“Active management is a zero-sum game before cost, and the winners have to win at the expense of the losers.”
                                                                                      -      Eugene Fama 

“The results of this study are not good news for investors who purchase actively managed mutual funds. No investment style generates positive abnormal returns over the 1965-1998 sample period. The sample includes 4,686 funds covering 26,564 fund-years."

                                                                                    -      James L. Davis  

Being an active investment manager in 2019 can make you feel like the salesperson trying to sell rotary phones in 1999. Each year the evidence piles up that active fund management cannot compete with passive (or index) investing over the long haul. One of the great tools to follow the performance gap between the two investment styles is the S&P Dow Jones Indices Annual SPIVA US Year-End Scorecard. In its sixteenth year of publication, the report is unique in that it compares apples to apples, takes into account survivorship bias, and reports equal and asset-weighted returns.
 
I think the report adds significantly to both individual investors’ as well as institutional investors’ knowledge. For individual investors, the data show how difficult it is to create an actively managed portfolio that can outperform an index-based approach over the long term. This is demonstrated clearly with outstanding data, great graphics, and down-to-earth descriptions of complex issues. For the institutional investor, the data break through some of the perceived notions and hardened views on why and how we (money managers) feel we will always be the exception to the rule. When I talk to my fellow institutional investors, I rarely hear about the fact that many haven’t beaten their respective index in 3, 5, 10, 15, and sometimes even 20 years. This industry has far too many underperforming managers making far too much money.   
 
The 2018 annual report was published on March 11 2019[1] and it – as usual – has little good news for active managers. For the ninth consecutive year, the majority (65%) of large-cap funds underperformed the S&P 500. Small-cap equity managers also found 2018’s gains and draw-downs difficult to manage with a large majority (68%) lagging the S&P SmallCap 600. Diving deeper into market segmentation, small-cap value and small-cap core had an abysmal 2018 with 83% and 88% underperforming their respective categories. In both the large-cap and small-cap categories, the idea that market turbulence creates a “stock picker’s market” was simply washed away with shockingly widespread underperformance.  In fact, compared with results from 2017, there was a 27% and 46% percentage point increase in the proportion of funds lagging the S&P 500 Growth and S&P SmallCap 600 Growth indices. Internationally things were no better. 96% (46 of 48!) of the S&P Global BMI’s 48 country markets declined. International and emerging market funds also struggled tremendously, with 77% of international funds lagging the S&P 700. The majority of emerging market managers failed to beat the S&P/IFCI Composite. As an example, even though the S&P Developed Ex-U.S. SmallCap index dropped over 18%, two-thirds (66%) of international small-cap funds failed to outperform their benchmark. With such results in “stock-pickers’ markets”, index funds have never looked better. 
 
However, the report shows that not all was a washout in 2018. U.S. large-cap value broke its losing streak with roughly 54% of the managers in the category beating the S&P 500 Value. In a strange (and seemingly inexplicable) finding, 84% of actively managed mid-cap growth funds beat the S&P MidCap 400 Growth index for the second year in a row. Another strange result was from bond fund market. 83% of government long funds and 91% of investment-grade long funds outperformed over the one-year horizon in 2018. In a true case of inversion and the fact that past results are no guarantee of future returns, over 90% of both categories lagged over the three-year period.
 
That seems to be about as good as the news gets in this year’s report. Funds continued their long-term underperformance with every category having over 80% of active managers underperforming their benchmark in both 10 and 15-year time periods.  The issue of survival continues to be a major issue. 57% of domestic equity funds, 49% of international equity funds, and 52% of all fixed income funds were merged or liquidated over the 15-year horizon. These numbers point out - with unusual clarity - the importance of correcting for survivorship bias.
 
What This All Means
 
The past 10 years have been very difficult stretch for active investment managers – whether they be value or growth, small or large-cap, foreign versus domestic. One of the mantras has been that long-term bull markets make everyone (and especially index funds) look like geniuses. We are told that once market volatility returns and stock prices began to wobble, then active managers will really begin to show their worth. The 2018 S&P Dow Jones Indices Annual SPIVA US Year-End Scorecard (along with other reports over the past 18-24 months) has knocked this theory into a cocked hat.
 
If the premise that volatility and draw-downs create the perfect opportunities for active fund managers is false, then where does this leave us? How do institutional and individual investors go about creating a portfolio that can successfully compete against their respective benchmarks?  First, I should say I have a vested interest in this debate. As an active investment manager, I believe my short and long-term records show it is possible to beat the markets over time. Utilizing data from my time at Dorfman Value Investments and my new firm Nintai Investments LLC, a composite of my individual account returns looks like this:

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*Macpherson DVI/Nintai Investments LLC Inception Date: September 2016
Macpherson DVI/Nintai Investments LLC returns reflect a blended management fee of 0.75% for Macpherson Nintai LLC and 1.5% for Dorfman Value Investments
***Previous performance is no guarantee of future returns***

Certainly a 2 ½ year time frame doesn’t offer a long-term perspective of my investment skills or abilities. Yet I think combined with my record from Nintai Partners (from 2002 - 2015), my outperformance of both the S&P500, the MSCI ACWI ex US, and an Index Blend show I have produced more than adequate returns for my investors over the years.   

Second, I believe there are some core tenets that apply to active management that can assist managers to beat their respective benchmarks. These can be found in reports like the S&P Dow Jones Indices Annual SPIVA US Year-End Scorecard and other performance studies. There are three that I think are vital to achieving long-term outperformance.

Underperformance is Often Tied to Survivability
Whenever you are reading a fund prospectus or listening to a presentation by a fund family, ask them a very simple question: How many of their funds have been closed or merged away over the last decade? Have the returns of those funds been included separately in their total return numbers – or included? For instance, many fund companies will take Fund X - which had a terrible performance record over the last decade – and merge into Fund Y with a much better return and voilà! The company no longer has a good return (Fund Y) and a bad return (Fund X), but now a single good return (Fund Y only) and the disappearance of bad data (sayonara Fund X). Even better is reading the corporate PR announcing such a merger. You will hear management discussing “remarkable synergies”, “outstanding fund leadership”, and “exciting new opportunities”. Always remember: if management can try to fool their shareholders so easily, it isn’t long before they begin fooling themselves. 

Turnover - Whether Portfolio or Managers - is Generally Bad
Nearly all turnover in the investment management business is an acknowledgment of an alternative outcome from the original plan. Some examples might be the investment thesis is broken/impaired, they partnered with the wrong management team, or they overpaid for the asset. I can’t think of many investment processes that are successful in the long-term that include high turnover as part of their strategy. Even in today’s investment world – where data is plentiful, easy to locate and even easier to utilize – turnover requires an enormous amount of effort to find investment opportunities, fully research the potential investment’s management, market, competition, product development, financials, etc. The US tax system penalizes investors for high turnover and the investment community preys on investors with every sort of fee that can be devised by mankind related to turnover. Finally, turnover robs an investor of the eighth wonder of the world – compounding. Every actively managed portfolio fight against these market characteristics on a regular basis. 

Utilize a Tool Fund Managers Generally Can’t: Cash
If you look at almost any actively managed fund you will find cash is 5% of assets or less. As an investment manager you will often here the old adage “I don’t pay you to hold cash”. As an investment manager myself, I make it clear to my investment partners/clients that cash can range anywhere
from 5 - 30% of total assets under management. In fact, I believe my investors do pay me to hold cash sometimes simply to not overpay for new assets or to sell assets when they are grossly overvalued. As of March 2019, I hold between roughly 15 - 30% cash in my individually managed portfolios. Individual investors have the luxury of holding as much cash as the case deems appropriate.  

Conclusions

The performance gap between actively managed portfolios and index-based investing continues to widen with time. It’s now 9 years since a majority of actively managed funds have outperformed index funds. The last several years show the gap growing, not shrinking. One of the last pillars in defense of actively-based investing (“we active managers will outperform when volatility rises and markets begin to oscillate”) has cracked and tottered in the last 6 months while markets swooned and returns dropped dramatically. For all the talk about how indexing has gotten too large and unwieldy, it’s important to realize that over two-thirds of invested dollars are still in actively managed funds. Until the large fund companies learn some new tricks, reports like the latest S&P Dow Jones Indices Annual SPIVA US Year-End Scorecard will continue to deliver grim news, and that’s not what any actively managed portfolio investor wants to hear. 

As always I look forward to your thoughts and comments. 

Disclosure: None

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[1] The actual report can be found here: https://bit.ly/2XZ8VVO. I highly recommend all investors read this report. The numbers provide real clarity on the chances of beating a generic index. Data like these – with years of outstanding insights – can provide investment managers and individual investors untainted information on the chances of outperforming their respective index. Such information can bring hard but necessary reality to investors of all stripes.  

