Category Archives: Portfolio Companies

Mercado Libre (MELI) transformed scarcity into competitive advantage

May 9, 2024.

Mercado Libre is an ecommerce and fintech company operating in Latin America (LATAM). Mercado Libre was established in late 1999 by cofounder and current CEO Marcos Galperin; headquartered in Uruguay, and incorporated in Delaware, USA. It started operating initially in Argentina in August 1999, by the end of the year had added Brazil and Mexico, the largest regional country markets. By the end of 2000 it added Venezuela, Uruguay, Colombia, Chile and Ecuador, and continued to expand. It IPO’d in 2007. It currently functions in 18 countries, including those previously mentioned, and Bolivia, Paraguay, Costa Rica, Dominican Republic, Guatemala, Honduras, Costa Rica, Nicaragua, Panama, and El Salvador. That is, all the Spanish speaking countries in the region plus Brazil.

MercadoLibre has become the largest ecommerce company in LATAM by revenue and unique visitors, as well as one of the leading fintechs by revenue. It is the surviving victor of a competition, over the course of its lifetime, with a number of regional and international ecommerce companies. This accomplishment speaks to the quality of the management and strategic success. I avoid novel companies. The historical record of MercadoLibre demonstrates that its management and workers are able to make the correct decisions and execute to continue profitable growth.

Given the strength of Mercado Libre’s human capital, this combines with Mercado Libre’s origin in LATAM in explaining some key traits of its history, as well as its particular strengths. In particular, Mercado Libre originated in an environment of scarcity of some needed resources.

Internet penetration is relatively less developed in LATAM, in the region of 70%. Accordingly, Ecommerce is also less mature. Online retail sales are about 5.6% of total retail sales, whereas in US they are 14%. However, both internet usage and ecommerce penetration are growing quickly. Approximately 192 million people in LATAM have shopped online, in 2024 this is expected to grow to 350 million. Of note, ecommerce growth requires popular participation with specifically digital finance tools, such as mobile or online payment apps, or virtual credit cards, not necessarily with traditional banking.

Public Transportation networks

The relative unreliability of state provided postage and delivery services, has provided an opening for Mercado Libre to build its own Logistics network. Mercado Envio has successfully enabled more efficient delivery than government networks. Moreover, a potential competing ecommerce business would either take the easier route of using Mercado Envio, or it would have to undertake the task of repeating the investment of fixed capital to replicate the Mercado Envio network.

Significant Unbanked Population

A significant portion of LATAM population is underbanked, not participating in the modern digital (non-cash) financial system, and not able to participate in ecommerce. For instance, less than 50% of the population in Latin America have a consumer financial institution account, whereas about 90% has the same in the US. This made it necessary for Mercado Libre to build a digital payment system and attract users, in order to enable consumers to use its ecommerce. This was Mercado Pago. In 2013, Mercado Pago had 28.6% penetration in payments on Mercado Libre platform. By 2017 this share had reached 81.9% and was no longer tracked in the 10Ks.

Whether the numbers given are precisely accurate is less important that what these patterns signify. They mean that MercadoLibre, in the course of growing into the largest ecommerce and digital payments platform in Latin America, has sat its disposal a runway of growth that is expanding in a way is qualitatively different from that for digital payments or retail companies in more developed countries.

Conversely, the conditions of scarcity of needed resources under which the company developed in the regional markets posed sharp challenges to company growth. MercadoLibre management took these on. And paradoxically, these challenges gave it opportunities to build a competitive advantages that are more comprehensive than those available to ecommerce players in more developed countries.

As CEO Marcos Halperin described:

In 1999, our company was a marketplace, an online auction site. We had not created Mercado Pago, Mercado Envíos or the other solutions and tools that enriched our value proposition to form the ecosystem that today makes life easier for millions of people in the region, reducing gaps and promoting development. When we started, those business units were not even ideas. But problems appeared, we turned them into challenges and generated solutions. We took risks with each of them, we had successes and errors, we learned, innovated and achieved the impact that inaugurated new paths” .

This is one of a series of articles on Mercado Libre.

United Health Group Competitive Advantages: Scale, Cost, Network – and Efficiency.

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April 25, 2024. How does United Health Group (UHG) drive its competitive strength in the US healthcare market?

United Health Group comprises two distinct, complementary business platforms, United Healthcare and Optum. UnitedHealthcare offers health insurance benefits under 3 divisions. UnitedHealthcare Employer & Individual serves employers of every size and private or public sector. United Healthcare Medicare & Retirement serves Medicare beneficiaries, including Medicare Advantage, and retirees. United Healthcare Community & State manages benefits for state Medicaid and community programs.

Market Share drives scale and derivative network advantages. Through organic growth as well as serial acquisitions, United Healthcare has become the largest insurer in the US, by premiums written and number of lives covered. Of note, it has the greatest number of Medicare Advantage clients. Its market share in a number of local markets is large enough to drive competitive advantages of scale; with a majority local market share of customers insured, it can demand lower prices from medical providers. Accordingly, it can offer lower insurance premium prices to payer clients such as employers. The low prices resulting from scale advantages, support the competitive advantage of network effect. The employers attracted by low premium prices, attract providers who need access to the population of insured patents.

Business diversification confers economic resiliency

Optum contains 3 segments: Optum Health, Optum Rx, and Optum Insight. These are diverse businesses that reinforce the business agility and competitive strength of each other and the United Healthcare insurance platform.

