
Another example of repurchases changing in their scope and value for corporations versus shareholders has been the explosion in repurchases. In a study by David
 
Ikenberry  Josef Lakonishok  Theo Vermaelen (“Stock Repurchases in Canada: Performance and Strategic Trading”), the authors state:
 
“In recent years, corporations have dramatically increased the amount of capital devoted to repurchasing their own shares. In the mid-1980s, repurchase program
announcements in the U.S. amounted to roughly $25 billion per year. Between 1996 and 1998 however, more than 4,000 open market repurchase programs were announced which, if fully completed, amount to roughly $550 billion. During the first quarter of 1999 alone, Securities Data Company reports nearly 350 program announcements totaling $40 billion. Interest in corporate repurchase programs is not limited to the U.S. as repurchase activity worldwide has grown in recent years. Countries such as Hong Kong and Japan recently implemented new regulations allowing companies for the first time to repurchase their shares. A recent Goldman Sachs study (March 1999) foresees stock repurchases becoming more common in Europe and discusses the potential impact on European equity values.”
 
Why This Matters
 
With this explosion in repurchases – yet no reduction in share counts – the obvious question is whether these actions have been a wise allocation of capital. If the answer is yes, then shareholders should whole heartedly encourage such behavior. If the answer is no, then shareholders – through their duly elected representatives on the company’s Board of Directors – should actively seek to stop these transactions.
 
Investors should look at share repurchases as no different than their value approach in their own investment process. If shares are bought at a discount to the company’s intrinsic value then this could be perceived as an appropriate allocation of capital. Repurchasing shares at prices higher than intrinsic value would be a poor use of capital.
 
Unfortunately, all evidence would suggest that companies go on repurchasing binges as share prices reach new highs and cease purchases as share prices reach new lows. The most recent example of this has been the example previously cited with new repurchase highs reached in 2019 as shares reached all time highs. Another example was the similar pattern in 2006 – 2009 as share repurchases reached all-time highs (for the time) in 2007 (the height of the mortgage asset bubble) only to see a near 75% drop in repurchases as the markets collapsed in 2008 – 2009 (see graph below). 
 
For any investor in a company that has followed this pattern of “buy high and stop buying when low”, they can safely assume management has a poor understanding of capital allocation. Any value investor should avoid companies run by such individuals.
 
Conclusions
 
The story of stock buybacks has been relatively consistent since the SEC’s policy change in the 1980s. The enormous number of buybacks – mostly purchased when stock prices are at all-time highs – have provided little to no advantage for the value investor. Only when enough shareholders speak up and force management – through Board oversight – to perceive stock buybacks as a means to improve shareholder returns will buybacks become sound capital allocation. As a value investor, I suggest readers find companies that have firm guidelines about buybacks which is tied directly to value versus intrinsic value. Partnering with such management gives an investor the best chance to see long term growth in their portfolio.


[1] “Net Buybacks and the Seven Dwarfs”, Jean-François L’Her , CFA, Tarek Masmoudi & Ram Karthik Krishnamoorthy , CFA, Financial Analysts Journal, December 12, 2018, pages 57 - 85

Just because everyone is doing it doesn’t make it right. Sometimes your way really is the best way. Just have the facts on your side.
 
“The young man knows the rules, but the old man knows the exceptions”.
 
                                                               -          Oliver Wendell Holmes Sr. 

“When the game is no longer played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were – not as they are. Essentially I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand even though it might mean forgoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully, and which, possibly, could lead to substantial permanent loss of capital”.

                                                             -            Warren Buffett (Partnership Letter, October 1967) 

In February 14 1797, a British fleet of 15 ships of the line under the command of Admiral Sir John Jervis met a Spanish force of nearly twice its size off Cape St. Vincent, Portugal. Two stories mark the initiative and confidence of the English navy at the time. In the first story, Admiral Jervis (soon to be Lord St. Vincent for his victory) sends a man to the foretop to tell him the size of the Spanish fleet. The following conversation took place between the lookout and Admiral Jervis.
 
