Niche opportunities in technology

This article was first published in Cuffelinks, 31 July 2019: https://cuffelinks.com.au/avoid-acronyms-hidden-technology-niches/
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Imagine it’s August 2030. On a crisp winter’s morning you grab a coffee in the morning en route to the golf course for a morning hit with your mates. As you drive from the cafe to the golf course, you reflect to yourself, ‘boy, how lucky am I? This great lifestyle had a lot to do with investment decisions I made 11 years ago. They have more than tripled since 2019.’

Back in 2019, the FAANGs (FAAMGs) and WAAAXs were the talk of the town. They were so hyped up that prices reached extraordinary levels. But now 11 years later, as it turns out, expectations preceded results and whilst these companies grew significantly, returns have been subdued as their growth was already priced in.

Luckily, you weren’t directly invested in these popularised companies. You were able to ride the technology boom without being exposed to the overheated stocks. In hindsight, the perfect window of opportunity to invest in other hidden gems was in 2019.

So where are the areas you need to pay attention to today, beyond the obvious? Is there a way to ride the technology boom without being caught up in overpriced stocks? I’ll share some of the areas I’m focusing on; you’ll see by the end there is indeed a common theme.

In plain sight

Over-popularised stocks always have monikers. They’re WAAAXs and FAANGs now, but in the 1960’s they were the Nifty Fifty. Stocks so over-referenced that commentators needed to coin a shorthand. Piling into an already overcrowded market is not where the value opportunities are.

A lot of the growth to date has been in software, but an area that is developing equally rapidly is personal devices. The next time you catch a flight or get on the train, observe how embedded technology is. How many headphones do you see?

In the US alone, the wireless headphone market is expected to grow 46% and the smartwatch market is forecast to grow 19% this year. Improvements in software have facilitated the ease of use of these devices. As buyers, we also make regular purchases so we can catch up with the advancements in battery life, wireless connection and noise cancellation technologies.

We are increasingly health-focused and that will continue to drive the development of ways we monitor our health. Smartwatches will increasingly shift from being basic trackers to more sophisticated health analysers and predictive medical tools.

Technology is a large but competitive market. It is very difficult for any one company to fully dominate. Natural niches exist. This is where the hidden opportunities can be found. For example, Apple dominates the everyday consumer market, however is less strong in devices for outdoor activities such as aviation, marine or the automotive market. Garmin is a founder-led company that has done well in these markets.

Home is where the heart is

So far technology platforms have focused on connecting people and correspondingly building communities. Over the next decade, the focus will shift towards connecting things. And we are just seeing the start of this with our homes. The smart home market is forecast to grow at 17% this year. Demand for wireless lights, home security, voice-controlled speakers, wifi-enabled temperature controls and smart appliances will continue to increase. Households will need to phase out older technology and energy-conscious consumers will look to mitigate against rising energy prices and reduce carbon emissions.

Companies like Signify NV (formerly Philips Lighting) have taken this one step further. Where else can you apply the same technology used in our homes on a larger scale? Answer? Cities. By installing connected light systems for Shanghai, the city can showcase interactive light displays and realise significant energy savings.

Traditional ‘boring’ manufacturing and engineering companies are often overlooked but yet remain integral and major contributors to technological growth.

Hidden oligopolies

Don’t let the headlines deceive you. Many advanced manufacturers represent great buying opportunities right now; with the trade war and Brexit causing market apprehension, their stock prices have fallen. There are many manufacturers that remain integral suppliers to the technology industry despite what you may read in the headlines. Microchips and glassware are the obvious over-mentioned examples, with Foxconn and Corning being the key suppliers for Apple. But even these companies no longer represent a hidden opportunity. We need to delve deeper.

Many ‘unsexy’ and often overlooked manufacturing companies are trusted suppliers of niche components to the world’s leading technology brands. Historically, global slowdowns have only been temporary. Quality manufacturers have always been able to refill their order book once the slowdown dissipates. The best time to invest in these oligopolies is during periods of uncertainty.

Deeper research can uncover less obvious, more lucrative gems. The hidden opportunities that have stood out to us have been very specialist manufacturers that make product-critical components with very few competitors. These companies control an oligopolistic market because they have scale and switching costs are too high for their customers. For example, companies like Omron, Cognex and Keyence Corporation sell niche sensors, lasers and measurement equipment that feed into the technology sector, benefiting from the growth whilst avoiding the limelight and intense competition.

What does wireless technology rely on?

More and more we are shifting towards a wireless world. All technology services rely on wireless infrastructure and this is an area many have overlooked that I am focusing on. It’s a surprising fact that many countries are still rolling out 4G including the US and India. Moreover, the rollout of 5G networks is only just beginning this year.

We have recently invested in a Swedish cable manufacturer (founder-led, of course) that supplies customised cables essential to the development of telecommunications infrastructure. The continual improvement in technology to improve wireless internet speeds has driven record-breaking demand from its customers.

Importantly, infrastructure requires constant renewal and demand for specialist cables will always follow.

Closing remarks

What will drive your returns to 2030? No doubt technology will play a large part, but history has always shown over-popularised stocks rarely make great investments. It’s usually the ‘hidden’ or non-obvious that represent the greatest opportunities. By the time companies have made it into an acronym, it’s too late.

