“I think a great capital allocator will intuitively understand that there really isn’t anything he or she can do to improve long-term returns. Most of the time they understand the decision to partner with a particular management team is the most fruitful action of the entire relationship.”
 
                                                                                   -         Bill Bishop 
“Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.”
                                                                                   -        Will Rogers 

There’s a lot to be said for both Mr. Bishop’s and Mr. Roger’s thinking - though I think good old Will would have been more successful if he had those seeing eyeglasses. And that’s the problem. Most of us might know a good company when we see one. We just don’t know whether it will be a great stock.  My last article discussed in detail (perhaps too much!) about what type of knowledge is necessary to really grasp the issues facing a modern US-based healthcare company. In that article I used iRadimed (IRMD) - an MRI compliant pump manufacturer – that makes pumps that can safely operate in an MRI setting. In the article, I walked through some of the major knowledge requirements I recommend an investor have as they begin their investment journey into the healthcare markets. 
 
The “Short and Shoddy” Healthcare Investment Process
 
Several readers have reached out to me since that article’s publication to see if it is absolutely essential that investors develop such a skill set.  It’s not unreasonable to see if there is a “short and shoddy” way to quicken the process. Some readers may be surprised to hear me say absolutely yes. There are several ways to do this. First – and the most obvious and easiest – is to find a high quality ETF or focused fund in the industry you look to acquire assets. For instance, the Vanguard Health Care Fund (VGHCX) is an outstanding way to get some healthcare coverage without a lot of real grunt work. Another approach is to find very high quality companies with deep competitive moats and long runways of growth. Of course, you have to wait for the right price, but if you are patient it is possible to find a company that can give you exposure and provide your portfolio with a decades-long anchor that can drive substantial outperformance. 
 
Since my article was on healthcare, I thought I’d use the same industry as an example of finding such a company. Let me start by saying that if there was an industry most suited for the “short and shoddy” approach, it would healthcare. Having made myself a complete hypocrite with this statement, let me explain my thinking. Healthcare - as an industry in the United States – is roughly one-half for profit and one-half not-for-profit. The for-profit part can be heavily regulated producing monopolies and duopolies. This can also create companies with extremely high returns and profitability. In a sense, there is no better market sector to stumble into diamonds without too much effort. There are three reasons for this.
 
First, a large portion of the healthcare industry is regulated by federal and state agencies. A lot of leg work such as product safety and good manufacturing processes (known as cGMP) are already inspected by industry regulators. Second, healthcare provides thousands of companies with exclusive rights to medicines or machines that save lives. This exclusivity can range from 7 - 20 years. Third, the healthcare industry is a steady marketplace. The life cycle of birth, life, sickness, and death is immutable. People need healthcare regardless of market conditions. For these reasons, healthcare can allow value investors to sometimes shorten (dare I say slightly cheat) their research process. This doesn’t take away from the fact that healthcare really is an incredibly complex ecosystem. It just means that if one knows what to look for, sometimes the diamonds are lying in plain sight.
 
So what should an investor look for in their “short and shoddy” investment research process? It isn’t much different than my existing approach, but might be slightly different than most other investors’. The key is looking or smaller companies with high returns on equity and capital along with strong balance sheets. This doesn’t always indicate a company with a wide competitive moat, but I’ve never found such a company without these type of numbers. Another thing to look for is announcements about FDA approvals for their products. Last, it should be in a segment of healthcare with steady revenue and growth. Think along the lines of something like lab testing or saline solution which is constantly used in a clinical setting.
 
An example of this type of company is Nintai Investments’ holding Masimo (MASI). With a market cap of $8.2B, MASI is in the mid-cap range with ample opportunity to grow over the next few decades. Masi is a medical device company focusing on noninvasive patient monitoring. It began by creating a device that nearly any hospital patient will recognize – an oxygen and pulse reader that clamps at the end of your finger tip and allows doctors to see your oxygen and pulse levels. Every emergency department and primary care physician uses these devices on a daily basis.
 
Masimo’s Financial Story
 
We can start by reviewing Masimo’s financials. These should tell a story of high returns based on a deep competitive moat combined with a company product in a steadily growing marketplace. First, the company as a long history of generating above average return on equity, return on invested capital, and return on assets. 

​While fluctuating year by year, on average the company has done an outstanding job over the long term. These types of numbers tell us two things: the company earns considerable profits on generated revenue and management has done a great job in allocating capital.  
 
From another angle, the company has done an outstanding job growing both earnings and revenue. While free cash flow has grown at a slower rate, it has picked up considerably and should continue to increase with Masimo’s recent deal with Phillips as well as leveraging its installed base. 

From a financial standpoint, Masimo’s story is compelling. It has been able to grow earnings and revenue at double digit rates while maintaining outstanding returns on capital and equity. These are all signs of a company with a deep competitive moat and a management team that knows how to take advantage of it.
 
Masimo’s Moat
 
Sometimes being able to ascertain the strength of a moat in healthcare can be difficult. Everything from the microbiology and chemistry behind a biopharmaceutical patent to understanding the technology, professional acceptance, and clinical outcomes of robotic surgery, can demand enormous industry knowledge. But there are some companies like Masimo that don’t require technological, industry, or clinical expertise. For instance, read Morningstar’s description of Masimo’s moat. In two paragraphs, a savvy investor can understand that the company has a strong competitive position.
 
“The pulse oximetry market is an effective duopoly between Masimo and Covidien (now Medtronic), with Philips and GE Healthcare representing a minority 10%-15% share. Masimo’s share of shipped units has grown from 30% at the beginning of the decade to nearly 50% today thanks to superior products that are more accurate and reliable than the competition. The company is agnostic about how its units get to market, whether directly in Masimo-branded monitors or through OEM devices using Masimo SET. Of the company’s approximately 1.5 million installed units, only a fourth are Masimo devices; the remaining three fourths are OEM multiparameter monitors containing a Masimo circuit board. This strategy has driven returns on capital substantially ahead of our estimate of WACC each year since the company’s 2007 IPO, which to us signals the existence of a moat.
 
