“Patience in Market, is worth Pounds in a year.”
- Benjamin Franklin, ‘Poor Richard’s Almanack’
Over the last four years, we have observed a clear split in the returns of Nintai portfolio holdings. Eight of our holdings (40%) have experienced losses greater than 30%. Conversely, four have returns exceeding 100%, and five more have returns over 50%. The stocks with the biggest losses have hampered the portfolio’s performance during this period. Interestingly, these same companies fueled our strong outperformance in the first four years. Frustrating times, indeed.
This quarter, we decided to review the worst-performing positions and see if any raise concerns about our business case. One of our main worries is the permanent loss of our investment partners’ capital. This can occur for various reasons. The company may have lost its competitive advantages (or moat), the business model could be outdated, or management might have proven to be poor at allocating capital. The question we seek to answer is whether Mr. Franklin’s thoughts apply here - will patience be worth pounds in a year (or more)? There are currently eight stocks that have losses greater than 30% since our initial investment.
Some Initial Thoughts
As we examine each of these companies, we try to assess underperformance in various areas. Some of our holdings have more influence over these than others. These include:
Regulatory Status: Because a high percentage of our holdings work in a regulated industry (healthcare), those companies in that industry are overseen or regulated by several federal agencies, such as the Food and Drug Administration (FDA) or the Centers for Medicaid and Medicare Services (CMS), which oversee patents, prices, product marketing, sales, and promotion, etc.
Government Policy: Over time, as new congressional leadership and Presidential administrations come to power, there may be significant policy changes. For instance, the latest Trump Administration took an aggressive stance regarding tariffs, which had an enormous impact on nearly every industry. Our role as investment managers is to identify companies that can withstand and overcome numerous unforeseen challenges.
Competitive Moat: Morningstar identifies five potential sources of a competitive moat: switching costs, intangible assets, network effects, cost advantage, and economies of scale. We mainly focus on network effects and switching costs when selecting portfolio holdings because most of our investments are in "asset-light” business models. Within that model, we appreciate companies that provide underlying platforms that enable the company’s relationship to extend deeply into the customer’s operations.
Allocation of Capital: We believe that over time, companies that produce returns on invested capital (ROIC) exceeding the weighted average cost of capital (WACC) will deliver exceptional returns for their investors. To do so, management must be outstanding allocators of capital. This means they must avoid expensive acquisitions, investing in businesses where WACC exceeds ROIC, or investing in assets that generate inadequate returns.
Free Cash Flow Growth: At Nintai, we believe the only real measure of value is the amount of future free cash an asset returns, discounted back to its present value. That amount is the basis for calculating our estimated intrinsic value. If our assumptions are off (and in the cases of these holdings, they most certainly are), then it’s likely our investment case is impaired.
Balance Sheet Strength: Another key factor we look for in any investment is a strong balance sheet. We prefer no short- or long-term debt, ample cash or short-term investments, and only a small amount of goodwill as part of total assets. We want the company to be fully prepared financially for the worst-case scenario we can imagine moving forward.
Some High-Level Thoughts
After spending considerable time working through each company’s numbers over the past five years, we’ve identified some common themes in their underperformance. These include the following.
There were no cases of decreased financial strength: None of the underperforming companies have seen a decline in their balance sheet strength. None have taken on any debt (short- or long-term) in the past five years. This reassures us that they can withstand an economic shock like the 2007-2009 Credit Crisis.
We were significantly off in our cash flow estimates: While their balance sheets remain strong, we underestimated the free cash flow of some holdings. Six of the eight companies that underperformed have seen free cash flow stay flat or decline. In each case, we projected a (positive) growth rate for the next decade. We didn’t do a very good job with our prognostication.
We overpaid in some cases: Due to our inaccurate estimates of free cash flow, we overpaid on several occasions. In others, we failed to maintain our margin of safety, which led to underperformance not reflected in our purchase price. Whether this was caused by environmental factors (such as tariffs or regulatory changes) or investing outside our circle of competence still needs to be addressed.
We overestimated customer “must-haves”: Several times in our investment history, we have mistaken our holding company’s offerings as a “must-have,” not a “nice-to-have." Several years ago, we believed that Corporate Executive Board (now part of Gartner) was a must-have for their clients. It seems we have made the same mistake in recent years as well.
We were poor policy prognosticators: Some of our underperforming assets have been influenced by changes in the regulatory environment. In these cases, we should have done a better job of identifying potential impacts and modeling the downside more accurately. Some impacts were unforeseen (such as conditional FDA approval), while others were fairly apparent (such as tariffs).
All these reasons challenge some part of our investment research process. We are reviewing them to determine (a) why they occurred and (b) how we can prevent them from happening again. Some say that achieving 60% accuracy in your stock picks is quite good. But that only tells part of the story. What really matters is how much each holding outperforms or underperforms. In this case, our winners have been successful enough to beat our closest benchmarks - the Russell 2000 and the Russell Mid-Cap Growth Index. Unfortunately, they haven’t been enough to beat the S&P 500, though we rarely invest in large-cap stocks.
Over the next several weeks, we will review each of our underperformers to identify what we got right, but most importantly, what we got wrong. We will discuss whether our investment case has been broken, and if so, why. Discussing your losers isn’t an easy thing to do, but it’s the right thing to do. We strive to continually improve our investment process, which is vital to achieving this goal.
