Honing the Opportunity Set – Part 2

The following is a Lakehouse Capital feature article published on 18th July, 2022.

Following on from our previous article ‘Honing the Opportunity Set – Part 1’, we return with the second part to complete our two part series to outline the remaining three key characteristics we seek when evaluating potential investments, including examples from our current portfolio.

Aligned and experienced management teams

The more skin in the game management has, the more you can reasonably expect that they will act in the long-term interests of shareholders.

Management teams who are incentivised to grow revenue or earnings at all costs will find a way to do so, whether it be through borrowing or raising equity to acquire their way there. Compensation structures that include per-share metrics help ensure profit growth isn’t coming at the dilution of existing shareholders.

A great example of an aligned and experienced management team in the Lakehouse Global Growth Fund is Constellation Software (CSU). Founded and led by venture capitalist Mark Leonard in 1995, the company acquires, manages and has built numerous software businesses that operate in niche verticals. For example, there’s Orion Wine Software, which helps more than 300 wineries around the world manage their operations. There’s also Caliber Justice, which helps large law enforcement agencies manage and track offenders from initial booking through to release.

CSU typically acquires the first or second-ranked business in a software vertical, expands market share, and drives out under-capitalised and inefficient competitors. This strategy has paid rich dividends — CSU has delivered Amazon-like returns for shareholders, compounding revenue at 25% for the last 18 years, while growing operating profit 30% per annum over the same period. Moreover, its operating margin has improved from 8% to 17% while the number of shares on issue have remained constant.

Leonard owns roughly 2% of the company or A$740 million worth of shares and has voluntarily waived his entitlement to receive a salary and a bonus for the last three years. Employees at all levels of the organisation are awarded an annual incentive bonus for working towards the company’s goal of increasing shareholder value, which the company believes is created by managing profitability (CSU uses the metric Return on Invested Capital to measure this) and revenue growth over the long-term. In addition, executive officers are required to invest 75% of their after-tax bonus into common shares of CSU to be held in escrow for a minimum period of four years, after which officers may choose to receive the entire bonus in cash. We believe this truly aligns the management team with the interests of shareholders – considering they all are one!

Conservative balance sheets

Companies with strong balance sheets can play offense when other people are playing defense.

At Lakehouse Capital, we seek to identify companies with strong balance sheets that are not reliant on external funding sources. This allows companies to continue to operate their business for the long run rather than risk having to go out to the debt or equity markets at unfavourable times (such as times we are currently experiencing) just to stay afloat. The more net cash the company has relative to its market cap, the greater strategic optionality it provides. This is especially valuable in bear markets where well-resourced companies can continue to invest and potentially accelerate market share shifts while their competitors are holding back new projects or reducing investment.

As far as fortress balance sheets go, there are few that can stack up to portfolio company Alphabet; the holding company that owns Google and other subsidiaries such as YouTube, Nest and Waymo, among others. Its highly attractive and capital efficient advertising business model has meant that Alphabet has built up an enormous net cash position over time, swelling to US$105.4 billion or 7% of its market cap.

Having a large net cash position while generating tens of billions in operating cash flow every year provides immense optionality. At a time where many technology companies, from small start-ups to large enterprises are laying off workers or pausing hiring due to the uncertain economic and funding environment, Alphabet can pick up top-tier talent and continue to invest in research and development. Moreover, it can take advantage of lower valuations and look to make strategic acquisitions such as its recently announced A$5.4 billion purchase of US cybersecurity firm Mandiant, which will be integrated with their Google Cloud Platform.

Finally, and this provides a nice segue into the last characteristic we look for in companies, Alphabet’s large cash balance allows it to opportunistically buy back shares at an attractive valuation, thereby shifting more value per share to the remaining shareholders. Indeed, its board of directors in April 2022 authorised A$70 billion in share repurchases (roughly a whole year’s worth of free cash flow, leaving its cash balance unchanged), up from A$50 billion last year.

Attractive valutions

For every company we look at, the last piece of the puzzle is valuation. However, this does not lessen its importance.

We seek to own the greatest growth companies out there, but if the market’s expectation of the company’s future growth prospects are well beyond ours, then we simply move on.

At the end of the day, we need to have conviction that based on the price we are paying, we have a high probability of generating a double-digit internal rate of return (IRR).

Using our Alphabet example, the stock currently trades for 18x consensus next twelve month’s earnings. This may look expensive compared to the S&P 500’s 16x, however consider that Alphabet is losing ~A$3 billion a year in its rapidly growing cloud division and ~A$5 billion on its “Other Bets” divisions that will, most likely, create some value in the future. In addition to taking into account its net cash position, the stock trades for a market multiple based on its core business’ earnings for a high-quality company that is likely to compound revenue at low double digit rates for many years to come.

The presence of one, or more, of the six business attributes covered in this two-part series does not guarantee a good investment outcome. However, experience and research would suggest they are good indicators for businesses that can succeed and deliver long term returns for shareholders. As discussed they are certainly attributes we seek but form only part of our overall assessment.  As always there is an element of art as well as science when looking for good long term investment opportunities, but starting with these strong attributes not only helps focus attention but ultimately helps to drive long term outcomes for our clients.

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.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.