Masimo has left the lumpy and sales-intensive capital equipment business largely to its OEM partners, while retaining the asset-light, high-margin sensor sales business. The company relies on razor-and-blade effects to establish the installed base from which it can drive repeat sales of its disposable and reusable sensors, generally under five- to six-year purchase contracts. Masimo sensors can be used across competing systems through universal adapters, but Masimo oximetry units use a closed architecture, creating a captive sales base. Further, the company has demonstrated its ability to successfully retain customers after an initial contract win; renewal rates have remained near 98% over time, which we believe illustrates the company’s superior value proposition.”
  
By now, we’ve learned relatively quickly that Masimo is a medical device company that achieves outstanding financial results driven by a duopoly in a healthcare market that has shown steady growth rates with predictions of more of the same over the next decade or two. All of this without going into the technology behind it, the science for which it is employed, and without knowing much about the end-customer, its competition, or its supply chain.
 
We’ve reached this conclusion by coming from the nearly opposite direction that Nintai Investments employs. In healthcare, we utilize deep industry knowledge to look for players that might be overlooked due to size, complexity, or flat-out “unsexiness”. We do this – as I discussed in “Industry Knowledge” – by looking at connections or business processes missed by many with less experience in the industry. But as I’ve often said, in value investing there are many ways to skin a cat.
 
Some Takeaways
 
I believe that deep industry knowledge can give investors a leg up in finding investment opportunities. Some of the most successful investments over my investing career have been found that way. But not all. Sometimes you can find a diamond in the rough - not by knowing where to dig - but simply by knowing what a diamond looks like. Many investment diamonds - meaning companies that you can hold for decades - have common characteristics that can help you create a shortcut in your investment research. Here are a few that I’ve found over the years that can help them shine brightly as you sift through investment dirt.
 
Duopolies:  Most companies that are monopolies are well known and hard to find at the right price. Duopolies have many advantages of a monopoly but often fly below the radar. A company like FactSet Research (FDS) is a great example. Remember: It doesn’t matter whether your holding is #1 or #2 position. Just make sure there is only two.
 
ROIC Far Exceeds WACC: Companies with strong competitive moats have their return on invested capital always exceed their weighted average cost of capital. Simply looking on GuruFocus’ 30 Year Financial tab under “Ratios” can give you both numbers.
 
Their Advantage is Locked In: You are looking for a company where their advantage is secure – whether by patent (like Masimo) or by switching costs combined with technological excellence (also Masimo). Their competitive advantage should be secure for the next 10 -20 years. There aren’t many companies that can say that. Whether it be Coke or Wrigley or Masimo, as an investor you shouldn’t be able to find any major reason why the moat could be filled in or outflanked.
 
The Balance Sheet Should Be Rock Solid: If a company has a strong competitive advantage, it shouldn’t be loading up on debt or issuing convertible debt. You want management to reinvest capital back into operations when ROIC exceeds WACC. Any profits they don’t need can be retained as cash on the balance sheet, used to repurchase shares (hopefully not overpaying), or sent back to investors in the form of dividends. Running an outstanding company should not be financial rocket science.
 
Finding a company with these types of attributes isn’t that hard. In today’s world, investors can create screens on GuruFocus or Morningstar in a matter of seconds.
 
One Last Thing
 
One thing I haven’t touched on in this article has been price. In the past few pages, I’ve shown you how to create a “short and shoddy” investment approach. It can help you find diamonds in any type of industry. But it doesn’t tell you what to pay for that diamond. At Nintai Investments we use a discounted free cash flow model to ascertain value. What approach you use is entirely up to you. I should warn you up front - the lack of industry knowledge abandoned in the “short and shoddy” approach will hurt in calculating valuation. A lot of assumptions that are used in calculating value come from deep industry expertise. But if you are committed to the “short and shoddy” method, then attempt whatever is your preferred way to calculate value and come up with a number. If the price is right, then congratulate yourself for find a truly affordable diamond in the rough.
 
Conclusions
 
It’s unlikely you will find us employing the “short and shoddy” approach to finding investment opportunities in Nintai portfolios. As a professional investment manager I will use every piece of data and run as many spreadsheets as possible to increase my chances at outperforming the markets. I employ researchers or buy industry research to try to make the most informed and knowledgeable decision I can. If pressed, I would probably still rank an industry focused index fund over the “short and shoddy” approach. That said, I encourage investors to create a few search screens and find out what shows up. This isn’t an investment recommendation in any way, but more a research recommendation. It may not be exactly to Will Roger’s methodology, but I can’t help but think you wouldn’t get a nod or a wink when you told him you invested in the “short and shoddy” way.
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: Masimo (MASI) is a holding in some of our personal and institutional accounts.  

“An expert knows more and more about less and less until he or she knows everything about nothing.”

                                                                                                   -        William Mayo 

I was recently reading a great piece by Grahamites on Gurufocus (“Blind Spots in Investing”. It can be found here) and his cautionary tale about his research process related to DeVita (DVA). One of the real challenges I’ve found to exist in investing is the breadth and depth of research/knowledge that is required to have an advantage in portfolio selection. Grahamites faces the same dilemma all of us face – acquiring valuable knowledge. Let’s face it. In today’s content driven world knowledge is a pretty cheap commodity. In fact, there is far more knowledge than required out there today. But is it the knowledge we need? 
 
Before you get started, I should warn you this article turned out far larger than I originally intended. My initial thought was to scrap it, but it suddenly occurred to me that researching a company and acquiring knowledge really is this involved, complex, and timely. So if you pressed for time, the short and shoddy can be found in the conclusions section.
 
Industry and Company Knowledge: What Am I Getting In To?
 
