"When you have to make a choice and don't make it, that is in itself a choice."
- William James
One evening a Cherokee elder told his grandson about a battle that goes on inside people. He said, "My son, the battle is between two "wolves" inside us all. One is Evil. It is anger, envy, jealousy, sorrow, regret, greed, arrogance, self-pity, guilt, resentment, inferiority, lies, false pride, superiority, and ego. The other is Good. It is joy, peace, love, hope, serenity, humility, kindness, benevolence, empathy, generosity, truth, compassion, and faith." The grandson thought about it for a minute and then asked his grandfather, "Which wolf wins?" The old Cherokee simply replied, "The one you feed."
- Traditional American Indian Proverb
Over the years, I've been asked many times what is the one major question I ask when looking to invest in a stock. It's pretty difficult to pick just one thing. For instance, in most cases it is critical that the company has a management team focused on costs and capital returns. In some industries where margins are tight, the ability to focus on costs, production methods and distribution costs is vital. In some industries the ability to navigate research and development and meet regulatory requirements is vital.
It's pretty hard to nail down one specific thing that would make Nintai Investments say "Aha! That's the perfect investment. We MUST have it in the portfolio." There are a lot of moving parts that make for a great company. So how do you rate each component? Which piece is the keystone block that holds it all together?
Invest in what got you there: your competitive moat
Of all the statistics and the ratios that drive my interest in a company, the cap or keystone is the company's competitive moat. A great moat drives high return on capital, high return on equity, high free cash flow ratios and other sustained high margins. Great management will focus on how to widen and strengthen their moat. They realize they need to dance with the one who brought them there.
Morningstar identifies five sources of a competitive moat - the network effect, customer switching costs, intangible assets, efficiency scale and cost advantage. Most companies with a wide competitive moat will have at least one (and probably more) of these competitive advantages. Every company I own in a Nintai portfolio has a laser like focus on one of these advantages.
The network effect
Every day, leaders of Mastercard (NYSE:MA) look for ways to strengthen their company's network advantage. Whether it be against fellow duopoly member Visa (NYSE:V) or a smaller up and comer like Discover Cards (NYSE:DFS), Mastercard's network (who uses their cards and who accepts their cards) constantly strives to find new tools, advantages, discounts, etc. in order to bring in new customers and maintain existing ones. This competitive strength will continue to drive Mastercard's competitive advantage for decades to come. As a shareholder, we look to see revenue growth and higher returns on equity as some of the statistics showing the continued strength of the company's moat.
Customer switching costs
SEI Investments (NASDAQ:SEIC) provides investment processing, management and operations services to financial institutions, asset managers, asset owners and financial advisors in four material segments: private banks, investment advisors, institutional investors and investment managers.
The company's services are deeply embedded in all of their customers' operations. The cost and time requirements to switch their systems to a new vendor is staggering. The potential for errors in the transfer of data, downtime in the course of switching vendors and amount of time teaching a new internal system are all deeply complex and involve high risk. Combine this with the risk placed on the core functions of the customers' systems - daily fund accounting, SEC filings, etc. - and one can see how difficult it is to make the decision to pull the plug on SEI Investment's products and suddenly move to a new vendor.
Novo Nordisk (NYSE:NVO) has been a leader in the treatment of diabetes for almost a hundred years. Armed with intangible assets such as FDA (in the U.S.) and EMA (in Europe) regulatory approvals, patents for drug levers of action and intensely deep organizational knowledge about diabetes and its treatment history, it's hard to see a new competitor coming along and suddenly overturning Novo Nordisk's competitive advantage in these intangible assets. Combined with a network effect of prescribing physicians who implicitly trust Novo Nordisk's knowledge with the disease along with billions of dollars sitting on the balance sheet while producing billions more in free cash flow, you've got a company with a wonderfully deep moat.
Veeva Systems (NYSE:VEEV) has the most in-depth customer relationship management vertically focused on life sciences (specifically pharmaceuticals). The efficiency that Veeva brings to their space has driven out nearly every home-grown model and small boutique player. There simply isn't room for another player than Veeva within the space. The company is now taking that industrial dominance and looking to add new verticals to its expertise such as consumer goods, chemicals and cosmetics (all industries with similar CRM and regulatory needs). Veeva's extraordinary depth of knowledge drives out a need for other competitors. By constantly focusing on adding new functionality, applications and knowledge, the company continues to widen its moat.
By far, this is Nintai's smallest source of competitive advantage or moat. As Amazon (NASDAQ:AMZN) has always said, "your margin is my opportunity". Even Walmart (NYSE:WMT) - the king of margins for decades - found itself unprepared for Amazon's pricing revolution. At Nintai, we believe this is the weakest of all moat characteristics. The closest we've come to owning a company that made price a key component of its competitive offering was Fastenal (NASDAQ:FAST), and we sold that position in 2015. For the longest time, management utilized cost structure as a means for driving business to Fastenal distribution centers. They focused this along with the ability to carry nearly every part (in a just-in-time model), and the company dominated the industry parts business. This has changed somewhat as they have focused more on a network effect with vending machines on site, cutting out delivery time.
Nintai focuses on companies with high returns on capital, equity and assets, as well as high free cash flow margins, growing businesses and good management. The way to get there is to identify your core competitive advantage and focus on making it better every day. That's why you don't see Novo Nordisk suddenly purchasing an oncology immunotherapy firm, or SEI Investments purchasing a publishing company.
The Nintai portfolios are made up of companies that know what they do best and stick with it. With a portfolio run this way, you just need to sit back and make sure management has its eye on the ball. After that, let time do its magic and you'll be surprised how well your portfolio will do over time (though of course, past performance is no assurance of future returns).
As always, I look forward to your thoughts and comments.
DISCLOSURE: Nintai maintains positions in MA, SEIC, NVO, and VEEV
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This article first appeared on GuruFocus.