“The two most powerful warriors are patience and time.”
- Leo Tolstoy
“Great leadership is about continual change. An outstanding leader is always seeking opportunities in failure and always seeking improvement from success. Patience is key, but does not guarantee long-term prosperity.”
- Iwasaki Yatarō
In Japan, the Sengoko period (or as translated into English “The Age of Warring States”) ran from roughly the mid-fifteenth century and ended with the Battle of Sekigahara in 1603. During that time, Japan was engaged in nearly constant civil wars as a series of very powerful regional leaders known as dâimyo battled to become the sole leader (the Shogun) of the country. One such leader named Takeda Shingen was considered an odds-on favorite - a great military leader, a wise civil administrator - he certainly had the credentials. Unfortunately, he ran up against two other leaders - Oda Nobunaga and Ieyasu Tokugawa - who would eventually precipitate his downfall. In a likely apocryphal story, a lead retainer sat with him and told him a story about a prince who worked hard at becoming the leader of his province. This prince spent all his time building, tearing down, fighting wars, and then rebuilding. It suddenly dawned on this prince that if he had simply been patient - allowed his population to grow, used a growing tax base to build out infrastructure, and so forth - he would have been far more powerful. In being so active, the prince had lost track of his greatest asset - time. Takeda recognized the point of his retainer’s story immediately. But by then it was too late. Within 5 years Takeda’s entire kingdom and family would be gone.
I bring up the story of Takeda Shingen because many investors see their investment world through his eyes. They feel action is necessary to achieve success. That through inaction they are somehow losing a step on their road to financial success. Yet study after study has shown that inaction is a good thing. It cuts down on costs, it allows compounding to work its magic, and it allows an investor to get on with the most important things in life - living.
Why Time Matters
It’s amazing when you think about. What is the only force guaranteed to fill in the mightiest competitive moat? Time. Have you ever seen the greatest monopoly beat Father Time? What strongest empire, what greatest military power, what most violent tyrant has ever beat out time? Who is the sibling of compounding that makes it the eighth wonder of the world? It is time of course. For compounding cannot grow, cannot prosper, nor create any change at all….without time. What is the cheapest asset in all the investor’s arsenal of weapons? Time! It costs nothing, it has no ego, it will not fight with you, it will simply and quietly provide you with companionship every step of your investment journey.
Outstanding businesses will utilize time as an asset to grow competitive advantages, open new markets, and deploy existing capital into profitable growth. At Nintai, we look for managers who find ways to create business growth where return on capital far exceeds weighted average cost of capital. Combining this in a business model that requires little capital to begin with (thus allowing for the creation of a fortress-like balance sheet), leadership has created a business with a long runway of profitable growth. At Nintai, we look for companies where that profitable growth and strong balance sheet can be estimated to survive - and thrive - for decades.
Is There Such a Thing as Too Much Time?
Some of my readers might be thinking at this point that this is another article on the value of time and money (which I’ve written about previously). But as Robert Abbott has pointed out, I have a passion for inverting many issues. Why should the concept of time be any different? So today I thought I’d look at when time is the enemy of your investment holding. Much like Shingen, great companies can let time eat away at their advantages – ranging from competitors to regulatory approvals. Every quarter – when Nintai Investments quickly reviews portfolio holding performance – we keep an eye on several numbers that might reflect that time has eaten away at our investment case. If any changes in these areas show up, we will completely take apart the business case developed earlier in the year and rebuild it from the ground up.
Falling Return on Invested Capital (ROIC)
The first item we look at is to make sure management is still allocating capital at exceptional rates. ROIC is the amount of return a company makes above the average cost it pays for its debt and equity capital. If the holding is going to continue to generate long-term outperformance, it is vital that ROIC exceed the company’s weighted average cost of capital (WACC) by a generous margin. A fall in ROIC can tell you management has taken its eye off the ball in several ways - it might be having difficulty in finding profitable investment opportunities, competition may be cutting into core customers and industries, or might just have simply invested in some truly unfortunate ventures. Falling ROIC can sneak up on you. If you think Boards and management will keep an eye on it for you, think again. In a 2013 survey by McKinsey (McKinsey Quarterly, “Tapping the Strategic Potential of Boards”, February 2013), less 16% of Board members knew that ROIC is the primary driver of value. If you believe ROIC is such a powerful driver - which I do - then I highly recommend keeping a close eye on ROIC.
Falling Free Cash Flow Margins
As a value investor who utilizes a discounted free cash flow model to calculate value, free cash flow (FCF) is one of the most important margin numbers I watch (compared to say gross or net margins). At the end of the day, cash keeps the doors open and free cash allows management strategic flexibility in terms of future capital allocation of returns to investors. FCF margins can drop for several reasons but the one that gives us the greatest concern at
Nintai is losing the ability to price products and services. Many great companies share the same attribute of making their product in the daily operations of their customers. It almost makes it impossible for the customer to haggle or obtain pricing power over the long term. Think of Guidewire’s (GWRE) InsurancePlatform which operates many property and casualty insurers claims, billing, and policy functions. The amount of effort it would take to change vendors, remove one system, install a new one - all while maintaining consistent uptime and coverage - is a difficult action to justify. Another reason might be a large increase in capital expenditures which might reflect the same type of problem - having to increase spending to fend off competitive inroads to a holding’s customer base. When I see a significant decrease in FCF margins, this will generally have a direct impact on my discount model’s valuation. It’s never a great way to start the day.
Drop in Cash or Increase in New Debt
Another sign that will catch my attention is to see a drop in cash on the balance sheet or - more importantly - the issuance of new debt. Generally, Nintai Investments runs a focused portfolio of roughly 20 - 25 position. Of these, roughly three-quarters will have no short or long-term debt. Occasionally, companies will issue debt for larger capex projects or acquisitions. Examples this might include Nintai Investment holding Novo Nordisk (NVO) which usually runs a very tight balance sheet with very little short-term debt (in the tens of millions of $$) versus having billions of dollars or short term instruments. The company has recently expanded its debt for new acquisitions. Obviously we want to see these type of deals generate high ROIC and see real value from the risk generated by a weakened balance sheet. Another example which we see an a wholly negative light was former Nintai Partners holding Qualcomm (QCOM) which took on an enormous debt obligation to fund share repurchases. No matter the calculations made, we see this type of action indefensible related to investor risk/reward. In many cases these types of transactions are simply a transfer of wealth from option-enriched managers hitting pay dirt when investors buy back millions of shares at inflated prices. In Qualcomm’s situation, we sold out of our entire position and never looked back.
Conclusions
Investing in a small business that generates high return on capital, equity, and assets, has high free cash flow margins, and deep competitive advantages can be a wonderful partnership that lasts for decades. It’s the backbone of our investment strategy at Nintai Investments LLC and has provided the firm and its investment partners with outstanding returns since 2002 (of course past performance is no assurance of future returns). Having said that, finding companies where time aids in their growth and only strengthens their businesses is hard work. Time can erode any competitive advantage, fill any moat, and weaken any management team. Keeping an eye on several core measures can make sure you move on in a timely manner. Change happens. None of us like it. But I guarantee you none enjoy it less than lose who some of the core building blocks of their portfolios or daily living. Just ask Takeda Shingen.
DISCLOSURE: Portfolios that I personally manage are long GWRE and NVO. Nintai has no position in QCOM.
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