“The ideal business is one that earns high returns on capital and can keep using lots of capital at those high returns. That becomes a compounding machine. If you can put $100 million into a business that earns 20% on capital, ideally, it would be able to earn 20% on $120 million the following year, $144 million the following year, and so on. You could keep redeploying capital at these same returns over time. But there are very, very, very few businesses like that.”
- Warren Buffett[1]
Our recent annual report to our investment partners began by discussing some important numbers or characteristics we look for in an investment. I wrote:
“At Nintai, we manage a focused portfolio of about 20 – 25 positions, which we have held for decades. Because of that, we have specific criteria that we feel are vital to outperform the markets in the long term. Before we get into the requirements, some core beliefs drive our decision-making. First, free cash flow is a far better measure than earnings when calculating valuation. We believe earnings can be manipulated in so many ways that their utilization in valuation tools is a waste of time. Second, we believe the best measure of a wide competitive moat is the sustained outperformance of return on invested capital (ROIC) over the weighted average cost of capital (WACC). When a company can generate ROIC greater than its WACC for over one or two decades, it has a wide moat. Last, we look for investment opportunities where the company’s free cash flow grows, but its price keeps dropping. We see those opportunities as a spring getting increasingly tightened that must eventually be released.”
This overview briefly describes some key metrics that drive our investment decisions. But more detail might help with numbers.
Two key metrics we use at Nintai Investments are a company’s return on invested capital (ROIC) and its weighted average cost of capital (WACC). We look for companies whose ROIC consistently outweighs their WACC for extended periods - usually one or two decades. I stress the word consistently because we aren’t fans where it might exceed for three or four years and then drop below for a year or two. We want to see ROIC beat WACC every year for a decade. Another number we look for is free cash flow. An investment should grow free cash flow annually for at least eight of the last ten years and continue that for the next decade or two. Eventually, that growth must, by the nature of its numbers, decrease over time as the company expands. It’s much easier to grow free cash flow 10% off a base of $100 million than $10 billion. Last, we would like to see the share price grow at a rate similar to that of the free cash flow. When the former grows faster than the latter, we can begin to see the price/valuation ratio force, which can lead us to reduce (or sell outright) our position.
Purchasing a company with these characteristics doesn’t guarantee a quick gain. Charlie Munger clarified that you should likely outperform over the long term. But the difficult part is hanging in for the long term. At Nintai, we are content to wait for three, four, five, or more years if the conditions we’ve discussed are being met. If they are, and the share price continues to lag or go down, we will likely add to our position over time.
Let’s use a specific example before I discuss how our model portfolio has performed over the last decade. One of our holdings is Veeva Systems (VEEV). We’ve held the stock (including in our previous firm, Nintai Partners) since 2004. Here are the first numbers we look at: free cash flow versus share price.
- Warren Buffett[1]
Our recent annual report to our investment partners began by discussing some important numbers or characteristics we look for in an investment. I wrote:
“At Nintai, we manage a focused portfolio of about 20 – 25 positions, which we have held for decades. Because of that, we have specific criteria that we feel are vital to outperform the markets in the long term. Before we get into the requirements, some core beliefs drive our decision-making. First, free cash flow is a far better measure than earnings when calculating valuation. We believe earnings can be manipulated in so many ways that their utilization in valuation tools is a waste of time. Second, we believe the best measure of a wide competitive moat is the sustained outperformance of return on invested capital (ROIC) over the weighted average cost of capital (WACC). When a company can generate ROIC greater than its WACC for over one or two decades, it has a wide moat. Last, we look for investment opportunities where the company’s free cash flow grows, but its price keeps dropping. We see those opportunities as a spring getting increasingly tightened that must eventually be released.”
This overview briefly describes some key metrics that drive our investment decisions. But more detail might help with numbers.
Two key metrics we use at Nintai Investments are a company’s return on invested capital (ROIC) and its weighted average cost of capital (WACC). We look for companies whose ROIC consistently outweighs their WACC for extended periods - usually one or two decades. I stress the word consistently because we aren’t fans where it might exceed for three or four years and then drop below for a year or two. We want to see ROIC beat WACC every year for a decade. Another number we look for is free cash flow. An investment should grow free cash flow annually for at least eight of the last ten years and continue that for the next decade or two. Eventually, that growth must, by the nature of its numbers, decrease over time as the company expands. It’s much easier to grow free cash flow 10% off a base of $100 million than $10 billion. Last, we would like to see the share price grow at a rate similar to that of the free cash flow. When the former grows faster than the latter, we can begin to see the price/valuation ratio force, which can lead us to reduce (or sell outright) our position.
