Lucy Chou (Luna Partners): Why do you like Mercado Libre?

Lucy Chou, Luna Partners

“MercadoLibre is a great example of a shooter, right? You have this amazing TAM growing very, very rapidly […] And then you have an early market leader with what we believe to be sustainable competitive advantages.”

[00:32:16]

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Lucy Chou [00:00:00] We’re trying to build our firm as we’re building our strategy for the long term and partnership is an incredibly important part of that. I think the rest of it is, you know, seeing authentic and true to ourselves and what I mean by that is we are young, we lean into that. We’re scrappy and we love that. We’re really hardworking, we’re honest and we think about honesty as general, but also intellectual. It’s the deeper analysis.

It’s how you take all that information and actually come to the investment decision. And the art, I think, is where differentiated thinking comes into play. And so how do we execute the art? So we are fundamental value investors at our core. We’ve chosen to take a modern approach to it, and so another way we like to talk about it is value investing with a twist.

So what does that twist entail? Right. We use additional frameworks and analysis in order to better our investment process. It could be the dominant leader in e-commerce and maybe in payments, they are in a strong duopoly, right? Either of those scenarios could play out in 10 or 15 years. The only thing we’re confident in is that MercadoLibre will be some sort of clearish leader in this space.

Tilman Versch [00:01:03] Dear viewers of Good Investing Talks, it’s great to welcome you back and it’s great to welcome Lucy Chou of Luna Partners for the first time. She’s an emerging manager and she started with her firm in late 2021. And for the beginning of the interview with Lucy, maybe I want to start with the firm name. So Luna Partners. Does it have a deeper meaning or is it just a firm name? And hi, Lucy.

Lucy Chou [00:01:30] Hi, Tilman. Thank you so much for having me. Yeah. So I love our name. It’s actually the combination of my name and my partner’s name. So my name is Lucy. My partner’s name is Nate. So it’s the first letters of my name and his name put together. And then, you know, we also love the fact that it’s sort of celestial, right? It’s a Latin word for moon. And, you know, we’re big fans of space. My partner is like an amateur astronomist. So yeah, I think it combines our names, shows partnership and then has the steeper meaning of the moon.

Tilman Versch [00:02:04] So investors can go to the moon with you?

Lucy Chou [00:02:06] Yeah, that would certainly be the hope and the dream over the long term. Yeah.

Tilman Versch [00:02:10] What is your way of starting your own firm? So when I looked at your CV on LinkedIn, I saw that you had Merrill Lynch, Goldman Sachs, and Stock Bridge Investors, which are just small, pure firms you worked with. Why haven’t you kept going on building your career there and why did you choose the more painful part of being an emerging manager?

Lucy Chou [00:02:37] Yeah, it’s a great question and it’s something, you know, I’ve given a lot of thought about because of your point, right? I certainly could have just continued being an investor at someone else’s firm. And I think about this answer sort of in two ways. First is the investment strategy and philosophy that we have built at Luna, I think, you know, what we have built is really unique and being able to build it from the ground up really allows us to create a strategy, a process that’s entirely our own and differentiated. The second part, which I think is equally as important, is building a culture and a firm that feels very authentic to who I am and who my partner is.

I think, you know, working at some other firm, and I’ve worked at amazing firms with incredible people. But creating your own firm is an entirely different bucket, right? You have to build from the ground up every aspect of it. And so that was really important to have a firm that felt very, very authentic to who I am.

Tilman Versch [00:03:36] What didn’t feel authentic at these other places? You don’t have to dump them, but you also seem to be building something against some of the things you learned in the industry or these other places.

Lucy Chou [00:03:51] Yeah, look, I know, to be clear, like, I loved the firms I worked at. I think they had incredible people and incredible values. I think it really is two things, you know, the investment strategy aspect I talked about and, you know, I’m happy to go into more details of exactly sort of the modifications that we’ve made to traditional value investing, which I think are quite differentiated.

But I think on the culture part and what feels authentic to myself, you know, I do feel within Wall Street there is at times are type of what an investor should look like or a fund manager should look like, right? And like I think the easiest example of that is by gender, right? Most people who work in this industry are male or most fund managers are male and I think it’s not necessary there’s anything negative about the firms I worked at, certainly not.

It’s more, you know, I didn’t want to fit in a cookie-cutter type box. I didn’t want to meet certain expectations to look a certain way to be a certain way. And I think, you know, by building my own firm, I didn’t have to compromise any part of myself.

Tilman Versch [00:04:53] You already mentioned the different shader or the wish to be different, so what makes you as an investor and your firm’s culture different?

Lucy Chou [00:04:58] Yeah. So I think the way I think about it and the way I think about investing is, you know, investing is an art and a science, right? The science aspect is information gathering. Its technicals, its valuation, it’s the first stab at analysis. The art is putting it all together. It’s the judgement. It’s the deeper analysis. It’s how you take all that information and actually come to the investment decision and the art; I think that is where differentiated thinking comes into play.

And so how do we execute the art? We are fundamental value investors at our core, but we’ve chosen to take a modern approach to it. And so another way that we like to talk about it value investing with a twist. So what does that twist entail, right? We use additional frameworks and analysis in order to better our investment process. Some of these examples would be, you know, we’ve developed an internal four business model framework. And we only invest in opportunities that fall into one of these four categories and I’m happy to talk about that in more detail.

