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Thomas Macpherson
Thomas Macpherson
Articles (194)  | Author's Website |

Nintai's Dual Circles of Comfort and Competence

It isn't enough to just stay in your circle of competence

Being able to sleep at night is one prerequisite for an investment manager. Understanding the value of your portfolio is another. They aren’t mutually exclusive but they aren’t the same thing either. If you follow this formula I think you will generate more than adequate returns.” - Scott Simmons

As value investors you hear a lot about circle of competence. Warren Buffett (Trades, Portfolio) speaks about not going beyond the limits of this circle. Tom Watson – IBM’s (NYSE:IBM) founder – said, “I’m no genius, but I’m smart in spots, and I stay around those spots.” At the Nintai Charitable Trust we certainly don’t count ourselves among the hallowed halls of genius, so we try to stick around our spots as well. But this really only tells half the story of our investment philosophy. We use a separate – but interlocking – circle we call the Circle of Comfort. This is a series of measures we use that allows us to sleep well at night. They mostly have to do with the quality of the business we invest in – balance sheet strength, management team, returns on equity/capital, etc. Let’s assume we didn’t sleep for one night, but rather we pulled a Rip Van Winkle and slept 15 years. My guess is our investment would be in the same business line but would be worth a great deal more than when we went to sleep.

The dual circles

As shown in the graphic below, we see our best opportunities in the overlap of our Circles of Comfort and Competence. This means we look for companies with the financial ability to withstand a tremendous series of shocks along with a business where we can identify and quantify where these might come from (such as regulatory changes to new competitive offerings). There aren’t that many companies that meet our criteria. Our screen (using GuruFocus’ All-In-One Screener) has a tendency to show roughly 140 companies that fit into our Circle of Comfort. From there we further whittle down the list by companies that reside in our Circle of Competence.

A working example

As we mentioned, our “comfort” screen on GuruFocus brings up about 140 companies. You can recreate this screen by entering in the following criteria:

  • Cash to debt: >100
  • Debt to equity: <0.2
  • ROA 10-year median: >15%
  • ROE 10-year median: >15%
  • ROC 10-year median: >15%

After creating this list we can quickly rule out some due to lack of a competitive moat (Fitbit) (NYSE:FIT), corporate structure (Hugoton Royalty Trust) (HGT), or lack of industry expertise such as consumer retail (Lululemon Athletica) (NASDAQ:LULU). Of this list, nine companies are currently in the Nintai Charitable Trust portfolio. We definitely enjoy swimming in this part of the investment pool.

An example of such a holding is Intuitive Surgical (NASDAQ:ISRG). Relative to our Circle of Comfort, the company has 10-year averages of 30% ROC, 91% ROE, and 17% ROA. The company has no debt and $1.6 billion cash/short term instruments on the balance sheet. ISRG converts roughly 30% of revenue into free cash (generating $691 million in free cash last year) and maintained 26% net margins over the past five years. In the past three years the company has reduced outstanding shares from 41.1 million to 37.9 million. Overall we are quite comfortable the company could handle any series of catastrophic events including product litigation, public policy changes, and/or a deep recession.

In regards to our circle of competence, we are quite comfortable in estimating market growth, adoption rates, and customer satisfaction within the robotic surgery space. With a pool of roughly 75 current ISRG clients we know and communicate with, we can maintain a deep understanding of key issues surrounding their product. Serving on several health care boards also adds to our understanding of the space.

Conclusions

There are two models that guide my thinking at the Nintai Charitable Trust. The first is sleeping well at night by assuring I stay within my Circle of Comfort. This means finding compounding machines with rock solid balance sheets. Second is making sure I have deep knowledge of the industry in which the investment does business. This includes market drivers, competition, and public policy/regulatory issues. Through these I remain within my Circle of Competence. These models create a framework that assures I don't wander off into unsafe, unknown and unknowable investment traps. If that allows our Trust directors to sleep well at night and provide adequate returns, we couldn't ask for any more.

As always I look forward to your thoughts and comments.

