Tom was recently interviewed as part of the Brown University Virtual Value Investing Q&A Speaker Series. Check out the full interview below.

​“Moats are terribly important to the long-term investor. Any company that can maintain a wide moat over twenty or thirty years can smooth out an awful lot of poor investment decisions. Conversely, getting a moat wrong (through either not understanding its durability or its existence at all) can crush your investment returns. If I have one piece of advice for new investors, it’s to look to your holding’s moat – understand its components, understand its durability, and understand its role in your estimated intrinsic value”.   
 
This quote is from a speech I gave in 2011 to a collection of healthcare analysts who were grappling with understanding a company’s moat and its importance in a company’s valuation. Re-reading it eleven years later, I’m not sure I’d change a single word. The only addition I might make is to be “very” conservative in your estimates (not just conservative) when valuing a possible investment’s moat. 
 
Generally, when we get moats wrong at Nintai, it’s because of two things. The first is that business conditions change enough to impair the company’s ability to maintain the characteristics of a wide-moat business. Secondly, as investors, we convince ourselves the company has achieved a wide moat when one has never existed. In the final analysis, the damage is the same in both, though it generally goes much quicker in the latter than in the former. 
 
I’m going to discuss both cases in much greater detail. Both can be deadly when it comes to long-term performance. I recently wrote an article about New Oriental Education and Technology (EDU), a holding in some Nintai investment partner portfolios that lost 75% of its value in two days in 2021. That poor choice was a combination of Option # 1 (the company lost its ability to maintain a moat due to changes in governmental policy) and Option #2 (the moat we thought the company had was much weaker in reality). 
 
In today’s article, I wanted to discuss Option #1 (why a company's moat might fail) in much greater detail. Before I get started, it might be helpful to quickly review what Nintai thinks are the primary sources for sustainable moats. 
 
A Brief Review of Moat Characteristics
 
A competitive moat is a term first used by Warren Buffett to describe a company's competitive advantage over time. This competitive advantage creates an “organizational moat” that makes it more difficult for competitors to capture market share, increase prices, or build a better mousetrap. The broader and deeper the moat, the better the protection and the greater the likelihood the moat is sustainable over the long term. No company has better articulated Buffett’s concept of moats than Morningstar. Their “Economic Moat Ratings” are essential in understanding how a company derives its moat, sources, durability, and trend. The company’s “Why Moats Matter: The Morningstar Approach to Investing” by Heather Brilliant and Elizabeth Collins remains a true classic. 
 
Morningstar’s Types of Moats: We agree with Morningstar that there are certain forms of moats.[1] These include Network Effect (whereas more users join a network, the more powerful it becomes as dictated by Metcalfe’s Law), Intangible Assets (where patents, brands, or regulatory approvals can create legally-derived moats around a business), Cost Advantage (where a company can keep costs down, but profits up regularly), Switching Costs (where it becomes cost and skills prohibitive to remove a product from the customer’s business processes), and Efficient Scale (where several players dominate a market that lends itself as too expensive to build out a competitive offering – like pipelines). We use some specific measures at Nintai that we think are critical components to any company with a moat. 
 
High Returns on Invested Capital:  Companies with wide moats can use capital to produce high returns on said capital. In plain English, this means a company can utilize capital (such as cash, debt, or money raised through stock sales) by deploying it into either existing operations (such as building a new plant) or new operations (such as an acquisition or creating a new product) that generates high returns on the invested capital. Great companies find ways to use the money to increase their moat, while poor companies generate inadequate capital returns by squandering it on bad business deals or product development.
 
High Free Cash Flow Conversion: At Nintai, we look for companies that convert 25% or greater revenue into free cash flow for at least the past ten years. After paying all the bills to keep the business running (labor, SG&A, leases, capital expenditures, etc.), the company clears over one-quarter of all revenue as wholly theirs. This demonstrates that the company can achieve extremely high profitability and has enough cash to little to no need to go to the capital markets or raise debt. 
 
Competitive Strength: We also look for companies with obvious competitive strengths. Easily identified strengths are monopoly or duopoly (when there are only one or two companies in that line of business, an investor should expect to see higher growth rates and increased profitability. Another example is dominance achieved through regulatory or patent protection. When a pharmaceutical receives a patent for a particular molecule or product, this guarantees exclusivity for anywhere between 7 - 15 years. Not bad if you’re the only company treating a specific disease. 
 
Excellent Capital Allocators as Managers: Just because a company can achieve high returns on invested capital and find ample opportunity to invest in the current business doesn’t mean they will. An equally important component has a management team with the discipline to stay with projects that aim for high returns on invested capital, as well as the discipline to reject those that don’t have those characteristics. 
 
Why Moats Fail or Get Filled In
 
Of course, nothing is better for an investor than bringing a company into the portfolio and watching it broaden its moat, grow revenue, increase profitability, and successfully allocate capital to grow the company over a ten to twenty-year period. At Nintai, we’ve been lucky to have a couple of these, including Manhattan Research (MANH), Intuitive Surgical (IRSG), and FactSet Research (FDS). Unfortunately, we’ve also had more than our share of portfolio holdings where the moat disappeared, along with our investment case and investment returns. Several great (perhaps that’s not the word) examples from Nintai’s past include Corporate Executive Board (merged) and New Oriental Education (EDU), and Computer Programs and Systems (CPSI).  
 
Each of the latter cases involved companies that faced a rapid decline or collapse in their competitive moat. This further led to a near-complete collapse in stock price and competitive position. In each of these cases, one of three reasons led to such rapid changes. 
 
Government Regulations Change: The old phrase goes that the good Lord giveth, and the good Lord taketh away. Indeed, nothing could be more accurate than the case of New Oriental Education and Technology. For nearly two decades, the ruling Chinese Communist Party (CCP) encouraged families to invest in learning English as a second language, getting tutoring services to improve those skills, and leveraging EDU’s country-wide infrastructure to increase their skill sets. In 2021, the CCP pulled the rug out from tutoring companies complaining they were forcing families to spend too much on education as a percent of their total family income. In one week, the government completely obliterated the business and investment case in the mainland China for-profit education market. 
 
New Technology/Product/Process is Developed: Sometimes, it’s as simple as competitors exploding on the scene with a new product or offering that instantly makes a business or product obsolete. For instance, in most major cities, there are a limited number of hackney medallions that allow you to drive a taxi. In Boston, there are 1,825. At its height, cabs picked up 14.6M fares in 2012. That number dropped to 5.9M in 2018. In 2021 it was estimated to be roughly 2.3M. The cost of a medallion has fallen from $900,000 in 2013 to $34,000 in 2021. The reason for this collapse? The democratization of ride-sharing through Uber and Lyft. In the blink of an eye, the entire business model of the taxicab in major cities was blown apart. 
 
Management Takes Their Eye Off the Ball: Occasionally, great companies will have management takeover that aren’t as good capital allocators as their predecessors. A former holding in the Nintai Charitable Trust portfolio - Computer Programs and Systems (CPSI) - saw return on equity drop from 43.3 in 2014 to -11.6 in 2017 under new management. This type of collapse in return on equity reflected a broader breakdown in the company’s moat, leading to the permanent impairment of Nintai’s capital. In this instance, management took its eye off the ball of the electronic health/medical record (EHR/EMR) space and lost its competitive advantage over the next few years. The stock price shared an equally severe drop, and Nintai’s investment was permanently impaired.
 
Signs of a Deteriorating Moat
 
What should an investor look for when identifying if a portfolio holding’s moat is deteriorating in size or scope? Here are some things we look for at Nintai Investments. 
 
Revenue Decrease: a slight and consistent decrease in revenue tells you more about an eroding moat than one awful year. When a company sees revenue decrease year-over-year for an extended time, it can mean the company’s product is losing the loyalty of customers, loss of pricing power, or that the company simply isn’t executing its strategy very well. Whatever the reason, decreasing revenue is not what an investor is looking for in a company with a narrow or wide competitive moat. 
Profit Decrease: Another sign of a deteriorating moat is squeezed gross and net margins, or most importantly, a decrease in free cash flow or free cash flow as a percent of revenue. Any of these three might suggest the company no longer can keep costs contained (raw supplies costs have increased or the labor market is too tight) or worse; it is losing the battle of maintaining control over pricing versus customers who don’t see the value anymore.
Decreasing Market Share: A clear sign of an eroding moat is when a portfolio holding sees a marked deterioration in market share. Numbers like this reflect something either very wrong at the portfolio company or something very right at a competitor. As an investor, we prefer to see it the former, not the latter. Why? Because this is something in the company’s control that with the right management team, strategy, operational team, and adequate capital, can be solved. That said, any solution must thread the needle of all these listed issues as well as complete them in a reasonable period. Many customers won’t have the patience to see a vendor go through a series of missteps.  
Specific Government Action: In some instances, a government may change its policies and have an enormous impact on a company’s moat. For instance. Mexico’s government provides supportive policy to three Mexican publicly traded airport operators – Grupo Aeroportuario del Pacifico (PAC) holds the most significant passenger market share at 26%, compared with 23% for Grupo Aeroportuario del Sureste (ASR) and 15% for  Grupo Aeroportuario del Centro Norte (OMAB). Any change in government policy - such as moving to a more free-market model or a change in licensing – could dramatically impact each of these companies’ competitive moats. 
 
A Note on Speed
 
Some of the previously mentioned events can lead to much quicker moat deterioration than others. For instance, a change in government policy - created by a change in administration or simply an unplanned policy change - can destroy a moat in days. For example, Nintai’s investment in New Oriental Educational (EDU) lost its entire moat and most of its valuation in just 72 hours in the summer of 2021. Others, such as decreasing market share, can take years of erosion to eat away at a company’s moat. In Computer Programs and Systems case, it took several years before the extent of damage to the company’s moat was identified.
 
Questions to Ask Going Forward
 
Inevitably, an investor will own a portfolio holding that shows the signs of a weakening moat, as described in the previous section. When this happens, there are several questions the investor should ask relative to the future of the moat, can/will it return, or is there an opportunity to create an entirely new moat.  
 
