Tag: Publications

When turnarounds work

Posted on by Lawrence Lam

This article was first published in Money Management, 15 August 2019: https://www.moneymanagement.com.au/features/expert-analysis/when-turnarounds-work
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Investing in corporate turnarounds is like buying a broken vintage car. Most will end up in decline, but a special few will be fixed and reward their owners handsomely. When corporate turnarounds work, they yield spectacular returns in the multiples. This is the model private equity firms employ. So can ordinary investors apply the same principles to profit from these special situations? What factors should be considered in the analysis?

Many investors shy away from turnarounds. After all, the company in consideration is usually experiencing historical decline. Think about Qantas ten years ago. From 2008 to 2010, Qantas revenues fell by $2 billion (13% decrease over the 2 years). Add to that an industrial dispute that lasted 2 years, Qantas was a very unpopular blue chip. It’s share price fell by 82% from 2007 to 2012. But we all know what has happened since then. It turned out to be the perfect window of opportunity to invest as Qantas has returned a multiple of 4x total shareholder return since then.

Corporate decline or multi bagger turnaround?

Most corporate turnarounds will not work. These companies have left it too late to adapt to changing business environment. For example, many retail companies reliant purely on foot traffic have realised too late they should have invested heavily in online sales (think J.C.  Penney).

But environmental challenges exist all the time. This is not the cause of failure. It is the inability to adapt and evolve that leads to erosion of a business model. For every J.C. Penney, there are companies like Home Depot that have continued to grow with the market.

As investors, we focus a lot on asking ourselves, “are we being too optimistic? Is this a bubble?” but we should equally consider the flipside, “are we being too pessimistic? Is the stock underpriced?” Opportunities reveal themselves only to those that investigate further.

This was why Warren Buffett invested a quarter of his assets in American Express when its share price halved in 1964. The company had been left with an immense financial obligation after being defrauded by one of its clients. The trust in the brand had been severely damaged and the company was in trouble. Despite this, the clue to the future growth of Amex was in the Oracle’s analysis. After delving deeper, Buffett concluded the fundamentals of the company were robust. Customers continued to use Amex cards and the brand was unlikely to be permanently impaired. The rest is history.

Just because a company’s share price is declining, shouldn’t mean it’s an automatic write off. The very essence of investing urges us to seek out the truth through analysis.

But most struggling companies aren’t like American Express. Many have weak underlying fundamentals. Everyday investors don’t have the ability to aggressively restructure companies like private equity firms. Does this exclude investors from participating in potentially lucrative turnarounds? What are the clues investors can use to determine if these companies will be future multi baggers?

Against the conventional wisdom of corporate boards

Clue 1:

Look for companies with a smaller-sized board with less external directors. Corporate turnarounds require rolling up of sleeves. The board’s role in getting their hands dirty has greater value than being a typical challenger/debater when crucial decisions are required. Executive directors are likely to add greater value in this respect than non-executive directors.

Conventional wisdom dictates that corporate boards should separate the role of CEO and Chair. External independent directors should be favoured. Textbooks say this governance model is how corporations maintain proper checks and balances.

This doesn’t work for turnaround situations. A core ingredient in any turnaround is the minimisation of bureaucracy. The company needs all hands on deck and all hands need to be fully aligned. Often hard decisions need to be made, and made with conviction. This is not the time for board politics; independent directors looking for their next board gig won’t help the situation. Conventional governance doesn’t work in this case because there are too many chefs in the kitchen.

 Surprising research

Clue 2:

Companies that implement ways to grow themselves out of decline are more likely to be multi bagger turnarounds, as opposed to those that reactively cost-cut when times get tough.

Fixing a broken vintage car isn’t easy. It requires correct diagnosis of the issues and then applying the right actions. Most of the time CEOs aren’t focused on the correct areas. Research has shown that turnaround strategies focused on building and growing are significantly more effective than those on cost-cutting[1]. It requires greater courage to launch new products or increase research and development spend in the face of decline. Most CEOs are reluctant to take career risk with this approach when conventional cost-cutting exercises like downsizing can yield immediate short-term improvements.

The right person to lead the turnaround

Clue 3:

Founders are more likely to lead a successful turnaround of their companies.

Crucial to any successful turnaround is a CEO who is resourceful, creative and an adept capital allocator. There’s a certain type that fit this mold well, those founders our fund is very familiar with.

The benefits of investing in founder-led companies are well-known. This is our fund’s specialty. It also happens to be underestimated by many investors. Founders who remain long-term managers and owners of their companies are the best candidates to lead a successful turnaround. Captains of their own leaking boat are highly motivated to repair it permanently rather than jump ship. The Corporate Governance International Review found there to be historically a 24% greater likelihood of success when founders led a corporate turnaround[2].

There are many examples of these types of leaders, the well-known ones are of course Steve Jobs and Howard Schultz. The resurrection of Apple and Starbucks can only be attributed to the brilliant impact of these founders and the heart they had in their business.

A little-known Belgian with the midas touch

Clue 4:

Look for close alignment between board, management and ownership. This is often represented by economic interest or voting rights. Being joined at the hip pocket is a wonderful thing. Strong leaders who stand to gain as much as owners is a strong clue for the likely success of a turnaround.

One media-shy businessman has had an incredible track record of rebuilding companies. Luc Tack hails from a small country town in Belgium called Deinze. I confess that our admiration for Luc’s abilities is biased. Our fund is invested alongside him and we stand to benefit from his nous.

The son of an operator of a small flax factory, it was 1979 when young Luc saw an opportunity in the growing Belgian furniture market. But it wasn’t selling furniture itself, that was far too competitive for Luc. The real opportunity was in supplying the wood instead. So the 21-year old flew to the United States, secured a wood supplier and founded a company called Oostrowood.

As he later recalls, his long-term business mindset came from his mother who always said to him, “do not cackle, lay eggs”, and laying eggs he did.

