Expert Panel: Finding Generational Businesses | FinFest

Bryce: [00:00:15] Welcome to another episode of Equity Mates, a podcast that follows our journey of investing, whether you're an absolute beginner or approaching Warren Buffett status. Our aim is to help break down your barriers from beginning to dividend. My name is Bryce and unfortunately not as always. Ren is not here today. He has got COVID again and so is at home recovering. So we wish him all the best in his recovery and hopefully he's back in the studio in no time. So what we have today is one of our favourite sessions that was actually hosted by Ren from Fin Fest 2022. The session is called How to Search for Generational Businesses, and we have a panel of experts, each specialising in a different area of the market. So we have Paul Wilson from Baylor Dorr, who specialising in that early stage tech. We have Will Dowd, who is from Fairlight Asset, and he specialises in global small caps. And then we have Adam Milne from Wilson Asset Management, who specialises in Australian large caps. So experts focussing on all different parts of the markets and around sort of gets them to explain the process that they go through to find those truly long term generational investment opportunities. That's about a 30 minute session and it was one of the most popular at FinFest, so we're really excited to be able to bring that to you today if you weren't able to get to FinFest. Now, one other massive ask that we do have of you, if you could, is to vote for us in the Australian Podcast Awards. We've been nominated for three awards, best publisher up against the likes of ABC, SBS. We've been nominated for Commercial Campaign of the Year. You may remember the Super Hero Super Saturdays commercial campaign that we did last year, and we've also been nominated for Best Business Podcast with our news show, The Dive. So we're really excited about that to make the finalists. But there is a popular podcast award if you could head to Australian Podcast Awards dot com slash vote and type in Equity Mates investing podcast and throw a vote our way. That would be much appreciated. The voting closes in about a week's time, so there's not a lot of time and we would really appreciate it if you could throw a vote our way the more votes than Marija. We're up against some massive podcasts here in Australia, but we'd still just love to see the support from our community. So that's australianpodcastawards.com/vote and then type in Equity Mates investing podcast and we should come up anyway. Thanks for the support. We couldn't have made the awards finalists list without you. As always, we love the Equity Mates community. The support and commitment that you give us allows us to do what we do anyway. Without further ado, here is how to search for generational businesses hosted by ALEC with a panel of three experts from FinFest. 

Alec: [00:03:13] A massive thank you to Brian and to Steak for being the major sponsor, the headline sponsor of FinFest. We couldn't have done it without Brian, his team and all of stake so a massive thank you. If people are out in the bull market, over at the food trucks at a bar, we've got plenty of seats here, so please come join us. Beanbags at the front. I made a mistake in the introduction. The bar is open now. I wanted to clarify that. So plenty of drinks are available. But look, I'm really excited for this session. I think as investors, you know, there's a lot of ways to invest, there's a lot of ways to make money. But the one thing that Bryce and I have learnt time and time again, year after year, is investing at its core, is trying to find those generational businesses, those incredible businesses run by incredible teams that you want to put your money with and let them go to work. And so we were really keen to kick off the main stage with this session and get three different types of investors, investors looking at different companies of different sizes and really draw out the commonalities of what makes those great businesses. So without further ado, pull Will. Anna, thank you for joining me by way of introduction, why don't we go down the panel? Tell us a little bit about yourself and the type of companies you invest in. 

Paul: [00:04:34] Okay, thanks, Ren. So often by little technology investments, we invest in high growth tech companies at the expansion stage. So that means businesses that are generating about $5 million or more and we look to help take them on their journey to be $1,000,000,000 or more. That usually means addressing global markets. We've done a lot of software companies, but not exclusively. We invest across the information technology spectrum. I also had sort of Baillie Dorr. I'm an investor and director and the Rajasthan Royals cricket team in the Indian Premier League, artisan skin health and wellness clinics, kismet movies and the various fitness studios, Bondi Beach. 

Will: [00:05:16] Good morning, everybody. My name's Wil. I'm a co-founder at Fellow Asset Management. And so we run one fund, an international small-cap fund. And so it's worth just touching on into small cap in the international space is a little bit larger than in Australia. So for us a small cap is a business that's a market cap of about us 10 to 20 billion. So you know, in an Australian terms that would be Sydney Airport or ResMed or Cochlear. So these are, you know, large businesses that have been around for many decades, have been profitable, profitable for a long period of time. And then when we're when we invest, we have a very strict set of quality criteria that we are looking for. So we want high returns on capital, long tenured management teams, very long track records of profitability and growth. And so as a result, we actually really only invest in a handful of sectors and that's on purpose. So we're looking for industrials, technology, businesses, health care businesses and consumer discretionary and consumer technology. So that really takes 95% of the market off the table to begin with. And we also only invest in developed markets. So the US, Europe are what we're looking for. So that's kind of our universe that we're in.