The second is how we source. We source from conventional methods like top downs, bottoms up, from colleagues, from other funds, from letters. But we will also source from unconventional ways, Reddit, social media or my partner watches documentary sometimes ideas fall out of that or we will talk to friends outside of finance to see what products or applications or businesses they’re using, or even what I personally will use.

And I think the point here is to source from everywhere, and the idea that good ideas can come from anywhere and to not sort of fall into, you know, the conventional echo chamber. I think another modification which is probably the largest modification we make to conventional value investing is the incorporation of behavioural finance factors.

And it’s based on the premise that things are worth what people are willing to pay for them, right? And so we spend a lot of time thinking about other market participants and what other market participants are underwriting and it can fall into the quantitative bucket where we will consider trading momentum, technicals, ownership trends, even trending of Wall Street estimates. With the idea that, you know, if we love a business and the long-term fundamentals are amazing, but price momentum is against us, we might start that position with a very small size or we might wait until momentum turns and then invest.

And then the second bucket of behavioural finance considerations is more the fundamentals, the qualitative. And so this is where we really ask what is the market choosing to underwrite or not underwrite that we are underwriting.

And so we’re trying to think like are we calling the market winner early when there are still a lot of competitors and the rest of the market is not doing. Underwriting higher pricing power for a company or greater margin expansion in the long-term versus the rest of the market is not yet convinced of that. So that’s sort of the type of fundamental behavioural finance considerations that we factor in.

And I believe is, you know, just to be clear, like we still are fundamental value investors at our core, but we believe these additional modifications and frameworks allow us to over the long run come to better and repeatable investment outcomes. So I would say that’s sort of how we’ve differentiated ourselves on the investment strategy side.

Tilman Versch [00:08:32] So you try to understand Mr Market, but Mr Market is also many, many depressives. So it’s a bit of a challenging way. How do you stay sane when trying to understand charts and figures?

Lucy Chou [00:08:44] I mean, that’s the thing. I think that’s also part of the reason why we initially decided to start incorporating behavioural finance factors, right? Because I think with value investing, in its purest form, investing in the market can drive you crazy because a lot of times you’ll start feeling like, oh my gosh, this is such a great company.

But the share price keeps going down, or the value is never being realised the way that I see intrinsic value. And so we’re really honestly trying to take some of that frustration out where instead of sort of banging our heads why isn’t this happening, we’re trying to understand why isn’t it happening and if like can we maybe, around timing and sizing, invest in a better way where we incorporate some of those considerations around other market participants.

Tilman Versch [00:09:33] So it’s also self-therapy in this insane set-up to a certain level?

Lucy Chou [00:09:37] Yeah. Absolutely. I mean, it’s really in, look, in things about learning about the world, it’s about being really curious and thoughtful, but it is also about trying to understand what other people are thinking and I love it. I think it’s really fascinating to try to understand other people. And this is sort of a grand-scale way of doing that.

Tilman Versch [00:09:58] That’s surprising because most investors just see numbers and there are no other people involved in these trades.

Lucy Chou [00:10:04] Yeah, that’s a fair point, yeah.

Tilman Versch [00:10:07] And coming back to your firm, which goal do you try to achieve for you and your client base?

Lucy Chou [00:10:15] Yeah, I think we like to be quite explicit about what we want to target. And so I think when you look at the US markets over long periods of time, that’s typically returned on an annualised basis, you know, high single digits, 9–10%. And then we looked at sort of, you know, the best long-term value investors that we could think of and they typically were able to annualize at mid-teens to 20% target.

And so our target, starting this firm was, you know, we want to be reaching that 20% target or higher, right? And so every investment opportunity when we think about investment strategy in the process we’re building, our intention is to have them have the potential to reach that 20% or exceed it. And so the way we do that is, you know, as I mentioned, we do this sort of investment fundamental by investing with a twist.

And we believe our alternative or modern modifications will help us achieve that. So that’s what we’re trying to bring to the client in terms of investment returns and strategy. The second aspect, and we talked about this a little bit, is about the culture and the firm that we’re trying to create. And I guess just to give a little more detail on that of what we want to bring, right? Because that can mean many things.

For us, I would say that the first and most important thing is partnership, right? I think, you know, we talked about this, but even within our name, it’s a combination of mine and Nate’s name, our partnership is key. But it’s not just a partnership between us, right? We think about our clients as partners, vendors, colleagues, and anyone we interact with.

We want to be building a long-term partnership, right? We’re not trying to do this sort of impersonal, transactional-based, short-term relationships. What we’re trying to build our firm as we’re building our strategy for the long-term and partnership is an incredibly important part of that.

I think the rest of it is, you know, seeing authentic and true to ourselves and what I mean by that is, you know, we are young, we lean into that, we’re scrappy and we love that. We’re really hardworking, we’re honest and we think about honesty as general, but also intellectual, keeping ourselves accountable and knowing that, you know, we have no other incentive or alignment or bureaucracy other than sort of 100% focused on becoming better investors and getting to better outcomes for our firm and for our clients.

