Luma Funds

C A P I T A L M A N A G A M E N T

Finding the compounding machines

JC Rodriguez

“Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t, pays it.”

- Albert Einstein

Compounding, in the realm of investing, is quite frankly the most important element in obtaining long term riches. A mechanism that requires time, patience, and trust. One that if implemented correctly, will suddenly expand to unimaginable levels. Don’t believe me? Let’s look at the numbers.

Let’s assume the market grows at 10% over the next 30 years. If you started with $10,000 and never added another penny, at the end of the 30 years, you’d have $174,494. That is 17 times your original investment! Now let’s see what a difference of an additional 2.5% would do. Now instead of earning 10%, you earn 12.5% over the next 30 years. What are you left with? $342,433! That is double the amount obtained before! 34 times your initial investment. Compounding at work.

Now let’s assume you are adding $10,000 per year for 30 years (which is not unreasonable considering you could add to your 401K). Earning 10% per year for the next 30 years. At the end of 30 years you’d have $1.8 million. At 12.5%, you’d have just over $3 million!

It's the process where earnings from an investment are reinvested, generating their own earnings over time. This creates the snowball effect, where your money works harder and harder for you.

The significance of a long-term investment horizon cannot be overstated when leveraging the power of compounding. So how do we put this concept to work? By finding Compounding Machines. What are Compounding Machines? These are great companies that are able to reinvest their earnings back to the business and earn high return on the invested capital. Building on their previous success over and over again.

What do we look for in Compounding Machines?

Companies we can understand with superior economics. Companies that are able to earn a high return on equity. Profitable businesses, with little need for capital expenditures, and the ability to earn high margins.
Companies with sustainable competitive advantages that allow them to maintain their position and earn high returns.
Companies that have long runways. Growth opportunities to deploy their capital by either gaining market share through their competitive advantages of participation in a secular growth story.

High ROE:

Great companies earn high returns on their invested capital. A company with excellent economics is able to earn high earnings with little deployed capital, in turn earning a high rate of invested capital. This does not include companies that are highly leveraged by using lots of debt to finance the company’s operations. We are talking about companies that have superior economics.

Sustainable Competitive Advantage (MOAT):

Scale Economics, Network Effects, High Switching Costs, Strong Brands (Loyalty), Superior Technology or Patents. These are all examples of competitive advantages that allow companies to either be the low cost producer, or are able to raise prices and earn higher returns. Most importantly we need to be able to see with some level of certainty that their competitive advantages will continue to stay intact.

Growth:

If a company earns a high return on invested capital but does not have any potential for growth through an expanding market share or secular growth, then the company is no different than a bond. Something that pays a coupon to investors but will not grow over time.

If you have these elements in place then we wait for the market to provide us with an opportunity to invest. The tricky part is that most people know these companies are great and have priced them accordingly. But there are the occasional mispricings that provide opportunities. When those opportunities present themselves you have to act with conviction, because they don’t come often. The last step after investing is to just wait. Wait for the returns of a superior business to bear fruit over the long term all the while keeping an eye on the economics of the business and the strength of their moat.

. . .

Story + Numbers

JC Rodriguez

I once knew a man named Mr. O’Hara. Mr. O'Hara would tell me these outlandish yet entertaining stories. I enjoyed his company because he captured my attention, even though I always questioned if his stories were true. I’m a skeptic at heart. But Mr. O’Hara, man, was a natural salesman. In a previous life, during the 80s and 90s, he was an investment banker for Merrill Lynch. He’d paint these pictures only seen in Hollywood movies of the rough-and-tumble world of finance. Stories matter. Stories light up our neural networks, allowing us to feel and remember. But you have to be careful with stories because, more often than not, they are too good to be true.

When it comes to investing, every company has a story. That’s where stock evaluation really should begin. Most investors start by looking at a chart, PE ratios, or some financials. When flipping through the weekly Value Line reports, I have no choice but to look at a few numbers to decide if I want to investigate further. But I’d say you won’t get a true picture until you know the story.

The story begins in the industry the business is involved in. Although I’m a bottom-up investor, meaning I look at the companies first when deciding on an investment rather than looking at the big picture first, you have to understand the industry before you delve deeper into the companies. Why? The base knowledge of an industry will help you understand what to look out for. For example, a utility company is highly regulated and prone to monopolistic dynamics. Or are you looking at a disruptive startup with a new discovery challenging the status quo?

When looking through Value Line, I’m only looking at numbers of companies in industries I understand. If you know the industry dynamics and you know where the company stands in the life cycle (startup vs. mature company), you are already ahead of the game in being able to evaluate a good investment.

So what sort of things do I look for in the story? After I have become familiar with an industry (like trends, key metrics, margins, product life cycles, etc.), I then look at each individual business and figure out where they stand against the competition. Does the company have a competitive advantage? What is it? Do they have a scale advantage, network advantage, or high switching costs? Is it sustainable or vulnerable to competition? How early in the life cycle of the business are they? Are they raising capital through equity? Do they have fast-growing revenue with zero profits? Are they investing heavily for future growth? Or are they a cash machine? Is the business mature with big profit margins? Are they still finding ways to reinvest back into the business, or are they divesting through stock buybacks and dividends? Are they nearing the end of the corporate lifecycle? Are revenues falling? Has their product lost market share, or is the industry going away? Are they having to raise capital by selling underperforming assets? Or, worst of all, are they selling preferred stocks? Knowing where the company stands in the corporate lifecycle allows you to paint a picture without relying on the Mr. O’Haras of the world. Just about every earnings call will have some corporate executive talking about how everything is going according to plan. You’ll hear some fund manager who has a large stake in a company touting the performance of a company they own. You have to be an investigative reporter.

