Source: Bloomberg

Tesla (TSLA) has garnered a huge amount of attention from the media, consumers and investors over the past four years and continues to do so today. Its stock valuation is the subject of lots of debate but the bull case is predominantly hinged on the strong growth the company has shown in shipments of its first two production cars, the Model S and Model X, with great anticipation ahead of the production launch of its more mass market oriented Model 3 series later this year.

While investors tend to get enamored with high growth companies, we thought it was interesting that a low growth company, Ferrari (RACE), has outperformed Tesla, the hyper growth company, since it went public in October 2015. As the Bloomberg graph illustrates, Ferrari stock has returned 64% while Tesla has returned 46% during that time period despite the fact that Tesla’s revenue growth is expected to average 10x Ferrari’s over then next 4 years. Many would probably scratch their heads at this phenomenon and ask, “How could that possibly make sense?”! We believe the answer lies not in the relative growth numbers but the Return on Invested Capital (ROIC) prospects of the businesses, the more powerful economic metric when it comes to long-term returns for shareholders of businesses.

As passionate as I am about stocks, my passion for cars is not far behind. And no car company has been as exciting to track as Tesla since it debuted its first volume production car, the Model S in 2012, blowing away auto journalists’ and customers’ expectations of the 100 year old concept of what a car is supposed to be. Moreover, its brilliant CEO Elon Musk has done what was considered impossible to do — bring to market clean electric vehicles that customers would not only find alluring (cars have always been a mix of passion and utility) but would also be willing to pay a premium for given their early stage in scaling technologies like the battery and manufacturing volumes. Within 3 years, the Model S became the best selling vehicle in its category in the US and the world with nearly 25% and 20% market share, respectively. Further, US market share had risen over 30% by 3Q16.

 

Given how discerning these luxury buyers are when they can choose any $100K vehicle they desire for the amenities, performance and status, Tesla’s quick rise to market share dominance in the category is a strong testament to its strategic execution in design, marketing, engineering, and capital acquisition and deployment in a category that relies on technical and manufacturing expertise, brand power, distribution, and large capital deployments. Starting a new car company that could succeed by trouncing its high end competitors, especially an electric car company at that, was probably one of the challenging feats to pull off in the modern world. And yet, Tesla has done it and set its sights on getting to the next order of magnitude in volume with the upcoming production ramp in the midsize luxury vehicle market with the Model 3, which already has over 400K preorders with accompanying $1000 deposits for each… sight unseen let alone test-driven.

Bleeding Edge Performance….

Style+Utility….

©Tesla

Unmatched Hardware+Software Technology….

©Tesla

Zero Emissions….

Clearly Tesla has done a lot of things right involving big bets in technology, positioning, distribution, and investment that others had failed to make (high end performance/luxury positioning, vertical integration of key bottlenecks – building supercharger networks and battery Gigafactory, focus on superior safety, direct distribution/no dealer network, low maintenance model, software-driven/autonomy focus with iterative/licensing model vs traditional hardware based 7 year cycles, etc). In fact its success has driven almost every major car manufacturer to invest in EV and autonomy platforms to compete. Government regulation has been a huge impetus with increasingly stringent emissions standards and incentives, but clearly Tesla’s business positioning, engineering, and business model has blazed a path that conventional automakers were not really considering viable. Now nearly every major automaker is investing full steam ahead to prevent their own future diminution or demise. Check out the market share Tesla has achieved in the Model S segment again… 20% in 3 years!

And the midsize workhorse market is next… its not just the luxury segment, but also the non-luxury mid size segment that will also be available for the Model 3 to compete against given the range of likely price points, experience with Model S buyers, and the highest customer satisfaction/loyalty ratings Consumer Reports has ever measured. In this segment, the declining battery costs and lower operating costs will make the Model S (as well as other EVs) more and more compelling financial competitors as well.

Tesla had been the most exciting public car company… until Ferrari went public in October 2015.

©Ferrari

Of course Ferrari has been many a 15-year-old’s dream car and a very few (read exclusive) successful 45-year-old’s trophy car. It is much more about emotion, passion, and experience than transportation and an entirely discretionary purchase. The sound, the speed, the F1 racing legacy (400MM global fans), and the shapes are all part of the experience that come with a Ferrari.

©Ferrari

Of course we haven’t mentioned a very important aspect — being part of an elite club. There have only been 7-8K Ferraris sold annually for the last 5 years (fewer in prior years) and estimates put the number of millionaires and billionaires at 15-35MM globally (depending on methodology), the target buyers. In order to buy the latest high-demand Ferrari or a limited edition supercar, you have to own one first — being able to front the cash is not enough. 2/3 of new Ferrari buyers are repeat buyers. An ASP of $250K-$1MM+. These are incredible statistics that bode well for the makings of a highly profitable defensible business.

In fact, when it comes to its very limited edition supercars like the LaFerrari, Ferrari’s million dollar sale prices still leave a lot of money on the table for its elite cadre of customers who see the resale value of their cars rise multiples of their purchase price.  For example, LaFerrari went into production in 2013-15 with 499 vehicles sold for over a million dollars.  Resale values were in the $3MM range immediately after they went into production and more recent sales indicate a value of $5-7MM just a couple of years later.  It’s no surprise that the two most expensive cars ever sold at auction are both Ferraris as are 7 of the top 10 and 15 of the top 20!

Whereas Tesla aims to bring its stylish, high tech, everyday highly utilitarian, green-clean cars to the masses, Ferrari aims to keep its race inspired cars exclusive and exclusively for driving pleasure.

©Ferrari

Tesla started from the top of the pricing and volume pyramid and is working its way down while Ferrari is happy to stay at the top. The result is a huge disparity in expected growth rates, with Tesla aiming to grow its production volume from 80K cars in 2016 to 1MM by 2020 or 88% CAGR, while Ferrari is looking to get to about 9K cars by 2019 from 8K in 2016, or a 4% CAGR, and targeting a number over 10K units over time. Both currently sell cars with ASPs in the 6 figures, though Tesla’s ASP will likely fall to about 50K as it scales its higher volume Model 3 towards the 1MM unit goal.

Given the disparate growth goals, with Tesla targeting 22x Ferarri’s goal, the stock performance of the companies is astounding, with Ferrari up 64% since it went public in October 2015 and Tesla up 46% during that same time frame.

While Tesla’s $142K Model S P100D production car can match Ferrari’s exclusive $1MM+ LaFerrari 0-60, its stock has not been able to keep up. Which begs the question, why? We posit that the difference lies in the return on invested capital expectations of the two companies.

