For much of the past seven years, various stock market pundits have been declaring that the stock market is wildly overvalued and headed for a crash. Much like earthquake insurance being easy to sell just after an earthquake, the proclamations of a stock market bubble found a ready audience among investors who had experienced the 2008 stock market crash less than a decade after the Dot-Com bubble. However, while the stock market might be in for a decline of 10% or 20% any time (these sorts of declines happen regularly; note the 15% decline from December 2015 to February 2016), stock market bubbles are not common occurrences and investors who see them around every corner are like the fabled economist who has predicted nine out of the last three recessions.

First, let’s define what we mean by a “bubble” and why it is entirely different from the normal (but often scary) run of the mill volatility that stock market investors must accept in exchange for earning higher rates of returns than low volatility assets typically provide. A bubble is formed when investors bid up asset prices to irrational levels based on an illogically optimistic view of the future or the belief that they can sell the asset to other investors at an even higher price without regard to any fundamental value that is intrinsic to the asset.

The first famous bubble was Tulipmania in Holland in the 1600s.  For psychological reasons that can be difficult to explain (because the very nature of a bubble is illogical) people started buying and trading tulip bulbs and as the fad caught on the price of certain tulips skyrocketed to values higher than the cost of a home. When the bubble popped, again for no particular reason other than the psychological mania running its course, prices of tulip bulbs fell back to pennies and investors who had got caught up in the bubble were wiped out.

Bubbles like Tulipmania, the late 1920s just before the Great Depression, the Dot Com bubble and the housing bubble all tend to be based around an illogically optimistic view of the future that takes hold with investors. While they are illogical, it is difficult for humans to identify them in real time because we are all influenced by the same socio-psychological memes that are causing the bubble in the first place. But in retrospect, bubbles are pretty easy to see.

For instance, here’s the Dot Com bubble illustrated by Jake at EconomPic Data (an excellent blog that’s been illustrating market and economic trends since 2008):

Source: @EconomPic

This chart shows the valuation of growth stocks vs value stocks since 1978. You can see that historically growth stocks have sold at relatively small valuation premiums during periods of investor pessimism such as in the early 1990s recession and during the Great Recession in 2008-2009. They’ve traded at higher premiums during more optimistic times. But during the stock market bubble of 1997 to 2001, investors paid irrationally high premiums for stocks with strong growth prospects. While the rest of the 40 year time period showed growth stocks trading at premiums of 20%-60% over value stocks, at the peak of the Dot Com bubble the premium reached almost 140%.

Today, growth stocks trade at a premium over value stocks of just 30%, below their long term average. If you look at the technology, consumer discretionary and industrial sectors, where many growth stocks reside, you’ll find that their current PE ratios are not inflated at all, but instead are just about in line with their long term average levels. It is the stocks of slow growing, conservative, historically “safe” businesses that are driving up market valuations (see this post for a case study of a “safe” bubble stock we wrote last year).

This chart from Econompic shows the historical forward returns to growth stocks based on their valuation premium over value stocks. The red circle is the Dot-Com bubble. Subsequent to this time, returns to growth stocks were terrible. The blue circle highlights the past times that growth stocks traded at a similar premium to value stocks as they do today. As you can see, these level of valuations have typically led to growth stocks outperforming. Far from being a bubble in speculative stocks, today’s market valuations are for growth business are consistent with historically attractive levels.

Source: EconomPic

Like the person buying earthquake insurance just after an earthquake, investors are looking at yesterday’s crisis and assuming it will repeat. But that’s not how bubbles work. Bubbles are a mania connected to the psychology of crowds. In the Dot Com era, serious investors came to believe that the business cycle was dead and that we’d never have another recession. That sounds crazy today, but it was one of the irrational beliefs that super charged the Dot Com bubble. Not all stocks went up in value. In fact, even at the peak in March of 2000, many stocks of slow growing “old economy” businesses were incredibly cheap. Today, investors believe in the New Normal, that economic growth will be forever be lower than we’ve seen historically.

Now readers may point to some examples of excitement about speculative investments. We certainly aren’t saying that stocks are cheap or that all growth stocks are good buys. But with growth sectors of the stock market selling at average valuations while “safe” sectors like utilities and consumer staples are trading near all time highs, and bond yields near all time lows, investors are voting with their dollars in favor of slow growth investments, not chasing speculative investments.

