In our post on the threats and opportunities facing health care investors in the decade ahead, we described the way that the US health care system is woefully inefficient to a degree that sets it apart from the rest of the world. The chart below shows how the US spends far more per capita on health care while receiving quality of care on par with Chile and the Czech Republic. The arrows show how the US should be able to deliver over six additional years of life expectancy at the current level of spending (green arrow), or be able to cut spending by 30% while still delivering the best health care system in the world (orange arrow), or slash spending by 65% while still maintaining the current quality of care (red arrow).

So how do we tackle this problem? While there is likely no single grand solution, we believe that the “smartest people in the room” when it comes this question work at the Advisory Board Company (ABCO). Indeed, when the ObamaCare insurance exchanges rolled out in such a catastrophic manner that it appeared the system might fail as soon as it got started, who did the government turn to but former Advisory Board CEO Jeffrey Zients.

time-cover

That’s Jeff in the middle. Thirty days after he was asked to lead a “tech surge” to fix the ailing website, the online exchanges were working. While there is plenty of criticism of ObamaCare, today the functionality of HealthCare.gov is a non-issue.

Years ago, Advisory Board was a consulting company that worked with best in class, predominately nonprofit hospitals to identify best practices for keeping costs under control and improving the health status of patients. Because any given hospital doesn’t want to participate in numerous research co-ops of this kind, Advisory Board created a competitive advantage by being able to attract the very best research participants. With access to these insights, the company packaged them up into recommendations across a range of topic areas which they then sold to hospitals across the country.

Over time, the company found that often times their clients wanted to implement their recommendations, but there weren’t software solutions on the market to do so. This lead to the company developing a thriving subscription-based, software-as-a-service business providing custom tools designed to implement their evidence-based recommendations.

So how exactly does the company help their customers improve the quality of care they provide while reducing costs? Some examples:

  • Crimson Technology Suite: Provides the ability for a hospital to integrate data from multiple sources and manage workflows designed to deliver patient care at high fidelity to best practices.
  • Physician Offerings: The company offers other tools which help physicians control spending on supplies, analyze the profitability of various surgical areas, and complete required documentation.
  • Revenue Cycle: Advisor Board offers a range of tools designed to help hospitals manage getting paid for their services. As any person in the US knows, hospital billing is notoriously complicated and inefficient. From the patients’ perspective, it is often difficult to know why you are being billed a certain amount or even what it is for. From the hospitals’ perspective, it is a huge financial challenge that so much expensive care is provided with payment coming many months later. Unlike almost every other business, hospitals generally provide treatment without really knowing how much or when they will get paid.
  • Value Based Care vs Fee for Service: As medicare and private insurers transition from paying hospitals for the services they provide to the value they deliver (ie. number of people who are cured of cancer at a rate above established benchmarks, rather than number of cancer treatments provided), they need significant help from Advisory Board to manage the analytics needed to track their quality of care and receive insurance reimbursement.

This combination of top-notch research based on the input of participants in their proprietary research co-op with custom built technology tools for implementation lead to the company growing revenue by 4x (15% a year) during the decade leading up to their fiscal year ending in March 2014. A lot of this growth was organic, but the company also used their broad visibility into their customers’ needs to identify small, private companies offering new tools, acquired them at very early stages (sometimes pre-revenue), and then successfully rolled the solutions out to their entrenched customer base.

Growing this fast didn’t take much reinvestment of earnings beyond acquisition costs because of the asset-light nature of their business model. In fact, because the company signs customers to multi-year contracts and enjoys 90%+ renewal rates, they generate significant cash from the deferred revenue they book. This led to free cash flow running at two to four times the rate of net income.

While the company doesn’t need to purchase a lot of assets to grow, they do need to invest in their income statement. Since newly released software tools have all of the expenses of mature programs, but much more limited user bases, these early stage programs have lower (even negative) profit margins. But as each tool matures, it generates strong margins. As they pursued their growth opportunity, the company’s operating margin fell from the low 20s to about 7%. However, we believe that as the company matures and new software tools become a smaller portion of the total tool offering, the company’s profit margins will expand materially.

