Joe Magyer and the team at Lakehouse Capital went into March with cash levels at around 14% - “on the high side” by his own admission. The team had been grappling with two issues; first, that investors and the general public had underestimated the impact of COVID-19, and second, that they don’t time markets. Magyer says however, that while many investors focus on the level of cash held, it’s the positions in the other 85-95% of the portfolio that really matter. Rather than focus on cash levels, instead they took the opportunity to reduce investments in companies that looked vulnerable, while buying more in companies whose prospects should hold up.
With both the Lakehouse funds comfortably outperforming their benchmarks in March, I got in touch with Joe to see how he’s positioning for this new investing environment. He tells us what to look for and what to avoid, why he took some money off the table with Afterpay, and he shares two stocks that are well placed to thrive.
When did you realise that COVID-19 represented a material problem for markets and what action did you take?
We spent the first quarter balancing two strongly held views. The first was that the virus was likely to wreak far more havoc than most realised. The second was that we are long-term investors, not market timers, and had high confidence that governments and central banks would unleash everything at their disposal in order to soothe financial markets.
We made our first COVID-19-influenced trade in late January when we reduced our stake in Booking Holdings, which struck us as seriously exposed but with little concern reflected in the share price. By late February it became clear to us that the situation was out of control and we entered March with cash positions of around 14% at our funds, which is on the high end of what we tell investors to typically expect.
We spent late February and the month of March reducing risk in some areas while being opportunistic in others. In terms of managing risk, we pruned positions in companies where we have concerns about demand shocks, supply chain disruption, issues with business continuity during a period of social distancing, and general balance sheet health.
Meanwhile, we opportunistically increased our holdings in companies that could prove medium-term beneficiaries including market leaders who we think can strengthen their position during a recession or digital-first businesses who should see engagement and adoption pulled forward because of social distancing.
Ultimately, we were significant net buyers during the period and reduced our cash allocations. That said, while investors have a tendency to focus on whether someone is at, say, 5% or 15% cash, what is far more important is the positions that sit inside the 85 to 95% of the portfolio that is actively deployed.
We know of some managers who prefer to flatten out their holdings and diversify during major market downdrafts so that they have a better chance of catching the turn. We think that’s antithetical to the purpose of active management, though, not to mention illogical in an environment where selectivity pays, and few companies will come out stronger on the other side of the crisis. As such, we’re a bit more top-heavy than usual even for our typically high-conviction style.
What are the core assumptions about COVID-19 and the related economic disruption that you’re basing your investment decisions on?
We still have a balanced view of the situation and are ever conscious that the market is not the economy. We fully acknowledge the economy will get worse before it gets better, however, the market has a long history of rewarding patient, long-term optimists. For that matter, markets usually turn before the economy bottoms, a point which seems to catch many inventors flat-footed and shouting at the rain during market rebounds.
Also core to our thinking is that investors should not underestimate the determination of politicians and central bankers to stabilise the economy and pacify financial markets, if for no other reason than to keep their jobs and save their reputations. No, showering financial markets with liquidity does not solve the underlying problem, but it goes a long way towards de-risking markets and supporting the prices of financial assets.
Lastly, we are optimistic that better and more widespread testing, trials and use of new treatments, and the increasing adoption of effective, low-cost means of reducing the spread of infection including temperature checks, wearing masks, and washing hands with soap are becoming more widely acknowledged and adopted.
Again, we expect the economy will get worse before it gets better, and for that matter we expect markets to stay volatile until there is high confidence that the situation is under control. Nonetheless, we think there are still plenty of attractive individual opportunities and reasons to stay long-term optimistic.
Which of these assumptions present the biggest risk?
The biggest blindside to longs would be if it turns out if most individuals are able to get the virus more than once, which would leave most of the developed world locked into some form of social distancing until highly effective treatments and/or a vaccine is developed. Thankfully, most evidence points in the other direction and we have somewhat of a natural hedge to this risk as the longer this drags on the further adoption curves will get pulled forward for our many digital-first portfolio companies.
