Weekend Reading

2 December 2016 | by Paul Perrino, CFA

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

While We Weren’t Looking, Snapchat Revolutionized Social Networks (Farhad Manjoo, @fmanjoo, NYT)

Most people over 25 have heard of Snapchat, but haven’t given it much thought. However, it has quietly surpassed Twitter in the number of daily users. Usually, this kind of news would get a lot of media attention, but it’s been largely ignored. This could be because their user base is primarily “teenagers and 20-somethings.” The structure of Snapchat, from disappearing messages to the order of posts, has captivated their users and caused them to behave differently. It’s perceived as sharing (and viewing) a more authentic version of your life with your network, than on Twitter or Facebook. Facebook has started playing catch-up, with the development of their Live feature.

Cut the Top U.S. Corporate Tax Rate to 22% (Gene Epstein, Barron’s)

There is much anticipation for a decrease in the corporate tax rate. Barron’s determined that a 22% tax rate (down from 35%) would be revenue neutral to the US Government. The rationality for the tax cut being tax neutral for the US government is driven by economist Art Laffer’s research. His analysis is driven by two factors: “if the tax collector claims a lower share of income, there is an incentive to produce more income. Second, a lower rate means there’s less incentive to spend time and effort avoiding the tax.” The corporate tax system is also plauged by tax avoidance strategies which have caused many firms to have large cash balances that remain overseas. Lowering the corporate tax bracket could cause these funds to come back to the US and filter their way through the system.

Does Decision-Making Matter? (David Brooks, @nytdavidbrooks, NYT)

The drive and motive behind how we make a decision may be more important than the process used to make a decision. Economic models were built on the assumption that we’re all rational actors. “Kahneman and Tversky demonstrated that human decision-making is biased in systematic, predictable ways. Many of the biases they described have now become famous — loss aversion, endowment effect, hindsight bias, the anchoring effect” Mr. Brooks adds that curiosity can be a powerful driver in how we make decisions.

Sustainable Sources of Competitive Advantage (Morgan Housel, @morganhousel, Collaborative Fund)

Analyzing competitive advantages is a primary factor in how we invest at Ensemble Capital. Business is a brutal game. If there is a good idea making money, people will notice and attempt to replicate it. The ability for a company to structure their business to minimize someone’s ability to replicate it and steal its margins can have a material impact on the value and success of a business. The author offers five characteristics not typically found in business school text that can help maintain a competitive advantage.

Stock Returns Versus GDP (David Merkel, @AlephBlog, The Aleph Blog)

While over the long-run the growth in business earnings and GDP are correlated, this doesn’t necessarily hold true in the short-run. A short-term rise in economic growth doesn’t mean stock prices will rise. David Merkel argues this could “happen to stocks in the US if there is enough demand for capital from the US government to rebuild infrastructure.  Let the US government try to borrow more than $1 Trillion per year.  Watch interest rates rise, and watch stocks fall, as government borrowing crowds out private investment.”

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Most people think that if something is good, more is always better. But that’s rarely true. One of the most important concepts in economics, The Law of Diminishing Returns, shows us that each new unit of something good tends to produce less good than the previous unit. The easiest way to think about this is eating candy. No matter how much you love chocolate, the 10th piece doesn’t give you as much pleasure as the first piece and the 100th piece makes you sick.

Despite the economic roots of this concept, many economists (and much of Wall Street) think this issue doesn’t apply to the diversification of equity portfolios. But as we’ll show, more is not always better and the value of diversification diminishes much faster than most people think.

The chart below, based on data from the classic book A Random Walk Down Wall Street by Burton Malkiel, shows how adding a third or seventh or fifteenth position to an  equity portfolio materially reduces the volatility of returns. However, by the time a portfolio has twenty or so holdings, the incremental reductions in portfolio volatility from new holdings is very small.

benefits-of-diversification

Burton Malkiel, a strong proponent of diversification and a skeptic of active management, says in the book:

“By the time the portfolio contains close to 20 equal-sized and well-diversified issues, the total risk (standard deviation of returns) of the portfolio is reduced by 70 percent. Further increase in the number of holdings does not produce any significant further risk reduction.”

Malkiel’s research was based on randomly selecting stocks, so if an investor builds a portfolio of 20 energy companies or 20 technology companies, their portfolio will exhibit far more volatility than the chart suggests. But so long as the members of the portfolio are companies with diverse end markets, business models, etc, a purposely selected (rather than randomly selected) portfolio of 20 or so companies is very likely to capture the bulk of available diversification benefits.

Of course, investors do not seek only to reduce risk. They also want to maximize returns. If you are actively picking stocks that you hope will outperform, it becomes clear very quickly that it is quite hard to find a lot of good ideas. A realistic investor knows that even their best idea has a very good chance of underperforming, despite their best efforts. So a smart investor will build a portfolio of a number of stocks that they expect will beat the market. But there are limits to the number of stocks an investor can know well and have a reasonable basis to believe will outperform. So while more stocks will reduce volatility, it also requires adding stocks to the portfolio that the investor believes has less potential to outperform.