Optum Rx is a Pharmacy Benefit Manager (PBM) which creates switching costs competitive advantage related to contracts with employers. PBM scale attracts drug makers and pharmacies who need access to the insured patient population. Low Cost competitive advantage results because the PBM can demand lower prices from these pharma companies and pharmacies. These lower prices attract employers, which attracts drug makers in a virtuous cycle. UNH actually ranks third in market share, among large US PBMs

Optum Health operates medical care providers; chiefly primary care, urgent care and outpatient surgeries, as well as a wide range of ancillary care services. Optum Health operational efficiency is guided by data, technology and analytics of Optum Insight, described below. These tools improve care practice and reduce cost. When patients covered by United Healthcare insurance use care from Optum Health, the relatively favorable value/cost ratio obviously reduces costs for the insurance group. But these attractive margins also attract business from other insurers.

The business diversification brought by Optum Health benefits UHG by increasing revenue when medical care utilization increases, such as during seasonal epidemics. This gives UHG an advantage which pure play insurers do not have because their medical loss ratio (MLR), the proportion of revenue paid in claims, must increase during such episodes.

Optum Health includes Optum Financial, including Optum Bank. With over 24 million consumer accounts, nearly $22 billion in assets under management, Optum Financial facilitates payment flows for consumers, via tools which include Health savings accounts, Flexible Spending Accounts, Health Reimbursement Arrangements and other financial benefits. Optum Financial charges fees and earns investment income on managed funds

Optum Insight is an analytics and consulting service business made possible by the digitalization and exploitation of data resulting from the considerable experience of UHG. It has likely the largest medical records data collection in the health insurance market, including over 285 million lives of clinical data and claims (URL 2023 10K) In this division, data is harnessed to various important applications for insurers, providers and patients. Meanwhile, the evolution and growth of the Optum Health care provider business gives United Health Group an experiential advantage that pure play insurers do not have. It serves as a living laboratory of the Optum Insight management intelligence.

In essence, the Optum Insight business consists in harnessing data to increase economic efficiency and consumer, payer and provider engagement in healthcare. Increasingly, this consists of the application of digital tools, with Artificial Intelligence (AI) in an important role. Software tools obtain a higher gross margin than the healthcare provider business they are deployed in. By reducing friction, improving the patient and provider experience and reducing costs of inefficiencies in the US healthcare system. Optum creates value which drives its competitive advantage.

For providers and insurers, Optum optimizes revenue cycle including coding, billing, utilization review. Medical records and claims data is exploited using AI, including novel natural language recognition software which it patented. It provides management consulting and clinical quality guidance resources to enable modernization of administration and improved business efficiency including value based care. Digital transformation reduces administrative costs and delays.

Optum thus provides diverse resources to enable client insurance or care provider businesses to improve their performance. Especially the smaller companies in these industries tend to have thin margins. A contract with a consulting client may include a financial or performance outcome which must be attained in order for Optum to be paid for practice changes or software tools it advised and managed. At times, the Optum Health segment acquires businesses that were not financially successful enough to remain independent, as in the recent case of the national physician practice network of Steward Health.

Optum Insight reinforces the competitive advantage of the United Healthcare Group by increasing efficiency and raising margins of all UHG business segments. And Optum’s management consulting services do not benefit UHG just by compensation for the services rendered. Contracts whereby Optum Insight is deeply involved in clients operations likely have advantages of switching costs. Moreover, a client such as a medical provider group which increases profitability because of Optum management consulting, can raise United Health insurance margins by tolerating lower insurance reimbursement, in order to serve the patient population of United Health insured consumers. This is where the larger amounts of revenue is created, as a result of the work Optum does to reduce business costs for the care provider entity, such as hospital or practice. The management consulting work of Optum reinforces the scale and low cost competitive advantages that enable UHG to attract employers and other payers of health insurance.

Of the 4 business segments of UHG, Optum Insights has the highest operating margin. However, because of recurrent acquisitions, Optum Rx and Optum Health segments have grown faster in size. Nevertheless, as I described, I feel the business activities housed in this smallest segment are key to sustaining the company’s competitive advantage.

Over 10 years from 2013 to 2022 (I read 10 years of annual reports for this), UHG Operating Earnings were contributed by the 4 business segments in proportions which changed as follows. In 2013: United Health: 74%, Optum Health: 9.85%, Optum Insight: 8.6%, Optum Rx: 7.4%. In 2022: United Health: 50%, Optum Health 21%, Optum Insight: 13%, Optum Rx 16%. Over the decade, the percentage of Operating Earnings provided by United Health insurance segment declined from 74% to 50% of the corporate total, with those of the other three segments increasing. Earnings of Optum Rx and Optum Health rose more than those of Optum Insight, because they included the earnings of newly acquired companies.

The Operating Margins of the 4 segments have changed as follows: 2013: United Health insurance: 6.4%, Optum Health: 9.9%, Optum Insight: 19%, Optum Rx: 3.1%. 2022: United Health: 5.8%, Optum Health: 8.5%, Optum Insight: 24.6%, Optum Rx: 4.4%. Optum Insight is the most profitable as a business, although it produces the smallest proportion of operating profits.

Regarding current valuation of the stock, the price/earnings (PE) ratio is currently 21, approximately the same as the average of the last 10 years.

From 2014 to 2023, annual diluted EPS rose 4.186 times over, from 5.7 to 23.86 dollars per share. Meanwhile, ROIC, in mid-teens, and ROA, over 20%, have been quite consistent. Discovering United Health Group (UNH), a Novel Portfolio Holding. | amateurinvestor.net In recent quarterly earnings reports, the stock sells off somewhat when the medical loss ratio (MLR) is reported to exceed analyst expectations, regardless of the fact that UNH beats earnings expectations. It also declined when CMS raised Medicare reimbursement less than expected. Thus, the stock price is essentially unchanged for the year.

