Time Arbitrage and Financial Strength

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Nov 14, 2014
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The balance sheet is the barrier to the long-term arbitrage. We want to have the investment right even if we have the timing wrong”. – Chuck Royce (Trades, Portfolio)

Over the next few weeks, I wanted to take the time to discuss some of the investment errors that we made at Nintai. The examples I have chosen to use may not be the funniest (like missing a decimal when entering a market order) or the most costly (investing in a shoe company seemed like a really good idea at the time), but cases that taught us very powerful lessons and impacted our entire investment process.

As mentioned in last week's article, Warren Buffett (Trades, Portfolio) has likened investing to being at bat in baseball where they don’t count strikes. The ability to be patient and wait for the fat pitch is a remarkably powerful idea rarely utilized on Wall Street. In a recent interview with Morningstar’s Christine Benz, Jack Bogle stated the S&P 500 SPDR (SPY) traded $160B worth of shares in one week alone that represents 100% turnover in 7 days or an annual turnover of over 5,000%[1].

This type of widespread market trading demonstrates a powerful mistake we made over the first several years at Nintai. For multiple reasons we were unable – or unwilling – to allow a time arbitrage trade to play out in our portfolio. As our experience grew, we began to realize that time arbitrage was one of the more important arrows in our investment quiver.

Time arbitrage: A definition

Time arbitrage simply means using a short-term price drop (created by an event such as quarterly earnings miss) as a means to invest in a company with a solid long-term prognosis. The investor then uses time as the means to achieve the investment return as the markets acknowledge their thesis. To be a successful time arbitrage play, the following conditions need to be met by both the potential investment and the investor.

  • The company’s long-term business prospects need to reflect a contradiction in the short-term market event that created the initial price drop. In other words, the long-term competitive position and growth assumptions need to remain valid over the long-term.
  • The investor must have the ability to remain fully invested in the company’s stock. This means the investor must not be forced to sell the position due to margin calls, lack of patience/focus, or other reasons to abandon the position.
  • The company must have the ability to withstand the pain of market displeasure. This includes support from the Board, key investors, and the organization in general.
  • The company must have the financial capability to ride out any negative impact of the negative market event. This includes sufficient assets, ability to generate enough free cash, and/or maintain access to the capital markets.

Each of these conditions could be the basis for an entire article, but it is the last I want to focus on this week.

Time arbitrage and financial strength: Analysis

A fundamental mistake we made when Nintai began investing was not immediately grasping the relationship between time arbitrage and the strength of a company's finances. The vast majority of our fellow investors didn't – and still don't – see such a connection. One person who did was John Maynard Keynes. His famous statement that the market can stay irrational longer than you can stay solvent is usually seen as a warning to the individual investor. One thing the market crash of 2008-2009 clearly demonstrated was that Keyne’s warning is as applicable to publicly traded companies as much as it is to the individual investor.

So why is this important to investors? Let’s take a look at returns for the years 2007-2011 as well as ten (10) year average annual returns for a selection of Nintai portfolio holdings versus a range of broader indexes. Of the five (5) stocks I selected from the Nintai portfolio, these are companies that a) we owned in the portfolio for the entire 10 year period, b) had no short or long term debt during the selected period and c) remained free cash flow positive for the entire period. The three (3) indices included the Vanguard S&P 500 Index, the Vanguard total Market Index, and the Vanguard Global Equity Index.

On average, the companies with no debt and substantial free cash flows dramatically outperformed the broader indices during the years of 2008 and 2011 (both known for their dramatic price drops) as well as 10-year averages. A sample of the Nintai portfolio holdings show an average loss in 2008 of -22.4% versus an average equity index loss of -40.8%. Similarly, in 2011 the Nintai companies returned on average 9.3% versus a loss in the indices of -0.6%. Over the (10) ten-year period of 2005–2014, the Nintai companies averaged an annual return of 11.3% versus an index return of 7.8%.03May20171258471493834327.jpg

Time arbitrage and financial strength: Findings

So what does this mean? We believe the findings of this very unscientific research conveys several important messages. First, time arbitrage is an extraordinary tool available to all investors. Second, time arbitrage as a tool can be extremely powerful in both down and up markets. Third, time arbitrage can increase the odds your good investment will produce great returns if chosen with certain criteria (strong financials) and an adequate discount to intrinsic value. Conversely, poor investment decisions (companies with poor financials, lack of discount to intrinsic value, etc.) cannot necessarily be arbitraged into good investments. At a more macro level, we believe there are three (3) findings that can be critically important to individual investors as they look ahead.