A 50th or 100th “best idea” isn’t likely to add much in the way of potential outperformance. But it also isn’t likely to add much in the way of lower volatility or reduced risk. So why do most professionally managed, active investment portfolios own well over 100 stocks?

There are two key reasons for professional active investment managers to own way more stocks that they need to.

The first is because it helps them not underperform by too much, but the price they pay is reducing their potential to outperform. If you own 25 rather than 200 stocks, the volatility of your portfolio won’t be much higher. But the tracking error of your portfolio to the benchmark will likely be higher. That’s because while your portfolio will be diversified from a volatility standpoint, it will be quite different from the benchmark. This is called having a high “active share” and research shows having it is a critical key to potential outperformance. But having a portfolio that is quite different from your benchmark means that while it might not be more volatility, it won’t “track” the benchmark as closely. Most managers don’t have any confidence that their clients (or their bosses) will tolerate any length of time where they underperform, so they own more stocks in order to reduce their tracking error. But this has the effect of greatly reducing their ability to potential outperform over time.

The second key reason is that the collective market cap of the stocks you own in your portfolio places a limit on how much assets you can manage in your strategy. A portfolio of 25 stocks will have a collective market cap that is lower than a portfolio of 200 stocks, so the manager, who gets paid for managing more assets, can make more money if they manage a strategy with more stocks in the portfolio. This is why you see relatively focused funds close their doors to new money, while the typical, excessively diversified fund rarely closes to new investors.

So diversification is great, but its benefits are realized with far fewer stocks that most people realize. If your goal is to match the market performance (which is a perfectly reasonable goal) than buying every stock in the market (ie. broad diversification) makes perfect sense. But if your goal is to beat the market, the level of diversification should be optimized, not maximized. What you want to avoid at all costs is attempting to beat the market by investing in strategies that are excessively diversified.

Thanks to Lawrence Hamtil of Fortune Financial for urging us to address this topic. You can read Lawrence’s blog here.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Despite the fact that individual companies, industries, and sectors have different fundamentals and outlooks, most of the time stocks trade as a group. How much the market is moving is usually the major driver of sector and even individual stock moves.

But this tight correlation between sectors, industry, and stocks has been completely broken since the presidential election. To our way of thinking, the “story” of the market is not best described by observing that the market is up 2%, but instead, is best understood by the two charts below.

This chart shows the performance of the various sectors making up the S&P 500. You can clearly see how after trading as a group prior to the election, in the days after the vote the performance of various sectors exploded in different directions with financial stocks ripping higher while consumer staple and utility stocks experienced what amounts to a mini-crash for these defensive (historically low volatility) segments of the market.

sector-performance

Source: @mulletHF

This dynamic is playing out among individual stocks, not just sectors. The chart below shows how “dispersion”, the difference between individual stock returns versus the market overall, has also exploded to levels not seen since 2009 during the financial crisis.

dispersion

Source: Wall Street Journal

This sort of market behavior isn’t good or bad. The market cycles through times when individuals stocks and sectors trade mostly in line with the market vs periods when they post wildly different results. But in trying to make sense of market behavior, the returns of market averages are more relevant during times of tight correlation and low dispersion but they don’t tell the full story during times of low correlation and high dispersion.

We view the current market environment not as one of a gently rising market, but rather as a period of violent re-pricing of underlying sectors and individual companies. Given our strategy at Ensemble Capital of building focused portfolios of individual stocks without a mandate to own all sectors, we welcome periods when the market rightly or wrongly sends prices in all different directions.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Weekend Reading

18 November 2016 | by Paul Perrino, CFA

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

Is Netflix Disney’s next big buy and is Reed Hastings its next CEO? (Peter Csathy, @pcsathy, TechCrunch)

Netflix’s rise has caused a shakeup in the media industry. Distributors, such as AT&T, are now trying to compete on equal ground with OTT‘s, by acquiring content creators. AT&T recently acquired Time Warner for $85 billion. This now gives AT&T control over such content assets as HBO and Truner. Consolidation among content creators may also be appealing, if one has a better direct distribution infrastructure or management. In the case of Disney, Netflix may be their solution.

Trouble Brewing in Commercial Real Estate (Peter Grant, @PeterGrantwsj, WSJ)

The real estate market is still working through the loose lending that occurred before the financial crisis. “Ten-year loans issued in 2006 and 2007 are now coming due, and many borrowers aren’t able to pay them off despite rising property values.” Mortgages that are more than 60 days late on their payment saw a 1% increase in September to 5.6%, “from a 4.6% delinquency rate earlier this year.” Rising interest rates and defaults in commercial real estate could lead to a slowdown in the sector.