As we intimated previously, a preeminently successful health insurance company such as UHG has a history of continuing to raise revenue and profitability despite the apparently ever-present nemesis of medical costs, and ever reluctant (but inevitably materializing) payment for these costs. Having started a position in UNH about a year ago, ideally I would have waited until some of these transient misfortunes occurred, in order to obtain a lower price. Apparently, we do not live in an ideal world.

In Optum Insight, digital transformation, including AI, will continue to progress into the healthcare industry, liberating value, and no doubt United Healthcare Group will continue to lead here. Whereas AI is now a “hot topic” and expected to create vast stockholder wealth in a rush, healthcare insurance companies never seem to be popular. It seems UNH stock is held hostage to expectations regarding the MLR, regardless of its ability to consistently beat earnings expectations. The advantage of this is that it is less likely to rise euphorically, with subsequent dramatic drops in price. Instead, it must earn its way up in price through demonstrated, sustained earnings growth. As it has done, with an average annual return of 25.18% as of April 24, 2024, since March 1990. The total return calculator (including dividend reinvestment) only goes back to that date. But the stock had doubled between IPO on October 16, 1984, and April 1990.

Q1 2024: Adobe beats as usual Earnings and Rev estimates, but Stock sells off on worry about near term growth

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March 18, 2024. In the First Quarter (Q1) of fiscal year 2024, Adobe beat earnings and revenue expectations. One of the take-home messages of the earnings call webcast was that monetization of AI related features would be apparent in the second half (H2) of the fiscal year (Adobe fiscal year ends in very early December, so H2 would start in very early June). While Adobe beat analyst earnings and revenue expectations for Q1, its guidance, predicted rev and earnings for Q2 2024, was less than what analysts had expected, calculated. Did this affect their financial discounted cash flow models, which determine whether the stock price represents a worthwhile purchase point? Presumably this is why the stock briskly sold off about 13% after the earnings release. If we go ahead and attribute a rational justification to the revaluation. Company leadership, including CEO Narayen, repeatedly stated that guidance of predicted revenue and earnings for the entire fiscal year 2024, which had been made at the earnings release for q4 2023 as per custom, were unchanged, and that accelerated usage of apps and forthcoming monetization of AI related features was proceeding apace and quite satisfactorily. The CEO outlined that the accelerating proliferation of digital content resulting from the spread of AI related software, increases demand for the Adobe suite of media editing software, which is the best positioned to effectively function in a commercial environment in which copyright must be respected, and in which the digital content editing process must integrate in the corporate workflow, which includes related downstream usage for digital marketing.

I am making no change in allocation to ADBE. Why do I choose to trust the leadership word that revenue and earnings will remain satisfactory this year? ADBE consistently beats rev and EPS expectations. This can be easily seen for example on the https://www.msn.com/en-us/money personal investing website. Find ADBE, earnings, earnings history. More fundamentally, the competitive advantage of ADBE enables it to successfully compete with potential rivals. This competitive advantage lies, just as CEO Narayen outlined, in the market dominating position of Adobe creative software in companies. Adobe is reinforcing and adapting its market dominance here by adding the new capability of AI. As AI is integrated progressively into creative and digital marketing software applications, on one hand it becomes more efficient to create sophisticated content and use it more effectively in digital marketing. This raises value provided per cost to the client. Just because AI may mean that fewer professional designers are required in existing projects, does not mean they won’t be employed in new projects elsewhere. On the other hand, AI tools mean content creation becomes easier and can be used more widely in the enterprise and out of it, by non-professional creators. In fact, overall demand for digital content creation is accelerating and this means more demand for Adobe software.

Context of Competitive Advantage in the Health Care Insurance System.

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Feb 15, 2024. In early 2023, I became aware that United Health Group (UNH) was likely to possess a durable competitive advantage, since it had evolved over about 40 years to become a market dominating company, with an impressive total stockholder return. In order to discover the basis for this competitive advantage, I searched in vain for a book written by or about UNH founders or the company history. I did find a book about the US Healthcare insurance system history: Ensuring America’s Health: the Public Creation of the Corporate Health System. Christy Ford Chapin, published 2017. The following historical outline of the US health insurance system takes liberally from this interesting book.

From the inception of the income tax in 1913, fringe benefits including employee health insurance, were made tax deductible. Over time, public demand grew for comprehensive health insurance. At the time of price controls during the war time economic policies of FDR, employers offered the tax-deductible employee health insurance fringe benefit to augment compensation and attract workers. The employer tax deduction for employee health insurance was more specifically codified in the Internal Revenue Act of 1954.

In insurance markets other than health insurance, the insured outcome is something that all parties to the insurance contract have an incentive to avoid. A driver tries to avoid car damage, a home owner avoids burning his house down; the insurer certainly shares the sentiment. As premiums exceed claims most of the time, the company can accumulate a “float” of funds to be invested in order to earn additional income and build the financial resources to fund future claims. The size of the financial reserves thus accumulated, is the basis for the insurer’s promised ability to back claims successfully.

In contrast, in the health insurance market, the customer finds it desirable to make claims for service, a sentiment shared by the provider, and there are no clear definitions as to what services are legitimately necessary for health. This means that health insurance is unprofitable in the sense that claims paid will tend to approach premium revenue, leaving no room for accumulation of float. This means that it is a peculiar property of the US health insurance market, that the insurance company must be an important arbiter of the reimbursement rate for health care services. Because in order to be profitable, the insurance company must devote systematic attention to controlling medical costs, where neither customer nor service provider have an incentive to do so.

