Our Investment Strategy and Portfolio Selection Process
“All human evil comes from this – man’s inability to sit quietly in a room” - Blaise Pascal
“We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking whether we have an apparent advantage over other market participants in any potential investment. If the answer is negative, we do not invest.” - Seth Klarman (Trades, Portfolio)
Over the past eighteen (18) years of managing our partner’s assets, the most frequent questions we are asked about are a.) How do you decide what goes into the portfolio and b.) How do you manage risk? We think the questions are actually quite closely correlated.
We see risk as the possibility of permanent capital impairment. No investor likes it and no investor wants it in their investment portfolio. We believe mitigating risk happens at the level of stock selection. We posit that certain companies possess the financial, business, competitive, and management attributes that lead to reduced risk (meaning permanent capital impairment) in the investment portfolio. These attributes include the following:
Stock Selection Criteria
Financial Strength: The Nintai portfolio is made up of 20 companies (through October 31st, 2014) that exhibit remarkably strong financials. Fourteen (14) of the twenty (20) companies in the portfolio have no short or long term debt. On average, companies in the portfolio convert one (1) dollar of every four (4) dollars in revenue into free cash. The total portfolio has roughly $12.3B of long and short-term debt versus nearly $33B in cash on the balance sheets. In addition, the portfolio generates nearly $26B in free cash annually. Simply put, our portfolio companies could pay off their entire debt in roughly six (6) months from free cash flow without impacting their business operations.
Market Strength: The Nintai portfolio focuses on companies with strong competitive advantages – or moats – as Warren Buffett (Trades, Portfolio) would say. Of the twenty (20) stocks in the portfolio, fifteen (15) qualify for Morningstar’s wide moat rating. We define wide moat in several ways – return on capital consistently exceeding weighted average cost of capital, consistent earnings and free cash flow growth, high returns on equity and assets, and projected stability of these over next 15-20 years.
Utilizing these as our measures let’s quickly look at holding FactSet Research Systems (FDS, Financial). The company has an enormous competitive advantage in their subscription based financial data and informatics offerings. Roughly one (1) of every four (4) dollars in revenue converts to free cash. Previous five (5) year return on equity has averaged 34.5% while generating an average return on invested capital of 41% over the same period. Free cash flow has grown by roughly 16% annually over the past 10 years. These are all statistics of a company with clear competitive advantages and a wide-moat to protect its core business.
Capital Allocation: With these excess profits, we look for management to be wise allocators of capital. In general, we look for returns on invested capital greater than 15%. The weighted average of the total portfolio’s ROIC is 24.7%. In essence, the money that management has put back into the business has earned us -- as an investor -- roughly 25% returns. We greatly admire management that wisely uses capital to grow the business and – when not possible - returns the excess to their shareholders in the form of dividends or stock buybacks.
Discount to Fair Value: After calculating the intrinsic value of a company, we look to purchase it’s stock at a sufficient discount to fair value. This provides us with adequate investment returns and downside protection in the case where our assumptions may be flawed. We generally look for a discount of at least 25% to fair value before we will invest. Of all the measures utilized by our team this is without a doubt the most subjective. However, by utilizing conservative estimates based on previous performance we believe our estimates can get us within the ballpark of an acceptable valuation.
Investment Portfolio Positioning
At the end of each quarter we take a look at how our portfolio stands against the greater markets. We do this as a means to test our portfolio positioning and predict future returns. We measure the portfolio in 5 key categories against the Morningstar Total Stock Index: P/E, ROE, ROA, Market Valuation and Projected Returns (5YRS). We strongly believe performance of the fund will exceed market returns if the following conditions are met:
- The P/E of the portfolio is significantly BELOW the S&P 500 and;
- The portfolio's ROE and ROA greatly EXCEED the S&P 500 and;
- The portfolio's projected 5 YR EPS growth Rate greatly EXCEEDS the S&P 500 and;
- The portfolio’s valuation is markedly less than the Total Market Valuation as measured by Morningstar and;
- The portfolio consists of companies meeting our previously discussed selection criteria.
One of the greatest strengths an investor can bring to their portfolio is the ability to demonstrate patience and keep a long-term perspective. We strongly agree with Ben Graham’s thesis that in the short term the markets are a voting machine and in the long term a weighing machine. We find it extraordinary that a company’s single quarterly earnings report that misses Wall Street expectations by 5% can send its respective stock down by 25%. We update our portfolio valuations every quarter and are surprised if we see significant changes. When that happens we see that more as a failure on our part as intelligent business owners than anything the company might have done that quarter. Because we look at valuations from a long-term (or weighing) perspective, we think long and hard about the companies we invest in, test whether such a company is within our core competence, and vigorously test our assumptions.
After we’ve made our decision to invest, each position in our portfolio represents roughly 5% of our total assets. If our analysis should prove correct we generally hold our investments for greater than 10 years. Of our current portfolio such companies as Fastenal (FAST, Financial), Expeditors International (EXPD, Financial), FactSet Research (FDS, Financial), Waters (WAT, Financial), Qualcomm (QCOM, Financial), and Intuitive Surgical (ISRG, Financial) have been held for at least a decade. Since 2005 our portfolio turnover has equaled roughly 2-3% annually. As Warren Buffett (Trades, Portfolio) was so apt to point out, making an investment decision is like being in a baseball game where they don't count strikes. With that in mind, time and patience are extraordinarily powerful tools at your disposal.
Over the past decade we have been blessed to partner with extraordinary investors who have given us the freedom to manage their portfolio as we recommend and who never demanded redemptions at all the wrong times. But our investing career has never been a straight positive arc moving perpetually upwards. In my next article, I would like to take the time to talk about the investment mistakes we’ve made (and I assure there have been many!) and use several use cases to go step-by-step through the decision making process and articulate where we got things wrong.
The Seth Klarman (Trades, Portfolio) quote at the beginning of this article discusses the arrogance of investing. We believe this is equally true when writing about investment strategies and portfolio selection. While it is arrogant to suggest one investment strategy is better than others, we’ve learned there are many ways to make money on Wall Street. This article is simply another method at investment strategy that has worked for us over the past decade. We are always excited to hear about different methodologies and/or comments about our thinking. That’s what makes investing so interesting – it is a never-ending quest to understand more and continuously tweak your mental models. We look forward to your thoughts.