AFRAID OF WHAT COMES NEXT FOR THE MARKETS AND ECONOMY? READ THIS (Jason Zweig, @jasonzweigwsj, JasonZweig.com)

The results of the election shocked many, but even if the result was what you expected, the resulting week after the election may have been a surprise. Asian stocks and US futures dropped more than 5% during the night of the election. The US market rebounded and ended positive at the close of open market hours on that Wednesday. Hindsight is always 20/20 and it’s not always clear how the market will react to certain events.

TRADE THE “MAYBES” AT YOUR PERIL (Claus Vistesen, @ClausVistesen, Alpha Sources.CV)

This is a quick summary of some of the potential impacts and unknowns from the result of the election.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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One of the more counterintuitive things about forecasting the future is that long-term trends are generally easier than short-term trends to predict. The idea that it is easier to predict what will happen over the next five years than it is to predict what will happen next quarter is a key reason why long-term investing works better than short-term trading.

One concrete example of this dynamic at work is the fact that we all know that a forecast about the weather on this coming December 4th is just a guess, but we certainly feel comfortable with the idea that we can reliably predict what the average temperature will be in December 2020. This post from Nate Silver’s 538 discusses this phenomenon and shows how our ability to predict the weather in the short-term only extends out 3 to 5 days, while at the same time we have the ability to make accurate forecasts about global weather patterns that stretch years into the future.

Similarly, investors have no ability to predict what the market will do the next day or even the next year, but we can make reliable forecasts about what they market will do over the next couple of decades. Ben Carlson explored this concept earlier this year where he showed that rolling 30-year returns for the stock market have averaged about 11% a year with a standard deviation of just 5%. The worst 30-year return was just south of 8% a year for the 30-year period beginning at the top of the 1929 stock market bubble before the Great Depression. The best was a little less than 15%. The last 30-years have seen annual returns of just shy of 10%.

screen-shot-2016-05-13-at-3-07-32-pm

Source: A Wealth of Common Sense

Sidenote: keep those long-term returns in mind when you hear people say that you should plan on low stock market returns in the future. Anyone suggesting that the stock market will return less than 8% a year over the next 30-years is actually saying that we’re in for the worst market of all time, worse than the 30-year periods that included World War II, the Great Depression, the Financial Crisis, the Dot Com Crash and the hyper-inflation of the 1970s.

But what about next year? Or even what about tomorrow? Investors have demonstrated zero ability to predict what the market will do in the short-term. For a real-time case study, see the unexpected market impact of the US presidential election results. The market could be up 30% in 2017 or down 30%. Or more in either direction. Or flat. It is impossible to say. But while long-term trends still have significant variability and investors must realize that just about anything can happen in the future, many long-term trends have a far more narrow range of likely outcomes than do short-term trends.

The average mutual fund holds a stock for about a year before selling. That means that their decision-making process is focusing on short term (unpredictable) metrics. These sorts of investors/traders might call themselves long-term investors, ape the slogans of Warren Buffett and discuss their valuation discipline, but really they are just trying to guess how many iPhones Apple will sell this quarter, what the price of oil will be next quarter or, in the longest time frame, what hospital spending might be next year in light of potential changes to ObamaCare.

Long-term investing shouldn’t mean that you hold stocks for many years no matter what. It means that you make decisions based on long-term outlooks. How many iPhones can Apple sell over the next five years? What oil price is required over the next 10 years to stimulate enough oil production to meet demand? How will health care spending trend over the next two decades as our country grapples with how to restrain the #1 driver of Federal debt?

The reason focusing on these long-term trends is the right way to approach investing is not because long-term investing is somehow morally superior to short-term trading (we like to make money quickly rather than slowly, all else equal), but because these long-term trends are far more predictable than short-term trends.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Weekend Reading

11 November 2016 | by Paul Perrino, CFA

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

Shift From Active to Passive Investing Isn’t What It Seems (Barry Ritholtz; @ritholtz; Bloomberg View)

There is a lot of analysis and articles about active versus passive investing. The most common error they make is the inclusion of “high-priced closet indexers” as part of active management. These “active” mutual funds typically hold hundreds of stocks. This causes their gross performance to mimic their index. Once you subtract their fee, they consistently underperform, which is what those articles show. You can read more about this here in: Portfolio Management The True Cost of Diversification.