There’s a common theme for the next frontier of technological growth – the rising importance of not only software, but the hardware and ancillary pieces that will accompany this growth. We still live in a physical world and the hard infrastructure remains an increasingly important medium through which we can interact with technology.

Start your search in the areas above and you’ll be well placed to ride the tech boom without the inherent risks of overcrowding.

Happy compounding.

About us

Specialists in uncovering the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. Our portfolio is made up of stocks that sit outside typical index constituents.

Lawrence Lam
Managing Director & Founder

Data: a different way to discover quality companies

A shortened version of this article was first published in Equity magazine 23 Apr 2019 issue: https://www.australianshareholders.com.au/equity
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With the abundance of data in this digital age, more than ever, private investors have the opportunity to stay ahead of the pack and find rewarding investment opportunities. But it’s not just about access to data.  It’s about being clever and filtering for investment opportunities that others don’t see. In this article I’ll highlight a different approach to generating quality investment ideas by applying a different lens. I’ll also share some common pitfalls I’ve observed and experienced myself.

Start broad

You generally don’t attend an auction and buy a house just like that without having first looked at a variety of neighbourhoods and inspected multiple properties. Why? Because it’s helpful to have multiple data points to compare and consider. Yet in the investment world with even bigger dollars at stake, many investors have, whether conscious or subconscious, preconceived notions about certain asset classes, sectors and geographies. They prematurely make assumptions that constrict their universe without having first considered the wider world of opportunities. How do you know your favourite bubbly is champagne without trying or at least knowing about prosecco, cava or sekt?

The classic illustration of this is a phenomenon known as home country bias. Australian investors collectively hold 66.5% of their portfolios in Australian shares, yet Australian stocks represent only ~2% of the world’s stock market.[1] The same is true even in the US, where US investors allocate 79% of their portfolios to US markets, which although large, comprises only 51% of the world market.[2] Why is that? There is no plausible objective rationale linked to achieving more favourable investment returns by investing in this way. Other than perhaps fear of the unknown and comfort in the known.

Diagram: Despite the small size of the ASX, home country bias still exists[3]

Digitisation of just about everything has made data commoditised. Many private investors today have the same opportunity as the world’s largest fund managers to access global data. This has neutralised the huge informational advantage that institutional fund managers once had. The abundance of quantitative tools such as Morningstar, broking subscriptions, stock screeners and other filtering tools found online has aided the search process. Many of these tools are free. Though there are of course additional paid resources that investors who mean business should utilise. These include Factset, Capital IQ, Reuters and Bloomberg, some of which we ourselves employ at Lumenary Investment Management.

The lesson? There are a world of investment opportunities that exist if you start your search broadly. Begin with the widest available dataset and minimise the presumptions you make, be it geographies, industries or sectors. Start the dataset of your stock screener by capturing as much of the investable universe as you can, rather than having the inclination to filter opportunities out too early.

Know you will underperform

Assuming you’ve found a suitable data source for yourself as a private investor, how do you discover those hidden investment opportunities that others have missed?

To start, investors need to strive to be above-average. Being above-average means thinking and seeing opportunities differently to the rest of the herd. Which means taking a risk. You’re not going to catch alpha by following the pack.

Even though you may be trawling through the same information, that edge over the consensus comes from analysing it different and not having the same assumptions and consequently, conclusions. This is exactly what will lead you to opportunities others may overlook. But be prepared: being different evidently means performing better than others and potentially worse in certain periods.

Only investors who are comfortable venturing from the flock (and by definition, over-performing and under-performing the market average) should consider the below ways to view the world differently.

All companies are the same

Companies should be seen as vehicles for generating investment returns. It shouldn’t matter where the vehicle is domiciled, or what sector it belongs to. Its job is to get you from A to B the fastest by using the least amount of fuel. The outputs of the vehicle and its efficiency is what matters. Many investors can get sidetracked on proxy data, often industry-specific, when what ultimately matters is the profitability, solvency, efficiency of capital allocation, and growth potential of the company.

Counter-intuitive as it may be, yes, you should be comparing apples with pears and making a decision on which ones tastes better. Why sit there and select the best apple out of the orchard, when overall the pear still comes out on top?

Many investors are indeed too fixated on individualised sector-specific metrics when undertaking their stock analysis. To overcome the risk of missed opportunities, retailers should be compared with technology companies which should be compared with manufacturers which should be compared with pharmaceuticals. The metrics of comparison should be the same: the returns they provide the investor.

Using the same data but applying a different lens

In Moneyball[4], the Oakland A’s baseball team developed a specific statistic termed ‘on-base percentage’ and discovered it to be an excellent predictor of player success. Even though the source data was widely available, no other teams read the data and correlation as Oakland. Same data, but a different way of thinking. This difference in perspective gave the Oakland A’s an edge.

as Warren Buffett says, “You never know who’s swimming naked until the tide goes out.”