Anna: [00:06:29] Hi everyone. My name is Anna Moon. I am an equity analyst at Wilson Asset Management. I work in the large cap fund called WAM leaders where listed at ticker is w, l a and we invest in the ASX 200. So these are the household names of Australia. It's your Qantas, it's your Transurban, your Woolworths, your Telstra, your BHP of the world. So we have quite a different approach to investing. We're very top down. Obviously these names aren't undiscovered gems, so we focus very much so on the macro economic environment, which I'm not going to go into in more detail later. 

Alec: [00:07:04] Yeah, great. So as you can see, three very different, I guess investing focuses, but at the end of the day, what you guys are all trying to do is find great businesses. And so let's maybe start with how you would define a great business and in your areas of the market, maybe give us an example of a great company that you found before that you stay up at night dreaming that you'll be able to find again. So why don't we start with you, Anna? 

Anna: [00:07:29] So I think it starts with the industry that it operates in and it's pretty easy to work out when industries are good or bad. I think a good way of thinking about it is supply and demand. If you have an industry where there is limited supply but insatiable demand, that's a great place to invest. And then when you're looking at a company in that space, does the company have a good control over the industry supply, whether that be by way of IP, raw materials or just being the best competitor in the space? Some kind of moat is very important. I think if you couple that with a good management team and. Earnings growth of double digit for the next decade. I think that would be a generational business, in my opinion. In the large cap land, they are harder to find because they are already very well developed and at some stage they were probably incubator companies and have made their way through the ranks and to the with, you know, the big boys playing the ASX 200. But one that comes to mind for me is the lithium produces the pure play and that space on the ASX 200 is Pilbara and that has those characteristics of supply and demand pretty clearly. So there is a very limited supply of lithium. Australia is very lucky to have a number of producers. We have Pilbara, we have all can we have mineral resources and the large cap space and. It's become pretty clear that any supply that's coming on is being pushed further out. And there are a lot of challenges with exploration. So it's a very limited natural resource and yet demand is only growing every day. I think the penny has really dropped. The common factor is that there is just simply not enough of it to go around and for them to all meet their growth targets. And I was in Perth a couple of weeks ago and speaking to all these companies and they were saying that these comment factories like Tesla, like Volkswagen, are bypassing the OEMs and having negotiations directly with the producers. And so I think that really plays into that strategy. And Pover has gone from $0.50 to $5 in less than two years. So that's certainly one that we've been watching. 

Alec: [00:09:48] How about you, Will? 

Will: [00:09:49] Yeah. So I think it's a seller's philosophy that we want to try and find the 30 best businesses that nobody's ever heard of. And the way that we do that is we just try and find the most boring businesses we can that are super profitable in the nations that they operate in. And so for us, our North Star on quality or finding a generational business, we always come back to return on capital. So that's effectively the profits of the business divided by the assets or the money that the business has spent to generate its competitive position. And so for us, we want businesses that have decades of track records, of earning returns on capital of 15, 20% or above. And so a really good example of that is actually flights large, largest holding at the moment and we've owned this business for more than five years and I think this would definitely be the best business that nobody's ever heard of. It's called Constellation Software. You might not have heard of it. It's got a market cap of 30 billion. It's got 30,000 employees. And if you could go back 25 years ago, you know, back to the future style, you would actually choose to invest in Constellation and not Amazon, not Netflix. It's delivered investors a return of 3% per annum for the multi-decade. It's still an amazing business, but it just does so by operating in these very small, profitable niches. And so the best way to describe this business is it's effectively the Berkshire Hathaway of software businesses. So it started 30 years ago. What it does is acquires very small software businesses in very small nations that don't attract any competition. And so you think of if you're a pharmacy and you need software to do your prescriptions or you are a golf course, you need software to do tee off times or you're a taekwondo club and you need software to track your belt. So we're talking about very small nations. And there's actually what happened 30 years ago, an entrepreneur has seen this nation has built a business around it, and now they don't grow very fast, but they also don't attract much competition because, you know, you Microsoft. So your recipes of the world are not that interested in getting it to these small nations. And so what you have is across the world, hundreds of thousands of these small businesses, all the owners now need to retire. So there is a wave of effectively transition that needs to happen. And Constellation software, what they do is they go to these owners and they say, we'll help you transition and we'll buy this business from you. And so because they're small and they operate in small nations, they can buy these businesses at four times, six times earnings. So you think about, you know, as long as your profits don't go down, that's a day one return on capital of 25%. But what makes it really interesting is when we think about the future growth runway of this business, Constellation has acquired about 500 of these businesses. They do about 50 per year, but they estimate that they've got about 1% of the total addressable market of these small software businesses around the world and they actively track about 50,000. So when we look at the track record of that business, multi-decade, really high returns on capital. And then looking forward, we think, you know, there's many years left where that can continue to just hoover up these small businesses and earn sort of 15, 20, 25% returns day one.