Silicon Valley Decides It’s Just Too Hard to Build a Car (Keith Naughton, Alex Webb, and Mark Bergen; @KeithNaughton@atbwebb, and @mhbergen; Bloomberg)

Silicon Valley is known for their ambition, but they are finding out that building a car is a lot harder than they thought. The auto industry has spent decades developing the mass production process and tech companies are realizing they need to leverage their experience. It’s not a one-way street. “Where automakers come up short is attracting sufficient numbers of software engineers, which they lack by the thousands. Technology now represents half the cost of a car…”

Uber’s Self-Driving Truck Makes Its First Delivery: 50,000 Beers (Alex Davies, @adavies47, Wired)

The technology offers truck drivers true “level 4” autonomy. The truck still needs a driver to handle side streets but is fully autonomous on the freeway. This allows the driver to work on paperwork or “or even catch a few Z’s.” It’s believed that this will lead to safer roads. “Some 400,0000 trucks crash each year, according to federal statistics, killing about 4,000 people. In almost every case, human error is to blame.”

U-Haul Parent Amerco: Ready to Move (Andrew Bary, Barron’s)

The CEO of U-Haul display’s many of the same characteristics as the CEO’s profiled in William Thordike’s book The Outsiders. He “pays no attention to Wall Street; doesn’t manage earnings; rarely meets with investors; gets paid modestly by CEO standards, with total compensation of about $1 million in each of the past two years; oversees a thrifty corporate culture; and is focused on the expansion and management of the company’s truck-rental and self-storage businesses.”

On the lighter side….

Authorities Break Up Active Management Cell (Joshua Brown, @ReformedBroker, Ritholtz Wealth Management)

This is one of the funniest investment management related stories I’ve read in a while.

 

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Every great investor has learned from the greats that came before. Reading Benjamin Graham, Warren Buffett, Charlie Munger, Phil Fisher and a host of others is absolutely required. But learning from those that came before does not mean devining a set of rules that have been handed down and must be followed. The investment greats are not deities whose words are eternal, they are simply people who discovered important elements of successful investing, but whose words must be interpreted carefully before applying to the current environment.

Robert Hagstrom has called investing “the last liberal art”. Understood this way, it is clear that studying the great investors of the past and present should be approached as one might study philosophy rather than physics. There are few immutable laws of investing. Instead, the great investors offer frameworks for thinking about investing that can be used to wrestle with new investment opportunities and environments. The reason Benjamin Graham’s writings, first published over 80 years ago in the midst of the Great Depression, are still relevant today when analyzing software as a service, biotechnology, and social media companies is because Graham’s most important lessons are not found in specific formulas, but in his investment philosophy.

Recently, the investment manager John Hempton of Bronte Capital, who writes a very intelligent and well regarding blog, wrote about a particular lesson from Warren Buffett. John is clearly a brilliant guy and a successful investor, but his interpretation of Buffett’s lesson runs counter to how we think investors should interpret the investment greats.

Hempton wrote:

“One thing that had a profound effect on me was Warren Buffett’s twenty punch card. (Quoted here…)

Buffett has often said, “I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”

There are plenty of people out there who call themselves Buffett acolytes – and as far as I can see they are all phoneys. Every last one of them. Find any investor who models themselves off Warren Buffett and look at what they do. And look at their investments against a twenty punch card test. They fail. They don’t even come close… I used to profess myself a Buffett acolyte too. But somewhere along the line I realised I was a phoney too.”

Hempton seems intent on self-flagellation for his supposed sin of failing the “twenty punch card test”. But we think he’s missing the point by reading Buffett literally rather than figuratively.

Buffett, like many great teachers, offers his wisdom in the form of parables. His instruction to use a twenty punch card ticket to measure your lifetime allowance of investments is meant not as direction to only make twenty investments, but rather as philosophical guidance to help people make their own decisions. Since we know that Buffett himself has made far more than twenty investments, we’d have to call him a “phoney” as well if we were going to interpret his advice literally.

So if Buffett isn’t actually calling for investors to limit themselves to twenty investments, what is he trying to say?

One lesson is that investors should have a bias to inactivity. This lesson was explored by John Huber on his Base Hit Investing blog when he too responded to Hempton’s post. But inactivity, or “buy and hold” investing is another Buffettism that has been fetishized as if it was morally superior to make money slowly rather than quickly. Huber knows this well and some time ago explored the idea that rapid turnover of a portfolio is indeed one way to generate outsized returns.

We feel that the most important lesson of Buffett’s punch card parable is that investments should be made with deep and careful consideration. An investor who strives, as Buffett does, to produce investment returns that are superior to the market needs to acknowledge that doing so is difficult. If all it took to beat the market was to hear an exciting story, peruse Yahoo finance and look up the PE ratio, beating the market would be easy and we all could find hundreds of stocks that were worth investing in.

What Buffett is trying to tell those who care to listen is that you should approach investing as if you had a limited number of opportunities. By considering each investment against a bar of “does this qualify for my twenty card punch list?”, you are forced to greatly raise your requirements and only make an investment when your odds of success seem very high.

The fact is, beating the market is incredibly difficult. But one thing we do know is that investors that own hundreds of stocks (as the average mutual fund does) systematically underperform, while those that manage focused portfolios of a small number of high caliber investments outperform at a much higher rate (for instance, see here, here and here).