"There are eight sail of the line, Sir John" 
"Very well, sir" 
"There are twenty sail of the line, Sir John" 
"Very well, sir" 
"There are twenty five sail of the line, Sir John" 
"Very well, sir" 
"There are twenty seven sail of the line, Sir John" 
"Enough, sir, no more of that; the die is cast, and if there are fifty sail I will go through them"
 
But that wasn’t the story that really made the Battle of Cape St. Vincent so famous. Rather it was the bursting forth of Horatio Nelson’s genius that stole the day. At a critical moment in the battle, when Jervis signaled for his ship to tack in succession (this maneuver called for each ship to turn through the wind in the same place as its leader and was a traditional ship handling instruction for the past 200 years), Nelson realized that such a maneuver would place the latter part of the English fleet in danger. He wore (the opposite of tacking) clearly in violation of his orders and proceeded to take on 6 of the largest Spanish ships with only his 64 gun Captain. This group included the Santísima Trinidad, the largest ship afloat at the time and mounting 130 guns, the San José, 112, Salvador del Mundo, 112, San Nicolás, 84, San Ysidro 74 and the Mexicano 112. Amazingly, Nelson succeeded fighting alone for 20 minutes and captured both the San Nicolas and the San Jose. It was the beginning of what was to be called the “Nelson Touch”.
 
Now that I’ve prattled on about maritime warfare in the early French Revolutionary wars, I wanted to discuss why both Nelson and Jervis’ rule breaking hold a great lesson for value investors. Many times, value investing isn’t dissimilar to heading into a fleet action like the Battle of Cape St. Vincent. There are many variables that impact decisions (the direction of the wind compared direction of market sentiment), the fog of war can be thick, loud, and disconcerting (think of the din of cannon fire and dense smoke and compare that to watching a re-rerun of any trading day in the two weeks following the collapse of Lehman Brothers), and the heightened emotions of winning or losing (think of the emotion of watching one of your fleet strike its colors versus seeing a portfolio holding drop 35% in two hours). The ability to stick to your process, and keep your emotions in check are as important today in front of your computer screen as it was on the quarterdeck of a flagship in the Age of Sail.      
 
Training Your Mind, Mastering Your Process  
One of the reasons why Admiral Jervis was so confident taking on the Spanish fleet (even if it numbered 50 ships) was the knowledge that his crews were the best trained in the world. Every ship was a well-oiled machine that Jarvis knew could hold its own against any two Spanish ships. This type of training and discipline is required in value investing as well. When a stock price drops dramatically, a value investor knows their process inside out and has the discipline to act only when it meets his or her criteria. For instance, at Nintai when a stock on the watch list drops by 5% or more in one trading day we know exactly what steps to take - read up on the latest corporate releases, search for competitive news stories, rerun the valuation model with any new inputs, etc. It’s a set process that we can run in less than 2 hours which gives our team the necessary facts to make a decision. Step two is having the discipline to follow the facts to their logical conclusion – a decision based on solid criteria we’ve followed for over a decade. The last thing a successful value investor does is run around and haphazardly purchase stocks because of Mr. Market’s manic moods. The discipline to find the right shares, at the right price, for the right portfolio are all earmarks of the tight discipline of a value investor.     
 
If Your Strategy is Sound, Follow Through With Everything You’ve Got
If you feel your investment strategy and process meets your goals and provides you with the best chance at outperformance, then never fear being aggressive in your actions. If you expect your results to be different than the major indexes, then your actions must be - by their very nature - different than those indexes. You can do this in several ways - have different portfolio holdings, have similar holdings but in very different percentages, or a combination of the two. Many successful value investors have been quite focused in their portfolio designs holding sometime as few as 5 stocks. At Nintai we generally hold no more than 20 holdings in our portfolios. We do this for several reasons. First, there simply aren’t that many companies that meet our investment criteria. Second, even fewer trade at enough of a discount to our estimated intrinsic value to meet our required margin of safety. Last, we want each position to be large enough to have a meaningful impact (both good and bad) on our performance. Several years after Horatio Nelson died, one of his “Band of Brothers” recalled “Nelson was entirely his own creature. People called his approach ‘The Nelson Touch’. It really was HIS approach. Nobody else could copy it. And no one achieved anything like his results after he passed from the scene.” Like Nelson, at Nintai we have our own unique investment methodology. Over time - and with the success we’ve had (though past performance is no assurance of future returns!) - we remain aggressive in our portfolio design. In the final analysis, our returns will certainly be our own. We are quite proud of that.     
 