As the reader can probably tell, we are big admirers and believers in Tesla’s achievements and capabilities. However, as investors, it is hard to value the company given its nascent business model. We can get some idea of what it could look like, but given the very different business model Tesla has relative to traditional automakers (direct distribution, supercharging infrastructure, battery plants, high software content, EV powertrain, etc.) and the onslaught of competition on the horizon from the major automakers, including historically successful and scaled brands, its hard to have much confidence on the ultimate economics that will accrue to Tesla. There are strong signs that the auto market will be disrupted and valuations across the auto industry certainly seem to point to it, but its hard to know what a super successfully scaled Tesla will look like economically 10 years out.

These are not issues for Ferrari. It is an entirely discretionary luxury good, with a strong brand and experience. This is the heart of its moat and drives the underlying economics of its business. There is very little guess work involved in understanding the nature of its business and how it is likely to evolve, especially with a management team focused on preserving its moat and economic characteristics. As a result, Ferrari shows an exceptional ROIC of ~100% with very little incremental capital required for it to grow its business at the rates it targets. The low capital intensity results in strong free cash flow generation, which is at the heart of any company’s long term value. By comparison, the average S&P 500 company has about a 10% ROIC. Incredibly, Ferrari’s ROIC is in the same league as high IP content, asset light companies such an Apple (AAPL), Google (GOOGL) or MasterCard (MA). Most analyst compare it to high margin, highly valued consumer luxury goods companies like Hermes (RMS FP), Richemont (CFR VX), and LVMH (MC FP) instead of the traditional capital intensive automakers for the same reason.

Tesla, on the other hand, has a business whose ROIC is undeterminable at this point given the rapid growth it has exhibited and the very capital intensive nature of its growth going forward. It is scaling out from the high end, low volume to the mass market, which necessarily appears to have structurally lower ROIC. Will it have the ROIC of Ford at ~8-10%** or BMW at 17-20%** or Porsche’s at 30-40%**? We can get some idea by comparing the volumes and ASP ranges for each of these manufacturer’s to get at potential return structure (see source notes in table below).

Certainly there appears to be a pattern here that indicates an inverse relationship between ROIC and volume. ASP is of course a strong determinant of volume since lower prices open up sales to larger numbers of consumers, while lower volume desirable cars command higher ASPs and margins.

One caveat is that an electric powertrain has an inherently lower level of complexity (electric motor vs internal combustion engine, single speed vs 5-8 speed gearbox, significantly fewer parts) and a cost heavily driven by the the battery costs. However battery costs are expected to fall rapidly over the next 5-10 years with scale and improving technology. In addition, Tesla has a high software component to its cars that deliver tangible value to the customer such as its Autopilot semi-autonomous driving software for which it charges 5-10% of base car ASP, which drops directly to the bottom line. As volumes scale, software driven features such as a fully autonomous upgrade, Uber like service features, or even supercharging/battery swap fees may bring in incremental high margin revenue to a fixed asset/cost base. On the other hand, the economics of battery plants and solar panels/roofs (without any value-added proprietary technology, integration, or user interface driven excess profits) may be profit/ROIC dilutive.

Getting back to the stock performance we’ve seen so far, we’ve had many conversations with investors about Ferrari and Tesla and why we own Ferrari but not Tesla despite our positive views on the latter. By far, most see Tesla as a high growth company accompanied by a high return (albeit also very volatile) stock. From our perspective, Tesla could very well end up owning a significant share of the very large auto/transportation market, but how much it will end up winning and importantly what those economics will look like are unclear. This makes it hard to know how to value the business with any level of certainty or margin of safety. Instead, it is a much more straightforward bet that Ferrari will continue to inhabit the dreams of many a 15-year-old and collection of a few 45-year-old enthusiast looking for the particular experience it delivers, with predictably fantastic economics inherent to its business model. At the end of the day, we as shareholders of a business care about the stream of free cash flows a business we own will generate, for which a determinately high ROIC is a much stronger driver than high revenue growth and an indeterminate future ROIC. Of course for a given level of ROIC, higher growth is more valuable than lower growth. And there is certainly a trade off between the value incremental growth adds vs incremental ROIC.

So far though, the market appears to have come to our view that Ferrari’s slower growing highly profitable business has been the more undervalued, higher prospective return company than the faster growing, world changing Tesla.

Clients of Ensemble Capital own shares of Ferrari (RACE), Apple (AAPL), Alphabet (GOOGL), and MasterCard (MA).

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.

Share on FacebookTweet about this on TwitterShare on LinkedInEmail this to someone

Ensemble Capital chief investment officer Sean Stannard-Stockton recently sat down with John Rotonti of The Motley Fool to discuss our investment philosophy. A couple excerpts are below. You can read the full interview here.

John Rotonti: How do you define a high-quality business?

Sean Stannard-Stockton: The most important indicator of quality is the strength and sustainability of a company’s moat. A moat is a set of competitive advantages that protect a company from competitors. The fact is that most businesses do not possess much of a moat, and so while they may experience good results – or even great results for periods of time – if their business prospects are compelling, they will attract aggressive competition.

High-quality companies, with significant and sustainable moats, are much more in control of their own destiny. While they will face unpredictable challenges, their moat protects them and provides them with the room to adjust to changing conditions and maintain long-term profitability

JR: Please explain how you narrow down your investable universe and how large that universe is.

SSS: Our investable universe is all U.S.-listed companies with a market cap in excess of our equity assets under management (currently about $450 million). Because we run a concentrated portfolio of 15 to 25 companies, we generally would not invest in a company with a market cap less than our AUM, because doing so would require us to own a large enough portion of the business that liquidity would become an issue and we would feel a need to actively engage with the board, which is something we have not done historically.

However, while this investable universe is very large, we only invest in companies that pass our rigorous requirements that they have a strong and sustainable moat, have a management team focused on generating strong returns on invested capital and maximizing shareholder value, and operate an understandable and forecastable business.

While these requirements are not complicated, they eliminate the large majority of companies. One way to estimate the percentage of companies that we might deem investable after completing our full due diligence process is to note that Morningstar, the only sell-side research organization that rates companies based on their moat, assigns their “wide moat” rating to just 10% of the over 1,500 companies they cover.

JR: How do you approach valuation?

SSS: We think that for the sort of companies we target, the only reasonable way to think about valuation is as the present value of future distributable cash flow. As shareholders, this is really the only claim you have that makes your shares valuable.

Of course, discounted cash-flow analysis is sensitive to a range of factors that allow people to abuse this tool to generate whatever fair value they have in mind. At Ensemble, we have a disciplined framework for generating these inputs that protects us from backing into the valuation we want and instead keeps us focused on the true intrinsic value of a business.

