April 2023 Commentary

In the investment business, by far the best path to creating
wealth – wealth being defined as assets/capital that you
will not consume in your lifetime – is compounding. Yet the
pressure to force change, to recognize short term
conditions, to adapt or conform to others’ beliefs away
from the compounding model, is constant.

A recent poll found that a large majority (60%) of
Americans agreed that the federal government is spending
too much. However, when asked to select specific areas for
cuts, the only category a majority wanted to shrink was
foreign aid, representing less than one percent of total
spending. While the concept (reduce spending) may be
correct, the strategy (shrink foreign aid) is misguided.
The concept of compounding is intuitively understood by
everyone. Yet the application of the compounding
principle in investing is misapplied.

For example, ten years ago Nvidia – the inventor of the
graphics processing unit (“GPU”) – was a $7 billion USD
company generating $0.33 per share in cash (about 10%
yield on a share price of $3.50 USD pre-split) and
compounding capital at roughly 15% per year. The
Company maintained a debt-free balance sheet with $3.7
billion in cash, with a dominant and growing market share
in GPUs, and 25% of its revenue spent on R&D to maintain
a healthy pipeline of powerful products. And just as
important, gross margins had grown from 35% to 52% in
the prior three years.

Had one purchased the Company ten years ago for $3.50,
the compound annual return on Nvidia to its March 31,
2023 price of $269.64 would have been roughly 55%.
That’s per year; in aggregate the return, before dividends,
would be 8,227%.

Rising revenues, expanding margins and profitability, and
multiple expansion. Now that’s compounding.

Granted, Nvidia is a cyclical semiconductor company. Lots
of volatility. And, at present, in a cyclical low so growth has
slowed. And valuation has become an issue with investors
plunging into the stock given the intertia of stock price
movement over the past few years. At a market cap of
$668 billion today, Nvidia is no longer the same type of
investment. It’s been a wonderful decade but the
likelihood of Nvidia generating a similar return profile over
the next ten years is very low.

We, as investors, can so easily get lost in the weeds.
Dithering over small changes in the quarterly financials.
Focusing on what management says about the quarterly
expenses or their expectations for the coming quarter.
Macro talk on the economy. Worrying about the nickels
and dimes on earnings forecasts.

There are forests … and then there are trees.

Why do small cap indices outperform in the long term?
Because they contain a few businesses like Nvidia that will,
over the fullness of time, compound at high rates and
generate performance above all the other smaller
companies along with all the larger companies as well.
And you really don’t need many of them. Morgan Housel
quoted Warren Buffett as saying he’s owned 400-500
stocks in his lifetime and made most of his money on just
10 of them.

The “trick” is to uncover those ten. Look for great business
models in smaller companies that have a successful record
of generating predictable cash flow. Narrow that group to
those with strong capital allocations, measured by high
returns on capital. Winnow that list down to those that
have avoided leverage, or debt financing, to build the
existing business. Finally, start interviewing the
management teams of the residual group to uncover the
very best at what they do. Simple.

Okay, maybe not so simple. But when you find a company
that meets these criteria, one should buy and hold .. and
hold .. and hold .. and hold.