When investing in a new company, there's a lot to consider. Past performance, management's track record and future earnings potential are all critical areas to explore. But according to Joe Magyer, CIO at Lakehouse Capital, the most important consideration is a company's balance sheet, particularly in the wake of a pandemic. It is a company's balance sheet that will differentiate them from competitors and allow for their outperformance. 

"Companies with strong balance sheets can play offence when everyone else is playing defence."

In this extended interview, Joe outlines why a company's balance sheet is critical for their success, his experience investing through market lows and his short and long-term outlook for the US. Joe also reveals one Australian stock that has adapted to the COVID-19 structural shift, has a strong balance sheet, and will continue to perform long after the crisis is over.

Timestamps

• 0:00 - Joe's grandfather planted the investment seed
• 1:23 - Joe's investment process through COVID
• 4:57 - An example of a company meeting his investment criteria
• 6:03 - Reasons behind Joe's conviction to invest during March 2020
• 7:07 - U.S. Outlook

Edited Transcript

What influence did your Grandfather have on you?

For context, he was an entrepreneur, very successful, retired in his late 30s. Hardcore, hands-on, man's man, who in his free time decided to build a lake house. So he chose the site, designed it himself, built it himself, that kind of guy. I could never do anything like that.

We would spend our summers up there. All the other grandkids would be out playing in water, and running around, and shooting BB guns and all that kind of stuff, I would be hanging out with my Granddad and he would be watching CNBC and thinking about his portfolio. He'd been retired for a long time and he was really passionate about it. We would sit around and talk about the kinds of businesses he was invested in, the tailwinds behind them, the fundamentals. We'd watch CNBC. And he talked about, "Okay, here's what's happening. Here's what that means. Here's why that matters. Here's what I think is stupid." It was really fun and enriching and really sparked that with me at an early age.

So, for my 13th birthday he bought me a 10 shares of Shaw Industries, which probably wouldn't be recognised by a lot of Australians. It's the world's largest carpet manufacturer, which was later acquired by Berkshire Hathaway. From a very early age, I was following stocks and markets and it just spiralled. And it's been my passion for a long time.

How did your investing change during COVID-19?

Pre and post COVID, we value companies with extremely loyal customers, unique and enduring IP, or network effects. That's at the economic model level.

At the more investment trait level, strong balance sheets. That's one that a lot of managers talk about, liking companies with strong balance sheets. But in March and April, you got a good sense from looking at managers' results how much they really valued strong balance sheets. Companies with strong balance sheets can play offence when other people are playing defence.

Nine years out of 10, people don't pay a lot of attention to balance sheets because so long as the P&L is going fine, what's the problem?

But it's that maybe one year out of 10, where having a strong balance sheet can mean thriving while your competitors are firing a lot of people and bringing in costs. That's something that we've always prioritised and continue to do so.

We also looking for a strong, competitive advantage. Not just having a competitive advantage, but the advantage is accelerating or improving at rates of change above what the market appreciates. Aligned leadership teams who have skin in the game. Paying a reasonable price for all of that. Those are things we're always looking for.

I'd say within the heat of COVID, particularly when we realised in late January, that the tourism sector, for example, would be hit. We lightened up on Booking Holdings, which we had at the time. It was already a weakly held position in terms of what we own, but we took some money off the table. A few weeks later, we exited the position. It was very clear to us that things were going to get much worse than the government was alluding to, or consensus estimates reflected. With Booking, the consensus at the time was the room nights would be down 4% year on year. We looked at 9-11, exogenous the shocks in the US and that was crazy to us that it would only be down 4%. We thought that things could get much worse. We went ahead and exited and literally, that afternoon, they pulled the guidance. So we were just ahead of the curve there.

During the heat of it, I think we were more conscious of those risks, but more opportunistically, we also realised social distancing is going to change the game in terms of how a lot of these business models work. We were very aware that there are a lot of businesses that might look statistically cheap, but might be relying on large crowds coming through the business. Is that essential to the model? Because a vaccine could be a pretty long way off and they may not have the balance sheet to survive.

More optimistically, does this suddenly drive demand because people were staying home and leaning more into 'digital first' companies, who were net beneficiaries. It's funny, because that was a whole market cycle in the span of three months. But end to end, we still have the same core philosophy in what we're trying to achieve. In the middle, we were leaning more into it. Today, I'd still say we're leaning into more 'digital first', less consumer than usual. But we're always on the lookout for new opportunities and have to keep your eye out for what's happening.

What's an example of a company that fits this criteria?

Whispir (WSP), domestically, is a good example. Whispir provides software and messaging tools that allow companies, governments, or agencies to contact employees or customers quickly, efficiently, and automatically. Where that's come into play over the past few months is Business Continuity Planning (BCP). They saw a big influx in government customers who suddenly realised, "Hey, we need to communicate with a lot of citizens or people taking tests and do it effectively. We need to be able to track it. It needs to be an auditable record of all this happening."

So to them, it was a structural up shift in not just usage, but companies dusting off their BCPs and getting more serious about it. I don't think that changes in a post-COVID environment. I think that's going to be a new default and the level has been set higher. It's reset to a new level, but we think it'll still keep going at kind of historically normalised rates.

What gave you the conviction to buy during March?

We're longterm investors. Everybody says they're a longterm investor. Investing against the grain, being greedy when others are fearful and taking a long term perspective, those are all easy to say. But when the chips are down and you're experiencing the steepest market draw down in history, you learn a lot about people's true execution of the philosophy. We did a lot of buying and it worked well for us. But the way we viewed it, a lot of these companies would come out stronger on the other side.

To be blunt, it's the steepest market draw down in history. If you can't find something that's attractive, like what have you been doing with all your time?

That really underscores the importance of watch-listing, which is something we spend a lot of time on. We get to know our companies really well, but we also have a queue of ideas. We continuously watch businesses that we think have a competitive advantage, but the price isn't right.

What is your outlook for the US?

America is going through a tough time right now. I've got friends, family, and colleagues over there, and it is a very difficult period. In a way, America is the worst positioned country for COVID, because it is so decentralised and freedom and individuality is so celebrated. A lot of the time that's great. A pandemic is the worst case situation, exacerbated by having a reality TV star elected as president. The reality is there's no putting the cat back in the bag in the US with COVID. It is just so widespread. It's more a question of how they're going to navigate living with it, which is broadly true everywhere, but particularly in the States. Like everyone, I'm rooting for a vaccine coming sooner rather than later, I'm rooting for continued improvements on treatment.

There have been improvements there, which is good news. Ultimately, (virus infections are) more of a V-shape instead of whatever shape it might turn out to be with the economy. That said, the companies we own, we think, are well positioned regardless of the environment.

With companies that are digital first, for example, if this were to drag on, we think that they'll be robust throughout that because you'll see more of a continued demand pull-forward. They have good balance sheets. The longer this drags on, weaker competitors pull out. A lot of venture backed companies are really struggling right now. So, your public companies that are well capitalised, it's entrenching them even further. We are absolutely rooting for a big V-shape and a turnaround in the economy. But because the companies we own are just generally so robust, the longer it goes on the stronger they come out on the other side. So we feel like there's a natural, 'eat your cake and have it too' situation with the strategy today.

This video was recorded on the 10 July 2020

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