During the dog days of summer, we usually move everything outside, work on the deck, and suck up the summer sun. We take the down time to evaluate roughly one-half to two-thirds of our portfolio holdings. This includes taking apart the business case, looking at the competitive markets, diving into new products and services, and completing a truly deep dive on the company financials. We do this for two reasons – one is we want be assured each and every portfolio holding can still be considered very high quality. Second, we want to look back at our projections (strategic, operational, and financial) and be assured our assumptions are valid, valuations have not decreased (hopefully increased!), and the share price has not gotten too far ahead of our estimated intrinsic value.
For some of our investment partners, these revised investment cases and valuation spreadsheets are like Christmas in July and August. For others, they go the pile to read after a relaxing summer vacation. We’re fine with either. We simply want our partners to have as much knowledge as we would like if we were in their shoes.
I thought I’d break this in to two separate articles. The first part is reviewing what we would consider obstacles in defining quality for a possible investment. This isn’t a complete list. It isn’t even a full description of each item on this list. But I wanted to make it as simple as possible for investors to understand why poor quality can impair your returns. The second part is describing what we consider quality at Nintai Investments. Some readers will say “Oh God. I’ve heard all this before”. If you are a long term reader of my writing then you probably have. As Aristotle said “We are what we repeatedly do. Excellence, then, is not an act, but a habit”. Nintai Investments (and its predecessor Nintai Partners) would have achieved very little as a company or an investment manager if we didn’t constantly hammer away on the concept of value. Looking through my last 100 articles, the second most common word was “quality” – coming up a total of 232 times. (“Value” was the number one word cited 431 times).
Obstacles
In some ways it’s much easier to identify what’s NOT quality than defining what IS quality. Some attributes that make up a non-quality company are the following.
Excess Goodwill: In almost any acquisition, the agreement between acquiree and acquirer involves a certain amount of negotiating that leads to overpayment. At Nintai Investments we recognize that’s part of the animal spirits that make up the capitalistic system. Having said that, I can remember a management team that completed $23.6B in acquisitions from 1998-2002. Over the period of 2003 – 2006 the company wrote off $23.2B of those acquisitions (a whopping 99%!). Management claimed this was a victimless crime – acquisitions were made nearly entirely in stock so who was harmed? Let me just say that when management can’t see the damage from the the evaporation of over 65% of total assets on the balance sheet, then they certainly don’t represent quality in our books.
Excessive Stock-Based Compensation: A cousin of the goodwill excess, is the gross overuse of stock-based compensation. Again, many claim this is a victimless crime until the payments are expensed under the cash flow statements. This snaps many heads around. For many companies, this type of executive compensation is simply a transfer of wealth as the company announces billions in stock buybacks while simply seeing those very stocks slide out the side door as enormous pay packages for executives. When you see a company announce a $500M stock buy back and total shares outstanding either remain flat (or worse increases) then it’s a good chance this is not an excellent company.
WACC Exceeds ROIC: Don’t get hung up on the acronyms in this section. This simply means the company’s return on capital is less than its cost of capital. Let’s use a simple example to highlight this problem. Imagine you see that steak is on sale by 8% this week at the supermarket. Excited at the thought of eating steak all week, you whip out your credit card and purchase $100 worth of beautiful Delmonicos. You smile at the 8% in savings. Yet consider the other end of the transaction. The rate you pay your credit card is 24%. So while you’ve saved that 8%, the cost of that return is 24%. The formula is simple: 8% - 24% = -16%. Your return on invested capital has been far exceeded by your weighted average cost of capital. This type of disastrous financial model is sometimes explained away by the famous (or infamous) line – “don’t worry we’ll make it up on volume”. Any company that shares similarities to this example is certainly not a quality company.