Successful value investors find a way to ask the right questions and sift through the data to acquire truly valuable knowledge. I break such knowledge in to three buckets – breadth, depth and accuracy. If an investor can capture knowledge with these three criteria then they are 90% to the way in finding a great investment opportunity. Equally important to broadly capturing the right strategic knowledge, is getting company specific data - along with market and competitive data - which puts you in the position to know a company as well as the CEO herself. This type of knowledge takes more time and more grunt work than the first. It’s where I’ve found most investment managers fail. They find the concept of investing in a company exciting, but are often bored by the specifics that make it tick and -in the long run - succeed. Knowing that a company has a high return on capital is helpful, but knowing how it achieves those numbers is essential.                                                          
 
Before getting into the nitty-gritty about knowledge, I thought for the sake of today’s discussion, I’d use Nintai Investments’ holding iRadimed (IRMD) as a working example. The company is a wonderful healthcare technology company focused on manufacturing magnetic resonance imaging (MRI) infusion pumps and patient monitors. Since MRIs are huge magnets, it is essential that anything with metal be excluded from the imaging room. iRadimed manufactures both pumps and monitors that meet those safety standards. As we discuss how knowledge is critical for investors to acquire, gather, and synthesize, I will discuss the company, its products, its customers, and its competition in greater detail.     
 
The company is in an industry – health care - that requires an insatiable desire to learn and the capacity to synthesize knowledge. After being able to locate great data, an investor will need to know the breadth, depth, and accuracy of knowledge specific to all the moving parts of the ecosystem that iRadimed thrives in. The essential components of knowledge required - clinical care players, clinical care process, technology requirements, research and development, regulatory review and approval, competitive landscape, pricing and reimbursement models (we will get to all of these in detail later) – means that investors need both a strong structural research process (how to define and get the breadth, depth, and accuracy of research) along with tremendous applied knowledge and industry expertise.
 
We first purchased the stock in September of 2016. It peaked earlier in 2019 rising nearly 200% from our purchase price before dropping by nearly 50% since then. As of July 2019, we’ve roughly doubled our share price. Was all of that gain due to our research? Certainly not. Did all the knowledge we acquired position us to better understand the investment opportunity? You bet.
 
The Three Characteristics of Strategic Knowledge
 
Let’s start with the three dimensional approach that I mentioned about higher knowledge. First is breadth. What I mean by this is defining the limits of the company’s strategy and tactics. Is the knowledge in well-defined siloes or does it bleed into other company functional units or market segments? For instance, a technology company may focus on laser measurement tools but find its markets ranging from home-improvement to general contractors to national defense spending. In the case of iRadimed, the company’s technology and market is completely focused on facility-based MRI machines. Even this itself is quite broad and can include privately held imaging centers, mobile MRI providers, hospital-based imaging units, and research institutions. It does not include other types of imaging (CT-scan, X-ray), new technology requirements (such as prone-based units versus raised or fMRI versus traditional MRI). By placing a firm barrier around your product segmentation (meaning a defined “breadth”), technology requirements, or functional area, an investor can develop a deep expertise for a specific part of the organization or market.   
 
In depth, I am talking about understanding the limited reach within either the customer’s organization or marketplace. For iRadimed, it deals solely with imaging groups. It doesn’t sell into other parts of the hospital, it doesn’t deal with other parts of the healthcare industry other than MRIs. It’s sales force can focus on certain individuals with a specific expertise (such as VP of Imaging) with a very focused financial model and a specific focus on technology components that reside in a specific part of the organization. For instance MRI compliant IV pump parts (sold only to the Imaging Center) are not like light bulbs (sold to general purchasing with customers throughout the organization with hundreds of specific requirements (wattage, dimming, white vs. natural, etc.). As a value investor, this allows me to develop a very deep knowledge of the imaging segment of the healthcare industry.
 
Finally is the accuracy of the research. Being sharply focused allows an investor to have timely data (pricing, market share, sales growth, gross/net margins, competitive sales data, research and development costs, etc.). An awful lot or time is spent in our field calculating “value”. Bad or stale data can play old Harry with your estimates and lead you far astray from a real versus imagined value opportunity. The smaller the segment that needs to be researched, the less the chance for being far off in your calculations. Additionally, valuable data (whether because its timely or because its accurate or even rarer – both of these) can be an extraordinary competitive advantage in the investment management business. When running a focused portfolio, one great investment can make or break your performance record over the long term.
 
These three characteristics define the scope of knowledge required to best understand major segments of the business. The will allow you as an investor to then roll up your sleeves and begin capturing data that drives your investment case. Without the first group, the second group of detailed research questions will be muddled, misguided, and provide no value in developing your business case.
 
Company and Industry Knowledge: The Nitty Gritty
 
After gathering the strategic knowledge I just discussed, hopefully you found a market and a company that look like something for further evaluation. You now need data - and ultimately knowledge - on every major aspect of what makes a company successful and how it works within a specific industry. Your major concerns at this point are:
 

1. Who do I talk to and what do I read to collect all the information necessary to acquire adequate knowledge required to make an informed investment decision?
2. What do I need to know about the company that can inform me about where it will be 10 - 20 years from now – from product and service, profitability, financial, management, and technology aspects?
3. What do I need to know about the market/industry that can make my investment case close enough to be helpful in developing long-term investment assumptions?   

   
Let’s start with the company continuing to use iRadimed as an example. What are the key knowledge components of the business we must understand to inform us about long-term value? The first bucket is related to their product. The following questions will allow us to better understand how it works, how long can we expect it to work, and what progress is necessary for it to still be a market leader in 2039?
 
Product Development
 

1. What is the development history of the product?
2. Are members of the iRadimed team part of that development history? If so, for how long? In what role/capacity?
3. Does the team have experience with the end-user community (meaning the healthcare imaging community)?
4. Does the product work in both an industrial as well as academic/research setting?
5. What is the development time line for next generation development?

