At the highest level, at Nintai we think the following characteristics make up quality.
- Run by management who allocate capital like it is their own money. Nothing turns us off as much as individuals who think of the company purse as their own personal piggy bank. We also want individuals who see themselves as stewards of their shareholders. Every action should be about building value for them. Building empires or funding pet projects simply don’t wash.
- The company generates extremely high return on capital, return on equity, and return on assets. What we mean by this is when the company spends money it achieves good profits from the effort. If management spends a dollar to build a new product, we like to see five dollars in return. Much like a person who doesn’t want to spend good money for a dishwasher only to have to spend hundreds more in repairs, we like to see good money spent on even better returns.
- The company has a competitive moat generated by internal competencies (very high quality control, streamlined/efficient manufacturing, great personnel policies, etc.) and external advantages (product/services deeply embedded in client strategy or operations, product hard to replicate due to intellectual property rights or patents, etc.) Both of these show up in the company’s returns on capital and equity.
- A fortress-like balance sheet and cash flows. Nintai looks for companies with no or very little debt. If the company holds debt, we look for the ability to pay off such debt within 12 months through ether cash on the balance sheet or free cash flow. We look for free cash flow (meaning all cash remaining after paying all its bills) to be at least 25% of total revenue. As we’ve said many times before, it’s very rare for a company with no debt to go bankrupt.
- We like to purchase a company’s shares for a substantial discount to our estimated intrinsic value. As much as shoppers don’t want to overpay for the groceries, their car, or their home, we like to have what Ben Graham called a “margin of safety” in case we get our estimates wrong.
In the final analysis, we want to purchase a company that will provide Nintai with the ability to compound its capital at a rate greater than its competitive index. More importantly, we want to purchase companies at a value and a quality that will minimize our chances of permanently impairing our investors’ capital. That’s a fancy way of saying we hate losing our investors’ money.
Because of this, most days you will find us hard at work taking apart business cases, looking at the competitive markets, diving into new products and services, and completing a very 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 they’ve increased), and the share price has not gotten too far ahead of our estimated intrinsic value. When these reviews are complete, we share our findings and recommendations with our investment partners in the form of investment cases and valuation spreadsheets.
When we begin the evaluation process of a potential investment, I think it’s critical that at completion you have a clear understanding of what parts of the company demonstrate outstanding quality characteristics, what do not, and what actions could lead to the degradation of such quality. We feel it’s equally important to understand the same characteristics about the company’s value. Whether you are a sophisticated, professional asset manager or an individual investor just starting in investing, the ability to identify quality and value, understand their resilience, and how those characteristics convert to competitive and financial strength is the most essential arrow in your investment quiver. If you don’t understand what makes up quality, then you don’t understand what creates value.
As we begin the process of thinking about what makes up quality, I thought it might be helpful to discuss not only what it is and what it is not. It’s important to get these two lists firmly in your head. Nearly every decision you make in your investment career, will center on what is and what is not to be considered quality. One mistake - and rest assured you will make more than one mistake in your investment lifetime - can cause considerable havoc in your long term results and in meeting your investment goals. At my mentioning of the word quality, some of my readers will say “Oh God. I’ve heard all this before”. And 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 quality and its relationship to value. Looking through my writings since June 2018, the second most common word was “quality” – coming up a total of 232 times. (“Value” was the number one word cited 431 times).
So Just What Does Quality Mean?
At Nintai Investments, we utilize roughly 16 measures that help us create a list of “quality” companies based financial, operational, strategic, market-based, and competitive characteristics. These criteria generally leave us with about 40 of 3,671 (1.1%) total United States publicly traded companies, 300 of 17,602 (0.23%) total Asian publicly traded companies, and 90 of 8300 (0.50%) total European publicly traded companies. This leaves us with roughly 400 - 450 companies globally that meet our statistical measures of quality. If you add the criteria of value (meaning trading at a discount to our estimated intrinsic value) the number drops to less than roughly 10 - 15 at any one time. That’s a pretty small investment universe!
Earlier I outlined some the characteristics we look for when it comes to identifying a quality company. One might think that high-quality companies simply feature the opposite traits of poor-quality companies, but that’s not entirely accurate. A quality company has characteristics unique to their category - in much the same way as poor quality have their own. As Tolstoy wrote, “All happy families are alike; each unhappy family is unhappy in its own way”. To supplement the list I cited a few pages back, here are some the very high level components that Nintai thinks makes up a truly quality company.