Because of the poor economics of health insurance, early (following the Great Depression era) insurance policies covered a limited range of essentially catastrophic coverage. In the 1940s employers began to offer naturally desirable more comprehensive health insurance partly to stymie labor unions’ influence. As private insurance spread rapidly to become a popular benefit, unions demanded comprehensive coverage for their members as a counter for moderated wage increase. Physicians’ groups encouraged private insurance, while insisting on fee for service, and fended off insurer influence over reimbursement or choice of care. Physicians feared insurer restrictions on price and provider independence, which they considered to be a gateway to government sponsored coverage and associated control of reimbursement and practice. Private insurance companies, while unsettled about low margins, had similar fears regarding the development of government insurance, therefore tended to supply demand for progressively more comprehensive policies. Their business grew rapidly. Health care insurance was paid for by a third party, namely the employer, union or government. Regarding government payment, at this point in history, it was the growing Federal Employees Health Benefits Program which paid for and in effect subsidized private insurance for federal employees. With prices determined by providers and ancillary healthcare service or equipment providers, who could be confident their costs would be covered, consumers were not restrained by prices, and healthcare price inflation exceeded that in the rest of the economy.

In the absence of other restraint on prices, private insurers gradually began to take a role in determining reimbursement. They were aided over time and experience by the evolution of actuarial data needed to do this effectively. As health insurance became more comprehensive, the many claims to be covered, involved innumerable conditions and treatments. Over time, the complex data sets needed to make sense of claims administration were developed, at times including data sharing among different companies. This developed expertise in controlling reimbursement costs.

Healthcare inflation was a public policy issue which led to the formation of Medicare and Medicaid, the feared government sponsored plans, after at least a decade of discussion and negotiation. By that time the private health insurers had established a business infrastructure to address billing and payments. In the political conflict between proponents leaning toward a government single payer system and those for private insurance, the use of the private insurance company model to administer the government sponsored systems, subject to government regulation and funding, was appealing as a viable compromise.

The creation of fully government funded health insurance, administered as it was by private insurers, who would thereby profit, meant that the private insurer model was further embedded in the structure of the US health care. As price inflation did not abate, the insurance companies gradually increased their control over reimbursement, leading to DRGs, formation of HMOs, PPOs, and the current system, of which value based care is the latest attempt to maximize value per cost, while optimizing outcome as a value to the customer.

In summary: private health insurers play an indispensable role as mediator, or market maker, in the US health system. They insure comprehensive health insurance, which most of the population regards as indispensable. This is paid for at least as a strongly established expectation, if not legal entitlement, by employers and, ultimately, state and federal government. Because of the natural incentive to consume healthcare, in the peculiar economics of healthcare insurance policies, claims made tend to chase the level of premiums revenue, and gross margins are correspondingly attenuated. But because of inexorably expanding demand, and reliable payment for insurance, health insurer revenues will tend to continue rising. A company which has a market dominating position in this ecosystem, has access to total addressable market which will likely grow for the foreseeable future. Market growth is driven by population growth, especially of the aged; increase in price and frequency of utilization; increase in government funding, among other factors.

The question remains, how can a company establish a market dominating position in this system? It would need to widen the gap between claims expenses and premiums revenue; that is, minimizing the medical loss ratio (MLR), funds paid for medical costs of members, divided by premiums revenue. By economies of scale, in which an insurer accesses a relatively larger population of customers (potential patients) as members, it could demand relatively lower reimbursement prices from healthcare providers. Meanwhile, access to a large number of providers attracts contracts from large corporate employers and large numbers of individuals, government entities or other payors. Moreover, it can build access to a diversified network of healthcare facilities that build on mutual synergies, to encourage lower prices as well as attract business from payors. For instance, association with a large number of rehabilitation medicine providers could lead them to accept a lower reimbursement bid, if the insurer is also associated with a correspondingly large number of referring orthopedists.

Other than minimizing the MLR relative to premiums revenue, the health insurer could create additional revenue streams by selling other services, derived from its experience in insuring, that raise productivity and lower costs for its customers as well as providers. For example, healthcare billing software, clinical pathway analytics, pharmacy services.

Finally, the insurer could build or acquire healthcare providers that are incentivized to reduce cost relative to value through management guidelines developed by the previous insurance experience.

In a subsequent article, I will outline how United Healthcare uses these strategies to maintain a consistent competitive advantage relative to other insurers.

Discovering United Health Group (UNH), a Novel Portfolio Holding.

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Feb 9, 2024. In 2022, risk-on stocks in the US markets fell. My portfolio holdings at the time, Microsoft (MSFT), Adobe (ADBE) and Visa (V), all growth stocks, participated to varying degrees. They all have persistently high gross and net margins, and consistently high returns on invested capital. These are key signs of the presence of a durable competitive advantage of their business, and these are traits I screen for in routine searches for investments. In spite of their outstanding financial accounting features, all were falling in 2022. MSFT and ADBE especially had price earnings multiples which had been climbing for years, based on expectations of continued earnings growth. They were therefore vulnerable to a downward revision of earnings expectation.

But not all stocks in the market were falling. I wondered, was it possible that there were companies with strong business qualities, but which I had previously failed to identify as investment candidates, because their financial statements had features which differed from those of my customary investments? I reasoned that furthermore, such undiscovered businesses would likely have historical returns which did not necessarily correlate with those of my current portfolio holdings.