So there’s nothing “phoney” about having made more than twenty investments in your lifetime. In fact, I doubt any successful investor has ever made that few. Instead, it is the Buffett acolytes who mistakenly hear his advice as a sort of Ten Commandments of investing that miss the many deep and everlasting lessons he has imparted over his career.

Warren Buffett, of all people, would readily admit that investing is difficult and no checklist of rules will ever turn someone into a great investor. But by grappling with the lessons of the great investors of the past and present (certainly not Buffett alone), investors can attempt to distill some form of insight that can help them in their journey.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Multiple news sources are reporting that Time Warner is on the verge of agreeing to be purchased by AT&T for about $86 billion or a total enterprise value of $108 billion. Time Warner’s willingness to sell at this price suggests that the management team has lost confidence in their ability to navigate the changes being wrought by streaming technologies. Yet, the deal also supports the idea that the market is materially undervaluing content companies.

A little over two years ago, the company rejected an offer from 21st Century Fox to buy the company for about $80 billion* (enterprise value of $97 billion). At the time, Time Warner said that the Fox offer significantly undervalued the company. It was reported that Fox was willing to offer as much as $89 billion (enterprise value of $106 billion, essentially the same amount under discussion in the AT&T transaction), but people close to the deal said that Time Warner wanted “well over” $93 billion (enterprise value of $110 billion).

The acceptance of the AT&T deal at essentially the same value as what Fox was said to be willing to pay over two years ago — despite Time Warner generating almost $7 billion in free cash flow since rejecting the deal — strongly suggests that management has a significantly degraded outlook for the future of their business. It is a well-accepted fact that the rise of streaming video content is disrupting the media industry. At the same time, content owners like Time Warner are seeing the value of their content increase as a new group of bidders (Netflix, Google, Apple, Amazon, etc) correctly recognize that whether it is delivered via internet enabled streaming or traditional television infrastructure, consumers want to watch quality content. The challenge for content companies like Time Warner is making sure that they retain or even enhance the monetization of their content assets as the means of distribution evolve.

The decision to sell to AT&T implies that Time Warner management believes they are simply not up to the task of managing their valuable assets through the transitions roiling the industry. Yet the deal also suggests that investors have been significantly underestimating the value of Time Warner’s content and likely are similarly underestimating the value of other content focused media companies. Just prior to rumors of the deal coming out on Friday, Time Warner was being valued by the market at just $63 billion (enterprise value of $86 billion), a large discount to the AT&T deal price. Even so, this price was close to a 52-week high as the market had valued Time Warner at an average price over the last year of just $59 billion and as low as $51 billion back in February.

What is curious about Time Warner throwing in the towel on their ability to navigate the transition to streaming on a standalone basis is the fact that the company owns HBO, which has the potential to become a significant player in global, direct to consumer distribution through HBO NOW. This potential was recognized by Netflix, the leader in the move to streaming video back in 2013, when on the eve of launching House of Cards, the first Netflix Original show, their head of content Ted Sarandos stated bluntly “the goal is to become HBO faster than HBO can become us.”

While Time Warner has put resources behind HBO NOW and it has had some success in building a direct distribution business, the management team has seemed to believe that it is more important to protect their legacy business and their $1.3 billion annual dividend rather than invest aggressively in preparing their business for the transition to streaming.

By selling to AT&T, Time Warner is waving the white flag and admitting that Netflix has become HBO before the company could become Netflix. Therefore, their best option is to sell to a distributor like AT&T, which itself needs content to compete effectively against Netflix and other streaming platforms.

While Time Warner may have failed in their attempt to deliver on  their plan to “create significantly more value for the Company and its stockholders” after rejecting the Fox takeover, the AT&T acquisition highlights the critical value of content. While many players have been late to fully act on the imperative to adapt to the changes brought on by streaming, at least some executives recognize the that there is huge opportunity in addition to the risks. Chief among those forward thinkers is John Malone, the billionaire famous for his role in developing the cable TV industry from its infancy, whose current collection of media assets have outperformed Warren Buffett’s Berkshire Hathaway over the past decade even as the disruptive threat from streaming has coursed through the industry.

For some time now, Malone has been making the case that streaming technology increases the value of content because suddenly that content can be monetized on a global scale rather than via local, legacy TV distribution systems. At the same time, distribution systems need quality content because streaming destroys the local monopolies that distributors have had in the past and so consumers will select those distribution offerings that deliver the best value for high-quality content.

Of course, not all content travels globally. While Seinfeld reruns might still command high value in the US, this content is unlikely to travel well to India, Korea or Italy. So when it comes to the value of content, it will be all about high quality, globally relevant content. This is one reason why a media company like Discovery Communications (controlled by Malone) is so well-positioned for the shift to the global stage, where the company already gets half of its revenue, more than any other publicly traded US content company. Discovery focuses on non-fiction content, such as nature documentaries, which are inexpensive to produce and are relevant to consumers around the world.