By the nineties, Oostrowood had transformed itself into a wooden flooring company and Luc began moving into an equally unsexy industry – textiles. Weaving mill companies Ter Molst and Oostrotex were eggs laid in the nineties that would later prove crucial to Luc’s future success.

On the back of the success of his diverse businesses, in the early 2000s Luc took majority control of a struggling weaving loom manufacturer called Picanol. It was 2009 and the quiet entrepreneur pumped 15 million euro into the then-ailing company that was on the verge of bankruptcy. No one else believed in the company at the time. It was a neglected manufacturing business riddled with internal division and hadn’t adapted to the changing market.

His first objective as CEO was to turn a profit. He announced that for as long as the company made losses, he would not pay himself a salary. He suffered for only one year. Since his tenure, the company has increased its revenues by 2.5x and almost tripled its net profit.

To this day, Luc Tack sets himself a measly salary of 100,000 euro each year. His focus remains firmly on laying eggs.

In closing

Investors can make a lot of money from corporate turnarounds and have lower risk as prices are depressed. The clues above help you to see whether a company has the heart, stomach and brains necessary to change their fortunes. Sometimes things aren’t as dire as we think.

Happy compounding.

About me

Lawrence Lam is the Managing Director & 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. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

[1] Abebe MA, Tangpong C. Founder‐CEOs and corporate turnaround among declining firms. Corp Govern Int Rev. 2018;26:45–57. https://doi.org/10.1111/corg.12216

[2] Abebe MA, Tangpong C. Founder‐CEOs and corporate turnaround among declining firms. Corp Govern Int Rev. 2018;26:45–57. https://doi.org/10.1111/corg.12216

Lawrence Lam
Managing Director & Founder

Niche opportunities in technology

Posted on by Lawrence Lam

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

Investing like Howard Marks during the GFC

Posted on by Lawrence Lam

This article was first published in Livewire, 29 April 2019: https://www.livewiremarkets.com/wires/investing-like-howard-marks-during-the-gfc
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Great investors have an uncanny ability to find attractive investment opportunities in any market. During the depths of the GFC when fear of the unknown paralysed most investors, Howard Marks, co-founder of Oaktree Capital Management, invested an average of USD $625 million per week during 2008-2009. A shrewd (and profitable) decision in retrospect, it was far from an easy decision at the time. Headlines from the Wall Street Journal read ‘Worst Crisis Since ‘30’s, With No End Yet in Sight’. Yet through those dark days, investors that found opportunity in that moment have been rewarded in multiples.

The climate today is one of uncertainty and hesitation. Market commentators have been referring to the current cycle as ‘it’s currently three quarter time’, implying we are 75% through the market cycle, with one quarter remaining before an impending downturn awaits. I don’t ascribe to this view. The issues with this mindset are two-fold. First, investing is not a football game – there is no guarantee of four precise quarters. Second, profitable companies exist in all market cycles, even in recessions. In fact, exceptional companies expand market share from competitors during downturns. Adversity is the friend of great companies but the enemy of the mediocre. In investing, many players can continue kicking goals even after the final siren.

The opportunity to invest like the 2008 Howard Marks exists today. As Mario Gabelli (founder of GAMCO Investors) says ‘If you don’t look, you won’t find’. So how does one find the hidden opportunities that others are blind to?

As Mario Gabelli (founder of GAMCO Investors) says ‘If you don’t look, you won’t find’.

Trade wars, Brexits, slowdowns and other red herrings

To find the diamond in the rough, you must first be open to looking for them. It is a great temptation to many investors to abandon the search for opportunity when faced with today’s latest headlines. But the more investors that abandon the search, the greater the reward for those that continue. The only relevance that headlines might have, is their effect on pricing, not on the value of the opportunity itself.

I’ll illustrate what I mean by way of example. We’re an investor in an advanced manufacturer domiciled in Hong Kong with a market capitalisation of USD $500m. On the face of it, an advanced manufacturer with plants in China and customers in the US doesn’t have a bright outlook. The ongoing US-China trade war would be a concern to most investors. However for opportunistic investors, the hidden opportunities present themselves when you look beyond the macroeconomic red herrings and delve deeper into actual business-related facts. After all, we are investing in companies, not economies.

This lesson was reinforced for me when I spoke to to the CFO of the company. It turns out the newly-imposed 25% tariff only applied to 7% of total revenues. Actual business impact was minimal. In addition, he told me one of their largest customers, Google, had instructed them to ship their finished products to Taiwan instead of the US. By doing this, Google would be able to bypass the impact of the tariff. Importantly, it is easier for Google to change the delivery supplier than to change the manufacturing supplier.

So what does this example highlight? We invest in businesses. Not economies. Therefore investment decisions should be based on business-related facts, not high-level economic facts. You won’t find the hidden opportunities if you’re distracted by the red herrings. For most investors who choose to wait until the macroeconomic dust settles, the hidden opportunities won’t exist anymore.

But don’t complain the next time you hear someone provide a macroeconomic reason to justify their decisions. It is their approach that provides us with the mispricing and the very existence of that limited edition piece that no one even knew about.

Mining for gems

Silent opportunities can often be found in the detail that others overlook or don’t take the time to see. This was one of the free kicks our fund benefited from when we invested in a Belgium-based weaving loom manufacturer with a market capitalisation of EUR $1.5 billion. On a standalone basis, I was already more than satisfied with the success of the weaving loom business. Tick. The company is led by a motivated and intelligent entrepreneur. Second tick. This company also owns 38% of a EUR $1.5 billion chemicals company. On my continued mining, I discovered that this 38% holding was recorded at book value. This is a crucial detail. It means that the assets of the weaving loom manufacturer reflect the price it paid when it acquired the chemicals company years ago, not the current market value. It is akin to buying a house, then discovering upon moving in there is treasure hidden in the backyard. Triple tick. Following further investigations, I was pleased that the hidden treasure was real and it was undervalued by the vendor. A bonus sweetener for an already quality house.