Is the Moat Permanently Impaired?: The first question an investor should ask is whether the moat has been permanently impaired. Events such as the loss of a patent, a radical change in government policy, or the launch of a truly ground-breaking new product by a competitor can usually mean the damage can be ascertained quickly. But most cases aren’t so clear-cut. Sometimes it can take several quarters or even years before the erosion, and its certainty becomes clear. We’ve found the best way to mitigate the risks associated with this long-drawn-out process is to know your portfolio holding, market, and competitors exceptionally well. If the investor isn’t willing to do some real, in-depth leg work, then find a quality index fund.  
 
Can the Company Rebuild the Moat?: This is one of the more difficult questions an investor will have to answer about moats. The company and its team have already built a moat, so we have a cognitive bias in our thinking that says they should be able to do it again. But you have to let all that information go and dwell on the facts of why and how they lost the moat. It would seem unlikely they can rebuild the exact same moat because that one blew up. So, what would need to change? Strategically? Operationally? Does the company have a management team capable of identifying the required changes? Does the company have the capital required to make the changes? Again, an investor needs an in-depth knowledge of what made up the previous moat, what a new one might look like, and all the necessary information on competitors, markets, strategy, operations, financials, etc.
 
Can the Company Build a Different Moat?: This question can usually be answered the quickest of the post-impaired questions. We have found over time that it is challenging to not only rebuild a competitive advantage but to build a moat in an entirely different field. You certainly want to believe in management. After all, they’ve shown remarkable skill and drive in creating a solid business already. Who says they can’t do it again? But building a moat in an entirely new field or industry is another whole ball of wax. Having confidence in your management to rebuild an existing moat is one thing, having it in them to build a moat in an entirely new industry or vertical? That’s more likely to be a pipe dream. 
 
Conclusions
 
Building a business surrounded by a deep competitive moat is quite a task. Identifying a market, creating a product, fending off competitors, and achieving long-term growth are all marks of a great management team.  Inevitably, the hallmarks of such success tend to get weathered and fade away. For a host of reasons (listed previously), a portfolio company’s moat can (or will) deteriorate with time. The challenge for the investor is to purchase shares when the moat is in the ascendancy and not overpay in those circumstances. The second key is recognizing when a moat is weakening, identifying the causes, and ascertaining whether management can turn the situation around. A wise investor can sometimes avoid conditions that lead to crack-ups in a business’s competitive moat. But we all make mistakes. This article can’t guarantee you won’t make such a mistake in the future. But it hopefully outlines some of the issues an investor can keep in their desk drawer and pull out now and then to refresh their memory. 
 
As always, I look forward to your thoughts and comments.
 
DISCLOSURE: Nintai currently owns New Oriental Education and Technology (EDU) and Manhattan Associates (MANH) in both client and my personal investment account. 

[1] These examples are components of Morningstar’s “Economic Moat Rating” and “Moat Sources”. More information can be found here. 

“I claim we got a hell of a beating. We got run out of Burma, and it is as humiliating as hell. I think we ought to find out what caused it, go back and retake it.”
 
                                                               -      Joseph “Vinegar Joe” Stillwell 

“I like people admitting they were complete stupid horses' asses. I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.”
 
                                                               -     Charlie Munger 
 
Looking back, 2021 was when Nintai suffered from several organizational failures that led to poor investment decisions. This was most evident in our purchase of New Oriental Education and Technology (EDU). The stock has been the worst investment in our near twenty years in investment management. Following the collapse of the stock price in the summer of 2021, we focused on three areas. First, can an investment case still be made for New Oriental, or is the stock so impaired that we should write off the losses and move on? As a quick summary, we think there is a case to be made for holding the stock because our estimated intrinsic value exceeds its current stock price. Should the stock reach anywhere near that, we will exit the position entirely. Second, where exactly did we get the investment so wrong? What steps within our process failed? We’ve spent much time breaking down the process and have identified several significant problems. These include multiple instances of cognitive bias. In plain English, we found various ways in which our own brain developed muddled thinking habits over the years that blinded us to the warnings about the company. It also included a failure in our investment process. Specific cautionary steps we have created over the years failed regarding the New Oriental investment. Simply put, our process took on too much risk without fully understanding the perils of the investment environment. In part two of this section, I will detail the specific procedures that proved to be inadequate. Our last area of focus has been developing a way to prevent such a mistake again. We recognize that not every investment will turn out to be a winner (at least we learned that over the years!). We have developed a revised process that slows our thinking down, puts more checks and balances in place, and forces us to delve deeper, ask more questions, and rely on more disparate data than previously. We think these steps can help prevent another such decision like the one which led to the outsized losses of New Oriental Education investment.    
 
The Dangers of Cognitive Bias
 
Cognitive biases develop when our brains simplify our thinking about complex problems. A good percentage of these biases have to do with memory – both our cognitive memory (the fear we had when we first had a stock significantly drop or feeling of satisfaction when we sold a position at a profit) and our genetically programmed “memory.” The latter can be seen when we mistakenly see a pattern where one doesn’t exist. In investing, seeing ten profitable earnings releases in a row might have you predict an eleventh without sufficient evidence to back up that prediction. This type of bias was formed tens of thousands of years ago. Our ancient hunter-gatherers recognized that a pattern of prints could be followed successfully for that night’s dinner. Our genetic memory doesn’t remember that 1 out of 100 of these trails led to a saber-toothed tiger, not a roebuck. In that one instance, the hunter-gatherer was the dinner. Other biases have to do with simplification created by lack of attention. We can’t remember everything all the time, so we make hierarchies of what’s important to notice, thereby making a shortcut in our decision-making process. There are dozens of identified cognitive biases, each capable of creating terrible damage in our decision-making process. 
 
Here at Nintai Investments, we are as susceptible to these biases as any other human. We tried to build strategies that take these into account, and over the years, we’ve felt we did a pretty good job. And then 2021 came along. Our failings during the year were broad and diverse. Over the last sixty days, we’ve worked hard to identify what went wrong to improve our processes to prevent these mistakes from happening again. Here are some of the cognitive biases we identified that tripped us up in our investment with New Oriental Education.     
 
Anchoring Bias: When you rely too much on an initial piece of information that keeps focused on old data. This “anchoring” means you don’t consider more recent data. In this case, Nintai had invested in New Oriental previously and made a considerable return on our investment. By anchoring our thinking on the previous investment, we lost sight of the risks associated with the current investment. 
 
Blind Spot Bias: This is when you reject information because you think the source is biased (and it disagrees with your opinion or finding). For several years, we have heard that the Chinese Communist Party (CCP) felt the economy had moved too close to capitalistic practices. We chose to ignore this thinking. We chalked it up to the usual anti-Communist croaking by certain western writers when we should have talked to Jack Ma or people familiar with Jack’s experience with the CCP.
 
Confirmation Bias: Somewhat an inversion of the Blind Spot Bias, this one is where you lock on information that confirms your theory or decision to the detriment of information that contradicts it. For instance, looking back at our research of EDU, I found that we read pro-investment studies at nearly four times the rate of dissenting views. We fell prey to the same mistake many older value investors made in 2006-2007 with financials. Everyone had seen this before, so everyone did the same thing, regardless of the data that showed this time it was different. Our work with New Oriental mimicked this only too well.
 
Hyperbolic Discounting: This bias is when you look for a short-term gain (at much higher risk) over the more tedious and less heroic long-term gains achieved through patience and longer workout times. At Nintai, we’ve traditionally looked for companies that we can partner with for decades that hopefully achieve slow and steady growth in free cash flow. We’ve never been much to finding fallen angels and hope to see relatively quick profits. That is until New Oriental. Looking through our analysis, it’s clear that the idea of a relative short gain could help offset our underperformance through the year up to that point. We haven’t done that in our career previously, and we learned why we wouldn’t be doing it in the future. 
 
These are four (and there were more!) cognitive biases that played a role in our poor decision to invest (and then double down) in New Oriental Education stock. I hope this helps illustrate some mistakes that Nintai was guilty of and hopefully learn from going forward.
 
How Did Nintai’s Process Come Up Short?
 
We’ve spent a great deal of time looking at what went wrong over the past year, with a particular emphasis on our decision-making surrounding New Oriental Education. I previously discussed the cognitive biases I was guilty of over the year. These I group as individual faults made through human miscalculations. The second large category of mistakes reflected a breakdown of an organizational nature. In these instances, business processes focused on factors that simply didn’t matter and missed things that mattered very much. These failures are easier to identify and remedy because they are process problems, not human problems. The breakdown in our organizational processes falls into four significant findings. Each of these on its own could have created the opportunity for poor decision-making. The presence of all four nearly assured it. 
 
Breaking the case was inadequate: I have written previously about our process of “breaking the case,” or where we invert our assumptions to the point that the investment case is broken. We do this in many ways – decreasing free cash, decreasing market share, increasing sales and administration costs, creating litigation costs, etc. One of the things we’ve never really built into our models is the state government actively seeking to destroy an entire industry in one fell swoop. Our problem, in this case, was believing the Chinese government would want as many of its citizens educated and trained as possible. Overall, our breaking the case model had gaping holes in its methodology and scope.  
 
New Oriental was out of our wheelhouse: Looking back over our investment career, most of our successful investments have been in two industry verticals – healthcare and technology. More particularly, many of these companies have been in either healthcare informatics or technology-based platforms. Some of our least successful – such as Computer Modelling Group (CMDXF) – have been industries where we have no distinct edge in knowledge (in CMDXF’s case, the energy industry). It should come as no surprise that New Oriental Education was not in any of our circles of competence. We had no edge in China as an investment environment or education as an industry vertical in this instance. Looking back, I would say both were almost anti-circles of competence. 
 
We underestimated non-corporate risk: As I mentioned previously, it’s clear we have focused far too much on business risks to the detriment of regulatory or government risk. Interestingly, when we look at any possible healthcare investment, we spend an enormous amount of time understanding the risks related to FDA regulation, regulatory approvals, etc. In this case (again, because of our lack of industry and geographic knowledge), we spent far too little time understanding the CCP’s role in government regulations, setting industry priorities, or capitalistic models in the Chinese economy. While we did a decent job understanding the industry, competitors, and the company’s financials, we dropped the ball investigating outside the walls of New Oriental.  
 