Customer Churn/Turnover is in the Double Digits: A company that relies on constant turnover and finding new customers is highly likely to be a low-margin business with no moat. Some businesses are notorious for churn which further drives down margins. Take for example wireless phone companies. You constantly hear of dissatisfied customers, switching from Sprint, to Verizon Wireless, to US Cellular, to AT&T Wireless. It’s a never-ending movement seeking the Shangra-La of coverage with constant rebate offers, and fine print that can only be found on the seventh level of Hell.
The Company’s Product Is A Nice-to-Have: The road to personal wealth is littered with the wreck of thousands of businesses that were the “new hot thing” until they weren’t. You’ve probable owned one of these in either your personal or professional lives. These are products or services you swear you can’t survive without until the next recession hits and you have to choose between keeping the lights on or having that $59/month answering service. The one that provides an $8/hour operator with the most gorgeous Scots accent and gives your company that “international” flavor. Pretty cool when you are rolling in dough, but the first to go in tough times. The company’s price falls 85% before filing for bankruptcy late Friday night when it’s impossible to save even the smallest part of your investment.
Capital is Essential to Business Operations: The first trading under the buttonwood tree on Wall Street was designed to meet the needs that all capital markets provide – creating access to capital. Well run markets and companies will dip their toes (hell…even their entire lower waist) to obtain capital to increase production, complete an acquisition, or extend operations overseas. This financing can be in either debt or equity in structure. The trouble begins when debt (or issuance of equity) becomes necessary simply to keep the doors open. When a holding maxes out its credit line or raises $2B in convertible debt to “explore strategic solutions”, this certainly isn’t a quality company.
Conclusions
There are many ways to make money on Wall Street. Since its first trades in the 18th century, the New York Stock Exchange has seen hundreds – if not thousands – of techniques used to make money in the buying and selling of equities. Since then we’ve had an explosion in the number of exchanges along with the types of things to trade ranging from corn futures to collaterized mortgage securities. At Nintai Investments, we’ve tried to keep our investment model simple and limited in its adoption of risk. We don’t trade derivatives in any way, shape or form, we don’t short, we don’t trade debt, and we avoid anything but the highest quality in companies. This article has briefly discussed what is not quality. The next article will discuss the qualities we look for in an investment - and more importantly – why its critical to our long term success as investment managers. Please feel free to send in any comments or questions and we will try to reply as soon as possible. We hope everyone finds a way to stay cool.
For some of our investment partners, these revised investment cases and valuation spreadsheets are like Christmas in July and August. For others, they go the pile to read after a relaxing summer vacation. We’re fine with either. We simply want our partners to have as much knowledge as we would like if we were in their shoes.
I thought I’d break this in to two separate articles. The first part is reviewing what we would consider obstacles in defining quality for a possible investment. This isn’t a complete list. It isn’t even a full description of each item on this list. But I wanted to make it as simple as possible for investors to understand why poor quality can impair your returns. The second part is describing what we consider quality at Nintai Investments. Some readers will say “Oh God. I’ve heard all this before”. If you are a long term reader of my writing then you probably have. As Aristotle said “We are what we repeatedly do. Excellence, then, is not an act, but a habit”. Nintai Investments (and its predecessor Nintai Partners) would have achieved very little as a company or an investment manager if we didn’t constantly hammer away on the concept of value. Looking through my last 100 articles, the second most common word was “quality” – coming up a total of 232 times. (“Value” was the number one word cited 431 times).
Obstacles
In some ways it’s much easier to identify what’s NOT quality than defining what IS quality. Some attributes that make up a non-quality company are the following.
Excess Goodwill: In almost any acquisition, the agreement between acquiree and acquirer involves a certain amount of negotiating that leads to overpayment. At Nintai Investments we recognize that’s part of the animal spirits that make up the capitalistic system. Having said that, I can remember a management team that completed $23.6B in acquisitions from 1998-2002. Over the period of 2003 – 2006 the company wrote off $23.2B of those acquisitions (a whopping 99%!). Management claimed this was a victimless crime – acquisitions were made nearly entirely in stock so who was harmed? Let me just say that when management can’t see the damage from the the evaporation of over 65% of total assets on the balance sheet, then they certainly don’t represent quality in our books.