The same principle applies to investing. Investors should view timeframe as an important differentiator. Whilst most investors filter for a 3-5 year horizon, applying a longer view in your quantitative tools will give you a different lens. Quality companies come to the fore during adversity and the phonies are found out. A valuable lesson for those investors often caught up in bubbles is to increase the horizon of analysis to cover at least one market cycle (typically 8-12 years). A company may look great in over the short-term, but as Warren Buffett says, “You never know who’s swimming naked until the tide goes out.”. At Lumenary, we analyse companies over a 10+ year horizon to avoid the skinny dippers.

Even after you’ve searched and found quality companies, the process isn’t over – it’s just the start. A lot more work still needs to be done and here are some mistakes I’ve made, and have seen others make.

Caution: the common pitfalls

Rigidity

Stock screeners can help investors automatically filter a large universe, but be mindful that they are very black-and-white. For example, if investors screen for a threshold level of profitability, they may miss opportunities if a great company falls just shy of the required threshold. It’s still a great investment opportunity, but you would have missed it altogether. For this reason, we at Lumenary do not use automatic screens. We prefer to manually review financial data which allows us to exercise flexibility and human judgement. Human judgement is what allows us to consider various data sets for how we want to process and analyse it, rather than having a program form conclusions for us.

Price ignorance

Many US investors in the 1960s and 1970s were burnt when they discovered that quality companies didn’t automatically lead to great returns. Surely investors couldn’t go wrong with quality companies such as General Electric, IBM, Gillette and Xerox? The issue, they found a decade later, was that the Nifty Fifty, as glamorised by institutional investors, were quality companies but purchase price was too high. The mantra ‘growth at any price’, isn’t a solid investment strategy. Even when you’ve found a quality company, the purchase price is still an important driver of future returns.

Diagram: The Nifty Fifty experience showed the importance of not over paying.

Ephemerality

When investors search for companies of high quality, they can become attached to particular metrics. As the Oakland A’s discovered, the profitability of rules-based methods diminishes as they become more popular. As more baseball teams adopted the ‘on-base percentage’, the more it became the average and eventually lost its effectiveness. The lesson for investors? Remaining above-average requires a continuous evolution of search criteria to remain ahead of the pack. Predictive models are successful for a period of time, but no universal rules persist forever. Be flexible and fluid to stay ahead of the pack.

Closing remarks

Data is critical for the search of new investment opportunities. For the enterprising investor seeking to be above-average, it’s critical to see the world with a different lens. Use data differently to develop alternative ways to filter stocks and don’t prematurely hinder your search. Quality companies have proven performance over the long-term, so measure them over a longer horizon, otherwise it becomes hard to differentiate the stayers from the sprinters. And just as you’ve discovered a quality company, remember this is just the start of the process. Much more work remains to then consider its competition, moat, management, business strategies and valuation.

Happy compounding.

About me

Lawrence Lam is the Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach.

Lawrence Lam

References

[1] https://personal.vanguard.com/pdf/ISGGAA.pdf

[2] ibid

[3] https://www.visualcapitalist.com/all-of-the-worlds-stock-exchanges-by-size/

[4]   Hakes, Jahn, K., and Raymond D. Sauer. 2006. “An Economic Evaluation of the Moneyball Hypothesis.” Journal of Economic Perspectives, 20 (3): 173-186.

Mindset of an astute investor

A shortened version of this article was first published in Cuffelinks: https://cuffelinks.com.au/mindset-astute-investor/
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Investing is about understanding businesses and as with all things business-related, nothing is ever clearcut. Businesses are comprised of a set of strategies which have been selected and implemented by management. However no one can guarantee the success of a business strategy – not even management themselves. So what hope does an investor have? In this article I’ll explore the characteristics of a certain type of investor who holds an advantage. I’ve termed them the ‘entrepreneurial investor’.

Business owners think differently

In 1947 Benjamin Graham coined the term the ‘enterprising investor’. He outlined how an edge could be gained by delving deep into the numbers to determine the true underlying value of a business. But that edge is harder and harder to find these days. There are simply less cigar butts and more people looking for a free puff. It’s a tough game if you’re only relying on that strategy.

So if studying the numbers won’t give you an edge, what will?  One of the answers I believe, lies in the saying ‘walking a mile in one’s shoes’. If you’ve ever run a business or grown a business, big or small, you have an edge over those that haven’t.  You are an entrepreneurial investor. You possess an understanding of business that can’t be understood through research alone. As important as the numbers are, they are only the first step of analysis. What’s more important is being able to judge which numbers are important and knowing when to use intuition.

So put yourself in the shoes of a founder – someone focused solely on growing the business over the long term. What truly matters to you and how you operate your business will be drastically different to a fly-in CEO chasing a bonus.

If you haven’t owned a business or run a business, all is not lost. You just need to understand a few principles of how good business owners think, then apply them to your judgement as an investor.

Seeing opportunities when conservative investors don’t

Running and growing a business involves the optimisation of multiple levers – decisions about the best allocation of fixed resources for maximum long term return. If you have been in that position, you will know what constitutes good capital allocation

I’ll illustrate this by way of a real life example of a company we are currently tracking. Consider a dominant furniture retailer going through a transition period. After many years of leading the market, lower consumer sentiment has led to a recent decrease in sales. In addition, customers are increasingly heading online for homewares. Investment analysts have punished the stock for its recent earnings decreases. In response to the evolving market, the founding family and majority shareholder recently appointed a new CEO with a mandate to spend significant resources on a new digital online store. This expenditure has led to an even greater short term cost blow out.