 
Overall, iRadimed’s team was in on the ground floor in the development of MRI compliant pump technology. Roger Susi, founder of iRadimed was also the founder of Invivo Research - the first MRI compliant pump. After selling the company and watching competitors implode, Roger founded iRadimed to drive the technology into the 21st century. The team had deep ties into the imaging community as well as strong relationships with FDA regulators vital for future product approvals. iRadimed’s product works in any MRI facility – whether commercial or academic. In the last several years, iRadimed has broadened its work into the adjacent field of MRI-compliant monitoring systems that work hand and glove with their IV pump systems.
 
Regulatory
In healthcare, regulatory can be all-encompassing (such as biopharmaceuticals) or not relevant at all (selling over the counter cherry throat lozenges). In this case, iRadimad operates in a highly regulated part of healthcare.
 

1. What products currently have FDA approval and what is the length of their patent protection?
2. What has been iRadimed’s history when it comes to FDA submissions and approval rates?
3. For instances such as complete response letters, how has the company dealt with these? Have they been successful in overcoming them?  
4. What new products are under review currently and what does the submission pipeline look like?
5. As the company looks at overseas expansion, what is the status of IRMD’s filings in the EU, and Japan markets.

 
The MRidium pump, the iRadimed 3880 monitor, and the iMagox pulse oximeter are fully approved by the FDA and are being use in the clinical setting today. As of the end of Q1 2019, the company still operates under an Open Warning Letter first received in 2014 related to the MRidium 3860 and 3850 software upgrades. While still open, the FDA gave 510(k) clearance in 2016. In addition, in January 2019, iRadimed received notification that the Agency’s review of their 3880 MRI compatible patient vital signs monitoring system could not be completed as aspects of clinical evaluation reporting, as required by newly issued guidance from the European Union. IRMD immediately suspended shipments of their 3880 patient vital signs monitor to all markets requiring a CE Mark. They are addressing the technical non-conformity, though temporary EC Certificate extends through July 27, 2019.
 
Competition
Competition can be the key driver in how long your investment’s moat maintains its depth or generates high returns on capital. In iRadimed’s case we are lucky in that the company has a true monopoly protected by FDA approvals. That said, it is still critical to understand where competition may be coming from.  
 

1. What companies (if any) provide MRI-compliant IV pumps, monitors, or pulse oximeter? If any, what is their regulatory status in US or overseas markets?
2. Are there any current filings with the FDA seeking approval for any of the three IRMD products?
3. Since Bayer’s departure from the MRI-compliance space, has any other healthcare or technology player discussing the space?
4. Has there been any discussion of mergers or acquisitions to try to merge technologies or products?

 
Competition in the MRI-compliant market has been nearly non-existent since the FDA granted IRMD their 501(k) FDA Premarket license. Bayer’s departure from the market has only tightened IRMD’s monopoly position.
 
Market Size and Growth
Finding a compounding machine means finding a company in a large and growing market. Understanding healthcare markets can be a little tricky with patents and FDA approvals.
 

1. What is the number of existing MRI machines in the US and globally?
2. Where are these machines located as a % of total? Private imaging center? Ambulatory hospital, in-patient hospital, for-profit hospital (Morristown) versus not-for-profit (VA hospital system) research facilities?
3. How many MRI’s are retired versus new purchases? Leases?
4. What is the average daily use of each machine? Imaging for what therapeutic area? (Oncology, gastro, neuro, etc.)?
5. What is the reimbursement ratio public versus private insurance?

 
Infusion Pump Market
 
Combining Nintai Investments’ research with iRadimed’s, we think there are roughly 12,000 MRI scanners installed around the globe. iRadimed has a set of safety standards required within the MRI facility, so not all facilities can be identified as a possible client. Many sites purchase multiple pump systems for each MRI screener installed. Based on historical sales and customer pump purchases, IRMD estimates the current global market opportunity represents approximately 18,000 MRI compatible IV infusion pump systems, of which approximately 55% are located in the U.S.
 
Monitor Market
 
Nintai Investments’ research shows that multi-parameter monitors is a market where mot adoption has taken place. Much like MS Office, IRMD’s focus is on next-gen functionality and hardware replacement. Global sales is estimated by iRadimed to be roughly 1200 units with over three-quarters of sales in the domestic US market. Growth is estimated to be 6-7% annually on a base of $70-$80M in revenue. iRadimed is hoping to get customers to move to a multiple unit purchase model similar to the pump systems.  
 
Sales Outside the Imaging Room
 
iRadimed is looking to pilot sales forces in both the Emergency Departments (EDs) and Intensive Care Units (ICUS) as many patients in these settings are at high risk of needing MRIs for clinical assessment.
 
Evolving Commercial Strategy
 
After extensive conversations with management, channel distributors, customers, though leaders, regulatory officials, etc. we think iRadimed’s two pronged commercialization approach is spot on. Two key conditions drive this: currently IRMD is the only approved MRI compliant solution in the marketplace. This truly is a monopoly. Second, iRadimed for the first time in its history has an MRI-compliant platform with IV pump combined with a multi-parameter monitor. Focusing on these two messages, IRMD is building out a sales force that will look to grow the business in the high single digits for the next 15 – 20 years.   
 
Research Components
 
Researching all this data, synthesizing it into actionable data, and then deriving real knowledge isn’t easy. It takes a lot of people to help you understand all of these moving parts. For Nintai Investments, it took approximately 400 hours to talk to a host of individuals and gather any follow up research including trade journals and professional studies, conferences, and peer reviewed papers. Here’s a small selection of that research.  
 

