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Stressing Quality and Price...Again


"The investment management business (it should be a profession but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false."

"Don't do anything because when you try to do something, it is on average a mistake." - Charles Ellis



Sittin' on top of the world


Since the 2009 bottom of the credit crash, we've had an over decade-long market expansion which has provided investors with the longest bull market in recent history. For those at the end of their investing career, this has been a huge tailwind, allowing for far more generous performance any would have thought possible.

Better quality, cheaper prices

At Nintai, we believe in a fundamental investment concept. If we invest in a bucket of companies with significant advantages in quality (higher returns on capital, equity, assets, free cash flow margins, no debt, etc.) combined with valuations (a blend of cheaper attributes, including estimated intrinsic value from our discounted cash flow models and cheaper price-earnings ratios), we can expect to outperform the broader markets over the long term.

The concept of purchasing higher-quality companies or looking to purchase shares at a discount to estimated intrinsic value isn't anything new to the value investment community. I have found it is rarer to combine the two as a foundation for your investment strategy. When I utilize Morningstar's portfolio manager research tools to find funds with a high portfolio match, I've found only two with a greater than 25% overlap of our holdings. About 45% had no stock in common at all. With numbers like this, the reader can see it's pretty rare to find the concept carried out on a regular basis. What's equally rare (as far as I can see) is articulating the idea that the highest-quality companies purchased at good prices can provide significant downside protection during a bear market. In general, I've found that companies and management that generate great returns on capital and have little or no debt are businesses that thrive in bull or bear markets, in expanding or recessionary economic times. Combined with holding significant cash, I feel comfortable that when the inevitable market tumble comes along, I've reduced the risk of capital impairment as best as I can in today's markets.

Nintai's Abacus reports give a quick graphic overview in how we are doing in meeting the goals of a portfolio consisting of outstanding quality at value prices. Later on, I will walk readers through the summary report and take a look at how we are doing in meeting Nintai's investment strategy and check in on performance.

It all starts by finding corporate excellence

Any research we do at Nintai starts with locating companies with outstanding business characteristics. We locate these in multiple ways - GuruFocus' All-in-One Screener, conversations with thought leaders, meetings with corporate executives and so on. Once we've found a company that meets our criteria, we will begin the in-depth process of really understanding the company's strategy, products, markets and competitors. If we've done our job, we can run a summary "quality" report on Nintai Abacus and make sure the portfolio is meeting our strategy.

Let's use a blend of our investment partner portfolios to demonstrate what I mean by a "quality" summary report. In November 2019 on average, the Nintai Investment portfolios shared the following attributes: return on capital (42.8%), return on equity (31.7%) and return on assets (19.2%). This compares to the same numbers for the S&P500 (source: Morningstar's "Portfolio X-Ray" reporting function): return on capital (3.28%[1]), return on equity (1.21%), and return on assets (2.11%). These numbers show that - in general - Nintai's portfolios have created a basket of holdings far more profitable than the S&P 500. Additionally, the debt-to-equity ratio of the S&P 500 (as of August 2019) stood at 0.89 (source: Haver Analytics and Standard & Poor's) versus 0.023 for the Nintai portfolios.

Why are all the numbers important? First, a basic tenant at Nintai Investments is to prevent permanent impairment of our investment partners' hard-earned capital. We've found over time that companies with little or no debt[2] and who are also highly profitable (both from a free cash flow perspective as well as capital returns) minimize that risk. Second, we've found that management teams who act prudently with their investors' capital are great stewards to partner with over a decade or two. Last, companies with these characteristics are generally outstanding businesses with outstanding fundamentals and deep competitive moats. All three of these play a vital role in having a blow up in the portfolio that can lead to truly horrendous losses. At Nintai, everything begins by investing in outstanding quality.

Finding value in a value investment strategy

Finding outstanding, profitable and prudent companies is, of course, only half the battle. Buying them at a discount to my estimated intrinsic value is the second piece of equally important halves. In finding value, we use two different and distinct methods. The first is company specific. We utilize a discounted free cash flow model to ascertain the value of each individual holding (or potential holding). As this information is proprietary, I will simply say the aggregate price-value ratio for the Nintai portfolios is 0.91. This is to say our portfolios currently trade at a 9% discount to our estimated intrinsic value. Value ranges from 137% (overvalued) of our estimated value to 72% (undervalued). As a portfolio of individual stocks, we see some investment opportunities in several holdings trading at significant discounts to their estimated intrinsic values.

The second approach we take to value is comparing the total portfolio to the S&P 500. This gives us an idea as to how the portfolio's value is to the general markets. While we put a great deal of effort into the DCF model, we think looking at the broader markets is equally valuable. There are two numbers we look for in the broader markets review. First is how our portfolio price-earnings ratio looks against the S&P 500's ratio. This tells us how expensive the portfolio is against the broader markets. The second is analyzing the portfolio's five-year earnings growth projections against the S&P 500. This gives us a look at whether we are paying more or less for future growth versus the general markets.

The S&P 500's price-earnings ratio - as of November 2019 - stood at 22.95. The Nintai portfolios average price-earnings ratio was 18.8 at the same time - an 18.1% discount to the S&P 500's price-earnings ratio. This tells us the Nintai portfolios are currently trading significantly cheaper than the S&P 500. Great news. In addition, the Nintai portfolios have a five-year estimated earnings growth rate of 11.1%. This is roughly 17% greater rate than the estimated S&P 500 rate. We now know the portfolios are cheaper than the S&P 500 as well as estimated to grow much faster. What's not to like about those statistics?

Putting it all together

All of these numbers can certainly make your head spin and do nothing but sow confusion among our investment partners. Because of this we created the Abacus reporting system, which can show these numbers in an easy-to-read graphic. Seen below is the past few pages of content in a format that is much easier to understand.

Our investment partners have a tendency to look at the rating arrows (all green is what they are looking for here) and ask any questions related to those. At the core, the graphic quickly encapsulates

  • Does the portfolio meet our quality criteria in general and against the S&P 500?
  • How does the portfolio compare in value against the S&P 500?



A number we look at carefully is the combination of the S&P 500 price-earnings relative number as well as the S&P 500 projected earnings per share growth relative number. Here we combine the fact that the portfolio is 18% cheaper than the S&P 500 and is estimated to grow 17% faster, giving us a 35% "combined value rate (CVR)." We are satisfied with a CVR over 25%. We have nearly always outperformed over the next three to five years if the number exceeds that amount. Equally important is adding up the S&P 500 relative number for return on capital, return on equity and return on assets. Here we look for a sum called the "combined quality value (CQV)" greater than 5. The current portfolio CQV is 6.6.

Conclusions

I've written about the Abacus tool we use several times before. The reason for its importance is that it provides a quick way to ascertain how your portfolio stacks up against the S&P 500 from a quality and value standpoint. At Nintai, we think a combination of buying a set of stocks that are qualitatively better and provide greater value provides an investor with a better chance at outperformance - in the long term - than any other investment approach.

As always, I would love to hear your thoughts and comments.

[1] Meaning the Nintai Portfolio return on capital is 3.21 x the S&P 500's return on capital

[2] Out of roughly 20 - 25 Nintai holdings, at least 15 holdings will generally have no short or long-term debt.

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This article first appeared on GuruFocus.