Conservative investors would steer clear of this investment. On the surface it seems like a dinosaur industry set for extinction. Investors would look instead for the ‘safe’ cash cow blue chip that pays a high yield.

However for entrepreneurial investors, this represents a clever investment opportunity. Sentiment is low and the stock has not been this cheap for many years. The significant investment in the online store is a shrewd move by the founders. The direction towards digital distribution has been managed prudently and early results are promising. The once-off investment cost has masked the imminent turnaround. This transition represents a sensible opportunity to take a calculated risk.

Entrepreneurial investors understand that allocation to growth projects is not optional, it is a necessity. Risk is part and parcel of improvement. Improvement is not a choice; if you’re not improving, you’re a sitting duck. What’s most important is that the allocation of capital to this project is thoughtfully considered and prudently managed. In this case, this is a favourable risk/reward tradeoff even though conservative investors may see differently.

Betting on moats, not news

Anyone who’s started their own business venture knows that new initiatives take time. Usually longer than anticipated. Jeff Bezos, one of the world’s most successful founders, outlines his thinking on results – “Today I’m working on a quarter that is going to happen [3 years from now]. Not next quarter. Next quarter for all practical purposes is done already and it has probably been done for a couple of years.”

For most fundies, Bezos’s 3 year time frame is too long. Afterall, a fundie could change careers multiple times in that period. Fundies need to pick up quick results and so they favour a quarter-to-quarter game of news arbitrage. Because this approach is short term, it relies on betting on news announcements, rather than betting on business moats. For investors to truly bet on a business moat, they need to allow ample time for the growth initiative to crystallize. This requires patience and an understanding that initiatives take time to bear fruit.

One such business I visited recently in Japan transformed itself from a printing company into a data provider. They now dominate the Japanese food industry – a slow moat-building process which has taken them 10 years to establish. Initially starting by digitising print data for their customers, they developed software that now owns the pricing data of the Japanese food advertising market. Because the moat has taken so long to build, it is very difficult for competitors to erode.

The most important thing in business

Business owners understand the power of human nature. People, when aligned and motivated, can achieve great things. Drive, heart and nous are the most important things in a business but are instead often overlooked in favour of well-credentialed management teams with little vested interest.

When Warren Buffett took over Berkshire Hathaway, it was a struggling textiles business. Although you wouldn’t have backed the original textile business itself, you would have backed Buffett’s ability to change the core business. Great operators with the right motivation will find a way to navigate through any challenge.

Australian visionaries Roger and Andrew Brown (ARB Corporation), David Teoh (TPG Telecom), Andrew Hansen (Hansen Technologies), Frank Lowy (Westfield), Barry Lambert (Count Financial), and Graeme Wood (Wotif.com) have been the heart and soul behind their companies. These founders have demonstrated an incredible ability to compound shareholder wealth i.e. their own wealth. Those who have invested alongside them have been repaid handsomely. They’ve all demonstrated a shrewd ability to take calculated risks and look for hidden opportunities.

Entrepreneurial investors understand that backing the right people is just has important as backing the right business. To do this sensibly, investors need to ensure there is genuine motivation and desire to further the growth of the business for the long term. For this reason we favour investing in founder-led companies.

Closing remarks

Investors with experience owning and running their own business have an edge over the typical conservative investors. They’ve been in the shoes of management. They know what’s important and they’re comfortable backing the right people with carefully considered strategies. They recognise that business success requires continual improvement and calculated risk-taking.

By drawing on this experience and combining it with financial analysis, they have more strings to their bow than the typical conservative investor. There is no better example of a business owner, entrepreneur and investor than the the world’s greatest entrepreneurial investor himself, Mr Warren Buffett.

Happy compounding.

About me

Lawrence Lam is the Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach.

Lawrence Lam

Beyond the numbers: 3 key factors to consider

This article was first published on Livewire Markets
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History’s greatest investments weren’t only decided on calculators. Investing is an art, not a science and the ability to analyse beyond the numbers is how you will make great investment decisions. Although number-crunching is a crucial aspect of valuation, it is not the be-all and end-all of investing. Here are 3 important, but often undervalued company traits you should pay closer attention to.

Who are your fellow shareholders?

Numbers, tables and charts jam-packed into one tight A4 page. That’s what the first page of any institutional stock research paper will look like. But as with all things (including investing), it’s not the quantity of information that matters most, it’s the quality.

One attribute you’ll rarely find in these institutional research reports is the list of substantial shareholders. The shareholders list isn’t considered a key piece of information because it’s not comparable across companies. It also requires more work to dig up and understand the background of each substantial shareholder. In contrast, the price-earnings ratio, dividend yield and earnings per share are easy to understand concepts that can be applied across every company. It makes for easier cookie-cutter analysis, but not necessarily better analysis.