This mirror image to the Dot-Com bubble isn’t a coincidence. When bubbles burst they cause the burned investors to promise themselves they’ll never make the same foolish mistake again. In the wake of the Dot Com crash, investors swore off growth stocks and decided they would only invest in something tangible. Something with real value, unlike the paper trading vehicles of Dot Com stocks. Something like… houses.

The stock market crash of 2008 was not due to a bubble in stocks (stock valuations going into the crisis were pretty much right in line with average historical valuations), it was due to the popping of a bubble in home prices and the devastating impact this had on the economy. With their firm commitment to never make the mistake they made during the Dot Com bubble, many investors, with the very best intentions, focused their attention on what seemed like the exact opposite of Dot Com stocks. But like a crowd of passengers all lurching to the other side of a boat in stormy weather, the rejection of growth stocks led to a new bubble forming. Investors were making the same mistake, but because houses felt so safe compared to Dot Com stocks, they believed they were doing the exact opposite of the mistakes they made in the late 1990s.

So with the collapse of the housing bubble, what did investors do? They promised themselves that they would never speculate again and they invested in bonds or just held cash in the bank. Maybe these investments would generate low returns, but gosh darn it they weren’t going to crash… right?

If the natural bubble follow up to the twin crashes of Dot Com stocks and housing is super conservative investments, investors might not experience negative returns when the bubble unwinds. Instead, their loss may just have been the opportunity cost of missing out on the 13% annualized returns offered by the stock market since the end of 2010. Or, if we get a big surge in interest rates, we might well see a selloff in supposedly “safe” areas of the stock market such as Utilities and Consumer Staples.

While “safe” assets aren’t supposed to see sharp losses, they also haven’t historically traded at such high valuations. The risk in these “safe” assets, which represent the opposite of the go-go growth stocks that most investors assume must drive a stock market bubble, was apparent in the aftermath of the most recent presidential election. When the 10-year treasury yield ran from 1.4% in June of 2016 to 2.6% in December 2016, the utilities sector lost 14% even as the overall market rallied 10%.

The bottom line is that investors worrying that the stock market is too high and due for a decline need to recognize that it is not speculative growth stocks driving the rally, but conservative, low growth companies that have reached record high valuations. This stands on its head the way most investors think about stock market bubbles. We can’t prepare for the next crisis by buying insurance against the last crisis. Unfortunately there are new and different lessons for investors to learn in the years ahead.

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

16 September 2017 | by Paul Perrino, CFA

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

The curse of middle-aged capitalism (Robert J. Samuelson, The Washington Post)

The business landscape has undergone a change. “In 1975, 109 firms accounted for half the profits; by 2015, 30 companies did.” Those 30 companies are much different than the 109 in 1975. They’re older. This average age has increased because of merges. Small firms are being bought out by companies that are making huge profits, such as Apple, Google, and Microsoft.

China Fossil Fuel Deadline Shifts Focus to Electric Car Race (Bloomberg News)

Following the plan from the UK, China announced to end the production and sales of fossil-fuel-powered vehicles. The exact time-table is still under discussion. This shift is expected to improve the air quality, which has been an issue in China. They’re already selling EV. BYD, BAIC and GM delivered over 83,000 EVs in the first seven months of 2017. This may sound like a lot, but that only represents “0.04 percent of its 2.1 million vehicles sold in total in China during the seven months.”

How Kirkland Signature Became One of Costco’s Biggest Success Stories (Sarah Nassauer, @SarahNassauer, WSJ)

Costco developed a strategy to help their customers find the best quality products and save money. This came through the development of Kirkland brands. By simplifying the packaging and eliminate the marketing costs, Kirkland can offer similarly sourced products at discounts.

Apple explains what exactly happened when Face ID ‘failed’ during iPhone X demo (Chance Miller, @ChanceHMiller, 9to5)

During the Apple event this week there was a hiccup during the iPhone X demo. When Craig Federighi went to demo the new face recognition software by unlocking the new iPhone X with his face, the phone appeared to not recognize his face and required the text pass-code to unlock.

Clients of Ensemble Capital own shares of Costco (COST), Google (GOOGL), and Apple (AAPL).