The sale of Time Warner will be seen over time as one of the seminal moments of the shift to a global, streaming-enabled media industry. What we know now is that Time Warner simply wasn’t prepared to make this shift on their own, although just two years ago when they rejected Fox’s offer, they had not yet recognized this reality. Going forward, we believe that Netflix’s success in becoming HBO before HBO could become Netflix establishes it no longer as a disruptor but as the leading player in the global, streaming-enabled media industry. As other players race to catch up, we expect that consolidation will continue as the players come to terms with the fact that they must be part of a global distribution platform of high-quality content in order to thrive. Indeed, with an enterprise value of $56 billion or half the price AT&T is paying for Time Warner, it seems quite likely that Netflix may see intense interest from potential acquirers such as Apple, which itself discussed buying Time Warner, Amazon, Google or even a content owner such as Disney.

You can learn more about Ensemble Capital’s view on the media industry in Part I and Part II of our series Of Media & Moats.

*Attentive readers will note that the $107.50 price reported to be offered for Time Warner shares seems to be a large premium to the $85 offer Fox made. But Time Warner has spent a lot of money buying back shares in the last two years so the $107.50 price equates to market cap only 7.5% higher than the Fox bid and a 3% discount to the price Fox was said to be willing to pay. But Time Warner has also taken on more debt since then (which the buyer will take on the responsibility of paying off), so when taking the debt into consideration, the AT&T offer is a 2% superior offer to the amount Fox was said to be willing to pay.

Ensemble Capital’s clients own shares of Netflix (NFLX), Discovery Communications (DISCA), Alphabet (GOOGL) and Time Warner (TWX).

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Weekend Reading

21 October 2016 | by Paul Perrino, CFA

A summary of this week’s best articles. Follow us on Twitter (@INTRINSICINV) for similar ongoing posts and shares.

Some Big U.S. Cities See Apartment Rents Fall for First Time in Years (Laura Kusisto, @LauraKusisto, WSJ)

Increasing rents have been a hot topic in many major cities over the past few years, but it looks like that’s starting to reverse. San Francisco, which has seen some of the fastest rent increases was down 3% over last quarter. As rents in these popular areas are declining, they’re starting to increase in more affordable cities, like Sacramento, which saw a 12% increase in rents in the last quarter.

Cheap Luxury Goods in the U.K. Lure Shoppers (Saabira Chaudhuri and Simon Zekaria, @SaabiraC and @SimonZekaria, WSJ)

Since the passing of Brexit in the UK, the pound has gotten cheaper compared to other major global currencies. This has benefited tourists shopping in the UK. A Louis Vuitton Speedly 30 bag, which costs $1,115 in the US only costs $802 in the UK. “…these tourists are buying an average of 10 items, or double the count from last year.”

The Difference Between Rationality and Intelligence (David Hambrick and Alexander Burgoyne, NYT)

The rational investor is a common character in academic finance. However, there usually isn’t much analysis on how to identify or how to become that mythical person. “…Professor Stanovich and colleagues have introduced the concept of the rationality quotient, or R.Q. If an I.Q. test measures something like raw intellectual horsepower (abstract reasoning and verbal ability), a test of R.Q. would measure the propensity for reflective thought — stepping back from your own thinking and correcting its faulty tendencies.” Through their tests and training, they’ve found that R.Q can be developed.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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Recently, Arif and I had the pleasure of meeting with Raj, the very insightful author of the Scuttlebutt Investor blog. Scuttlebutt is a term used by the legendary investor Phil Fisher, who, along with Charlie Munger, was largely responsible for shifting Warren Buffett’s attention away from the “cigar butt” deep value investments favored by his mentor Benjamin Graham and towards high-quality companies. After our meeting, Raj sent us a handful of follow-up questions about our investment approach that we thought we’d answer here.

Since we started writing Intrinsic Investing we’ve gotten lots of emailed questions from professional and casual investors alike (feel free to contact us yourself), which we answer directly or sometimes work into our posts. We try to keep the content here accessible to a general audience while also trying to examine investing in a detailed and nuanced way. But due to the nature of these questions, this post will be geared more towards professional investors or anyone interested in the fine details of how we evaluate potential investments. All content in italics are questions from Raj.

I know that you generally look for businesses that generate high return on invested capital (ROIC). Would this lead you to a natural predisposition for asset light/software types of businesses? These will nearly always generate higher ROIC than an asset intensive or asset medium business like a railroad or manufacturing company.