“A man always has two reasons for doing anything: a good reason and the real reason.”
                                                                           
​                                                                                            -      J.P. Morgan 

‘I asked the investor why he was withdrawing from the fund and he said he thought we were stupid. When I pointed out that our long term-term track record was superb, he said ‘I can take you lookin’ smart for years, but when you look stupid, that don’t look or feel good no matter how smart you might be’”.
                                                                                           -     An Anonymous Fund Manager  
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Over the course of my investment career, I’ve often run my portfolios slightly different than the rest of the financial services industry. With the blessings, investors in my old firm did well over time (though I must by conscience and law state that past returns do not guarantee future results). It wasn’t all peaches and cream though. There were times that my corporate investors and employees questioned not only my intelligence but sometimes even my sanity. It’s easy to look stupid in the investment world. That being said, I would argue there is distinct line between looking stupid and acting stupid, but they can look awfully similar at times. 
 
Most Wall street fund managers prefer not to look stupid in their own right. Given the choice, billions of dollars will be allowed to run like lemmings right off a cliff without a whiff of remorse – as long as they go as a crowd. It isn’t just publicly traded companies and their investment management owners. Private equity acts in a similar fashion. One year all the rage will be dental supply companies, then lab testing facilities, followed by auto supply parts dealers. Like the thundering herds of buffalo of old, investment money and its managers can rarely be blamed for moving in such an enormous mass.
 
This herd mentality combined with the growth of index or passive investing through ETFs had led to an enormous amount of closet indexing. This means an investment manager might have a portfolio with a 97% match to some index such as the S&P500 or Russell 2000 guaranteeing they never lose (or gain) more than the 3% of the index yet charge 1.25% for the privilege of doing so. It has a very poor track record of making investors rich, but making money managers quite wealthy in their own right. Where are the customers yachts indeed?     
 
In 2007, my portfolio at Nintai Partners had become vastly different in make-up than most anything else on Wall Street. Roughly 35% of my total assets were in cash. Not short-term bond funds. Not even short-term US Treasuries, but cold hard cash sitting in our corporate checking and savings accounts.  (My current portfolios at Nintai Investments LLC aren’t much different as of March 2018 ranging from 20-30% in cash as a percent of AUM) At the time, many people – including active money managers, corporate directors, and my fellow employees/investors thought I was looking quite silly for arguing there simply no places to safely employ our capital. The economy seemed to be moving from strength to strength, the VIX was at all-time lows, and we seemed to have put the technology bubble well and far behind us.
 
Unfortunately, the line between looking stupid and acting stupid can be crossed without ever recognizing what happened along the way. A rather unfortunate example of this has been Bruce Berkowitz’s Fairholme Fund (FAIRX). I should be upfront that this look at Mr. Berkowitz’s isn’t an attack or judgment on his process. He’s proven many times over that fortune favors the bold. I tip my hat to Fairholme and Berkowitz for not giving up on a process that has worked 30 years. Indeed, in 2010 Berkowitz was awarded Morningstar’s manager of the decade 2000-2010. 
 
All that said, the Fairholme Fund has absolutely devastated its long-term return history over the past decade with huge bets in Sears Holding (filed for Chapter 11 bankruptcy protection in October 2018), St. Joes Holdings (Berkowitz serves as Chairman of the Board and the stock has returned -8.2% annually since for the past 10 years), and Imperial Metals III (-35.7% annualized return since 2013). These returns have produced an underperformance of the S&P500 by -7.8% over the last 10 years and -14.6% over the past 5 years. During his successful run many claimed Berkowitz looked stupid (but nobody laughed from 2000-2010), but many more feel today he has acted stupidly. The answer? Who knows. Stupidity – much like beauty – is in the eyes of the beholder. 
 
Why This Matters
 
The concept of looking stupid can play a huge role in an individual or institutional investor’s thinking and application of their investment process. For someone like Bruce Berkowitz, it means very little – his confidence in his process has been honed over 30 years – and allows him to continue to choose and hold investments regardless of how others perceive his abilities (It should be noted he’s had significant redemptions combined with the aforementioned losses).
 
Looking Stupid versus Acting Stupid: Internal versus External Thinking
One of the distinctions I think that exists between looking and acting stupid are based on internal versus external perceptions. For instance, the act of looking stupid is generated nearly entirely by outside views of your actions – meaning your investors (if you are a money manager) and other investors think you are stupid. I find it rare when individuals themselves think they are stupid. The assumption is that most investors who think that way about themselves would find a new line of work or suddenly become tremendously excited about index funds. 
 
Looking Stupid versus Acting Stupid: System 1 vs System 2 Thinking
I have found that most of the time acting stupid is generated internally by bad thinking – generally letting what Danny Kanhemann calls System 1 thinking overriding the individual’s System 2 thinking. A classic example would be selling a stock simply because it dropped 30% (System 1 thinking) versus ascertaining why it dropped and what its current worth is at the time (System 2 thinking). This type of behavior could be classified as acting stupid, not looking stupid (though it may be both).
 
So what’s an investor to do? How do you know you are simply looking stupid and not acting stupid?  I might suggest there are several things to implement in your investment process to help discern between the two.

1. Develop and Stick With Your Process: Much like any other professions, if you have a process that has achieved success then stick with it. As the saying goes, dance with the one that brought you. Over 25 – 30 years, most investors have gone through several business cycles that tests whether their investment process is viable. Having others call you stupid is one thing, but feeling that you are acting stupid means you’ve lost confidence in your process. This rarely leads to positive outcomes.
2. Patience, Patience, Patience: Every investment process – growth versus value, small-cap versus large-cap will have its good and bad years. The key is avoiding emotional decision-making or being placed in situations where your decision making is forced outside of your process. If you’ve been previously successful, have the confidence to wait out the markets and let your process work for you.  
3. Be Your Own Palm Tree: Strong But Flexible: If you are relatively new to the investment world, I always suggest investors develop their own investment process (or mimic one) but be flexible enough to learn from their mistakes and tweak the system as they go along. Think of this as a pre-cursor to recommendation numbers 1 and 2. But don’t mistake: no investment dog is too old to learn new tricks.

 
Conclusions
 
On March 11 2019 - after 4 months of in-depth research including reviewing financials, talking to management, customers, thought-leaders, and competitors - I decided to purchase F5 Networks (FFIV) back into my individually managed portfolios. I had sold it over a year ago after its price reached over 155% of my estimated intrinsic value at the time. A drop in price combined with a substantial increase in my estimated valuation brought the stock back into but territory. All of this followed my process that has worked for me over 20 years. On Tuesday, March 12 2019 – the day after purchasing shares – the stock dropped 12%. I can’t think of a better example of looking stupid. But did I act stupid? Time will tell but certainly the drop in price (and its associated news) – had zero impact on my estimated intrinsic value. By sticking with my process and being patient, I feel confident I will avoid acting stupid.
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: I hold F5 Networks (FFIV) in several investment accounts I personally manage.   

I once heard a story from an old Marine who managed two tours in Vietnam before getting a one-way ticket home after losing his arm. The first time he was wounded (the first of four Purple Hearts), he was getting some quick first aid from a field medic while lying flat on his stomach with his ass up in the air. He said the last thing he remembered before the morphine took hold was the medic saying, “This ain’t no touch football. Out here it’s a contact sport.”

Most of the people invested in Kraft Heinz this last week have realized Wall Street is a contact sport. The company announced earnings last week where they threw everything but the kitchen sink (and some might say the toilet was part of the inventory tossed) at investors. The company wrote off more than $15 billion related to previous acquisitions and revealed a Securities and Exchange Commission investigation. Kraft Heinz also reported a fourth-quarter loss of $12.6 billion, or $10.34 a share, on sales of $6.9 billion, up from $6.84 billion a year ago. Much of that loss was due to non-cash impairment charges of $15.4 billion to lower the carrying amount of goodwill in certain reporting units.

There isn’t a really nice way to report numbers like those reported by Kraft Heinz. Results like these can create permanent capital losses for investors and put a huge dent in long-term investment returns. As an investment manager or individual investor, this is a gut-wrenching time to decide whether to add, hold or sell some or all of your position.

As investors face enormous losses like some holders of Kraft Heinz today, there are some key questions that are helpful moving forward. But before we get to these, there are a couple of areas that I think investors missed in their initial valuation of the company. Warren Buffett did a great job describing his errors in this interview and walked through where he made some mistakes.

Consumer buying habits didn’t change -- their brand choice did 
Costco’s Kirkland brand is an example of a competitor stealing a march on their core competition. Kirkland Signature (its in-house brand), is enormous. Last year, it brought in roughly $40 billion in revenue, which was an 11% increase from 2017. That number represents more than Campbell Soup, Kellogg and Hershey combined. Think about that for a moment. The Kirkland brand is only 27 years old versus Campells (started in 1869 and currently selling in 120 countries), Kellogg (started in 1898 and currently selling in over 160 countries) and Hershey (started in 1894 and sold in 60 countries.) Compare these statistics to Kirkland (founded in 1992 and sold in only 760 Costco stores in 11 countries). Kirkland accounts for roughly one-third of all Costco revenue and is growing at nearly double the rate of total store sales. In summary, a brand only 27 years old lapped some of the most respected and oldest brands in the world.