Tilman Versch [00:12:32] To follow up on this, how long have you been in the investing game? Is it like you say with 50, we want to do something else or are you more in this Buffet model of like you have to carry me out of here when I’m dead?

Lucy Chou [00:12:47] Yeah, I definitely think the latter. I mean, we always joke about this, but, you know, Nate and I both recognise how privileged we are to be doing this incredible job so early on in our careers. What we always say like this is hopefully, you know, forever more our last and final job. This is the last if we can, we want to be building our firm for decades to come.

And this is the only job I want to do. And I think it’s an incredible job. You know, sometimes when I really think about it, it’s pretty amazing to have a profession where especially our strategy, right? It’s sort of inherent in our strategy as a long-term value investor.

What you’re essentially doing is just getting the ability to learn about the world, right? Trying to envision in 10 or 15 years how the world will look, and especially, as a generalist, I get to learn about everything. And so that’s pretty amazing that is a job just to learn and sometimes it’s just learning for the sake of learning, which is amazing. So yeah, hopefully, I can be doing this for the rest of my life.

Tilman Versch [00:13:47] Before we jump into your research process, we already talked about a bit, maybe a question about the outside world of investing for the viewers of this channel. It’s hard to believe that there’s something else outside of investing. But what are important things you have achieved outside investing or is there anything you would even label as an outstanding achievement you can share with us to learn more about you?

Lucy Chou [00:14:16] Yeah. I think that’s tricky because I would say the most important thing in my life, you know, maybe hand in hand with investing are my relationships and so I’m really, really passionate about being a good friend or a good daughter or a good wife or a good sister or even, you know, hopefully in a few months a good aunt, right?

So I also think that and this is a very common thing where I think, you know, as I’m in my late 20s, early 30s now and I think, you know, as people get older, people start moving away, right? I feel like in this stage of life everyone’s all my friends, my family, everyone’s starting to move to different cities or different locations, and I think one of the things that really, really concerned, but also passionate about is staying in touch and maintaining this relationship ‘cause life is sort of taking a different route for everyone right now.

So I would say, as weird as an achievement, I don’t know that this is a necessary achievement, but I’m really passionate about being on top of my relationships and those are the most important things to me. Yeah.

Tilman Versch [00:15:18] And are there any things outside of investing that keep you pushing even harder to achieve success in your profession? So with Buffett, for instance, it’s these relationships he has in Omaha where he is kind of like also saying I just do this to make my friends in Omaha rich and support the people who trust me and distrust fuels him further. So is there anything like this for you?

Lucy Chou [00:15:45] Yeah, I mean, I think it’s a few things, right? like one certainly is, you know, the trust that our clients and my family have put in me, right? So I think it’s a very similar thing to what Buffett is saying is, you know, so many people from my family, my friends, you know, my old colleagues who’ve mentored and supported me, I think a lot of people have helped me along with this journey and that certainly helps fuel me.

I think also part of it is just innate, right? It’s a desire like I love investing, but to do what I want to do with the rest of my life I very much don’t view it as a job. It very much feels like a calling or a passion in life. So part of it is innately driven. And then I do think there’s maybe like third aspect which, you know, realistically, right?

And I don’t want to make this into a whole thing. But, you know, finance has typically historically been, you know, a male-dominated field. And I think, you know, I’ve had incredible mentors and it’s been such a privilege to get, you know, the things I’ve gotten.

And I think, you know, there is something nice about thinking even, I guess, even after this day, you know, something, I’ll talk to students from my former college or high school and a lot of young women will reach out to me and I think that’s really important to sort of keep that process going if that makes sense because I’ve had incredible sort of female mentors who have helped me along the journey.

There’s probably this third aspect that is being driven by sort of, maybe this external knowledge that, you know, being where I am isn’t I shouldn’t take it for granted, I guess, is my point.

Tilman Versch [00:17:16] So that’s also a bit the role model Lucy to unintelligible.

Lucy Chou [00:17:20] I mean, I don’t know I would go so far to say role model as I think I’m still quite early in my journey and, you know, there’s, I’m still trying to figure out a lot of things. And so I wouldn’t necessarily say role model, but I’d say, you know, certainly like where I’ve been able to give advice or where, you know, someone can look at me and be like, oh, that’s cool that she’s doing it. Maybe, you know, that’s something I’m interested too. I think that’s incredible.

Tilman Versch [00:18:21] So let’s jump to the research part I’ve already mentioned, but before that, maybe can you elaborate a bit more on your style of value investing, value investing with a twist? I hope it’s no arm twist. We played this too much with my cousins as a kid.

Lucy Chou [00:18:38] Yeah. So I sort of discuss it. So value investing with a twist, we’ve made modern modifications to value investing and so that was incorporating the four business model categories sourcing from anywhere and everywhere. And then incorporating behavioural finance factors.

So sort of touched upon those, but maybe I’ll go into more detail on the four-business model framework if that works. So when we looked at history and when we looked at sort of our personal investing experience, anecdotally, as well as research from investors that we admired, I think that there were a few characteristics that fell out that were commonly shared characteristics of companies that would compound at above market rates for extended periods of time. So we took those common characteristics and created four categories. And those categories are compounders, shooters, cyclicals, and transformers.