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

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, 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 September 2017 | by Paul Perrino, CFA

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

The Internal Combustion Engine Is Not Dead Yet (Norman Mayersohn, @n_mayersohn, NYT)

While many automakers, like Ford, have shifted to developing hybrid or electric cars, Mazda has developed a new combustion engine that is “20 to 30 percent more efficient than the company’s best existing engines.” The professor of mechanical engineering at MIT thinks the combustion engine will still have a major role to play for some time.

Robopocalypse Not (James Surowiecki, @JamesSurowiecki, Wired)

This counter-piece to many Silicon Valley leaders, like Y Combinator’s Sam Altman and Tesla’s Elon Musk, argues that there isn’t any evidence that this is occurring. “Back in the heyday of the US economy, from 1947 to 1973, labor productivity grew at an average pace of nearly 3 percent a year. Since 2007, it has grown at a rate of around 1.2 percent, the slowest pace in any period since World War II.”

The Housing Industry Still Hasn’t Realized It’s Building Too Many Homes for Rich People (Daniel Gross, @danielgross, Slate)

There could be a number of new home buyers being priced out. The number of high-end homes being developed isn’t keeping pace with overall income growth. “In July, 9,000 new homes worth more than $500,000 were sold in the U.S.—only 8,000 homes worth less than $200,000 were.”

 

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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Brands are a key source of value for many companies. But while brands might seem a natural part of the economic order, they are a relatively new invention. 150 years ago, canned food companies learned that by building a trusted brand, consumers would pay a premium price in exchange for avoiding the spoiled food that was common in canned food at the time. Then, in the 1950’s the Mad Men era gave rise to today’s super brands as companies learned they could differentiated themselves via mass brand marketing campaigns as markets became crowded with competitors and consumers found themselves overwhelmed with trying to choose between so many seemingly similar products.

Here’s Marc De Swaan Arons writing in The Atlantic [emphasis mine]:

“There was a time, going back at least 70 years, when all it took to be successful in business was to make a product of good quality. If you offered good coffee, whiskey or beer, people would come to your shop and buy it. And as long as you made sure that your product quality was superior to the competition, you were pretty much set… The shift from simple products to brands has not been sudden or inevitable. You could argue that it grew out of the standardization of quality products for consumers in the middle of the 20th century, which required companies to find a new way to differentiate themselves from their competitors.

In the 1950s, consumer packaged goods companies like Procter and Gamble, General Foods and Unilever developed the discipline of brand management, or marketing as we know it today, when they noticed the quality levels of products being offered by competitors around them improve… As long as the brand was perceived to offer superior value to its competitors, the company offering the brand could charge a little more for its products. If this brand “bonus” was bigger than the cost of building a brand (the additional staff and often advertising costs), the company came out ahead.”

These brands created value by lowering “search costs” for consumers. Search costs are the costs incurred by a prospective buyer in trying to determine what to buy. In the case of a consumer packaged good like canned food, toothpaste, or laundry detergent, the search cost for consumers is the cost of trying to determine the quality of the product and weighing this against price differentials prior to purchase. By eliminating this cost for the consumer, companies with a successful brand were able to charge more for their products, even while providing an improved cost/benefit offering to the consumer. The consumer could pay more for their products, because doing so reduced the search costs they were otherwise incurring.

Companies with a trusted brand could earn excess economic returns so long as the cost of building the brand costs less than the premium consumers were willing to pay for a product due to the brand. Because brands have historically be very durable (notice the global brands that were built in the 1950 are still dominate today), they created an economic moat that caused these companies to generate outstanding returns for shareholders.

Many of the most well known brands in the world are based around reducing search costs. For example the Coke, Gillette, and Yellow Cab brands are assurances of quality and value that reduces the search costs of consumers looking to purchase beverages, razors and transportation.

But what if a new way of reducing search costs is developed? What happens to the value of these brands?

An alternate way to reduce search costs is for the distributor rather than the product manufacturer to play this role. The success of Costco is in large part built on the idea that any product sold in their stores is of high quality and is a good value. Costco leverages their scale to identify high quality, good value products and deliver them to consumers. This process reduces the value of brands and allows Costco customers to confidently buy non-brand products or products with limited brand recognition. In this way, Costco has managed to earn excess economic returns, even while selling the products in their stores at close to cost. Because consumers pay for the privilege to shop at Costco, the Costco membership can be thought of as the company charging directly for lowered search costs and inserting themselves between the consumer and the branded products.