It’s Not About Quantity, It’s About Quality
I’ve found over time that long-term success requires long-term quality. In the beginning of his career, Warren Buffett certainly had success with companies that meet the cigar-butt criteria. But Charlie Munger has argued the real investment successes at Berkshire Hathaway have come later, particularly after the tectonic shifting purchase of See’s Candies. At Nintai we drifted in a similar way, starting with the one-puff wonders we bought in March and sold in April after a 15% gain. Over time, I began to realize my more natural state was not the nail biting, manic purchasing and selling, constantly on the lookout for bad news, dyed-in-the-wool value investor of the 1950s-1960s. Rather I was far more slothful, indolent, and upbeat to really be able to enjoy that type of investment life. I learned – much like Nelson – that a smaller force made up of the highest quality could generate enormous success. It wasn’t just about the quality of my holdings though. It also was about the quality of my successes.  I had many small 5-10% gains with my cigar butts, but I found the 5 and ten-baggers were high quality companies that I bought and held for a decade or more. Simply put, quality companies mean higher quality successes.      
 
Conclusions
 
So what happened to Nelson after he violated Jervis’ orders? Old Jarvy was known for breaking an officer who willfully didn’t follow orders and there was certainly no clearer case than this. It is said that after climbing on to the deck of the Victory (Jarvis’ flagship), Jarvis hugged Nelson in a most un-seamanlike manner. Jarvis’ flag-captain - in a pique - after seeing a disobeying officer receive a hug (a hug forsooth!), complained to the Admiral that Nelson’s actions were a clear violation of his orders. Jarvis turned to him and said, “It certainly was so, and if you ever commit such a breach of orders, I will forgive you also.” Nelson went on the become a Knight of the Bath and win crushing victories in the Baltic, at the Nile, and of course his masterpiece, the Battle of Trafalgar which cost him his life.    
 
By following your own convictions and strategies in investing, it’s unlikely to cost you your life (or at least let’s hope so!). But the outcomes can certainly put your name in a book of rarified names. Not everybody who lives by their own rules will succeed like Nelson. But many of the greatest investors  - Warren Buffett, Jack Bogle, Michael Steinhardt, Charlie Munger, etc. - have withstood tremendous pressure to conform and give up their independent thinking. If your technique works for you (and that’s really the definition of success) then continue playing by your own rules. In the end, it’s really all you got.     
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: None

“When we control a company we get to allocate capital, whereas we are likely to have little or nothing to say about this process with marketable holdings. This point can be important because the heads of many companies are not skilled in capital allocation.  Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities.  They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.  To stretch the point, it's as if the final step for a highly-talented musician was not to perform at Carnegie Hall but, instead, to be named Chairman of the Federal Reserve.”
 
                                                                                       -        Warren Buffett 

When my partners and I first came up with the idea of starting our second company, (which eventually went on to become Nintai Partners - a healthcare-focused consulting firm) we spent a great deal of time thinking about the areas of the business we performed poorly or in areas we simply didn’t perform at all. We eventually chose 3 areas to focus on:
 
Employee Ownership: We felt the strongest performance we saw in our field was driven by employee ownership. We didn’t mean stock options that represented 0.01% of the firm that vested after a ridiculous number of milestones had been met. We felt ownership should be achieved in a straight forward, substantial, and timely manner.
Compensation Driven by Customer Satisfaction: Most consulting firms have a pretty uniform approach. Partners create and maintain relationships that led to the largest engagements possible, middle-management/project leads look for as many project amendments that help beat revenue goals, and project staff work ridiculous hours in a controlled panic to achieve seemingly impossible project deadlines with little incentive to create long-term value. We designed a firm that compensated staff on long-term value created by their project. 
Retain Earnings to Drive Book Value: Our goal was to retain earnings and use them to create an internal investment fund. This fund would be the main driver of value for company shareholders. Owners could log on and see exactly how much each share was worth and calculate the value of their share of ownership.   
 
After several years of growing the business, attending Board meetings, and managing the internal investment fund, it suddenly became clear that I was engaged in an activity that no academic program had even remotely touched on - allocation of capital. It took several more years to define that role, create a process that could assist in making better decisions (there are no “best” decisions), and work with the Board to find a way to measure how successful we were in our efforts. Much like Warren Buffett’s comment, none of us in senior management had any real training or experience in allocating capital. One of the partners was great in sales and marketing, I was trained in operations management, and the other partner we used for their connections in the local business community. Each Board meeting turned out more excruciating than the last as one particular member hammered home that my job as managing partner was to “allocate capital - pure and simple”. When that job was complete he said, then I could hopefully return to my shareholders and convince them I had worked in their best interest. It was certainly a different way of looking at things. 
 