After all of this work is done and you feel there is an understandable story, you then look closely at the numbers. Only then will you be able to paint the entire picture. Are sales growing? Are industry-wide sales growing, or are they gaining market share? Do they have growing profit margins? Great! Sign of a competitive advantage. Are profits getting reinvested back into the business, earning high returns on invested capital? Great! Sign of a strong business. And so on.

There is nothing that will afford you the best opportunity for good results more than digging deeper into the story and the numbers. Too often I hear people talk about charts and numbers. That’s great. As Warren Buffett says, “There are different ways to get to heaven.” I think in order to stand out from your competitors, the investing public, you need to really get to know the story behind the numbers. Only then will you be able to, with conviction, determine what the future might look like and whether or not it makes sense to put your money to work.

As the saying goes, “Don’t let the truth get in the way of a good story.” Go out and put in the work to find the truth in each story.

. . .

SemiconductorS: Are They worth the trouble?

JC Rodriguez

Semiconductors 101

Semiconductors are made by imprinting a network of electronic components onto a semiconductor silicon wafer. These devices are designed to perform various functions such as processing, amplifying and selectively filtering electronic signals, controlling functions and processing, and transmitting and storing data.

Yes, that's a lot. Basically it's the little chips inside your phone, computer, tv, set top boxes, servers, cars and more, that make these electronic things work. Each has different functions from processing information to keeping data memory.

Investing in Semiconductor Companies

Semiconductors have been some of the most difficult and hated stocks on Wall St for years. Why? It's a tough business. High capital expenditure requirements, cyclicality, rapid changes in technology which renders inventory obsolete, high research and development costs, and intense competition. Ugh, who wants to go through the trouble?

But things have changed. There has been more industry consolidation, the limits of the technology are being reached, cyclicality is slowing down, a more digital world demanding more data processing, storage, and analysis, all show a changing and a bit more predictable outlook.

As more companies depend on cloud computing, AI, mobile devices, and more devices needing semiconductor equipment like "internet of things," auto digitalization, and automation, we will see higher demands for these little tiny chips the size of a thumbnail that can have up to 20 billion transistors. Yep that number is right.

What Does This All Mean?

Even though the macro picture looks promising, it doesn't make it easier to pick out the winners and losers. Companies can come out of nowhere to take the lead with the latest technological advancements. Companies that have such a strong hold on the industry are subject to cyclical risks, capital investment, geopolitical implications, supply chain issues, R&D costs, and more. With the optimistic outlook of a growing market, all stocks in this space have seen big valuation increases over the past two years.

Great Companies Doesn't Mean Great Investments

As with any industry there will be winners and losers. In the technology sector that sentiment is amplified. You'll see the rapid growth of industry learning technology providers, while the rest are left in the dust. Investors are willing to pay a premium for the fast moving, high earning potentials in the industry. Certain companies may have technologically superior products, providing them with long runways of growth and profitability. The more evident the case, the higher the multiple you'll have to pay. Once you missed out on the move it becomes more difficult to evaluate where the top will be. This is why at times great companies don't make great investments. If everyone knows it's great and it's priced into the stock, you are then limiting your chances of future gains.

How This Applies To Our Approach?

When I look at a company to invest in, I go through the tried and true approach taken by Warren Buffett and Charlie Munger. First, I look for businesses I can understand. Second, I look for companies that have a sustainable competitive advantage that allows them to earn a high return on invested capital. Third, I consider the management teams, looking for honest and capable executives. Finally, I look for companies that are selling at a discount to their intrinsic value.

It's a simple approach but difficult to execute. Why? Well it's hard to find great companies that are selling at what we believe is a discount to their true value. The anomalies are hard to find especially when everyone either knows the company is great or they have priced it so high because of great expectations. When I do find these great opportunities I know they don't come very often, so I take an aggressive approach to investing. Then I do nothing. I let the company bloom overtime. A company with sustainable competitive advantages like a strong brand name, network effects, high switching costs, distributions advantages, economies of scale allowing it to be the low cost provider, or a technological advantage, that allows it to earn a high return on their deployed capital, will over time compound and provide us with great returns. The key is to have the patience to let the story play out.

So I ask you the question. Are semiconductor companies worth the trouble? Well it all depends on your ability to spot which will be the long-term winners. Within our approach of investing in businesses for the very long term, that becomes a bit more challenging. Huge gains could be had in this space, but a disciplined approach to investing that looks to provide gains while minimizing losses might consider this industry a bit challenging. I will always be looking for companies that have a sustainable competitive advantage that will sustain high return on invested capital over the next 5 years. That's my approach and I plan on sticking to it.

Opinions expressed here are not to be

taken as investment advice. Consult with

your own investment advisor.

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