So compounders are typically the market leaders. We’re looking for, hopefully, you know, natural monopolies, oligopolies, duopolies, that sort of thing operating in relatively more mature markets but with still steady growth. Given those industry dynamics, they tend to have really strong margins and really strong cash flow generation. And we also look for management teams that are, you know, experienced, established leaders.

Shooters are what we would consider, you know, future compounders. They are earlier in their market leadership. They’re in terms that are growing very, very rapidly and their market leadership is not definitive, but it is early. There are early indicators of it. For example, you know, there are early indicators of it and because of those dynamics, they maybe aren’t super profitable today but there is a viable path to profitability. And so we’re looking for early indicators of that like good unit economics, future pricing power or increasing spend efficiency. And this is a space where we like our leaders to be sort of visionary CEOs like we love CEO founders.

Cyclicals are companies that, you know, have a lot of the same characteristics as compounders and shooters. They operate in cyclical industries, but we also recognise that you know, cyclical industries come with their own risks and not every cyclical opportunity is a great one. And so we also look for additional characteristics in the industry and timing is really important. So for example, a recent demand shock with a delayed supply response. Or, you know, healthy levels of leverage in the industry, good secular tailwinds that have that are timed well, that sort of thing.

And then Transformers, our final bucket, our companies that are undergoing some sort of transformative action at which we define as, you know, really large recent M and A some sort of a structuring or turnaround story with the idea that once they’ve undergone this sort of transformative action, they will become a compound or a shooter.

I would say that what we have found is that when a company falls into one of these four categories, that’s what we would consider a high-quality business and something that would be worth consideration in our portfolio. We’ve also found that over the past few years, the types of opportunities that we’re best well equipped to analyse and then come to an investment in are the compounders and shooters category.

So that does make up the majority of our portfolio. We still look at cyclicals and transformers. But, you know, they are higher risk investments, but also, you know, higher return opportunities. But just for those we would demand sort of a higher level of conviction.

Tilman Versch [00:22:06] Can you maybe give an example for each category? So what’s the Optimus Prime and Transformer space or…?

Lucy Chou [00:22:13] Yeah. So I would say, you know, for a transformer, Boeing, would be a good example of that where, you know, clearly a lot of recent issues, a lot of restructuring. But the intention is, you know, few years down the line, returning to be sort of a compounder. Cyclical would be Cleveland Cliffs, which is a US steel business.

We think it’s a really quality business. A lot of reasons why. So it operates in essentially within the US. There are four major steel companies and so it operates in sort of favourable kind of dynamics. It’s run by an excellent management team, but it is still a cyclical industry.

Shooters, MercadoLibre is a great example of that where, you know, it’s an early market leader and really, really rapidly growing TAM. We love that business. It’s actually our largest position right now.

For compounders, you know, I think we have a few examples of that, but one would be something like Workday, which is really a clear leader and sort of the HR space. It’s sort of a mix because it’s a little bit of a shooter in the sort of financial space. But I would say in its core business in HR, you know, it’s a clear market leader, mature market, growing well, solid management team that’s been around for a while, great business as well.

Tilman Versch [00:23:28] With your research project process, what kind of aspect do you spend the most time on?

Lucy Chou [00:23:35] I think we spend the most time thinking about the business and industry. And what I’m and what I mean by that is, you know, we’re making these long-term investments bets and we’re trying to think about where all this will look and what the world will look like in 10 years and how the company’s products will fit into that world.

And so the best way we can do that is really understanding the customer, understanding the customers’ motivations, the product and how it serves that. And then how the product will also evolve over time. And so I think to do that, you really have to deeply understand, you know, the context, the different motivations, the company’s evolution over time.

And I think that’s what we really focus on versus more near-term stocks or financial metrics. That’s still important. But for the long-term bad, I think really understanding the industry and context is more important and more critical.

Tilman Versch [00:24:31] And which three investment mistakes have improved your research process the most?

Lucy Chou [00:24:41] So I think. OK, I’m going to answer this in sort of a weird way because I think to your point, our mistakes have driven changes in our investment process. So maybe I’ll start with the process changes and how that came out of mistakes.

So I think the four-business model framework that we talked about. I think when we initially started, we had a general idea of what a high-quality business felt like to us, but it was much more in some way subjective, right? We were just looking for, oh, good, TAMs, good management teams., you know, strong growth, but what does that really mean?

And I think that led to some early mistakes where defining being more crisp and defining quality more clearly has allowed us to really crystallise what we’re looking for versus initially, I would say, we invested in some relatively lower quality businesses which were not the right decision for us.

And so I think really crystallising these four categories and more clearly defining them and what exactly we’re looking for, that’s maybe first, I would say the second and this sort of goes hand in hand with that mistake is the reason why we looked at lower quality businesses is because a lot of times they come with much higher return.

And I think what we have come to realise is no, there is a quality bar threshold that we will never dip below regardless of the return, right? That’s just not what we do. We’re not well equipped to understand companies that are lower quality.

And I also think that this also sort of helped us crystallise our behavioural finance considerations because in the beginning, similar to sort of four business model framework and quality, we knew we wanted to incorporate behavioural finance considerations, but we were sort of vague about it. We were like, we’re just trying to understand what market participants are thinking.