“Never Invest” wasn’t broad enough: W.C. Fields’ adage was that actors should never work with kids or animals. Over time, at Nintai, we’ve developed similar “Never Invest” conditions. These include significant debt, no moat, and low-margin businesses. For instance, we’ve never invested in the consumer retail space because they almost always have all those conditions, not just one. We overlooked when it comes to New Oriental that we should never invest in a country where the ruling government has the power/capabilities of disrupting or eliminating a company’s business model or industry. Though they may look like they are invested in a capitalistic model (like Russia or China), certain countries do not have the political or economic infrastructure to guarantee investor or corporate rights. 
 
How to Prevent This Again
 
“We do not learn from experience; we learn from reflecting on experience.”
 
                                                              -        John Dewey 
 
Now that you (and we) know what went wrong in the New Oriental investment, I wanted to take the time to discuss what steps we’ve taken to make sure this doesn’t happen again. 
 
Non-business risk is just as important as business risk: I’ve spent tens of thousands of hours learning what makes businesses tick for over two decades. I’ve learned what role strategy and operations can play in creating a moat, how the lack of access to capital can bring a company to its knees, and how unethical management can start rotting a company from the head down. One thing I haven’t focused on enough is that risks outside the company – governmental, socio-economic, or political – can be as severe in size (or even more severe) than those within the company I mentioned previously. It’s easy to make assumptions or have cognitive biases in such issues as the political structure of a country. For instance, in China, I made a mistake to assume that the ruling CCP would do what’s best for its people as seen through the eyes of a quasi-capitalistic system. I didn’t take into account two risks. First, the government would unilaterally act seemingly detrimental to its people (meaning millions will no longer have access to top-quality tutoring). Second, the government would act in such a manner as to call into question (from the West’s standpoint) an entire generation of capitalistic moves that created an opportunity for millions of its citizens. 
 
Going forward, we have broadened our risk assessment tools adding new sections on government and politics. This will include new sections specifically discussing the nature of these risks and any mitigation steps Nintai can take before investing. This might range from requiring a more significant margin of safety to adding the company to the “Never Invest” category. In addition, we have built new steps in our modeling (such as “Breaking the Case”) where non-business risks impact valuations to a greater degree. This includes government intervention in customer markets, unilateral powers vested in the government, or actions are taken to retain control that impacts the company or its business model. 
 
Clearly define your circles of competence: At Nintai, we’ve never explicitly stated what lies within our circles of competence. Our corporate structure and management agreements do not prohibit me from investing in any type of industry or specific company as Chief Investment Officer. Over time, we have recognized that our expertise lies in the areas where Nintai Partners conducted business. This included healthcare, healthcare informatics (the use of information and data in strategy and operations), and technology platform companies (where the company provides a platform that integrates a client’s information systems). Secondary (but equally important) are companies that meet specific characteristics in the structure and operations. These include high returns on capital/equity/assets, high free cash as a percent of revenue, little or no debt, a competitive moat, excellent capital allocation skills by management, and trading a discount to our estimated intrinsic value. Unfortunately, New Oriental was far outside our circles of competence regarding knowledge about the investment country or the industry. If we were asked today to check off the significant characteristics cited, it would go something like “little to no knowledge of Chinese economic policy?” Check. “Little to no understanding of the Chinese educational system?” Check. “Little to no understanding of the ESL/tutoring/certification studies market?” Check. It is not a great performance from our risk management process.
 
Going forward, we have created a system that makes a structured view of our circles of competence, including industries, geographies, markets, regulations, etc. This new system requires that any potential investment be vetted through these circles’ characteristics. Any company that meets less than an 80% overlap is immediately rejected. We will also be adding this to Nintai’s annual review of current holding to make sure the holding hasn’t drifted outside our circles of competence.  
 
New categories of “Never Invest”: As I’ve mentioned previously, over time, we’ve developed a list of “Never Invest” companies or industries that don’t meet our investment standards are we don’t understand. Until this year, we’ve eliminated companies or industries because we couldn’t quantify the risk. For instance, in many biotechnology companies, we simply cannot tell the odds of a company getting FDA approval for a new product. We know it’s low, just not exactly how low. With our investment in New Oriental Education, we realize that there are opportunities where the level of risk can be quantified, and it’s simply far too much. In this instance, the risk is that the CCP can eliminate the company’s entire business model in one brief announcement. While it might seem unlikely they would do this, the consequence could be (and have been) catastrophic.
 
Going forward, we have added a new bucket of “Never Invest” companies and industries driven by the fact that outside risks are simply far too impactful, no matter what the chance. This might include companies that are beholden to one or two products for most of their revenue or similarly might count on a single client for much of their revenue (Skyworks Solutions came close to this with their Apple relationship). It will also include risks outside of the business (such as New Oriental) where a single event such as an earthquake or governmental edict can impair our investment case. Hopefully, this new addition to our risk assessment process will prevent another poor investment outcome, such as New Oriental Education. 
 
Final Thoughts
 
2021 was another year dominated by COVID, though there was some heartening news when several effective vaccines became available. We found out exactly how resilient the economy was as we had several new waves of variants without a dramatic impact. Unfortunately, we saw an increasing polarization within our political system, starting with the January 6 insurrection and attack on the Capitol. The markets had another banner year, with the S&P 500 gaining nearly 27%, the Dow Jones roughly 19%, and the NASDAQ 21%. It was the twelfth year of a bull market that started at the end of the Great Recession. 
 
2021 was undoubtedly a disappointment to Nintai Investments and most of our investment partner portfolios. No investment manager will ever get every pick correct unless your first name is BERNIE and your last name starts with M_A_D_O_F. Confessing poor judgment and owning up to your mistakes is never easy, even if you are Charlie Munger. But as an investment manager, I feel it is my responsibility to take credit (not sure that’s the word I’m looking for) for the wins and the losses. More importantly, I believe each of our investment partners is due to an explanation as to how we will prevent such a mistake going forward. I hope this report has provided that to our investment partners.

"The strategy of buying what's in favor is a fool's errand, ensuring long-term underperformance. Only by standing against the prevailing winds - selectively, but resolutely - can an investor prosper over time. But for a while, a value investor typically underperforms."
 
                                                                                              -     Seth Klarman 

I recently read an article ("Investing When Everything is Expensive") by John Rekenthaler, Vice President of Research at Morningstar[1]. He discusses why it might be necessary to rethink the concept of "core" and "explore." The former is plain old generic stuff such as blue-chip US/foreign equities and high-quality debt. The latter are investments that might seem more risky but likely to outperform over the investor's lifetime. For me, the article resonated because Nintai has found itself looking like one of those dogs trying to find just the right spot for their morning business. We all know the look - nose to the ground, running in circles, revisiting spots they just investigated a minute before. When every asset class is inflated in price - core or explore, bond or stocks, domestic or foreign, wide moat or no moat - we find ourselves trotting around, looking at every class for some obscure gem of an investment. We got into investing in 2003-2004, so Nintai missed that period in 1999-2000 when many stocks were egregiously overpriced. But even then, many bargains were to be had in non-"e” or technology such as manufacturing or utilities. In today's market, every asset class we play in is overvalued. We don't see any screaming bargains in our investment horizon. 
 
What makes this particularly painful is that our investment partner portfolios have underperformed over the past twelve to eighteen months as we hold significant cash positions, and our portfolio stocks have been hit hard after nearly a decade of outperformance. Nothing is more frustrating and stomach-churning than underperforming and knowing there is little you can do about it. "These are the times that try men's souls," said Thomas Paine. Mr. Paine had the heart of a value investor experiencing a sustained bull market. 
 
A Quick Review on Strategy 
 
Before I get into why it is so challenging to be a value investor in expensive markets, I thought I'd quickly review our investment methodology here at Nintai and how it relates to our actions in these overpriced times.
 
Focused Portfolios: At Nintai, we operate in a relatively simple format of being invested or not. We run a focused portfolio (anywhere between 15 - 25 positions dependent on size or investment need. As I've discussed previously, we focus on companies with high returns on assets/capital/earnings, fortress-like balance sheets, deep competitive moats, and managed by great capital allocators. After running a search with such criteria, there are generally only 150-175 companies worldwide the meet our demands. By its very nature, our investment strategy forces us to focus on just a few holdings and to hold them for the long term. 
 
We Hedge with Cash: We use a simple model when it comes to investing. We are invested in our focused portfolio holdings, or we hold cash. We aren't limited to any particular model in our investment management agreements. We could use actively managed funds, ETFs, or even individual debt instruments as hedging tools. I don't do this for the simple reason our partners invest with us to use Nintai's strategy – not for me to use a competitor's model. Consequently, when no opportunities arise with Nintai's strategy, I will hold cash. This can sometimes drive cash to 30-35% of total assets under management. 
 
Valuation Drives Portfolio Holding Make-Up: How much we hold in equities or cash is driven solely by valuation. By this, I mean that we use two distinct valuation measures – one individual and one broad. The first is the valuation of each holding. If we think the valuation of a specific stock is compelling, we will likely add to the position, thereby necessarily driving down the portfolio's cash position. The second (and somewhat in congruence with the first point) is that I will likely hold more cash if I feel the markets – as an aggregate - are overpriced. Conversely, if I think markets have gotten far ahead of themselves (an example might be our aggregate portfolio is 125% above our estimated intrinsic value), I will sometimes shave 5% off every individual portfolio position.

Where We Stand Today
 
As of November 29, 2021, the S&P 500 stands at 4668, up roughly 22% year-to-date and roughly doubled over the past five years. Morningstar currently has its total rated stock universe approximately 4% above fair value. It calculates that the healthcare and financial sectors (by far Nintai's majority of holdings are in these two sectors) are 6% and 10% above intrinsic value, respectively. Other indicators reflect a much higher valuation versus historical data. For instance, the Schiller PE ratio has only been higher once before in the late-1990s before the technology bubble and crash. From the old-fashioned PE ratio to the newer PEG ratio, nearly every historical measure is at all-time highs. Fighting this trend, the current Nintai holdings are trading – in aggregate – roughly 11% below our estimated intrinsic value. The aggregate PE ratio of most portfolios is less than half the S&P 500s. At the same time, returns on equity, capital, and assets are substantially higher than the market averages. 
 
