The following article appeared on Livewire on June 13, 2019.
One of the first questions we get from potential investors is how we whittle down our investable universe. Our preferred approach is to take the long, scenic route: lots of reading, meetings, and competitive analysis that leads us from one opportunity and ecosystem to another. It’s an enjoyable process, however, not everyone has the time or energy for such an organic approach. Enter screening, which is an efficient shortcut for boiling down a large investable universe to a more focused opportunity set ripe for exploration.
We have three philosophical tenets that inform our approach to screening.
The first is that, as long-term, business-focused investors, our primary aim with screens is to identify potentially outstanding businesses first and then to figure out whether the price is appropriate after we’ve done the work on the business. Starting from the opposite direction — e.g. sifting through 52-week lows or statistically cheap valuations — is more likely to steer us into a value trap than it is to help us find the kinds of long-term leaders that we seek.
A second point we’re conscious of with screening is to respect that we’ll need to do our own primary research regardless of what pumps out of the screen. This point may sound obvious, however, years of experience has taught us that even respected data providers can sometimes have gaps in their data, particularly when it comes to share counts with smaller, off-the-beaten-path companies. It may sound a trivial point but we run across such inaccuracies on a regular basis.
Lastly, we know that some of the best opportunities screen horribly on traditional measures and are thus overlooked by screens and more conventional investors. For example, screens focused on conventional measures of value or profitability would have almost certainly never favoured Amazon, which has increased by around 472% in USD terms over the past five years.
Rather than try to work with a single screen that encompasses every positive trait we seek, we run multiple screens based on a smaller number of traits that we think correlate well with long-term outperformance. We end up casting a wider net as a result but think the extra layer of effort is worth the trouble.
Seeking multiple ways to win and few ways to lose
All that said, let me lay out the kinds of opportunities we seek at Lakehouse. On a high level, we’re looking for asymmetric opportunities where we think there are multiple ways to win and few ways to lose.
Such opportunities are hard to find, and we’re not always right in selecting them, but we like to think that by systematically seeking positively skewed outcomes one can tilt the odds in their favour.
One such angle is around attention. The fewer brokers, funds, and financial journalists there are sniffing around a business, the better the odds that an investor who is willing to do his or her own homework can find a valuable variant perception. In that spirit, and knowing that the median company in the S&P/ASX Small Ords is followed by around 7 analysts, let’s search for companies with fewer than 7 analysts covering them.
Sticking to smaller companies, let’s limit the universe to ASX-listed companies outside the ASX 100. Let’s also limit our downside potential somewhat by limiting our search to companies with market capitalisations above $200 million, which will clear out many subscale businesses. Let’s also place an emphasis on cash in the bank and screen for companies that have more cash than debt.
To the upside, and in the spirit of identifying fast-changing situations that the market might be overlooking let’s screen for companies where the revenue growth rate over the past year was faster than in the prior comparable period. Accelerated, in other words. Let’s also screen for trailing revenue growth of greater than 20% as it boosts the odds of breakout potential (also the risks, for that matter, but that’s where the ‘further research’ part comes into play).
Lastly, and possibly to the disappointment of those who enjoy throwing cash into holes in the ground, I’m going to filter out utilities, energy, and materials, sectors known for historically low returns on capital. (Note: For colour on why I don’t spend much time on these sectors, I recommend this article on ROIC by McKinsey).
Below are the 29 companies that pop out of the screen. Before going any further, though, please note that I am not vouching for or recommending these companies as a group. They are simply the outputs of a screen that I think might produce ideas worth further research. No doubt many will be busts and investors should do their own homework when evaluating potential investments.
Source: S&P Global Market Intelligence
It’s a long list, eh? Well, that comes with the territory of turning over many rocks and running screens from many angles. Fortunately, we’re not forced to randomise our research process and the companies operating in industries where analysts already have spent some time or that are known for historically high returns on invested capital (e.g. application software) might be good jumping off points.
Also, while reiterating that investors should do their own homework, I must say that one of the companies that popped out of this screen, Audinate, is one that we own and have spent a lot of time on.
For that matter, I should note that the Lakehouse Small Companies Fund also owns shares of Catapult, ELMO, and EML Payments, each of which does not receive much attention from the investing community, is growing at healthy rates, has leaders with skin the game, and has models built on recurring revenue.
We don’t own most of these companies, of course, but the fact that we’ve looked at many and own a few does suggest that this screen is barking up the right tree in terms of some traits we find compelling. Here’s hoping that the premise — searching for dynamic, underfollowed companies — makes for some fruitful further research.
Disclosure: Joe Magyer and the Lakehouse Global Growth Fund own shares of Amazon.