Somehow, sometime in late 2022 I discovered, or was affronted by, the somewhat outrageous but undeniable fact that the largest public health insurance company, United Health Group (UNH), had an average annual return since its IPO, higher than that of the mighty MSFT. As of Jan 31, 2023, using a free online stock total return and dividend calculator, I found the average annual return of UNH since IPO on Oct 16, 1984, was 26.14%. This beating MSFT, which since its IPO March 16, 1986 had a average annual return of 25.14%.

How could this be? In order to find some basis for the first-class total stock return of United Health Group over its history as a public company, I naturally needed to check out its financial statements and relevant ratios. One pretty good source of this information that I use is stockanalysis.com. There, I found that in the past 10 years, UNH gross margin was never as high as 30%, and net profit margin barely reached 6% in 2022. These poor margins were the reason UNH had been rejected in my occasional screens for good investments up until now.

Brief research into UNH history told a story of a company which grew through mergers and acquisitions as well as organically, to become the dominant public diversified health insurer.

Upon further review of UNH financial statements and ratios, we do see some inviting accomplishments over the past 10 years. Notwithstanding relatively low profit margins, revenue has grown consistently. Annual earnings growth has outpaced revenue growth, suggesting economic value added. Return on invested capital (ROIC) has been in mid-teens. Return on equity (ROE) has been over 20% for most of the past decade. Return on assets (ROA) has been almost always lower than 8%; balance sheet assets, including goodwill, have grown along with revenue. This is likely because UNH has grown through acquisitions. Liabilities have kept pace and in fact grown a bit faster than equity, However, the debt/ equity ratio has usually ranged between approximately 50% and 75%. Indebtedness has grown somewhat but interest coverage is still about 10x currently.

We see evidence of consistent consideration for shareholders. The company paid dividends annually since 1990, and increased the dividend annually since 2010. Consistent growth in free cash flow, accompanied by reduction in number of shares outstanding.

The combination of sound financial statements and the world class shareholder return since IPO in the 1980s, suggests the existence of a durable competitive advantage, interestingly, in spite of the narrow gross and net profit margins. The longevity of the company implied it had successfully adapted to maintain its competitiveness in the evolving healthcare market. Durable competitive advantage, and the ability to continue adapting its product in a profitable way, to the market as it evolves, in order to perpetuate the company’s market dominance, are the seminal qualities of my favored type of long equity investment, which I term the “eternal company”.

How could a company continue to grow its earnings over 5 decades, surviving 6 recessions, while earning a net profit margin of less than 6% ? I endeavored to discover the history and basis for UNH competitive advantage, which I will describe in a subsequent article.

Balanced fear and trust in portfolio construction

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1-10-2024 Humans have an emotional basis for thought, including their portfolio investment decisions. Therefore, practically speaking, a successful investment strategy must be able to operate while being associated with these emotions, functioning both in spite of, as well as because of them.

The market correction of 2022 was related to the Federal Reserve’s increase of interest rates, with consequent fears of prospective slowing of economy, and associated adjustments in analysts’ models and earnings estimates. Market downturns cause fear among holders of stocks. This is not totally avoidable, and it happened to me.

Why was I afraid? Unfortunately, I had committed a major error in my role as investor, an error which had become a pattern over several preceding years. New time constraints occurred, related to devotion family demands, passionate commitments to fulfilling personal pursuits, and duty to professional demands. Therefore, over a few years I had much reduced my formerly practically constant reading about my companies and investing in general.

Bearing in mind the nature of my investments, “eternal companies” with a durable competitive advantage that have the “culture” and capital, human and financial, to adapt to continue dominating their market. These companies can weather an economic downturn and rise with the recovery and continue on their march to growth. We know this because they have done so repeatedly over their history, and they continue to develop the qualities which drive this durability. And so these companies do not require constant monitoring to see if their earnings are finally coming into existence, or if paying customers are appearing, as is the case with some novel hot companies. Indeed, this is one specific advantage of the “eternal company” concept for the individual investor who has done the work to select investments, but does not want to spend an inordinate amount of time on an ongoing basis, worrying about his portfolio.

However, because I was no longer keeping close track of my investments, having reduced my immediate awareness of my portfolio companies’ current achievements and strengths, I was vulnerable to the fear which affects the ignorant in a market downturn. In the anxious and volatile market of Summer 2022, recession was widely predicted by economists for early 2023. I began to read again. I did not in panic sell my holdings at the low points. This was because I know they are sound investments and this attachment has an emotional tone. However, while I refreshed and reestablished my current knowledge of the repertoire of business strengths of my companies, I felt the need to do something to protect my portfolio from a time period of losses of unpredictable duration. I searched for a suitable candidate investment to which I might allocate part of my capital. One which did not correlate with my current holdings and might therefore better withstand a possible upcoming recession.

Thus, at approximately the end of January 2023 I shifted some funds from my current holdings, to a novel portfolio component: United Healthcare Group (UNH). I reallocated approximately 1/3 of funds from ADBE, 1/4 from MSFT, and less than 1/4 from V. I made these moved because of anxiety regarding recession, rising interest rates and the effects on tech and digital finance stocks. But I made only a partial reallocation, because I trusted my current companies would certainly eventually recover and in fact likely take market share during any recession.

As the broad market recovered in the second half of 2022, it became clear that I had traded a portion of funds out of my current holdings, just in time to miss the major recovery run ups of 12.3% for V, 49.3% for MSFT and 60.6% for ADBE. In contrast, UNH only appreciated approximately 8% between January30 and the end of 2023. My return on investment for 2002 would have been better had I remained fully invested in my original portfolio of eternal companies.