But don’t complain the next time you hear someone provide a macroeconomic reason to justify their decisions. It is their approach that provides us with the mispricing and the very existence of that limited edition piece that no one even knew about.

Closing remarks

Rare stones exist everywhere. In order to find them, investors must ignore the red herrings and remain open minded even when situations seem most dire. Opportunities are most plentiful during uncertain markets but if you wait until the dust settles, everyone is looking at the same thing with 20/20 vision.

Adversity is the friend of quality companies and an enemy of the mediocre. The experiences I’ve seen demonstrate why it pays to keep searching for facts that relate to the company, not the economy. The more you focus and seek out opportunities, the greater the odds stack in your favour.

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

Posted on by Lawrence Lam

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

Posted on by Lawrence Lam

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

Posted on by Lawrence Lam

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

Posted on by Lawrence Lam

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

Picking better eggs and baskets

Posted on by Lawrence Lam

This article was first published on Livewire Markets
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In this wire, we discuss building a diversified portfolio without sacrificing on returns. Not only is it essential to diversify your eggs across different baskets, it’s equally important to make sure you’ve got concrete eggs and steel baskets.

Focus on defense, but don’t forget about your offense

Given the current focus on regulation and risk management stemming from the Royal Commission, it’s not surprising to see most funds err on conservatism with their approach to investing. Willingness for fund managers to deviate from industry norms with asset allocation or stock selection is at all time lows. I’d like to highlight that there is nothing wrong with this approach. In fact it’s perfectly understandable given there is no incentive for salaried fund managers to punt one’s career unnecessarily. It’s safer to stick with commonly accepted mainstream trends. However the result of this is herd behaviour often represented by portfolios with an over-diversified soup of stocks that closely resemble an index Exchange Traded Fund (ETF). You’d expect to be getting average returns if you’re sticking to the herd.

Whilst the focus on risk management is important, there are many ways to achieve this without blindly increasing the quantity of stocks in your portfolio. For enterprising investors, just because you’re focusing on downside protection doesn’t mean you should lose focus on your offensive game. We’re here to make money. So we need to find the optimal trade-off between risk and return. I’d proffer this balance is not optimal in a portfolio with hundreds of stocks. So what’s the right balance? Here’s some food for thought below.

You are already life-diversified

From a life perspective, you are most likely quite diversified already. If you own a home or investment property, you already have significant exposure to property. If you have an offset account with your mortgage, you will already have exposure to interest rates. If you have a mainstream superannuation account you will most likely be highly diversified already – ‘balanced’ funds typically hold thousands of investments across all asset classes. If you run your own business, then you have already dedicated significant personal funding and time to one equity investment. If you’re employed full-time, your wealth is strongly linked to your employer and the industry they’re in.

As you can see, even before you’ve started actively investing, you will likely have exposure to specific asset classes and industries. When it comes to stock market investing, you should consider filling the gaps in your life. For example, if you’re employed by an Australian company, focus internationally. Start by looking for stocks in different geographies and industries for companies that you aren’t already exposed to.

Your customers will protect you

The stocks in your portfolio have customers and these people and businesses are your customers too. They are the ones who will protect you from the next downturn.

Your customers should be widely dispersed across the world. Your customers should also be diversified across multiple industries and product lines. The trap that professional fund managers fall into is they become sector specialists. They become biased towards one industry with a concentrated set of customers. As an individual investor, you have the freedom to float across industries and capture the most loyal customers of each country in each sector.

For example, Fuchs Petrolub (FPE.DE) is a boring family-owned company in Germany. It also happens to be the largest independent lubricant manufacturer in the world. Fuchs makes custom lubricants for industry-critical machines. They service customers all over the world in all industries ranging from manufacturing, auto, aviation, construction and racing. For as long as friction exists, there will be a need for lubricant. By investing in just one company, you’ve accessed a loyal global customer base diversified across geographies and industries.

Think of the underlying customers in your portfolio as adding a layer of reinforcement to the shells of your financial eggs, and giving you further protection against a falling market.

The false comfort of quantity

Conventional practitioners of diversification are uncomfortable with a portfolio consisting of a small number of stocks. They believe there is a magic minimum number of stocks they must hold which will protect their portfolios from any downside. In reality it is the quality of your holdings which is far more important than the quantity. As we saw in the Global Financial Crisis (‘GFC’), when markets crash, all stocks crash. It doesn’t matter how many you hold.

Quality companies are the ones that will bounce back quickly from downturns. These companies have loyal customers and their products or services will always remain valued by society. They will continue to generate profits through any macro environment. Quality companies will have a prudent attitude towards debt so are unlikely to default.

Instead of focusing on reaching a magic number of companies in your portfolio, focus on the goods or services each company offers. Focus on the quality of their product offering. How essential to society are their products and services? A quality company will have customers continuing to buy their products through any cycle.

Concluding remarks

The mainstream approach to diversification states that purchasing a large number of different stocks is the safest and best-performing choice regardless of market conditions. Followers of this approach seek to build a financial safety net by gathering together many stocks. The trap here is that over-diversification of your stock portfolio is neither an effective safety net in difficult times nor an optimal growth strategy in good times. While it is sensible and valuable to seek a variety of investments, there comes a point when blindly adding to the quantity of different stocks you own does little or nothing to improve the quality of your portfolio.

Remember, your ultimate aim as an investor is to make money in a way that effectively balances risks and returns. Rather than following the conservative herd, you should begin by looking at your stock portfolio within the context of your financial life as a whole. Avoid the temptation to acquire ever-increasing numbers of stocks. and devote yourself to seeking a limited number of high quality companies.

The aim of a well diversified portfolio is to serve as wide a range of loyal clients as possible by investing in as small a number of companies as possible. Rather than focus on more eggs and more baskets, focus on choosing concrete eggs and steel baskets.

Happy compounding.