High returns on invested capital come from one of two sources; 1) Large amounts of revenue generated for each dollar of invested capital, known as high “turns” of invested capital and/or 2) high levels of after-tax profits generated per dollar of revenue, known as high-profit margins. Turns x margin = ROIC (this is a rearrangement of the formula for ROIC we presented here). In order to generate high ROIC, a company must either have very high profit margins or need low levels of invested capital (ie. be “asset light”) or a combination of the two.

Because profit margins are bounded (pre-tax profit margins can’t exceed 100% and all companies pay some tax) it is difficult for a company to generate outstanding ROIC simply through a high profit margin. The far more common path is for a company to craft a business model that does not require them to invest too much new capital in order to grow. These asset-light companies are very prevalent in Ensemble Capital’s portfolio.

However, we do not restrict ourselves to buying asset-light companies. Some companies spend an enormous amount of money on capital expenditures (fixed assets such as factories, technology hardware, and property), but the nature of their business does not require them to carry much working capital (the difference between short term assets like inventory or accounts receivable and short-term liabilities like accounts payable and deferred revenue). In fact, some companies actually operate in a negative working capital condition which leads to them gathering cash faster than they need to pay it out causing cash to pile up on their balance sheet as they grow rather than them needing to invest cash into their balance sheet. So some companies can generate high ROIC even while spending a lot of money on fixed assets because their working capital needs are minimal or even negative.

Finally, while we do focus on high ROIC companies, what is most important to us is that a company has a strong set of competitive advantages that will allow them to protect and maintain a solid level of ROIC. First Republic, a bank that we recently profiled, would fit this mold as would the diamond retailer Tiffany. Because we believe these companies can generate solid and sustainable ROIC, we believe we can value them and therefore will consider them for investment. However, these companies deserve lower valuation multiples than high ROIC companies.

I would point out that asset-light companies are seen in many different industries, not just areas like software. For instance, our portfolio holding Landstar Systems is an asset-light business despite operating in the trucking industry. But their business model has them focused on logistics. By not owning the trucks themselves they are able to generate around $6 of revenue per year for each dollar of invested capital on their balance sheet (ie they generated invested capital turns of 6x).

For tech companies like Apple or Google, the ROIC is typically so high, based on the nature of the business and given the small denominator, that it almost seems not meaningful. Do you make adjustments to capitalize certain expenses in this case like marketing to make it more meaningful? Or is that just the nature of the beast; tech software and asset-light companies will have a higher ROIC given the nature of business?

The impact that higher ROIC has on valuation is not linear. A company growing 5% with a 20% ROIC will be able to distribute to shareholders $0.75 for each dollar of earnings vs a 10% ROIC company distributing $0.50. This means the improvement of ROIC from 10% to 20% increases cash flow per dollar of earnings by 50%. A 40% ROIC company will be able to distribute $0.875 or just a 17% improvement over the 20% ROIC business. So there is no need to adjust a company’s ROIC just because it is super high. As it gets higher and higher, it ceases to have much incremental impact on valuation.

We do frequently make adjustments to financial statements. Our goal is to understand the true cash economics of the business model. GAAP accounting is very helpful in this regard, but it is not the optimal way to understand cash economics. While capitalizing expenses that are expected to pay off in future years (such as some marketing expenses, research and development, etc) makes good theoretical sense, we’ve found that it is much simpler and just as accurate to instead base your terminal earnings multiple on a profit margin that assumes these sorts of expenses are at run rate levels once growth reaches its sustainable rate. In other words, rather than doing detailed capitalization accounting because you think 10% R&D spending is really “growth spending”, simply set R&D spending at the level you think is needed to drive long-term sustainable growth when you are setting your terminal value.

How do you calculate the denominator for ROIC? I think your post on ROIC didn’t delve into the specifics of the calculation of the denominator. But I think you might have said that you do not include goodwill. Help me understand this. The way I think about it ultimately all decisions of investment are buy or build decisions. If a company builds a new business, their ROIC is impacted to the downside by the investment in the new property, plant and equipment (PP&E) at market rates. However, if we exclude goodwill, then they are not being impacted to the downside for acquisitions. They are only being impacted by the book value increase in PP&E but not the market value they paid for said assets. Can you help reconcile this?

When calculating invested capital (the denominator for ROIC), we include all tangible balance sheet items involved in operating the business. This means we exclude liabilities related to debt as well as assets and liabilities that are non-operating (such as pension liabilities). In growing the business, these balance sheet items do not need to be invested in and thus are not part of invested capital (this isn’t to suggest they are irrelevant, just that they are not part of calculating ROIC).

The key to thinking about invested capital is realizing the whole value of this analysis is trying to understand how much cash the company will need to consume as it grows and how much will be available to pay out to shareholders. If a balance sheet item will not produce or consume cash as the company grows, it isn’t relevant to the calculation of ROIC.

What about goodwill? This is the item on the balance sheet that accounts for the amount a company has paid for past acquisitions that was in excess of the value of the acquisition targets’ book value (ie. the value on their balance sheet). Raj rightly points out that goodwill accounts for part of the cash a company paid for past acquisition so why would we exclude this amount in evaluating the returns on invested capital?