We continue seeing the financial failures of M&A
In his interview with Becky Quick, Warren Buffett was quick to point out he (or they - meaning Berkshire Hathaway and 3G) paid a great price for Heinz but a terrible price for Kraft. This overpaying came into clear focus after Berkshire announced it will write down $3 billion and Kraft Heinz will write down $13.5 billion in brand value.

I have written previously about how and why most mergers and acquisitions fail. Most of the errors lie with management overestimating the amount of synergies they can achieve with growth and underestimating the difficulty in achieving cost savings without doing long-term structural damage to the company. Another problem lies with management – listening to those consultant and investment banker faeries on their shoulder – when they conduct a merger at exactly the wrong time. Either consumer habits are changing, markets are reaching nose-bleed price levels, or they simply see a need to create a larger empire.

Berkshire and 3G were guilty of a little bit of the first two. They obviously thought they could trim significant fat and jump start growth. After all, 3G had made itself a specialist in acquiring companies, cutting costs dramatically and producing surging earnings. Revenue per share has been $21.6 billion (2016), $21.4 billion (2017) and $21.5 billion (2018). Earnings per share have been $2.81 per share (2016), $8.95 per share (2017) and -$8.39 per share (2018). I wouldn’t count any of these numbers as something to particularly boast about.

With the misjudgment in the adoption of in-house family brands (like Kirkland) and the financial missteps in the Kraft acquisition, it’s a good time for investors to ask themselves what to do when faced with such a large impairment in both the company’s books as well as its investment portfolio. I find that asking several questions can help me sort out the problem and help make my choices clearer.

Is this your problem, the company’s problems, or both?
Sometimes an impairment can be caused by the investor by paying too much, overestimating revenue, market sizing or similar. Other times an investor may pay a reasonable price (or what they think is reasonable) and see the price drop for no apparent reason or have Wall Street not understand the quarterly earnings. Finally, there is the most painful: when both you (the investor) and the company get something terribly wrong such as regulatory approval failure, a huge earnings miss and a particularly bad M&A deal. 

In the first case, it’s critical the investor consider what they got wrong and check its impact on valuation. Only the investor can help make a decision in this case. In the second case, if the investor runs the numbers and sees no impact in their valuation, then by all means purchase more if it makes sense. In the last case, it’s imperative the investor not fool themselves by reading too much into management’s investment case, completely rerun their valuation model and make the call whether management’s failure is worth maintaining a partnership.

Is the loss permanent in nature?
Another question to ask is whether the loss in permanent or temporary. Reading through the Kraft Heinz earnings report, it would certainly seem the loss is going to be very long in nature – if not permanent – without much guidance going forward in how it will right the ship. In these instances, your tax status (taking the loss) or your inability to wait potentially years to return to growth might recommend you sell. But, should you feel the losses can be made up and they are mere bumps in the road, then it might be best to continue to hold.

How can the loss be redeemed?
Of vital importance in understanding the nature of the loss, the investor should have a clear understanding of how management expects losses to be redeemed. Some might be able to do so with additional cost cutting (seems unlikely at Kraft Heinz) or by revenue growth (equally hard as driven by the Kirkland example or relationships with retailers). It seems that without some major strategic shift and hit to pricing, Kraft Heinz is in quite a bind to develop a plan for strong growth going forward.

Does the impairment have a tail wind or head wind?
It’s important to ascertain whether the holding is facing head or tail winds going forward. In some cases it might even be mixed. I think it would be hard to find evidence to suggest Kraft Heinz’s industry is looking at a strong or even weak tail wind. The evidence we’ve seen to date – combined with Kraft Heinz’s management comments on their call – would suggest the company sees a slight to moderate headwind over the next few years.

As an investor considers their position, knowing what long-term trends predict is critical. If the industry portends future strength in industry patents, this would be quite different than Kraft Heinz facing long-term pricing, product placement and demographic nutritional focus. When looking for a turnaround, always try to find one with a good following industry tailwind.

Is management sharing in your losses?
Last, but not least important, is whether management is suffering along with shareholders. If board members reprice options to reflect lower prices, or the company increases grants as shareholders suffer, look for a new holding. Investors should partner with management who suffer to the same extent as their shareholders. All too often you will see management’s compensation be finessed to make sure they receive the same – if not more – than the previous year’s compensation. C-suite management works for the board of directors and the board of directors look out for the fiduciary responsibility of their shareholders. Make sure everyone is sharing losses equally.

Before concluding, I want to say up front this isn’t a knock on Warren Buffett, 3G or the Kraft Heinz management team. I know very little about the industry, the company and all the work that has gone into building the company. I also know very little why you – the investor – might be either a holder of the stock or a bystander. Only those with skin in the game can really make these very tough decisions.

Conclusions
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There’s an old saying that you never take a loss until you sell. Like all well-aged adages, there’s quite a bit of wisdom in it. The difference between a paper loss (the price is down but you haven’t sold) versus an actual loss (the price and down and you did sell) can be all the differences between a successful and non-successful value investor. Understanding when your capital is well and truly impaired can help you make some difficult decisions. Like our Marine learned (in a far more difficult way), this ain’t no touch football. The decisions that are the most disastrous are when you listen to the fear in your gut as well as to some charlatan who hits a button with the sound effect of someone screaming “SELL! SELL! SELL!”.
Investing in Wall Street can be a contact sport. The better your game plan, the better your reasoning, and the better your understanding of the potential loss you face, the better your results will be over time.

Ever since we’ve had the luxury of spare time to think about who we are – and what makes us tick – man has pondered on the process of thinking. What causes it? Where does it take place? What tools are used in developing our theories, questions and answers? Robert Epstein - editor in chief of Psychology Today - wrote in an article in May 2016[1]:

“In the earliest one, eventually preserved in the Bible, humans were formed from clay or dirt, which an intelligent god then infused with its spirit. That spirit ‘explained’ our intelligence - grammatically, at least. The invention of hydraulic engineering in the 3rd century BCE led to the popularity of a hydraulic model of human intelligence, the idea that the flow of different fluids in the body - the ‘humours’  - accounted for both our physical and mental functioning … By the 1500s, automata powered by springs and gears had been devised, eventually inspiring leading thinkers such as René Descartes to assert that humans are complex machines. In the 1600s, the British philosopher Thomas Hobbes suggested that thinking arose from small mechanical motions in the brain. By the 1700s, discoveries about electricity and chemistry led to new theories of human intelligence – again, largely metaphorical in nature. In the mid-1800s, inspired by recent advances in communications, the German physicist Hermann von Helmholtz compared the brain to a telegraph. Each metaphor reflected the most advanced thinking of the era that spawned it. Predictably, just a few years after the dawn of computer technology in the 1940s, the brain was said to operate like a computer, with the role of physical hardware played by the brain itself and our thoughts serving as software. The landmark event that launched what is now broadly called ‘cognitive science’ was the publication of Language and Communication (1951) by the psychologist George Miller.”

My apologies for such a long quote, but it’s an outstanding example of the expansion of our own views of the human being’s ability to think, discern, calculate and work out increasingly difficult and complex problems facing us as a race and a species that happens to reside on a planet with finite resources and   - with some certainty - finite time.
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Most of my readers at this point are probably asking what has gone wrong with my limited cranial capacity and what this has to do with value investing, but I assure you it does a great deal. As we expand our understanding of how we think and feel about investing, we increasingly develop the field of behavioral finance. This field focuses on three key concepts: what are the best means (and tools) to assist humans find ways to manage and develop self-control, how to isolate areas where humans show the least rational behavior and limit their impact, and what cognitive biases influence our investment decisions.

Losing (and Finding) Self-Control

Certainly, losing self-control can be one of the easiest ways to lose your hard-earned investment dollars. Whether it be Newton getting back into the South Sea bubble after having exited with great gains (he simply couldn’t resist seeing his friends make even more money) or an investor using vast amounts of margin to increase their gains, all too often investors lose self-control and take actions that are impulsive and self-destructive.

The ability to build emotional guard rails – barriers that keep your emotions on the straight and narrow – can make a huge difference in long term-investment returns. There was a great story where Abraham Lincoln wrote an extraordinarily cutting reply to a general’s update. Historians found the document later[2], but what was most interesting was discovering Lincoln’s technique of using an unsent letter folder to guide him in his more emotional moments. I try to do this with trades. I find if I’m willing to make the trade one week after making the initial decision, then I will likely proceed. I see it as my own “draft emotional trading folder.”