Nintai has been down this path before when we thought markets were wildly expensive. Our last experience was during 2006 – 2007, just before the real estate crash and the ensuing global credit crisis. For almost the entire year of 2006, the Nintai Partners fund held nearly 45% of total assets in cash. We avoided corporate and government debt as fervently as equities. As a result, we could find little value in domestic or foreign markets, debt, or equities. In the ensuing market crash, we significantly outperformed the markets after trailing for several years of slight underperformance. Indeed, much of our long-term outperformance was generated in the single year of 2007 when we beat the S&P 500 by nearly 30%. 
  
We are currently looking for ways to batten down the hatches but not get left behind by the S&P 500's double-digit annual returns. This is the rub, of course. You must attempt to prevent a permanent loss of capital in a sudden market crash but at the same time stay as invested as possible to allow compounding to work its magic. As we take the necessary steps to obtain that balance, we try to focus on several core tenets.  
 
To thine own self be true (your process is your guide)
Generally, value investors underperform in prolonged bull markets. It can seem that every decision you make has the markets go against them. Stocks that you purchase drop by another 30% over the first few weeks. Even companies that present shining earnings quarter after quarter can stagnate and underperform for years at a time. No matter how much you hear about the latest nanotechnology, day trading with options, or how value investing is dead, your process must always be the anchor in your decision-making. Your process must be your guide. As a value investor, your methodology rests on the simple premise that a company's share price will inevitably be matched by its intrinsic value. It can take years for the markets to reach these same conclusions, and to date, they usually do so. Hold on to that fact dearly. 
 
This ain't no fantasy football (valuations are only reasonable when based in reality)
One of the problems with expensive markets is the growing ability of Wall Street, investment advisors, and personal investors to convince themselves that prices really aren't that bad. That 55% projected growth rate over the next decade might just be reasonable if you hold your nose and believe in management's claims. Never, ever do this. Your job as a value investor is to question everything in your investment case - including claims by management and your assumptions for valuation. Every investment debacle I've had (and there have been quite a few) has been caused by my inability to force some form of brutal reality into my assumptions.    
 
Just because the market is crazy doesn't mean you should be too 
A corollary to the previous point can be summed up by that phrase so many of us heard from our parents. "You wouldn't jump off the bridge because everyone else is doing it, would you?". We would frequently answer that; of course, we wouldn't do something so ridiculous. If you wouldn't do it as an eighteen-year-old, why do it as a seasoned value investor? Of course, the pressure is intense when talking heads slam buttons that scream "Buy! Buy! Buy!" or you read how some new prodigy achieved 94% returns on only ONE stock that he's more than happy to share with you for only just $499 right now!  Just because networks allow this type of behavior on their shows doesn't mean you need to listen. Base your decisions on a well-reasoned and well-researched process that meets your goals. Anything else looks like a lemming running at top speed with all its friends and relatives, and we know how that ends.   
 
Conclusions
 
Investing in expensive markets can be costly in more than one way. Elevated prices supported by nearly a decade of steady gains can make you want to overpay for a stock that looks so good on quick review. It looks even better when you hear about it at the staff Christmas party or your New Year's party with your neighbors. You can frequently hear them talking about how 
 
their outstanding stock-picking abilities paid for that BMW or pool. Don't believe it for a moment. Most gains in the market are made by purchasing shares at a reasonable price and selling them when overvalued. That's value investing. Buying expensive stocks and selling them after they become more expensive (hopefully) is a process dependent on the greater fool. When stocks are trading at such all-time highs and nosebleed valuations, it's hard to know who's the real fool. Be careful. It might just be you.
 
As always, I look forward to your thoughts and comments. 
 
DISCLOSURE: I have no positions in any stocks mentioned in this article.


[1] John is a brilliant writer with the rare attribute of being able to see the investment process from many different angles and disciplines. I highly encourage my readers to go to Morningstar and become regular readers of John’s “Rekenthaler Report”. You can find his writing here.  

"The first thing [in credit] is character, before money or anything else. Money cannot buy it. A man I do not trust could not get money from me on all the bonds in Christendom. I think that is the fundamental basis of business".
                                                                -   J.P. Morgan in testimony to the Pujo Committee, 1912
 
"Nobody who has run a business thinks 'Geez, I'd like to run this thing right into the ground, make the business so worthless that some could buy it pennies on the dollar.' No, most managers want to make the most prudent decisions to maximize the value of the company. Being a good manager isn't the best training at being a value manager". 
                                                                -  Joel Alscot   

When I first began investing (and this takes me back nearly 40 years ago) in an economics class, I saw stocks simply as a symbol in the financial section of our local newspaper. How quaint. An actual physical newspaper. My understanding of management was absolutely nil. That changed after I graduated from college, and several friends and I started a company together. I knew nothing about running a business or my relationship with shareholders (shareholders?) vis a vis being a senior executive. I got an education very quickly, starting with my first Board meeting. I quickly learned several lessons that were pounded into me by several members. 
 
It's all about allocation of capital: My job - I quickly learned - was to make decisions on allocating capital and achieving the best return I could for the company, and therefore, for our shareholders. Nothing was more essential, and nearly every major decision we made was part of this allocation process – human resources, deal structures, infrastructure spending, etc. By the end of the first year, I was thinking like a capital allocation machine. 
 
Honesty is still the best policy: My Board expected me to report the good and the bad clearly and succinctly without any gobbly-gook or hiding the facts. If we made a mistake, it was best to describe what happened and how we expected to prevent it from happening again. Our Board made it very clear: the worst thing we could do was make a mistake and hide it. When we did this we prevented them from assisting us in finding a solution. 
 
First principles thinking is the best thinking: The Chairman of our Board was a huge proponent of reasoning by first principles. This is a form of reverse-engineering a problem by removing the fuzziness and vagueness of assumptions and focusing on the essentials. Rather than assuming something works because others (our ourselves) have always done it in a particular way, you can go to the most basic level and assemble the building blocks based on facts. Many times you find assumptions can lead you far astray. 
 
After our fourth year in business, our company began an internal fund to invest our retained earnings and increase the book value of our shares. I quickly realized the views I had learned and adopted as an executive were the same values I wanted to see in companies that became our investments. I still think they are the best core values to find companies that will outperform over the long term. Here are a few examples of how I applied my learning in portfolio selection.
 
Allocation of Capital
 
When I first had a conversation with the senior management team of FactSet Research (FDS) in the 2000s, I was struck immediately by their focus on capital allocation. One executive said to me:
 
"We have a lot of choices in what we can do with our capital. We are an asset-light business, meaning it doesn't require a lot of assets to run our business, we are a relatively non-capital intensive business model. It could be easy for us to go out and do a zillion smaller acquisitions or one huge acquisition or buy a new technology for our operating platform. But you know what? We've run the numbers over and over. Frankly, we can achieve the best returns on capital by incrementally spending the money on our business and retaining capital on the balance sheet. Would it be sexy to do a huge deal? Sure! But it wouldn't be our shareholders who win. It would be investment bankers, accountants, and those of us in senior management. We try to remember every day we work for our shareholders. Return on capital means return to shareholders."  
 
From 2006 - 2020, FactSet achieved an average Return in Invested Capital (ROIC) of 34.6% versus an Average Weighted Cost of Capital (WACC) of 8.3% (source: Gurufocus). Over that fifteen-year time frame, WACC never exceeds ROIC in a single year. Now that's discipline in capital allocation.
 
Honesty and Integrity 
 
You get the feeling watching the news today that not many managers are a paragon of virtue. Stories of embezzlement, failure to pay vendors, gaming the numbers to meet earnings - the list goes on and on. At Nintai, the older we get, the more critical management becomes in the outperformance of our portfolio holdings. Negative things generally happen when good companies are taken over by bad managers (to paraphrase Warren Buffett). Some of the worst things happen when managers turn out to be untruthful or lack integrity. We haven't seen many companies implode when competent and ethical managers run them. Conversely, the investment journey is littered with companies led down the garden path by unscrupulous management. 
 
In 2019, we sold a biotechnology company out of our investment partner portfolios, the Nintai Trust portfolio, and my personal portfolio. The company was accused of overcharging the Center for Medicare/Medicaid Services (CMS) for its products. It's an all too common technique in the industry that provides a quick, highly profitable, (and illegal) manner for juicing revenue at no additional costs. The problem I've always had with this is two-fold. First, these types of issues always start at the top. You simply can't create an entirely 
 
fictional billing process along with a new revenue stream that impacts corporate revenue without senior executives' knowledge. Second, managers who believe these types of lies begin to push the envelope in other ways, such as off-label marketing and even fabricated research results. Executives willing to put patient lives at risk and overcharge those least capable of paying are some of the worst individuals I've been involved with and have happily cut all ties. 
 
First Principle Thinking
 
Applying first principle thinking isn't always a natural approach to problem-solving. In my case, it took years of note-taking and reminders to make the process a fundamental step in making decisions.  
 
A Lesson in Debt: While running my business (which I still do at Nintai Investments with only three shareholders), I quickly learned that debt could be a double-edged sword for the business. While it can provide opportunities to invest in growth, all too often, debt can be an albatross around the neck when times get hard. We've all heard the phrase "you can't go bankrupt without debt." First principle thinking allows us to break this down into different pieces. First, without debt, you can't go bankrupt. Second, debt can’t be serviced at the worst time. Third, companies often generate low returns on debt financing. Ergo, it's hard to get in trouble without debt. Consequently, in my history as a money manager, roughly 75-80% of my portfolio holdings have (or had) zero short- or long-term debt. 
 
A Lesson in Costs: When I talked to the former CEO of Fastenal (FAST) – a past holding in the Nintai portfolios – he frequently would tell me about how excited he was to obtain low costs, not just in his business, but even his personal life. Low costs were a passion for him and a sign of personal integrity. For example, he said to me once:
 
"What most people fail to understand is that to have low prices, you have to have low costs. I know that sounds crazy, but you'd be amazed by the examples I've seen where management thinks the company should have low costs, but management shouldn’t. Take a look at their corporate offices, their expense accounts, the flashy clothes. Rot starts at the head of the fish. If you want low prices, then low costs start at the very top – with the Board and the executives." 
 
