Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 305

Joe Magyer on pricing power, customer loyalty and the network effect

Introduction: Joe Magyer is Chief Investment Officer of Lakehouse Capital, and Portfolio Manager of two unlisted funds, the Lakehouse Small Companies Fund and the Lakehouse Global Growth Fund. Much of this discussion relates to the Small Companies Fund which invests in small, fast-growing companies in Australia and New Zealand.


GH: One of the main characteristics you look for in a company is pricing power. How do you identify it and convince yourself that it's enduring rather than short term?

JM: On the analytical side, we want businesses with high and stable gross margins, and if they don't have that, then odds are they don't have pricing power. The tricky part is going beyond that. Businesses that have exceptional pricing power usually don't come out and say it bluntly. They don't want regulators and competitors to know and they don't want to upset customers. So you have to piece it together. We also look at results relative to volumes and what competitors are doing.

It's not hard to raise prices during an economic expansion. But we saw some businesses in the US that prided themselves on CPI plus price increases for six or seven years and then they gave it all back during the last recession. Anytime you see that, that's a big turnoff.

GH: And you focus on brand loyalty. How do you test or verify that?

JM: That's one of my big, personal fascinations. Most investors chronically underestimate the value of extremely loyal customers. It’s partly because they're so rare, and partly because in Australia, so many investors cut their teeth on mining and retail banking, neither of which are known for extreme loyalty.

GH: Banks tend to take advantage of existing customers and chase the new ones.

JM: Yes. John Mackey, who's the founder of Whole Foods and on our parent company Board of Directors, told me if you treat your customers like an annuity, you open yourself up to disruption. It doesn't mean that they're going to run away but you put a target on your back. So that's why we focus on loyalty rather than just switching costs.

Let's say you’ve got two businesses, one with 90% retention and another with 80%. Optically, that's not a big difference. In practice, the one with 90% retention has an average customer life of a decade, and the other is five years. So the business at 90% can spend twice as much to acquire customers, which is a huge strategic advantage. Or they can pay the same amount and get double the margin per customer. Either way, it's a far superior business and much more stable.

GH: And what’s the difference between loyalty and switching costs?

JM: Switching costs make it a headache for businesses to move on, and while that's valuable in terms of keeping customers, we much prefer to see loyalty based on products and services that delight the user. Instead of just seeing, say, 90% retention, which is still great, we find revenue retention that's above 100%. Customers are so delighted that they expand their spend. For example, more than half the customers that use Atlassian are like that, it’s a product that people love that's hyper scalable.

GH: What's the best example of pricing power, retention and loyalty you have seen in an ASX-listed company? One that even surprised you, maybe after you've invested?

JM: Altium (ASX:ALU) has been a phenomenal success story that not a lot of people pay attention to. And I think it's because their core product is not very accessible to everyday people. It's software for designing printed circuit boards, not something any of us are likely to be using. But over the past several years, they consistently raised prices with rising retention rates. That's a rare phenomenon. It shows the quality of the work and product enhancements they've made. They shorten the product release cycle, iterate faster, now they do upgrades faster, and customers reward them with a willingness to pay more for the products. You don't see that every day.

GH: That's a great example but it wouldn't strike me you would have the expertise in that technology, yet you invested at an early stage. How do you gain the confidence to invest in a company that makes printed circuit boards?

JM: A lot of fund managers pride themselves on qualitative research, but more valuable is working off the full data set of a company-wide story. With Altium, we looked at competitor results to see what they were doing, and it was clear that Altium was gaining share the market while raising prices. I would never try to master the art of designing circuit boards.

GH: Isn’t the major difficulty investing in an Afterpay or Altium that there’s so much dependence on future growth, with P/Es of 50 or 80, or not even a making a profit. How do you convince yourself not so much about the current business, but the incredible growth trajectory?

JM: We get fired up about situations with self-reinforcing dynamics. The network effect is one of those. My affinity for networks is that it's hard to find any other business model where so much value can be created so quickly. The market is often shocked and surprised at how quickly it can all came together, and Afterpay is an example of that. By the time a lot of fund managers even understood the thesis, there was already a lot of value creation and millions of customers. We love companies with lots of optionality and Afterpay has that.