Allocating Capital: Everyday Life of the CEO
 
In the course of daily living, we are constantly making decisions about allocating capital. Ranging from whether that membership at the gym is worth it to deciding when to replace the old car with a new one, how we allocate our hard-earned dollars is a vital part of our daily life. Yet somehow - through the course of getting all that corporate in-house training or attending classes for that professional license  - many managers seem to have lost their ability to calculate whether that corporate porterhouse steak is more valuable than the filet they looked at last week. That’s truly unfortunate, because senior executives are faced with how, when, and where to allocate capital on a fairly regular basis. In the corporate world, allocation focuses on four major capital categories - mergers and acquisitions (M&A), capital expenditures (CapEx), dividends and share buybacks, or research and development (R&D).
 
It’s important to remember that not all capital allocation is equal in either complexity or impact. For instance, some CapEx is allocated specifically to grow the company. An example might be a new plant to increase manufacturing capacity. Staying with that example, replacing equipment in an existing plant might be solely for the maintenance of current manufacturing capacity. This distinction is vital when it comes time to calculating return on capital for the year. As a senior executive once said in a meeting to discuss capital spending “I don’t like to pay for the privilege of standing still. If I’m going to lay out some serious cash, let’s make sure we aim to grow and to win”.   
 
Management are better at certain types of capital allocation than others. For instance, we know the record for mergers and acquisitions is quite poor. Management has a tendency to get the animal juices flowing and the next thing you know we’re looking at a shiny new toy obtained at nose bleed prices. Management also does a relatively poor job when it comes to stock buybacks. Over time, we’ve come to see that management buys back shares when they are at their most expensive but stop buying when share prices drop. The link between price and value seems to be obscured if not entirely forgotten during these times. As Warren Buffett pointed out “the first law of capital allocation - whether the money is slated for acquisitions or share repurchases - is that what is smart at one price is dumb at another.”
 
So what are we to do if so many managers are so bad when it comes to allocation of capital? It’s not an idle question. Adam Weiss of Scout Capital pointed out that if you buy something with a 10% free cash flow yield and hold it for 3 years, management will be responsible for allocating a third of the intrinsic value of the company over that time. After ten years that jumps to 60%. As a shareholder, what could be more important than that? The answer is not much. So its beholden to shareholders - and through them Board members - to speak up and make sure senior managers understand its importance. At Nintai, we think there are three areas where focus  - through training and incentives  - should be applied. 
 
Establish a Link Between Price and Value
In many cases, senior management can lose sight of the requirement that value be commensurate with price when it comes to capital allocation (meaning you get a dollar – or more – back from the dollar you’ve allocated). An example of this is the history of value destruction through managements’ M&A activity. Until corporate boards make the link between what management pays and the value created (or not create in most cases) by acquisitions, it is likely we will continue to see deals driven solely by ego, empire building, and false hopes. In the words of Robert Fuller “tsk….tsk…what a way to run a railroad!”. 
 
Reward Management When Long-Term Value is Created
To reinforce the relationship between price and value, corporate boards should be looking for ways to compensate management for such value creation. Ways to measure such success should be left to board compensation committees, but it would seem to me several issues should be addressed in these awards. First, value creation should be focused on the long term. Second, a distinction should be made between value created by cutting costs and value created by growth. Third, value should be of a permanent nature, meaning growth isn’t transitory but multi-year in scope.
 
This Isn’t Just for the C-Suite
Understanding the link between price and value isn’t a concept for just senior management. Mid-level managers and line employees should be trained to think in such a manner from day one. If the expectation is that employees with strong performance records will find their way up the greasy pole, then corporate leadership should be thinking about training for all aspects of the business. A great example of this is training by Boston Consulting Group in their “CFO Excellence Series” (an overview can be found here). When one becomes aware that capital allocation is one of the most critical means of translating corporate strategy into action, then training can’t begin soon enough.
 