3 ways you can beat the fundies

Posted on by Lawrence Lam

This article was first published on Livewire Markets
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It’s ironic I’m writing my first wire to outline techniques you can use to beat professional fund managers. The fact is, most people assume that professional fund managers have an informational edge over everyday investors. This isn’t true.

These days public information is so widely available and accessible that seeking out detailed information on any listed company isn’t that hard.

Some think fundies have access to meet with company management which gives them an additional informational advantage. This is true only to an extent. The edge is in the ability of fundies to eyeball CEOs and get a sense of the qualitative aspects imperative to a successful business, like culture. But that aside, from an information perspective, these days transcripts of analyst calls can be easily found online. Even if there are meetings, CEOs will always tow the company line and tell fundies what the market already knows.

The only other advantage fundies have isn’t informational. It’s time. They have time to dig out the information because it’s their full time job. But you’ll be pleased to know that there is a finite set of information available. Just because they spend 10 times more hours researching a company doesn’t necessarily mean they have 10 times the advantage over you. There’s only so much relevant information available. At the end of the day, one person still has to synthesise it all and make a call.

As long as you dedicate the appropriate time to turning over the rocks, you can do just as well as us fundies.

Assuming you have the time and patience to do this, here are 3 ways you can beat the fundies at their own game:

1. Ignore the noise and seek out the true source of information

Focus on facts first. Don’t get distracted by macro themes and economic forecasts. Forecasts and thematic investing make for great newspaper reading, but they aren’t factual. It’s based ultimately on others’ opinions. The closer you can get to the true source of information, the better quality information you’ll have to make decisions. You are investing in stocks after all, not economies. And if you look hard enough, you can always find companies that will grow through all types of economic environments.

So instead of reading others’ opinions, your time is better spent understanding a company. What are its business lines? What products do they offer? Who are their customers? What advantage do they have over their competitors? You can find this all online. Start with the current annual report. Then go back historically to see if management have delivered on its original plans. Management presentations, substantial shareholders lists, remuneration and KPI information should all be available on a company’s website. If you find the details about the firm’s activities too complicated, you should move on to the next company.

Social media platforms can be a great source of customer information. Check feedback from customers. How do staff feel working for the company? This information isn’t hard to find. It’s a matter of dedicating the time to it. Spend more time with the true source of information and less time on others’ opinions.

2. Fish in under-fished ponds

Fundies face many structural constraints that you don’t. Larger fund managers are incentivised to spend more time managing the risk of their business, rather than their portfolio. They end up reverting to herd mentality. You can see this when fund managers hold the same stocks, in the same markets.

As a private investor, you don’t face these same constraints. You have the freedom to search in other sectors/markets. You don’t have to find sexy stocks. Boring stocks can be just as profitable. Notice the latest fad and and start your search in the opposite direction. Find companies that have a small public share float. These are founder-led companies where the owners still own a significant portion of the shares. Large fund managers must deploy their capital and companies with small public share floats just won’t capture their attention.

Your advantage is entering into an under-researched trade so you can maximise your chances of finding a good company at a reasonable price. For Australian investors, it’s very easy to get the full list of companies on the ASX sorted by industry on the ASX website. The significant shareholders list is provided in every annual report.

Besides from searching based on sectors, you can look for opportunities in other international markets. Start with markets that others aren’t talking about. There are many free and paid online tools that you can use to find solid companies in these markets. Most allow you to apply a filter that you can use to research further and narrow down your choices to just a few. Take advantage of these little-known companies with less analyst coverage. As the company lays down its promising business expansion plan, you could be in the privileged position of paying the undervalued price before it makes its ultimate positive earnings announcement. Thus, you’ll beat the fundies who will have to deal with a crowded market later on.

3. Focus on quality, not quantity

Fund managers have a business to run as well as a portfolio to manage. Their priority is to spend time marketing to increase the size of their fund and therefore fee income. As they become larger, they are forced to deploy more money in the stock market. Inevitably they can’t spend too much time analysing any one company. Instead they start with the market index and tilt according to which sectors they think will do well. This leads to bloated portfolios that correlate highly with the index. This approach to investing won’t give you significant outperformance – it will give you average returns.

Since you don’t have these constraints, take your time to seek true quality in companies. Start from the ground up and focus on quality over quantity. A concentrated portfolio of solid companies you know intimately will perform better than a scatter-gun portfolio of thousands of stocks you haven’t spent much time understanding.

Concluding remarks

To overtake a car, you can’t drive in the same lane. Don’t assume that fund managers have a huge advantage over you. In fact, they face many structural constraints that you don’t. Choose a different but wiser approach to investing in the stock market and you can beat the fundies. Rely less on hearsay and develop a culture of getting factual information directly from the reliable source. Analyse all the information at hand and focus on quality over quantity. Be patient and be willing to invest in non-mainstream brand name companies. If you approach investing the same way as everyone else, you’ll get the same outcome as everyone else. Happy compounding.

Profiting from the “G” in ESG

Posted on by Lawrence Lam

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

Posted on by Lawrence Lam

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.

 

Sensibly Predicting the Future

Posted on by Lawrence Lam

A shortened version of this article was published in Money Management 15 February 2018 issue

 A practical framework for analysing the future prospects of a company, without getting carried away with market sentiment.

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In this article I want to outline a framework for assessing the future prospects of a company. This controlled framework of thinking will maximise the chances of picking great investments. Importantly, it will minimise the chances of getting carried away with overly optimistic or pessimistic opinions and potential misjudgement.

 

It’s essential to form an independent judgement rather than rely on the views of others, otherwise the risk of herd mentality increases. Unlike in the African savannah, staying with the crowd does not guarantee safety in the financial world – in fact history tells us that following the financial herd can be extremely risky.

So whilst I don’t profess to be able to predict the exact future earnings of a company, I do offer a way of thinking which may assist an independent thought process. The end goal is to make sound investment decisions which will hopefully lead to long term profit.