The biggest risk that no one is talking about is the chance that governments and central banks overshoot on stimulus. True, the stimulus used to treat the GFC didn’t move the needle on inflation, but governments and central banks have also gone much harder, much faster this time around. Frankly, when I heard the world’s most powerful central banker say last week that “the one thing I don’t worry about is inflation,” I could not help but think that is exactly the risk that we should keep in sight. We’re not sitting around expecting hyper-inflation, but we do plan to keep a closer eye on prices than usual. And again, though, we have some natural hedges to such risk given our bias towards payments businesses and companies with pricing power.
What are some attributes that are more valuable to investors now?
Qualities such as extreme customer loyalty, unique and enduring intellectual property, and pricing power afforded by a strong value proposition married with diffused customer and supply bases are all unusually attractive right now. Also, while we have a general bias towards founder-led companies, we place outsized weight on high insider ownership today as managers with their fortunes and reputations almost entirely on the line are far more likely to fight tooth and nail to preserve and grow capital.
What are some risks that are best avoided altogether?
Significant operating leverage still probably does not get enough playing time. We’re surprised at how well many companies that might be considered defensive in a typical bear market are thought of in that light in a period of social distancing. We’re also particularly leery of companies right now with significant supply or customer concentration.
What’s your take on the outlook for Afterpay?
We’re still long-term optimistic about Afterpay but took some money off the table to right-size our position size relative to the now-wider range of outcomes. The market is confident that growth will slow and bad debt debts will increase, and we don’t disagree, but we still have a meaningful position in the shares and our view is Afterpay is better prepared to navigate the current environment than most appreciate.
Unlike a big bank, whose loan book turns as slowly as a battleship, Afterpay has a much more nimble model because it turns over its receivables book 13 times a year. The company has also started pulling levers such as tightening approval rates for new users and higher-risk purchases, right-sizing market spend, and pulling forward the first instalment payment for most purchases for most users in Australia, which will improve capital velocity.
Ultimately, the position is further out on the risk curve today than most companies we own but we have significant confidence in Anthony and Nick, and think that the business still has significant growth potential on the other side of this crisis.
Could you discuss two stocks that will benefit from changes in business or consumer behaviour?
PayPal has long gobbled up share of online payments with total payment volume growing at a 25% annualised rate over the past five years. The economic slowdown will hurt discretionary spending and cross border trade, however, social distancing is pushing current online shoppers to do more shopping at home, which plays into PayPal’s hands, and is also driving consumers who haven’t made the jump to shopping online to give it a whirl. It helps that the business is profitable, cashed up, and should be able to play offense during a tough time. Despite all this and a clear strengthening of the thesis, the shares sell in line with forward and trailing multiples from the past three years.
Nanosonics is a business with a long runway that just got even longer. The COVID-19 health crisis is absorbing the full attention of hospitals currently, however over the medium-term we could see adoption rates for Nanosonics’ suite of high-level-disinfection products brought forward and increased as hospitals place more weight on disinfection. The business’ heavy R&D focus has it on a path to launch a new product soon with additional products to follow in the years ahead. Nanosonics is very well positioned to drive its global expansion, with solid cash flow, a fortress balance sheet, and promising product pipeline. It helps that the shares sell for around 20% below their highs despite an arguably stronger raison d'être.
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Nanosonics and Afterpay are holdings in the Lakehouse Small Companies Fund. Joe Magyer owns shares of PayPal, which is a holding in the Lakehouse Global Growth Fund.
One of the more lucid analyses that I have read, thank you for cutting to the chase.
Please get Joe Magyer from Lakehouse Capital back more often. Exc interview and I learnt a lot despite reading stuff like this for 30 years! It will be insightful to learn how well Lakehouse have performed post annual reporting season in August.
After pay has been on a roller coaster tear, whipsawing erratically. Those who managed to get in around the $10 mark recently have already been rewarded handsomely circa 200%! I wonder if Joe managed to trade the whipsaw wild ride!
I note that Afterpay have just announced that they are exercising an early call option and repaying their $50 million 7.25% fixed rate bond @ 102.50 plus accrued interest on 27 April, two years before it is due. This doesn't sound like the behaviour of a company which is having any sort of problems.