This episode yielded a couple of investor lessons. By regularly reading, keeping informed about your own investments, you are continually aware of the reason that they are sound investments. Had I done this, I might have held onto my ADBE, MSFT and V with more confidence, knowing that the companies would certainly survive and thrive. Even should a recession have occurred, as companies riding a wave of secular market expansion, they would play an early part in the rebound of market sentiment as the prospect of tangible economic growth reappeared ahead.

Second, equally important: regularly search for novel portfolio candidate companies which are in a different business and sector than current holdings. Do this research in anticipation of a change in economic conditions which makes the novel companies a relatively better value. In this way, you can be ready to shift allocation into them at this relatively lower valuation compared to your current holdings. Moreover, preferential selection of companies in different sectors promotes construction of a portfolio whose future performance is less vulnerable to economic changes which harm a specific sector. Finally, keep informed of valuation conditions in the various market sectors so as to know when they are likely to present relatively better values and opportunities for purchase.

Because I did not maintain this regular, anticipatory research, I had yet to identify new portfolio candidates with relatively more attractive valuations, by the time MSFT, ADBE and V hit new highs in the second half of 2021. Instead, I delayed until they had already reached subsequent 52 week lows in Spring of 2022. I therefore lost the initial period of advantaged returns which could have resulted from diversification into non-correlating holdings.

Notwithstanding my apparently poorly timed UNH purchase, portfolio performance (IRR) for calendar year 2023 was quite good at 43.2% This was a product of both the durability of my long term holdings, and that of the new investment. I continued to trust in my long term holdings and therefore resisted selling them completely even in the face of significant price declines. This was balanced by anxiety regarding further losses related to a recession, prompting my search for a company meeting my investment criteria, with returns not likely to correlate with my current holdings.

I admit these emotionally related errors not just because I value transparency and truthfulness. It is important to know that an investing strategy can be reasonably successful in spite of your fears. A strategy which depends on perfect logic is pure fantasy.

Interestingly, the selection of UNH actually represents an evolution of my eternal company criteria. This innovation was stimulated by necessity, the mother of invention. I will describe my process for selecting UNH in a separate article.

VISA Q1 2017 Earnings, harvesting market growth, ploughing and sowing for the future

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February 4, 2017. VISA Q1 2017 (2-2-2017) earnings call was led by Alfred Kelly Jr., who became CEO, replacing Charlie Scharf on 12-1-2016. Al Kelly graduated from Catholic, Christian Brothers affiliated Iona College, in Westchester, NY, with undergraduate and MBA degrees. He worked in the Reagan White House as manager of information systems (using DOS, or Windows 2.0?) from 1985 to 1987, then held a range of important roles at American Express for the next 23 years. He has been on the VISA Board of Directors since 2014 and therefore played a role in approving the current strategy.

In the earnings call, Kelly noted that VISA strategy will remain as is, in a seamless transition with the previous CEO. He noted VISA has a talented leadership team; strong relationships with issuers clients, acquirer clients and merchant clients. It is important to learn about and address their business needs while reducing friction in and enabling digital payments. VISA is in an industry with strong growth. In developing markets, middle classes and governments are demanding payment digitization. In developed markets, ecommerce and mobile payments are displacing checks and cash. VISA is a leader in payments technology and constantly supports innovation in ecommerce and novel forms of payment digitization.

I will address the overall strategy of VISA, which describes how VISA fills a key criterion of an Eternal Company investment: the ability to extend its competitive advance into evolving new markets, in a separate post.

Following is a summary of Q1 2017 financial results. Rev and EPS exceeded expectations as accelerating business more than offset exchange rate shifts. GAAP Q1 rev up 25%, EPS 7%. Adjusting for the non cash gain in Q1 2016 from writing off the VISA Europe put, adjusted EPS up 23%. Payment volume growth increased 1-2 % in most geo regions. Cross border payment growth accelerated 2% from 10-12% globally excluding VISA Europe. Including VISA Europe impact, they accelerated 10%. Process transaction growth accelerated 15 from 12-13% driven by India and US.

Did not issue 2$ Billion in debt as panned to finance VISA Europe acquisition as well as other costs. VISA has 8$ Billion offshore, will await Trump plan for corporate tax reform which may well allow cash efficient cash repatriation. Until then, used commercial paper issuance to fund stock buyback and operating cash needs.

The only region with reduction in growth was Latin America, due to Brazil.

The integration of VISA Europe is proceeding and will continue throughout 2017. Europe represents meaningful growth opportunities, with large opportunities to displace cash. Plan to advance digital payments by rolling out tokenization, VISA Checkout, and supporting digital wallets. VISA continued to focus on local market priorities alongside client engagement. The vast majority of VISA payments volume in Europe remain under contract and is therefore protected in the short term.

The deliberate process of consultation of VISA Europe staff was completed later than expected. New hiring, investment to integrate technology with that of the international VISA system are adding expenses as planned. As cost reductions are realized and Europe clients access global VISA capabilities, earnings will accrete and value will be realized for shareholders, as planned since the takeover was announced. Equity dilution related to the purchase is being offset by accelerated share buybacks.