First separate facts from predictions

Donald Rumsfeld once said “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know”

This is not only true in politics, but also in investing. Information about a stock allows us to determine its true value. This information can either be in the form of facts or predictions. Facts are proven pieces of information and should form a core component of determining value, whereas predictions are not guaranteed and come at a greater risk. Less faith should be placed in predictions. The first step is to recognise factual information from predictions / assumptions.

Mixing both fact and prediction taints factual information with subjectivity. For instance, Nike Inc is a world leader in sports shoes and clothing (fact). Given its market leading position, its sales should continue to grow at roughly 8% p.a as it has done for the past 5 or so years. The second part of the statement is a prediction. The amount of revenue growth it will achieve is not clear and not guaranteed. Although Nike is an innovative company that constantly reinvests in research and development, there remains a level of uncertainty that needs to be acknowledged.

The first step of sensibly predicting the future is to determine today’s value based on today’s data. Assumptions can be made but do this separately and attach a separate value for assumptions. Without distinguishing between fact and forecast, we can’t be clear on how much of our decision is grounded in fact or based on blue sky assumptions.

Start with the facts, not opinions

Any prediction of the future should first start with today’s facts. For a company, the current value can be determined with great certainty based on the facts presented in a company’s financial statements. Investigate any other hidden value the company might have. For example, does it have any subsidiaries that need to be revalued? Other assets such as land or options which aren’t regularly revalued may also be a source of hidden value. Companies may also have secured long term contracts with its customers which will have value. Today’s facts should lay the foundation for the overall analysis of a company’s future prospects. At this point, make no assumptions yet, this is the next component of the company’s value.

Nike is a powerhouse brand, its low level of debt and its continuing pipeline of patented technologies is a genuine intangible asset that is a threat to any competitor contemplating entering the sports shoes market. It also has a strong culture through the everlasting spirit instilled by founder Phil Knight via his holding company Swoosh LLC.

To value Nike, we should start by focusing on existing facts and ignore any predictions for the time being. Assuming no future increase to its 2017 reported EBIT, my estimate of value for each Nike share is USD $25-$28. This value is my estimate of what Nike is worth based on its most recently announced earnings – no blue sky assumptions at this stage.

Forecasts – the possible, plausible and probable

The difficulty with predicting the future is because history doesn’t repeat itself. But for certain companies and industries, forecasts can be relatively stable. For example, Nike competes in markets that are more mature and stable than tech companies like Amazon. The markets that Amazon competes in are new and evolving, whereas the demand for sports shoes is relatively stable – weekend warriors will continue to compete in their favourite sports.

Leading New York University finance scholar Aswath Damodaran favours the use of three categories when evaluating a forecast: possible, plausible and probable. By evaluating a forecast as either possible, plausible or probable, it becomes clearer to an investor how much reliability should be placed in any forecast.

In the case of Nike, whilst it is possible that new competitors will take market share away from Nike, I think this is not a plausible scenario over the next 10 years.

The probable outcome is that Nike will remain ahead of its competitors Adidas and Under Armour. It will remain a strong brand through its innovative founder-led spirit and its product lines will continue to expand.

I think it is probable that Nike will continue to grow revenues at an average rate of 8% p.a over the long run and continue to generate it’s very high returns on invested capital (currently around 25%-30% p.a). By separately valuing the growth component of Nike, I think that Nike is worth around USD $60 to USD $65 per share (an additional USD $40 for growth), compared to its current stock price of around USD $59.

A sensible approach to the unknown unknowns

The current value of a company (based on today’s facts) combined with the forecast (taking into account likelihood) gives us a holistic prediction of the company’s future value. This framework minimises the risk of misjudgement but it doesn’t eliminate the risk of unforeseen circumstances – the unknown unknowns.

Unknown unknowns such as wars, political crises, natural disasters may strike and disrupt the original forecasts that were made. These risks will always exist and shouldn’t prevent a sound investment from being made.

Unknown unknowns will always exist in the financial markets. Even the most sensible predictions are never guaranteed. One way to approach the unknown unknowns is to judge how likely the company is to survive any external shocks. Unknown unknowns will affect all companies, but those with low debt, strong market positioning and quality management will survive these unforeseen shocks. These are the attributes I look for to buffer against the risk of unknown unknowns.

Applying the framework

The framework for predicting the future can be thought of like a tree. The current facts form the roots and trunk, forecasts form the branches and the unknown unknowns form the leaves. Sound predictions will be grounded in a solid foundation of facts. Forecasts should be used, but only if the likelihood is high. Uncertainty will always exist but if the prediction is grounded in a solid foundation of facts, it will be clear what impact unforeseen circumstances may have on the prediction.

Be wary of placing too much reliance on predictions and promises of performance rather than proven factual results, especially in volatile environments. Sound investment decisions are rarely made purely on blue sky predictions.

In the case of Nike, my valuation is currently based on a strong foundation of facts demonstrated by its impressive track record and dominant market position. I have estimated the value of the company based on its current financial performance. This forms the basis of the valuation. An additional portion of value is attached for probable growth which is distinct to the base value. It is clear how much reliance I have placed in fact versus prediction. Whilst there are no guarantees in the financial markets, for a company like Nike, I get added comfort that it should be able to withstand any unforeseen risks due to its low level of debt, strong brand and founder-led culture.

This framework doesn’t guarantee investment returns like the sports almanac, but it does provide any investor with a way of thinking about the future in a sensible manner.

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

 

Compounding: the not-so-secret sauce to extraordinary returns

Posted on by Lawrence Lam

Published in Money Management magazine 14 September 2017 issue.

Lawrence Lam looks at why compounding should not be overlooked for investors with a long investment horizon during a low growth environment.

