The following article appeared on Cuffelinks in April 17, 2019.
For all their speed and dynamism, change is slow in coming to both sports and investment management. Basketball hoops have hung at 10 feet ever since James Naismith invented the sport back in 1891. In the investment arena, even though most Australians have been online since 2001, it is still common for investors in an unlisted managed fund to provide a wet signature with their applications.
Culture can change faster than the rules of engagement, but the tendrils of tradition are still long and potent. There aren’t many hard rules around where baseball players may stand on the field, for example, but teams today still use the same positions as did the first World Series winners, the 1903 Boston Americans.
Where change can happen, though, is when it comes to how best to connect and focus the team. For example, since the creation of the National Basketball Association, players have been lumped into three positional categories – guard, forward, and center – and that mix was only marginally more refined in the 1980s. Unless a team had a Michael Jordan (and there is only one of those), the standard basketball strategy was to try to find a big man to build around. The nine highest-paid players in the NBA were all big men.
NBA coaches and executives slowly realised, though, that if the ultimate goal of an offense was to put a ton of points on the board, the best way to do so was to take more and better shots. It sounds obvious in hindsight but slowing down to pass the ball to your least-skilled player so that he could try to make a difficult shot with another 7-footer in his face was not an optimal strategy.
The net effect is that today’s NBA is scoring a staggering 21% more points per game than it did 20 years ago while also shooting for a higher percentage. Oh, and by the way, only two of the 10 highest-paid players today are big men. The other eight are more agile guards and forwards who can find open space and create their own smart shots.
The ‘big man’ problem in investment management
Investment management, particularly among global equity funds and those with wide mandates, has its own version of the flawed ‘pass it to the big man’ model that has been culturally slow to change.
Let’s say that you’re a portfolio manager overseeing a team of analysts. Let’s also say you are fundamentally-focused and long-term-driven, so odds are good that the ultimate objective of your idea generation process is to identify outstanding businesses to buy and hold.
Most global funds follow tradition and establish their teams around one of two sets of fault lines: sector or geography. On the face of it, these are practical structures because they cover the waterfront, provide diverse feedstock for the idea-generation process, and allow individual players to play to their strengths.
The rub is that, for a fundamental, long-term-driven investment process aiming to identify outstanding businesses, a forced choice between focusing efforts along the lines of sectors or geographies is a false dichotomy.
There are also other large inherent problems reminiscent of the ‘big man’ problem. For example, not all sectors are created equally. As a study by McKinsey emphasised, industries with sustainable barriers (e.g. software and household products) tend to have high and persistent returns on invested capital, while industries that are capital intensive (e.g. materials and energy) and highly competitive (e.g. retail and transportation) tend to have persistently low returns on invested capital.
If the ultimate goal is to find outstanding businesses, sending an analyst to find a long-term winner in energy or retail is like sending them to the desert to find a glass of water. Maybe they’ll get lucky but they’re more likely to come back thirsty and sunburnt. Or, to bring it back to basketball, it’s like giving the ball to your center, asking him to take 15-foot jumpers with a fellow giant in his face, and then wondering why you keep getting outscored.
Also, just like any basketball player will heave up shots – even poorly selected ones – if that’s what their coach asks of them, analysts also have a habit of falling in love with their area of coverage. Ask an analyst to cover energy and, if for no other reason than career preservation, they’ll probably pitch you a steady flow of ideas from the space even if the timing is off because that’s the job you’ve given them.
A ‘fascinations’-based framework
Rather than ease into one of these traditional frameworks at Lakehouse, we inverted the process and asked a very basic question: what is the best way to identify outstanding businesses to buy and hold for the long-term?
Starting with that fresh sheet of paper, we focused on the backbone of our philosophy: well-run, competitively-advantaged businesses that can reinvest at high rates for a very long time offer the most compelling potential for the long-term investor. That clarity led us to focus on our core fascinations when it comes to stock selection:
Loyalty: Think enterprise software, payment processors, subscriptions, or any other form of business with an intense focus on customer loyalty and retention. Importantly, we view loyalty as not just switching costs, which make it difficult for customers to move on, but also the delivery of value and delight to customers that makes them want to stay.
Businesses with extremely loyal customers are often underestimated by the market because of their staying power, pricing power and ability to cross- and up-sell. In our experience, many investors lump recurring revenue businesses into one big pile, which creates an opportunity for discerning buyers to separate the coal from the gems.
Networks: Think marketplaces, exchanges, payment networks, social networks, or any other form of business exhibiting network effects. We’re passionate about businesses with network effects because many of them scale quickly and capital-efficiently, creating a significant amount of value in short order. Markets tend to underestimate the staying power of a leading, well-established network.
IP: Think brands, data, patents, or even corporate cultures that are difficult to replicate. Businesses with strong IP have enduring pricing power and, often, an innovative culture and strong distribution network that creates and scales new and valuable IP.
The strength of fascinations
Ultimately, the beauty of a fascinations-based model is that we’re not trying to cover all parts of the waterfront. We’re covering places where empirical research suggests we’re more likely to find more and bigger fish. The approach also has the benefit of developing deep subject matter expertise on business models and ecosystems.
A fascinations-based framework may not suit every situation. Traders need not apply, for example, or deep value investors who jump from one beaten-down market or geography to another. For the long-term, fundamentally-driven shop, though, we think letting one’s core investing beliefs and fascinations drive process rather than a following a false construct is a far more sensible approach.
Joe Magyer is the Chief Investment Officer of Lakehouse Capital, a sponsor of Cuffelinks. This article contains general investment advice only (under AFSL 400691) and has been prepared without taking account of the reader’s financial situation. Any person reading this message should read the product disclosure statement and seek professional advice.
Lakehouse Capital is a growth-focused, high-conviction boutique seeking long-term, asymmetric opportunities. Lakehouse is the investment manager of two strategies: the Lakehouse Small Companies Fund and the Lakehouse Global Growth Fund.