Alec: [00:12:51] I love that. And Will and I didn't compare notes beforehand, but on Monday's Equity Mates podcast, we actually talk about Constellation Software. So if you want to learn more about Constellation, listen to the podcast, how to get a shameless plug in there. How about you, Paul? How do you think about generational businesses and is there one example that comes to mind? 

Paul: [00:13:10] Sure. I'm going to pick up on a couple of points that animate supply demand, economics, talkback. Firstly a great business as opposed to generational business and really bring it back to some old school thinking around Porter's five forces. So what's the relationship with suppliers? What's your relationship with customers? What's the risk of competitors and what's the risk of product substitution? And so if you can think about those elements for a business that has established a really good product market fit that customers love, then we think you're in a terrific position and you can start to think about, well, how long will that endure? What's what sort of growth should it achieve? And then how much did you pay for it? Example I'm going to give you is is the Rajasthan Royals so. We can come back and touch on this further when we talk about generational businesses. But if you think about the royals and those key aspects. Supply in this case is is the players and all the power really sits with the teams in that particular scenario the customers is they the Indian public? There's 1.4 billion just in India and then millions more around the world. And so once again, there's no single customer that obviously is going to provide any and any counterbalance of power. If you think about product substitution, you're really just betting on will the Indian public keep liking cricket? And that's kind of the bet you're making. And then for competition, there's a big moat, lots of reasons for it, but really no one else in world cricket comes within, oh, 20 times in terms of the player salaries that are available in the IPL. So I think it's a really great business. 

Alec: [00:14:59] I love that and I love the spread of companies. We've just talked about Australia, lithium producers, Canadian software company and then an Indian cricket team. It really does show that there's so much opportunity out there in different sectors and different countries gets excited about investing. So I guess the question is, you know, there's 40,000 listed companies around the world, I think more than 2000 just in Australia. And Paul, in the unlisted space, I don't even know how many companies that you could potentially invest in. How does the process start? How do you go about researching? How do you go about identifying potentially great companies? And then what tools and resources do you use to, I guess, build a thesis around them? Paul, why don't we start with you?

Paul: [00:15:41] Oh, sure. It's an interesting question. How does a process start? And I had to really make myself think, because for us, the process is just always ongoing, always evolving. It's almost like a living thing. We don't really usually sit down and start a process to look for a company. We're constantly absorbing information, adding that to our knowledge base, adding it to our precedents. If we start to like a sector, we'll do deep dives and we'll start to understand those supply demand forces, competitive forces. Does anyone have a moat and then incrementally go from there? Oftentimes, we'll get to meet and interview various players within a sector and it can take us quite a while to develop who we think, if any, are going to be the enduring winners within a sector. So that's how I'd describe it. It's just a never ending ongoing evolution of thinking.

Alec: [00:16:32] Yeah, Will, how about you? 

Will: [00:16:34] Yes, we're a bit different in how we go about it. We've got very strict quality hurdles for the businesses that we will invest in. So there's 5000 small and mid-cap companies in the world. And then if you sort of layer on some return on capital hurdles, profitability hurdles, you know, low leverage, you actually whittle that down to about an investable universe of 200 companies. And so we effectively start with that pool of 200. Get to know them very well. And the way that we do that, we're 100% bottom up investors. So we don't do market timing, we don't do macro calls, we're not looking at, you know, where commodity prices and whatnot are going. So for us it's truly to go to the company filings, pick up their annual report, you know, read what management is saying, and then we spend the rest of the day in front of spreadsheets and reading transcripts. So not particularly glamorous, but that is how we do it for us.

Alec: [00:17:21] And then, Anna, how about you? 