But at the end of the day, our valuation process results in an implied P/E ratio, which provides us with a sanity check. If the implied P/E ratio doesn’t make sense to us, we’ll stress-test our valuation model to understand what assumptions are driving the unexpected output.

In general, because our portfolio is full of “capital-light compounders” that can distribute cash to shareholders even while they grow, the fair-value P/E ratio of our holdings is higher than the P/E ratio of the market as a whole, since the market is made up primarily of companies with mediocre returns on invested capital and average growth potential.

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.

Share on FacebookTweet about this on TwitterShare on LinkedInEmail this to someone

Warren Buffett is generally credited as the most successful investor of all time. But those seeking to learn from him must recognize that there have been distinct phases in his investing career. And we are seeing his next evolution play out right now.

Buffett is famous as a value investor, for paying cheap prices for stocks. This image comes from Buffett’s initial investment philosophy built around the teachings of Ben Graham. Graham had become an investor during the Great Depression and he recognized that some stocks were so cheap that no matter how badly the companies performed fundamentally, the stocks could still do well. These sorts of opportunities became far more rare in the years after World War II, when Buffett was a young investor and so his thinking evolved to incorporate the philosophies of growth investor Phil Fisher. Buffett was also strongly influenced by his partner Charlie Munger’s thinking that some growth companies could be bought at “fair” rather than cheap prices.

“It’s far better to buy a wonderful company at a fair price than a fair  company at a wonderful price. Charlie understood this early; I  was a slow learner.” Warren Buffett, Berkshire Hathaway 1989 annual letter

This evolution from a Ben Graham value investor to a Fisher/Munger quality focused investor is fundamental to understanding Buffett’s legacy. It highlights that Buffett’s advice is not about a formula or set of rules that are set in stone. Instead, they are context specific. In the wake of the Great Depression, you could buy stocks for less than the net cash on the company’s balance sheet and a valuation-first philosophy made sense. But over the last 50 years, a quality-first approach (with a continued appreciation for not overpaying for quality) has been a much better fit for the economic and market environment.

One of the key things that Buffett has looked at during this phase of his investment career has been companies that have an opportunity to re-invest a lot of capital at attractive rates of return.

“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns.” -Warren Buffett, 2003 Berkshire Hathaway Annual Meeting

But now, Buffett has pointed to something new. Something so important that even though it was reported on in real time, he thinks people didn’t appreciate enough the importance of his comments.

“I believe that probably the five largest American companies by market cap…they have a market value of over two-and-a-half trillion dollars…and if you take those five companies, essentially you could run them with no equity capital at all. None.” -Warren Buffett, 2017 annual meeting.

Buffett went on to call these “ideal businesses”, the same phrase he used in the past to refer to companies that reinvested massive amounts of capital at high returns.

Then, the next day in a CNBC interview with Becky Quick, Buffett referenced these comments again saying “I did mention one thing at the meeting, which I don’t think people appreciated at all… So you have close to 10% of the market value perhaps of the United States in five extremely good businesses that essentially take no capital. Now that was not the case in the past.”

The “five extremely good businesses” that Buffett is talking about are Apple, Microsoft, Amazon, Google and Facebook (Buffett is quick to remind the interviewer to include Facebook in the list when she leaves it out initially). Then, when Quick asks him “Would you like Berkshire’s businesses to be more reflective of that sort of new paradigm?” Buffett says “I’d love it.”

Apple, Microsoft, Amazon, Google and Facebook. That’s Warren Buffett’s idea of what he’d like to see Berkshire Hathaway’s portfolio look like going forward. These are the new “ideal” businesses in his view.

If that statement doesn’t reflect a new phase in Buffett’s investing career, I don’t know what would.

But it is important to note this isn’t a rejection of the past, it is an evolution in his thinking that is entirely philosophically consistent. In fact, one good way to understand the evolution is using Connor Leonard’s moat framework that we discussed in a recent post. Buffett is just moving his focus from “reinvestment moat” businesses to “capital light compounders”.

Buffett’s genius doesn’t rest on some key insight he discovered long ago. Buffett’s genius is that he is a life long learner. He recognizes his mistakes and learns. One of those mistakes was not investing in Google, which Charlie Munger declared at the meeting should have been “easy” and that they “screwed up” not investing in the company. But then Munger, teasing Buffett, says the key thing that has made Buffett great:

“I think it’s a very good sign that you bought the Apple stock,” Munger told Buffett. “It shows either one of two things: Either you’ve gone crazy or you’re learning. I prefer the learning explanation.”

Ensemble Capital’s clients own shares of Apple (AAPL) and Alphabet (GOOGL).

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.

Share on FacebookTweet about this on TwitterShare on LinkedInEmail this to someone

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

It’s not Armageddon for all malls, some are turning store closures into higher rents (Krystina Gustafson, @KrystinaGustafs, CNBC)

It appears that the brick-and-mortar retail space is changing. Large department stores were the primary driver of mall foot traffic. Landlords needed to entice big box stores to lease in their mall. Consumers tastes have now shifted from department stores to specialty shops. A great example of a specialty retailer is L Brands (LB) or Apple (AAPL). During our last quarterly call, Arif reviewed the retail landscape and LB. You can see the excerpt from the transcript here.

The death of retail is greatly exaggerated (John Biggs, @johnbiggs, TechCrunch)

The change the book industry experienced a decade ago is a good example of what’s happening in retail now. The book industry didn’t die. It just changed. It redefined the book buying experience. Consumers that previously bought at large, chain bookstores (like Macy’s in retail) are now buying from Amazon.com. They didn’t go to those stores for the experience. They went there to buy a (typically widely published) book. Amazon is able to provide the same service at a cheaper price. “So again, as in the world of books, the long tail is eating the old and decrepit body. But the long tail again does something clever. The key, then, is for the startup to fill that niche with cool stuff that people want and that is available down the street and not around the world.”

Quantitative Investing: A Crisis Waiting to Happen (Jason Zweig, @jasonzweigwsj, WSJ)

There is an underlying assumption in quantitative investing that cause them to be “fatally flawed.” The assumption that what’s happened in the past will persist into the future. Quantitative investing looks at the previous behavior of various factors and assumes they’ll continue in the future. Mr. Brookstaber reminds us that “A crowd isn’t the simple sum of its parts. Individuals, acting as a group, behave differently than in isolation. As a crowd becomes ever-so-slightly larger or smaller, its behavior can change in big, and unpredictable, ways.”

Rent or Buy? More Young People Are Choosing Homeownership (Laura Kusisto, @LauraKusisto, WSJ)

Homeownership peaked before the financial crises, then declined to hit a 50-year low in 2016. It has since reversed. This is also the first time since the peak that “new homeowners outstripped that of new renters.” Millenials have been slower than previous generations to purchase their first home. The burden of high student loan balances and rising rents have contributed to this delay. A continuation of this new homeownership trend could be positive for the US economy.