His application of first principles came intuitively to him. Query: how do you achieve low costs and high returns to shareholders and customers? Answer: Have the lowest costs. It might not seem like rocket science, but frankly, I haven't found many other executives like him nor holdings as successful as Fastenal. 
 
What This All Means
 
So what does all this mean? Focusing on the lessons I learned from running my own business (both in the past and present) helped me to understand the type of company I'm looking to create and run is the type of company I would like to add to my portfolio. Several themes emerge from that.  
 
They're human beings, not robots
 
We often hear the comment that when you invest, you buy a piece of a business, not a stock share. That rule is equally valid when it comes to an investment's management. You are purchasing the qualities of a set of human beings, not a computer named Hal that runs the ship. First and foremost, managers are people just like you and me, filled with emotions like fear and joy or uncertainty and egoism. They have good days and bad days. What is necessary before anything else is that we are aware we are purchasing the rights to a human management team that reflects their emotions, skills, and values. These values will hopefully provide shareholders with adequate returns over the long term. Of course, as an investor, we expect management will make mistakes. That's part of being human. We just need to be made aware of them – quickly and openly – and plan accordingly. 
 
Values still matter
 
No matter what you may hear on the TV or read on the internet, at Nintai, we like to think that values still matter and good guys (and women) still finish first most of the time. Those that cut corners, fudge numbers to meet aggressive quarterly earnings, or create neat little off-balance sheet SIVs will eventually be hung up by their own petard. None of those scenarios are good for shareholders. Equally important is the way management communicates with shareholders. At Nintai, we like to invest in management who see us as business partners. Therefore, we want management to communicate with us in an honest and open approach helping to make the best investment decisions. When mistakes are made (see the previous point), we like our portfolio holdings' management to own up to them, explain what went wrong, and hear how they intend to prevent a repeat in the future. Bottom line: integrity still matters a lot. 
 
It's easy to forget what matters
 
I've noticed over the years our willingness to let unacceptable cases slide in some cases and not in others. It's important to realize that "it's OK because everybody does it" is just as dangerous as a case of apparent specific personal misconduct. Let me give you an example of what I mean.
 
Case 1: You read an article about a Wall Street financier who knowingly bundled together bad debt (voila! Let there be good debt) and created fictional debt instruments to be sold to unknowing investors. These instruments lead to the creation of a financial bubble that costs thousands of jobs and billions in dollars of losses. 
 
Case 2: A co-worker comes to you and asks for money to help fund a family member fighting cancer. After writing a check for $500, you find out the story was a lie, and there was no family member and no cancer. Instead, they used that money to finance a vacation to Bali. 
 
Now answer these questions as quickly and honestly as possible. 
 

1. Which case made you angrier at a purely emotional level?
2. Which individual would you least likely do business with in the future?

 
If we are being honest, just about everybody has a far more visceral reaction to the second case versus the first case. But as an investor, it's vitally important to see both as clear-cut cases to reject both individuals in a potential investment. Just because everybody is doing it (think about how widespread the problem was in the first case) doesn't make it right. On the other hand, the lack of individualized anger (such as case 2) also doesn't mean it's OK to ignore it. Have your standards and stick by them no matter the scope or size.
 
Conclusions
 
Another J.P. Morgan story relates that he thought someone failing to pay back five dollars told him more about somebody than not paying back five million dollars. Over time I've realized that genuinely great managers who produce outstanding long-term results have ethics that consider the small ($5) or very personal (the cancer scam) value just as much as driving overall corporate values. They all matter equally. Look for managers who, through their values, create value in your investments. It isn't easy. Doing the right thing isn't always the easiest path. But it is one we admire greatly at Nintai.  
 
As always, I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai has no positions in the companies mentioned within this article. 

“Ambiguity is central to Boyd’s vision. It is not something to be feared but something that is a given . . . We never have complete and perfect information. The best way to succeed is to revel in ambiguity.” 
 
                                                                              -      Grant Hammond[1] 

In 1961, Colonel John Boyd – working with Thomas Christie – wrote an article named “Aerial Attack Study.” Boyd trained as a fighter pilot, but his mind quickly developed beyond the cockpit. Aerial Attack Study introduced the military to the concept of “Energy-Maneuverability Theory” (E-MT). Boyd’s and Christie’s work was vital in understanding the various tradeoffs when working on aircraft design. E-MT was a breakthrough of immense value because it gave engineers a process to calculate how any design can be superior or inferior when measured against another. E-MT analyzed how swiftly and efficiently an aircraft could change its energy use, speed, and acceleration or potential versus kinetic energy. This analysis could then be converted to a numerical value of how well a plane maneuvers under various conditions. This process enabled fighter pilots to “converse” with engineers in their language by describing dogfighting jargon in mathematical terms. E-MT had a significant impact in creating the leading fighter aircraft over the next generation, including the F-15 Eagle and F-16 Fighting Falcon.  
 
Boyd’s next project brought him even greater fame – in terms of both name recognition and scope of impact. It also is where his thinking can best be applied to value investing theory and practice. Thinking at a higher level than his E-MT work, Boyd began analyzing what systems could be put in place to improve a fighter pilot’s speed/effectiveness in thinking processes and decision-making skills. From this, he developed the OODA  (Observation, Orientation, Decision, and Act) Loop. 
 
The OODA Loop begins by making two assumptions. First, Boyd contends that all intelligent life and human-developed organizations continuously interact with their respective operating environment. Second, all of these interactions can be broken into four major groups or functions. 

1. Observe: The utilization of all major senses in the collection of data. Boyd made it clear that data was a snapshot of what was happening within a complex environment at any one time. Observation information becomes obsolete relatively quickly. Therefore, observation requires constantly updating your data. 
2. Orient: After collecting data through observation, comes the synthesis and analysis of the data. The orientation phase is about reflecting on the critical data captured during observation and considering the next steps. Above-average orientation skills require great situational awareness and a process that uses multiple mental models. Boyd saw this as the most essential function.
3. Decide: The decision phase develops a series of suggestions taking into account all potential outcomes. A key component in the decision process is creating a strategy that screens out extraneous inputs and allows management or the individual to focus on the best possible choices, not all choices. 
4. Act: The steps and actions necessary to carry out the decision. In Boyd’s final presentation on the OODA Loop, he placed “Test” directly next to “Act” (this was changed to “Unfolding Interaction with Environment” and “Feedback” in his later presentations). In doing so, he clarified that he saw the Loop not just as a decision-making process but as an individual or organization-learning process. Thus, not only should we be constantly updating inputs, but we should constantly test our mental models throughout the Loop. 

Source:    “Science, Strategy and War,” Frans P.B. Osinga, Routledge Press, December 2006 
                  “The Tao of Boyd: How to Master the OODA Loop,” AoM, November 2020
 
After developing the OODA Loop, Boyd developed several thoughts about its effectiveness and some caveats in its usage.

1. The OODA Loop is a means to operating in a complex environment. Multiple inputs are constantly changing. The faster someone can obtain inputs, the quicker someone can produce decisions.
2. The OODA loop is only as effective as the time it takes to execute a result.
3. The person or organization that completes multiple OODA loops first derives the most value. 
4. The person or organization that adapts/updates their observation and mental models quickest, thereby evolving their OODA Loop, derives the most value. 
5. Limiting extraneous factors that can needlessly slow down getting to decision and action phases can significantly impact. 

 
The OODA Loop and Value Investing
 
So what does all of this have to do with value investing? At their highest level, the description of the OODA Loop and value investing share many common attributes. For instance, the OODA Loop has been described as “a learning system, a method for dealing with uncertainty, and a strategy for winning head-to-head contests and competitions. Another description is “the OODA Loop is a means to a.) observing complex organisms, whether they be an enemy pilot or a competitive corporate threat, b.) developing possible counter-measures through situation awareness and mental models, and c.) acting on such chosen measures.” 
 
Compare that with the following description of value investing as “a trading process based on uncertainty and risk in which a.) an investor looks to identify a discrepancy between price and value identified by b.) observation of corporate data and ecosystem characteristics and c.) observable investor behavior that leads to d.) a decision to allocate capital in the security.” At Nintai, we believe the major steps in value investing consist of these steps. 

• The investor sets specific criteria by which they search for possible investments. This can be by financial, capital return, industry, or country/region. As value investors, we are constantly updating both corporate and market information. Therefore, what may not meet our criteria one week might be ringing alarm bells just one week later. Similar to OODA Loop, “Observe.”
• Research is conducted through which estimated growth, profitability, market size, regulatory issues are identified and quantified. Information can be specific to a certain date (such as the balance sheet), a defined period (one-quarter, one calendar year, year-to-date, five-year average). A series of mental models will develop cross-functional ways to observe historical, current, and future value trends. Similar to OODA Loop “Orient.”
• Research ascertains the estimated intrinsic value of the company shares and matches it against its current trading price, and develops a series of possible recommendations. These might be to purchase at a specific strike price, buy increasing shares at share prices further decrease in price, sell a position when certain conditions are met (such as the holding taking on debt), or sell on specific market conditions (a competitor successfully launches a new FDA-approved drug). Similar to OODA Loop, “Decide.”
• When certain conditions are met (% discount from estimated intrinsic value) and reasonable suggested actions are offered (purchasing X number of shares representing only 30% of one day’s total trading volume), then action should place. Following up on these actions, we will spend a considerable amount of time evaluating the success or failure of the process. Similar to OODA Loop “Act.”

 
If this sounds similar to the OODA Loop, it should. Long-term successful value investors are constantly reevaluating not just their holdings (including management performance, product development, competition, market factors, etc.) but their very selection process (what factors are most important? How do we gather and collect data? How do we evaluate trends in the data, etc.?). At Nintai, we see the investment process must be continually reviewed and adapted to the ever-changing investment universe.
 