However, the last two years have been very challenging for the company. During the decade ending with their 2014 fiscal year (March 2014), the stock produced 13.3% annual returns vs the S&P 500 total return index appreciating at 7.4% per year. But over the next two years, the stock dropped in half while the S&P 500 rose 15%. This decline was primarily due to a slowdown in the company’s growth rate with additional market concerns related to the company’s acquisition of a business that provides very similar services, but to the higher education market rather than health care. Over the last year, the stock has been highly volatile, but has rallied by 40% vs the S&P 500 up 18% for reasons we’ll explain a bit later.

 

While 2014 revenue growth was over 14%, concerns about a pending slowdown were realized in 2015 as the company’s additions of new “contract value” (ie. new client contracts) began to run at a sequential growth rate that would not produce mid-teens growth over time. By mid-2016, the company was growing revenue at just 4% and the health care segment (more on the education segment below) was growing at what we estimate was just 1.5%.

This level of growth is not acceptable to typical growth investors and the stock was slammed. When the company issued 2016 revenue growth guidance in the mid-single digits in February of last year, there was a panicked rush for the exits by momentum/growth investors and the stock fell a remarkable 48% the next morning before rallying strongly off the low to finish the day down 27%. But that was the low for 2016 and leading up to the election the stock rallied almost 70% or to 23% above the price it was trading at the day before they lowered guidance.

Separately from the growth slowdown back in late 2014 the company made a major acquisition of a company called Royall & Co that provides similar research-based consulting and software tools to higher education organizations. While this seems like a departure from the company’s roots, its not. Advisory Board was founded in 1979 as a general consulting firm serving all industries. In 1997 the company spun off Corporate Executive Board (ticker CEB), which was a $2 billion market cap company in its own right at the end of 2016. The terms of the spinoff had Corporate Executive Board serving for-profit companies while Advisory Board retained the right to serve health care and education end markets. While Royall & Co made Advisory Board the largest player in the education market, they have long had their own education offering. Unfortunately, initially the merger looked very poorly executed with the Royall & Co executive team leaving the company unexpectedly shortly after the deal with done, casting major doubt on the largest deal in Advisory Board’s history just as their core health care business slowed sharply.

Today, the company continues to face slow demand for their core health care offering as hospitals have gone into panic mode after the election of Donald Trump and the selection of Tom Price as Secretary of Health signaled a potential rollback of ObamaCare that may massively crimp hospital budgets at least in the near term. But with the slow down is coming rising profit margins as our thesis that a slow down in new product launches would take the pressure off margins begins to play out.

But it is important to remember that Advisory Board gets paid to help hospitals plan for the future, decide on strategic priorities, run their businesses well and improve patient outcomes. The disarray that may result from the rollback of ObamaCare is an opportunity, not a threat to a company that helps hospitals deal with change. But there’s no doubt that in the short term, a freezing of budgets will make it hard to sell to new clients or increase the number of subscriptions. That being said, client retention rates have held near all time high levels.

Meanwhile, the company is rapidly growing its education business. Royall is back on track and the company’s in house developed education offering is growing quickly as well. While the company does not breakout their education business separately, we believe that their education contract value, the value of their currently contracted client work for education clients, stands at 33% of total company contract value. With education growing at over 20% while health care is only just now stabilizing after recent declines, we expect the education business to make up over 40% of Advisory Board’s business in a couple of years.

We’re not the only ones who think there is significant value in the company’s shares. Recently, Elliot Associates, run by billionaire hedge fund investor Paul Singer, has purchased an 8% position in the company. Given his past history of activism, it is no surprise that Advisory Board has now undertaken a strategic review, which we believe will result in one of a couple of outcomes 1) the outright sale of the company, 2) a deal to take the company private, 3) the sale or spin-off of the education business or 4) an aggressive plan to driven margins much higher and faster than the current market price implies is possible.

At about the same time as Elliot Associates took their big stake in the company, Corporate Executive Board, the sister company that Advisory Board spun off years ago as described above, announced they were being purchased by another company at a 25%+ premium to their market price. While CEB and ABCO serve different markets, the economics of their business are quite similar and CEB has similarly seen low growth. Historically the growth rate of Advisory Board has been higher than at CEB and we believe that the health care and education markets offer a far more expansive opportunity as an end market than the corporate sector that CEB focuses on.