Cable cowboy John Malone views a new landscape (Matthew Garrahan, @MattGarrahan, FT)

US pay-TV has been shrinking “762,000 subscribers across the industry cancelled their subscriptions in the first quarter, a fivefold increase on last year.” John Malone “says he is not worried: after all, these days cable is about much more than piping television into people’s homes. Now it is also a gateway to the internet and streaming services, from Netflix to Amazon.” Similar to the changing retail industry, the media landscape is changing. Consumers are opting to go directly to the content creator, but as John said, they’re still using Cable services for the gateway to those content providers.

Clients of Ensemble Capital own shares of L Brands (LB), Apple (AAPL) and Netflix (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.

Share on FacebookTweet about this on TwitterShare on LinkedInEmail this to someone

We recently hosted our quarterly client conference call. You can read a full transcript here. Below is an excerpt from the call discussing our investment in Oracle (ORCL).

Excerpt (Sean Stannard-Stockton speaking):

Oracle went public back in 1986, the day before Microsoft went public. During the quarter century leading up to 2012, these two companies generated very similar total returns for investors of approximately 6000%, making them both major blue chip companies.

But since 2012, Microsoft has almost tripled again (much better than the market overall) while Oracle has generated a total return of 40% or about half of the appreciation of the S&P 500 during that time.

We believe that rather than facing a permanently weaker future, Oracle is simply a couple of years behind Microsoft on fully transitioning to the reality of cloud computing and we believe that the market is only just starting to appreciate the degree to which this successful transition should lead to a much higher stock price for Oracle.

But before we delve into this transition, some background on Oracle. The company was founded by Larry Ellison. While Ellison is notorious in some circles, he is also unequivocally one of the great geniuses of the technology industry. While his best friend Steve Jobs owned less than 1% of Apple at his death, today Larry Ellison owns 27% of Oracle, ranking him as the largest individual holder of a company with a market capitalization of over $100 billion. Only Warren Buffett’s 18% ownership of Berkshire Hathaway and Jeff Bezos’s 16% stake in Amazon comes close. As an aside, many of the companies in our portfolio are managed by owners with large personal stakes in the business. L Brands’ Les Wexner for instance, owns 16% of the company.

The Oracle offering is complicated and the breadth of what they do is beyond the scope of this call. But at its heart, Oracle offers two platforms, a database that acts as the infrastructure for a myriad of critical corporate software applications, and a software suite known as Enterprise Resource Planning that allows companies to manage their business across planning, purchasing, inventory, sales, marketing, finance and human resources. For global companies coordinating employees, resources and activities around the world, ERP software is a must.
100% of the Fortune 500 use some of Oracle’s offerings, and their database, which powers not only Oracle’s ERP software, but much of the software offered by their direct ERP competitor SAP, is THE market leader. Their software is so important to other companies that it is one of the few technology implementation projects that is enough of a needle mover to be discussed on quarterly earnings conference calls.

The cost of switching ERP systems is massive, creating huge “switching costs”, an important competitive advantage that makes Oracle’s customer relationships very sticky. It isn’t just the cost of paying for new software, to switch ERP systems a company needs to spend vast resources retraining employees, rebuilding internal processes and changing how they work, while still operating their business. Remember, this software is used across entire organizations to coordinate activity in most business groups. Implementing a new ERP system takes years to complete and the cost is high enough that companies often measure their ROI on time periods of a decade or more.

But like all industries, the huge profits that Oracle earns have drawn competition. Remember, Oracle went public in 1986, but it was founded 40 years ago in 1977. Technology changes fast and over the past 15 years one of the most important changes to impact Oracle has been the shift from on-premise computing to cloud computing. Both Workday and Salesforce are cloud-based technology companies founded by ex-Oracle employees who have sought to use a modern cloud-based operating structure to compete against Oracle’s historically on-premise technology structure.

But Oracle hasn’t been sitting still. And those huge switching costs have afforded them strong competitive protection while they spent years rebuilding their software from the ground up to become a cloud first technology business and preparing themselves to eliminate the relatively short-term technology advantage that cloud-based competitors have had against them.

So let’s pause and go back to my earlier comparison to Microsoft. After seeing its share price go nowhere for a decade between 2002 and 2012, Microsoft got religion on transforming their software into a cloud first offering and the stock spent the next five years in a continuous rally that has led the stock to almost triple.

Beginning a year ago, Oracle’s cloud-based sales began to accelerate quickly. And on their earnings call in December, with their technology transformation to a cloud first business complete, their co-CEO Mark Hurd announced that they had actually stopped compensating their salespeople in their applications business for selling on-premise software.

We’ve seen with Microsoft, as well as other software businesses, that companies that successfully make the transition to the cloud are often well rewarded by investors. We believe that as this transition takes hold, the headwinds to revenue growth that have plagued the company in recent years will abate and profit margins will move materially higher, a pattern that is common to companies transitioning to cloud-based business models. The results from their most recent quarter announced in March support this thesis and we think the company and the stock have a bright future.

You can read the full transcript here.

Clients of Ensemble Capital own shares of L Brands (LB), and Oracle (ORCL).

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.

Share on FacebookTweet about this on TwitterShare on LinkedInEmail this to someone

We recently hosted our quarterly client conference call. You can read a full transcript here. Below is an excerpt from the call discussing our investment in L Brands (LB).

Excerpt (Arif Karim speaking):

L Brands is one of the newer names in our portfolio. It is the parent company of specialty retailers Victoria’s Secret and Bath and Body Works. Last year, Victoria’s Secret did nearly $8 billion in sales, virtually all of it in the US while Bath and Body Works did nearly $4 billion.

The stock has been under pressure over the last year due to changing consumer behavior in the mall-based retail business, and we initially started buying when the stock had already declined about 30% from its high. Shifting consumption patterns and increasing ecommerce purchasing behaviors have led to significant declines in mall traffic and pressured most if not all mall-based retailers, especially since the promotions-heavy holiday season last year. Despite making our initial purchases at levels that we felt were a discount to intrinsic value, the stock has continued to decline and as Sean noted, it was our weakest holding this past quarter.

In addition, Victoria’s Secret has been in the process of discontinuing and clearing out less differentiated apparel and swim wear, which have distorted mostly stable underlying financial results for the continuing business. These two factors combined to create a lot of noise around the stock while fundamentals have been mostly stable in the underlying business. Once we get past these factors, we believe healthy trends will reemerge in the go-forward business in the US while traction in their new China strategy will refocus investors on the very profitable and large growth opportunity offered in the global market place as I’ll explain shortly.

