“The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.” - Benjamin Graham
“You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself.” - Warren Buffett (Trades, Portfolio)
There are so many ways to approach value investing that sometimes one wonders if there is a single description that works for them all. I’ve tended to focus on a proposed definition by one of my first investment mentors (paraphrasing Graham).
“Value investment is purchasing an asset at a discount to its estimated intrinsic value. Nothing more and nothing less. Anything else is the same as gambling without knowing the odds and will likely make you look like a damn fool.”
At Nintai, that means calculating value before anything else. Yes, we do use screens to help identify companies that meet our investment criteria. But it’s important to understand these screens give us an idea of a company – not its industry, its Standard Industrial Classification code, its competition or management team. These screens simply give us a list of companies that have characteristics of high-quality securities trading at a reasonable price. Only after we’ve run a high-level valuation spreadsheet tab do we begin to ascertain the specifics of the potential target. Sometimes identifying this information is enough to rule out any further research. For instance, one time after finding a target turned out to be in the grocery business, we removed it right away from the watch list.
There are three major areas which I believe drive long-term competitive advantages. These include structural cash advantages, long-term cash generation and long-term value generation.
Structural cash advantages
The first - structural cash advantages – is the type of opportunity where the company generates excess cash and has opportunities to deploy this capital, generating returns on capital far in excess of its cost of capital. These are companies that can provide decades of profitable growth for equally patient investors. Examples of this type of business include Fastenal (FAST, Financial) and Expeditors International (EXPD, Financial). Both companies generated returns on capital in the high 20s versus a weighted average cost of capital in the mid-single digits. These are companies with opportunities to seek growth in their existing markets without having to overpay or take risks in the mergers and acquisitions marketplace. Deployment of capital is done with a clear focus in return on capital exceeding cost of capital.
Cash flow and balance sheet strength
The second category covers companies with a long history of free cash flow generation and pristine balance sheets. These companies have deep and wide competitive moats, allowing for pricing strength and free cash flow growth over generations. This can be achieved though brand strength, product monopoly or duopoly or the strength of its competitive position. Companies with these traits include Computer Modelling Group (CMDXF, Financial) or Fanuc (FANUY, Financial), which use their competitive advantages to generate positive free cash. In addition, these companies are wide enough to know how and when to use their capital for snap-on acquisitions that generate positive value for their shareholders.
Retained earnings and intrinsic value growth
The last type of company that Nintai looks for is one that has long history of retained earnings used to add additional companies (along with their retained earnings) to build value over the long term. In these companies, management makes the decision that M&A (generally through smaller M&A) can substantially increase the book value of their companies – and hence reward their long-term shareholders. Companies in this category consist of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) and Cognex (CGNX, Financial). In the case of Cognex, the company has increased retained earnings from $284 million in 2004 to $682 million in 2019.
Why this matters
In general, great wealth has been made in the “slow-is-steady” routine. For nearly ever great value investor, there is one who made a killing on one major bet. Many times, hedge funds are held out as the poster child for slow and steady returns. In fact, when one looks at hedge fund returns, we frequently find a good bet locked in solid returns over the next several years followed by substantial underperformance. An example of the hit-it-big then mostly lose it all is Paulson & Co.’s bet against the credit markets. This single bet brought the company’s assets under management up to $36 billion in 2011. By 2019, this number had dwindled to just $8.7 billion, of which nearly 80% to 85% was Paulson’s own personal funds. The Financial Times reported on Jan. 22, 2019 that Paulson was considering closing the fund and converting it to a family office.
Another example is value investors who have generally performed poorly since their doors opened. One such investor is Ronald Muhlenkamp (Trades, Portfolio) (underperformed S&P three-year: -9.4%, five-year: -9.7%, 10-year: -6.5%, 15-year: -5.3% and 20-year: -0.7%), whose record is a truly abysmal performance versus the S&P 500. David Winters (Trades, Portfolio) is another example of long-term underperformance withdrawals. Wintergreen Fund (Trades, Portfolio) saw total assets under management drop by roughly 90% between October 2005 and January 2019 before shutting down the fund.
One of the common themes one sees in these guru performances is a remarkable hubris that since their initial big win. Many great value gurus think the previous victories can be replicated over and over again. But much like Tolstoy’s unhappy families ("Happy families are all alike; every unhappy family is unhappy in its own way."), so goes value investing – every bear market is unhappy to its shareholders in its own unique way. Whether it be Paulson’s short on the mortgage asset business or Muhlenkamp's description of his business as “intelligent investment management to emphasize that we remove the emotion from investing. We might also be described as 'common sense' or 'no BS' investment managers,” value investors can get caught in the same confirmation feedback loop as any investor.
Conclusions
Value investing is about having a core set of values flexible enough to change with the times. I remember reading how Warren Buffett (Trades, Portfolio) had first invested in the Washington Post in 1973 at $11 million. When Buffett was planning on the transaction to spin off his 23.4% holdings in the Post to Graham Holdings (GHC, Financial), his stake in the Post was now worth $1.1 billion. Perhaps one of Buffett’s greatest attributes has been his ability to evolve with the investment times. Perhaps his greatest – and most profitable – shift has been from the cigar-butt model to purchasing great companies at fair prices. In my investing career, I’ve certainly exchanged some expansively acquired theories for those with more modern trends. By focusing on higher quality (defined by structural cash advantages, cash flow and balance sheet strength and intrinsic value growth) my ability to add vale to investor portfolios has increased dramatically. By finding great companies at fair prices, I’ve found ways to decrease turnover, reduce long-term tax liabilities and let management do the heavy lifting. You can do the same by evolving your own standards.
As always, I look forward to your thoughts and comments.
Disclosure: Nintai retains positions in Computer Modelling Group, Fanuc and Cognex.
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