Advisory Board as a stock has been volatile and subject to falling in and out of favor with momentum investors. But Advisory Board as a company has generated enormous value for their customers and shareholders over time. Their unique place in the health care ecosystem and special relationship with their customers via their research co-ops creates an enviable competitive moat around their business. If you return to the chart at the top of this post, it is clear that there is a huge amount of “fixing” to do in the health care sector. The move to the optimal outcome shown on the chart would result in cost savings equal to 6% of GDP! If Advisory Board can play a small role in making that happen, the company will rightly reap large returns for its shareholders, in addition to the value they will bring to their customers and the country.

Oh, and then there’s that whole education industry with its own runaway costs and poor student outcomes for them to address…

Ensemble Capital’s clients own shares of Advisory Board Company (ABCO).

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, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by Ensemble Capital or one or more of its clients you will find a disclosure regarding the security held above. Should Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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One way to think about the market rally may be just to focus on inflation. Most objective political observers say that president Trump’s fiscal proposals would create far larger deficits than the GOP has been historically willing to support and thus would generally be expected to be inflationary. The market got this right away with the biggest change in forward economic expectations since the election being inflation expectations, not real interest rates or growth (although the outlook for these has picked up as well).

Here’s the market implied outlook for inflation over the next five years.

The red arrow shows the bottom in inflation expectations occurred just as the stock market bottomed in February of 2016. The green arrow points to the election. While inflation is usually viewed as a negative, it is generally thought that some inflation, about 2% or a bit more, is a good thing. Historically the PE ratio on the S&P 500 has been highest when inflation is in this sweet spot.

Source: Crestmont Research

Notice that while the current market PE of 22x is above the long-term average, it is right in line with the average PE ratio seen during periods with inflation in the 2%-3% sweet spot. At Ensemble Capital, we don’t spend a lot of time trying to determine the appropriate valuation for the market as a whole but instead focus on the specific portfolio of companies we own. So we’re not arguing here that the current market is worth 22x earnings (it could be worth more or less), we’re just pointing out that the behavior of inflation expectations over the last year have a lot to do with understanding the market rally.

It is easy to think of the market rally as a reaction to the full range of president Trump’s policy proposals. But at the end of the day, market values are driven more by core economic metrics such as inflation, real growth rates, and real interest rates than the wide range of other policy issues that grab the attention of Washington. While these other issues may well be more important to us as citizens than issues like inflation and GDP growth, it is these core economic metrics that drive the stock market.

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, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by Ensemble Capital or one or more of its clients you will find a disclosure regarding the security held above. Should Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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Weekend Reading

24 February 2017 | by Paul Perrino, CFA

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

Apple Shares Hit All-Time Closing High as Investors Await Next iPhone (Tripp Mickle and Aaron Kuriloff, @trippmickle and @kuriloff, WSJ)

As Apple hits all-time highs, the Wall Street Journal reached out to our CIO, Sean Stannard-Stockton, CFA for comment and outlook. Here at Ensemble, we believe that the iPhone is more than a stand-alone product, but a sustainable franchise. See our post from September for more insight.

Buffett’s Berkshire Hathaway Bought Apple Near the Bottom (Nicole Friedman and Erik Holm, @NicoleFriedman and @erikholmwsj, WSJ)

Warren Buffett’s team made a $1 billion investment in Apple in May of 2016. At that time, AAPL was trading ~$90. As of yesterday’s close, AAPL is trading >$136. This reflects on-going changes at Berkshire Hathaway, away from Buffett and towards his team. Previously, Buffett didn’t invest in technology companies because “they are outside his ‘circle of competence,’ or areas of expertise.”

The roots of technological singularity can be traced backed to the Stone Age (David Krakauer, Wired)

The strive to go beyond our mental capacity has been going on for thousands of years. The first attempt was storing information on clay tablets. “Five thousand years later, silicon semiconductors, ferromagnetic films and floating gate transistors have amplified the recording power of clay a quintillion times.”