So, the industry pressure in the near-term has given us the opportunity to invest in a very rare type of company in the consumer discretionary space; one that has a strong moat and global opportunity. After all, underlying demand for underwear is not being disrupted and neither are soaps, lotions, and candles. In addition, the branded experience is not being disrupted either as we’ll discuss.

L Brands is just really beginning to tap the global opportunity, beginning with China, a market as large as the US, where the company launched the first two Victoria’s Secret stores last month to great fanfare and long lines of customers. In fact, Victoria’s Secret’s annual fashion show, a spectacle viewed around the world, is watched by 400 million people…. In China alone! The brand is indeed a global one with 800 million people watching the annual fashion show each year, highlighting the power of the brand and the experience.

In China, it is launching with strong brand recognition into a large, highly fragmented market with no strong incumbent leader and a middle and upper class that seeks out branded goods and experiences. After all, the Chinese middle class buy 1/3 of luxury goods globally. We expect strong growth to follow over the next decade as stores are rolled out with strong complementary ecommerce sales. Other parts of the globe are being served by select franchise partners and also have tremendous sales growth opportunity ahead.

As a result, we believe the market is significantly undervaluing the brand, product moat, and global expansion opportunity because of near-term changes in consumer purchasing patterns in the US. An indication of this is its 5% dividend yield, which in today’s rate environment would only be justified by a permanently declining business or unsustainable dividend, neither of which we believe to be the case.

Ultimately, we believe that L Brands will be able to successfully navigate changes in retail shopping trends under the leadership of its founder and retailing genius Les Wexner, as he’s done for 50 years. The company’s robust and faster growing ecommerce business at 17% of sales demonstrates this, and it’s more profitable to boot!

So a little background — L Brands was founded by Les Wexner, literally the inventor of what’s known as specialty retail in the 1960’s, an era when one-stop shop department stores selling everything were the norm. His insight was to optimize return on capital by focusing on specific niche products that catered to customer’s needs but also had a high turnover rate on the racks while carrying healthy margins. His first store was the women’s apparel shop called The Limited, started in 1963.

Since then he created or acquired new concepts and developed them under the Limited Brands umbrella including Express, Structure, Abercrombie & Fitch, Victoria’s Secret, Bath and Body Works, Lerners, and White Barn Candle Co. If store recognition is an element of success, many of you will probably recognize a few of these names from your visits to your local mall, a testament to Wexner’s knack for retailing. He is regarded as one of the greatest retailers ever.

Over time, Wexner has spun out or sold a lot of these store concepts as L Brands has evolved with the market. Today, L Brands is predominantly comprised of the two retail brands with solid competitive moats and business models — Victoria’s Secret and Bath and Body Works. We believe these to be highly resistant to the kind of commoditization that internet retailers like Amazon are driving in the traditional retail world. Both businesses are vertically integrated – meaning they make their own branded products, which they sell through their own branded stores and websites, with strong product and brand loyalty, that deliver emotional experiences beyond the products alone. It’s the differentiated, experiential nature of the products that make them highly resistant to the permanent disruption we see across the retail space.

Diving into the business, Victoria’s Secret (and its younger PINK subsidiary) sells women’s underwear in a store experience that provides a specialized one for the women it targets, generally in the 16-35 age range. It has 35% market share, nearly 10 times its closest competitor, and sells 6 out of every 10 bras in the US. The stores serve as galleries for these high turnover products while the brand’s appeal allows it to earn a high margin, driving strong returns on capital and making the business very valuable.

Its consumers shop there because fit, comfort, and style are very personal and individualized aspects of the product and the well-trained service staff are available to help customers figure out the products that would be best for them in a comfortable environment. In addition, it’s a category in which price is a lower priority for a significant segment of customers, indicating that these customers are willing to pay a premium for the product when it meets their higher priorities. The products are highly designed to meet the paradoxical priorities of durability for everyday use while also being composed of seemingly delicate materials and providing the right fit for various body types.

Bath and Body Works (and its subsidiary White Barn Candle) focuses on fragrance products such as soaps, lotions, and candles. It is the leader in this segment as a focused specialty shop with a strong following among its customers.

Again, this is the kind of product that is highly experiential (as of yet, there’s no way to smell scents online!). This makes the store an important aspect of the shopping experience. It is also a consumable product business that caters to a fundamental building block of every human experience. Whether it’s a scent to use on yourself or to create a certain atmosphere in your home, Bath and Bodywork’s products help customers do just that. For many of their customers, the scents they’ve been buying for years are an important part of their everyday routine. Any time the company discontinues a scent it triggers panicked buying as customers stockpile scents that they’ve used for years and don’t want to lose access to.

From an ecommerce perspective, companies like Amazon are generally distributors of products. They make it difficult for other undifferentiated retail distributors such as Macy’s, JC Penny’s and Target to compete effectively because they all have access to the same branded or unbranded products, and Amazon generally has a much better and more convenient customer experience and a lower cost model to boot. The staff of Ensemble are all Amazon Prime members and we fully believe in the distribution dominance of Amazon over traditional retailers.

However, companies with differentiated products, durable brand appeal, and strong customer service or experiences such as Victoria’s Secret, Bath and Body Works or companies like Apple, Nike, and Tiffany, can largely retain control of the distribution and profitability of their products. Their branded products are sought after by customers who will leave the online mall called Amazon and go to the branded sites in order to purchase these differentiated products. At the same time, these types of retailers can sell through Amazon if it suits their interests.

This is exactly the type of companies that we can have confidence in the future of even as customer buying patterns change. They may buy differently, and sales may be lumpy in the near term as channels shift, but as long as they keep buying the products our portfolio companies make, we believe shareholders will be rewarded over the long term.

You can read a full transcript here.

Clients of Ensemble Capital own shares of Apple (AAPL), L Brands (LB), Nike (NKE), and Tiffany (TIF).

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.

Share on FacebookTweet about this on TwitterShare on LinkedInEmail this to someone

We recently hosted our quarterly client conference call. You can read a full transcript here. Below is an excerpt from the call discussing our current views on financial markets and the economy.

Excerpt (Sean Stannard-Stockton speaking):

For the last two quarterly conference calls, which bracketed the presidential election, we’ve commented extensively on the intersection of politics, the economy and financial markets. Our message has been that while investors need to recognize the ways that public policy can impact the business prospects of individual companies, there is little evidence of any reliable way to predict how politics will impact the stock market. Indeed, investors have been best served historically by ignoring politics. Letting politics sway your investing can be harmful to your financial health.

