“I think a great capital allocator will intuitively understand that there really isn’t anything he or she can do to improve long-term returns. Most of the time they understand the decision to partner with a particular management team is the most fruitful action of the entire relationship.”
- Bill Bishop
“Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.”
- Will Rogers
There’s much be said for both Bishop’s and Roger’s thinking – though I think good old Will would have been more successful if he had those eyeglasses. And that’s the problem. Most of us might know a good company when we see one. We don’t know whether it will be a great stock.
In my previous article, I described in detail (perhaps too much!) what type of knowledge is necessary to grasp the issues facing a modern U.S.-based health care company. I used iRadimed (IRMD, Financial), an MRI-compliant pump manufacturer that makes pumps that can safely operate in an MRI setting, as an example while I walked through some of the primary knowledge requirements I recommend an investor have as they begin their investment journey into the health care markets.
The “short and shoddy” health care investment process
Since then, several readers have reached out to me to ask if it is absolutely essential that they develop such a skill set. It’s not unreasonable to ask if there is a “short and shoddy” way to speed the process. Some readers may be surprised to hear me say that the answer is absolutely yes.
There are several ways to do this. First – and the most obvious and easiest – is to find a high-quality exchange-traded fund or focused fund in the industry in which you want to acquire assets. For instance, the Vanguard Health Care Fund (Trades, Portfolio) (VGHCX) is an outstanding way to get some health care exposure without much grunt work. Another approach is to find exceptionally high-quality companies with deep competitive moats and long runways of growth. Of course, you must wait for the right price. But if you are patient, it is possible to find a company that can give you exposure and provide your portfolio with a decades-long anchor that can drive substantial outperformance.
Because I previously wrote about health care, I will use the same industry in an example of how to find such a company. Let me start by saying that if there was an industry most suited to the “short and shoddy” approach, it would health care. Having made myself a complete hypocrite with this statement, let me explain. Health care – as an industry in the U.S. – is roughly half for-profit and half not-for-profit. The for-profit part can be heavily regulated, producing monopolies and duopolies. This can also create companies with extremely high returns and profitability. In a sense, there is no better market sector in which to stumble onto diamonds without too much effort. There are three reasons for this.
First, a large portion of the health care industry is regulated by federal and state agencies. Much legwork, such as product safety and good manufacturing processes (known as cGMP), is already inspected by industry regulators.
Second, health care provides thousands of companies with exclusive rights to medicines or machines that save lives. This exclusivity can last for seven to 20 years.
Third, the health care industry is a steady marketplace. The cycle of birth, life, sickness and death is immutable. People need health care regardless of market conditions.
For these reasons, health care can allow value investors to sometimes shorten (dare I say, slightly cheat) their research processes. This doesn’t mean that health care is not an incredibly complex ecosystem. But it does mean that if you know what to look for, sometimes the diamonds are lying in plain sight.
So what should an investor look for in their “short and shoddy” investment research process? The method isn’t much different from my existing approach, but might be slightly different from most other investors’. The key is looking for smaller companies with high returns on equity and capital, along with strong balance sheets. These companies will not always have wide competitive moats, but I’ve never found such a company without these numbers. Another thing to look for in companies is announcements about Food and Drug Administration approvals for their products. Last, the ideal company should be in a segment of health care with steady revenue and growth. Think along the lines of lab testing or saline solution, which is constantly used in clinical settings.
An example of this type of company is Nintai Investments’ holding Masimo Corp. (MASI, Financial). With a market capitalization of $8.2 billion, Masimo is in the mid-cap range with ample opportunity to grow over the next few decades. Masimo is a medical device company focusing on noninvasive patient monitoring. It began by creating a device that nearly any hospital patient will recognize – an oxygen and pulse reader that clamps at the end of a patient's finger tip and allows doctors to see their oxygen and pulse levels. Every emergency department and primary care physician uses these devices on a daily basis.
Masimo’s financial story
Masimo’s financials should tell a story of high returns based on a deep competitive moat combined with a product in a steadily growing marketplace. First, the company as a long history of generating an above-average return on equity, return on invested capital and return on assets.
While fluctuating year by year, the company has done an outstanding job on average over the long term. These types of numbers indicate two things: The company earns considerable profits on generated revenue, and management has done a great job of allocating capital.
From another angle, the company has done an outstanding job growing both earnings and revenue. While free cash flow has risen at a slower rate, it has picked up considerably and should continue to increase following the company's recent deal with Phillips. It will also benefit from the company leveraging its installed base.
From a financial standpoint, Masimo’s story is compelling. The company has been able to grow earnings and revenue at double-digit rates while maintaining outstanding returns on capital and equity. These are all signs of a company with a deep competitive moat and a management team that knows how to take advantage of it.
Masimo’s moat
Sometimes, ascertaining the strength of a moat in health care can be difficult. Understanding everything from the microbiology and chemistry of a biopharmaceutical patent to the technology, professional acceptance and clinical outcomes of robotic surgery can demand enormous industry knowledge. But there are some companies like Masimo that don’t require technological, industry or clinical expertise. For instance, read Morningstar’s description of Masimo’s moat. By reading two paragraphs, a savvy investor can understand that the company has a strong competitive position.