Irrational Behavior

Buying 1,000 shares of ACME Rubber Band company because everyone else is would be classified as lack of self-control. Purchasing shares of ACME Rubber Band company for $1,000 per share after estimating a fair value of $50 per share would be considered irrational behavior. Neither will likely lead to great results, but some might consider the latter more dangerous because a certain level of conscious thought has gone into the process and the individual has decided – for whatever reason – to ignore their (rational) estimate and forge ahead.

Irrational behavior implies that the investor has the possibility of utilizing rational behavior. Building a process to prevent making an irrational decision is similar to helping maintain self-control – with one exception. When delaying after making an irrational decision, one should always seek to see what a rational decision might look like.

Create a Process that Questions your Key Assumptions

In his classic 2006 paper, “Behaving Badly,” James Montier (of then-Dresdner Kleinwort Wasserstein) interviewed 300 investment managers and asked them if they produced above-average, average or below-average results. Seventy-four percent of the 300 fund managers surveyed believed that they had delivered above-average job performance. The majority of the remaining 26% of those surveyed believed that they were average in their performance. Nearly 100% of those surveyed felt that their performance was average or better. Basic statistics, of course, show that only 50% of the sample group can be above average.

Further research has shown that not much has changed since Montier completed his research in 2006. The issues that showed up in his research – confirmation bias, anchoring, disposition effect and so forth – are just as prevalent today as they were in 2006. The key is building a process that can scrub out these inherent biases and question your assumptions. Whether this is the Nintai “Getting to Zero” process or your own personalized method that finds a way test or break your case, include it every time you evaluate a potential investment.

Why This Matters

Over the years I’ve written a lot about high fees, turnover and how investment managers rarely outperform the markets in the long term. All of this is still as valid today as the day I first wrote about it. But the simple fact remains that investors underperform – whether investing themselves or by utilizing professional money managers through mutual funds, hedge funds and so forth – mainly for reasons centered solely on their own behavior. It’s easier of course – and contains some truth – to blame this underperformance on others.

You can’t stop doing it until you recognize it
When I was growing up as a kid, it seemed there was always a “leg-bouncer” in most families. You know the one – sitting at the dinner table or watching a movie – and the leg is bouncing up and down. A never-ending motion that seemed to shake the house from floor to roof. I was (un)fortunate enough to dwell in a house with two – my brother and me. I’m not sure we were fully cognizant that we were doing it on a regular basis and that it was annoying, until my father developed a way to “assist” us in identifying the problem. We certainly didn’t forget it a second time! That type of jolt to the system – which immediately brings you in contact with your unfortunate habit – makes it much easier to identify it the next time you start and even easier to try to stop.

It’s nearly impossible to stop, but try to minimize the effect
Many of the biases we bring to our investment process are hard to stop entirely. An investor whose thinking is subject to confirmation bias would be more likely to look for information that supports their original idea about an investment rather than seek out information that contradicts it. Over time, the ability to break entirely free from this bias is very, very small. If you find that confirmation bias constantly seeps into your thinking, develop a process that tries to limit its impact, not eliminate it. I look upon eating more healthy as much easier than dieting. If I try to eliminate all sources of my weaknesses – chocolate, ice cream, cookies and so forth – I find I completely fail at my objectives. Eating a salad once per week made changing my eating habits far easier over the long haul. Incremental change in your investment process will likely be more effective than suddenly trying to emulate Ben Graham overnight.

Thinking is a never-ending process
I keep a log and quote book that tracks thoughts and quotations that I find interesting – as well as valuable – in helping me think differently. Not every quote or thought is earth-shattering in its importance or fundamentally changes the way I approach value investing. But over time I find they slowly impact my daily thinking and investment process. In writing this article I went through the three volumes I have in my office, counted the total quotes and ranked them on a 1-to-3 basis with 1 being a quote that profoundly changed my thinking and 3 being a quote that had little or no impact on my business thinking.

Over the past 16 years, I have written down roughly 1,300 quotes or roughly seven entries per month. Of these 1,300 quotes I ranked roughly 15% as 1 (profoundly impactful on my thinking), 20% as 2 (moderate impact on my thinking), and 65% as 3 (little or no impact on my thinking). The fact that nearly two out of three quotes made little or no impact isn’t discouraging at all. In fact, to me it demonstrates the need to keep learning, keep researching and keep writing things down never ends. You never know when that diamond might show up in the rough.\

Conclusions
Every day it seems we find some new twist in how our brain works through investment decisions. Whether it be research on biases[3] or the difference in emotional responses to losses versus gains, we are always learning ways in which the investment brain works.

Returning to the quote that opened this article - Epstein’s “The Empty Brain - the breadth and depth in the development of human thinking is truly amazing. No matter where you are on your investment journey continuum – just starting out or nearing retirement – or where you are in the learning process, the ability to keep learning will give you a leg up or a decided disadvantage in the long run. The path you choose – and the success you have – will be greatly determined by how you think, what you think about and how much you think in total.

There is an old story about Hubert Lyautey, a French army marshal, elder statesman and former administrator of the French colony of Morocco. In the story, Lyautey goes to his gardener one day and asks him to plant a certain type of tree in the back garden of his chateau. The gardener objected, knowing the tree grew at a remarkably slow pace and that it wouldn’t flower for at least a century. “In that case,” Lyautey replied, “there is no time to lose. Plant it this afternoon.”

Time is Multi-Dimensional
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The concept of time - and how you use it - is of vital importance to the value investor. Time can be multidimensional. An investor can use their time to research an investment opportunity or read an investment classic to help further develop their investment strategy. This use of time provides no direct value to the concept of time value of money, whereas time can be directly applied to this theory by investing and holding a company's stock for 20 rather than 30 years. Seen through the eyes of our French marshal, one use of time would have been researching and making a decision on a type of tree to plant. Another possible use of his time might be taking (starting that afternoon) every moment available to him to get better – and faster – returns on his decision. As a value investor, I would humbly suggest the marshal had it right when he emphasized time spent putting your asset to work is more important than the time it takes in picking the type of asset itself.

That doesn’t mean an investor should randomly choose any old asset to purchase and then sit and wait 30 years for it to produce value. Rather, I am suggesting that the preponderance of time should be spent letting it work its wonders in value creation, while much less time should be spent on the characteristics of the asset and decision process in selection. For instance, Lyautey may have chosen his tree for the flower or scent it generated (this seems logical since the gardener stressed the time to flowering). It would seem logical the marshal would spend far less time thinking about the type of tree (say a non-flowering elm versus a flowering dogwood) than in the time to letting the tree grow to maturation.
​
A value investor should be no different than our good marshal. Should the investor spend several years deciding whether a real estate investment trust stock or a large-cap technology dividend stock be a better portfolio holding or should they make a quick, well-reasoned decision and then let time generate dividends and stock price appreciation?

A Working Example

A company I invested in when I was at Dorfman Value Investments (and that remains in my personal portfolio at Nintai Investments LLC) is iRadimed (NASDAQ:IRMD). iRadimed engages in developing, manufacturing, marketing and distributing magnetic resonance imaging-compatible products such as IV pumps and other electronic equipment. As the only manufacturer of IV pumps than can be used safely in an MRI environment, the company provides enormous benefits to hospital patients receiving IV drugs who need to get an MRI.

Essentially, an enormous magnet or any pump with a metallic component can capably create a terrible accident within the MRI imaging center. Pumps with any metallic parts require the pump to be outside the imaging room, which requires either disconnecting the pump and stopping treatment or running a 75 to 100-foot extension tubing to the pump outside the room. Neither are safe or recommended solutions. iRadimed's equipment requires none of these workarounds and can be placed directly adjacent to the machine.

iRadimed is a long-term play on the growth of MRI imaging over the next decade. With an estimated growth rate of roughly 4-6%, the imaging market might seem like a slow-growth industry. The company's technology (both the MRI-compliant IV pump and data box) currently represents only 27% of imaging units at Tier 1 and 2 hospitals. Penetration is even less among smaller hospitals. By using a razor or blade model, the company is building a base of steady revenue over time. A final gem is that iRadimed is the only Food and Drug Administration-approved solution, granting an exclusive monopoly for years to come.

In this instance, we are faced with a similar problem facing the marshal and his backyard tree. First, is the company an investment that meets our criteria? Is it a company that has criteria we are specifically looking for in an investment? Second, if iRadimed turns out to be a company that both merits our consideration and meets our purchasing requirements, how important is time in both when to purchase as well as the length to hold it in the portfolio, and how this could impact our investment returns?

Approaching these issues, I generally think of time in four separate ways.

A well-developed process saves time: Having a well-developed selection process allowed the team to identify iRadimed as a potential investment quite quickly. It had no short or long-term debt, $31.2 million in cash on the balance sheet and generated $4.9 million in free cash flow. The company’s 39% return on capital far outweighed its 13.7% weighted average cost of capital. The company converted 17% of revenue into free cash and generated mid-20s return on equity. The stock traded at a 28% discount to our estimated intrinsic value. After spending roughly 60 days working diligently to identify the source of the company’s moat, its competitive position (easy, it had none), we knew we had a gem of a business that we could safely hold until at least 2024 (or eight years from date of purchase) and probably much longer knowing that development and FDA approval processes can take up to six or seven years.