The Importance of Orientation
 
John Boyd felt the most important of the four steps in the OODA Loop was orientation. In one of his presentations, he stated: 
 
“Orientation isn’t just a state you’re in; it’s a process. You’re always orienting.”
 
As I pointed out in the last section, Nintai sees the process of orienting our thinking as a never-ending process. This is perhaps the greatest symmetry between Boyd’s work and value investing. One of the failings in nearly every value investor (this author included) is constantly failing to update our orientation. Too often, we get stuck in a pattern of thinking which locks us into a particular model or pattern of assumptions. For value investors, this can be costly. For fighter pilots, it can be fatal.
 
One method that Boyd suggests using is applying a set of mental models regularly until they become second nature in your thinking process. Boyd lists seven disciplines that are a must for any strategist. These include:

1. Mathematical Logic
2. Physics
3. Thermodynamics
4. Biology
5. Psychology
6. Anthropology
7. Conflict Resolution (Game Theory)

 
These models are essential for any person or organization to orient themselves in their environment. Understanding these disciplines allows an individual to see their position from many disparate and unique viewpoints. In addition, constant orientation leads to the ability to act quickly and – most importantly – with the best chance of obtaining outstanding results from your decision-making. 
 
Again, this sounds remarkably similar to Charlie Munger’s concept of a “Latticework of Mental Models,” which he believes creates a powerful method of objective – and evolving – thinking. Thus, while Charlie’s disciplines[1] may differ somewhat from Boyd’s, the concepts meld pretty easily. 
 
Conclusions
 
One thing that has always interested me in value investing is the constant need to acquire knowledge. Whether improving or altering my thought processes to the knowledge of a specific industry or market verticals, roughly 80-85% of my day is spent thinking and researching. Does this mean we get everything right? Absolutely not. But it does mean that Nintai can hopefully gain the ever-so-slight edge over the marketplace, which allows for long-term outperformance. Investors can continually adapt their thinking and investment processes by studying such works as Boyd’s. The history of business – and nations – are replete with organizations that got caught in a cycle of actions that never considered changes in their operating environment. As a value investor, the OODA Loop can be a helpful tool to evolve your thinking from valuing a business to understanding changes in specific industry verticals. Next month I will use a specific case study that discusses how Nintai uses Boyd’s work in understanding changes within a specific portfolio holding.   
 
Until then, I look forward to your thoughts or comments.
 

[1] Math and Inversion, Probability, Chemistry, Statistics, Economics, Evolutionary Biology, Psychology, and Engineering 

I recently discussed Nintai's performance numbers with a group of analysts who wanted to know the secret sauce that generates long-term outperformance. Many of the questions centered on our stock-picking ability, market timing, and ability to identify business trends leading to outstanding growth. I made it pretty clear the evidence suggests there aren't many individuals who can repeatedly pick stocks that outperform (certainly we can't!), there are even fewer who can choose the highs and lows of markets (definitely not Nintai!), nor do we have a business divining rod that identifies the next hot "it" thing in the markets (we are so far from what's hot in business, I'm not sure we would know "hot" if it hit us in the nose). At Nintai, we think the more active we are, the less effective we will be in the long term. Unfortunately, our circles of competence are limited, and our crystal balls are pretty fuzzy. So instead, I told this group of analysts that our success had been driven by finding several compounding machines throughout my investing career and riding them for as long as possible.
 
What exactly is a "Compounding Machine"?
 
Compounding machines are simply companies that consistently grow free cash flow at substantial rates over a decade or two creating long-term value. This can be achieved through competitive advantages gained through internal and externally-facing moats. Additionally, these companies often generate high returns on capital and maintain fortress-like balance sheets. These attributes drive steady growth in the intrinsic value of the business. When I describe it like that, it seems like a pretty straightforward process. You simply have to find these types of companies, back up the truck, purchase a significant number of shares, and merely wait ten to twenty years as management and the company work their magic. What an easy world value investing would be if it was so simple. But, of course, we all know it doesn't work quite like that.  
 
Finding compounding machines requires several major buckets of data. Some are easier to find, while others are more difficult. Overall, it requires a significant effort to create a process, identify opportunities, research candidates, and track holdings. The primary information and process requirements can include the following. 
 
Quantifiable Data
 
In some ways, this is the easiest part of the process. A single search query can identify some (but certainly not all!) compounding machines on a search platform such as Gurufocus' All-in-One Screener. Search criteria might include the following.
 
Return on Equity (10 Year Average) > 15%
Return on Assets (10 Year Average) > 15%
Return on Capital (10 Year Average) > 15%
Free Cash Flow Margins (10 Year Average) > 25%
Free Cash Flow Growth (10 Year Average) > 10%
Debt/Equity Ratio (1, 3, 5, and 10 Year) < or = 0
 
This search on Gurufocus will likely generate less than 100 companies, and we haven't even begun to screen on valuation. An investor could probably do fine simply by investing in a broad bucket of such companies trading near their 52-week lows.
 
Non-Quantifiable Data
 
A simple query in a database can't discover some characteristics. While such searches can sometimes be good starting places, many compounding machines can only be found through the hard work achieved by rolling up the sleeves and better understanding specific industries or verticals. This includes a lot of time researching individual companies, their operations, competitors, product development, regulatory challenges, etc. In the course of this research, an investor should be looking for four broad themes.

Outstanding Capital Allocation
This is a multi-faceted attribute. It includes management that can identify great capital investment opportunities. It also requires management to say no to opportunities that might not reflect their core competence or provide adequate margins. Finally, it includes creating a business that operates in an environment where opportunities exist for allocating capital in existing business lines that can generate long-term runways for growth. 

Deep and Wide Inward/Outward-Looking Moats
In last month's presentation to the Gurufocus's "Value Investing Live" series, I discussed in depth the idea of inward and outward-looking moats. In summary, outward-facing moats keep competitors at bay through a series of strategic and operational advantages.  Inward-facing moats keep customers locked in by having products or services essential to their customer's business model, strategy, and operations. Capital compounders must have strengths in both of these, not just one.  

Expanding Market Opportunities   
This, too, is multi-faceted in that opportunities must be both in existing customers (by selling deeper into the organization) and new customers in either existing markets or new markets (this can be demographically and functionally). Compounding machines are generally strong in both of these but lean towards the former (broadening existing bases) and aim for the latter. Most avoid costly acquisitions as a means to growing market share or revenue. 

Self-Fund Growth with Existing Internal Capital
​Compounding machines tend to require very little capital to achieve growth. Because of this, nearly all new opportunities can be funded with either free cash flow or cash on the balance sheet. Most of these companies have extremely strong balance sheets with little or no debt and very high free cash flow margins (meaning the percentage of revenue converted into free cash). With extremely low weighted average cost of capital (WACC), compounding machines can achieve high returns on even lower margin growth. 
 
An Example: Veeva (VEEV)
I have written about Veeva extensively over the last two years (including a recent presentation on Gurufocus' Value Investing Live), so I won't spend a lot of time rehashing previous content. Instead, I wanted to show a graphic that demonstrates the compounding nature of the company. Seen below is a quick overview of the growth in the company's free cash flow, earnings, returns, and valuation. The reader can see strong growth combined with consistent profitability and high returns. In combination, these drive an ever-increasing estimated intrinsic value. 

Nintai estimates growth and returns will be very similar over the next decade or two (with slowing growth rates due to size). Veeva is the very image of a compounding machine. 
 
Conclusions
 
The goal of every value investor - indeed every investor - is to create value over the long term that outperforms the general markets. Compounding machines can play a huge role in achieving those results. Finding companies with wide moats run by great capital allocators in growing markets is the holy grail at Nintai Investments. When we can find a company with these attributes (and the price is right), we will generally invest a substantial portion of our capital in the stock. We will then try to sit quietly and let management do the heavy lifting and perform their wonders. A successful investor once said that it isn't the investment manager that produces excellent returns but rather the management and companies in the portfolio. That individual understood the concept of compounding machines. It would behoove all investors to follow her lead.    

Tom Macpherson presented on Gurufocus' Value Investing Live, a series of presentations and interviews of today's leading value investors. Thank you to the Gurufocus team and members for such a great experience!

"As the hunter-gatherers began to identify certain species of game easiest to kill, humans began to understand that habitation in the areas where these species abounded was just as important. It wasn't just the roebuck that was important, but the habitat where they lived that meant life or death for their clan".
                                                                                  -     Richard Daly 

For value investors, one of the holy grails has been finding companies with wide competitive moats. These are investments with common characteristics – return on capital higher than the cost of capital, high margins, steady revenue/earnings growth, and dominant market share. These companies can be tremendous long-term investment opportunities. As an investor becomes more experienced in research and identifying such companies, it becomes apparent that such investment opportunities are often clumped in industries with a penchant for individual-wide moat investments. Much like our hunter-gatherer ancestors learned, it isn't just the individual investment but the industry/market that can lead to long-term outperformance. This is an ecosystem that creates an environment which - by its very nature - is conducive to deep competitive advantages. There is, of course, no hard and fast rule, but over time at Nintai, we've identified several critical aspects within specific industries that lead to high percentages of investment opportunities. 
 
Asset Light and Capital Light: Generally, industries and their companies that require high capital infusions, are asset-heavy, and have significant organizational needs (such as unfunded pensions for tens of thousands of former employees) and complex infrastructures (large manufacturing plants). They also have lower gross and net margins, lower free cash flow, and significant capital requirements. An example of this is large legacy manufacturing industries on which the great American middle class was created – steel, automobiles, etc. During the mid-20th century, these companies were able to achieve significant competitive advantages against other global competitors. But much like England in the early-20th century, competition in Asia slowly ate into profits and provided much cheaper labor and operating costs. The steel and automobile industry simply couldn't keep up with the demands for expensive pensions, new capital improvements, or new technologies that increased operating efficiencies. That doesn't mean there aren't some gems in such industries. Companies such as Fastenal (FAST) or Graco (GGG) operate in traditional manufacturing yet achieve outstanding results with high return on capital and equity while maintaining extremely low debt margins. 
 