In India, Aggressive demonetization measures pushed by the government resulted in doubled transaction volumes but little revenue growth. Responsive to request by the Indian Government, VISA charged no fees for processing through 12-31-2016. VISA regards this as an opportunity to expand the network and acceptance internationally, focusing on building customer awareness and merchant acceptance

Kelly articulated “So.. when you consider the economics of the investment we will make in India, plus conservative pricing, it will not drive much profit this year. But this is a great year to make sure we do everything we can in one of the two largest population countries in the world to get as good a position as we can to help us over the next decade. “

I would like to make two observations on this lovely sentence.

1. It prioritizes strengthening the company competitive advance for the long term over short term profits

2. the nature of the VISA business supports long term investments such as the one mentioned because of its competitive advantage. The VISA services introduced into the developing India market will still be indispensable in 10 y. As long as VISA continues to support successful innovations in payments, while nurturing and strengthening its network security and reach, it will undoubtedly maintain its relevance and dominance in the market.

Management must defend and extend competitive advantage

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Dec. 8, 2015. The first criterion for an eternal investment is the presence of a durable competitive advantage. This means other companies are not able to compete with the company in its markets. But there a critical second two aspect of this feature. An impregnable competitive advantage by itself is not enough to confer everlasting earnings growth. A second critical facet of this feature is that management consistently anticipates or reacts to changes in the market or competitive landscape by finding profitable ways of extending the company’s competitive advantage into new markets that are tangibly related to its current markets. As technology evolves to change markets and create new markets, the company adapts to meet new demands. Otherwise, other so called “disruptive” companies will meet the demands of those new markets. in some cases, new technology can abruptly threaten a company’s product with obsolescence. Then, the company must either change its business to adapt to the new market, change to serving a market related to its original product, or fold. The cash built up through its current strong franchise, and expertise in serving the current market, should give the company a head start in adapting to change. But in order to execute this, management must maintain a culture which detects looming changes, proactively develops new initiatives and enforces profitability. Indeed, it is management culture that establishes dominance in different, evolving markets over the history of a long lived, “eternal company”. The continuation of a company’s competitive advantage into the future is not guaranteed, but shaped by management culture.

One might say that no competitive advantage is truly eternal. The foreseeable future inevitably gives way unforeseen innovations. Competing companies use these to erode the formerly dominant company’s market share. Undoubtedly this does occur, and recently there is much talk of “disruptive innovation”. In many cases the problem may be more that management of company A does not efficiently enable utilization of novel tools to maintain its domination. Or, does not imaginatively envision how the new tools can be used to extend its markets. This might apply to Microsoft in the years between 2000 and 2014, when it seemed to focus more on maximizing profit from the windows, office, server franchise, rather than expanding into new markets for its software afforded by digital readers and mobile phones. In fact, arguably Microsoft’s own management which impaired its revenue growth, as much as the strength of Apple or Google. In other words, it is not that android or iOS phones have destroyed the market for Microsoft Office products, far from it. Rather, they have created a large new market for mobile computing, a market related to Microsoft’s market for its productivity software. And Microsoft has failed to extend its dominance into this new, related market. In 2014, in a vigorous departure by new CEO Nadella, Microsoft began making a concerted attempt to forge into the market for mobile productivity software, for example by releasing Office for iOS and Android. More interestingly, work on this software had begun under the previous CEO Balmer. But more interestingly still, the strategy of creating Microsoft applications for other companies’ platforms had been heavily utilized in earlier Microsoft history, so it was actually part of the engineering and management culture.

Competitive Advantage is at the intersection of Market Need and the Company’s Unique Ability Supply It.

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Oct. 22, 2014. Focus is crucial In order for a company to build a competitive advantage (the same might be said for a person). A company must first recognize the potential advantage, and focus in order to capitalize on it. A competitive advantage is at the intersection of the most urgent market need and the unique ability of the company to uniquely supply that need. Efforts are focused on developing that ability, and ignoring other less rewarding aspects of the company.

Adapting to focus on meeting the current market needs therefore builds the company’s competitive advantage. But the market does not remain static. In order to continue dominating markets that change, the company will need to develop new strengths. The source of strength at one stage can be used to build new sources of strength. Hence, the company must adapt again. Over time, evolution occurs and the degree and nature of change can be striking.

The story of the early Microsoft is a good example of this. In 1975, Bill Gates and Paul Allen had a competitive advantage in that they had high IQ’s and had worked extremely hard to develop their programming skills, devoting most of their time to that end since the age of 13. At that time, the most practical computers available were termed minicomputers. These were smaller, more physically more practical than the mainframes which had hitherto dominated computing. Minicomputers were pioneered by companies like Digital Equipment Corporation. The programmer communicated with using a keyboard, generally remotely. Different users would book on the remotely located minicomputer. Bill and Allen had spent essentially all their otherwise unoccupied time learning use mini-computers since high school and had faced a constant battle to find time on a shared minicomputer. They realized that computing power would be valuable if it was available on computers conveniently located at the user’s location, whether home or office. Processors were becoming cheaper, smaller and more powerful, so in theory it seemed computers would follow to make this vision possible, although the established computer hardware companies were sticking to more developed markets. So they were aware of a possible new market opportunity which would match their strengths.

In 1975, Ed Roberts in Albuquerque NM had a company called Micro Instrumentation and Telemetry Systems (MITS), selling electronic equipment. In 1969 he moved it out of his garage and focused on selling kits to build calculators. He was wiped out by Texas Instruments’ and others’ entry into the market in early 1970s. Roberts shifted to using the new micro-processors, introduced in 1971 by Intel, to create computers that were small and cheap enough to be used by a single hobbyist. This new chips enabled the entire CPU to be contained on the single small chip. Roberts sold a kit to make a portable computer using the 1974 8080 Intel chip. The computer was called the Altair, the term “personal computer “, was coined by Roberts.