Excessive Stock-Based Compensation: A cousin of the goodwill excess, is the gross overuse of stock-based compensation. Again, many claim this is a victimless crime until the payments are expensed under the cash flow statements. This snaps many heads around. For many companies, this type of executive compensation is simply a transfer of wealth as the company announces billions in stock buybacks while simply seeing those very stocks slide out the side door as enormous pay packages for executives. When you see a company announce a $500M stock buy back and total shares outstanding either remain flat (or worse increases) then it’s a good chance this is not an excellent company.
WACC Exceeds ROIC: Don’t get hung up on the acronyms in this section. This simply means the company’s return on capital is less than its cost of capital. Let’s use a simple example to highlight this problem. Imagine you see that steak is on sale by 8% this week at the supermarket. Excited at the thought of eating steak all week, you whip out your credit card and purchase $100 worth of beautiful Delmonicos. You smile at the 8% in savings. Yet consider the other end of the transaction. The rate you pay your credit card is 24%. So while you’ve saved that 8%, the cost of that return is 24%. The formula is simple: 8% - 24% = -16%. Your return on invested capital has been far exceeded by your weighted average cost of capital. This type of disastrous financial model is sometimes explained away by the famous (or infamous) line – “don’t worry we’ll make it up on volume”. Any company that shares similarities to this example is certainly not a quality company.
Customer Churn/Turnover is in the Double Digits: A company that relies on constant turnover and finding new customers is highly likely to be a low-margin business with no moat. Some businesses are notorious for churn which further drives down margins. Take for example wireless phone companies. You constantly hear of dissatisfied customers, switching from Sprint, to Verizon Wireless, to US Cellular, to AT&T Wireless. It’s a never-ending movement seeking the Shangra-La of coverage with constant rebate offers, and fine print that can only be found on the seventh level of Hell.
The Company’s Product Is A Nice-to-Have: The road to personal wealth is littered with the wreck of thousands of businesses that were the “new hot thing” until they weren’t. You’ve probable owned one of these in either your personal or professional lives. These are products or services you swear you can’t survive without until the next recession hits and you have to choose between keeping the lights on or having that $59/month answering service. The one that provides an $8/hour operator with the most gorgeous Scots accent and gives your company that “international” flavor. Pretty cool when you are rolling in dough, but the first to go in tough times. The company’s price falls 85% before filing for bankruptcy late Friday night when it’s impossible to save even the smallest part of your investment.
Capital is Essential to Business Operations: The first trading under the buttonwood tree on Wall Street was designed to meet the needs that all capital markets provide – creating access to capital. Well run markets and companies will dip their toes (hell…even their entire lower waist) to obtain capital to increase production, complete an acquisition, or extend operations overseas. This financing can be in either debt or equity in structure. The trouble begins when debt (or issuance of equity) becomes necessary simply to keep the doors open. When a holding maxes out its credit line or raises $2B in convertible debt to “explore strategic solutions”, this certainly isn’t a quality company.
Conclusions
There are many ways to make money on Wall Street. Since its first trades in the 18th century, the New York Stock Exchange has seen hundreds – if not thousands – of techniques used to make money in the buying and selling of equities. Since then we’ve had an explosion in the number of exchanges along with the types of things to trade ranging from corn futures to collaterized mortgage securities. At Nintai Investments, we’ve tried to keep our investment model simple and limited in its adoption of risk. We don’t trade derivatives in any way, shape or form, we don’t short, we don’t trade debt, and we avoid anything but the highest quality in companies. This article has briefly discussed what is not quality. The next article will discuss the qualities we look for in an investment - and more importantly – why its critical to our long term success as investment managers. Please feel free to send in any comments or questions and we will try to reply as soon as possible. We hope everyone finds a way to stay cool.
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