Substantial shareholder lists tell you things that the numbers simply can’t show. They tell you the people behind the company you’re investing in. More importantly, if you dig deeper, you can ascertain what their motivations are.

Businesses (and their success) is driven by people. Owners of the business (people), and the managers they choose to run the business (people), all contribute to how desirable their product or services are to customers (people). The measurement of success in how well these people interact is ultimately reflected in profits.

At the end of the day, people drive profits. Not numbers. Understanding the motivations of people behind a business is a significant clue to understanding the long-term drive of the company.

For instance, take Myer (ASX:MYR) as an example. Founded in 1900, the company grew significantly under the ownership of the Myer family over the next century. But as Myer acquired more businesses over time, it required more external funding and the shareholders register changed significantly. Although numbers improved under private equity ownership from 2006 to 2009, the motivations of private equity firms were very different to its original founders. Looking beyond the numbers was key to avoiding the IPO in 2009.

Predict your customers’ needs

If people drive profits, then profits can only be made if customers are truly satisfied. By investing in a company, their customers become your customers. The happier your customers are, the more they want to do business with you, and the more they will line your pocket.

The numbers-based desktop approach is to predict future revenue by extrapolating the trend of the past few years. This is a useful rudimentary tool but in order to understand the total picture, you should also pay attention to customer feedback. In a global world where customers have expanding choices, customer loyalty is hard to come by. Tastes are fickle. This makes it harder to estimate revenues using only historical numbers. Customer loyalty is best understood by customer feedback, not by extrapolating past numbers. Understand the psychology of your customers and you will understand how your profits will grow.

Many fundies missed the demise of Research In Motion Ltd (now known as BlackBerry Limited TSE:BB). They had taken the revenue growth from 2009 to 2012 (which almost doubled during this period) and assumed that the same growth would continue. Instead, from 2012 to 2015, revenue fell 80%. If the focus had been on customer feedback instead, it would have been obvious that customers never really got used to the physical keyboard – touchscreen was the way to go.

With the wide availability of online customer feedback, it’s not hard to find out what your customers think of the products / services your company offers. Even better, examine the product / service yourself. Do you like it enough to be a repeat customer? Has the company shown a willingness to adapt to feedback quickly?

Extend this qualitative research to employee satisfaction and you’ll get an even better picture of the company’s prospects. Examine the personnel the company is hiring, the skills they are looking to fill, and the feedback from existing staff. This will tell you how they’re looking to grow.

Broadening your field of vision

There are rarely any one-horse races. In any market, there are always multiple competitors, each vying for a stake of the market share. As an investor, we’re not tied down to any one horse. We have the freedom to analyse the field and choose the best horse who will run the best long-term race.

Unlike institutional fundies, nimble investors have the freedom to explore freely across multiple industries and geographies. If your investigations into a company leave you underwhelmed, move on to its competitors. Chances are the original company is only mediocre because it’s facing a successful competitor. Extending this concept, you should explore freely across borders and industries. These days, competition is more likely to come from overseas and other unimaginable industries.

Who could have imagined 6 years ago that a solid company like Cabcharge Australia Limited (ASX:CAB) would face immense competition from a US-based company, let alone a technology company with no experience in the transport sector? Take the blinkers off and move freely across country and sector to find the best horses in the global race.

All listed companies around the world must provide commentary about their performance and outlook on a regular basis. There you’ll find clues about where they see threats coming from. From there you can dig further to discover the emerging horses in their market. Meeting with management has the advantage of better understanding of how they view their competitors, but this is opportunity is harder to come by for individual investors. Instead, company transcripts of Q&A sessions with shareholders will contain a treasure trove of information about their competition. Once you’ve identified the competition, read the competitor’s analysis on the market and you’ll gain the challenger’s perspective.

Closing remarks

The motivations of a company’s owners, the psychology of it’s customers and the strategy of its competitors are key factors of future profitability. These traits are often time-consuming to uncover and the analysis isn’t black-and-white in nature. They aren’t easy to ascertain. But this is where the true value lies. It is this understanding that separates a enterprising investor from those that rely only on widely disseminated numerical data. Look beyond the numbers and you’ll be closer to uncovering the truth. As Peter Lynch says ‘in investing, the person that turns over the most rocks wins the game’. Happy compounding.

Lawrence Lam

Profiting from the “G” in ESG

This article was published in Money Management 7 May 2018

ESG is critical to sustainable outperformance, but where should we focus our research efforts and what are some practical ways to profit from companies with good governance?

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The relationship between ESG and investment returns is a well-studied area. In this article I won’t be rehashing the detail of the research, which, by the way, show a positive link between ESG factors and financial outperformance of companies. Instead, I’ll be discussing the most important factor, governance. This isn’t a theoretical exercise, it’s an exercise in finding factors that lead to lower risk and higher return companies.

Do ESG factors actually lead to outperformance?

In short, yes. There have been many academic studies in this area and 89% of these studies show a strong correlation of companies that demonstrate high ESG ratings and financial outperformance over the medium to long term (3 to 10 years). Deutsche Bank’s paper “Sustainable Investing: Establishing Long-Term Value and Performance” is a comprehensive summary of all studies conducted in this area, conclusively demonstrating that ESG is not only a good measure of the ethical and moral behaviour of a company, but is critical to the long-term profitability of all companies.

