The following article was featured in Livewire on July 31, 2023.
Over the last twelve months, investor concerns were again dominated by inflation, interest rates and the potential for a global recession. Whilst we consider and appreciate the risks of each, particularly the possibility of a significant economic slowdown given the recent rapid rise in interest rates around the world, our passion and strength lies in analysing businesses, not predicting (largely unknowable) macroeconomic outcome
Are we going to have a recession this year?
The short (and honest) answer is we don’t know. As it stands today, uncertainty is high and we have conflicting signals on each side. On one hand, leading indicators, such as the inverted yield curve, suggest a high likelihood of a recession in the year ahead. On the other hand, lagging indicators such as labour market data and until recently, retail data – continue to surprise and suggest potential resilience in earnings and economic growth. There’s a whole lot of noise and data out there to satisfy whatever view people seek to justify.
The fact is we have just experienced one of the steepest monetary tightening cycles in history. Given the speed and magnitude of the move in rates, and the lag effects associated with them, we believe there is a meaningful probability that some economies could tip into recession. (For what it’s worth, Goldman Sachs had the odds of a U.S. recession at 25% in early July, and recently reduced it to 20%.)
If a recession were to occur then corporate earnings growth would slow – or reverse. However, this will not mean the world is ending. We are confident that if such a scenario comes to pass, our portfolio companies are well placed to not only weather the storm, but perform in a relative sense.
Our day to day focus is not on short-term performance or the latest economic data point, but the consistent application of a process that emphasises quality and patience. Doing so puts time on our side. We’re very specific about the traits we seek in businesses we own. Namely, we look for:
Strong positions in growing markets. Industry leaders capture an outsized share of industry profits, and growing markets put the wind at their backs. This is all the more true in the winner take most markets for which we have a particular fondness.
Durable competitive advantages grounded in scale, strong brands, network effects, or high customer loyalty. We have an appetite for businesses with wide and widening moats. In particular, we’re fond of businesses with extremely loyal customers and highly visible recurring revenue streams. Indeed, 18 of the Lakehouse Small Companies Fund’s 20 holdings today have models explicitly built upon recurring revenue streams.
Pricing power with customers and suppliers. Pricing power is the financial distillation of a business’ competitive position. Little wonder that many of the world’s most successful businesses are price setters while laggards are price takers.
Aligned and experienced management teams with strong track records of capital allocation. The importance of management increases exponentially next to a company’s growth and reinvestment rate. As it happens, our portfolio companies are collectively growing very quickly, so we make it a point to get to know the people leading our companies and their track records.
Conservative balance sheets. A well capitalised business will almost always live to see another day. One better, it can play offence while others play defence. We’re not dogmatic on owning businesses without debt – some businesses are more valuable to shareholders when a prudent amount of leverage is applied – but we have a strong bias towards balance sheets with untapped capacity.
Attractive valuations that afford upside to our estimate of fair value. Valuing the types of high growth companies we prefer can be an exercise in false precision. Nonetheless, while we’re not slaves to spreadsheets, we strive to pay prices that we think boost the odds of a favourable outcome.
It’s unusual to find opportunities that tick a few of those boxes at a time. In our experience, though, they tend to most often be found in software, healthcare and consumer markets. That’s why, despite our being generalists with a range of experience across multiple sectors, these areas are a particular focus for us.
One business that passes our filters
The silver medal contributor for the portfolio in FY23 was Cettire (ASX: CTT), whose shares rose seven fold during the year. As a young, rapidly growing company there remains a wide range of outcomes for this business and we continue to size our position accordingly. Cettire is not widely known, and less widely understood in the investment community, so we’ll quickly recap.
Cettire is a fast growing ecommerce portal focused on branded and luxury fashion. The business operates a capital light drop shipping model, which means, unlike traditional retail businesses, the company does not hold inventory. In fact, the business operates a negative working capital balance where they are paid by their customers up to 60 days before having to pay their suppliers. This efficient funding model allowed founder, Dean Mintz, to bootstrap the business from its founding in 2017 to $85 million in annualised sales at IPO without any outside funding.
This capital light business model also allowed Dean to own 100% of the fast growing business up until he sold a third of it through the IPO in December 2020. He has subsequently sold down to a 45.9% holding, which is still significant but has been a jarring experience for the market. For our part, we don’t begrudge a founder reducing their exposure to their single largest asset. Indeed, an eventual sell down was a consideration in our investment thesis, it will diversify the shareholder base and add to liquidity over time.
Cettire has grown at an extraordinary rate since listing, with sales tracking toward a 17 fold increase over the last three financial years. To give a sense to Cettire’s scale, the company has a selection of more than 400,000 products across 2,500 brands, that it sells across 53 markets to 314,000 active customers and is run rating at close to $400 million of sales for the fiscal year.
Generally speaking, we remain cautious on consumer dependent businesses given elevated inflation and higher interest rates are proving a headwind. So whilst we are positive on the business, our caution is managed via position sizing, with Cettire ending the year as a modest holding in the Fund. We are also mindful that the business has been scrutinised for its escalating customer acquisition costs, calling into question the company’s profitability. But this needs to be balanced with the fact the company is continuing to invest in its ecommerce platform, rapidly pushing into new markets, and spending ahead of attracting customers in those markets.
We remain enthused by what the business has achieved in six short years, Dean’s strong focus on optimising for profitable long-term growth, and that Cettire continues to self fund and grow at high double to triple digit rates, with a long runway ahead.
Take a different approach to investing
Donny Buchanan is the CIO and Portfolio Manager of the Lakehouse Small Companies Fund. This article contains general investment information only (under AFSL 526842) and has been prepared without taking into account the reader’s financial situation. The Lakehouse Small Companies Fund owns shares in Cettire.