Anna: [00:17:23] Yeah. So the universe that I invest in is extremely well defined. This ASX 200. So there's 200 companies and we are extremely active managers. Our turnover is around 100% a quarter of our fund, which is one and a half billion. So there's a lot of money being transacted every day. So we really value liquidity. So we stick in the largest caps of the large caps. And again, because these are household names that are extremely well covered, everyone's aware of them, it's quite hard to get an edge from a fundamental view. So instead we apply a top down approach and empirical evidence suggests that greater than 50% of returns and large caps can be attributed to macroeconomic factors. So we spend all our time sweating over the macroeconomic environment and when I say macro, I mean we watch foreign exchange markets, we watch commodities, we watch fixed income markets and look at them with a fine tooth comb. And then we take views on these aspects of the different markets and we apply them into buckets, and then we choose the buckets that we want to invest in and then and then look at the stocks within them. So we start very macro. The world is changing a lot at the moment. It's extremely volatile. So there is a lot of opportunities in the large cap space for us, but I spend a lot of my time running screens, so looking at price performance, looking at changes in expectations versus the market, because markets are all about expectations. If you have a view but the market has the same view, you're not going to make money. It's kind of trying to work out where we're different, where we have an edge and going from there. When it comes to sources of information at a stock level, I think there's no better place to hear it from than the horse's mouth. So we spend a lot of our time talking to management companies. That's clearly a little bit harder for investors like yourselves. But at the moment it's AGM season, so if you're wanting to find out about a company that you're wanting to invest in or invest in, I do recommend that you listen to the AGM call, hear the chairman chairperson speak, hear the CEO speak, read the slide pack. They really slide packs onto the ASX. You can have a look at them. And then similarly all listed companies in Australia report at least twice a year and they will do an earnings call and the first half of the earnings call, about 30 minutes, they're talking through what's happening, the key drivers of the business. And then there is about 30 minutes of Q&A where analysts from banks like Jp morgan and Goldman Sachs really grill the company on the issues and the opportunities that they think are most important. So I think that's a really good source of information for everyone to look at. 

Alec: [00:20:06] But now I guess the rubber hits the road when it comes to investing in individual stocks with valuations. And I imagine for the different universes that you're investing in, valuation is looked at differently or you know, you perhaps use different methods to value companies. So why don't we start in the large cap space? How important is valuation in your world and what are the methods or the tools that you're using to value investment opportunities? 

Anna: [00:20:38] Valuation is everything. You can have a fantastic company, but effects on extreme valuation. You might have missed the opportunity to make that alpha. So valuation is everything for us. When it comes to valuation, a share price is derived by its price, so the price to earnings ratio, you have the valuation of the company and you also have its earnings. So we look at both parts. So we think there is an opportunity for the earnings to improve? That's box number one. That has to be ticked and then is the opportunity for the valuation to get greater. And that's box number two. That has to be checked. So when things are entering our portfolio, they have to tick both these boxes in quite a compelling way. So given our universe is very mature, we look at these p e ratios across all our names. I'm sure it's different for the companies that are in those early stages and aren't earning profit yet, but that is how we generally look at names. We can also look at dividend yields, free cash flow yields, but generally all companies in our universe can be assessed on those same metrics, which makes it a little bit easier for us.

Alec: [00:21:47] So in the large cap space, valuation is everything will take us into the world of global small caps. How important is valuation? 

Will: [00:21:54] Yeah, I'd have to echo his thoughts on that. We're definitely very disciplined on valuation and it sounds like we have a relatively similar approach. The great thing about having quite a simple philosophy and being very stringent on the companies that we do let into our universe means that we can actually really got one valuation apart so we can apply to everything. So, you know, as investors, we don't need to be trying to figure out unprofitable miners and all this kind of thing. So we've got one approach and we stack all of our companies up. I'm using that one approach, and then what we do is for the absolute best businesses, we'll give them a little bit more leeway on valuation because we think that over time the absolute best businesses tend to surprise and can compound a little bit faster than you think. But for us, yeah, it's really just your rank and stack of all those businesses and then and figure out the three that are the most attractive. 

Alec: [00:22:42] And now, Paul, take us into the world of high growth ventures. How do you think about valuation? 