Time as a compounder beats selection nearly every time: We knew that even if our selection process and research methodology were wrong, the time value of money meant compounding over the period we were looking at (eight to 14-year holding period) would likely beat the selection process each time. If your initial selection process is solid, the power of compounding time can frequently (but certainly not always) beat out any failure in your selection process.

You never gain time back, you only give it away: Every moment we weren’t holders of iRadimed stock was a period of time we were giving away an FDA-mandated monopoly and hospital acceptance of a new technological innovation. Every month we spent on the sidelines was a month we would never get back from a competitive position, customer position and innovation position.

Time heals many, many mistakes: In the few months after our initial stake was purchased, the share price dropped by roughly 30%. This was due to the fact iRadimed’s only competition had gone bankrupt several years before and the boost in sales as it captured these customers was winding down. In our models, we knew a 10-year holding period would smooth out these numbers and 15 years would make them look nearly non-existent. Within 24 months, the position had doubled in price.

Some Lessons

Whether investors realize it or not (and certainly most professional investment managers do not), investors allocate not just capital, but they also invest time. In many cases, investors generate a negative return on their time. They do this in several ways.

Most investors fail to see time as a commodity: Time spent on the investment process – everything from stock research to writing annual reports to meeting Securities and Exchange Commission and state regulatory requirements – uses the commodity of time. How it used, how you decide whose time will be used and your ability to use it wisely is no different than deciding on what marketing mix works best or how much capital to allocate to industry conferences. Time goes by no matter what you do or say, so use it like any other commodity – wisely, efficiently and cost effectively.

They fail to measure return on their time: I was guilty of this when I first started in the investment process when I starting investing Nintai Partner’s internal profits. I couldn’t tell you how much time I had spent on researching Company X, which returned 25% annually over 15 years, or how much time I had spent researching Company Y, which lost 5% annually over eight years. The one thing I can almost assure you is that you will spend far more time on your losers than your winners.

The ability to do nothing is sometimes the most effective use of time: When one looks at modern investing - whether it be individual investors or institutional investors - many think activity (usually with an emphasis on trading) is the most effective use of time. In fact, many fund managers with low turnover will openly tell you about calls they receive from investors who tell them they don’t pay them to sit and play tiddlywinks. I’ve found in my career, time spent reading up on holdings or improving my process far outweighs turning over my entire portfolio each year. 

Many investors think of time as a lineal tool - something to either take advantage of ("You may delay, but time will not, and lost time is never found again”) or to try to avoid (“The two rules of procrastination: 1) Do it today. 2) Tomorrow will be today tomorrow.”). Yet time is far more complex than that. Time is a commodity and assets no different than dollars (after all, there is even a phrase for that – “time is money”). Decisions have to be made about what to give up, when to give it up and at what consequences. Alternatively, when using time as an asset, we have to consider what other assets are given up and when that might happen. I have found those investors who find a way to devise a process in which to see time as an asset, how to allocate it and understand the costs of those decisions are generally more successful value investors than others.

In my final segment on thinking differently, I’m going to take a look at how some of the best investors learn how to think about thinking in a different light – how to achieve better use of it, what successful thinking means and how one applies it. Until then, I look forward to your thoughts and comments.
Disclosure: I own shares of iRadimed in my personal account at Nintai Investments LLC.

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” 
                                                  -    John Maynatd Keynes

“Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others…which by definition means your thinking has to be different.”

                                                  -    Howard Marks

When I began investing nearly 30 years ago, it was pretty much accepted that the efficient market hypothesis (EMH) was the gospel of successful investing. If you went to any Barnes & Noble’s or Borders book store (how quaint!) or took a class in college on investing, you were likely to get the simple message that stated asset prices reflect all available information all the time. The implication being that it is impossible to outperform the market consistently on a risk-adjusted basis since market prices should only react to new information. Any outperformance could be explained away by luck, circumstance, or a random standard deviation event that could be washed out with time. Warren Buffett’s classic response to this theory was his “The Superinvestors of Graham-and-Doddsville” published in Columbia Business in May, 1984 . This article, along with additional research, has called into question the validity of the EMH school and its major claims. 

Over time it has become apparent to many that long-term outperformance of the general markets is possible – regardless of claims by EMH proponents. Individuals have beaten a wide range of bogies – ranging from the domestic S&P500 to the overseas MSCI ACWI ex USA, large cap to small cap, growth versus value. Certainly Mr. Buffett’s classic article appears to have taken some the certainty of EMH and knocked it into a cocked hat.  

As I’ve spent time reading, researching, and interviewing great value investors, I’ve found the vast majority have a tendency to see things differently. Whether it be Charlie Munger’s “invert….always invert” or Ben Graham’s classic “margin of safety”, every successful value investment manager has a tendency to have their own unique thought/evaluation process or valuation methodology. 

In a recent article (“The Best Investment Advice I Ever Got”, December 31 2018) I discussed getting advice from a Board member that really made me think about my approach to value investing as well as capital allocation. Beyond the learnings I discussed in that article, one major concept was really driven home and that is the only way to overachieve (or underachieve as well!) the general markets is to think differently. For me, I’ve found that means approaching investing in several unique ways. The first is to think about quality and not quantity. I sleep better and am more comfortable investing in companies with outstanding quality measures. I’m simply to indolent and my circles of competence too small to try to understand how to turn a failing company around. The second is to think about how to approach allocating my time. There’s only so much of it, so I’d prefer to use my time in the most exciting and interesting investment opportunities as well as utilizing it in areas where I can be most effective. Sitting around and trying to find companies that are likely to fail and then betting against them I find both depressing from a moral standpoint and frankly I’m not very good at it. Last, is spending time thinking about how I think. By learning to approach things from a different angle, bringing additional data to the conversation, and creating models that generate different (and increasingly intriguing) questions, I find my outcomes are generally better in terms of performance and the role as a capital allocator far more interesting. 

Similar to my last multi-volume articles of fundamental business analysis, I thought I’d spend some time working through the process of thinking differently – what it means, what are some processes, and what are some working examples. In this – the first of three – I thought I’d start by taking a look at one of the main drivers of how I think differently from more traditional value investors – focusing on quality over quantity.  

Thinking About Quality….Not Quantity

In one of Warren Buffett’s many notable analogies, one of the more interesting to me has been the idea that an investor has a punch card with only 20 available punches (or investment opportunities). He describes the concept in the following manner: “I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches - representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all. Under those rules, you'd really think carefully about what you did, and you'd be forced to load up on what you'd really thought about. So you'd do so much better."

Frankly, I don’t know many - if any - investment managers who have lived by such a strict regimen. One of the real advantages an individual investor has over professional managers is you can begin such a process as Buffett’s punch cards at any time over your investing career. Whether you are just starting out or have been at it for 25 years, honing your portfolio down to just 20 stocks can be a great exercise. No matter how you define quality – high returns on capital or equity, deep competitive moats, zero debt, etc. – as you hone your portfolio down, it will inevitably be very different than any major index.  

As an example of this type of punch card focused, low turnover investing, I thought I’d take a look at some of the initial investments made in the early days at Nintai Partners’ internal investment portfolio (neither the company nor its investment portfolio exists anymore). With 20/20 hindsight, I’m surprised by the large percentage of holdings that remained in the portfolio for the entire lifetime of the firm. Of a total of 31 investments made from 2001-2002, roughly 55% were held until the firm closed in 2015. 

Looking at the history of these holdings, roughly one-half of the investment portfolio (we generally held portfolios with 20-25 holdings) punch card had been punched within the first year or two of investing. In nearly everyone of these holdings, the investment was in a company that met our own “high-quality” definition: high returns on equity, assets, capital, little/no debt, significant competitive advantages (often a monopoly or duopoly), and managers who were outstanding capital allocators. 

A Working Example

One of the companies that was an initial purchase in the Nintai Partners’ portfolio was Manhattan Associates (MANH). The company originally turned up in a research report we were generating for a supply management business. After the project was completed, we spent a great deal of time doing further research and made out first share purchase in July, 2001. We added to the position all the way though 2010 when the shares dropped significantly below our estimated intrinsic value. Seen below is a high-level summary analysis of the company and some key measures we looked at to assist in our investment decisions. 
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We saw the company as a classic instance of quality preventing us from spending time researching a huge quantity of potential investments.
 