1. IRMD Management
2. Former competitors: such as Baxter product Associate Vice-President, Executive Director, Sales Directors, Technology Leads, Business Managers, Research and Development, Market Access, etc.
3. Hospital Administrators: VP Imaging, Data VP, MRI Ops Team, Safety Council
4. Ambulatory MRI Private Center: Executive Director, Technical Lead, Ops Manager, Technicians, Safety Coordinator
5. Regulatory: FDA Imaging Lead, Research Coordinator, Consulting MDs
6. Managed Care: SVP Imaging Strategies, Executive Director, Reimbursement, Director, Image Resources and Clinical Outcomes
7. Medical Research Facility: Executive Director, SVP Technology, Senior Director, Image Services
8. GE Health: VP, Research, Director, Image Services
9. Canon Health, SVP, Market Strategies and Product Development, AVP, New Technologies.   
10. Thought Leaders: Harvard Medical School, “The Whole Brain Atlas”, Keith A. Johnson, MD, Professor, Harvard Medical School
11. Thought Leaders: Greg Freiherr, The Freiherr Group
12. Thought Leaders: Eliot Siegel, MD, Professor of Diagnostic Radiology and Nuclear Medicine, University of Maryland School of Medicine
13. Thought Leader: Ezequiel Silva, MD, FACR, Chair, American College of Radiology Commission on Economics

 
Trade Journals
 
Imaging Technology News
Diagnostic Imaging
Radiology (Journal of the Radiology Society of North America
 
Conclusions
 
As you can see, Nintai Investment’s research methodology is a robust process in trying to acquire knowledge that will best inform us about a potential investment. I should note that roughly 1 out 50 of these processes will lead to an actual investment. That doesn’t really bother us though. Acquiring knowledge on MRI imaging might help us when we look at a potential investment in a physician group in southern California or a patient outcomes informatics firm on the inner Beltway of Boston. Nearly no knowledge in these processes goes to waste. Much like Charlie Munger’s view of lattice work, research like this layers another piece on to our knowledge lattice work. A word of caution. Nearly every successful value investor I’ve met loves this process. They’d rather read the latest peer reviewed study on how demographic changes in Ithaca drove a cancer blossom in De Moines than attend the latest Avengers-franchise film. But if you have a strange passion like some of us – or want someone like that managing your funds – you might be hard pressed to find a better fit.
 
As always I look forward to your thoughts and comments.
 
DISCLOSURE: iRadimed (IRMD) is a holding in some of out personal and institutional accounts.   
 

"Today, the stock market has become a device to offload risk to the public market and cashing in -- it is an "exit" not a growth vehicle."
                                                                                   -     Hedgephone
 
“Capital markets are the essential tool to make capitalism work, and most importantly, work well. Keynes said that when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. Has anyone noticed that asset bubbles are coming more frequently with greater impact? Who would have thought we could have a technology bubble and crash followed by a real estate bubble and crash only seven years later? My greatest fear is that speculators are using the markets to offload their risk to an increasingly complacent public market.”
 
                                                                                   -     Richard Addison    

Recently I wrote about the concept of “responsible capitalism” in a reply to Howard Marks’ memo “Growing The Pie” (the article can be found here). One of the subjects I discussed was the changing role of capital allocation in the public markets. More specifically, I discussed the role of increasing complexity and financial engineering that assures that hedge funds and large institutional investors make a great deal of money while putting a great deal of risk on the individual investor and reducing their share of the pie.
 
It made me think of the story of two tourists who had purchased tickets to participate on a safari. The first tourist smirked at the second when he noticed his seat was the closest to the ground. He said to his companion, “I may have paid more, but I’ve got the best seat to see the animals”. His companion smiled, took his friend’s ticket and turned it over. It read “This seat - while having the greatest views also carries the greatest risk. Please be advised you may need to vacate your seat in the case of an animal attack”. After reading this, the second tourist smiled and said, “It isn’t always the price and the view. Sometimes it’s where you sit that does you in”.  
 
The Changing Role of the Capital Markets
 
If Wall Street’s job is to allocate capital “for the singular purpose of maximizing shareholder returns”, sometimes I’m confused by the transactions I see announced on the financial news. In a well-functioning market, capital should flow to companies and concepts that have the greatest potential return to investors. As an example, take two fictional companies that have filed S-1s with an intention to go public over the next 90-120 days. The first company - Acme Rubber Band (DOINK) – generates $15 of earnings on $150 of revenue (a P/E ratio of 10), earns 15% return on equity, and has been growing revenue at roughly 11% annually over the past 10 years. The second company - Shmaltz Quick Fix Solutions (STEAL) has not produced positive earnings in its history, has negative return on equity, and burns through roughly 33% of its cash balance each year. All things being equal, one would think that Acme should have an easier time underwriting its initial public offering (IPO) than Shmaltz. In Acme Rubber Band’s case, we have a company that has generated significant returns for its initial (private) investors. The company is now seeking to access capital to help ramp up sales, marketing, staffing, or production. Additionally, it may use IPO proceeds to pay off short or long-term debt. Finally, they may use some of the proceeds to pay off earlier investors should they seek to exit their current position. In essence, Acme has gone to the markets to continue their growth story and seek new investors and capital in the continuation of that journey.
 
Schmaltz Quick Fix is really quite a different story. In this instance, the company may try to pass this off as looking for investors in their growth story, but they really don’t have one. Their finances are a wreck, their growth is not profitable, and there is a fair chance that any new capital will be used to pay off previous investors and keep the doors open. In the words of Hedgephone, this IPO is an exit strategy for previous investors, not a growth strategy for new investors.
 
Investors - who by their very nature must be allocators of capital - should seek two things when making a decision to invest in an IPO. First, which company has the best chance of achieving above average returns on capital in its operations and strategy? The answer to this question is vital to value creation and investment returns in the long term. The choice between Acme and Schmaltz couldn’t be starker. Second, how is the deal structured, how will the capital raised be employed, and how will it drive returns for investors? This question tells us which investors will see a return and which that won’t. In other words, where are they in the safari seating plan? Without knowing the exact deal structure it’s hard to make a fully documented choice. However, with the historic data we have, I’d say the circumstances certainly lean in Acme’s favor.
 