Since 2013 we’ve been told by financial forecasters to expect a new world of low earnings growth. We’ve been told that the economic challenges in the US and Europe combined with deceleration in China has led to a new shift in economic paradigm – the “low growth environment”. Investors should temper their return expectations and respond by focusing on high-income assets such as bonds, infrastructure investments and high-dividend paying stocks. In short, capital growth will be hard to achieve, so the advice has been to focus on seeking yield/income generation instead.

For investors with a long investment horizon, I offer an alternative view. I highlight why investing purely for yield overlooks one of the most powerful and not-so-secret concepts in finance – compounding. In this article I’ll highlight why focusing on compounding can lead to superior long term returns.

Compounding – the eighth wonder of the world

Einstein once said “compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t, pays it.” A few centuries earlier, Benjamin Franklin wrote “Money is of a prolific generating nature. Money can beget money and its offspring can beget more.” The advice given by Mr Einstein and Mr Franklin holds true even in today’s uncertain economic environment. In essence, the value of a dollar invested does not grow in a straight line. It grows exponentially. So an investor can truly harness the power of compounding by remaining invested for as long as possible, allowing returns to hockey stick in investments that have the highest return. The below chart from JP Morgan Asset Management visually illustrates the power of compounding.

Firstly, the chart shows that by consistently reinvesting, the value of an investment grows exponentially. The more money you have working for you, the more offspring it will beget you. The weakness of focusing solely on yield is that one ignores the value of reinvestment and instead values withdrawing cash from the investment. In the process of blindly searching for yield, one overlooks one of the greatest advantages an investor has. For an equities manager, instead of focusing on stocks that pay out a large portion of their earnings as dividends, the power of compounding can work in your favour if you select stocks with high rates of capital reinvestment.

For these stocks, cash is retained in the company rather than paid out in dividends. Provided the cash is used sensibly in value-adding reinvestments, it continues to compound at a much higher rate within the company rather than being paid back to investors as cash. So why choose to receive cash now when keeping the money invested generates a higher return?

Total shareholder returns: dividends or capital growth?

Unless you are a retiree or have a strong preference to receive cash, a sensible investor would choose to keep their investment compounding at high rates rather than be paid out. This holds true especially in today’s low interest rate environment. Dividends paid out as cash earn low single digit returns, whereas keeping the money on the compounding train yields the return on equity being generated – most likely higher than current interest rates if the stock has been carefully selected. So although the investor receives less cash now, the money is reinvested back into the company to develop new products, innovate, expand the business, and ultimately increase the intrinsic value of the stock.

So if an investor has a long term horizon and does not have a strong need for cash, they would choose to invest in great compounders where high rates of reinvestment lead to intrinsic value growth, as opposed to cash cow stocks that pay high yield and therefore unable to compound significantly. Total shareholder returns should be the focus, not just yield.

Compounding is even more important in times of uncertainty

The focus on yield comes from the rhetoric that we are in a time of unprecedented uncertainty in global politics, markets and economics. Established companies with long histories are subject to disruption and it has become increasingly difficult for companies to grow earnings. If we take a longer term perspective we can see that this simply isn’t true. For long term investors it would be dangerous to act on these short term economic forecasts.

The chart below shows McKinsey’s study of the average historical rate of return on invested capital (ROIC) from 1963 to 2004 of 7,000 publicly listed non-financial US companies.

ROIC is an indicator of how effective companies are at generating returns on their capital reinvestments. For investors in companies, it is a proxy for the rate of compounding they can expect if a company was to retain its earnings rather than pay them out as dividends. Since 1963, we have had numerous wars, oil shocks, the introduction of the internet and multiple economic cycles over this long term period, the fact is that average ROIC has remained stable. Companies retaining cash to reinvest in their business have generated a return of 7% to 10% regardless of the macroeconomic environment.

History doesn’t repeat, but it does rhyme. And the weight of history tells us that companies will continue to compound at much the same rate. Especially in these times of technological change, it is important for companies to reinvest to adapt to new competitors to drive future growth. Now is the time to invest in companies focused on growth and reinvestment, not cash cows that return high yields.

Harnessing the power of the compounders

The ‘low growth’ rhetoric isn’t a mindset we ascribe to. On the contrary we remain optimistic about the long term prospects of quality companies. We take a long term investment strategy, we aren’t desperate for cash and would much prefer to maximise total returns rather than simply focusing on yield and miss the benefit of compounding.

The challenge for most investors is not to seek the shelter of yield in times of uncertainty, but it is to find those investments that will continue to compound over the long term.

The historical ROIC from the chart above is an average of US companies. Knowing that history is in our favour is one thing, but fully capturing the benefits of compounding still depends on being able to select specific companies to invest in.

There are many ways to do this and I’ve highlighted only one way in this article via the ROIC. Another way to identify quality compounding investments is to align with quality management. A company’s ability to compound depends on its management’s ability to recognise new markets and execute growth strategies for the long term benefit of the company.

It also depends on the opportunity set available to each company and for this reason it is worthwhile for most investors to consider looking at the entire universe of companies on a global scale. The chances of finding great compounding opportunities is much improved by looking beyond local borders.

For those investors currently focusing solely on yield, you might be unnecessarily narrowing your investment options and missing out on some great compounding companies. They may not be great yield investments, but you’ll have the exponential force of compounding working in your favour instead.

 

Lawrence Lam is Founder & Portfolio Manager of Lumenary Investment Management, a global equities investment firm focused on investing in international founder-led companies.

www.lumenaryinvest.com

How recognising value can help you construct a robust portfolio of quality stocks

Posted on by Lawrence Lam

Published in Money Management magazine 6 July 2017 issue.

Enterprising investors should distance themselves from the crowd by investing heavily in valuable companies for long-term returns, Lawrence Lam writes.

The fundamental question that drives long term investment decision makers is how best to allocate their capital for optimal returns.  So for those investment managers or fund-of-fund managers investing in the equity markets, their ability to recognise and allocate capital to valuable companies, or align themselves with fund managers that can, will drive investment performance over the long run.