Not All Allocation of Capital is Created Equal
 
As I mentioned at the beginning of this article, there are four major ways that management can allocate capital - M&A, CapEx, Dividends/Buybacks, and R&D. Each of these require their own form of expertise. For instance, M&A center on two completely different - yet connected  - skill sets. In the first, management should have strong internal mental models on calculating valuation. Second, management should have extraordinary self-control that allows them to sit and take 20 pitches in one at bat without taking a swing. While these may seem mutually exclusive, the two skill sets actually are quite complimentary. In this case, the whole is greater than the sum of its parts.
 
 A distinction is made between capital allocation that is necessary to keep the doors open (defined as working capital) versus capital allocated to facilitate growth. Working capital is a simple calculation: current assets less current liabilities. It is possible that a company might have positive current assets - or even by technically profitable - but be forced to cease operations as it has insufficient liquidity. Because Nintai doesn’t invest in companies with such type of balance sheets or cash flows, there isn’t any reason to spend much time on this type of situation. 
 
But we are definitely interested in the distinction between allocating capital for growth and allocating capital for maintenance. At Nintai we generally avoid capital intensive industries. Examples are industries that require steady capital injunctions to simply keep up with competitors or keep the business running. This might include the railroads or the steel industries in the 1970s. Another example is industries that require significant R&D to simply find replacements for an ever evolving list of non-patented direct-to-consumer product. In both cases, capital is employed to maintain market share and less to drive growth.
   
Asset Light or Capital Light Models
 
At Nintai, we have a bias towards businesses that are asset light or capital light in their strategy or structure. These are businesses that require little capital to maintain the business. Any new capital can either be used to grow the business or be passed on to shareholders. Examples of this include Nintai holdings SEI Investments (SEIC), Veeva (VEEV), or Manhattan Associates (MANH). Each of these companies share similar capital structures – little-to-no-debt, low average weighted cost of capital, high return on capital, and very low capital needs.
 
Another aspect of these companies (it’s unclear which came first - the competitive moat or the asset light model. One thing is certain though - they intertwine) is the deep competitive moat surrounding each of them. Not only does it take little capital to maintain their outstanding business characteristics, but also their respective leads in their markets. For instance, Manhattan Associates currently fields a return of return on capital of 68% - rising steadily from 12.8% in 2010. As Manhattan has dug its moat deeper and wider it has achieved an increasing return on capital.
 
It should be stated that while some asset light companies achieve high returns on capital, not all do. Bausch Health Companies (BHC) - the former Valeant Pharmaceuticals - created an asset light business based on raising prices and in-licensing orphan drugs. While that worked for a while – the company grew revenue per share from $5.46/share in 2004 to $30.48/share in 2015 - the inevitable bill came due on $30 billion in debt - and the company saw return on capital collapse 34% to -2.4%. After teetering near bankruptcy for a short will and a fire sale of assets, the company is slowly righting itself.
 
What Bausch Health and Manhattan Associates can tell us is that allocation of capital can bring either long-term success or long-term failure. A company simply can’t be successful when managers are poor capital allocators. As the former Valeant - now Bausch - shareholders can tell you, if your managers aren’t successful at allocating capital, then its shareholders won’t be successful investors. Traders may succeed - but not long-term shareholders.
 
Conclusions
 
At Nintai, we’ve learned over time (and through painful experience sometimes!) that our most successful investments have been with managers who created a business whereby they could generate high returns on capital and – in the long term - generate significant shareholder value. The characteristics of those businesses are:

• The company is run by managers who understand the link between price and value;
• The company’s average cost of capital far exceeds its return on capital;
• The managers create/sustain a business with a wide competitive moat;
• The company can employ capital internally to create additional growth, market share, and shareholder value

 
Given these characteristics, management can create a virtuous cycle that consistently - and profitably - grows the company creating long-term value for its shareholders. As Warren Buffett pointed out in the beginning, most managers aren’t trained to create and run such an investment gem. When you find management capable of creating and sustaining such a model, then hang on and let them do all the heavy lifting. The only real question is why do anything else?
 
As always I look forward to your thoughts and comments
 
DISCLOSURE: Nintai Investments has a long position in MANH, SEIC, VEEV

At a macroeconomic level, Nintai has never tried to divine exactly where the equity markets, US economy, or global economies are headed. It’s a loser’s game if an investor feels they can time their exposure to any of them. We have always tried to find companies with deep competitive advantages where their product and services are vital to their customers strategy and value proposition. Balancing that with incredibly strong financial performance and pristine balance sheets, we think our portfolio holdings will do well in nearly any market. 
 
