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Thoughts on 2018 Performance

- By Thomas Macpherson

The following is an update on the 2018 performance of individual accounts I run along with the returns of the Hayashi Foundation - a not-for-profit fund based in Japan, of which I am currently chief investment officer.

Getting these numbers to accurately reflect returns has been quite an adventure. As many of you know, I left Dorfman Value Investments and opened my own investment firm - Nintai Investments LLC - on Oct. 1, 2018. The numbers in this report reflect a composite of fees from both Dorfman and Nintai. The Hayashi Foundation charges a set 0.25% management fee and calculations were made on the yen-dollar conversion as of Dec. 31.

While I was pleased with the both the individual portfolio's and Hayashi Trust's relative performance for the year (beating the S&P 500 by roughly 5.5% for 2018), absolute returns were disappointing across the board. Even with cash at nearly 25% of total assets under management for the most of the quarter (and year), the composite portfolio lost 14.1% in the fourth quarter. This is extremely disappointing. The fourth quarter's underperformance was caused by a widespread drop in multiple portfolio holdings. I deliberately invest in companies with pristine balance sheets, deep economic moats and growing free cash flow to offset losses to the downside. With double-digit drops in 17 of the 21 portfolio holdings during the fourth quarter, I added to positions aggressively over the second half of 2018.

For the year, Nintai Investment's (and previous DVI) portfolios, plus the Hayashi Foundation, outperformed the S&P500 1.71% (net of fees) to -4.38%. Last year, my significant cash position was a drag on returns. In 2018, the case was altered. Here are the Nintai Investment and Hayashi Trust account returns for periods ended Dec. 31.

Please note the returns reflect a 1.5% management fee through Oct. 31 (utilizing Dorfman Value charges) and a 0.75% management fee for Nov. 1 through Dec. 31 (utilizing Nintai's management fee charges). The Hayashi Trust charges a 0.25% management fee.

There weren't many areas to hide from the losses in 2018. The only two major sectors to show positive returns were utilities (up 0.5%) and health care (up 4.7%). Others showed medium losses, such as consumer discretionary (down 0.5%), information technology (down 1.6%) and real estate (down 5.6%). Others showed substantial losses, including consumer staples (down 11.2%), financials (down 14.7%), industrials (down 15%), communication services (down 16.4%), materials (down 16.4%) and energy (down 20.5%)

2018 was the year the bull market ended in a series of spectacular drops and rises rarely seen in the past decade. The Trump administration's announcements to impose tariffs on China, negotiations on a new North American Free Trade Agreement treaty and criticism of the Federal Reserve Board on its rate policy all added to a profound sense of uncertainty in both the economy and the markets. For most of the year at Nintai Investments and the Hayashi Trust, I found the risk-reward of market highs combined with these aforementioned macroeconomic issues quite poor for value investing. Our large cash position allowed me the opportunity to take advantage of mispricing late in the fourth quarter.

Last year I discussed with my investors my role as an allocator of capital, seeking to maximize returns while simultaneously minimizing risk. As a value investor, the opportune moment of low risk and achieving potentially high long-term returns is a rare moment in time. Mispriced value - combined with the high quality I look for in portfolio holdings - might come along every six to eight years. I've written previously these opportunities at mispriced value can happen in one of two ways (or both). First, the markets suffer a collapse of confidence and the general indexes head toward (or enter) bear market territory.

The second is when a great company misses Wall Street's expectations and the stock price drops below my estimated intrinsic value. The latter part of 2018 has seen both of these. As I write at year-end, many major indexes are close - or already in - bear market territory.

Additionally, 12 of the 26 holdings in the individual portfolios and Hayashi Trust dropped at least 10% since purchase. In nearly every case, I added substantially to my existing position.

The Losers

Going hand in hand with holding cash during a downturn, the ability to not permanently impair capital is the second-best way to assure adequate long-term returns. Each of the companies listed as losers this year saw me double or triple my positions over the course of the year. I am confident none of these companies will come remotely close to creating a permanent loss to my investments.

Loser: Computer Modelling Group

Computer Modelling Group Ltd. (CMDXF) is a Canadian software company that specializes in integrated analysis and optimization, black oil and unconventional simulation, reservoir and production system modelling for the petroleum industry.

The decision to purchase Computer Modelling has been proven to be a net negative in nearly every possible way. Oil prices continue to drop, licensing fees continue to drop and revenue continues to slightly contract. The upside? Free cash flow grew slightly in 2018 and the company continues its generous dividend policy with a 10-cent (Canadian) dividend, creating a yield of 6.90%. That said, we have been steadily adding to the Computer Modelling portfolio with five additional purchases in the fourth quarter.

I continue to be impressed with Computer Modelling Group's management and am impressed with the board's decision to hire Ryan Schneider, formally chief operating officer, as the new CEO. I believe Schneider understands the necessary steps required to get the company back onto a growth trajectory. Oil reserves are increasingly in areas where extraction costs are nearly cost prohibitive. The ability to calculate potential reserves without drilling will become increasingly important. Computer Modelling Group's platform and strength of their internet protocol leads me to be confident that demand will remain strong over the next decade.