Why are companies with high ESG scores outperforming? The findings show that these companies have a stronger reputation, have higher client satisfaction ratings, are more long-term oriented and this virtuous cycle drives continual financial outperformance.

In addition, 100% of these studies found that these ESG companies have access to lower cost of financing. They can borrow at a lower rate from both debt and equity funding sources. Their sustainable approach to business buys them greater freedom and trust from the funding market. The funding market views these companies as lower risk and therefore affords them a lower cost of funding.

ESG is not an exercise in philosophical values. It is a key factor in the long term financial success of companies. For any investor, this represents an attractive and sustainable investment opportunity.

Environmental, Social or Governance – which factor matters most?

All three factors are quite distinct from each other but the factor that is most correlated to outperformance is governance. Academic studies have defined good governance as having a board structure that is transparent to shareholders, having low CEO turnover, having a strong link between performance of management and employees, having a strong commitment to shareholder protection, strong legal protection for investors and transparency of shareholder disclosures.

In a Quarterly Journal of Economics study, Gompers, Ishii & Metrick’s paper “Corporate governance and equity prices” showed an 8.5% per annum outperformance based on an investment strategy that bought firms with a high governance rating and sold firms with a low rating over the period from 1990 to 1999.

From a practical point of view, since governance is the foundation of how all company decisions are made, a strong culture of governance has a flow on effect to a company’s attitude towards environmental and social factors. The G is the primary factor which leads to good decisions about the E and the S.

A different take on good governance

To summarise, ESG leads to outperformance. Of the E, S and the G, good governance is the most important factor. For investors, the pond of companies with good governance is where one should focus on casting a wide net in. All else equal, this is where the greatest probability of profitability will lie.

So where are these companies with good governance? Previous academic studies have focused on identifying the traits of good governance. These are the proof points of good governance, but they aren’t the underlying cause. Good governance is a fluid concept that can be achieved in many ways. The same measurement of good governance cannot be applied across all companies. It depends on a company’s industry, size, shareholder base and competitive environment –  there is no ‘one size fits all’ definition. Ultimately, good governance is having alignment between shareholders and management. This leads to sound business decisions and the proof of this is profit.

So rather than looking for the symptoms of good governance, we should be looking for the diagnosis. It is the cultural DNA of any business that drives its neural network – this is the basis for good governance. From my experience, I have found one key factor common in companies with good governance. The key factor is the influence of its founder. We’re more likely to find companies with good governance if the founder or their family remain influential over the business. This may be in the form of board directorships, management positions, equity holdings or all of the above.

As we review the traits of good governance, we find that founder-led businesses are well placed given their unique cultural DNA.

Transparency to shareholders – shareholders, management and the board may be the same people. Often being a a key shareholder, the founder’s representation at board level guarantees a strong level of alignment between owners of the business and its key decision-makers. Whilst independent representation is important, too much independence dilutes the cultural DNA. Independent input must be encouraged, but final decisions are still made by the founder.

Low CEO turnover – founders or their family may still be involved in managing the company. The CEO, and board of directors may not be the same person, but if they are from the same family then this usually gives a greater level of management stability.

Strong commitment to shareholder protection – founders have skin in the game.  The founder’s long-term financial interests are aligned with shareholders. Alignment is strong if founder-led companies have demonstrated long-term profitability and have held equity over multiple generations. The risk of unfair treatment of minority shareholders is minimised because founders are aligned to shareholders.

The path to investment profit

Today, a large spectrum of founder-led businesses exists. They can range from small tech-startups through to generational companies in very traditional industries. In fact 5 of the world’s largest 8 companies are founder-led. The list includes Alphabet, Facebook, Berkshire Hathaway, Alibaba and Amazon. Globally, there are thousands of companies in the founder-led universe to choose from.

Credit Suisse Top 20 family-owned companies by market cap

Source: Datastream, Credit Suisse Research.

Some will argue that a few founder-led businesses have bad standards of corporate governance and lack transparency. But this may be true of all companies. There are good and bad businesses of all types. Importantly, what is the definition of corporate governance? Are we measuring corporate governance according to a rigid scorecard system, or are we measuring corporate governance based on what truly drives each company? Are we applying a standardised set of traits which don’t account for the unique characteristic of each company? The answer is that traditional ESG scorecard measurements are not a good indicator of good governance because governance is much harder to quantify than environmental and social factors.

In findings published by Credit Suisse (“The CS Family 1000” report), companies where founders or their family with at least 20% influence via shareholding or voting rights outperformed their peers by 4% per annum.

Moreover, they found that although governance scorecard ratings were weaker (only slightly weaker) in founder-led companies, it didn’t matter because the template scorecard measurement was not a good predictor of outperformance – in theory, founder-led companies should be performing badly, but in practice, this wasn’t the case. For example, Google’s scorecard is weak because it does not disclose how its executives are rewarded. However Ebay does, and thus scores higher than Google. But the textbook measurement doesn’t address the underlying cause. Google has performed much better than Ebay not because of it’s scorecard rating, but because it is founder-led.