But now we’ve really sort of categorised it into one is the quantitative factors and one of the fundamental factors. And I think this matters, particularly around the value versus quality point, because I think in certain scenarios, as stocks get cheaper and cheaper, you think to yourself, oh, this is a better and better buying opportunity, but what the behavioural finance has taught us in some of those scenarios because we will factor like price momentum, is that sometimes when the price is going down and momentum is against you, you don’t necessarily want to invest, right? And that sort of counter to a lot of the foundational aspects of value investing which say, oh long-term fundamentals haven’t changed if its stock goes down.

It’s great. It’s cheaper. It’s like a better opportunity, but no, we realized sometimes like the negative price momentum is you can fall into a value trap, or you’re trying to catch a falling knife on the way down. And those are scenarios that we want to avoid where you might get stuck in dead money or worse for extended periods of time. So that’s a second.

And then I think the third is just generally across our investment process and also definitely applies to the first two is documenting, memorialising things. We’ve gotten a lot better of writing down everything we’re thinking at a point in time, so it’s really, really hard after an event has occurred to think back to what you were thinking about beforehand.

And obviously, I mean from the very start we had, you know, processes where we wrote things down, but I feel like over time we’ve gotten more religious about that and really trying to understand when we get things wrong, why did it go wrong? When we get things right, how did it go right and how can we how can we replicate that?

And I think it’s really critical to our process because it helps us sort of stay accountable to ourselves, particularly as a small firm with only two partners, right? How can we really, really stay accountable to ourselves, to our mistakes, to our successes and sort of how can our process evolve? Because we see our process as not a static thing, but something that should continuously be evolving.

Tilman Versch [00:28:23] So if you think about your process in two lines, one is showing up and one is showing a downward trend. And maybe go back five years, you started three years ago, but maybe you go back five years in your investing framework. What kind of aspects made this process and what kind of aspects might this process like going down and up?

Lucy Chou [00:28:46] And down and up is in terms of like time we spend doing them?

Tilman Versch [00:28:49] Time spent or intensity of research or what is important for you? I already mentioned this a bit, but maybe to outline your transition there.

Lucy Chou [00:29:01] Yeah. I think, so we have kind of mentioned this but I think, you know, where we have spent the most time historically but it only continues to grow more important is around the quality of the business over the long-term.

So really focusing on the fundamentals and how, you know, customer interest will evolve, how the product will evolve, will this company serve its customers interests in five years and 10 years? I would say where we spend a lot less time now, but this has been true from the start, but probably progressed even further is around metrics I think when you’re betting on things where you want them to chew on five or ten years, you know, the slight margin moves for quarter here or there or slight growth dips up and down in quarter to quarter basis are not super important.

We obviously have a long-term model and that’s why we pump out our returns. But and we’ve run triangulations, we do all the analysis, but, you know, and I mentioned in the beginning, I think that aspect of investing is not super interesting, right? It’s mostly commoditized. Anyone can do evaluation and technicals. I think the real higher-level thinking is sort of thinking about 5 or 10 years down the line.

And so this smaller category, we still do it. But if, to me, it feels more like a check-the-box thing. I think the only other thing though I would add and this is sort of counter to what I’ve just said in the caveat is when you are a really long-term investor, it’s very, very easy to dismiss short-term movements or short-term volatility or missteps as like short-term noise, they’re not important, right?

And if anything, a lot of those times were like let’s say a company misses one quarterly earnings, whatever. One quarterly earnings expectation a lot of times that’s like a great opportunity to buy. I having said that you also have to be cognizant of the fact that is that sort of short-term misstep, an indicator of a broader trend changing.

That’s the only thing that really, really cautious about when we sort of think about the short-term things, but for the most part, those don’t worry us and we have the privilege of that because we are long-term investors.

Tilman Versch [00:31:14] You mentioned already that MercadoLibre is your largest position, so let’s talk about it how did you get in touch with the company and what was the initial dance you did before investing?

Lucy Chou [00:31:28] Yeah. So MercadoLibre is currently our largest position. It’s about 25% of our portfolio. I guess just to give a little context, so it’s, you know, it’s listed on NASDAQ, MELI. It’s about a little under 100 billion in U.S. market cap.

So I heard about the name, frankly, a long time ago, I think at my back at my old job and that’s sort of how it sorts of initially sparked my interest. I’ve heard about it periodically throughout the years, but when I was starting Luna, that was sort of one of the first names that I needed it looked really, really interesting, and compelling. Let’s do a bit more work. And it’s been an investment, I think nearly since we’ve started and since that time it has only grown in position size.

Tilman Versch [00:32:14] And what was the dance you did have at the beginning like the analysis dance? Maybe the dance was a bit too short as a picture?

Lucy Chou [00:32:16] Oh, OK. Yeah. Sorry. Yes, so. I guess the dance we did was, I guess like, so our initial process for looking into any business is quite similar, right? We start thinking, We look at the filings, the presentations, that sort of thing and we’re trying to understand as its core, what is this business, what does it do, what’s the industry?