In this article, I outline my approach to recognising valuable companies. This is a framework of thinking based on investing as though the entire business is being purchased, as opposed to viewing a stock as just a price that fluctuates on a stock exchange. When we invest, we back companies, not stock prices.

Investing in valuable companies is profitable

The pursuit of allocating capital to valuable companies is driven by the objective of profit and investment performance, it is not a theoretical exercise of proving corporate best practices. A portfolio of valuable companies will hold up much better in market downturns and be more resilient against incoming disruptive competitors. Since company value drives stock price in the long run, being able to recognise these valuable companies is highly profitable.

Characteristics of a valuable company

A valuable company is one that provides a product or service that its customers want and find value-adding to their lives. How badly the customers want their product or service is a key driver of how valuable a company is. It’s no surprise that Apple, currently the world’s largest company, produces the product that everyone in the world cannot live without. Accordingly, its stock price appreciation has also been phenomenal.

However not all value is equal. Consider the common everyday fidget spinner. The low-friction plastic toys that seemingly defy Newton’s laws. They are currently wanted badly by many, but yet their manufacturers will certainly not make great investments in the long run. The distinction is that a valuable company provides a product or service that is useful and will remain valued by its customers.

There are many ways in which a company can remain valued by its customers and I think about these in two broad categories – internal and external. An analogy to illustrate these categories is that of an enterprising fisherman who is standing next to other fishermen at the side of a river. The enterprising fisherman decides to bring a longer fishing rod to access fish that other fishermen can’t reach. The ploy works well initially, the enterprising fisherman manages to catch more fish. However, the other fishermen standing nearby realise and they too bring a longer rod next time. Eventually all of the fishermen realise and any ongoing advantage to the enterprising fisherman is neutralised.

This analogy describes internal value. The enterprising fisherman improved her chances by internally creating an advantage independent of the other fishermen. However internal value alone is temporary as competitors imitate and eventually erode any such advantage.

In contrast, external value is an attribute that suppresses or discourages competitors and enables a company to remain valued by its customers. If the enterprising fisherman established exclusive ownership of a longer rod and no other fishermen had access to this special rod, then she would have generated tremendous external value. External value is often referred to as an economic moat, these are rare and those that have it are hard to dethrone in the business world.

As investors, we want to find these companies and back them to the fullest.

Ways to spot a valuable company

Many companies innovate and develop internal value. But as we can see, a truly valuable company is one that remains valued by its customers over the long term. This edge can only be sustained if they have an external advantage over its competitors – an economic moat.

Extensive literature has been written about economic moats since Warren Buffett first introduced the concept. Pat Dorsey, formerly of Morningstar, did extensive research on this topic and wrote a book called The Little Book That Builds Wealth. In it he summarises the following types of economic moats to look out for in valuable companies:

  1. Economies of scale
    These valuable companies have developed a supply chain advantage that enables them to deliver their products or services at a lower cost to their rivals. An example of one such company is Inditex. The Spanish clothing company best known for the brand Zara is able to mass produce fashion at a lower cost and faster turnaround time than its competitors such as H&M and Uniqlo. This advantage comes from being able to negotiate lower manufacturing and logistics costs. Operational leverage means that each new piece of clothing produced costs less than the previous item.
  2. High switching costs
    A company with this economic moat has a captive customer base. The cost of switching away is too great and customers are locked in to using the products or services of these companies. An example of a company with a captive customer base is Oracle. The software company has developed database programs used by many corporations. It is too costly and risky for large corporations to migrate their databases once they have been established in Oracle. Similarly, medical equipment suppliers have a captive market as it is often too risky to trial unfamiliar medical equipment and put patients’ health at risk.
  3. Network effect
    A company can create an effective monopoly by connecting different customers through the use of its products. The network effect is commonly observed in valuable technology companies that have created platforms for users to interact. Examples are Facebook, Ebay and Uber. As more users sign on, the network of customers becomes more appealing for new users to sign on. Stock exchanges such as NASDAQ or ASX have also created an economic moat by monopolising the market for buyers and sellers of stocks.
  4. Intangible assets
    This type of economic moat is distinctly different from the accounting concept of intangible assets. Intangible assets in the sense of economic moats can be:
  • Unique corporate / governance structure

We believe that this the most commonly overlooked form of economic moat. From our experience, the structural set up of a company is the DNA for the overall success of the business. We find that companies led by brilliant founders have an advantage in the way they are set up that enables quicker response to their customers and an unrelenting focus on reinvesting in their own business. This type of economic moat has a strong multiplier effect when combined with other forms of economic moats. To us, it is no surprise that five of the world’s six biggest companies are still founder-led.

  • Government approvals / licences

Exclusive government approvals for companies create a barrier to entry for other competitors to freely enter the market. These are valuable intangible assets – think Transurban, which has exclusive government rights to operate and maintain toll roads around the world.

  • Intellectual property

Patents, trademarks and copyrights protect innovative companies from imitators. Pharmaceutical companies such as Sanofi and GlaxoSmithKline aggressively protect their patent pipeline. Apple has a portfolio of patents protecting its designs. Intellectual property protection eventually does expire and for this reason we consider this to be a temporary form of economic moat.

  • Brand

Iconic brands have created a deep-rooted psychological association with its customers. This is a powerful economic moat that lasts generations. Nike and its Swoosh logo have created a strong emotional connection with aspiring sports people around the world. LVMH, the French company behind luxury brands Louis Vuitton, Moët and Hennessey have created a brand that loyal customers aspire for. Different brands have created associations to different customer emotions. The stronger the emotion, the strong the affinity the customer has to the company.

  • Geographical advantage

As Mark Twain once said “Buy land, they’re not making it anymore”. This advantage is easily recognisable and most common in infrastructure or real estate stocks. From experience, the effectiveness of this type of moat has diminished with the rise of technology and for this reason we favour other types of moats.