Governance is a key driver for investment profits, but as an investor, look beyond the traditional rigid definition of good governance and seek out the underlying driver. I have found that founder-led companies the ideal place to start in the search for outperformance.

 

At the time of writing, Lumenary was not an investor in any of the stocks mentioned.

 

Rethinking Blue Chip Investing

This article was published in Money Management 12 April 2018 issue

Not all blue chip stocks are the same. I outline a different way to think about long term blue chip investing.

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Not all blue chip stocks are the same

Blue chip stocks are considered safe investments because they are the largest and most recognised companies in the world. In most cases large companies will be safe investments, however size does not always guarantee safety. In some cases, blue chip companies can become complacent and subject to disruptive competitors which is why investors should be vigilant when investing in traditional blue chip stocks.

Companies that are already very large and have dominant market share need to use their competitive advantage wisely to maintain their market dominance. It is imperative they do not rest on their laurels. For the largest companies in the market, the risk of being surprised by incumbent competitors is much greater than the potential to gain more market share. In other words, blue chip stocks have limited upside but face greater downside risk.

There are many examples of market leaders being made redundant in the current age of digital disruption, but I draw my experience from an example that was played out over many decades. The example is of Eastman Kodak which, in its prime, was the iconic photography company in the world.

The lesson in the Eastman Kodak example is that even the bluest of blue chips are not immune to downfall. The downfall was not due to one discrete event, but was a series of misjudgements by management over several decades. As a long term investor, how do we differentiate between a solid blue chip company and one that will decline over the long term? I think the answer lies in identifying the three categories of blue chip stocks.

Blue chips: the Growers, the Status Quo and the Faders

At the turn of this century, General Electric (GE), Microsoft and Exxon Mobil were the 3 largest companies in the world. Investing in these companies would have generated reasonable returns (GE being the laggard of this group). Fast forward to today and only Microsoft remains in the largest 3 companies list. GE and Exxon Mobil, whilst still considered blue chip, have both fallen outside the top 10.

History tells us that in all likelihood, today’s blue chips will not remain there forever – the dominance of companies is temporary and only as good as their relevance to tomorrow’s customers. The constant evolution of the list of blue chip stocks is much like the rankings of tennis players.

I find 3 categories of blue chip companies that aptly describe their ongoing evolution:

The Status Quo

Most blue chip companies fit this category. These are large companies that will continue to have some form of relevance to its customers. They have established competitive advantages but are capped by a saturated market. The Status Quo will continue performing reasonably over the long term. Microsoft, Walmart, Johnson & Johnson, Nestle and Shell come to mind in this category.

The Growers

These are blue chip companies that do not rest on their laurels. They continue to behave as a young company, spending a lot of money on innovation and reinvestment. These companies are already successful in their own right and are comfortable with new business ventures and their potential failure. This category covers a large group of companies that are usually slightly younger than the average blue chip. Nike, Tencent and Ping An Insurance Group fit within this category.

The Faders

There are a minority of traditional blue chip companies that will become irrelevant over time. They may currently be the largest players in their industry, but historical success becomes their enemy. Size of the organisation inevitably slows down decision making processes and they become fixated on historical business lines. These dinosaurs will fade over time as they become sitting ducks for the Growers. In a few severe cases, they can even disappear into oblivion as we have seen with Nokia, Research In Motion (Blackberry) and Eastman Kodak.

But how does one tell if a company will be a Fader or just merely Status Quo?

Avoiding the Faders

Borrowing from Carl Jacobi’s quote “Invert, always invert”, I like to think about the problem in reverse. If we want to invest in great companies with blue chip qualities, then we should start by avoiding companies that are likely to be Faders. So what makes the perfect Fader?

Complacency

Just like Eastman Kodak, these companies fail to constantly innovate before it’s too late. These blue chips prefer to pay out a large proportion of earnings as dividends, leaving very little for reinvestment. If they do reinvest, they make poor decisions regarding which segments to focus on. They are cash cows focused on yesterday’s businesses. Be wary of large corporates that have below-average levels of reinvestment and very high dividend payout ratios. Management is usually bureaucratic and have very little equity ownership in the business.

Irrelevance

Whilst they may be the largest player in their industry now, Faders operate in industries that can be bypassed. For example, traditional print media companies are losing business to digital advertising. The more complex the business model, the greater the risk of being bypassed. Products or services which are not essential to humans will be irrelevant over the long term.

Too dominant

Investing in a company that is already the dominant market leader is risky – if you’re already at the top, there is only one way to go. Dominant companies have already reached maximum market penetration so the need to innovate new products is even greater. Investing in Motorola in 1994 at the peak of its dominance turned out to be a risky strategy as it was eventually outmanoeuvred by Nokia. Just as Nokia was the dominant leader in mobile phones in the 1990’s, it was usurped by the Blackberry which has now been surpassed by Apple and Samsung. For this reason I am wary about investing in Apple and Alphabet because they are the dominant forces in their industries. There are less risky alternative stocks that still offer the same blue chip qualities for an investor.