This type of discussion isn’t entirely academic in nature. Over the past twenty to thirty years, the idea of Schmaltz being taken public – on a major exchange - has gone from being laughable to entirely plausible. What might have been seen as a lark on the Pacific Stock Exchange in 1980 is an almost everyday occurrence on either the NYSE or NASDAQ today.   
 
A Working Example: Chuck E. Cheese
 
We can move the discussion from the hypothetical to the real world by using an example of a recent IPO announcement for a company known by many readers with young children – Chuck E. Cheese. The company was started in 1977 with its first Chuck E. Cheese Pizza Time Theater in San Jose, CA. After filing for bankruptcy in 1984, it was acquired by ShowBiz Pizza Place, In 1998 it became CEC Entertainment. In 2014, the company was acquired and taken private by Apollo Global Management. Apollo paid roughly $1.3B for CEC’s restaurants in 47 states and 14 countries. The company also has 144 Peter Piper Pizza units in six states and Mexico.
 
The IPO Announcement
 
After 5 years of ownership, Apollo is looking to cash out and make a return on its initial investment. CEC announced that its parent company would merge with Leo Holdings, a special-purpose acquisition company. The new company will be known as Chuck E. Cheese brands, and it will trade on the NYSE under the ticker CEC after the deal closes sometime late in the second quarter. In their announcement, the companies stated the new organization will have an enterprise value (market cap + debt – cash) of $1.4B. After all of the accounting and corporate engineering shenanigans, Apollo will retain 51% of the new corporate entity.
 
The IPO announcement reads as follows:
 
CEC Entertainment, which owns the Chuck E. Cheese pizza/entertainment chain expects to start trading with an anticipated initial enterprise value of ~$1.4B or 7.5x the company's estimated 2019 adjusted EBITDA of ~$187M. CEC and Leo Holdings (NYSE:LEO) a publicly traded special-purpose acquisition vehicle, along with CEC parent Queso Holdings, agree to combine. Queso's controlling stockholder is an entity owned by funds managed by affiliates of Apollo Global Management (NYSE:APO).
Immediately following the closing of the proposed transaction, Leo intends to change its name to Chuck E. Cheese Brands and trade under the ticker symbol CEC. Apollo funds won't be selling any shares in the transaction and will continue to be CEC's largest shareholder with about ~51% ownership. Concurrent with the consummation of the deal, additional investors will buy $100M of common stock of Leo in a private placement. After any redemptions by the public shareholders of Leo, the balance of the ~$200M in cash held in Leo Holdings' trust account, together with the $100M in private placement proceeds, will be used to pay transaction costs and de-leverage the CEC's existing capital structure.
 
For those having a hard time following the financial engineering, I’ve enclosed a chart that graphically demonstrates the organizational transactions that gets us to the new/old Chuck E. Cheese.   

​Now at this point, you may be leafing back through this article thinking “that valuation is pretty close to what Apollo paid back in 2014”. Indeed, the new company’s enterprise value of $1.4B is only slightly higher than Apollo’s original purchase price of $1.3B 5 years ago. It certainly doesn’t seem like much of a return. But here the hypothetical examples of Schmaltz and Acme become frighteningly relevant. CEC Entertainment is going public as a means for Apollo to exit with its gains locked in. The source of Apollo’s profits - $1B in debt taken on by CEC – will be partially paid off by investors in LEO. The remaining will be paid off from the promised “high growth” coming from the new entities sales and operations. Those numbers – which will become the issue for CEC’s new 49% owners. In the words of Hedgephone, CEC’s IPO is a device to offload risk to the public market and cashing in -- it is an "exit" not a growth vehicle (strategy).”
 
Over the last four quarters, comparable sales have improved sequentially, rising from 1% in second-quarter 2018 to 7.7% in first-quarter 2019. However, overall revenue increased just 1% last year to $896.1 million as its store count fell from 754 to 750. CEC reported operating income of $50.8 million last year which seems adequate until you realize the company had $76.3 million in interest expense. Suddenly CEC moved to a net loss of $20.5 million. CEC has nearly $1 billion in debt on its balance sheet, which explains its crushing interest expense and its inability to make a non-EBITDA profit.
 
A Lesson to Be Learned
 
If one to were to take an old-fashioned view of the capital markets, capital should flow to companies and their investors that will provide the best opportunity of achieving outstanding returns over the long-term. That’s certainly the way I look at the role of the markets. With that said, I find very few opportunities in the IPO market. I think there are far too many “exit” vehicles rather than “growth vehicles”. Far too many deals are structured to make money for past investors, not future investors. That doesn’t mean I don’t think there is a role for the public markets or the IPO process. Far from it. They provide a vital role in capital liquidity and access to the capital for small and upcoming ventures. But as an older – more prudent – investor, I look to invest with management where both internal and external shareholders have the opportunity to compound their returns over an extended period of time.
 
Value investors should never lose focus on the two words that make up their occupation. “Value” means purchasing an asset at a discount to its estimated intrinsic value. “Investor” means utilizing time and the power of compounding to achieve adequate returns over the long term. When a company comes to the public markets as a result of financial engineering and accounting gimmickry – to paraphrase the words of John Maynard Keynes - the job is likely to be ill-done. To put in the context of our big game safari tourists, always make sure you purchase the ticket with the best seating – not from the lion’s standpoint, but from a survival standpoint.
 

Q2 2019 Returns
 
The past 6 months have been an indexer’s dream. You simply couldn’t choose a bad asset class. It's difficult to imagine that the second half of 2019 could be kinder to multi-asset investors than the first half. 1H2019 was the best first half to a year for the S&P since 1997. At the same time, the iShares Core U.S. Aggregate Bond ETF had what looks like its best half on record. In a true testament to just how over-the-top the bond rally was, the German 30-year bond logged a total return of some 15%. That would be the second-best 6-month return in a quarter century and very nearly better than the S&P's first-half gain.
 
