Sticking to your mandate with a gun to your head

David Thornton

Livewire Markets

When the market is in free-fall bar one sector - cough, commodities - you are presented with a binary choice. 

Do you A) chase the market to salvage some performance, or B) stick to your mandate and what you know?

Donny Buchanan from Lakehouse Capital chose option B. Sticking to an investment process that has worked in the past and, when the market turns, has a very good chance of working again. 

In today's episode of The Rules of Investing, I sat down with Buchanan to talk all things damage control, understanding growth stock valuations, and portfolio positioning as we make our way through the bear market. 

Stick to your mandate

Buchanan saw his end of the market, small caps, lose over 25% of their value from peak to trough.

Rather than chase the commodities rabbit in the hope of stemming the overall losses to the portfolio, Buchanan stresses the need to stick to what you know. 

"We're very clear about what we do, and we do what we say on the tin," he says. 

"If we had been chasing resources and energy, I told our investors very candidly that that should be a cause of concern for them."

That means staying fully invested. 

"We're not paid to get out of the market entirely, so you still have to wear it," Buchanan says. 

Still, Lakehouse trimmed a few positions.

"We had a position in Nitro Software, and they were doing very well through the pandemic with digital documentation and e-signature. But we also follow Adobe and DocuSign," he says. 

"The tide was rising fast and lifting all boats, but we thought Adobe and DocuSign, when things were slowing down, were getting aggressive."

So Nitro was out.

The freed-up capital was put to work in the form of initial public offerings - namely Pexa and SiteMinder. Two software companies that sit squarely in Lakehouse's sector expertise.

"They're the market leaders in what they do," Buchanan says. 

"Pexa are the dominant property settlement platform in Australia, they've got almost the entirely of the market. When it comes to refinancing, they have over 90% market share."

"SiteMinder facilitate smaller hotels through their booking and payment systems."

Growth companies are hard, but not impossible, to value

Growth companies in the tech sector have seen the greatest value accretion in history, with truly mind-blowing price-to-earnings ratios. 

Is it warranted? In Buchanan's view it is, but not every time. 

"IT is the bleeding edge and innovation, and there have been extraordinary levels of wealth created in very short spaces of time," says Buchanan.

"Retail and institutional investors can get carried away with that at times and lose their head on valuation."

This has been alluring to investors. 

However, these companies are valued on projected revenues rather than profits. Indeed, some of these companies go years without turning a profit, instead reinvesting every dollar of revenue in order to grow market share. 

Buchanan points to Xero (ASX: XRO) as a company that has done it right

"Xero's printed accounting losses since its inception and they've just continued to reinvest. You can't see the value creation that's happening there until you fully appreciate the business. For every dollar they've spend on sales on marketing, they've generated multiples of that in lifetime value," he says. 

It's easy to build a narrative around these companies. 

On one level this makes sense. Market share today for tomorrow's revenue. But the ultimate purpose of any commercial business is to turn a profit. 

"At the end of the day, businesses need to make money. They can't invest in customer acquisition and push out the cashflow indefinitely," he says. 

"The chickens have come home to roost, and people are figuring out which businesses have real cashflows behind them and which were a bit more conceptual in nature."

A stock for the bottom drawer

As part of our regular 'favour questions,' I asked Buchanan to offer up one stock he'd own for five years if he could own no others. 

He went with Audinate (ASX: AD8), developers of patented audio-visual networking technology.

"Despite being a tough operating environment, I think the management has done an incredible job doubling down and investing for the long-term," he says. 

Their focus is on proliferating that eco-system, and that ecosystem will be there for the next decade, it could be several decades."

Buchanan says they've won the market on audio and they're very well placed to win it on video. 

"I'm absolutely convinced that they'll be the dominant platform in the future," he says. 

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David Thornton
Content Editor
Livewire Markets

David is a content editor at Livewire Markets. He currently hosts The Rules of Investing, a half hour podcast where he sits down with leading experts across equities, fixed income and macro.

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