I think what immediately struck out initially with MELI is the industry contest is incredibly important to a company like MELI. It’s dealing with a huge TAM with two major secular tailwinds behind it. So first is LATAM e-commerce penetration, LATAM e-commerce penetration is well below what it is in the US.

It’s typically been slower or behind for a handful of reasons, including lower Internet connectivity, and logistical infrastructure problems. COVID has obviously helped accelerate this. And you have also had companies like MercadoLibre who have poured billions into building out the infrastructure. And so that has helped a lot.

The second is payments, right? LATAM economies have historically been cash-driven economies. And that’s because, you know, banking was inaccessible. They were incredibly high fees, low transparency, concerns around fraud and similar to e-commerce, COVID has helped accelerate this and but in addition to that, you also have had the rise of fintech companies like MercadoLibre’s product, Mercado Pago, which have allowed easier onboarding.

They’ve had lower fees because of at scale and their software and they also have a lot more transparency. And so what is really critical with MercadoLibre and what we’ve spent a lot of time thinking about is just the industry backdrop in the context of those sort of two major tailwinds. And then once we figure that out, our next consideration was, OK, so we have these awesome tailwinds.

How does MercadoLibre sort of fit within that context, right? And so MercadoLibre is the largest e-commerce platform in Latin America, right? And there are many reasons for that, including, you know, first mover advantage. They have incredibly strong brand recognition. They have incredible local expertise.

They’ve been operating in the industry for over two decades at this point. They have a ton of investment in infrastructure that I mentioned fulfilment centres and then also, and this is really important, is the ecosystem of payments in e-commerce. That’s incredibly valuable, right? It makes their consumers across both sorts of platforms and all the offerings incredibly sticky, with lower churn, and higher engagement.

They also have access to amazing data, so one of their big payment growth drivers is around credit, right? And through the marketplace, they have access to tonnes of credit data for their customers and so they’re able to use those to incorporate into their credit risk assessments and roll out loans and offer credit cards to their consumers.

And so we sort of see this very much as a great case of a shooter and this is from the categories that I just talked about. MercadoLibre is a great example of a shooter, right? You have this amazing TAM growing very, very rapidly with two main secure tailwinds that we really understand and stand behind. We’ve seen them occur in other countries. And so we really see that being something that will happen. And then you have an early market leader with what we believe to be sustainable competitive advantages.

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Margins, I believe are in the low to mid-teens even margin right now. So it’s not super profitable, but at the same time, we see really a viable path to future profitability. They have 50% gross margins. They’ve had increasing spend efficiency and they have a management team that’s sort of led by the, you know, visionary CEO, founder types. It’s Marcus Galperin who founded the company back in 1999 when he was at Stanford Business School, and so we think it’s an incredible business for all those reasons and, you know, we think it’s a very reasonable valuation given its growth profile. And so yeah, it’s our largest position.

Tilman Versch [00:36:18] But generally, e-commerce isn’t the best business if there isn’t this growth. So you said you focus on good business, so how it is not the best business where you have a competition? Where Chinese people can enter, with Temu can enter, Rachin? can enter, where Amazon is always a threat. How do you make sure this MELI is a good business?

Lucy Chou [00:36:48] Yeah. So that’s a great question because, you know, the competitive landscape is definitely one of the key risks for this company, right? I think what we have decided and spent a lot of time thinking about is how sustainable are the competitive advantages that MercadoLibre has, right?

And we think they are sustainable, right? We think, you know, we talked about a few of them, right? They have extreme local expertise. They’ve been doing it for over 2 decades. They have the first-mover advantage and strong brand recognition and they’ve just gotten the consumers in and they’re quite sticky. We see, you know, the billions of infrastructure investments that they have put and I think one of the most critical is sort of what I talked about the ecosystem between payments and marketplace.

And I think once you have consumers who are using both payments and marketplace, they’re incredibly sticky and they have a lot of touch points with the company and it sort of ultimately leads to lower churn and just higher engagement. And I think it makes really, really hard for other players to displace them. And I think you’re seeing that slowly come true, right? I mean, I feel like one of the biggest entrances that were quite noisy was, you know, Sea and Shopee a couple of years back and, you know, since then they’ve sort of pulled out.

We also feel like we see it within the metrics themselves, right? MercadoLibre sort of talks about how they don’t really see any of their share declining. They, in fact, see their share increasing. I think you also see it just like broadly in their top-line numbers. They aren’t really slowing down in growth, but they’re still able to grow despite the fact that you have these sorts of noisy other entrances coming in.

Tilman Versch [00:38:25] And if you look under the hood with MercadoLibre, it’s not an easy case to underwrite because it’s an e-commerce play. But then it’s also a fintech, so it’s turning into a bank and they offer credit cards. Lending and lending are tricky compared to e-commerce. So how do you make sense out of all of this?

Lucy Chou [00:38:48] I think that’s why, you know, we spend a lot of time diligencing our companies, right? You know, we spend, I mentioned weeks, if not months, actually most of the time I don’t even know I say a week, but most time months sort of trying to understand a company and an industry.

