Honing the Opportunity Set – Part 1

The following is a Lakehouse Capital feature article published on 3rd June, 2022.

Here at Lakehouse Capital, we are long-term high-conviction growth investors. We believe to outperform the market, investors must think differently than the market. So, to facilitate divergent thought, we have developed a unique investing process. Rather than utilising the traditional industry or sector organizations, our team organises investment opportunities into three categories that we call Fascinations including Network Effects, Intellectual Property, and Loyalty. All potential investments are categorised into at least one (if not more) of these Fascinations. We discussed these Fascinations in detail in our recent series that can be found here

The investing process does not end there. Just exhibiting one (or more) of these three Fascinations does not necessarily mean a business is a sound investment. In order to make that determination, our next step in the process evaluates all potential investments for six key characteristics:

1. strong position in a growing market,

2. pricing power,

3. durable competitive advantage,

4. aligned and experienced management team,

5. conservative balance sheet, and

6. attractive valuation.

While every investment may not exhibit all six key characteristics, the more the better. In the following article, the first in a 2 part series, we will outline the first three key characteristics, including highlighted examples from our current portfolio.

Strong Position in a Growing Market

A key characteristic we evaluate in our investment process is that the company holds a strong position in a growing market.

Its importance is derived from our tightly-held belief that industry leaders tend to capture an outsized share of industry profits and that growing markets put the wind at their backs and time on their side.

One example of a company in our portfolio with a strong position in a growing market is MarketAxess. As the leading electronic trading platform globally for fixed income markets, MarketAxess facilitates trading of U.S. high-grade bonds, U.S. high-yield bonds, emerging market debt, Eurobonds, municipal bonds, U.S. government bonds and other fixed-income securities among more than 1800 active institutional investors and dealer firms. 

MarketAxess exemplifies our Network Effects Fascination as, at its core, the platform’s value increases with every subsequent buyer or seller that joins the platform. Put simply, more clients means deeper liquidity and greater trading efficiency, ultimately leading to superior price discovery and better outcomes for clients, which in turn attracts more clients. 

To understand the competitive position in this growing market, it is important to note that the fixed income markets have failed to adapt to electronic trading methods at the same pace as equity markets. Today, most fixed income products are still traded over the phone with one party directly calling another party. As a result, electronic trading as a percentage of all trades ranges from 10% for US Municipal bonds, up to 65% for US treasuries, but both compare poorly against more than 90% across US equities.

Conducting transactions in the traditional way creates a variety of short-comings, including limited liquidity, limited price transparency, significant transaction costs, compliance and regulatory challenges, and difficulty in executing numerous trades at once. The MarketAxess platform solves all of these problems. 

Our long term investment thesis sits on three components. First, the global fixed income markets will continue to grow over the next decade. MarketAxess management estimates that the total addressable market will increase from a $5 billion opportunity today to $8.5 billion opportunity in 2030 through growth in existing products as well as the launch of new product lines. Second, we expect that electronic trading as a percentage of daily volume traded will continue to increase based on the higher overall efficiency in comparison to traditional methods. This is ground by the fact that the share of overall U.S. Treasury trading volume executed electronically has grown from 31% in the midst of the global financial crisis to 65% in 2021. And third, we project that MarketAxess will increase their market share of all fixed income trading driven by the network effects that are already at play. Electronic trading market share continues to grow, and MarketAxess boasts about 20% of total market share in the combined US high grade and high yield products, and achieved record market share in U.S. high‐yield, emerging markets, Eurobond and municipal bond markets in the past fiscal year. By emphasising new platform capabilities and product categories, we expect that the company will maintain its strong position in this growing market for many years to come.

Pricing Power

Another key characteristic we desire is pricing power.

At Lakehouse, we see pricing power as the financial distillation of a business’ competitive position.

We prefer businesses with price-setter rather than price-taker characteristics and evaluate a company’s pricing power in many ways: sustained high margins over time, contracted annual price increases above the pace of inflation, absence of direct competition or substitutes, low cost to benefit ratios, to name just a few.

One example of a company in our portfolio with high pricing power is LVMH. LVMH is a luxury goods conglomerate, made up of 75 unique brands across six business segments including wine and spirits, fashion and leather goods, perfumes and cosmetics, watches and jewelry, selective retailing, and others. Known for luxury craftsmanship and attention to detail, LVMH brands include Veuve Clicquot, Louis Vuitton, Fenty Beauty, Tiffany & Co, Sephora, Royal Van Lent Shipyard, and many more.