So while the mainstream and financial news media are covering politics around the clock, we’d argue that the most important drivers of financial markets this past quarter have been basic economic trends.

The fact is, the US economy continues to improve. Almost a quarter million jobs were added to the US economy in both January and February and the three month moving average for the first quarter was in line with the job creation levels we’ve seen throughout the recovery. Importantly, over the last year people have been coming back into the workforce and the percentage of Americans who are employed or actively seeking employment has started to rise. While this metric fluctuates, the 12-month average participation rate is now increasing after being in continual decline since 2008. Today, there are 8 million more jobs in America than there were just prior to the financial crisis.

Unemployment claims are exploring new lows this week. The number of people who reported filing for unemployment benefits this past week registered at the lowest level of the recovery and indeed is the smallest number of people to file for unemployment in any week since the early 1970’s when the US workforce was literally half the size it is today. As a percentage of the workforce, there has never been a time when so few people have been reporting the loss of a job. And in addition to new jobs, wages have been growing recently at the fastest rate since the end of the financial crisis.

Interest rates are moving up. The 10-year treasury yield averaged 2.4% in the first quarter. While this is still well below the long term average, it is the highest average quarterly yield in over two years. The last time we saw as big of a move up in interest rates was in 2013 when the stock market raced higher by 32%.

But higher interest rates seem like a bad thing to most people. So why have rising interest rates generally been associated with a strong stock market since the Financial Recession?

Over the longer term, the yield on the 10-year treasury bond has tended to approximate the rate of growth of the economy. So while low rates might spur borrowing to finance investments and large consumer purchases, if the economy is indeed going to eventually return to the rates of growth we were accustomed to for the 50 years prior to the financial crisis, interest rates should move higher. While the bond market is not that great at predicating the future, its behavior is supportive of the idea that the economy is improving.

In general, the stock market has rallied during period of low rates increasing back towards average levels as the economy recovers from weak growth. While the stock market generally does poorly when interest rates increase to above average levels at the tail end of a robust economic boom. So for the time being, we would expect ongoing increases in long term interest rates to coincide with solid stock market performance, as it has recently.

Inflation has also been picking up. Like with rising interest rates, most people perceive rising inflation as a bad thing. But economists generally believe that a low, but positive rate of inflation is good for the economy. Historically, market PE ratios have been highest when the rate of inflation is between 2%-3%. This is in fact where inflation expectations were during much of the initial market rally from the great recession lows during the 2010 to 2014 time frame. But starting in 2015, inflation expectations began to decline, falling as low as 1.2% as the market bottomed last year.

But since mid last year, inflation expectations have been increasing in a positive sign for economic growth. As we moved into the first quarter, inflation expectations once against moved back into the 2%-3% sweet spot for market performance.

One more counter-intuitive sign of the improving economy has been the increase in oil prices. The price of oil traded above $50 for much of the first quarter, the first time it has traded that high since mid-2015. A stronger economy demands more energy and while too high oil prices, too high inflation and too high interest rates can all crimp a robust economy, when they occur in the context of an economic recovery they are signs of economic strength.

So when we take a step back, what begins to emerge is a picture of an economy that recovered at a slower than average pace from 2010 to 2014. Then during 2015 and the first half of 2016, economic conditions seemed to deteriorate, with worries about a potential recession triggering the 15% correction in the stock market from December 2015 through February 2016. Since then, economic conditions have been improving again and the stock market has responded in kind.

Now don’t for a minute think any of this tells us what is going to happen next. These observations about the economy and market offer context for where we’ve been. Too many investors fret that the recent market rally is related strictly to possibly misplaced hopes about lower taxes and regulations coming out of Washington. But they are missing the fact that while politics has dominated the news cycle for the last year, the US economy has been in the midst of posting steady improvement.

You can read the full transcript 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, 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.

Share on FacebookTweet about this on TwitterShare on LinkedInEmail this to someone

WEEKEND READING

21 April 2017 | by Paul Perrino, CFA

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

Why Facebook Keeps Beating Every Rival: It’s the Network, of Course (Farhad Manjoo, @fmanjoo, NYT)

In previous posts, we discussed the impact of moats (HERE and HERE). Facebook created a moat by establishing one of the strongest networks. This network becomes more valuable the more people that use it. “What’s important is that Facebook has forced this coexistence [with Snap]. Facebook’s billions of users will now be introduced to Snapchat’s best features on Facebook’s own platform, eliminating, for a lot of them, any reason to switch. There is essentially no chance now that Snapchat will eclipse Facebook anytime soon, if ever. In other words, Mr. Zuckerberg has done it again; he has neutralized yet another rival.”

Toronto Home Prices Just Jumped Another 33% (Kim Chipman and Erik Hertzberg, @KimChipman1 and @ErikHertzberg, Bloomberg)

Over the past 3 years, the year-over-year (yoy) percentage increase in Toronto home prices have been rising. As of March 2017, this yoy increase reached 33%, which is 4 standard deviations from the mean. According to the Mayor of Toronto, it’s unclear what has been driving the rapid increase. This has started a debate among residents. Some are blaming foreign investment and are pushing for a “tax to curb price gains and discourage speculation”, but the data on foreign buyers is unreliable.

How Well Do Stocks Hold Up In Geopolitical Crises? (John Kimelman, @johnkimelman, Barron’s)

It may be counter-intuitive, but as your personal fear index goes up, that doesn’t necessarily mean the stock market is going to go down. In fact, “When it comes to major events like war, terrorism and even presidential assassinations, stock markets have proven to be remarkably resilient, assuming of course that these events don’t lead to a massive hit to the economy.”

How This Company Combines The Gig Economy Model With AI To Be More Productive (Jeremy Quittner, @JeremyQuittner, Fast Company)

First, let’s start with a quick definition for those who haven’t heard the term Gig Economy. It refers to this new type of labor market where individuals work based on short-term contracts or freelance. Uber drivers are the quintessential example of these individuals. This can be a great way to attract quality talent to complete a project, who might not otherwise want to become a full-time employee and without the high-cost of consulting firms. Their software platform, Orchestra, acts as the project manager by setting “up a dedicated Slack room for communication, and then plays umpire for the workflow, ensuring tasks are completed in order and on time.”

Corporate short-termism is a frustratingly slippery idea (The Economist)

The short-term focus of some investors and company management is not a new concept. McKinsey conducted a new study that looked at 600 companies they deemed to be “short-termist.” To be labeled a “short-termist” the company needed to exhibit “five habits: investing relatively little, cutting costs to boost margins, initiating lots of buy-backs, booking sales before customers pay and hitting quarterly profit forecasts.” Based on some of these characteristics you might assume the outcome of these companies is straightforward, however, “The theory of short-termism suffers from three difficulties: it isn’t an accurate description of what is happening across America’s economy; it doesn’t deal with the question of causality and, last, it is a distraction from the real difficulty.”