Certainly Wall Street disagrees with Nintai’s methodology. An enormous amount of sweat and treasure goes into calculating exactly where the economy will be 18 months from now, or what the Federal funds rate will be after the next Board meeting, or how the slowdown in Chinese auto imports will affect US-based auto parts stores. There are thousands of very bright individuals who work day and night trying to gauge the impact on individual stock prices or even the broader market indexes. In this article, I thought I’d share Nintai’s thoughts on the role macroeconomics can play in portfolio management, why most data are irrelevant for the average investor, and what data are actually critical to a value investor.  
 
Geopolitics and Its Impact on Calculating Value
 
The recent events surrounding the Chinese/US trading relationship is an example of the complexity that macroeconomics can present in calculating a portfolio holding’s intrinsic value. A note before I begin: this discussion will inevitability wander into the realm of politics. In the context of value investing, I have little interest in our current political environment with the exception of what impact it might have on my clients’ portfolios. I ask that any comments avoid purely political views or opinions.
 
The current administration made it clear in both their campaign and through current policy that existing US policy towards trade with China needed to change dramatically. The big issues include the current trade deficit, intellectual property rights, market access, government industry subsidies, and currency exchange rates. At Nintai, the first step we take after identifying the core issues is to ascertain which holdings could be impacted by geopolitics. In this instance we might ask several questions that would help us identify these companies.

• Which holdings have the highest percentage of revenue generated overseas with a focus on mainland China? (Further research might entail which competitors would also be impacted, finding local Chinese-based companies that would not be impacted, or the stickiness/depth of the Chinese relationship)
• Which companies have supply chain or key outsourced partners in mainland China? (Here we would look to ascertain the complexity of the supply chain, number of subcontractors required, and location of alternate supply chain companies)
• How important are each of the five key issues listed above. For instance, which holdings are reliant upon intellectual property rights? This might be either in revenue generation (examples might include biopharmaceutical drug patents or author copyrights) or in operational costs (examples might include patent in production process or a technology patent in a product component).
• Which companies can find offsets to increased tariffs and what is the nature of those offsets? (examples might include passing them off further down to distributors or consumers or relocating parts of the supply chain)  
• Last - from a policy standpoint – which holdings are in industries most (or least) likely to have the financial and political wherewithal to seek (and get) exemptions from any possible new tariffs or regulatory policies such as non-importation bans? (An example might be Apple which received a waiver from the Trump Administration)

 
Answering these questions should give an investor a relatively comprehensive (but high level) view of the risks facing each of their respective holdings. Will it - or can it - give an investor enough information to make detailed changes in their estimated intrinsic value estimates? It’s unlikely. But can it answer the “bigger than a breadbox, smaller than elephant” when it comes to potential impact? Certainly. Answering these questions can give an investor broad enough knowledge to know which holdings are at risk, how big the risk is, and whether there are tools or processes that can help mitigate that risk.   
 
A Working Example: Skyworks Solutions
 
To show the difficulty in trying to define both the risk (where you can define possible outcomes) and uncertainties (where you cannot define possible outcomes) in a macroeconomic setting, I thought I’d use the China/US trade issues and look at current Nintai portfolio holding Skyworks Solutions (SWKS). Starting with President Trump’s statement in March 2018 that “trade wars are good, and easy to win”, the current Administration has made over 200 statements that a trade agreement with China is “very, very close”, “separated by the narrowest of margins”, “just about done”, “a done deal” to be compared with the less far less enthusiastic “a pretty significant gap”, “not much progress”, “they are going to have to give”. This isn’t making any judgment against the Trump Administration (though we might quibble with the idea that trade wars are easy to win). The whiplash from so many contradictory and misleading statements by administration spokespeople has made any of their predictive qualities useless going forward. With threats of tariffs ranging from 5 - 15% on everything from auto imports to flamethrowers (flamethrowers? Yup. Take a look at the full list here), it’s very difficult to make long term profit projections. It’s particularly hard if you do the bulk of your business in the international markets.
 