LVMH is one of the strongest examples of the Intellectual Property Fascination because LVMH’s products are distinguished by reputation. While the brands are considered fashionable, the powerhouse could never be considered a fad. The company traces its roots back to the 14th century, when champagne producer Claude Moët decided to build on the work of Dom Pérignon. Maintaining these roots of legacy craftsmanship continues to be a defining focus for the company.

By capitalizing on the value of the IP, LVMH is also one of the most evident examples of a business with pricing power. To find proof, investors just need to look back at the company’s operating history. Gross margins over the past 15 years have been relatively stable – including through recessionary periods. And for a more recent example, in February, the eponymous Louis Vuitton brand increased prices,ranging from 4 – 30%, on canvas and leather bags and accessories. A spokesperson for the company commented that the increase in price was to reflect “changes in production costs, raw materials, transportation as well as inflation.” And still, demand remains strong.

Actions like these reinforce our long term thesis that LVMH will remain a dominant business driven by pricing power. To maintain this pricing power, management must continue to protect the existing IP, including brands and production processes, as well as innovate for the future. While this can be challenging for many, LVMH has a demonstrated track record (over a couple centuries) that leads us to believe that they will continue to win for the foreseeable future.

Durable Competitive Advantage

Another key attribute we require our portfolio companies to have is a durable competitive advantage. This can be grounded in scale, strong brands, network effects, and/or high switching costs. Even better, we look for business models that are exhibiting directional improvements in those advantages. 

One example of a company in our portfolio with a durable competitive advantage is CoStar. CoStar is the largest provider of data, analytics, and online marketplaces to the commercial real estate industry in the United States and the United Kingdom. The business has four key segments including CoStar Suite, the  group’s original real estate data service containing proprietary data sold to institutional players; Multifamily, a network of apartment listing platforms; Commercial Property and Land, a variety of commercial property listing platforms such as LoopNet, BizBuySell, LandsofAmerica, and more; and Information Services.

CoStar is unique in that the business exhibits qualities of all three of our Fascinations. The company’s marketplaces have the largest audiences within their segments which further necessitates use by all industry players, driving strong network effects. CoStar has more than 30 years experience building the proprietary data set and continues to invest heavily in research and technology to further its bank of intellectual property. Lastly, CoStar Group’s customer retention rates average above 90% and exceed 95% for customers of five years or more, pointing to extreme customer loyalty for its mission-critical services. 

These economic attributes afford CoStar multiple sources of competitive advantage. The scale and depth of the company’s IP is large, powering the creation of dominant brands across multiple business segments. As the data collected continues to grow every day through new listings and research efforts, the network effects continue to grow stronger, too. This data is critical to Costar’s customers’ operations, with 98% of commercial real estate professionals stating that they rely on either CoStar or LoopNet for commercial real estate data in a 2018 survey. Given the indispensable nature of the data, high barriers to entry created by the historical dataset, and the lack of competition, CoStar Suite has essentially become a cost of doing business in the commercial real estate industry.

While having one source of durable competitive advantage is strong and relatively rare, CoStar Group demonstrating multiple durable competitive advantages makes it a sound long term investment opportunity. The performance of the company’s stock has suffered year to date (although to be fair, what hasn’t?), but we continue to feel that investors are underestimating and underappreciating the long term growth opportunity. With unmatched scale, strong brands, ever-increasing network effects, and high switching costs (driven by a lack of available substitutes), we see CoStar positioned to outperform the market for years to come.

Disclaimer: Equity Trustees Limited (‘Equity Trustees’) ABN 46 004 031 298 | AFSL 240975, is the Responsible Entity for the Lakehouse Global Growth Fund and the Lakehouse Small Companies Fund (‘the Funds’). Equity Trustees is a subsidiary of EQT Holdings Limited ABN 22 607 797 615, a publicly listed company on the Australian Securities Exchange (ASX: EQT). The Investment Manager for the Funds is Lakehouse Capital Pty Ltd (‘Lakehouse’) ABN 30 614 957 603 | AFSL 526842. This publication has been prepared by Lakehouse to provide you with general information only. In preparing this publication, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Lakehouse, Equity Trustees nor any of their related parties, their employees or directors, provide any warranty of accuracy or reliability in relation to such information or accept any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statements before making a decision about whether to invest in these products.

The Target Market Determination for both funds is available at www.www.lakehousecapital.com.au It describes who each financial product is likely to be appropriate for (i.e. the target market), and any conditions around how the products can be distributed to investors. It also describes the events or circumstances where the Target Market Determination for the financial product may need to be reviewed. Lakehouse, its directors, clients, employees, and affiliates, may, and likely do, hold units or securities in entities that are discussed in this presentation and ensuing question and answer sessions.