Purchasing a company with these characteristics doesn’t guarantee a quick gain. Charlie Munger clarified that you should likely outperform over the long term. But the difficult part is hanging in for the long term. At Nintai, we are content to wait for three, four, five, or more years if the conditions we’ve discussed are being met. If they are, and the share price continues to lag or go down, we will likely add to our position over time.
Let’s use a specific example before I discuss how our model portfolio has performed over the last decade. One of our holdings is Veeva Systems (VEEV). We’ve held the stock (including in our previous firm, Nintai Partners) since 2004. Here are the first numbers we look at: free cash flow versus share price.
Veeva’s free cash flow has grown at an annual rate of 35.5% over the last decade. Through 2020, the stock price increased even faster. But starting in 2021, the stock price declined steadily as free cash flow maintained its steady growth (as you can see on the right side of the graph). We are happy to continue holding the stock (in this case, even adding to our position) until the markets recognize that the company’s value has increased. Why has the stock price decreased over the past five years? First, the price/value ratio was stretched in 2020. There was a case of irrational exuberance, for sure. But now? We think there has been a case of irrational depression.
Here is the second set of numbers we discussed previously. (I'm sorry for the sizing issue. Excel doesn’t make this easy!)
Here is the second set of numbers we discussed previously. (I'm sorry for the sizing issue. Excel doesn’t make this easy!)
As you can see, over the past decade, the company’s ROIC has exceeded its WACC by a substantial margin. This demonstrates a deep and wide competitive moat, and we expect it to continue over the next decade or two. If it does (and there is no assurance it will), we should end up with a respectable long-run return to Charlie Munger's point.
Let’s examine the aggregate Nintai Investments portfolio. Here, we see a tale of two returns similar to Veeva's. The portfolio's share price grew faster than free cash flow at the beginning of the decade, while it lagged over the last five years.
Let’s examine the aggregate Nintai Investments portfolio. Here, we see a tale of two returns similar to Veeva's. The portfolio's share price grew faster than free cash flow at the beginning of the decade, while it lagged over the last five years.
This reflects the change in market performance as the Magnificent Seven and artificial intelligence began driving returns while the rest of the markets lagged.
How about the portfolio’s ROIC and WACC numbers? These show that, in the aggregate, the portfolio’s competitive moat remained deep and wide over the entire decade. In other words, the portfolio’s strength has not lagged even as its share price growth has over the past five years.
How about the portfolio’s ROIC and WACC numbers? These show that, in the aggregate, the portfolio’s competitive moat remained deep and wide over the entire decade. In other words, the portfolio’s strength has not lagged even as its share price growth has over the past five years.
Conclusions
Charlie Munger’s wisdom cut across many areas of knowledge. As he stated, he utilized a latticework of worldly wisdom. One of his remarkable insights was that return on invested on capital (ROIC) was an outstanding measure of how a company should perform (price-wise) over the long term. Comparing this against the weighted average cost of capital (WACC) should tell us whether the company has a wide competitive moat that can maintain high profitability. At Nintai, we seek out companies with high ROIC, substantial free cash flow margins, rock-solid balance sheets, and great managers keeping a hawk-like eye on these numbers. To Munger’s point, we think this will lead to long-term outperformance against the general markets. That said, it doesn’t mean the portfolio will consistently outperform. In the short term, there will be periods of underperformance. The challenge is remaining focused and controlling your emotions during these times. Investors should be handsomely rewarded over their investment career if they can do this.
Disclosure: Veeva is a portfolio holding in Nintai Investment portfolios as well as Mr. Macpherson’s personal portfolio.
[1] “Buffett and Munger Unscripted,” Alex W. Morris, page 15, 2003 Berkshire Annual Meeting
Charlie Munger’s wisdom cut across many areas of knowledge. As he stated, he utilized a latticework of worldly wisdom. One of his remarkable insights was that return on invested on capital (ROIC) was an outstanding measure of how a company should perform (price-wise) over the long term. Comparing this against the weighted average cost of capital (WACC) should tell us whether the company has a wide competitive moat that can maintain high profitability. At Nintai, we seek out companies with high ROIC, substantial free cash flow margins, rock-solid balance sheets, and great managers keeping a hawk-like eye on these numbers. To Munger’s point, we think this will lead to long-term outperformance against the general markets. That said, it doesn’t mean the portfolio will consistently outperform. In the short term, there will be periods of underperformance. The challenge is remaining focused and controlling your emotions during these times. Investors should be handsomely rewarded over their investment career if they can do this.
Disclosure: Veeva is a portfolio holding in Nintai Investment portfolios as well as Mr. Macpherson’s personal portfolio.
[1] “Buffett and Munger Unscripted,” Alex W. Morris, page 15, 2003 Berkshire Annual Meeting
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