Revenue: With the exception of the Great Recession, MANH saw relatively steady growth from 2001 – 2015 growing revenue from $156M in 2001 to $556M in 2015.
Profitability:  The company saw return on equity and return on capital expand from 12.8% and 32% in 2001 to 54.8% and 62.1% in 2015.
Fair Value: Nintai Partners’ estimated intrinsic value increased from $8.00 in 2001 to $50.00 in 2015. Share price increased from $7.52 in 2001 to $71.16 in 2015.
Shares Outstanding: While increasing ROC dramatically during the 2001-2015 time period, management purchased shares in large amounts decreasing outstanding shares from 123,000,000 in 2001 to 74,000,000 in 2015. 
Balance Sheet Strength: The company had no debt starting in 2002 remaining debt free through 2015 and saw cash on the balance sheet increase from $104M in 2001 to $129M in 2015.
Free Cash Flow: Free cash flow increased from $33M in 2001 to $132M in 2015.
 
Conclusions
 
From 2001 until the closure of Nintai Partners in 2015, Manhattan Associates allowed Nintai’s management to steadily invest in a a high-quality company that simply got better over time. Management didn’t need to be looking for a portfolio replacement on an annual basis, they weren’t reading hundreds of annual reports, and they didn’t need to question whether there were better opportunities to allocate capital. Over the full time of Nintai’s investment, the company’s stock achieved an annual return of 21.7%
 
Once you find a company of extraordinary quality at a reasonable discount to your estimated intrinsic value, it makes sense to let management and time to do the heavy lifting when it comes to investment returns. Whether it be a jumbo cap (like Warren Buffet’s Coca Cola (KO) purchase or a much smaller company like Manhattan Associates, finding a high-quality company at a discount price – combined with the advantage of time – can make your long-term returns compelling.
 
In my next segment, I will discuss the concept of time and how it is greatly misunderstood in the investment process. Until then, I look forward to your thoughts and comments. 
 
DISCLOSURE: Manhattan Associates is owned in several Nintai Investments LLC individual accounts.

In this - part four - of a four-part series on fundamental business analysis, I will continue using SEI Investments (SEIC) as a case study taking readers through the three major components of a successful FBA. In this article, I will bring readers through the major steps in analyzing the history of SEI Investment’s growth and whether that growth can continue. In particular, I will focus on whether the company’s growth has added value - and will continue to add value - through scalability, capital allocation, and strength of management.
 
A Note on Value versus Growth
 
Many dyed-in-the-wool value investors look for companies with low price to earnings (PE), price to book (PB) and price to sales (PS) ratios (like my former co-worker and friend John Dorfman). Most don’t prefer to pay up for growth like I am. In my world, I find it hard to achieve long-term value creation by simply buying something super cheap and hoping it becomes less cheap. This certainly separates me from the Ben Grahams and Walter Schloss’ of the world. Some – like John – insist I’m not a value investor at all but rather growth-at-a-reasonable-price (GARP) investor.
 
Yet to me growth AND value are an essential part of my investment thesis as an asset manager. But it’s not just growth for growth’s sake. Many people cite the following quote from Warren Buffett to highlight his thinking that the distinction between growth and value is really just a straw argument.  
 
 “Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago).
 
In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
 
Most people put emphasis on the first part paragraph of this quote, and quite entirely miss the vital importance of the latter paragraph. That last sentence takes some time to sink in. I got a much better understanding of it now after running a business myself. Growth can most certainly have either a negative or positive impact. As a manager and owner, one is constantly pressed for growth – whether it be greater market share, increased revenue, earnings growth, etc. But one should always remember - growth comes at a cost and growth doesn’t always create value.
 
Utilizing SEI Investments, I wanted to evaluate the value of growth and its impact on long-term value creation. I think there are four major components to growth that need to be analyzed before an investor can be comfortable they are investing in a true compounding machine.  
 
Scalable: The first area of interest is whether the growth achieved previously can be achieved in the future. In other words, is the growth scalable? This can be achieved in many ways. Is the market large enough that growth can be maintain simply by growing customer base regardless of competition? Conversely, if the market share is finite, can the company continue to capture market share by beating its competition? In the case of SEI Investments, according to Statista, the financial technology (FinTech) market has grown by 11.8% since 2008. Estimated CAGR growth through 2023 is 8.2% with an end value of $1.3B. Over the past 10 years SEI Investments has grown revenue by 4.6%, earnings by 10.8%, and free cash flow by 7.7%. These numbers include the Great Recession of 2008-2009 which hit the company’s growth hard. Looking at Statista’s market growth numbers, its entirely possible that SEI Investments could grow over the next 10 years just as well the previous 10. Its growth numbers are pretty much in-line with industry averages. Growth certainly seems scalable without even having to capture additional market share.   
 
Capital Returns and Requirements: Growth adds no value if the cost of achieving it exceeds its financial benefits. One way to measure whether SEI Investments’ growth has added long-term value is to measure its return on capital (ROC) versus its weighted average cost of capital (WACC). In other words, is it making greater returns than it costs to finance it. For the period 2008 – 2018, SEI Investments’ average return on capital was 35.1%. For the same period, it weighted average cost of capital was 10.0%. Over the same duration, SEI Investments’ average capital expenditures averaged 5.4% of revenue. Here we have a company operating with small amounts of capital spending and high returns on capital. In my experience, these are hallmarks of a long-term compounding machine. 
 
Quality Maintenance: Another essential component for having growth add value is that quality is not lost as the corporation expands its operations, staff, and product lines. Achieving rapid growth and developing an unhappy (and shrinking) customer base is not a means to achieving long-term value. One way to look at whether quality is being maintained (particularly in the service industry) is customer retention. Happy customers are long-term customers. In talking with SEI Investment’s management in October 2018 management cited the following retention rates by product group. Private Banks (94%), Investment Advisors (97%), Institutional Investors (96%), Investment Managers (94%), Investments/New Business (too early to tell). Retention rates in the mid-90s tell me that SEI Investments’ customers are a quite satisfied group and over time should provide the company with a strong and steady base for growth.
 
Management Ability: Management has to have the ability to manage growth that achieves long-term value for its shareholders, the company, and their employees. Obviously achieving high returns on capital and equity demonstrate a certain ability to wisely allocate capital. Another great measure is to take a look at goodwill on the balance sheet. Goodwill is simply the difference between what management pays for an asset and its actual value. The values employed are somewhat subjective (meaning defining current value), but it’s obvious management might not be great capital allocators when you see vast amounts of goodwill written off over time. In SEI Investments’ case, the company carries just $64M in goodwill on a balance sheet that has $1.9B in total assets. This represents just 3.3% of total assets. For the 10 years previous to 2018 that number was 0%. No question that management has wisely allocated capital over time. 
 
Conclusions
 
The process of fundamental business analysis should give an investor a much better understanding of a potential holding. Whether it be the company’s financial position, its competitive moat, or management skills (along with many other aspects of the business), the investor should be able to have a conversation about the company that demonstrates a deep knowledge of how the company makes money, how it’s going to keep making money, and how it will compound value to its shareholders over the long-term.  
 
SEI Investments is a gem of a business. As a holding in Nintai Partners’ investment portfolio, it steadily added to my long-term investment returns. When I first purchased the stock in 2003, I paid $14.41/share. The company was generating $2.86/share in revenue and $0.71/share in free cash flow. It was achieving return on equity of 43.7% and return on capital of 57.8%. When I sold the company in 2015 the company was generating $7.87/share in revenue and $1.97/share in free cash flow. It was generating 26.1% return on equity and 50.3% return on capital. I sold the shares at $51.29/share. I would have likely continued to hold the stock if I hadn’t closed down Nintai Partners. I repurchased the shares while at Dorfman Value Investments. 
 
I hope this series has helped investors understand the value of conducting fundamental business analysis for any possible addition to their portfolio. Achieving a deeper understanding of how a company makes money and its potential to add long-term value to your portfolio returns can be a huge advantage over Wall Street who remain focused on quarterly earnings. As an individual investor, this long-term advantage can make all the difference between adequate and outstanding returns. 

In this - part three - of a four-part series on fundamental business analysis, I will continue using SEI Investments (SEIC) as a case study taking readers through the three major components of a successful FBA. In this article, I will bring readers through the major steps in analyzing a company’s moat. This will include the major traits of the moat, how the company developed and implemented these components, and steps required to maintain or even broaden its existing moat.
 
It might be good to start by defining what the meaning is of a moat and its major components. I define a competitive moat as the capability of a company to outperform its competitors by achieving high returns on capital, increasing market share, and structural advantages in technology, operational efficiencies, etc. It achieves this moat with a business model that fosters these advantages over a period of 10 to 20 years. Morningstar lists five major sources of moats. These include:
 
Network Effect: Similar to Metcalfe’s law, the more people who use a network, the more powerful a network becomes. A great example of this Uber. The greater the amounts of drivers and riders, the more valuable the Uber network becomes.
Switching Costs: Once a company’s product becomes embedded in the business operations of customers, the harder it becomes to remove the product/system and replace with another. An example of this is electronic health records within the hospital setting. After training, development of order sets, and operational customization, switching to a new system becomes nearly impossible.
Intangible Assets: This can include patents or licenses. This assures customers must use the product or service that is legally or from a regulatory standpoint the only option. FDA approved drugs are a great example of this.
Pricing: Sometime the big guys can simply outprice the smaller guys. Just ask any local store that competes against Wal-Mart.    
 