And I think, also, to your point, right allows us to see opportunities because particularly with more complicated or complex businesses, it takes time to really, really understand them and sort of be able to unlock that value. So I really think the biggest thing is around time and sort of the dedication to really understand a business well and like in practicalities, the ways we do that are, you know, there’s like the obvious, you know, you go through all the filings, all the presentation, you look at competitors sort of all or most of the publicly available information out there.

But, you know, what, we will also like look at blogs, we’ll talk to experts, we’ll read expert transcripts. We’ll try to, you know, like this in business, but just like any of our investments where we can like personally test the product, we’ll do it. We’ll even talk to other people who have tried the product or all sorts of experts in the industry, that sort of thing. Yeah.

Tilman Versch [00:40:00] But how do you dissect the financial institution, part of MercadoLibre that is not like falling into shades at a certain time if they give that much credit?

Lucy Chou [00:40:11] Yeah. So they do not give out a tonne of credit information. I’ve seen a couple of reports like under JP Morgan just pulling out where they tried to dissect it. But you have to make so many assumptions that I don’t know how reliable that ends up being. I think that is a really, really tricky part.

And, you know, what, maybe this is a good time to discuss like one other thing of investments that we try to categorise. So there are some investments where, you know, we’re very, very detailed in the financials and there’s a limited scope of sort of potential earnings outcome, right in five or ten years. And with those, you know, being precise is helpful and, you know, those can be great investments with great returns and then there are other types of investments and MercadoLibre sort of falls in that bucket where the bet is not on precision, right?

To tell you with any level of certainty in 10 years that e-commerce penetration is going to be, you know, X per cent in eight years or 10 years or 12 years is sort of ridiculous, or even to tell you, and part of this is because MercadoLibre does not disclose a lot of detail about how, you know, their credit does versus there are other sorts of fintech products. They tell you with any sort of level of precision, exactly how their margin will play out over the next two years, three years, let alone 10 years, is incredibly hard.

And I think that’s the wrong sort of bet because we would be precise without really being accurate. The bet with MercadoLibre is sort of a big broad strokes bet, right? Our bet is, look, you have these great two amazing secular tailwinds. They’re going to play out whether it’s doubling penetration in eight years or 12 years, we don’t know.

And then you have MercadoLibre and we’re calling them as a leader. So there are many ways in which you can play out. They could be the dominant leader in both e-commerce and payments. They could be the dominant leader in e-commerce and maybe in payments, they are in a strong duopoly, right? Either of those scenarios could play out in 10 or 15 years.

The only thing we’re confident in is that MercadoLibre will be some sort of clearish leader in these spaces. The reason why I bring this up is it helps us sort of think about what are the key risks and what exactly are we underwriting. Because to your point, it’s incredibly difficult to model with any level of certainty five or 10 years out at a company, but particularly a company like MercadoLibre, which is incredibly complex financials, incredibly different businesses and also more importantly, may not be important, equally important, right? They’re very early in their journey and there are a lot of dynamics at play. I would also know like MercadoLibre, they don’t give out any financial targets, right?

From what I remember, they don’t even give out next quarter or a year from now. So it makes it incredibly difficult to forecast for them. But the way we think about it is it’s a big broad strokes bet. And not all of our bets are like this, right? There are other bets where we have very, very precise detailed models and we track very closely certain KPIs.

They’re just different types of bets and a little bit, sorry, I love these patches from security analysis by Graham and Dawn where they talk about how security analysis is not always about knowing exactly what intrinsic value is but it’s about knowing that intrinsic value is just adequate to make the relative to the market price to justify the investment, right? And in layman’s terms, you can look at a man and know that he is overweight without knowing his exact weight. Or you can look at a woman and know that she is old enough to vote without knowing her exact age. And in this scenario, as long as we get the broad strokes, big bet with MELI correct, the returns work out.

We obviously still have a very detailed model and we do lots of revenue triangulations, lots of margin analysis and sensitivities. But for MELI, it’s certainly, for us, a different type of bet and it also sort of speaks to the risks that we monitor.

So for Melly, we’re more focused on watching the trends and making sure is there a structural reason why, you know, e-commerce penetration or did the rise of digital banking will not happen the way we think will, eventually, right? Is there a competitor coming up who’s going to suddenly take a tonne of share or sort of hinder MELI’s growth over the next 10 years, right? That’s sort of what we are watching out for versus there are other types of bets where, you know, we’re much more closely tracking certain smaller financial KPIs, if that makes sense, yeah.

Tilman Versch [00:44:28] It does. As a final question on MELI. What role does analysis of management play for you with this case and then maybe also in general, we didn’t talk that much about management.

Lucy Chou [00:44:42] Yeah. So, I mean, management’s really, really important because it ultimately comes down to their execution. There are definitely scenarios where we feel it’s more important on a relative basis and that would be, you know, transformers, for example, within our four categories, that’s where it’s really, really critically important because they’re going through some sort of transformative action.

The execution is really critical. I would say it’s still important when you’re looking at a compounder, but maybe less critical just because those are established mature winners and good fields and so like the leaders were looking for there are more like we want experienced solve leaders.

Do they need to be the best of the best and the most forward-leaning, maybe not. Versus, you know, when we look at shooters which is the case when MercadoLibre, we’re looking for visionary CEO, founder types, who like they live and breathe by their company, right? We don’t necessarily love CEOs, who jump around from spot to spot. I think that’s maybe the CEO better suited for a transformer if they’re really good at executing a very specific thing and that’s what they do from company to company.