For the Blind, an Actual-Reality Headset (Geoffrey Fowler, @geoffreyfowler, WSJ)

Out of the fictional world of Star Trek Next Generation, technologist at eSight created a visor to help the blind see. The visor contains small cameras on the front and magnified displays inside the visor. This allows the individual to see a focused, high-resolution image up close. This creates a new world and experience for the users. “She [Yvonne Felix] recalls the first time she saw ‘Starry Night‘ with her eSight visor on, it made her cry. ‘I saw every little stroke. When I saw the color mixtures and how thick the paint was, it was the most overwhelming moment of my life,’ she says. ‘I thought that never in my life would I be able to see something so beautiful.'”

Texas Oil Fields Rebound From Price Lull, but Jobs Are Left Behind (Clifford Krauss, @ckrausss, NYT)

The decline in oil prices over the past few years have caused oil companies to become more cost conscious and turn to technology. “Roughly 163,000 oil jobs were lost nationally from the 2014 peak, or about 30 percent of the total, while oil prices plummeted, at one point by as much as 70 percent.” This is changing the face of the industry from wildcatters to computer programmers.

Ensemble Capital’s clients own shares of 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, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by Ensemble Capital or one or more of its clients you will find a disclosure regarding the security held above. Should Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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The chart depicted below charts the prices of the following companies and index (in alphabetical order): Amazon, Apple, Facebook, Google, Microsoft, Salesforce.com, and the S&P 500 Index.

Can you guess which stock price curve belongs to which of the companies listed above?

Source: Google Finance

Here’s a little more information from 2012 to help you guess:

Now, rank order your guess on stock performance for the companies and the S&P 500 returns now and see how well you do, from first to seventh.

Here are the companies’ FY 2016 results with cumulative growth compared to 2012 in the table above:

Wanna change your initial rankings?

Here is the actual return data and ranking of performance:

  1. AMZN 291%
  2. FB 250%
  3. GOOGL 180%
  4. CRM 122%
  5. MSFT 121%
  6. S&P 500 80%
  7. AAPL 78%

Take a look at the chart again now that you have the legend for it and look at the path of each stock relative to the others over the 4 year time period (we’ve now included the legend with the original chart for your convenience):

 Source: Google Finance

The market system is messy in how it values in absolute and relative terms the future health of businesses and this shows in the path of the stock returns.  Assessing stock performance annually loses sight of the long-term creation of business value that stock performance eventually must reflect.  And that really is the takeaway here.

Could you have guessed how these stock returns would have turned out?  Of course in rank ordering these, no one could have escaped their general (or specific) knowledge of how well the companies have done since 2012.  But MSFT doing better than AAPL? Or AMZN doing better than FB (given stupendous user, revenue, AND profit growth) or CRM (leader in SaaS adoption)? May have been surprising.

Just for kicks, we snuck in Netflix in the 2nd table of 2016 performance.  Of all of these successes, NFLX was the one that was most down and out in 2012, having just announced its business model shift wholeheartedly to its unprofitable streaming service and the split of its Qwikster DVD by mail fiasco in October 2011 that proved to be a disastrous decision in subscriber churn to both the separation and the requirement to pay separately for its “meh” streaming service.  Here is the graph above now including NFLX:

Source: Google Finance

Wowza! Netflix’s stock performance at 1300% is about an order of magnitude better than the other Internet-enabled services companies we looked at, which were all leaders in the space and have done very well since.  But the huge winner was the company whose starting position was highly in doubt as a mediocre cheap service (really kind of an afterthought on what to watch and how much you paid as a subscriber) and has over the space of only 4 years built itself into a leadership position of a global scale media company, with nearly 100 million subscribers worldwide, and one that is seen as the biggest threat to the traditional trillion dollar global media industry.

In concluding, our point here is that investing is a hard game to tackle.  While as fundamental investors, we at Ensemble Capital always seek out companies with strong moat characteristics trading below our estimate of their intrinsic values, the actual performance of companies we or anyone chooses to invest in will in the long run reflect business performance.  However, over shorter time frames, we can see how messy the market system of valuing that business can be.  Additionally, a change in market perception of a business as one with no-moat to one with a good moat, as the case of Netflix demonstrates, is a very very valuable thing when it comes to ascribing business value.  We certainly agree with that.