- Benjamin Franklin, ‘Poor Richard’s Almanack’
Over the last four years, we have observed a clear split in the returns of Nintai portfolio holdings. Eight of our holdings (40%) have experienced losses greater than 30%. Conversely, four have returns exceeding 100%, and five more have returns over 50%. The stocks with the biggest losses have hampered the portfolio’s performance during this period. Interestingly, these same companies fueled our strong outperformance in the first four years. Frustrating times, indeed.
This quarter, we decided to review the worst-performing positions and see if any raise concerns about our business case. One of our main worries is the permanent loss of our investment partners’ capital. This can occur for various reasons. The company may have lost its competitive advantages (or moat), the business model could be outdated, or management might have proven to be poor at allocating capital. The question we seek to answer is whether Mr. Franklin’s thoughts apply here - will patience be worth pounds in a year (or more)? There are currently eight stocks that have losses greater than 30% since our initial investment.
Some Initial Thoughts
As we examine each of these companies, we try to assess underperformance in various areas. Some of our holdings have more influence over these than others. These include:
Regulatory Status: Because a high percentage of our holdings work in a regulated industry (healthcare), those companies in that industry are overseen or regulated by several federal agencies, such as the Food and Drug Administration (FDA) or the Centers for Medicaid and Medicare Services (CMS), which oversee patents, prices, product marketing, sales, and promotion, etc.
Government Policy: Over time, as new congressional leadership and Presidential administrations come to power, there may be significant policy changes. For instance, the latest Trump Administration took an aggressive stance regarding tariffs, which had an enormous impact on nearly every industry. Our role as investment managers is to identify companies that can withstand and overcome numerous unforeseen challenges.
Competitive Moat: Morningstar identifies five potential sources of a competitive moat: switching costs, intangible assets, network effects, cost advantage, and economies of scale. We mainly focus on network effects and switching costs when selecting portfolio holdings because most of our investments are in "asset-light” business models. Within that model, we appreciate companies that provide underlying platforms that enable the company’s relationship to extend deeply into the customer’s operations.
Allocation of Capital: We believe that over time, companies that produce returns on invested capital (ROIC) exceeding the weighted average cost of capital (WACC) will deliver exceptional returns for their investors. To do so, management must be outstanding allocators of capital. This means they must avoid expensive acquisitions, investing in businesses where WACC exceeds ROIC, or investing in assets that generate inadequate returns.
Free Cash Flow Growth: At Nintai, we believe the only real measure of value is the amount of future free cash an asset returns, discounted back to its present value. That amount is the basis for calculating our estimated intrinsic value. If our assumptions are off (and in the cases of these holdings, they most certainly are), then it’s likely our investment case is impaired.
Balance Sheet Strength: Another key factor we look for in any investment is a strong balance sheet. We prefer no short- or long-term debt, ample cash or short-term investments, and only a small amount of goodwill as part of total assets. We want the company to be fully prepared financially for the worst-case scenario we can imagine moving forward.
Some High-Level Thoughts
After spending considerable time working through each company’s numbers over the past five years, we’ve identified some common themes in their underperformance. These include the following.
There were no cases of decreased financial strength: None of the underperforming companies have seen a decline in their balance sheet strength. None have taken on any debt (short- or long-term) in the past five years. This reassures us that they can withstand an economic shock like the 2007-2009 Credit Crisis.
We were significantly off in our cash flow estimates: While their balance sheets remain strong, we underestimated the free cash flow of some holdings. Six of the eight companies that underperformed have seen free cash flow stay flat or decline. In each case, we projected a (positive) growth rate for the next decade. We didn’t do a very good job with our prognostication.
We overpaid in some cases: Due to our inaccurate estimates of free cash flow, we overpaid on several occasions. In others, we failed to maintain our margin of safety, which led to underperformance not reflected in our purchase price. Whether this was caused by environmental factors (such as tariffs or regulatory changes) or investing outside our circle of competence still needs to be addressed.
We overestimated customer “must-haves”: Several times in our investment history, we have mistaken our holding company’s offerings as a “must-have,” not a “nice-to-have." Several years ago, we believed that Corporate Executive Board (now part of Gartner) was a must-have for their clients. It seems we have made the same mistake in recent years as well.
We were poor policy prognosticators: Some of our underperforming assets have been influenced by changes in the regulatory environment. In these cases, we should have done a better job of identifying potential impacts and modeling the downside more accurately. Some impacts were unforeseen (such as conditional FDA approval), while others were fairly apparent (such as tariffs).
All these reasons challenge some part of our investment research process. We are reviewing them to determine (a) why they occurred and (b) how we can prevent them from happening again. Some say that achieving 60% accuracy in your stock picks is quite good. But that only tells part of the story. What really matters is how much each holding outperforms or underperforms. In this case, our winners have been successful enough to beat our closest benchmarks - the Russell 2000 and the Russell Mid-Cap Growth Index. Unfortunately, they haven’t been enough to beat the S&P 500, though we rarely invest in large-cap stocks.
Over the next several weeks, we will review each of our underperformers to identify what we got right, but most importantly, what we got wrong. We will discuss whether our investment case has been broken, and if so, why. Discussing your losers isn’t an easy thing to do, but it’s the right thing to do. We strive to continually improve our investment process, which is vital to achieving this goal.
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