Market Volatility: A Time for Testing
As a long-time value investor, I've grown up with the first principle that market downturns allow you to buy more of the stocks you love the most. Who can forget Warren Buffett (Trades, Portfolio)'s classic analogy about buying steak or hamburger on sale? But like many of those things that are good for you in theory but truly wretched in practice (prune juice, 5:30 a.m. exercise routines or the dreaded tetanus shot), watching the prices of your investment partners' assets take some dizzying drops really isn't a lot of fun. In theory, watching iRadimed - with its FDA-mandated medical device monopoly - become one-third cheaper without any apparent change in its valuation is theoretically exciting. Watching it happen in real time on your computer is - as Keb' Mo said - "a whole notha' thang."
That said, it is equally exciting - but in a far more pleasant way - watching a company on your watch list announce a slight miss in this quarter's earnings (along with a slight downward revision in its guidance) and drop by 35% in a single day of trading. It's days like this that make for a happy value investor and a proud new owner of an outstanding asset.
I bring this up because we saw the market react with its usual hyper-sensitivity as it measured the risk brought on by a 31-word tweet by the President of the United States and an equally short and brusque retort by the People's Republic of China. Across the board we saw these two things create wreckage within our investment partners' portfolios - Adobe down 4.6%, Guidewire down 4.7%, even Mastercard down 4.7%. Our portfolios were down from 1.68% to 2.17% today.
Competence and comfort tevisited
Over the past week, we've been helped tremendously by the same things that held us in good stead in the 2007 to 2009 crash. A healthy cash balance (from 19% to 28%) and a range of companies with extraordinary strengths such as business monopolies and duopolies, returns on capital in the mid-60s, and debt-free balance sheets. While it's agonizing to see large drops in price as happened this week, not once over the past week have I been concerned about a permanent impairment of any of our investment partners' capital.
I've written previously about our dual circles of competence and comfort. This past week has challenged Nintai in both spheres. We are quite comfortable that our investment holdings (about 20 as of Aug. 1) are in industries or business models that we feel we have a knowledge-based competitive advantage. To paraphrase Tom Watson, we know our spots and we stick close to them. But it's days like Monday, Aug. 5 - when the market drops by 3% - that we really get to test our circles of comfort.
There isn't any real-time way to test how successful you have been until you get ready to sleep and your level of discomfort is no different at 8 p.m. than it was at 8 a.m. It turns out I was as relaxed on Monday night as I was Monday morning. We didn't wander too far from our circle of comfort as well. Several things made this possible.
Characteristics of comfort (derived from competence)
First, no matter what the president might tweet at 1 a.m. or should he unexpectedly raise tariffs, people will still need MRI imaging of their bodies (iRadimed), doctors will still need to measure their patients' oxygen rates (Masimo), and businesses will still need to know exactly how much inventory is in their warehouse (Manhattan Associates). Our portfolio companies have products and services that are deeply embedded in their customers' operations (SEI Investments), are vital in patient clinical care (Craneware) or even provide some of the most powerful daily living tools of modern society (Mastercard).
Second, the vast majority of our investment partners' portfolio holdings (16 of 21 total companies) have no short- or long-term debt. On average, these companies convert one-third of their revenue into free cash. Over one-half have reduced total outstanding shares by 10% or more over the past five years. The company with the largest debt (Biogen) currently has $6.4 billion in long-term debt (no short-term debt) but has $3.0 billion in cash and short-term securities and generated $6.3 billion in free cash flow over the trailing 12 months. These are portfolios made up of companies with fortress-like financials - including pristine balance sheets and staggering free cash flows.
Last, in our portfolios we have partnered with managers who have a long history of outstanding capital allocation. Whether it be Rene Goehrum (Biosyent) with a five-year average return on equity of 27% or five-year average return on capital of 68%, or Robert Willett (Cognex) with a five-year average return on equity of 19% or five-year average return on capital of 52%, we go to bed each night knowing that each portfolio holding has a management team dedicated to driving outstanding shareholder returns. Each has an outstanding record of achieving great operational and strategic results. We simply couldn't be in better hands.
All three of these characteristics give us great comfort in times of market volatility and geopolitical uncertainty. They also give us the confidence that we can take advantage of days when we might see a significant drop in one of our watch list companies. Because we stick to our circles of competence and comfort, we have found that companies in the same industry, with similar business model and comfort characteristics (as discussed above) can be outstanding candidates for Nintai's capital. For instance, with our knowledge gained from several health care holdings, Nintai was able to make a quick - but we think remarkably structured and researched - decision to snap up Abiomed after it dropped over 30% in a single trading day after disappointing Wall Street with quarterly earnings and reducing its full-year guidance. With similar characteristics to several existing holdings, we were able to deploy capital with a high degree of confidence and comfort.
I would be remiss to point out that even after the sturm und drang of the past week Nintai's cash positions remain between 15-20% of total assets under management. We've reached the maximum number of positions we like to manage, so any capital put to work in the future will likely be additions to existing positions. With most Nintai portfolios trading at roughly 10% below our estimated intrinsic value, we don't see a lot of value out there - even taking into account some of the big market moves we've seen recently.
What we have (re)learned
Much as the Talking Heads said that it's the "same as it ever was," all the recent geopolitical drama and market drawdowns have confirmed some of our core principles.
Noise reduction headphones and the mute button are your friends: If you happened to be watching any financial news channels over the past week, you would have been whipsawed by claims that the global economy is melting down, the U.S. economy is melting down, U.S. earnings were better than we expected, the Fed was a patsy to the White House, the Fed didn't listen to the White House, stocks were melting down and stocks were melting up. All of this usually emblazoned in capital letters and a size-48 font. My advice? Turn off the Wall Street Wall of Sound, put on some meditation music, and go for a walk in the woods. With the exception of a single new purchase, Nintai's portfolios are the same today as they were three months ago. Patience isn't just a virtue, it's a winning strategy.
The circles work: By understanding your portfolio holdings - from their balance sheets to their place in their industry ecosystems - and purchasing companies that are financial fortresses, your circles of competence and comfort will generally show their value in times of dramatic market volatility. If you feel comfortable heading out this week on vacation, leaving all access to the markets and your brokerage accounts behind, and not hearing a single bit of news for two weeks, then congratulations. You've achieved investing nirvana. If you can't, then roll up your sleeves. You've got work to do.
Remember: Glory comes in bear markets: Nearly every value investor I know who has a great record earned it during down markets. They made it because they understand the real meaning of "value." They recognize that bull markets end up resulting in long-term overvalue. In these times, they've sold out of many of their positions and focus on the fact that any real value in down markets is in assets immune to emotional turmoil and investor fear - like cold, hard cash. Value investor stars salivate for those trading days and weeks that continually grind downwards. That's when real "value" is generated for such investors.
As we enter another period of volatility similar to 2018's fourth quarter, Nintai is planning to enjoy the last hazy days of summer, time away from the office and listening to crickets along with some Mozart. We suggest everyone do the same. Let the markets generate investment opportunities through their emotional overreactions to quarterly earnings and presidential tweets. As value investors, we know that great companies occasionally go on sale and investor panic creates the basis for long-term returns. By focusing on two simple circles, the recent market fluctuations can create outperformance and emotional balance. Don't let those opportunities slip by.
As always, I look forward to your thoughts and comments.
Disclosure: Nintai currently has long positions in Adobe, Guidewire, Mastercard, iRadimed, Masimo, Manhattan Associates, SEI Investments, Craneware, Biosyent, Cognex and Abiomed.
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