Invest in what won't change: Lazard on why it avoids thematic opportunities

Lazard Asset Management's Matthew Landy has seen many a speculative growth bubble like this before. And he says it's helped him to inform his view about why the team doesn't chase the latest megatrend or thematic narrative investments. 

In his own words, he believes that the team is the "antithesis" of a thematic investor.

Indeed, he prefers to focus on what will not change over the next 10 to 20 years.

In this latest edition of Expert Insights, Landy and I discuss why this is the case and how to avoid investment traps. Plus, we'll take a deep dive into the essence of Lazard's investment philosophy - what makes up a strong "economic franchise"?

To find out, click to watch the video or read the transcript.

EDITED TRANSCRIPT

LW: How does the team think about longer-term thematics in the portfolio?

Matthew Landy: In a way, we are kind of the antithesis of a thematic investor. We are not trying to make a call on how the world is going to change over the next 10 or 20 years. In fact, really the question that we asked ourselves is what's not going to change over the next 10 years, over the next 20 years? 

In other words, are people still going to be drinking beer in 10 years' time? Are people still going to need pharmaceuticals and medical devices in 10 years' time? Are people still going to need security services for their homes in 10 years' time? Are people still going to want to have a flutter on the lottery in 10 years' time? Those are bets we are pretty comfortable making. 

On the other hand, are we all going to be living in the metaverse trading gorilla NFTs with Bitcoin? We'll leave that to people with better crystal balls than we have.

LW: What are the signs that an investment may be a value trap?

Matthew Landy: The whole point of what we do is to try and avoid value traps. If we actually think a business has an economic franchise and has barriers from our brands, from brand perspective, intellectual property, network effects like Visa, and so on, then we think it's unlikely they're going to be disrupted, but that doesn't mean it couldn't happen. We spend a lot of time worrying about that. 

If you own an economic franchise, the barbarians are always going to be at the gate trying to get in. And so we're always going to be looking for that. 

One example that comes to mind is IBM, which we actually owned in the portfolio many years ago. We'd included it in the universe and the reason we actually kicked it out, we sold it and deleted it from the universe.

And the reason for that is that we were concerned about the rise of cloud computing. And so IBM has a big systems integration business and has historically. Now, the issue with cloud computing is that you're basically taking the hardware off corporate premises, so big servers and IT systems, and putting them into the cloud. That means you're also taking a lot of the need for systems integration and the people involved in that away as well. 

So we saw a threat to IBM. It hadn't materialised yet. But we felt like, the question we always ask with technological disruption is this product a substitute, or is it a compliment to what the existing incumbent sells? 

In that clap case, it looked like a clear substitute. So we sold IBM. 

A converse example would be Microsoft, in the same industry. So back in 2012/2013, people were concerned about Microsoft being disrupted by cloud computing because people felt that would enable startups to come in and sell software on a subscription basis and take some market share.

We actually felt the opposite was likely because effectively what Microsoft was doing was they were going to companies and saying, look, we can save you 50% on your total cost of ownership of systems if you bring all of your software into the cloud. At the same time, they could increase revenue per customer, and they had a captive install base. 

So it was theirs to lose. So we actually saw an opportunity for Microsoft from the same issue. And as I say, we owned it for many years through the transition to the cloud.

LW: What are the qualities of a viable "economic franchise"?

Matthew Landy: If we delete a company from the universe, it's usually for a few reasons. One, it might have just gotten taken out in which case it probably is by in through M&A. So it may be actually permanently deleted. 

Second, we think there's a disruption or structural change issue - with IBM being an example of that.

The other reasons that we delete companies from the universe though are often capital allocation. So companies, we find even in our universe, capital allocation is a huge issue. These businesses generate lots of free cash flow, how they deploy that free cash flow can be value-creating or value destructive. There's a lot of M&A that gets done. 

Particularly, over the past decade, we think that has been value destructive. And if that value destruction is too large in proportion to their business, we think, well, you have bad capital allocation policies.

The other reason that we delete companies from the universe is that they sort of diversify away from their core economic franchise. So they buy another business and we don't think it has the characteristics that we are looking for.

It's too big of a business and we'll delete it from the universe. We'll keep a watching brief on companies if we do delete them. But generally speaking, once they're out, they tend to stay out, to be honest.

LW: Are there any sectors you flat-out avoid?

Matthew Landy: We always keep an open mind. And we're always excited to try and include a business in the universe if it makes it on the sort of test that we apply. In terms of energy and banks, it's extremely unlikely that we'll ever have anything in those sectors. There are a couple of reasons for that. 

We're effectively looking for businesses that have two characteristics, one of the big barriers to entry and two, forecastability. 

So we are looking for businesses that have forecastable long-run cash flow streams because that's the problem we think we all face as investors.

We're all making forecasts and that's difficult to do. And so we're trying to narrow down the forecasting era of the businesses we look at. 

Energy clearly doesn't qualify on that basis because we have no idea what the oil price is going to be like in 10/15 years. Nor do we know what any other commodity price will be. 

Banks have the issue of leverage. So they're typically highly leveraged companies. That's how they make their money. And if you have a rise in bad debts on your balance sheet, it can be very, very serious for the business as we saw through the financial crisis for many companies. 

Access companies with an 'economic franchise'

The Lazard Global Equity Franchise Fund seeks long-term, defensive returns by investing in listed companies which possess a combination of high degree of earnings forecastability and large competitive advantages. Find out more here.