Paul: [00:22:47] Well, I think it's fair to say the smaller you get and and the closer to start up, the wider range of outcomes you have. So it's definitely a combination of art and science. Fundamentally, valuation is all about the future cash flows. And so if the business is only generating 5 to $10 million at the time of investment, you have a huge range of outcomes and it all depends on execution. And so a lot of what we are doing is diligence, seeing the teams, the product marketing, what the customer thinks and try and narrow down the range of outcomes. Just to give you some examples, sight minor in the bilateral portfolio, the most recent cash realisation on that was at a value more than 20 times our cost last year or during the year. We we sold all of our position in H2 cluster, a dot or as a service business. That was an 8 million position that we sold for 118 million to more than 14 times money. And so what I'm saying is at the earlier stage, you are going to have some investments that can lose money, hopefully not too many. And that's a lot of what we're about, is protecting against that. But because of the wide range of outcomes, you can make many multiples of your cost. And so the valuation at entry point is slightly less impactful than, than at the other end of the market. 

Alec: [00:24:16] Yeah. So I hope that's the message that everyone's hearing from this session, that there are different ways to invest and different ways to make money in the stock market. You can invest in the the biggest companies in Australia or in the world. And the way you think about valuation is different. And also, you know, the macro factors are a lot more important. You can look at small caps where, you know, Will is a bottom up investor who is not thinking about the macro as much. And then Paul is looking for growth and, you know, potential, you know, massive returns. And it's all a little bit more uncertain as well. So depending on how you want to invest, what your temperament is, there's plenty of ways to invest. The important thing is understanding what works for you. So we've got a couple of minutes left. I want to finish with a final question and get back to an individual company. What's one company in your portfolios or on your watch list that you think has potential to be a generational business? And we say this importantly, remembering that none of these experts know your personal financial circumstances and you need to do your own research. But with that disclaimer in mind, Paul, why don't you kick us off? 

Paul: [00:25:26] Oh, I'd say within our portfolio site, minder is a generational business. The reason I say that, it's a it's a world leader. It sells into over 100 countries. It is a long way ahead of any of its competition. And it's a platform that sits in the middle of the ecosystem for technology, for the hotel industry worldwide. It started off servicing hotels, just getting their inventory out through online channels like Booking.com and Expedia. But it now has the right management tools, it has payments, functionality. It's got lots of different features. It's got more than 35,000 hotels on the platform. That's a multiple of any other player worldwide. And it also accepts other companies' technology onto its platform. And that's really important. So it's more akin to for that part of it, apps onto an app store and for every additional technology that comes on to the platform, it improves the experience for everybody. For every additional hotel that comes on, it improves the experience for everybody. It's a really nice flywheel and sightline. It just gets further and further ahead. And so we think it's got a wonderful, unassailable moat and a generation of growth and profitability ahead of it. 

Alec: [00:26:42] Great. Will, what's one on your watch list on the portfolio? Yeah, I'm going to. 

Will: [00:26:46] Lean into the most boring business you've never heard of. So this is a business that's always been too expensive for us to own. It's called Old Dominion Freight Line. And what it does, it's based in the US and it does less than truckload shipping services. So if you're a business, you need to move a pallet from A to B, you can't get an entire truck, you can't put in a parcel. These guys help you move it. But what matters for this business is it's been around for 100 years. The founding family still owns 15% of it. 97% of employees are shareholders, so truly long term thinking. And then what matters as well is I've actually spent the last 30 or 40 years strategically buying up plots of land around all of the major, major population centres in the US to put their distribution centres. And so if you think about you're a new competitor today and you're trying to compete with Old Dominion, you need to go to residents of these population centres and say, can I please put a distribution centre and have 100 trucks thundering past your house every day? It's impossible. You can't do it. So the competitive market is completely set. I went on at the time, I actually give myself a bit of a plug here because if you're interested in boring businesses, I'm actually talking more about Old Dominion at 4 p.m. so we can dive into it a little bit more then. 

Alec: [00:27:53] Love that and then Anna close us out. What's one business on your watch list or in the portfolio? 

Anna: [00:27:59] So I think there's so many exciting opportunities at the moment. Again, in large cap land where valuation is everything, that the price that you enter your investment at is equally as important as the price you exit your investment at. And there are a lot of attractive entry points at the moment for those names that have been hit by the short term pain that they might experience over the next 12 months with the fear of recessions coming on. So names that fit that bill for me are the likes of James Hardie. Supply and demand characteristics that I talked about earlier are extremely favourable. They have double digit earnings growth for the next decade to come, a good dividend yield and is just trading cheaper than they ever has. So that's the name for me, James Hardie.

Alec: [00:28:40] Great. Well, can everyone give a massive round of applause and thank our three experts? Paul, Will, Anna, thank you for sharing your time and your knowledge with us today.