In the last several decades, new industries have developed in the United States – technology, data & informatics, pharmaceuticals, etc. – that don't require significant capital injections, don't use sizeable unionized labor forces, and don't have many assets on the balance sheet. These companies came about in the early 2000s and became known as "asset-light" companies. Even large businesses like Schering-Plough (now Merck & Co.) were famous for shedding assets, moving employees from pensions to 401(k)s, and outsourcing core functions like research and development. These actions completely changed the business model, driving returns on capital and equity higher, increasing gross and net margins, and making these companies look much less like traditional research and manufacturing companies and more a modern marketing healthcare company. Some examples of industries with asset-light models include technology (software, informatics - meaning the integration and usage of data), health care (contract research organizations - CROs), and financial services (credit card processing, asset management)   
 
Ease of Competitive Dominance: In these asset-light industries, the ability to achieve competitive advantages is easier than others. Please note I didn't say they are easy; they are easier than others. These companies are run by focused, driven management teams that make dominance seem easy. But looks can be curiously deceptive. It can be easier to develop a competitive moat because the market conditions, product/service offerings, and raw materials might be subject to easier dominance. For instance, there are very few areas in the automobile industry where a company might capture significant competitive advantages. There is little need or ability to acquire intellectual property rights to lock out competition. The products are generally the same in concept (a four-wheel gas or electric vehicle with certain unique design features) and built/sold in remarkably the same way (internal design teams, multi-stage manufacturing processes, dealer-based sales). For instance, a company will likely achieve a limited dominance in certain demographic or regional areas through branding efforts or marketing messaging. Nowhere in this process is there a means to map out twenty years of market dominance. 
 
Another industry - informatics - is entirely different. The ability to capture market dominance is easier because nearly every product feature is based on intellectual property. For instance, IMS Health (the company merged with Quintiles and renamed IQVIA in 2017) was known for collecting healthcare data, including de-identified pharmacy data, pharmaceutical sales data, medical claims, and other data. The company had a monopoly on prescribing data that they sold to pharmaceuticals, thereby capturing a market essential to guiding pharmaceuticals to market and promote to in their sales teams. No other could provide this data as IMS had exclusivity in its sources. Thousands of companies have access to proprietary data when you think of it, which they repackage and sell to customers. The informatics market is replete with wide moat, small companies which are outstanding investment opportunities.
 
Examples of Small Wide Moat Markets: Some examples of markets can be found in all parts of the economy. Some include financials, healthcare, technology, and others. Nearly all of these are niche markets with similar characteristics – proprietary technology/data and platforms deeply embedded in client operations. The first is financial data. Examples of this include former Nintai holding FactSet Research (FDS), another former Nintai holding Morningstar (MORN), and Bloomberg (privately held). These three companies have growing opportunities in the financial industry with a focus on stock information, trading data, etc. Their proprietary databases and platforms are essential tools, and their platforms are an intricate part of much of the industry's operations. Many companies simply couldn't run without their services. 
 
Another industry is healthcare informatics. Here there are several sub-markets with powerful competitive moats. The first is pharmaceutical prescription data which I discussed previously using IQVIA as an example. A second is the electronic health record (EHR) market. Nearly every hospital utilizes an EHR to coordinate patient care, manage patient records, oversee drug prescribing, and control imaging such as x-rays or MRIs. EHRs are the platform on which nearly every hospital's operations run these days. Making a decision on which vendor to use is not only a multi-million dollar commitment but a decade-long decision that requires years of planning, training, implementation, and maintenance. Once a health system decides on which EHR vendor to work with, it takes something pretty drastic to force them to replace that vendor. Consequently, the EHR market is replete with highly profitable, wide-moat companies.      
 
High Margin Business Models: There are many business models that generate hefty profits even with small margins. An example of this includes the big box retailers, including both general merchandisers like Walmart (WMT) and Target (TGT) and specialty retailers such as Home Depot (HD), Lowes (LOW), or Best Buy (BBY). These companies can create wide moats but generally don't meet the quality standards we look for at Nintai. Using Walmart as an example, let's compare it versus Nintai Investments' holding Masimo (MASI). Walmart's gross, net, and free cash flow margins were 24.8%, 2.4%, and 4.6% in 2020. During the same period, Masimo generated 65.0%, 21.0%, and 16.3%, respectively. Walmart generated a return on invested capital of 8.3%, while Masimo generated a 39.7% ROIC. Walmart's debt to equity ratio (meaning how much debt does the company have as a percentage of its total equity) is 0.78 (short-term debt and capital lease obligation of $5.3B plus long-term debt and capital lease obligations of $60.0B versus total equity of $81.3B). Masimo's debt to equity ratio is 0.02 (no debt and total capital lease obligations of $34M versus total equity of $1.41B)  
 
While both companies have wide moats, Walmart's financial quality is considerably less than Masimo's (at least using Nintai's criteria). Masimo is more profitable, utilizes capital at a much higher rate, and has a fortress-like balance sheet. I should point out either company could be an outstanding or poor investment candidate given certain conditions. Walmart has been an excellent investment over the past 40 years. But given our druthers at Nintai, we'd prefer a company with high margins in a high margin business model than a low margin business in a moderate profit business model.    
 
Product/Services Create Monopolistic Opportunities: One of the things most overlooked in finding quality investment opportunities is seeking out companies that operate in industries where their product or service inherently creates quality and profitability in both good and bad economies. To do this, a company must have a product that is part of their customers' core business by its very nature. This is different than the EHR model I discussed earlier. There the product was deeply embedded in the business process of their customer. Would it be hard to rip the product out and replace it? Absolutely. Could the hospital operate if the systems went down? Surely. With difficulty, but they could certainly still operate. In this category, we look for companies that as the customer utilizes the product, it becomes nearly impossible to function without it.
 
A great example of this is credit cards. Try to imagine going through an average day having only checks and cash (since most credit card issuer networks also issue debit cards, I count them as the same for this exercise). Think of the daily activities where it takes a credit card to complete the transaction. Everything from purchasing gas to shopping at Amazon, renting a car, or staying at a hotel, many consumers would have to change their daily schedule drastically – or eliminate some tasks – if they lost the ability to use a credit card.  
 
Issues to Think About
 
Identifying industries or markets that have high percentages of quality-driven companies is only part of the research necessary. Whenever you find a niche that allows for highly profitable business models, you will likely find competition close on the leader’s heels. Capital flows to business strategies and markets that generate high returns. It makes sense. Success breeds success. Success breeds envy. Envy breeds greed. And greed breeds competition. So when you find that highly successful business model or market, remember to think about the following issues.  
 
Capital Flows to Success: Name any type of business that successfully grew from a startup to an industry heavyweight, and you will find numberless competitors seeking to break into the same market. A great example of this was office supply big-box stores. After the success of Staples, an astounding 131 companies received venture capital or private equity funding over the next half-decade. A company that creates a market niche with high profits will inevitably face an onslaught of new competitors seeking to steal that company's customers or market share. To see this in action, take any six months and follow the investments of the private equity community. You will likely see many investments in one niche market where managers have focused on outsized profits. One quarter might be drug laboratories and the following real estate informatics. Inevitably, profits in those markets drop after such a massive influx of capital.
 
Speed of Innovation/Product Development: Some industries see innovation take place much faster than others. For instance, the automobile industry has been notoriously slow in adopting innovation. The combustion engine has reigned supreme for nearly one hundred years regardless of new technologies that would be far energy efficient. On the other hand, the semiconductor industry has been a continuous struggle to keep up with innovation. Here moats are dug and filled in no time. Finding an industry where innovation widens moats over time is a prescription for long-term outperformance. 
 
Customer Fads: Some industries are prone to customer fads that come and go with remarkable speed. We've all heard of them – Ouija Boards, Game Boys, Beanie Babies, and Rubik's Cubes. These times may temporarily cause stock prices to suddenly soar but are just as likely to drop like a…..pet rock. Certain industries – like consumer electronics – come to mind when you think of industries that suffer from such market fads. If you choose to dip your toes in these waters, just be aware of the strength and depth of the moat. There's a big difference between a game whose name becomes part of our lexicon like Monopoly ("you're spending like it's monopoly money") versus Tickle Me Elmo. 
 
Conclusions
 
The adage goes, "fish where the fish are." No doubt, sound advice if your survival depends on successfully catching fish. Investing is no different. When looking for value-priced quality companies, start looking in industries with a penchant for wide-moat businesses. These markets may be hard to locate initially. Some industries take a great deal of research to find the underlying reasons for their wide moat (pharmaceutical informatics) versus those staring us in the face (pipelines). But once you've found such a sweet spot, spend a good deal of time understanding the industry dynamics and the sources of its moats. Like the hunter-gatherers of old, you might be fishing there for quite a while. 

"Don't worry. We might be losing a penny on each sale, but we can make it up on volume."  
 
                                                                                         -       Anonymous 
 "The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine."
 
                                                                                         -      Warren Buffett 

Revisiting Weighted Average Cost of Capital
 
One of the most interesting stories in the past 18 months has been the lack of discussion about the rapid fall and rise in the US 10-year Treasury yield. It isn't my intention to discuss the reasons for the changes or their meaning for the economy, but rather its simple impact on stock valuation. Such increases and decreases mean that any borrower will see a dramatic effect on their average cost of capital. With rates peaking at roughly 3.1% in October 2018, companies saw the rate drop by approximately 80% over the next 18 months. In less than six months, the 10-year US Treasury rate rose from 0.53% in October 2020 to 1.63% in March 2021. 
 
It's hard to overstate the impact these swings should have on the valuations of publicly traded equities. For those who use a discounted cash flow model (which we do at Nintai investments), a vital component in getting to an estimated intrinsic share value is calculating a company's average cost of capital. In our models, the most significant impact on that calculation is the 10-year Treasury yield. 
 
Before I get into that, a quick overview of United States Treasury note yields, how they are calculated, and their role in our financial markets. The Treasury note yield is the current interest rate paid on the 10-year United States Government Treasury note. The government pays the yields as interest for borrowing money through debt sales at monthly auctions. When the auctions take place, the government sells a specific dollar amount of bills (duration less than one year), notes (sold in 2, 3, 5, 7, and 10-year maturities), and bonds (30 years, reintroduced in February 2006).  For the sake of this discussion, we are only interested in the 10-year note.   
 