I concede that Nintai’s investment philosophy doesn’t excel in this type of market conditions. Our focus on companies with no debt, high returns on capital, deep competitive moats trading at a discount from our estimated intrinsic value go from being rare to non-existent. By the height of a cycle we might be as high as 30-35% in cash as a total percent of AUM. Nintai’s type of investment has also been penalized over the past 6 months. The rate of returns and the assets that have been achieving such outstanding results are outside our value-based thinking. Frankly, we have a hard time understanding markets like the ones we are seeing today. However, that doesn’t make it any easier for you or me. I’m not a big fan of losing and underperformance eats at me every night. I am as competitive as the next man, and it drives me harder to figure out a solution for the last 6 months’ underperformance.
 
The one thing Nintai will not do is panic and suddenly start purchasing block chain companies or Chinese pharmaceuticals. We are comfortable with our process over the long-term and don’t think the current market conditions can continue forever. In the final analysis, we’d rather not make as much in this type of market than to permanently impair our investment partners’ capital in a down market.   
 
We’ve been particularly disappointed with portfolio returns since Q42018. I’ve been most surprised by the fact that even when holding 20% in cash, the portfolio had drawdowns that match (and sometimes even exceed) the general markets. This type of performance tells us that our portfolio picks are underperforming but losses have been somewhat offset by a significant cash position. Over the past six months, the companies with the largest losses have no debt, high returns on capital and equity, and great free cash flow margins. Some of the disappointment has been environmental in nature (such as a holding’s double whammy of a potential China trade war and the threat of Mexican tariffs), but overall most have been large drops in stock prices matching more general market trading. This can mean one of two things - either we mispriced the valuation/risk of the holding or the markets are mispricing the valuation/risk related to the holding. We are spending an enormous amount of time trying to better understand who is wrong in their judgment.
 
We are clearly not pleased with our returns YTD. As mentioned previously, since January 2019, our portfolios have held roughly 15 - 20% in cash as a percent of total assets under management. This cash position has been both a drag during up markets (bad) and acted as a sheet anchor during down markets (good). The last two quarters have been extremely disappointing with the portfolio equities underperforming the general markets by a considerable amount. That type of performance – though short-term in nature – is a huge disappointment for this firm. 
 
If there is a silver lining in this type of underperformance, it is that it has created a value gap between the general markets and our client portfolios. As of June 30 2019 Morningstar has the total stock market valued at a 1% premium. Our average Nintai portfolio was valued at an estimated 9% - 11% discount to the S&P 500 as of June 30 2019. Total returns (less fees) year-to-date (2019), 1 year (July 1 2018 - June 30 2019) and since inception (September 2016) are seen below: 

A Note on Measuring Performance
 
One of things that I find particularly egregious is when investment managers cherry pick data or their respective benchmark to improve their (perceived) performance. Some try by comparing their large-cap US growth fund performance to the MSCI ACWI Index. Others might try to use a balanced fund benchmark to measure against their small-cap growth fund.  Recently Neuberger Berman published an article called “The Overlooked Persistence of Active Outperformance”[1] where they argue returns would be much better if you simply removed the lowest quarter of (under)performing funds (You can almost hear them sitting around their conference room saying “everyone deserves a mulligan”). I’d like to think how well Nintai has done if I could simply take back those nasty picks that represent the lowest 25% performers in the portfolio. With arguments like this, who needs attacks from index investor supporters?
                               
I’ve struggled at Nintai ever since we began as investment managers trying to find the best comparison to measure our performance. With an all-cap, all markets mandate, Nintai’s
portfolios tend not to be a perfect fit with the S&P 500 or a US-only index. For instance, our median portfolio holding market cap is 8% the size of the median S&P500 company. Roughly 20-25% of our holdings are non-US based companies. We also are very focused by industry – holding companies in only 5 of the 11 S&P industry categories.
 
In light of this, we try to give our investors a wide set of benchmarks for use in comparing Nintai performance. I start with the S&P 500 simply because this is de facto benchmark nearly every manager is compared against. I also include the Russell 2000 since this is the closest match by market cap. (The Russell 2000 median market cap is $900M versus the average Nintai portfolio’s median market cap of $721M). Fidelity also allows me to create an 80% - 85% equities and 15-20% cash benchmark. I include this because the Nintai portfolio usually holds 15 -20% of AUM in cash. (as of the end of Q2 2019 the average Nintai cash position was 26% of total AUM). Finally I include the MSCI ACWI ex-US index because of the substantial holdings in international stocks (as of the end of Q2 2019, the average Nintai portfolio had roughly 24% of AUM in international stocks).   
 
Nintai’s portfolios have generally outperformed the S&P 500 after fees. They have performed better against the other benchmarks. Which benchmark investors choose to use in measuring Nintai’s performance is entirely up to them. I think the best approach is to review performance against all and see – in totality – how the portfolio has performed. I haven’t found a reasonable way to create a summary of all the benchmarks and generate an average rate of return. Until we do, we will continue to provide investors with a relatively large portfolio/benchmark return chart.
 
One thing I can assure you. Whether our returns outperform or underperform the markets, Nintai will report results in a direct and forthright manner. We look to give investors information on their returns in the manner we’d like to have given to us. If our performance lags, you will hear about it.   
 