Sources of SEI Investments’ Moat
 
The company has created its moat through two product lines - TRUST 3000® and the SEI Wealth PlatformSM (the SEI Wealth Platform or the Platform). SEI owns, develops, maintains and operates these software applications and associated information processing infrastructure and facilities. Through their wholly-owned subsidiaries, they also provide business-process outsourcing services including custodial and sub-custodial services and back-office accounting services. Through its fully-integrated suite of technology and services, SEI Investments creates a turn-key offering that can be used by almost any asset management firm including private banks, trust institutions, and mutual fund companies. SEI Investments is perceived as a market leader in its technology, platform integration, breadth of offerings, and return on investment on their product and services.
 
Creating a Barrier to Entry
 
A vital aspect of SEI Investments’ competitive moat is the sheer amount of labor, dollars, and competitive intelligence that has gone into creating both TRUST 3000 and PlatformSM. Over the past 10 years it’s estimated the company has spent over $500M in product and research development. SEI Investments has increased R&D spending from 7.7% of revenue in 2015 to 10.2% in 2017. The ability of a competitor to have access to both the financial and intellectual capital to recreate these two platforms would be an extraordinarily difficult task. Once these products are launched, they are scalable to new customers at nearly no cost to SEI Investments.  This creates a business model remarkably light in assets (other than the intellectual property and proprietary technology) and requires little capital to operate and create growth.
 
Inverting this issue, the ability of SEI Investments to operate such an asset light business allows the company to generate remarkable gross and net margins along with returns on capital. This creates excess cash thst can then be employed in expanding internal capabilities (such as increased R&D) or acquiring outside functionality or snap-on acquisitions. This virtual circle creates a deep and ever-widening moat in its competitive space.
 
Switching Costs and Customer Dependence          
 
SEI Investments’ products and services are deeply embedded in the business operations of their customers. The TRUST 3000 platform is essential for asset managers to successfully manage all their securities processing and investment accounting for both domestic and foreign securities – two of the most important functions in the business. SEI Wealth Platform provides investment processing, infrastructure services, and advanced capabilities to support wealth advisory, asset management, and wealth administration functions. The Platform also provides global wealth management capabilities including a 24/7 operating model, global securities processing, and multi-currency accounting and reporting. Built around a client-centric relationship model, Wealth Platform uses an open architectural approach and supports workflow management and straight-through processing. Both of these platforms are provided in either a Software-as-a-Service or Platform-as-a-Service model.
 
The functionality of these two offerings mean the decision to switch out to a new vendor is neither cost-effective nor knowledge-based effective. As long as SEI Investments can maintain both a quality and functional lead, its moat is substantial from a switching cost or operational integration standpoint. The company manages or administers $920 billion in hedge, private equity, mutual fund and pooled or separately managed assets, including $339 billion in assets under management and $576 billion in client assets under administration. Putting a dime of those assets at risk is not worth it to the 8,900 clients who use SEI Investments’ products and services.
 
Regulatory Requirements
 
Anybody who has worked in the asset management business knows that state and federal regulators earn their dollars in the extent and detail of their regulatory oversight. Between the SEC, FINRA, and pertinent state regulators you better have your ducks in a row. And that ‘s not even mentioning all the overseas regulators and potential violations that can be achieved in a blink of an eye by some office in Kobe when you’re not looking. That’s where SEI Investments digs its moat even a little deeper and a little wider.  
 
SEI Investment’s customers face an ever-changing regulatory environment. For instance, recent (and continuing) legislative activity in the United States and in other jurisdictions (including the European Union and the United Kingdom) have made and continue to make extensive changes to the laws regulating financial services firms. Recent changes include the effectiveness of the Markets in Financial Instruments Directive (MiFID II) and pending effectiveness of the General Data Protection Regulation in the European Union and the U.S. Department of Labor's Fiduciary Rule. Every one of SEI Investments’ 8.900 clients know that the company’s products and services have to reflect these changes every day. There aren’t any competitors with the intellectual knowledge base, skill sets, regulatory knowledge, and technical abilities to update their product and service offerings on such a regular basis.    
 
Conclusions
 
A solid fundamental business analysis will dig deep into understanding how and why a potential portfolio holding has a competitive advantage. The ability to tie in knowledge about competitors, product and service offerings, customer segmentation business needs, regulatory requirements, and the company’s financial strength to maintain and extend its moat is vital. Without this understanding, it’s difficult to predict how successful this potential investment might be in 10 to 20 years. Is the fundamental business analysis process a perfect predictor? Certainly not. Will it help you understand the potential ability of the company to create long-term value?  Sometimes. But one thing is certain. It is unlikely to hurt in developing your understanding of the company’s business case.  
 
In the last part of this series, I will finish with researching the capabilities of a company to both produce and manage long-term growth. Until then, I look forward to your thoughts and comments.
 
DISCLOSURE: I currently own SEI Investments in individual investment accounts at Nintai Investments LLC as well as the Hayashi Foundation.   
 

​My previous article talked about the role fundamental business analysis (FBA) plays in my style of value investing. I thought I’d use a holding in both the Nintai Investments LLC and Hayashi Foundation’s portfolio - SEI Investments (SEIC) - to focus on how I utilize such analysis to both reduce risk and assess growth potential for each portfolio holding. At the end of each calendar year, I will complete an assessment of each holding as if it is a potential investment I might be interested in purchasing. This fresh start - so to speak - forces me to think through each component with an unjaundiced eye (hopefully!). The next three articles will go into detail about the three major components of an FBA.

1. What Story Do the Financials Tell?
2. How Exactly was the Moat Built and Maintained?
3. What are Characteristics and Capabilities of Growth?

 
My next three articles will delve into each of these three questions utilizing SEI Investments as a business case and walking through each component.
 
Corporate Summary
SEI Investments is a global provider of investment processing, investment management, and investment operations solutions. This includes the back-end operations of any medium to large investment operation. The company provides a platform flexible enough for family offices to large asset manages in both operations (fund administration, regulatory, etc.) and processing (by utilizing a technology platform that services clients’ sales to performance reporting). Recently, the company has moved into the investment management business itself offering financial advice and even managing SEI funds.
 
What Story Do the Financials Tell?
 
As of Q4 2018, in general, the financials of SEI Investments describe a company with compelling financial strength, very high liquidity, no debt, steadily decreasing share count, and a management team with outstanding capital allocation skills. Diving somewhat deeper, the company has high gross (55.6%) and net margins (31.5%), significant free cash flow margins (30.0%), and high returns on invested capital (26.4%). The company has been free cash flow positive since 2003, generated 4.8% average annual revenue growth of the past ten years as well as 10.6% earnings per share growth and 7.8% free cash flow growth over the same time frame. As one would expect, the company’s revenue and profits slumped during the 2008-2010 Great Recession though never achieving negative free cash flow during any of those years. In the period 2008-2018 the company share price increased by a cumulative 223%.  The story describes a steadily growing company (with the exception of the Great Recession) while consistently increasing revenue, earnings, and free cash flow in the high single digits.  
 
Cash Flow Statement
When I look at the statement of cash flows, my top priority is looking at the overall strength of liquidity of the company. In short, what areas of distress could cause significant damage to my business case. Several modern formulas such as the H-Score and Z-Score can help test the company’s overall financial strength. At a high level, these scores tell the investor what areas of weakness exist in the financial model of the company. The next area of priority is seeing a steady rise in free cash flow over a decade or two. As mentioned, SEIC achieved 7.8% annual growth in free cash when even including numbers during the Great Recession. The third area of interest is the quality and clarity of the numbers themselves. For instance, is there detailed information on the relationship between free cash flow and earnings? Do the earnings growth numbers generally move in a proportional manner with free cash? Last is the cost of stock-based compensation. Every share given out to management dilutes you as a shareholder. I cringe every time I see numbers stock compensation in the millions and dilution by 1-2% annually. SEIC has reduced share count from 216.6M in 2003 to 160.5M in 2018. Clearly management has not utilized stock options to the detriment of shareholders.
 
When I’m completed with my evaluation of the cash flow statement, I should have a very solid understanding of how well the company manages its cash flows, whether management are compensated in a shareholder-friendly manner, and whether management is trying to fudge the earnings numbers that simply don’t map to cash flows. Dishonest managers will seek to fool shareholders. The cash flow statement will give away whether they are trying to fool themselves. Finally, I should feel a level of comfort that even the worst-case scenarios can be handled with both free cash generated from operations and the availability of debt financing if needed.     
 