Excellence in Management: We look for management that have a vested interest in how the company performs (such as by purchasing shares in the open market, not stock option grants), has a history of outstanding management candidates usually found within the company’s ranks, deeply understands they work for both shareholders and their respective greater corporate community, and finally achieve outstanding results in both operational measures (return on equity, return on assets, etc.) and strategic measures (market share percentages, industry respect, product innovation, etc.). Most important than all of these, we look for management with a clear moral compass. This presents itself in such ways as forbidding financial transactions that profit management (such as renting a building they own directly or through corporate ownership), banning use of off-balance sheet gimmicks (such as special investment vehicles – SIVs), forbidding any type of family interactions with the business (such as placing family members on the Board), and the use of stock options as a transfer of wealth from corporate coffers to management’s pocket book. We feel strongly the fish rots from the head and it won’t be long before that rot works its way downwards.
An example of a management team that drives quality O’Reilly Automotive (ORLY). First, management compensation scheme keeps executives’ thoughts and actions on creating long term value for shareholders. Roughly one-third of compensation is calculated on a base salary. The remaining two-thirds is a combination of cash awards and stock grants based on return on invested capital, growth in free cash flow (not earnings), increase in operating income, and growth on store sales. Second, management has done an outstanding job at allocating capital. As I mentioned earlier, as an investor you always want to see management obtain a better return on capital than its cost of capital (meaning they make more money on the capital than it does to borrow it). In O’Reilly’s case, the company has averaged a 19% return on invested capital against Morningstar’s estimated weighted average cost of capital of 8% over the past ten years. While achieving such results, management has greatly expanded O’Reilly’s footprint though small “tuck-in” (meaning smaller, adjacent opportunities) acquisitions, never overpaying for new investment opportunities. Finally, the company has a long history of focusing on corporate governance including diversity, health & safety, training/promotion within, and corporate giving. Morningstar rates corporate governance as Excellent.
Create Deep Externally Facing and Inwardly Looking Moats: In both good times and bad, we look for managers who can create exceptional defensively and offensively balanced moats. By defensive moat, we mean management keeps competitors, the general business environment, and time from attacking its position of strength. Defensive moats consist of maintaining market share, achieving steady and high pricing power. Defensive moats prove their worth as competitors seek ways to chip away at high gross or net margins or high return on capital. However, managers can sometimes excessive spend blood and capital digging a defensive moat and trying too hard at maintaining the status quo. This type of one-way thinking can create significant weaknesses in looking for new offensive opportunities in existing customers, markets, or adjacent markets. An inward looking or offensive moat means management has developed the means to make their products and services essential to their customers’ strategy and operations. This type of in-depth value - for lack of a better term “the tape worm approach” – demands a nearly constant improvement in quality, increased scope of offerings, better quality, and new products/services on a remarkably frequent basis. An offensive moat is designed to find ever increasing opportunities (both in depth and breadth) with existing customers.
An example of a company working diligently at both defensive and offensive moats is Veeva (VEEV), a Nintai Investments holding as of January 2021. Starting out as a customer relationship manager spinoff from Salesforce.com, the company has initially focused on achieving market dominance in the pharmaceutical/biotechnology industry. As of 2020, the company contracts with 19 of the 20 largest industry companies. Its numbers tell the story of an incredibly strong defensive moat – 21% return on equity, return on invested capital of 49%, free cash flow margins of 38%. The company has grown revenue at 26% for the past five years and free cash flow by an astounding 60% over the same time frame.
But the company doesn’t just create a defensive moat. It has worked incredibly hard to keep expanding its moat within its customers. Average contract value per customer has increased by 167 times since 2006. Average product per client has increased from 31 in 2008 to 431 in 2020. Talk about embedding yourself with your clients. Veeva is a moat building domino.
Create a Rock Solid Financial Castle: At Nintai Investments, we look for investment opportunities that can survive the most violent shock to its foundations. This can include a sudden elimination of access to any capital (the type of shock that overcame the financial markets in 2007 - 2009), a rapid increase/decrease in the Federal Reserves’ prime rate, or the LTCM failure demanding government intervention to stave off financial disaster. All of these led to some form of catastrophic market failure. We look for a company that is reliant upon no one or no institution for survival or financial bailout in a time of market crisis. This requires a balance sheet with little to no debt (or the ability to pay 100% of liabilities with 1 year of free cash flow), high free cash flow yield, and outstanding returns on capital, equity, and assets. This demands we focus on cash rather than earnings because we believe in Alfred Rappaports’s “profits are an opinion, cash is a fact”. We recognize it’s very difficult to sniff out financial shenanigans if management is intent on cheating and the consequences be damned. But we think keeping a hawk eye on cash gives us the best chance to avoid partnering with an unethical management team.