But now the internet allows for the reduction of search costs on a global scale. Products like LaCroix sparkling water, Dollar Shave Club razors, and transportation service delivered via Uber have all exploded onto the scene, draining value from the Coke, Gillette and Yellow Cab brands because in each case, the online distribution of information radically reduced search costs for consumers. They didn’t need to buy these new products themselves to determine quality, instead they could plainly see their friends vouching for them on social media or via reviews on the distributors’ websites or apps. If these products were of low quality or value, this would have been quickly known to any consumer who spent a few minutes reading online reviews or searching their social media streams.

Over the last decade, unit sales of many branded consumer products has slowed considerably. Much commentary attributes this to changing consumer preferences (especially those of Millennials). But we believe something else is at work. Artisanal, local and other products without the backing of legacy brands are succeeding not solely because of new consumer preferences, but because with lower search costs consumers don’t need the Coke, Gillette or Yellow Cab brands to assure them that the products they are buying will be of sufficient quality and value. With search costs heading towards zero, products can succeed simply by providing quality and value, and so brands whose primary value is acting as a guarantee to consumers are quickly losing value.

For investors, this shift in economic value is incredibly dangerous. At Ensemble Capital, we focus on investing in companies with strong economic moats. Traditionally, strong brands have been viewed as classic examples of a moat. Coke, Gillette and Yellow Cab were businesses that you could have high confidence would be able to earn outsize returns on capital because their strong brands allowed them to capture economic value relative to companies selling similar products under less powerful brands.

It is important not to underestimate how powerful search cost brands have been in economic value creation in the past. Over the past 50 years, the top performing sector of the stock market has been consumer staples.

Now, however, the era of search cost brands is coming to an end. The moats are being breached. Over the long term, we do not believe that these types of brands will provide a significant competitive advantage to their owners and the companies will be forced to compete directly on quality and value instead of earning a return for selling reduced search costs.

But as the Yellow Cab brand suggests, search cost brands are not limited to consumer staple products. Why is it that while most people would never accept a ride from a complete stranger, they will happily climb into the back of a car painted yellow with the Yellow Cab brand? Because the Yellow Cab brand signaled to customers that the stranger driving the car would deliver them where they wanted to go at an agreed upon price and without risk of bodily harm.

But now we have Uber and we get this:

Uber cars are non-branded transportation. Uber provides distribution of transportation services, but not the transportation itself. The company has stepped in to provide a search cost brand that they are able to extend to all the non-branded providers of transportation that participate in their network. Uber’s value to customers is the elimination of search costs entirely so that at any given moment, in almost any urban setting, a customer can almost instantly be matched with an independent, non-branded provider of transportation and confidently climb into the back seat of the stranger’s car to be whisked to their destination.

Uber of course provides complex logistics and has developed powerful network effects, both of which are elements of its competitive advantage in addition to its search cost brand. Amazon similarly leverages this trio of advantages. While logistics and network effects are more obvious elements of Amazon’s moat, there is also the fact that many customers will happily buy whatever product has the #1 rank for a particular search so long as it has many customer reviews vouching for its quality and value. Amazon customers don’t need products to carry powerful search cost brands in order to confidently order something. They can just use the fact that the product being displayed has hundreds or thousands of positive reviews as a convincing substitute for a brand they recognize.

Similarly Dollar Shave Club used social media, especially shareable YouTube videos to build a multi-billion dollar company in just a couple of years. The fact they did it by piercing the previously ironclad Gillette brand makes clear that no legacy brand based on reducing search costs is safe. LaCroix sparkling water on the other hand seems more like Mark Zuckerberg’s proverbial “clown car that drove into a gold mine.” The brand has been in business for years, but was popular only in certain areas of the Mid West. But once a certain segment of trend setting customers found out about it, their constant social media posts extolling its virtues caused sales to explode and the product’s manufacturer to see its market cap rise by 5x in just the past two years. LaCroix didn’t succeed by slowly building up brand awareness and value until they were able to obtain shelf space and command a pricing premium that allowed them to profit from their brand. Instead, they made a quality product that delivered value and the search cost destroying power of social media rocketed the product to stardom.

The consumer staples sector and switching cost brands have offered a fertile hunting ground for investors for half a century. Many of the great investors of the past have built strong track records by riding the stocks in this high performing sector, which had the added benefit of offering low volatility resulting in even stronger risk adjust returns.