“The pulse oximetry market is an effective duopoly between Masimo and Covidien (now Medtronic), with Philips and GE Healthcare representing a minority 10%-15% share. Masimo’s share of shipped units has grown from 30% at the beginning of the decade to nearly 50% today thanks to superior products that are more accurate and reliable than the competition. The company is agnostic about how its units get to market, whether directly in Masimo-branded monitors or through OEM devices using Masimo SET. Of the company’s approximately 1.5 million installed units, only a fourth are Masimo devices; the remaining three fourths are OEM multiparameter monitors containing a Masimo circuit board. This strategy has driven returns on capital substantially ahead of our estimate of WACC each year since the company’s 2007 IPO, which to us signals the existence of a moat.
"Masimo has left the lumpy and sales-intensive capital equipment business largely to its OEM partners, while retaining the asset-light, high-margin sensor sales business. The company relies on razor-and-blade effects to establish the installed base from which it can drive repeat sales of its disposable and reusable sensors, generally under five- to six-year purchase contracts. Masimo sensors can be used across competing systems through universal adapters, but Masimo oximetry units use a closed architecture, creating a captive sales base. Further, the company has demonstrated its ability to successfully retain customers after an initial contract win; renewal rates have remained near 98% over time, which we believe illustrates the company’s superior value proposition.”
We have now already learned that Masimo achieves outstanding financial results driven by a duopoly in a market with steady growth rates and expectations of grow further over the next decade or two. We learned all of this without going deep into the technology or science related to the product, or the company's end-customer, competition or supply chain.
We’ve reached this conclusion by coming from the nearly opposite direction that Nintai Investments takes. In health care, we use deep industry knowledge to look for players that might be overlooked due to size, complexity or flat-out “unsexiness.” We do this – as I discussed in “Industry Knowledge” – by looking at connections or business processes missed by many with less experience in the industry. But as I’ve often said: In value investing there are many ways to go about doing one thing.
Some takeaways
Deep industry knowledge can give investors a leg up in finding investment opportunities. I have found some of the most successful investments over my investing career that way. But not all. Sometimes you can find a diamond in the rough – not by knowing where to dig, but simply by knowing what a diamond looks like. Many investment diamonds – meaning companies that you can hold for decades – have common characteristics that can allow you to create a shortcut in your investment research. Here are a few traits I’ve found over the years that make a company shine brightly as I sift through investment dirt.
Duopolies: Most companies that are monopolies are well known and hard to find at the right price. Duopolies have many advantages of monopolies but often fly under the radar. FactSet Research (FDS) is a great example. Remember: It doesn’t matter whether your holding has a No. 1 or No. 2 position. Just make sure there are only two.
ROIC far exceeds WACC: In companies with strong competitive moats, return on invested capital always exceeds weighted average cost of capital. GuruFocus’ 30-Year Financial tab under “ratios” can easily give you both numbers.
Their advantage is locked in: You are looking for a company whose advantage is secure – whether by patent (like Masimo) or by switching costs combined with technological excellence (also Masimo). Its competitive advantage should be secure for the next 10 to 20 years. There aren’t many companies that can say that. Whether the company is Coke or Wrigley or Masimo, as an investor you shouldn’t be able to find any significant reason its moat could be filled in or outflanked.
The balance sheet should be rock solid: If a company has a strong competitive advantage, it shouldn’t be loading up on debt or issuing convertible debt. You want management to reinvest capital back into operations when ROIC exceeds WACC. Any profits they don’t need can be retained as cash on the balance sheet, used to repurchase shares (hopefully not overpaying) or sent back to investors as dividends. Running an outstanding company should not be financial rocket science.
Finding a company with these types of attributes isn’t that hard. Today, investors can create screens at GuruFocus in a matter of seconds.
One last thing
One thing I haven’t touched on is price. I’ve shown how to create a “short and shoddy” investment approach that can help you find diamonds in any type of industry. But the approach doesn’t say what to pay for those diamonds. At Nintai Investments, we use a discounted free cash flow model to ascertain value. Which approach you use is entirely up to you. I warn you up front – the industry knowledge abandoned in the “short and shoddy” approach will hurt in calculating valuation. Many assumptions used in calculating value come from deep industry expertise. But if you are committed to the “short and shoddy” method, then attempt your preferred way to calculate value and come up with a number. If the price is right, then congratulate yourself for finding a truly affordable diamond in the rough.
Conclusions
It’s unlikely you will find us employing the “short and shoddy” approach when finding investment opportunities for Nintai portfolios. As a professional investment manager, I will use every piece of data available and run as many spreadsheets as possible to increase my chances of outperforming the markets. I employ researchers or buy industry research to try to make the most informed and knowledgeable decision I can. If pressed, I would probably still rank an industry-focused index fund over the “short and shoddy” approach. But I encourage investors to create a few search screens and see what shows up. This isn’t an investment recommendation in any way, but more a research recommendation. It may not exactly be Will Roger’s methodology, but I can’t help but think you would get a nod or a wink when you told him you invested the “short and shoddy” way.
As always, I look forward to your thoughts and comments.
Disclosure: Masimo (MASI, Financial) is a holding in some of our personal and institutional accounts.
Read more here:Â
Industry Knowledge: How Much Is Enough?Â
Chuck E Cheese and Market IPOsÂ
2nd-Quarter 2019 Performance ReviewÂ
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