I left university believing that successful investing was all about the numbers. Just fire up Excel, hand me some financial statements, and we’re off to the races.
Oh, to be young.
Real life quickly disabused me of such naive notions. While I’ve never been sharper with a spreadsheet I spend less and less time dabbling with them. Instead, experience taught me to focus on greater forces that drive long-term returns. Market structure. Customer loyalty. Culture. Management. Especially management.
The importance of quality leadership should be clear to anyone who has ever found themselves working for a bad boss. The problem is that finding out whether management is the real deal or full of hot air is as difficult as it is crucial. As Shane Parrish, the author of Farnam Street, recently said “If the cost to acquire information is quick, it’s probably not that useful.”
It takes focus, digging, and a bit of originality to get to understand management’s true worth. Our solution to this problem is multi-faceted — and a lot of work.
1. Start with the Numbers
Financial statements can’t tell you everything about a company’s leadership team — but they’re a good start. Tracking the growth in relevant key measures like earnings, book value, or free cash flow in per-share terms relative to peers is a good start, as is the total return shareholders have experienced under a long-serving CEO. And, if you’re a real nerd like me, you’ll want to double-click into a company’s returns on incremental invested capital to see whether management is creating value or setting cash on fire.
Determining the capital allocation chops of a CEO is a must, and it’s all the more important for the kinds of fast-growing companies that attract us at Lakehouse Capital. As Warren Buffett said in his 1987 letter to shareholders:
The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.
So you’d better figure this one out. Unfortunately, it takes some time on an aeroplane.
2. Hit the Road, Joe
Our teams have met with companies on 3 continents in search of winning ideas on the ASX. Sometimes it’s fun, like when you’re sauntering through San Francisco on a cool morning with some fresh sourdough and a hot cup of coffee. Other times, you’re eating scorpions on a stick in Beijing.
No matter where we go, though, we end up passing on the vast majority of the opportunities. Only about 1 in 5 of my team’s company meetings over the past 3 years have resulted in our making an investment. We’re picky. And that’s to say nothing of the scores of opportunities we kicked the tyres on but didn’t think were worth meeting.
We go even further with the companies we do end up pursuing: We’ve had a total of 46 meetings with the 21 companies in our model portfolio. We’ve even met with one company at offices in three different countries. Sometimes, you really do just have to go that extra mile (or 7,000).
3. Dig Deep & Filter
All this is in an effort to evaluate a CEO and the broader company on 4 parameters: Talent, alignment, honesty, and the little things.
Talent: Has the CEO improved the business during her tenure? Gained market share? Made smart acquisitions or divestments?
Alignment: Does management have financial, emotional, and reputational skin in the game? Are their remuneration packages aligned with long-term growth in intrinsic value per-share?
Honesty: Do company leaders have a clean rap sheet? Does the company own up to its mistakes or sweep them under the rug? How do they react to pointed questions or when they don’t know the answer?
The Little Things: Is management promotional? Is their office plush or simple? How do they treat their subordinates? Do they speak plainly or bombard you with buzz words and name droppings?
You also have to filter everything management says through a filter. I’ve never met an executive who said “You know what, our company is a dumpster fire. I suggest you move on.”
Instead, they are all unfailingly optimistic, confident, and believe “people are our greatest asset.” I’m not saying those feelings aren’t usually genuine… but you’ll hear them from every company you meet, which can trip up investors who are new to the business.
4. A 360 View
Sometimes it takes more than crunching numbers and a couple of meetings to determine management’s true mettle. Sometimes you have to get out and meet customers, suppliers, partners, lower-level employees, or even former employees. You have to be careful with this layer of research — reference bias can lead you astray — but sometimes you find a golden nugget.
A recent example is for an unnamed company that was looking to raise some fresh capital. I’d spoken with a potential customer who had a specific concern that, when I broached with management, they laughed off and swatted away.
However, in meeting with two of the company’s competitors, I learned that the potential customers’ concern was on the mark and a serious risk to future growth. It was a key factor that steered us away from investing, and one that never would have been unearthed if we hadn’t dug a few holes in search of treasure.
3 More Questions About Lakehouse Capital
My column last week, 8 Questions Answered About Lakehouse Capital, brought out a host of new questions from the 2,000 of you who have registered your interest. Here are some of the more popular ones:
When will you begin accepting investors?
ASIC gave our fund constitution a green light this week, which means that we’re able to chart our own course on launch. We plan to begin accepting funds from investors in mid-November.
What is the minimum initial investment for the Lakehouse Small Companies Fund?
The minimum initial investment for the fund is $250,000. We’re looking for a committed group of foundational investors to join us on the ground floor. We might lower the minimum down the line but the launch of Lakehouse Capital is a big, exciting move for our business and me personally, and we’re looking for investors who share that sense of conviction and long-term optimism. We also plan to give early investors preferential access to making additional investments in the future.
Will there be a cap on the amount of money you plan to raise?
Yes. We plan to accept more investors later but, when it comes to the launch, we will limit the funds we will accept so that we will be able to effectively put our investors’ money to work into our favourite small-cap companies.
Unfortunately, our willingness to forgo some funding might mean that not everyone who is interested in the fund may be able to join us at launch. We appreciate that will disappoint some would-be investors but think it’s the right call in order to best position our earliest investors for success.
In the long run, we’re looking to keep the fund small and nimble enough so that it can effectively put cash to work into our favourite small-cap companies. We’re looking to establish a boutique shop that prides itself on fresh ideas and long-term outperformance, and the Lakehouse Small Companies fund will never be a multi-billion-dollar asset gatherer stuck investing in the same widely held names everyone else picks over. Think Grange, not Koonunga Hill.
Expect more details on the fund, including a product disclosure statement (PDS) and how to invest, in the coming weeks. Meantime, our team continues to race towards the starting line as we’ve met with 5 companies each of the past two weeks!
Thanks to all of you for your interest in our fund, and speak soon!
Joe Magyer, CFA
Chief Investment Officer
P.S. A prime example of someone I consider a first-rate CEO is Bapcor’s Darryl Abotomey. I interviewed Darryl back in late 2014, and the shares have delivered a total return of about 122% since then. I thought you might enjoy the interview as it pulls back the curtain a bit more into our process.
The above article contains general investment advice only (Lakehouse Capital Pty Ltd is the Corporate Authorised Representative of The Motley Fool Australia Pty Ltd AFSL 400691).