About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 5.0/5 (12 votes)

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Comments

OPM Insights
OPM Insights premium member - 4 years ago

Hi Tom, Thanks for the article. Question about your first 2 filters. If debt to equity is 0, doesn't that filter out all companies with debt and thus make the "cash to debt > 100" filter unnecessary? What am I missing? Best, N

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Nelson. Thanks so much for your question. You would be right in noting it would not be necessary. The number on D/E is actually <0.2. I've corrected the article to reflect that. Thanks for catching it! Best. - Tom

Douglas Eugene
Douglas Eugene - 4 years ago    Report SPAM

Tom: Thank you for an excellent article. I'm finally learning to devote significant time reflecting and studying my investment process. Your overlapping circles provide an excellent framework--not only for the future, but also reflection on past decisions. (And if I'm honest with myself, there are a few holdings where they may meet "comfort" criterion, but not strong "competence" for me..thanks for sharing your insight.

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Douglas: Thanks so much for your very kind comment. We've come to these models over time and we've certainly learned a lot along the way. As the years go by we realize the processes that prevent mistakes of magnitude are far more important than models that predict the next ten bagger. Thanks again for your comment. Best - Tom

Pavel Gorobets
Pavel Gorobets - 4 years ago    Report SPAM

Hi Tom.

In some cases equity is relatively small or negative thus ROI and debt to equity numbers provide little or no value. How do you get around during your screening process?

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Pg: thanks for your question. As I mention in the article the screen is a guide only. It produces roughly 50-60 companies we would never invest in at the Trust. Your criteria might fit into that category. There is no screen that I'm aware of that will give us a list of only companies where we might invest. Hope this answers your question. Best - Tom

OPM Insights
OPM Insights premium member - 4 years ago

Hi Tom, do you mind sharing your research process if a company appears on the screener for the first time and falls into the comfort / competence zones? Do you read the latest 10K first? Is there a step before that? Whatever info you could provide would be greatly appreciated. Best, N

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Nelson. That's a great question. The first thing we do is really tear apart the financials over the past 10 years. We want to make sure we understand every line item to the point we could have a comfortable conversation with the CFO. Anything that doesn't make sense or appears out of the ordinary with no reasonable explanation kicks it out of the comfort circle. Next we read every 10-K and 10-Q for the past 10 years. Here we have a structured set of questions we are looking to answer. Next we try to obtain as many industry reports that we can. We don't read Wall Street analyst reports but rather reports from Gartner, Forrester, McKinsey, etc. We want to make sure we fully understand key aspects of the market - trends, competition, regulatory, etc. Next we listen to every quarterly conference call to get a feel for management. Are they honest in their disclosures? Do they understand their business and market? Do they treat analysts and their team with respect? If all of these steps are taken and we still see the company sitting in our dual circles then we begin the valuation process. Hope this answers your question. Best - Tom

OPM Insights
OPM Insights premium member - 4 years ago

Hi Tom, Thanks for a very thorough clarification. It's very helpful. Cheers, N

Zejia
Zejia - 4 years ago    Report SPAM

Hi Tom, thank you for sharing Nintai's investing experience as always. What I find is that your circle of competency does not sit still, but can be growing. And I find it's very important to proactively grow your circle of competence. For example, I am currently working in the airline industry where I build some knowledge on how an airline company run the business. If I stop here- only picking stocks from the aviation industry as I have the knowledge, my choice for investment will be very limited. In fact, I can't see any competitive moat that an airline company has over its competitors. So for me, I will have to research and understand other industries though I don't have the competency from my own life experience. That's the learning process that I can't stop.

Thanks again for this excellent article!

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Zejia. Thanks for a great comment. It's great to hear from you. I hope we see more of your writing and comments here on Gurufocus. You are absolutely correct that our circle of competence has widened. The Nintai database expanded from 1 industry to 11 industries in 15 years. A couple of things about enlarging the circle though. First, you need to continually update that circle. Second, the more industries you add to the circle the greater the work to keep that circle up to date and relevant. Eventually this limits the growth of your circle. In addition our circle stayed around industries that provide high capital returns, equity, and assets. This kept our circle from wandering very far from its center. As Clauswitz said, "He who defends everything defends nothing at all". That's a motto we lived by. Thanks again for a great comment. Best - Tom

Zejia
Zejia - 4 years ago    Report SPAM

I agree with you Tom. I do feel myself drifted and lose directions. Thanks for the insightful advices. Best, Zejia.

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