The sweet spot of blue chip investing

Investors should not take blue chip stocks for granted. As we have witnessed through history, investing in blue chip stocks does not guarantee safety. By systematically minimising each potential risk, an investor will naturally find themselves attracted to a certain type of company that maximises their chances of exceptional returns. These companies tend to be consistently expanding geographically or through new business lines, won’t have a generous dividend payout ratio and provide a service that will remain valued by society over generations. These companies are more likely to deliver on your blue chip investment objectives – steady, resilient and sustainable investment returns over the long run.

At the time of writing, Lumenary was not an investor in any of the stocks mentioned.

 

Why small to medium sized companies may not be as risky as larger stocks

Risk is dependent on each individual business and its activities, not whether the company is large or small.

Great small to medium sized companies are more likely to be overlooked by large institutional investors, and have more potential for growth.


The risk of investing in a company is determined by the strength of its business model and how well the business is run. Not by its size.

We are often asked for our opinion on whether investing in smaller stocks is riskier than investing in larger ‘blue chip’ stocks. To us, risk is the potential of losing the capital you have invested and from our experience, this is not dependent on the size of a company. Rather, risk is a result of its inherent business model, the competitive industry in which it operates, and how well the managers run the company. We can recall many examples of large ‘blue chip’ stocks which have gone bankrupt. Large Australian companies such as Ansett, HIH and One-Tel were once thought of as safe blue chip stocks. Lehman Brothers and Enron were amongst the world’s largest companies but failed due to excessive financial risk and mismanagement. These examples demonstrate that the riskiness of an investment cannot be generalised by the size of the business. In fact, our best investments have been in small to medium sized businesses that we have analysed with detail. The detail of the financial statements tells us the story of the business, its strengths and possible weaknesses. Only the detail can give us an objective measure of an investments’ true risk.

Pleasant outcomes of searching for small to medium sized businesses

Our definition of small to medium sized companies are those with a market capitalisation of less than $1 billion. Provided we have examined the detail, we favour small to medium sized companies. We have found several pleasant outcomes of doing so.

First, these companies have more potential for growth. These small to medium sized companies are usually younger businesses that have found a competitive advantage in a new industry niche. Compared to large, established businesses (think Telstra (TLS:ASX), big 4 Australian banks) which are established and grow slowly, smaller companies haven’t plateaued yet. They aren’t as heavily regulated and have more potential for upside.

Second, these companies are more likely to have strong founder ownership. The founder may still be involved in the day-to-day operations of the business and has not yet sold off their stake in the business. They are still hungry to see the success of their business. Conversely, large companies have complicated ownership structures and have many conflicting stakeholders to align and manage.

Third, these companies are more likely to be overlooked by institutional investors. Large institutional funds focus on larger companies because they have a lot of funds to deploy and smaller companies are too small for the size of investment they are after.

Provided that we are satisfied with the quality and risk of the business, our experience of investing in smaller companies has been a positive one and we continue to favour them in our search for quality long term investments.

Performance of the overall economy – why it’s irrelevant to most investors

Macro predictions about the performance of the economy or specific industries have limited value to us – we invest in specific businesses, not economies.

Lower risk and higher returns can be made from finding quality businesses in out-of-favour industries.


We invest in businesses, not specific industries or economies. Broad economic predictions have limited value to us

With the start of the new year, experts have put forward a bunch of financial predictions for the next 12 months. Where will the ASX 200 be at the end of the year? How will the property market behave? Will the Australian dollar be much lower than its current levels? Which sectors will outperform this year? Will small caps beat large caps again this year? To us, these are difficult questions that we don’t have the answer to. We have found the expert analysis an interesting read, but not something we are prepared to invest our money in. The poor track-record from the experts demonstrates exactly how difficult it is to correctly predict both the magnitude and timing of financial markets. For instance, ABC’s The Business has an annual review of economic predictions, pitting experts against students – more often than not, students come out on top: http://www.abc.net.au/news/2015-12-04/student-economic-predictions-humble-professionals/7002196.

Not only are the predictive arts extremely difficult and unreliable, we question its usefulness. We invest in stocks, not the overall economy or specific industry sectors. A prediction on the Australian economy, even if it is correct, only informs us of the overall average performance of all stocks, not a particular stock. In sporting terms, a correct prediction for the average time for all swimmers in a race still doesn’t help us predict which swimmer will win that race. We believe in studying the merits of each business objectively without the influence of market sentiment. We have found it useful to have this independent, unbiased foundation to our analysis.

Broad economic predictions inform us of market sentiment – we can use this to our advantage.

Broad economic predictions inform us where the market’s attention will likely be. Quality businesses at fair prices are less likely to be found in industries predicted to boom. Conversely, the market does not focus on out-of-favour industries – this is an ideal environment to find quality businesses at fair prices. We have found that the likelihood of finding a diamond in the rough is greater in these out-of-favour industries. For example, some of our best investments have been in finance businesses following the GFC.

As the pundits continue to issue economic forecasts (and subsequent revision updates that will inevitably follow) we will continue to focus on the main game – the merits of each individual business.

Further reading which may be of interest:

http://www.abc.net.au/radionational/programs/futuretense/why-pundits-and-experts-are-so-bad-at-predicting-the-future/6483666