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

Our foot is now firmly on the pedal

This article was first published on Livewire Markets
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Having spoken to many investors, the most common misjudgement I’ve observed is binary thinking. That is the tendency to think in black and white. Let me share two stories that illustrate why investors are missing out because of this, and how you can avoid the same pitfalls.

Investing with fifty shades of grey

In 2017 a reporter erroneously quoted Howard Marks, saying ‘Howard Marks says it’s time to get out ’.

Howard Marks denied this quote and responded ‘there are two things I would never say. One is “get out” and two is “it’s time”. I’m never that sure. And I don’t think anybody can be that sure.’

Marks further went on to say ‘It’s not a matter of in or out, today or tomorrow, all of which have so much precision and definiteness to them. But rather, think of it as a speedometer from zero to one hundred.’

Investors commonly oversimplify investment decisions based on market trends. This is fine except when investors react in a binary way. For example, popular current examples include ‘‘tech stocks are tanking, I should get out’, or ‘trade wars will last for a while, I shouldn’t invest in global equities’. Blanket thoughts like these are wealth harming. If your concern with the macroeconomy causes you to react this way, you’ll likely miss opportunities.

The lesson?

Right now general sentiment is negative. Human nature impels us to steer clear of equity markets. But don’t think in black and white. You have the option of adjusting your allocation to cash or stocks to capture today’s sentiment. You don’t need to be fully in or fully out of the market. In the past year, we’ve had our speedometer at 50.

But in the past few months, companies we’ve been stalking for a while have fallen into bargain territory. Our foot is now firmly on the pedal and we’re now cruising at 80, having recently snapped up a few quality buys.

Why you shouldn’t read the news

As humans, we are attracted to extreme statements. They capture our attention. We like them because they simplify how we see the world. They give us a short internal summary which we can easily file away in our memory bank. But the world is complex and investment opportunities are not black and white.

Right now all the economic headlines are negative. But it was only at the start of the year that the market was bullish. Headlines change on a dime. Whilst this makes for entertaining reading, they shouldn’t be used to form investment decisions. Journalists are here to sell papers after all.

Instead, investors should focus on the detail underpinning each company. There are always companies that make money even in the most dire economic environments (example below). Excellent investment decisions are made with a scalpel, not a hammer. It is the perception of a company’s prospects that can change overnight, not the actual prospect itself. Actual prospects often take years to play out. So read the company news section, not the economic headlines.

We’ll use Nike as an example given we’re an investor and I’m very familiar with them. Binary investors relying on economic headlines in 2008-2009 exited equities altogether based on 2009 headlines such as ‘The biggest crash since the 1930’s will take decades to recover’ and other similarly extremist views. Nike’s share price fell 20% and yet earnings were increasing through the GFC.

Investors who studied the company rather than the headlines would have reaped a handsome 400% reward over the ensuing 10 years.

The lesson?

There are successful companies in every country and in every economic environment. You just need to look for them. Be influenced by macroeconomic headlines at your peril.

Closing remarks

Investors can’t be blamed for thinking in extremities given recent news. But relying too much on popular sentiment can lead to missed opportunities. As the herd is withdrawing, quality companies are becoming better value.

For this reason, we are stepping on our accelerator.

If you find yourself following headlines, just keep the following quote in mind:

‘No one goes there nowadays, it’s too crowded’ – Yogi Berra.

This doesn’t just apply to industries and stocks, the sidelines can get overcrowded too. Remember it’s not just about Afterpay, or not Afterpay, Aussie or international. Oceans of quality companies in a range of industries and countries are thriving in today’s economic conditions.

If you believe the news, you won’t look twice.

And if you don’t look, you’ll regret missing the opportunities once this hoo-haa inevitably passes.

Pick up your scalpel, and happy compounding.

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