For MercadoLibre, and I mentioned this, their CEO is Marcus Galperin. He’s the founder and started really brilliant, really smart. And I think he’s incredibly long-term focused. That’s the other consideration for us. And what I mean by long-term focused is he’s making a lot of investments today that may hurt his P&L, but I think will be the long run we’ll pay out.

And so when we think about him, he sort of falls into our thesis, our bet on MercadoLibre, right? Because we don’t care about him sort of managing his margins or managing his P&L today. You care about him making the investments that are critical to set himself up for like 5 or 10 years, right? For a company like MercadoLibre, they can worry about margins, in my opinion, in 10 years when they are the leader and there’s plenty of time to do that. And so that’s sort of how the general framing of how we think about management teams, yeah.

Tilman Versch [00:46:38] Let’s sum up the interview, or let’s close the interview with the topic portfolio construction. How does MELI fit into your portfolio and what kind of role do the other four categories play? Do we have buckets that are only 10% Transformers or…?

Lucy Chou [00:47:01] So we use an investment frontier. It’s based on, you know, the efficient frontier in economics. We use an XY chart, and we essentially map two things. The first is an IRR. So we look at three-year and five-year IRR and that’s just off of our base case model.

The second input is a quality score that we come up with, so the quality score is subjective and it’s sort of an output of all the diligence we’ve done and it speaks to our perceived quality of the business but not only that, it also speaks to how much have we and could we have the diligence to the company. As in like if you had a business that we thought oh, this is probably a really, really high-quality business, but we can’t diligence in for whatever or was not diligencible then it brings the quality score down.

And so you sort of map those two things with all of our companies and also companies on our watch list, which are interesting companies but not quite in our portfolio yet. And the idea is to have as much staff, sort of most of our portfolio is composed of things sort of out to the top and to the right. In terms of diversification, so I sort of mentioned this, but most of our names are compounders and shooters, right?

I would say 60 to 70 of our portfolio over periods of time have been compounders and shooters. I would say transformers and cyclicals make up the rest of that. We do not have hard and fast rules in terms of size, sector, or industry.

I think what we’re more interested in is diversifying by tailwind. And so we try to think about the key tailwinds impacting our companies and making sure, you know, they don’t overlap too much. And also, you know, we want to be concentrated, right? We own 10 to 15 names and so, you know, if there’s a tailwind that we love, we want to pick one maybe at maximum two names that we think will benefit the most.

And then obviously just like on a practicality purpose, we do like look at correlations as new names come into our portfolio against our existing portfolio. But we don’t have any sort of hard and fast rules that are just sort of a sanity check for us. So that’s sort of how we think about portfolio construction.

Tilman Versch [00:49:08] And how did MercadoLibre grow into this 25% position of the portfolio or not even grow, was it like recently bought?

Lucy Chou [00:49:22] Yeah. I think it both grew and we have bought more as, you know, our conviction in the company has grown and we’ve also underwritten the model up a few times just as it has outperformed. I think, you know, it’s always been a big position for us from the very, very start.

We’ve always had a lot of connection, but just, you know, recently I think a combination of the opportunity to buy and also its performance over the past year has had it grown. It is one of our, I mean, I would say it is maybe our strongest conviction name and mid to high-level return based on our IRR.

So I think that makes it really, really compelling investment to have it be our largest. The other thing I would add is, you know, for example, those most recent quarters, they had an earnings miss, but they, you know, met expectations on the top line and because of that the share price dropped 15% on that day.

We looked at that and we very much felt that was sort of a short-term margin issue that was not important to the long-term fundamentals. We also felt like, you know, the stock had been performing well over the last year or so and so we took that as an opportunity to invest more. So that certainly has helped grow the position a little bit. But we did have a very sizable position before that as well.

Tilman Versch [00:50:35] And thank you very much for the great interview and your insights for the end of the interview. There’s always the chance to add anything we haven’t discussed or discussed a question we haven’t touched. So do we have something to add?

Lucy Chou [00:50:49] Yeah. So first thing, thank you so much, Tilman. I really enjoyed this chat and also, I just wanted to say, you know, you’re a Good Investing community, what you’ve built and created is pretty phenomenal and amazing.

And everyone I’ve chatted with through, it has been incredible. Second, you know, if anybody wants to watch or wants to follow along, we have a newsletter on our website, please feel free to join. And then the final thing is just, you know, and I sort of mentioned this earlier, but I’m very early on in my career and I recognise that there’s still a tonne for me to learn and figure out.

But at the same time, you know, if anyone’s watching, whether you’re in college or just out of college, you know, and want to chat about anything starting a firm or, you know, advice around banking or public equities definitely feel free to reach out.

I’ve certainly benefited and been privileged to have a tonne of amazing people above me have to do calls and coffee tasks with me. So definitely, you know, if you’re interested in chatting, reach out. I’m available on LinkedIn or via my website.

Tilman Versch [00:51:44] Thank you very much for the kind words the link to the website is below, so it’s just one click away. Thank you very much and bye-bye and also bye to the audience.