Once the debt has been sold, bills, notes, and bonds are traded on public markets, with investors buying and selling this debt and creating a market-driven interest rate. The rates generated in these markets for the 10-year note are vital in the financial markets. For instance, it is the proxy for many financial services such as mortgage rates. It is also used in determining interest rates on credit card debt. Trillions of dollars of financial instruments are affected by changes in these rates. 
 
The 10 Year Treasury Yield and Stock Valuation
 
For value investors, the 10-year note's yield has (or should have) an enormous impact on the valuation of publicly traded equities. When an investor looks to value a business, there are two calculations that play a tremendous role in estimating its long-term intrinsic value. The first is the company's return on capital (ROC). The second is its average weighted cost of capital (WACC). One of the most critical aspects of finding quality in a potential investment opportunity is a having a high return on capital. At Nintai, we look for companies that achieve 15% or greater ROC over the past decade. ROC is an excellent tool for getting a grasp on how well management teams allocate capital. But it's only half the equation (literally and figuratively!). Equally important is the company's weighted average cost of capital. A company always wants ROC to be significantly greater than WACC. It doesn't matter if they can generate an ROIC of 15% if their cost of capital is 18%. (Hence the opening quote about losing a small amount on each transaction, but making up for it in volume)
 
The weighted average cost of capital is one of those topics that inevitably leave peoples’ eyes glazed over when you bring it up. It's like discussing the interest rate you will be paying on that brand new sports car in the driveway. Not many people insist on diligently reading the term sheet. Instead, most dream of taking those sharp turns or doing racing changes on the interstate before trying to measure how the cost of capital might impact the long-term value of that new sports car. 
 
Return on Capital versus Cost of Capital: A Simple Example  
 
Let's use an example of an investor choosing to use cash obtained from a credit card advance to invest in stocks. It sounds crazy, but I've seen things more insane in my investing career. For example, let's start with the cost of capital. A cash advance can be obtained for the average credit card owner with two main items driving calculating the cost of that capital.
 
First, the card company will charge a fee which is generally based on the percentage of the transaction. For the sake of this exercise, let's assume the cash advance is $25,000. According to CNBC, the average transaction charge usually is between 3 – 5% of the advance amount. For this case, let's cut it down the middle and call it 4%. In this example, the individual will pay $1000 for the advance (25,000 x 4%). Second, the credit card company charges an annual interest rate fee on the balance. Let's assume the individual is not planning on paying off the balance for the first year but pay any fees and interest charges. According to the website creditcard.com, the average interest rate charged by the credit card company is 16.15%. For the first year, the individual will pay $4,037.50 (25,000 x 16.15%).
 
In this instance, cost of capital would be $1,000 + $4,037.50 or a total of $5,037.50. Put in the Wall Street terms, the cost of capital would be 4% + 16.15% or 20.15%. Of course, this number means nothing until we calculate the return on capital and see how the two numbers compare. 
 
To calculate return on capital, let's assume the individual wants to invest in a hot-shot stock growth fund that she's been assured is a real winner. We'll call this the "UltraHype Growth Fund" (which goes by the ticker BLECH). Over the past ten years, the BLECH fund has returned 11.2% annually. This is the starting point on the return on capital, but sadly not the final figure. The fund charges are very high – a 1.8% management fee. This is subtracted from returns, reducing the returns to 9.4% annually. Let's be generous and assume there are no additional costs like a load fee of 5.5% or 12b-1 fees or redemption fees. 
 
The return on capital number will be 11.2% of $25,000 or a return of $2,800. From that, we subtract the 1.8% management fee or $450. This leaves the individual with a net return of $2,350. Another way to calculate it is 11.2% - 1.8%, which generates a return on capital of 9.4%. 
 
It should be pointed out here, calculating the weighted average cost of capital and return on capital can be - and usually is - far more complex. It helps to have a calculator or Excel spreadsheet handy. For instance, the actual formula looks like this.

Suffice it to say our calculation in getting a cost of capital in this example is conceptually the same, but woefully deficient in terms of completeness. This is an article for investors, not a graduate accounting class!
 
So, where does this leave our individual? Did their move of taking a cash advance on their credit card pay off by investing in their expensive, hot-shot growth fund? The answer is a clear no. Their return on capital of 9.4% was swamped by their cost of capital of 20.15%. While it may seem obvious to any investor, it's important to point out this is a terrible use of capital. 
 
Cost of Capital and Stock Valuations
 
Having your return on capital exceed your cost of capital really shouldn't be that profound of a concept for individual investors, professional money managers, or senior corporate executives. Is should also be pretty clear that rising input costs in calculating your cost of capital will lead to higher cost of capital. The dramatic movement in treasury yields cited earlier will dramatically impact a company’s cost of capital. With rising Treasury yields, many company’s suddenly began to see WACC exceeding ROC in their returns. These changes should have been seen in valuations if investors were taking these changes into account. The exact opposite has happened. Except for the sharp drop in valuation in the spring of 2020 and their subsequent - and relatively rapid - recovery, the trend in stock prices has been nearly always upward. 
 
To apply this concept and see this disconnect in real terms, I want to use a holding in many of Nintai Investments’ individual portfolios - SEI Investments (SEIC). In December 2019, we estimated the company's weighted average cost of capital was roughly 9.4%. In that calculation, we included the federal funds rate of 1.87%. At that time, we estimated the intrinsic value of the company's stock was $55.20 per share. It was trading at roughly $66.00 per share or approximately 20% above fair value. By any standards, the stock was not a compelling buy. By December 2020, we estimated the company's weighted average cost of capital at roughly 7.9%. Nearly all the decrease in the WACC was the drop in the 10-year note yield. In our calculation, not much else changed. Revenue was flat, free cash flow was down slightly, and publicly traded shares were down slightly. There wasn't much to change valuation except the drop in the funds rate. But, boy, did that change our valuation. The $66 per share in December 2019 had jumped to $73 per share in December 2020. With the stock trading at $56 per share, the company was now trading at 23% below fair value - an enormous change in roughly one year. What had been a moderately overvalue company was now trading moderately below intrinsic value. On these numbers, we purchased shares in our portfolios. What a difference a year makes. 
 
But our example doesn't end there. The exact opposite happened from October 2020 to March 2021. The 10-year note rate jumped 0.53% in October to 1.63% just six months later. The example we just showed went in the exact opposite direction. With such a massive jump in the 10-year rate, companies' valuations took a whopper of a hit. SEIC's valuation dropped from $73/share back to $61 per share. With shares trading at $60 per share, they were now at fair value instead of 23% below intrinsic value.
 
Talk about a whipsaw! In a little over 16 months, SEIC went from moderately overpriced to moderately underpriced to roughly fair value, all due mainly to changes in the 10-year Treasury note yield which then impacted the company's weighted average cost of capital.  SEI Investments wasn't the only company that saw its valuations affected by its drop in the weighted average cost of capital. Every company in the public markets was impacted – some more than SEI, some less. Throughout all of this, overall yields didn't move much. The 10 Year US Treasury note yield was 1.73% on December 3, 2019, 0.92% on December 1, 2020, and 1.45% on March 1, 2021. But there was quite a gap between highs and lows. In August 2020, rates hit their low  0.52% and hit their high in December 2019 at 1.93%.
 
It's important to note that the markets overall were minimally impacted by these changes. From December 2019 to March 2021, the S&P 500 gained 25.4% rising from roughly 3150 to 3850. This even includes the massive drop in the spring of 2020 when the S&P dropped nearly 30%. 
 
What This Means
 
For all this data and heavy reading, you might be asking yourself at this point what this all means. It's a good question and an important one to answer. The most important lesson to understand is that having cost of capital exceed return on capital is not a recipe for outstanding long-term stock returns. It should be common sense to any investor, but roughly one-third of all publicly traded companies currently have WACC exceed ROC. Somebody is investing in these companies, so not everybody has learned this lesson.  Here are some other learnings to think about. 
 
WACC and ROC Must Be Measured Together: I have to concede that I searched for companies with extremely high ROC at the beginning of my investing career but never screened them for WACC. There is a particular bias that a company with high ROC couldn't possibly have even higher WACC. It happens, though. And like any other company with a negative ratio, it's a company that doesn't generate value. Always remember to look at both ratios, not just one. 
 
The 10 Year Treasury Yield Has a Big Impact: I used to denigrate investors who took a lot of time looking at macroeconomic issues because I felt they play a minor role in the business. I was right about that. What I was wrong about is that it plays a massive role in the stock. Remember: sometimes, a company's stock (and its price) has little to do with the company. This type of disconnect happens all the time. A significant rise in the 10-year note rate can drive up the cost of capital, making a dollar in the future worth a lot less. While the company might remain the same, its intrinsic value might decrease significantly. Never lose sight of the role of interest rates in valuation. 
 
In the Short Term Voting Machines, In the Long Term Weighing Machines: Having said that interest rates could affect valuation, it's important to remember the longer the holding and the greater the business's success (through quality and value) the less the impact of interest rates will be. This is a convoluted way to say that time and business excellence overrides the shorter-term impact of interest rates. Being patient and allowing time to work its magic can dramatically reduce some of the risks (but not all!) associated with cost of capital. 
 
Conclusions
 
For any long-term value investor (and what other kind is there? “Short-term value investor” is undoubtedly a contradiction in terms), the ability to find a business and management team that can produce value over a decade or two is the means to creating investment gains. The underlying foundation of this value creation is the ability to have the return on capital far exceed the cost of capital.  Given time and allowing for the weighing machine of the markets to work their magic, companies can become compounding machines for their shareholders. 
 
Understanding the dynamics of what constitutes the cost of capital and its relationship to return on capital is one of the most powerful concepts to a value investor. Looking at both and understanding the drivers of each, an investor has the tools necessary for making the best investment decisions possible. Will the markets always agree with you? Absolutely not. But an investor can go to bed each night fully understanding their investment has created value that day, that week, that month, that year, and hopefully the next decade or two. 
 
I look forward to your thoughts and comments. 
 
DISCLOSURE: Nintai Investments has no positions in any stock mentioned.