Ensemble Capital’s clients own shares of Apple Inc (AAPL) and Netflix Inc (NFLX).

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, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by Ensemble Capital or one or more of its clients you will find a disclosure regarding the security held above. Should Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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Most of the posts here at Intrinsic Investing focus on the portfolio holdings of Ensemble Capital and our investment philosophy. But with 2016 representing the first full calendar year for the Ensemble Fund, our publicly available mutual fund, we want to take the time to share an update on our performance. The press release below discusses the fund’s performance and our view on active investing during a time when investors are shifting towards passive funds.

You can learn more about the Ensemble Fund HERE, track our performance each month HERE and see the full holdings HERE.

If you’re unable to view the embedded image below, please click HERE to view the press release.

 

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, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by Ensemble Capital or one or more of its clients you will find a disclosure regarding the security held above. Should Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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Weekend Reading

20 January 2017 | by Paul Perrino, CFA

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

Ray-Ban Maker Luxottica to Merge With Lens Company Essilor, Creating $49 Billion Eyewear Giant (Inti Landauro and Manuela Mesco; @landauro and @manuelamesco; WSJ)

Instead of competing, these two industry leaders decided to merge. “The merger joins two companies that previously risked stepping on each other’s toes as Luxottica expanded into lens manufacturing and Essilor moved into frames.” The combined company will now represent over a quarter of the eyewear market. The next competitor in this space has a less than 4% market share. The next hurdle is to find a CEO that Mr. Del Vecchio is confident in. “In recent years, however, Mr. Del Vecchio struggled to delegate authority, dismissing one planned successor after another.”

Would you pay $1,500 a month to drive an Escalade whenever you want? (Gene Marks; @genemarks; The Washington Post)

One auto manufacturer is taking a page from the software industry and trying to shift from a single purchase model to a subscription based model. “It’s also a great way for a potential customer to test out a big ticket item before considering a future purchase. At least that’s what Cadillac is hoping.” Cadillac is now offering Book by Cadillac which allows “members” to have unlimited access to several models for as long as they want – registration fees, insurance, and maintenance included.

For Shale Drillers, Rising Oil Prices Also Come With Rising Costs (Lynn Cook, Erin Ailworth, and Christopher M. Matthews; @LynnJCook@ailworth@cmatthews9; WSJ)

In November 2016, Russia and OPEC agreed to curb oil production to increase prices. Since the meeting, oil prices have risen from ~$45 to just under $55. During this same time, US drillers added more than 90 rigs to take advantage of these rising prices. Most drillers view $55 as the breakpoint to profit from new rigs. But, at the same time, drilling suppliers started raising their costs, which is threatening this new activity.

Presidents Have Less Power Over the Economy Than You Might Think (Neil Irwin; @Neil_Irwin; NYT)

The impact a new President has on the economy is highly dependent on the economic cycle. “And the White House has no control over the demographic and technological forces that influence the economy.” The areas the Presidental office does influence, fiscal and regulatory, can take years before the benefits or costs are seen in an economy. It can be quite detrimental for someone to make investments based on their political views. “Ask a conservative who refused to invest in stocks while they notched a 182 percent gain during the Obama presidency — or a liberal who shorted stocks after Donald J. Trump won in November.”

Ensemble Capital’s clients own shares of Luxottica (LUX).

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, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by Ensemble Capital or one or more of its clients you will find a disclosure regarding the security held above. Should Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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If you invest in any health care related company today, you have to prepare for less and less money being spent in the sector in the years ahead. The United States economy faces a massive financial challenge to figure out how to provide for the health of our citizens and almost all potential paths to surmounting the challenge result in less revenue flowing to the health care sector.

This chart shows that far from a common problem, US spending on health care is out of control and an anomaly on the global stage.

life-expectancy-potential-1

What the chart shows is that the United States is a massive outlier compared to the rest of the world when it comes to the efficiency of our health care spending. While the US spends far more per capita on health care than any other country, the life expectancy of our citizens puts us solidly in the middle of the pack and on par with far less developed economies such as Chile.