1. Leveraged Balance Sheets Do Not Assure Better Returns

One of the issues I heard in business school finance classes as well as from investment bankers and analysts on CNBC is that companies should be better at leveraging their balance sheets. In this theory a certain amount of debt can maximize tax policy, generate higher returns on equity, and create the ability to acquire additional assets driving earnings growth. While some of these claims are without a doubt reasonable (taking on debt WILL increase returns on equity all things being equal), we simply believe we can sleep easier knowing our portfolio companies have rock solid balance sheets. If this means we forgo several points of return on equity and investment bankers make slightly less from our portfolio companies, this is something we can live with over time.

2. The Time Arbitrage Play Has Downside AND Upside Potential

As seen with our portfolio returns, time arbitrage doesn't just reduce downside risk/losses during times of financial crisis (though this is critical to our returns). We also believe the data suggest we can generate higher returns – in all markets – than the averages by time arbitraging companies with extremely strong financials. This allows us to not only sleep well during a time like the 2008 market crash, but positively be a Rip Van Winkle over the long term.

3. You Might Be Wrong Timewise, But Your Investment Thesis Was Correct

Ben Graham told us in the short term the markets are a voting machine, but in the long term they are a weighing machine. By utilizing time arbitrage we can allow our timing to be less important than making sure our investment thesis is correct. This was a huge lesson for us at Nintai. All too often in our early days we second guessed our investment decisions if our portfolio stock dropped by 15% over the first 12 months. Over time we realized time arbitrage was a tool that allowed us to deploy additional capital when we remain convinced our business case was intact.

Conclusions

A key lesson we learned at Nintai was that time arbitrage is an enormously powerful tool for the value investor. In a stock market where turnover in an average fund has increased from 23% in 1960 to 112% in 2013, the ability to hold on to a portfolio holding for decades can provide an enormous competitive edge. As we began to fully understand the power of time arbitrage combined with financial strength several things happened with our portfolio:

  • Our portfolio turnover decreased from 43% in 1996 to less than 2% by 2000. We have generally had less than 5% turnover over the past 15 years. Some years such as 2008/2009 have provided such extraordinary opportunities our numbers have occasionally increased beyond this.
  • The focus on Nintai’s ability to stay the course through financial strength has increased dramatically. As an organization and portfolio manager we have become increasingly aware of the value of cash. As an organization we retain far more cash on the balance sheet that we did I our early days. In addition, our selection criteria and its emphasis on financial strength have evolved with far greater/stricter requirements. In today's portfolio selection process, financial strength (defined by little/no debt, significant free cash flow, and high ROIC, ROE and ROA) is one of the top three (3) weighted criteria.
  • Most importantly we have recognized the value of time and its role in investment management in particular and life in general. As a cancer patient, we realize every moment is precious. Conversely, we realize time and compounding are an enormous tailwind the longer you let them work. As a great Chinese philosopher pointed out, a single drop of water appears to bounce off a rock but with enough time those drops can drill a hole directly through our stone.

If individuals can master their emotions and create a model immune from short-term demands, time arbitrage can be the platform for portfolio compounding machines. By using time to your advantage, investment portfolios can see dramatically less risk and loss in down markets and higher returns as markets expand. In the final analysis, isn’t that what we all look for as stewards of our clients investments?

As always we look forward to your thoughts and comments.

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[1] http://www.morningstar.com/Cover/videoCenter.aspx?id=670432