As mentioned above, the reason we are interested in ROIC is because of the way it can reveal how much cash a company can distribute to shareholders in the future. The value of a company in most cases is nothing more than the present value of the cash it can distribute, so ROIC is key to understanding intrinsic value. So long as your projections for a company’s future growth are not dependent on future acquisitions, that goodwill is an item on the balance sheet that will not consume cash as the company grows and therefore should be excluded from the denominator when calculating ROIC.

Now, if your intention is to judge the past capital allocation decisions of management, then including the money they spent on acquisitions is perfectly reasonable. But if you are trying to assess future cash generation, past M&A decisions are irrelevant. The exception to this is if you make an explicit assumption that the company will make acquisitions in the future. Then, of course, you must consider the cash they will use to complete these deals. We do not commonly invest in companies where explicit future M&A deals are part of our investment thesis. But we have written about the attractiveness of “platform companies” where acquisitions are part of the value creation story.

I know you look for businesses that are trading at a discount to intrinsic value. How do you think about the calculation of intrinsic value? Assuming you use a discounted cash flow, what discount rate do you use? Do you use the same discount rate across all businesses and then determine the margin of safety or adjust it dependent on the business?

The intrinsic value of a company is the present value of the cash the company can distribute to shareholders over time. This is also the intrinsic value of all financial assets. Sometimes people get lost in thinking about valuation and make it more complicated than it really is. But the whole point of investing is to turn money into more money and so the value of an investment is nothing more than the amount of money it will provide over time. This is why Charlie Munger has said, “All intelligent investing is value investing — acquiring more than you are paying for.” If you pay $2 for a dollar bill, you have no hope of being a successful investor. This isn’t to say that investors who buy growth companies (as we do) cannot be successful. It just means that successful investors must purchase investments for less than the present value of the cash they will create in the future; you must acquire more than you are paying for.

Since intrinsic value is the present value of future cash flows, the only theoretically accurate way to value a company is to use a discounted cash flow method. In practice, many investors use various valuation rules of thumb instead. But these approaches are just implicit, rather than explicit, ways to calculate a discounted cash flow.

At Ensemble Capital, we build an explicit five-year projection of cash flows and then capitalize (by assigning a terminal multiple to the final year cash flow) the cash flows beyond our explicit time horizon. This method projects the sum total of future cash flows that can be returned to shareholders and discounts them back to the present so we can evaluate the present value of the business.

Raj asks two very important questions: “What discount rate do you use? Do you use the same discount rate across all businesses?”

The discount rate is the rate of return that investors require to own the company. In calculating the value of a business that we intend to buy shares in, we don’t care at all what discount rate other investors might require or what the current market implied discount rate is. We only think about what rate we require.

This is a critical distinction from what is taught in most textbooks and how we believe many investors approach the discount rate. If your discount rate is based on a rate you think the market (other investors) thinks is appropriate, what you will end up calculating is the value that you might sell a company to other investors. This approach is a form of speculating. You are buying a stock based on how much you hope you can sell it to someone else for.

In assessing the intrinsic value of a company, we focus instead on how much value it has to us. Because we focus on analyzing high-quality, competitively advantaged businesses, we generally feel that we would view these companies as fairly valued if we earned a rate of return of approximately 9% per year. This is our required rate of return and the discount rate we use to discount future cash flows back to the present. Since we seek to make investments in stocks that are undervalued, we are seeking to earn returns in excess of our required rate.

We do use different discount rates for different companies. For the companies we focus on, our discount rate varies from 8% to 11%. All this means is that we think a company with a very stable, highly likely stream of future cash flows is fairly valued when it is priced to generate a lower rate of return (ie. 8%) than a company with a volatile, less predictable stream of future cash (ie. 11%). The more certain we are that we’ll receive a certain level of cash flows from a company, the lower the rate of return we require to own it. This is the reason why bonds earn lower returns than stocks. Their future cash flows are steady and predictable, leading investors to require much lower rates of return to consider them fairly valued than is generally required for a stock to be considered fairly valued.

So thanks to Raj for asking a great series of smart questions. Hopefully, this extended set of answers is useful to those readers who are interested in the nuances of our investment approach. In the long-run, your success as an investor is based on getting the big ideas right, not the minutia. But we also think that by thoroughly exploring your assumptions and the details of your investment philosophy, you force yourself to confront inconsistencies and come to a deeper understanding of what you believe.

Ensemble Capital’s clients own shares of Tiffany & Co (TIF), First Republic (FRC), Landstar (LSTR), Alphabet (GOOGL), and Apple (AAPL).

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter we file a 13F, which discloses all of our holdings. Please contact us if you would like a current or past copy of our 13F filing.

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