To get a sense for the degree of inefficiency in our health care system, the arrows on the chart above show different ways that our health care system could return to the spending/life expectancy curve that characterizes the rest of the world. The green line shows that the US should be able to increase life expectancy from 78.5 years to a best in the world 84.5 years without any increase in our health care spending. The red line shows that alternately we could slash health care spending by 65% while still maintaining our current life expectancy. The orange line points to what many people would see as the optimal outcome; cutting health care spending by 30% while increasing life expectancy to 82.5 years, in line with Switzerland and Norway, two countries that lead the world in life expectancy.

Life expectancy isn’t the only metric to gauge the quality of health care. But the chart below shows that the US ranks poorly on a range of health outcomes measures. We feel confident that no matter how it is measured, the US is spending far more per capita than any other country while receiving lower quality care.

quality-of-care

A reduction in health care spending seems almost unimaginable after years of runaway cost inflation, but the fact is that the high level of spending on health care in the US is a relatively new phenomenon. As recently as 1990, US health care spending as a percent of GDP was 30% lower than it is today, in line with the reduction described above that could be achieved consistent with delivering best in the world life expectancy levels.

hc-spending-as-of-gdp

Spending as a percent of GDP has increased around the world since the end of World War II. So increasing spending is not a U.S. only phenomenon. But during the last 25 years, the rate of growth in the US has far outstripped other developed economies, even while it has done little to increase the quality of care.

The impact of the inefficiency in our health care system is not limited to health. Government spending on health care is the #1 driver of the federal budget deficit and our growing debt load. So the inefficiency of the health care system is having a major negative impact on our economy. In fact, the issue is so large and urgent that it would not be an exaggeration to say that bringing the efficiency of the US health care system back in line with the rest of the world is the single most important thing our country could do to improve the long-term outlook for the US economy.

If you’re not convinced by the big picture data, check out this New York Times article from a couple of years ago detailing how in our health care system a single stitch can cost $500, Tylenol can cost $37 a pill and a bag of IV fluid can be marked up 13,600%. And see this article showing how if you go to the wrong hospital, you are three times more likely to die. There is little doubt that the US health care system is incredibly inefficient and exacting a huge cost without delivering commensurate value.

The problem for health care companies, as far as investors are concerned, is that the past 60 years have been characterized by the sector receiving a larger portion of GDP, with the last 25 years seeing US health care companies receiving a percentage of GDP that is far larger than in any other country. Should this trend be reversed, it means that for the next generation health care investors may well operate in an environment where health care spending contracts as a percentage of GDP, creating significant headwinds for health care stocks.

This chart shows the performance of the S&P 500 Health Care Sector vs the S&P 500 over the past twenty years. Investors who have enjoyed these market-beating returns need to realize that those returns were generated at least in part due to the American economy devoting an ever-growing share of total spending to the sector.

At Ensemble Capital, we don’t know exactly how the health care system will need to change to reign in cost inflation. But we do think that the decade ahead will be characterized by forces throughout the economy working to hold back health care spending creating a massive headwind for many health care companies. If solutions are put in place that bring health care spending back in line with a percent of GDP that falls along the curve in the chart at the top of this post, it will mean huge amounts of potential health care company revenue draining out of the sector.

But this does not mean that all health care companies will face tough times. Since the current inefficient system both costs too much and delivers inferior outcomes for patients, there is an enormous opportunity to both reduce health care spending while also improving the health care that Americans receive.

As we look at the health care sector for potential investment opportunities, we believe investors must apply a two-fold test to any company, 1) does this company’s products and services help reduce system-wide spending and 2) do these products and services improve patient outcomes?

This is not an easy test to pass. Many companies sell products and services that are helpful but do not deliver good value. Other companies might appear to reduce costs, but they do so by short changing patient health. But some companies deliver true value to the health care system. These are the companies that we believe will thrive in the years ahead.

While there are important political debates about the best way to structure our health care system, there is no constituency for continued increases in health care costs nor for reducing the quality of care. Consumers, employers, and the government are all under severe financial stress due to runaway health care costs while at the same time they receive inferior health care outcomes. Companies whose products and service perpetuate the current dysfunction are not likely to produce superior investment results for investors in the years ahead. But companies who can help fix the problem will be handsomely rewarded.

