In 16th-century China two businessmen walked to the daily opening of their village marketplace. One of the businessmen carried a bag of silver coins that he brought to his place of business each and every day. The second businessman carried nothing and laughed at his traveling companion asking him why he insisted on carrying around all his working capital in cash. He pointed out his investments – spread across three lower class retailers – allowed him to make additional money by purchasing parts of each business and collecting his due each month. The first businessman stopped and remained thoughtful for a moment. He finally replied, "My claim to what is owed me is based on the hard truth of this silver. What is owed is in my hand. Yours is based on conjecture. I will eat every day for the rest of my life because my assets are very real. You might eat very well this month but not so much after because you understand what is owed you, but not what your people can pay you".
Being a business owner: Ownership of what?
As the markets seem to reach a new all-time high nearly every month, an enormous amount our time at Nintai has been spent thinking of risk and financial claims of our portfolio positions. What we mean by this is the fact that each of our 20 stock positions gives us a legal claim to a portion of current and future assets/earnings of our portfolio holdings. As equity holders we stand at the bottom of the totem pole – behind holders of debt and preferred stock. Most investors don't think much about this issue on a regular basis. During the crash of 2008/2009 it became something far more real and visceral as many shareholders found their stock worth as much as the paper covering their basement den walls. Much like our second eponymous businessman, investors knew what they were owed, but had little understanding of what could be paid.
We've been giving this a great deal of thought because we think the strength of our portfolio assets and earnings are vital in assessing risk. We think some of the really disastrous losses over the past 15 years have been caused by investors losing sight of their position on claims to assets and earnings combined with a fundamental ignorance of their make up. Put more succinctly, investors weren't sure what rights they own and what assets backed up these claims.
A quote we have on our wall at Nintai is one of the lesser known from Benjamin Graham that states, “The really dreadful losses of the past few years were realized in those common-stock issues where the buyer forgot to ask ‘How much?’” We think there is a corollary to this. “Dreadful losses were also brought about by not understanding what the investor bought and what the investment could pay.”
A great example of this is a corporation’s level of debt and the potential risk that implies on your portfolio holdings. Ownership cuts both ways – while assuring you a percent of future cash flow, it also means that claim is offset by debt holders. Where you sit on future payment rights as well as understanding what your assets can pay you in the future is greatly impacted by levels of indebtedness.
We’ve seen this movie, too
All too often we hear individuals in the finance world say we’ve learned our lesson since the Great Recession. Companies – indebted to levels beyond reason – are features of a long distant past. The data tell us differently. In a recent study by McKinsey[1], the growth of debt on corporate balance sheets has grown slightly faster from 2007 – 2014 than the run up period (2000 – 2007) before the Great Crash in 2008-2009 (see graphic below).
We recognize there are various compelling reasons to see such increase in debt including historically low interest rates, significant capital spending that had been delayed during the Great Recession, and an equal surge in cash on the balance sheets[2].
These are all well and good. But it is as vital today as it was in 2007 to make sure your ownership is in a company where – for various reasons – management is prepared to survive limited or no access to the capital markets. Another equally daunting risk is that interest rates spike upwards and companies find themselves unwilling or unable to refinance existing debt. Your long-term investment returns will be starkly impacted on where you place your bets, what ownership guarantees you as a shareholder, and how the markets perceive the financial strength of the company.
As a working example of this thesis, I would offer a comparison between a holding in the Nintai portfolio and another entity with very different ownership and financial structure.
Dolby Labs
Dolby (DLB, Financial) is a leader in the auto, entertainment, and mobile audio space. Through its licensing model (which produces more than 90% of its revenue) the company generates nearly $1B in sales with 92% gross margins and net margins of roughly 20%. The company has no short- or long-term debt, and returns on equity, assets and capital of 16.2%, 15.2%, and 38% respectively. Finally the company has turned roughly 30% of revenue into free cash flow over the past five years. A compounding cash machine indeed. We purchased stock in the company in 2004 at a significant discount to fair value and believe the stock currently trades below its intrinsic value. In this instance we have purchased the rights of a company that produces growing free cash flow based on legally binding patents that management turns into high return research and capital allocation. What danger do we see in the case of an inevitable downturn? Is our ownership percentage at risk because of higher positioned stakeholders? As an organization with no debt and no preferred shares, we feel extremely comfortable knowing the risk of permanent capital impairment is relatively low.
Xerium Technologies
Xerium (XRM, Financial) went public in 2006 and manufactures and supplies materials used in the production of roll covers and paper-based clothes. The stock is up 45% over the past 12 months though it is down nearly 92% since it’s IPO. People often conflate high investment returns such as the past year in XRM's case with financial strength. In the case of Xerium nothing could be further from the truth. Saddled with enormous debt, investors have purchased rights in a company with no growth and a large group of stakeholders with preeminent claims ahead of them.
The company currently has $465M of long-term debt, pension liabilities of $75M, and $9M in cash on the balance sheet. Shareholders have been diluted nearly every year since 2006 with outstanding shares going from 2.2M in 2006 to 16.5M in 2014. The company has produced FCF only twice in the past 6 years with 2014 generating $-39M. Revenue is actually lower in 2014 than in 2005 going from $582M to $531M. On average the company has never produced a positive annual return on equity, assets, or capital.
For those investors who have purchased the stock and seen it increase 45% in the last 12 months, we would ask the same questions we posed in regards to Nintai’s ownership stake in Dolby. What danger do we see in the case of an inevitable downturn? Is our ownership percentage at risk because of higher positioned stakeholders? Is there a chance for permanent capital impairment? We believe the answers are very, very different in Xerium’s case. The fact the stock has risen so far in 2014-2015 tells us investors are losing sight of what they own and what Xerium can pay. To Nintai, this represents yet another example of why 2015 feels so much like 2007.
Conclusions
We are approaching levels in valuations where we believe investor returns will be based on three key components – their holdings were purchased at a significant discount to fair value, they have pristine financials, and they have highly sticky free cash flow. This doesn't put us very far from our everyday strategy of investing. But it does mean we spend a far greater time focusing on these three factors than at any other moment of our investing careers since 2007. Our recent sales of FactSet Research (FDS, Financial) and Manhattan Associates (MANH, Financial) reflect the fact that both companies easily pass the latter two criteria but miserably failed the first. When market valuations are at this level, a failure in any of these (both individually or in combination) can prove to be fatal to long-term investment returns. In sailing terms it’s time to batten down the hatches and prepare to scud if necessary. Those investors who fail to understand what they own – and even more importantly what their holdings can pay – will find themselves on a lee shore with little to no room to maneuver.
As always we look forward to your thoughts and comments.
[1] “Debt and (Not Much) Deleveraging”, McKinsey Global Institute, February, 2015
[2] It’s not all bad news. Two areas showed true deleveraging – consumers/families and the financial industry. There is more to the financial industry numbers than shown. It mostly reflects the real hit in the shadow banking field but we should celebrate when and where we can.