Loser: Cognex

Cognex Corp. (CGNX) provides machine vision products that help automate manufacturing processes. The company's products include vision software, vision systems, vision sensors and ID products. Vision sensors deliver simple, low-cost solutions for common vision applications, such as checking the size of parts. ID products read codes that have been applied to items during the manufacturing process. Cognex generates the largest portion of its sales in the United States and Europe. Cognex is a gem of a business. In July 2015, it completed the sale of its surface inspection systems division to AMETEK (AME) for $156 million in cash. With the sale, Cognex is focusing their efforts on discrete manufacturing where they see the greatest growth potential (11-13%) in discrete versus slower growth (5-7%) in surface inspection.

Cognex has an outstanding balance sheet and set of financials. It has no short or long-term debt, $405 million in cash on the balance sheet and generates $196 million in free cash flow. The company's 86.9% return on capital far outweighs its 14.04% weighted average cost of capital. Cognex converts 26% of revenue into free cash and generates mid-teens return on equity. The stock trades at a 19% discount to my estimated intrinsic value and yields 0.48%.

Since my initial purchase, I've made three additional purchases and, with its value as it is, will likely be buying more.

Loser: Biosyent

Biosyent Inc. (BIOYF) is a specialty pharmaceutical company focused on in-licensing or acquiring innovative pharmaceutical and health care products. The company markets these pharmaceutical products in Canada and other international markets. Biosyent seeks out products that have underperformed (through lack of marketing dollars, lack of product fit, etc.) and in-licenses them to fully support an integrated sales and promotional strategy.

I wrote about Biosyent's strategy in much greater detail in an article entitled, "Valeant and Biosyent: Opposites Don't Attract." In it, I discussed the difference between Valeant's strategy of purchasing drugs with dubious track records, assuming huge amounts of debt and raising drug prices by up to 4,000%. Compare this to Biosyent's strategy of purchasing quality drugs that simply don't have the marketing budget to get promoted or acquiring molecules in late-stage development and you have two very different companies.

Biosyent has a strong balance sheet. It has no short or long-term debt, $17.3 million in cash on the balance sheet and generates $4.7 million in free cash flow. The company's 58% return on capital far outweighs its 6.4% WACC. Biosyent converts 28% of revenue into free cash and generates mid-30s ROE. The stock trades at a 15% discount to my estimated intrinsic value. As the stock price has dropped, we added significantly to our position with purchases in October and November.

The Winners

Winner: Cash

For most of the year, cash looked like it was going to be a drag on returns, as it had been since 2011. The last three months of 2018, it completely redeemed itself. I've often mentioned that real value investors make their names in market downturns, not bull runs. This adage has served me well in the past and will likely continue into the future. At its peak, cash represented roughly 42% of my total portfolios.

Winner: iRadimed (IRMD)

IRadimed Corp. (IRMD) was up roughly 61% for the year. The company engages in developing, manufacturing, marketing and distributing magnetic resonance imaging (MRI) compatible products such as IV pumps and other electronic equipment.

Unfortunately, iRadimed is one of those stocks that you purchase and then it immediately drops by 30%. At times like this, it is essential you know the business inside and out. If the business case is broken, you are faced with a difficult choice. If the business case remains valid, then it is time to make additional - and significant additions - to the position. In iRadimed's case, the latter was true and I took the opportunity over the next six months to nearly triple the size of the original purchase. The 35% run up during the latter part of 2017 and then 61% in 2018 was driven by excellent management execution, strategic capital allocation and Food and Drug Administration approvals that brought the stock to record highs.

Winner: Novo Nordisk

Novo Nordisk A/S (NVO) is a Danish health care company. It is engaged in the discovery, development, manufacturing and marketing of pharmaceutical products. The company's business segments include diabetes and obesity care and biopharmaceuticals. As a pioneer in diabetes care, Novo Nordisk has been developing products since early 20th century. It currently garners slightly over one-quarter of the $45 billion branded diabetes treatment market. The next two decades will see enormous growth in the diabetes market. As obesity and age take their toll, the diagnosis and treatment of the disease will markedly increase until 2037.

As a leader in modern insulin analogs, Novo Nordisk leads in long term (Levemir) and short term (Novolog) as well as oral-to-injection transition (Victoza). The company just had a significant boost in clinical trial data, showing its ultra-long insulin is more effective, has greater dosing variables and less risk of hypoglycemia. All of these led to solid 2018 gains.


2018 was one of the more interesting years I've had in my investing career. The end of a bull run is never a pretty picture unless you have loads of cash you are looking to put to work and can find those price to valuation disconnects that get every value investor's heart pumping. I'm proud of the work of the many researchers who helped me identify, rip apart and make assessments on companies barely in my circle of competence. I am grateful for clients who have had the confidence their investment manager needs the freedom to wait for the right moment. But I am most grateful for friends, family and co-workers who helped me through the course of the year as I dealt with professional changes and medical treatments that saved my life. I wish everyone a happy and prosperous New Year.

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This article first appeared on GuruFocus.