Skyworks has faced a double blow with the government’s on-again off-again tariff threats with China (theoretically resolved with the “Phase 1 Agreement” agreed to on December 13 2019) and its equally confusing approach to large Skyworks’ customer Huawei. The stock price over the past year has a range from $60 - $103 per share. Which price is closer to intrinsic value? Utilizing macro-economic issues, it’s pretty difficult to come up with any solid number. For instance, in its recent earnings call (November 2019) management stated earnings would have been 20% higher with business from Huawei (the company is currently banned by the U.S. government from purchasing chips from Skyworks).
 
Between the risk of certain tariffs (which we can define by products affected, tariff rates, etc.) and the uncertainty (we simply cannot measure the probabilities of the Trump Administration implementing such tariffs) of the US pressing forward, it is very difficult to estimate the possible impact on our estimated intrinsic value. What we can do is summarize some of the bigger issues and keep an eye on certain high level risks and uncertainties.

• Skyworks generates a significant amount of revenue from overseas markets. In particular, the company works with some of the largest players in 5G based in Asia. Any tariffs implemented with China would have a moderate impact on Skyworks’ revenue and thus our valuation.
• 47% of FY2018 revenue was from one customer - Apple (AAPL). As stated earlier, Apple received a waiver from the Trump Administration in relations to tariff’s placed on Chinese imports. This helps mitigate the impact of any tariffs that center on Apple products.
• Skyworks’ is limited in its ability to offset any additional costs related to new tariffs or regulations. The company will likely offset these with a blend of increased costs to customers and cost savings generated within the supply chain.
• Last, Skyworks faces threats in two of the five issues cited earlier. This includes intellectual property rights (China requires access to proprietary information as part of many contracts) and supply chain location (the greatest threat here are new tariffs proposed by the Trump Administration on Mexico).

 
In most cases I don’t go beyond this in terms of research. I’ve learned that great management is many, many steps ahead of me in identifying where the economy might be headed and how this might impact their core strategies, product development, competitive landscape, etc. Going forward, I will look for how management has addressed these issues and how successful their efforts have been.        
 
The Devil is in the Details
 
Having discussed why I place such limited concern and effort on macroeconomic issues, there is one large caveat to apply – a very small amount of macroeconomic data is essential to calculating intrinsic value. It’s not a lot and it doesn’t require an enormous amount of work to gather it and apply it to your valuation tools. But one of the most important legs in the value investing stool - calculating intrinsic value - is impossible without it. Here are the macroeconomic data I follow closely.
 
Interest Rates and Cost of Capital: Federal Reserve policy can have a huge impact on short and long term interest rates. This directly impacts a portfolio holdings’ average weight cost of capital (if they need to tap the debt markets). This in turn has an enormous impact on return on capital and investment value generation. I’ve discussed this in greater detail several times, but it’s important enough to summarize it again. When utilizing a discounted free cash flow model to generate intrinsic value, even the slightest change in Federal Reserve policy can move valuations by 5 – 10%. This can be the difference between an adequate margin of safety or not.
 
Regulatory and Compliance: Over time, changes in the macroeconomic environment can lead to significant changes in state and federal regulatory oversight. As an example, the crash in the credit derivatives market during the Great Recession forced the Federal Reserve and Congress to implement sweeping changes in the financial markets including new capital requirements and the elimination of several core business lines in the largest banks. At Nintai, we are always looking for macroeconomic data that might directly impact financial and valuation models specific to any of our portfolio holdings.  
 
Conclusions
 
I was once having a conversation with several co-workers when the issue of spousal jealousy came up. After several individuals bemoaned their lot in marital life, one individual said “our therapist said that jealousy is like paying interest on a loan you never took out”.  I’ve found that in most cases spending time worrying about macroeconomic issues is much like the therapist’s advice. In most cases, the data really aren’t that helpful in ascertaining how much investor value can be generated over the next decade or two. In those limited cases (such as the Fed funds rate) a simple check on the latest 10-year Treasury will tell you everything you need to know to get started on generating the company’s average weighted cost of capital. The most important thing is to understand which data can help you focus on truly important issues (such as calculating the company’s value) and disregard the rest. Over time you will be amazed how much time can be spent on company-specific research. Much like the therapist’s couple, you will be surprised how much easier life will be when you focus on the things that matter.
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: Nintai Investments LLC is long Skyworks Solutions.