 

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.

Share on FacebookTweet about this on TwitterShare on LinkedInEmail this to someone

“Never, ever, think about something else when you should be thinking about the power of incentives.” – Charlie Munger

During our due diligence process on new investment ideas, we spend time looking at the structure of management compensation. We especially like to see significant insider ownership. That being said, we don’t go out of our way to target companies where the insiders are outsized owners.

But our portfolio is full of these “owner-operators”.

The list below was put together by @HarvestInvestor in December. It shows the 47 members of the S&P 500 where insiders own more than 5% of the company. Of this list, our current portfolio holds Oracle, L Brands, Alphabet, Cerner, Charles Schwab, Paychex, and Discovery Communications. This is an amazing overlap given that our core portfolio owns 20-25 securities. It means our holdings have insiders with 5%+ ownership stakes at 3.4x the frequency that you would expect to find by chance.

Adding to that list, our holding Luxotica is majority owned by the founding CEO and retired founder Phil Knight owns more than 15% of Nike in a combination of share classes and entities. Interestingly, MasterCard is 10% owned by the MasterCard Foundation. And while Broadridge’s CEO Rich Daly no longer owns a large stake in the company, he founded the proxy business that he sold to ADP back in 1989 before it was spun back out as a separate company in 2007. Likewise, First Republic’s Jim Herbert owns 1.9% of the company, but he founded the business himself in 1985 before selling the business to Merrill Lynch at the peak of the housing bubble and then buying it back with the backing of private equity partners in the depths of the financial crisis.

So what’s going on here? If we aren’t actively seeking out companies where the founder and/or management has a large stake in the business, how did we end up with so many of them in our portfolio?

As the Charlie Munger quote leading this post suggests, a big part of the explanation is the incentives of owner-operators often lead to them building the sort of companies we look to invest in. Owner-operators of companies care about the long-term value of their business, not the price of the stock next quarter. They care about the cash the business can generate, not the accounting earnings. They are answerable to themselves rather than to “The Street” and so they are willing to take actions that are non-conventional, daring and may require short-term pain in exchange for long-term gain. Its remarkable how many great businesses were dismissed as being “crazy” ideas early in their history. These ideas can only be brought to fruition by someone who is deeply, personally invested in its outcome.

But it isn’t only financial incentives. Owner-operators have often committed their entire life to their company. They remember the days they scrapped together $500 to start the business (Nike), they worked long nights in their dorm room while their friends were out partying (Alphabet), they decided to do the unthinkable and slash prices when all of their peers where raising prices, giving birth to a new business model (Charles Schwab). Their incentives transcend money because their company is their life. It is their reason for being. It is the first thing they think about in the morning and the last thing they think about at night because they are obsessed with an idea. They are what Charlie Munger has called “intelligent fanatics”.

What’s interesting is that most of the businesses in the world are small businesses that are run by owner-operators. But as a company grows, it generally needs to raise capital with the founding owner selling off pieces of the business. Once a company has gone public, the management team in place is usually “rented” by the shareholders to manage the company. There are many, many hard working dedicated CEOs who do not own big stakes in the businesses they manage. But the owner-operator starts off with a huge advantage because their incentives are not to meet the short-term demands of their employer but to drive the long-term value of the company.

So while all owner-operators do not build outstanding businesses, many outstanding businesses were built by owner-operators. Our portfolio is full of founder and owner-managed companies not because we target companies with this sort of management structure, but because we seek out outstanding companies that create shareholder value.

If you’re interested in learning more about owner-operated business, a firm called Horizon Kinetics has built an index of these companies and put together research on how they’ve performed over time. You can learn more about the index, their methodology for how they define owner-operators, and the long-term performance history of owner-operated firms vs the market here. (Note: we point to the Horizon Kinetics index as a resource to learn about owner-operated businesses, not as an investment recommendation).

Ensemble Capital’s clients own shares of Alphabet (GOOGL), Broadridge Financial (BR), Cerner (CERN), Charles Schwab & Co (SCHW), Discovery Communications (DISCA), First Republic (FRC), L Brands (LB), MasterCard (MA), Nike (NKE), Oracle (ORCL), Paychex (PAYX), and TransDigm (TDG).

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.

Share on FacebookTweet about this on TwitterShare on LinkedInEmail this to someone

In our writing here we’ve made clear the the single most important element of our investment approach is focusing on companies that have a wide competitive moat. Usually when people talk about different kinds of moats, they are referring to the elements of the business model that give rise to the company’s competitive advantages. These concepts, like being the low cost producer, having proprietary intellectual property or exhibiting network effects, have been well documented by many writers. Morningstar’s book Why Moats Matter offers an excellent overview. But just as important is the different types of opportunities that different types of moats can afford companies.

Our friend Connor Leonard who runs the public market portfolio at Investors Management Corporation has developed an excellent framework for thinking about moat outcomes.

Connor explained his thinking in two posts on Base Hit Investing last year, which you can read here and here. Here’s a quick overview:

  • Low/No Moat: Companies that may be perfectly well run and sell good products/services, but which do not exhibit characteristics that prevent other companies from competing away there profits if they start earning attractive returns. Most companies fall into this category.
  • Legacy Moat-Dividend: A company that is insulated from competition, but does not have much opportunity to grow through reinvesting cash flow. So they pay most of their cash earnings out as dividends.
  • Legacy Moat-Outsider: A company that is insulated from competition, but does not have much opportunity to grow through reinvesting cash flow. So they deploy their cash flow in service of acquiring other companies as well as paying dividends and opportunistically buying back stock, as described in the book The Outsiders.
  • Reinvestment Moat: A company that is insulated from competition and has the opportunity to reinvest their cash flow into growing the business.
  • Capital-Light Compounder: A company that is insulated from competition and has the opportunity to grow, but which doesn’t need to reinvest much cash to do so and is therefore able to return cash to shareholders even while growing.

Our approach to investing is very similar to Connor’s and we thought it would be worth looking at our approach and portfolio holdings through his framework.

Low/No Moat

We strive to avoid investments in this category. Morningstar, which rates companies based on an assessment of the quality of their moat, only assigns a Wide Moat rating (their top rating) to 10% of the companies they cover. But they assign the Wide rating to about 67% of the stocks in our portfolio and give a Narrow moat rating to another 28% (these percentages exclude the few companies in our portfolio that they do not cover).

