Dance With the One That Brought You

“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?

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Invest in what got you there: your competitive moat” data-reactid=”19″>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.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="The network effect ” data-reactid=”22″>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.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Customer switching costs” data-reactid=”24″>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.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Intangible assets” data-reactid=”27″>Intangible assets

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.