GH: Do you get most confidence from the business idea or is it about the people?

JM: It's a mix of both. When I came out of undergrad at 22, I thought investing decisions was about spreadsheets, but then you get out in the real world. In small caps, we are very focused on management. Small caps often don't have much of a balance sheet, they invest 100% or more of what they earn. So you are betting heavily on the capital allocation and the leadership skills of the team. We have visited the small companies we own an average of nine times. It's less of a factor for some of the bigger businesses we own. The more money you reinvest, the more important it is that the management gets all those things right.

We own Visa, and no offense to the team there, but I'm pretty sure it could be run by a ham sandwich for a year and most people wouldn't notice. There's a charm in that.

GH: You’ve had an excellent run recently, topping the Morningstar tables, but in the last five years, 'growth' has beaten 'value' across all sectors. Is the performance more than the right place at the right time?

JM: We ask ourselves this all the time. Every good investment outcome has an element of luck, for better and worse. We’ve had the wind at our back in terms of growth, and some of the industries we focus on have done well, particularly enterprise software. That said, we've selected well in those sectors, so it's not just sector tilts. We’ve focussed on enterprise software and recurring revenue business models but there’s some degree of fortunate medium-term timing.

GH: In a recent article in Cuffelinks, you wrote about ‘fascinations’. Tell me more about them.

JM: Most funds are built around trying to cover the waterfront. There’s a guy covering North America, this woman's in media, it’s sector based. We think there are big problems with this approach. You get pitched ideas from all your analysts, regardless of whether it's actually a good place to be investing because that's what you've told them you want.

Not all industries are created equally. Some historically have low returns on invested capital or volatile returns on capital. And some of them are at the higher end. I don't see a lot of appeal in focusing our time or capital on industries that might be melting ice cubes or price takers. Fortunately, here in Australia, many people focus on industries where that is the case, such as Materials, so we have less competition in other parts of the market.

Our ultimate objective is to construct a portfolio of businesses that we consider have superior long-term prospects and reinvestment potential. We spend a lot of time talking about the subjects that we're fascinated about.

GH: Have you got a couple of favourite stock stories?

JM: Sure. Audinate (ASX:AD8) is one of our favourites that not a lot of people are familiar with, and it's only covered by three analysts. The business has more than reached a critical mass. Its core product is a software protocol called Dante that allows different pieces of digital audio to talk to one another. And it ran away from the competition because its product has the lowest latency. You could have a big auditorium, and your microphone will connect to the speakers in a clear way. There were people in the space before them, but because their product is functionally superior, manufacturers rallied around them. There is now a clear market winner and speaker manufacturers who were on the sidelines now see a leader so Audinate is gaining share of that market. Over 90% of their competition is just cables but digital is a better option.

GH: Is this, say, in a concert or conference set up, instead of cables running along the ground, the equipment is linked digitally?

JM: Exactly. It's a big improvement and a high margin business, and they are pushing into AV, such as in a sports bar with lots of screens, solving the same cabling problem.

GH: And a second stock?

JM: We’ve already talked about Afterpay. A lot of people understand the Australian opportunity but we think the US market, new products and extending the brand give a wide range of options.

Facebook is the biggest position in the Global Fund. The business could not have looked worse in headlines over the past couple of years, and they've made a lot of mistakes which they were rightfully fined for. But a lot of people look at the headlines and assume that the business is doing poorly or even shrinking. The opposite is the case. More than two billion people use the core Facebook business monthly and it's growing in every region. Revenue was up 30% in constant currency terms year on year. Then you've got Instagram, Whatsapp and Messenger, each of which has more than a billion monthly active users.


Graham Hand is Managing Editor of Cuffelinks. This article is general information and does not consider the circumstances of any investor. Lakehouse Capital is a sponsor of Cuffelinks.

The Lakehouse Small Companies Fund owns shares of Altium, Afterpay Touch, and Audinate. Both Joe and the Lakehouse Global Growth Fund own shares of Visa and Facebook.

For more articles and papers by Lakehouse Capital, please click here.



How we have invested during COVID-19

Get me out of Australia?

After 30 years of investing, I prefer to skip this party


Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates


$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reason to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies will benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.


Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated investors' can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.



© 2021 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.