Winners and Losers
 
Two stocks led the way in Q2 – Veeva Systems (VEEV) and Manhattan Associates (MANH).  Veeva was up 27% in the quarter while Manhattan increased by 23%. Veeva’s May quarterly earnings exceeded both top and bottom lines. Management upped guidance (again) as well. Over the last year, VEEV has increased free cash flow by 37%, EPS by 71%, and revenue by 28%. We increased Veeva’s estimated intrinsic value by roughly 13% in February 2019 after the company raised guidance. We increased it by an additional 16% in May. The position gained roughly 185% since I purchased it in February 2018. ***Note: We eliminated the position entirely in early July 2019 based on valuation ***
 
Manhattan Associates continues its run as the acknowledged leader in warehouse management systems (WMS). In Q2 the company received the leadership award in Gartner’s WMS magic quadrant for the 11th consecutive year. In addition, Dennis Story was named CFO of the year. The company has ramped up R&D by nearly 40% to begin its push into AI-driven fulfillment workflow capabilities. While pushing down free cash margins from the mid-20s to low-20s, these efforts will likely prove to be the growth drivers over the next 10 – 20 years. Return on equity has jumped from 26% on 2012 to 73% in 2019. Return on invested capital has also jumped from 68% in 2012 to 247% in 2019. Shares outstanding has dropped from 124M in 2004 to 65M in 2019. Free cash flow margins remain in the low-20% range. The company has no debt and roughly $100M cash on the balance sheet.
 
Our biggest loser by far was PetMed Express (PETS). Nothing is as frustrating as spending 3 – 4 months completing intense research on a company, make a decision to add it to the portfolio, and then promptly see the share price drop by 35%. As a positive spin to all this, it gave us the opportunity to keep loading up on the stock as it continued to drop.
 
The markets seem to be spooked by the IPO of Chewy (the markets valued the company at $9B versus PETS market cap of $312M). There is of course the talk of Amazon driving out all competition, but it should be noted that PetMed Express is a licensed pharmacy in all 50 states, dispensing FDA approved medications not just OTC products. This requires registration with both State Boards of Pharmacy as well as federal registration required for Schedule V medication fulfillment. While growth slowed in 2019, I haven’t seen anything after talking to management, customers, veterinarians, and state Board members that suggests the business model is broken or impaired in any way.    
 
Portfolio Characteristics
 
The current Abacus view as of June 30 2019 shows that the Nintai Portfolio holdings are roughly 10% cheaper than the S&P500 and projected to grow earnings at a substantially greater rate than the S&P500 over the next five years. Combining these two gives us an Abacus Comparative Value (ACV) of +23. The ACV is a simple tool which tells us how the portfolio stacks up against the S&P 500 from both a valuation and an estimated earnings growth stand point. We like to see the portfolio below the valuation of the S&P 500 but with a higher 5 year estimated earnings growth rate. Like an increasingly compressed spring, these two numbers – combined with higher rates of return on equity and capital – should lead to long-term outperformance. An ACV of >15 has led to outperformance over 90% of the last twenty 5 year rolling periods.   

​If opportunities arise we will add or reduce position size. We might also swap out an entire position for a chance to invest in a situation with a better risk/reward profile. We will be actively looking to take profits or find cheaper prospects over the next 6-9 months.
 
We remain highly focused in industry and sector weightings. We currently have holdings in only 5 of the S&P500’s 11 categories - financial services, technology, industrials, consumer defensive, and healthcare. Industrials and consumer defensive are both extremely small holdings with roughly 90% of holdings in just three categories – financial services, technology, and healthcare. However, I should point out we see the categorization of the portfolio slightly differently. For instance, Computer Modelling Group is categorized as a technology company by the index. However, with 100% of its revenue derived in the oil and gas discovery process, I consider the company a way to gain exposure in the energy industry. 

​Turnover and Cash
 
Turnover for the quarter was roughly 13%. I expect this to drop as assets under management increase. I try to look for turnover of roughly 5-10% annually. This is dependent of course on factors such as overall market performance (steady increases over the past few years have forced us to take profits thereby increasing turnover) or individual stock performance (a sudden price drop of 20% might make for a compelling buy scenario). I have reached the upper end of stocks I look to own in the portfolio. It’s likely that most trading going forward will be additions or subtractions from existing positions. Occasionally opportunities may arise where I swap out an entire position for one that is either trading at a steeper discount to my intrinsic value and represents a step up in quality and potential long-term gains.
 
Cash as a percent of assets under management remains high at roughly 25%. This number is a reflection of the lack of opportunities to invest in the current markets. It is also a statement on the valuations of current holdings (meaning that individual portfolio holding valuations are at record highs) which forces us to take profits and reduce our holdings’ size.    
 
A Note on the Markets
 
If markets continue to push onwards to new highs it is likely this number will go higher. Gurufocus does a great job of providing investors with Warren Buffett’s market valuation indicator.  Buffett said the ratio between the Wilshire 5000 to the US gross domestic is “probably the best single measure of where valuations stand at any given moment.” As of June 30 2019 the ratio stands at approximately 1.44. Utilizing Mr. Buffett’s calculation, the ratio implies an annual return of -2.1% over the next decade. Additionally, Jack Bogle’s market return formula (dividend yield + earnings growth + speculative return) isn’t looking to knock it out of the park either. Current dividend yields are roughly 1.8%. I project earnings growth to be roughly 2 - 3% annually over the next decade. Let’s split that and say 2.5%. So far that gets us an investment return of 4.3% (1.8% + 2.5%). I’m assuming the speculative return (defined as the growth or shrinkage of the P/E ratio) will drive the P/E ratio closer to its long-term average of roughly 15. It currently stands at roughly 22. To regress to the median, the speculative return would be rough -4% annually over the next decade. This would give us a decade of roughly flat returns.
 
Both of these calculations would suggest there is considerable risk in the equity markets at these prices.  It is for this reason I have been taking profits – or eliminating entire positions – to protect against the downside. Until prices come down (or earnings show far greater growth estimates), then cash represents a safe holding to prevent a permanent impairment of your capital.
 
As Nintai Investments LLC, I take my responsibility seriously to wisely allocate capital, prudently manage risk, and attempt to generate adequate returns. Helping individuals and organizations achieve their life goals, support their corporate giving, or meet their retirement needs is a remarkable honor and mark of great trust. Every day we look to continue earning tour investment partners’ trust. Should you have any questions, please do not hesitate to contact me by phone or email. 
 
Thomas Macpherson
tom@nintaiinvestments.net
603.512.5358
 
My best wishes for a wonderful summer season. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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