An example of such a company is SEI Investments (SEIC), a Nintai Investments holding as of 2020. SEI provides investment processing, management, and operations services (what often referred to as “back office” operations to financial institutions, asset managers, asset owners, and financial advisors in four material segments: private banks, investment advisors, institutional investors, and investment managers.
As a company reliant upon the financial markets for 100% of its revenue, an investor can imagine the impact of the credit crisis of 2007 - 2009 and the ensuing market crash would have a powerful impact on the company’s operations and finances. It most certainly did. Revenue dropped from $1.37B in 2007 to $901M in 2010 - an extraordinary 34% drop. Free cash flow dropped from $282M to $177M in the same time - a 37% drop. For many companies a drop like this could cause management to hit the panic button. Such a huge decrease in free cash could put pressure on capital spending and debt servicing. Any hint of this - such the rumors swirling around Bear Stearns or Lehman Brothers could put the stock price into a death spiral.
SEI stock did drop horrifically like the rest of the markets but in time recovered. Most importantly there was no rumors of insolvency or inability to meet its obligations. Why was that? Certain part of that was the company had zero debt. No short term and no long term debt. It had roughly $400M in cash on the balance sheet and the previously mentioned $177M in free cash flow. For a company in the hardest hit industry in one of the worst crisis in Wall Street history, the company’s fortress-like balance sheet held the walls against all issues. This was a castle we were happy to hold.
A Singular Focus on Market Domination: We look for companies that seek to wholly dominate a market so large that the runway for growth is roughly 15 - 20 years. We want to know with some assurance the company will be in the same markets (or adjacent ones) dominating them with high market share, outstanding returns, and great gross and net margins for an extended period of time. Obviously it is difficult to find a company that operates in a monopoly or duopoly environment at a discount to our estimated intrinsic value, but it is possible in the micro to small-cap markets. Amazingly, companies with these attributes can be frequently found in the course of the markets’ daily trading. Generally monopolies and duopolies have intense competition as other companies’ leadership see the opportunity to get in on a profitable business segment.
But many duopolies and monopolies are founded by legal or regulatory rulings that are difficult to break through. Others are created through the ability of a company or a couple of companies to capture such a significant market share there simply isn’t room for any new competitors. A classic case of a duopoly is Visa (V) and Mastercard (MA). The latter is a Nintai Investments portfolio holding. While there are other companies - such as Discover (DFS) or American Express (AXP) - that offer card services, these two behemoths have essentially split the market between themselves.
What we look for the most at Nintai are companies with domination provided by legal means such as patents, regulatory approvals, etc. An example of this is iRadimed (IRMD) a Nintai investments portfolio holding. The company is the maker of non-magnetic MRI pumps and oximeters. This allows patients to have their IV pumps be brought directly into the MRI (magnetic resonance imaging) room without having to run long extension tubing outside vastly increasing the chances of a medical adverse event. This monopoly was created by FDA when IRMD received its FDA approval thereby winning a more-than-decade long prohibition of patent infringement. This type of monopoly will allow iRadimed to expand its markets, develop new products, and embed its in every ambulatory or hospital-based MRI imaging centers in the US. Now that’s what we like to own.
The Share Price Doesn’t Reflect its Value: One vital piece remains in finding a quality company. I will discuss it in much greater detail in “Chapter 2: Defining Value”, but let me summarize by saying quality must be linked to value to make it a compelling investment opportunity. There have been many examples in Nintai’s research where we have found a stock with every possible quality measure – except this one. For instance, in 2020 we continued to look longingly as Factset Research (FDS) a former Nintai holding which we sold out of because of price appreciation. It hasn’t come down since we sold it. To the contrary, the price has continued to reach new highs, sometimes trading at nearly double our estimated intrinsic value. No matter how impressed we were with the financials, management’s focus on profitable growth, and its near duopoly with Bloomberg (privately-held), we simply couldn’t justify paying such a price for quality.
This happens a lot. It is perhaps the hardest part of being a successful quality value investor. The desire is so strong to pull the trigger and become the proud owner of such a business. But there is perhaps no easier way to permanently impair your - or your investors’ hard earned investment dollars - than overpaying for a stock. Never forget that price and value change every day. It might be that you can purchase the stock next week, next month, or next year. Or you may never be able justify purchasing it. Either way, always keep the connection between quality and value.