We believe that Low/No Moat companies are so subject to the competitive nature of the markets in which they operate that their future is far more governed by luck than by conditions within their control. There’s no doubt that the stocks of these companies can experience periods of fantastic performance. And those that are in the right place at the right time can generate massive returns for shareholders. But we systematically avoid investing in these companies because we don’t believe we have any particular edge in understanding when is the best time to own them.

Note that Morningstar does rate our holding in National Oilwell Varco (NOV) as having No Moat. However, until 2015 they rated the company as having a Wide Moat. As oil prices fell, they downgraded the rating first to Narrow and then final to No Moat as a new analyst picked up coverage. We believe that this analysis is flawed.

Legacy Moat-Dividend

Even if a business does have a moat, they might not have much of an opportunity to reinvest more capital that is protected from competition. Plenty of companies make the mistake of using their cash flow to get into entirely new businesses or throw more capital against the wall hoping they can extend the life of their moat. But smart management teams recognize this sort of moat as an opportunity to milk cash flow out of the business in the form of dividends while simply maintaining, rather than expanding the business. Think of this sort of business as like a toll bridge connecting two busy cities. Building more toll bridges is futile, but so long as the number of people wanting to cross the bridge is steady, the business can throw off lots of cash in the form of dividends and is clearly valuable.

We don’t invest in many of these businesses as the “yield sign” in Connor’s framework suggests. But these sorts of businesses can make sense if the stock price is cheap enough. The closest to this type of holding in our portfolio is Pepsi (PEP), which over the last three years has returned more than 90% of its net income to shareholders in the form of dividends and share buybacks. But we think that Pepsi also has more growth potential than investors give it credit for and is thus a hybrid between a Capital-Light Compounder (see below) and a Legacy Moat-Dividend company.

Legacy Moat-Outsider

The book The Outsiders by William Thorndike is probably one of the most influential investing books of recent years, in no small part because it was recommended by Warren Buffett in one of his annual letters. The book is a series of case studies that describes how a small number of CEOs have used cash generative businesses as platforms to drive massive returns for shareholders by directing excess cash opportunistically between large stock buybacks, special dividends and acquisitions of other businesses. While studies show that mergers and acquisitions as a group are value neutral or negative for shareholders (on average the selling company gets all the excess returns), The Outsiders explored how some management teams focused on driving shareholder value with their M&A rather than simply using it as a mechanism to get bigger, have shown extraordinary success.

This category includes companies that have strong moats around their current business, but rather than simply paying out excess cash to shareholders they deploy cash opportunistically across various strategies, including mergers and acquisitions. In our portfolio, TransDigm (TDG) is the clearest example of this strategy and in fact the company was briefly mentioned by Thorndike in his book.

At Ensemble we do not focus on this type of business and believe that the bar for a management team to demonstrate the ability to execute this approach is so high that it is a relatively special situation and there are not a large number of these sorts of investment opportunities.

Reinvestment Moat

This sort of moat characterizes many large, high quality growth companies. A Reinvestment Moat company has the strong competitive advantages around their core business as seen in the Legacy Moats, but their market is not yet saturated and the company has the ability to reinvest the cash they generate into growing. One classic case of this sort of business is Home Depot in the 1990s. The company was pioneering the home improvement big box business model and from 1990 to 2000 was able to growth revenue from $2.8 bil to $38.4 bil (30% annualized growth), while net income went from $112 mil to $2.3 bil (35% annualized growth). It was able to do this because its business had solid returns on capital and the market was large enough that the company was able to reinvest all of the cash it was able to generate while borrowing even more money to fuel its growth.

Most businesses don’t have this opportunity. Returns on their existing business may be strong, but most companies don’t have the opportunity to reinvest their earnings at similarly attractive rates. Historically, public US companies have generated an average return on invested capital of 10%, yet have only been able to reinvest about half of their earnings at similar rates. So companies that can earn higher rates of returns on both their base business and new business are uncommon.

Our portfolio holds companies such as First Republic (FRC), Alphabet (GOOGL) and Tiffany & Co (TIF) that exhibit these characteristics. In each case, the company generates strong returns, needs to reinvest their earnings to fuel growth and has the opportunity to do so. However, compared to Home Depot which was reinvesting more than 100% of earnings to fuel growth, the capital requirements of growing First Republic, Google and Tiffany still leave room for the companies to pay a dividend or buy back stock. This feature is something we find highly attractive in the businesses we own and leads us to the moat type that is most prevalent in our portfolio…

Capital Light Compounders

A Capital Light Compounder is a business which exhibits strong competitive advantages and has significant growth opportunities, but which does not need much capital to pursue growth. We view these as dream businesses. They earn good returns today and they have the opportunity to grow materially in the years ahead. But they earn such strong returns on capital that they tend to always have cash pouring out of their business, even when growing rapidly or during recessions.

This wonderful situation means the businesses are resilient during difficult environments where they have plenty of cash on hand to go after opportunities just at the time when their competitors are forced to play defense. During good times, these businesses can pursue their core growth opportunity, while also paying dividends, buying back stock opportunistically or executing an acquisition when an attractive situation presents itself.

In our portfolio, companies such as Paycheck (PAYX), Advisory Board Company (ABCO), Broadridge Financial (BR), Landstar Systems (LSTR) and MasterCard (MA) are all good examples. These businesses generate returns on invested capital in the range of 30% to over 100% while simultaneously having the potential to grow earnings at annual rates from 8% to 14%. This ability to generate returns on each new dollar of capital they invest at rates of up to 10x better than the average company while growing at rates approaching 3x the average public company makes these businesses very valuable.

The fact that these businesses are so valuable (in short, because they can grow quickly while returning lots of cash to shareholders at the same time) means that these stocks often do not look statistically cheap on simplistic measures like PE ratios. This leads to value investors often ignoring them believing they are too expense, while growth investors will often only be excited during the early stages of rapid growth but lose interest when the growth rate slows to solid, but not exciting, levels.

We think that Connor’s framework for thinking about the benefits of moats is an important complement to frameworks that explore the various strategies that give rise to moats. A moat that allows a company to protect its profits and pay them out to shareholders is quite valuable. One that presents an opportunity to reinvest earnings at solid rates is even better. A moat that allows a company to do both at the same time creates a cash generating machine that we search far and wide to find.

Ensemble Capital’s clients own shares of Advisory Board Company (ABCO), Alphabet (GOOGL), Broadridge Financial (BR), First Republic (FRC), Landstar Systems (LSTR), MasterCard (MA), Paychex (PAYX), Pepsi (PEP), Tiffany & Co (TIF), and TransDigm (TDG).

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.

Share on FacebookTweet about this on TwitterShare on LinkedInEmail this to someone