Balance Sheet
The balance sheet is very different from either cash flow statements or income statements because they show the financial condition of the company at a particular moment in time rather than a set period (such as a quarter or year). Generally, this is year-end (either fiscal or calendar). The balance sheet ties into the cash flow statement in that it gives you another look at the liquidity of the company. You have both assets (what the company owns) and liabilities (what the company owes) listed on the balance sheet. The most critical aspect I look for is that the company has no (or almost no) debt. As I’ve said many times before, no company has gone bankrupt without any debt. The great news is that SEIC has no short or long-term debt. The second area of interest I look to evaluate is goodwill. Goodwill is the excess of purchase price over the fair market value of a company's identifiable assets. In plain English, how much did you overpay for assets that you acquired? Seeing numbers where goodwill makes up 25-30% of total assets can make me queasy pretty quick. Essentially that large amount of book value can evaporate over night if an auditor decides the asset has simply been inflated in price or has become impaired. The biggest loser when this happens? You – the shareholder. Currently, goodwill makes up 3.3% of SEI Investment’s total assets. That’s a great number to see as an investor.  
 
Income Statement
In the past 25-30 years, the income statement has become the most vital financial document for financial analysts. This is because it tells Wall Street whether the company will meet its expected quarterly earnings and whether future guidance will be in-line with analysts’ estimates. If you really want to play along with Wall Street’s earnings game, then this document is for you. For those more old-fashioned value investors, this document holds far less appeal. My first priority in this document is to make sure earnings growth/decreases generally match the free cash flow statement. The number of companies who manipulate earnings on a regular basis is truly shocking. Companies can do this in almost any conceivable manner. One is to report non-Generally Accepted Accounting Rules (GAAP) numbers such as claiming payroll really isn’t a cost. Others might claim revenues before payment is received. Another popular option is claim certain liabilities are “off-budget” and removed from the balance sheet. All sorts of techniques are used to manipulate earnings. Second, even with all these opportunities to cheat (for that is what it really is), it’s good to see earnings increasing steadily over time (sometimes this can be lumpy but that’s OK). Again, matching these numbers to free cash flow growth/decreases can make a big difference in your confidence of the numbers. SEIC grew earnings at roughly 10.6% annually from 2008-2018. The second area of interest are margins (gross, net, and free cash). These should show a steady pattern of solid performance if not slight improvement over time. Last – and most important – are the returns generated by the business: return on equity, return on assets, and return on invested capital. In general, these tell you whether management are adequate, good, or outstanding allocators of capital. In essence, are they are putting the company’s capital to work in a profitable manner that increases profits and grows the value of the business.   

Conclusions
 
As a value investor, understanding the financial reports of your portfolio holdings is essential to achieving long-term outperformance. Basic math skills and accounting are the language of business. If you can’t speak the language, you will be blind in areas of tremendous importance to assessing value and allocating capital. One doesn’t need to be a genius in algebra or advanced mathematics to succeed. I was a straight C and even D student in math right through college. But finding a mentor and several books that work through the issues and formulas I discussed here will be essential in your growth as a value investor.
 
In my next article, I will walk through how SEI Investments created, maintains, and hopefully increases its competitive moat going forward. Until then, I look forward to your thoughts and comments.
 
DISCLOSURE: I currently own SEI Investments in individual investment accounts at Nintai Investments LLC as well as the Hayashi Foundation.   
 

“Getting inside the guts of a business and understanding how it works really isn’t that interesting or sexy. I remember sitting on an assembly line and watching three people add a small piece of felt on to a rubber ducky. I must have spent three hours watching this process. The workers did these thousands of time each week. When I asked about it, management told me they had recently fired the entire team and hired outside temporary laborers to complete the work. We ended up not investing in the company but I did notice about 6 months later they were engaged in a huge product recall dispute because the felt pieces weren’t applied correctly and several children had choked on them. Now I didn’t KNOW this was going to happen, but in our deep dive research of the business, I’d seen dozens of areas where new management were cutting corners and I thought it was only a matter of time before something blew up. That’s why we conduct fundamental business analysis.”   
 
                                                                                                -      Wes Leason, Jr. 

Fundamental business analysis can either be the most exciting or most boring part of the investment process. As a former consultant, it is second nature for me to break down the major components of a company, create a business operations map, and then tie that to the broader markets, company financials, and direct competition. It’s a lot of work and I don’t know many other investors who complete a full business analysis. Some of this is due to the sheer number of stocks in the portfolio, others prefer to spend time focusing on ratios (price to earnings, price to book, price to sales) and some are focused on things like stock price momentum or macro-economic numbers.
 
Why Do It?
 
I’ve found that fundamental business analysis gives me a huge leg up on my competitors because it allows me to see my investment through the eyes of the business owner. I want to understand what the major drivers are of margins and free cash flow and what management can do to improve operations to maximize these. I’d like to understand what restrictions have been imposed on management’s capital allocation choices because of debt levels.  Essentially I want to understand the operations and key drivers of what makes this company successful and profitable. Equally – if not more important – I want to know what types of events would impact or impair my business case. Through fundamental business analysis, I look to get three key insights into the business.
 
What Story Do the Financials Tell?
 
As a value investor, I have a tendency to look at corporate financials a little bit differently than most. I start with the Statement of Cash Flows, move to the Balance Sheet, then finish with the Income Statement. I place very little emphasis on earnings. I’ve found over time they are the easiest numbers to manipulate. I try to stay focused on free cash. On the balance sheet I look for no short or long-term debt. I also look for high amounts of goodwill. Don’t get me wrong, some goodwill is valuable – like Coca Cola’s brand. Others, not so much. After purchasing aQuantive for $6.3B in July 2012, Microsoft was forced to take a $6.2B write off less than 6 months later. That type of unforced error drives me crazy. I like to see goodwill represent less than 5% of total market cap. Finally, I love to find companies where cash and cash equivalents can pay off all liabilities without even touching operating income. On the statement of cash flows I look for companies that convert roughly 25% of every dollar into free cash. 
 
In essence, the financials should show s company with strong competitive advantages achieved through high returns on capital, financial flexibility through no debt, and outstanding capital allocators in management. Inversely, the should tell you the areas of concern that might lead to real distress down the road.
 
How Exactly Was the Moat Built?
 
This question can only be answered by an extraordinary level of research where an investor really needs to roll up their sleeves and dig into the company, its markets, and its competition. Evaluating a moat is similar to 3-D chess. First, you must understand the dynamics of the moat (meaning its source: customer demand versus need, switching costs, brand strength, pricing power with vendors, etc.). Second, you must understand the market dynamics (key players and their relationships, product/service development, competitive players and their strategies, market niches, etc.). Last, you must be able to map out what you believe are the major trends and their outcomes for both your potential investment as well as the industry. This includes assigning a range of probabilities of these events happening. 
 
A great measure of how well you have succeeded in this endeavor is not only the level of comfort you have talking with management of your potential investment but also a wide range of players including vendors, competitors, and industry knowledge thought leaders. If you find yourself comfortable asking and answering questions to this range of players you’ve accomplished your goal. As an example, I remember the first time talking to a pharmaceutical company and they kept discussing ambulatory versus hospitalists. The fact I had to look it up meant I wasn’t nearly ready to invest.
 
What are the Characteristics and Capabilities of Growth?
 
Perhaps the greatest problem for management is the ability to handle growth. We’ve all seen those UPS or FEDEX commercials telling companies to “let us handle the growth in your shipping needs”. They run these ads for the simple reason it’s true. Most companies can’t handle growth, and growth is the only way you are going to achieve long-term outperformance in your investment portfolio.
 
In a McKinsey article[1], the authors point out some great reasons why companies hit a wall and can’t grow anymore. They range from growing market share until there are no additional opportunities, management becomes complacent as they’ve reached a level of performance that assures high profits and steady revenue for the company, or organic growth is no longer an option and they begin to look at M&A as an option (I’ve written about the generally horrible returns from M&A before so watch this carefully). A great example of dealing with these issues was a company I owned from 2000 – 2015, Fastenal (FAST). As a company that sold replacement parts it seemed the company has tapped out its market by saturating areas with distribution centers. The company came up with the idea of micro-centers provided through on-site vending machines. Customers can purchase the highest requested product right on site with no delivery wait time. Fastenal achieved another decade of growth through this strategy. Now if only I was smart enough to see that coming.    
 
Conclusions
 
Fundamental business analysis isn’t fun (unless you are odd like me) or sexy. The knowledge you gain from such research will pay you back in multiple ways going forward. Every time you begin the journey of learning about a potential investment and its industry, this knowledge builds on other companies and markets until you can weave that infamous “mental models” discussed by Charlie Munger. Understanding what happens in drug development can help you better understand the development of a software application. The more you learn the stronger the investor you will be. You can’t be unhappy about that.

DISCLOSURE: I do not own Fastenal in any of Nintai Investments LLC individual accounts or in the Hayashi Foundation portfolio. 
 

[1] “Why The Biggest and Best Struggle to Grow”, Nicholas F. Lawler, Robert S. McNish, and Jean-Hugues J. Monier, McKinsey, Commentary, January 2004   https://mck.co/2ChUvpw