Circle of Competence Issue #55

March 29, 2019

QUOTE OF THE WEEK

 

"If you are distressed by anything external, the pain is not due to the thing itself, but to your estimate of it; and this you have the power to revoke at any moment." - Marcus Aurelius, Meditations

 

 

FOOD FOR THOUGHT

 

Illumina 

 

I try to read through one 10-K a day as a habit that keeps the boundaries of my circle of competence expanding constantly. Sometimes I come across a company that I like for one reason or another and going forward, I will try to post interesting ideas from time to time. If you are interested in my latest ideas, check out issue 51 on Appfolio and Planet Fitness as well as one of my favorites, issue 33 on (Brookfield Asset Management's CEO) Bruce Flatt's talk at Google.

 

This week, I wanted to share a few notes on Illumina ($ILMN), but first a shout out to Nusair Bawla for the tip as well as David Gardner for connecting us through the Motley Fool podcast!

 

At a high level, Illumina sells genetic sequencing machines, consumable products that are used in the sequencing process, and ancillary services to researchers and clinicians (medical as well as agricultural). In trying to understand a new company in a new industry that I am admittedly a know-nothing in, I have relied on a few reports Nusair sent me to get up to speed on the basics of the genetic sequencing market as well as the latest 10-K. The biggest questions that will impact Illumina as a company in my mind are if 1) the market for genetic sequencing will continue to grow significantly and 2) if Illumina can capture a meaningful, profitable piece of the growth. 

 

Market growth

 

We are just beginning to unlock the potential for genetic research to impact medicine and agriculture as the cost of genetic sequencing continues to fall due to technological breakthroughs from the likes of companies like Illumina. Per Grand View Research's piece on next generation genetic sequencing, the NGS market is poised to grow over 10% annually going forward, with Illumina and Pacific Biosciences leading the pack in terms of installed sequencing machines:

 

"Most service providers employ platforms from Illumina, PacBio, and Oxford Nanopore Technologies."

 

According to ARK Research, genetic sequencing costs could reach the long desired level of $100 per run in the next decade according to Wright's Law of production costs (see below for a great paper on long run predictive power of Wright's Law), which would mean an exponential increase in the number of sequencing runs per year (translated: $$$$ for more machines, consumables, and services). 

 

Competitive Position

 

Illumina is the absolute market leader in terms of sequencing machines, with roughly 75% market share, and Morningstar believes that due to their machines' high throughput rates that potentially up to 90% of genetic sequencing runs come out of an Illumina machine today. Back in late 2018, they also announced a buyout of Pacific Biosciences to compliment their suite of short-read genetic sequencing machines (I'll spare you the technical details, but suffice it to say, they plugged holes in their product offering with this merger). The company generates enough free cash that if there are technological threats on the perimeter of their moat, they have a legitimate option to simply acquire the competitors. They also have the capacity to invest this free cash flow in up and coming startups, as they have in GRAIL, an early cancer detection company. 

 

Valuation

 

As of 3/28/19, Illumina traded at $305/share, roughly 54x trailing free cash flow. They have grown cash from operations at roughly 18% over the past 5 years and EPS at about the same rate. Notably, their returns on equity have been north of 20% for the last 4 years. While the future seems bright for this market leader, the valuation seems a bit rich. But with markets at near all time highs, I wouldn't mind a pullback to open a small position on the cheap. Disclosure - I am not long this security but may purchase shares in the future. 

 

Notes:

 

*Illumina 10-K

 

*As of the 2018 proxy filing, Illumina's CEO owned $20M  worth of stock with most of his salary paid in equity comp and their chairman owned roughly $100M worth of stock, so it seems that they like to eat their own cooking. 
 

 

Yield Curve Inversion

 

As a quick aside, is it time to start sharpening those pencils and raising some cash? 

 

*Ten year treasury minus 3 month treasury turns negative

 

 

WRITTEN WORD

 

- TOP READ: Lyft: a value investor's perspective (Gary Mishuris)

How could you not want to read an in-depth take on a money-losing IPO? Mishuris looks at the company from several angles including the ride sharing market, competitive advantage, management, and financial. After checking into his model at the end, it isn't hard to envision a scenario where Lyft gets to 100 million riders in the next decade as autonomous vehicles hit the roads and car ownership wanes. 

 

The humility curve: investing mistakes and learning (Tim Hanson)

While this piece is dated, it is worth reading Tim's wisdom accumulated over years of investing. The bottom line is that investing must be kept as simple as possible - in Buffett's words, one foot hurdles will suffice.

 

- Top investors' alpha over time 

Someone took the time to put together an incredible graphic illustrating how hard it is to beat the markets by a significant amount over time.

 

- Wright's law edges Moore's law in long term predictive power

Wright's law (better known as the experience curve) seems to be a better predictor of unit economic cost over time as cumulative production increases and can be more broadly applied to various industries over the long run.

 

- What is Amazon? (Zack Kanter)

Deep dive into Amazon's work as a company. This is worth the long read to learn more about Amazon's platform and flywheel effects.

 

- Life capital: a deep dive into income sharing agreements (Erik Torenberg)

Torenberg makes some interesting points about the applicability of income sharing agreements to various industries. The biggest pro for ISAs in education in my mind is that they align incentives of parties who enter into an agreement together: everyone either wins or loses together. No one profits while the other party benefits (like in the current ballooning student debt model). 

 

- D.E. Shaw: inside Manhattan's 'Silicon Valley' hedge fund (Financial Times)

This is a great profile of how man + machine can outperform an algorithm designed to do the same task. Fully automated quant firms like Renaissance Technologies that consistently outperform markets are rare, but hybridization of quantitative/systematic strategies and human discretion seem to be on the rise, with D.E. Shaw leading the way.

 

- Why not appoint an algorithmic AI to your board?

Some tasks like self driving cars are constrained, well defined problems - get from point a to point b without running into other cars or objects and while staying on the road. But other tasks like determining exact wording for risk disclosures or guiding a company for the long term benefit of shareholders are tasks without very firm bounds. It would be a Herculean feat, and require the highest level of artificial general intelligence to be able to serve as a fully functioning director. Not only this, but it would have to be able to explain its decision lucidly - can you imagine being told “you need to fire executive A” but having no idea what the reasoning is behind the algorithm's decision? 


 

SPOKEN WORD

 

- TOP LISTEN: Patrick O'Shaughnessy interviews Michael Mauboussin on the 4 sources of alpha (Invest like the Best)

Great interview discussing Mauboussin's research and sources of alpha in the public markets. The biggest takeaway from this episode for me was his paper on EV/EBITDA multiples and how to think about these valuation tools the correct way. Worth a read!

 

- John Hu interviews Daina Trout (Health-Ade Kombucha)

John does a great job interviewing Daina Trout from one of my favorite new consumer brands, Health-Ade Kombucha. Consumer goods are tough nuts to crack, but in hindsight they always seem so obvious. "Of course there was space in the market for a new healthy beverage like Kombucha!" Daina's story is entertaining and inspiring, especially for women entrepreneurs.

 

- Howard Marks and Bruce Flatt discuss the Oaktree/Brookfield merger (Bloomberg)

These two investors are some of the most astute alternative asset managers out there. When they speak, I like to listen. They seem to believe that their combination will only make their firms stronger.

 

- Barry Ritholtz interviews Roger Ibbotson on the history of finance (Masters in Business)

 

 

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