 How to profit from valuable companies

The source of value has evolved and will continue to evolve just as business models have over time. But the fundamental framework for spotting value will continue to apply as long as businesses exist.

Constructing a portfolio of valuable companies is a sensible method of securing pleasant returns over the long term. Sound businesses with economic moats are likely to remain valued by their customers despite incumbent competitors and other external market changes. As long as a company is valued by its customers, its value will be retained, and its stock price will follow eventually.

For the enterprising investor, there will exist an even greater opportunity to profit during certain windows when the stock price trades below its true value. These windows exist when the market panics and the herd forgets about the true advantages a company has. These opportunities offer an attractive deal to purchase a slice of a valuable company at a low price. It is in these windows that the enterprising investor should distance themselves from the crowd, invest heavily, and watch the returns compound over the long term.

Lawrence Lam is Portfolio Manager & Founder of Lumenary Investment Management, a global equities investment firm focused on investing in international founder-led companies over the long term. www.lumenaryinvest.com

At the time of writing, Lumenary Investment Management did not hold positions in any of the companies mentioned in this article.

The Intangible Quality of Great Businesses

Posted on by Lawrence Lam

Published in Money Management magazine 25 May 2017 issue.

Lawrence Lam looks at why investors should start searching for companies that are founder-led.

We all know this instinctively. We always do better at something when we truly believe in it – when we truly own it.

As Thomas J Watson Snr, former chair and chief executive of IBM, said “to be successful, you have to have your heart in the business, and your business in your heart”.

And yet for something that we all understand intuitively and has such a significant impact on investment decisions, very little attention has been paid to this in the business world until now.

Research from Bain & Company’s 2016 study of the S&P 500 over 14 years revealed that companies where the founder remained a core member of the management team outperformed other S&P 500 companies by 3.1 times.

Another study from the Journal of Financial Quantitative Analysis showed that founder-led companies outperformed the rest of the market by 4.4 per cent per annum over a 10-year period.

These numbers only prove what we already know. Founders put their heart in their businesses. They own their businesses. In this era of fly-in fly-out CEOs with large sign-on bonuses and short-term stock options, founder-led companies are quietly outperforming their more bureaucratic cousins. They’re proving that company performance is more strongly linked to genuine ownership than we first thought.

As the body of evidence supporting this phenomenon mounts, investment professionals and advisers are rethinking their investment strategies to capture the value produced by founder-led companies.

WHY ARE THESE COMPANIES BETTER?

And the reason why founder-companies outperform? It’s because their heart is genuinely in the business. It’s the difference between renting a house and owning a house. Sure, tenants will adequately maintain a house, but it’s not the same feeling. Owners really take care of the property like a home for the long-term, not a house they’re living in for the short-term.

The research shows that great non-founder CEOs exist and they too perform well, but there are an even greater number of great founder-CEOs. So if you had to pick a great CEO, you’ll more likely find one in a founder-CEO.
Bain & Company calls this ‘The Founder’s Mentality’ and it’s characterised by three features:

  1. A strong sense of higher purpose over a long-term horizon;
  2. Obsession with perfecting the customer experience; and
  3. An owner’s mindset – a great sense of responsibility and bias toward speed in decisions and actions.

These are the characteristics in a leader that money can’t buy. We’ve seen many corporations pay exorbitant bonuses to executives in the hope of inducing the same founder’s passion. Instead, what often prevails is that these corporate rock stars focus on managing expectations down so they spend energy justifying why the goalposts should be wider instead of aiming to kick longer.

In contrast, founder-led companies maintain a strong customer focus, cut through the internal bureaucratic hierarchies and sustain a high level of employee loyalty and engagement. If found early, these companies become great investments.

THE EFFECTIVE TIPPING POINT?

It is however a common perception that founders are usually seen as entrepreneurs who are great at innovating new ideas and growing small companies, but once the company grows too large, these founder-CEOs are out of their depth and they should hand over the reins to a professional non-founder-CEO.

This perception is just not true. Research from Purdue University shows that founder-CEOs evolve with the company. They develop managerial and administrative skills as the business grows and they also continue innovating much more than others; a key reason why their companies continue to outperform (think Steve Jobs, Bill Gates, and Mark Zuckerberg).

The study shows that founder-CEOs are more willing to engage research and development and are more effective in doing so – they get more bang for buck for their research and development spend.

What can hinder growth isn’t so much founder involvement, but rather internal headwinds that develop as the company experiences growing pains. Bain & Company’s study found that as size increases, layers form, and leaders can become increasingly distant from their customers. Speed of decisions decline. Bureaucracy and focus on the higher purpose is lost.

But remember, the feeling of owning a home is different to the feeling of renting one. For the exceptional few, the founder breaks through these constraints. They find a way. They have an ownership mentality and they do things differently. They hire the right people and clone the same ownership mentality in them. Importantly, they maintain a leadership role and never relinquish that to others. You can hire the right people with the right skills, but you can never buy the ownership mentality.

USING THIS PHENOMENON

We intuitively know this phenomenon is true so what can we learn from this research? We no longer need to rely on our intuition to explain the intangible qualities that founder-led companies have.

It explains why some of Australia’s best performing companies are founder-led. Great Australian examples include Nick Scali, Count Financial (since bought by CBA), Corporate Travel Management, Wotif (since bought by Expedia), and Reece.

It would have been a profitable venture had you invested in these companies in their early stages. As investors, founder-led companies are an ideal place to begin searching for investments. All else equal, they are less risky and give you a higher likelihood of outperformance.

And whilst not every founder-led company will be successful, the odds of finding a great company are higher. That’s why investors should start, not finish, the search for great companies here. We should still focus on the merits of the business, its performance and its competitive edge. If you can tick these boxes and have an inspirational founder at the helm, you can expect returns in the multiples.

Lawrence Lam is founder and portfolio manager of Lumenary Investment Management.

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AFS Licence 493790 ABN 31 616 119 941