It was the Altair that appeared on the cover of Popular Electronics Magazine in January 1975. Paul Allen spotted it at the newspaper kiosk in Harvard Square while visiting Bill. They realized this was an opportunity to apply their programming abilities with a future market.

Their first task in seizing this opportunity was to promise Ed Roberts they would create a version of basic that would run on the 8080 chip and be able to run calculations. Roberts did not take them seriously. Many enthusiasts had phoned him and made similar claims, hoping to score a contract. He told them all that whoever produced a working product first would get the deal.

The young men did what was required to overcome the obstacles involved. No one had ever written a version of BASIC for a personal computer like this one, since this was indeed the first one. They did so, with the help of fellow student Monte Davidoff. The young men did not even have an Altair to program on. Allen located a manual for the 8080 chip, and created basically an emulator on the PDP-10 microcomputer they used at Harvard. He saw this could be done because of previous work he had done with Gates in high school. Gates wrote the required version of BASIC that would run on the 256bytes of memory it contained. Davidoff wrote the portion that worked with mathematical calculations. Allen flew to Albuquerque at the end of Feb 1975 to show (to everyone’s amazement) that they had written software that could perform on the Altair.

The next step was follow through to turn this creation into a product that would sell. They wrote versions of BASIC that used more memory, and debugged. This required continuous work. Allen joined MITS as software director. Allen’s work colleagues at Honeywell, where he wrote “assembly code for a niche market machine” made clear they thought he was embarking on a foolish distraction, and assured him his job would be waiting for him when he regained his senses. Gates moved at the end of his sophomore year and eventually dropped out of College. They brought Davidoff and an old colleague Chris Larson.

Thus, the partners’ strength in terms of programming skill and agility, and extreme commitment to the task, combined with their focus on the one opportunity to feed a new market which they and apparently no one else were willing to pursue, gave them the start of a competitive advantage.

Demand for the relatively new personal computers was red hot on the part of hobbyists and amateurs. While no established computer related companies initially planned to create PCs using the new microchips, demand for the Altair was huge and MITS quickly became profitable. Micro-Soft, as it was initially called, was clearly supplying an urgent market need by writing versions of BASIC, the most practical and widely used programming language for everyday computer applications, for the Altair in its various models as well as other personal computers as they appeared.

What did Allen and Gates focus on in their new company? Software had hitherto been written by hardware companies for use in their computers. Now, Allen and Gates were writing BASIC and selling it to be used on computers made by someone else. Allen and Gates signed a contract with MITS whereby MITS would pay them per copy royalties for BASIC. In addition, 50% of software sold without hardware, and of software sold to other hardware makers (OEMs). The concept of selling software for people to use in this way was novel, many users copied the Altair BASIC without paying and revenues were initially poor. Gates, the more ebullient of the two, worked to establish the precedent of expecting to get paid for the hard work of writing software partly by writing hard hitting editorials in new magazines devoted to the novel computers. The custom of buying software took hold, without which the Micro-Soft business plan would not be viable.

Within a year of the emergence of Altair, MITS began to be superseded in the market by other companies building superior hardware, and soon new personal computers were being introduced each month. Eventually established companies such as GE and NCR came in. Micro-Soft (Paul Allen came up with this name) wrote versions of BASIC for each new OEM. Their strategy was to sell it cheaply enough to discourage OEMs from developing their own software. Micro-Soft became the software developer for the PC industry, and they continued making sure to provide BASIC for every new microcomputer on the market. In 1977 they added Fortran, a language used in scientific research and engineering, and then others such as COBOL.

In October 1976, Micro-Soft was registered as Microsoft Inc. in New Mexico, and moved into modest offices on Central Avenue, a humdrum low rent commercial neighborhood. Here is a plaque at the sight of the original Microsoft office. The building they originally occupied has since been replaced.

In 1977, prominent brand name companies entered the personal computer market. The TRS-80, Commodore PET and Apple II arrived. These were altogether more usable, with keyboards, monitors and graphics. MITS did not grow and adapt quickly enough to compete with these larger corporations. Microsoft parted ways with MITS after enduring an arbitration process, and proceeded to establish the standard software tools for PC’s. Microsoft provided BASIC for RadioShack’s TRS-80, the most popular PC that year. Apple could not produce an acceptable BASIC tool and licensed a 12Kbyte version from Microsoft. Computers became steadily cheaper and more powerful.

One weakness with this business plan, was that significant work was required to produce a software language for a specific new PC. The development of CP/M, an operating system developed by Gary Kildall of Digital Research, meant that if hardware providers could make their machines support the OS, then software tool providers could write for the OS instead of having to reengineer a programming language version for every single new processor or machine.

In time, 1980 to be precise, the then king of computer companies, IBM, would ask little Microsoft, as the provider of the most widely used programming language tools (while IBM had a version of BASIC, they knew Microsoft’s version was more popular with programmers), to provide programming languages for the new IBM PC they were secretly planning. Oh, and Microsoft was expected to provide an operating system as well to go along with the package. But that is part of another chapter, which occurred after the company had moved from desert Albuquerque to the Pacific Northwest, home for the founders.

Young people who do not follow the crowd can reach their full potential

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For a vivid account of early Microsoft history and the tale of how a couple of intelligent, determined youngsters, who thought out of the box and had the courage to act on their convictions, created what would become one of the most formidable companies in history, read the splendid Hard Drive: Bill Gates and the Making of the Microsoft Empire
by James Wallace and Jim Erickson.