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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.



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