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, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by Ensemble Capital or one or more of its clients you will find a disclosure regarding the security held above. Should Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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Yesterday we hosted our quarterly conference call. On the call, we discussed the implications of the U.S. presidential election and our investments in Paychex and DistributionNow. You can read the full transcript here.

Some excerpts:

  • On the election: “Suddenly, it seems quite obvious that the election of Donald Trump will result in lower corporate tax rates, less regulation, lower income taxes, government spending on infrastructure and a wide range of other pro-business policies. Yet if this outcome is indeed obvious, why then did market participants so broadly accept the idea that Trump’s election would lead to a market crash?”
  • On Paychex: “Over the last decade, the company has generated net income of over $6.2 billion while the company has reinvested nothing into working capital and just $100 million into fixed assets. With free cash flow in excess of net income in every year of the past decade, the company has been able to maintain a dividend payout ratio of over 80% even while opportunistically buying back stock, executing on the occasional acquisition, and yet have not had to take on any debt.”
  • On DistributionNow: “While their end market is highly cyclical, their cash flow is counter cyclical with them burning off inventory during down turns and investing to build their inventory when demand is strong. This internal counter-cyclicality was on display during the past two years when free cash flow was an amazing $2.95 a share in 2015 even while EPS fell to a loss of $0.62 a share as revenue collapsed by 27%… If you own DistibutionNOW, the cash generation dynamics provides significant protection against a financial crisis at the company when demand for their products goes through the occasional crash that characterizes the oil patch.”

Ensemble Capital’s clients own shares of Paychex (PAYX) and DistributionNow (DNOW).

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, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by Ensemble Capital or one or more of its clients you will find a disclosure regarding the security held above. Should Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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Weekend Reading

23 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.

Artificial Intelligence Makes Strides, but Has a Long Way to Go (Christopher Mims, @mims, WSJ)

Artificial Intelligence is hot topic in the IT world and has been the focus of a lot of investment since 2011, so much so, that the bid for people with these skills has dramatically increased and it has drained universities.  Angela Bassa of EnerNOC said “AI (…) requires three things that most companies don’t have in sufficient quantities.” 1) Amount of data, 2) incremental improvement, 3) scarcity of qualified people.

Apple Is in Talks With Hollywood for Early Access to Movies on iTunes (Anousha Sakoui and Alex Webb, @anoushasakoui and @atbwebb, Bloomberg News)

Apple is facing an uphill battle to get movie studios to allow them to release their new movies early on iTunes. Studios are receiving backlash from theater companies. Most of the profit received from theaters comes from concession sales, which will decline if people start watching movies at home.  Studios receive most of their profits from ticket sales at the box office. In 2011 when Universal tried to release a movie through Comcast cable, theaters threatened to not play their movie.

U.S. Home Construction Lags Behind Broad Economic Rebound (Chris Kirkham, @c_kirkham, WSJ)

The housing economy is still recovering from the 2008 financial crisis. Single-family housing starts remain at depressed levels. The current rate is similar to the rate of growth at the trough of the 1981 and 1991 recessions. This recovery has been slower than normal. One cause is millennials. They’ve been delaying their first home purchase because over the past 8 years they’ve been saddled with high student loans from ballooning tuition and tighter mortgage lending.

Hey Oil Market: Forget About OPEC for a Second (Liam Denning and Rani Molla, @liamdenning and @ranimolla, Bloomberg)

The average oil demand growth was primarily from OECD countries from 1985 to 2005. This has changed over the last decade. China now accounts for 40% of the growth in oil demand, but this is projected to decline over the next two decades. After the recent “airpocolypse” in China, they may be forced to look at ways to reduce pollution. “The burden of supporting higher demand thus begins to pass to India, along with a coalition made up of other industrializing bits of Asia and continued growth in the Middle East.”

Ensemble Capital’s clients own shares of 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, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by Ensemble Capital or one or more of its clients you will find a disclosure regarding the security held above. Should Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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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, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by Ensemble Capital or one or more of its clients you will find a disclosure regarding the security held above. Should Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

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