We believe that investors in these companies are in for a rude awakening. But there are brands that we believe are largely immune to these risk.

While many of the well known consumer brands derive their value by reducing search costs, there is another value proposition that some brands offer. An “identity brand” communicates something about the owner of the product to themselves or the rest of the world. The Ferrari brand for instance isn’t valuable because it reduces search costs. It is valuable because it tells the owner of the car as well as the rest of the world something important about who that person is. Tiffany’s little blue box is similar. While Ferrari and Tiffany brands both speak to quality, they are primarily brands whose role is to signal to the product’s owner and the rest of the world a key element about who that person is.

While high end, luxury brands are some of the most powerful, durable identity brands, there are also brands that speak to the buyers identity in ways that don’t relate to wealth. When my son was in third grade he came home from school one day and asked me if I was a “Nike guy or an Under Armour guy”. On the playground, a group of his friends had debated which one each of them were and he wanted to know what I thought. While neither brand signals to the world that the owner is wealthy,  they both speak to the owners identity. Many car brands are identity brands as well. Would you think differently about your accountant if she drove a Ford Mustang rather than a Volvo? Probably so.

Consumer staple products are items where the consumer wants the product to do a specific, simple job at fair price. Most people don’t have their personal sense of identity tied up in what soda they drink or brand of razor they use. Would you think differently about your accountant if she used Tide rather than All brand detergent? But many consumer products more generally do have issues of identity tied up with the functional role that they play. Many people care a lot about what car they drive, what jewelry or other accessories they wear and carry, what clothes and glasses they wear, what wine they drink, where they eat… the list could go on and on. These brands are about something more than a cost-benefit analysis. These brands provide non-functional, intangible value to the consumer that helps the purchaser more fully express who they are and what they stand for.

We don’t think the internet or social media or the logistical monster that is Amazon are doing anything to reduce the importance that people place on the role that brands play in developing and expressing self-identity. But we do think that these trends are bringing to an end the 70-year run of excess returns earned by companies who built their businesses on the back of search cost brands.

Clients of Ensemble Capital own shares of Costco (COST), Ferrari (RACE), Nike (NKE) and Tiffany & Co (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.

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Weekend Reading

19 August 2017 | by Paul Perrino, CFA

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

Google Is Developing Technology for Snapchat-Like Media Content (Amol Sharma and Jack Marshall, @asharma and @JackMarshall, WSJ)

The way many people are consuming news has been changing. They receive articles from many different news sources through Facebook, Snapchat, and Apple. Google is now trying to make a similar experience with “Stamps.”

Why Does Pessimism Sound So Smart? (Morgan Housel, @morganhousel, The Motley Fool)

The basic instinct for survival is a reason humans perceive threats and risks as urgent. For investors, this can translate into giving more attention to pessimistic news. Then the mind has a great way of rationalizing the urgency of bad news.

With $1 Trillion Chasing Deals, Investors Park Cash in ETFs (Sarah Jones, @BySarahJones, Bloomberg)

There is an excess of cash waiting to be invested in private equity. During this period, cash balances have increased to a recent high. Some institutional investors are looking for liquid investments to hold until the private equity fund is ready for additional investments.

Clients of Ensemble Capital own shares of Google (GOOGL) and Apple (AAPL).

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

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, 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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Source: AutoEvolution.com

A year ago, when Ferrari’s well-regarded CEO, Sergio Marchionne, was asked if it would jump into the high end luxury SUV foray, he responded “You’ll have to shoot me first” before Ferrari makes an SUV!

A year later, during Ferrari’s (RACE) latest 2Q17 earnings conference call, he confirmed the rumors circulating that the team is developing a vehicle capable of traversing through “sort of uncharted territory”. But he asked for observers to reserve judgement on calling it an SUV of the ilk that a BMW (BMW GY) or Bentley or Porsche (VOW GY) have on the market, i.e. hold the firing squad for now!

So no, there are no credible photos of concept vehicles of the new Ferrari yet and the headline photo is obviously someone’s attempt at forcing a Ferrari SUV into being — die hard fans (with means) won’t have to take fulfilling their desire for a FUV, i.e. Ferrari Utility Vehicle, into their own hands for much longer!

Ferrari’s engineers are currently working on the concept and the company will discuss its idea with its most loyal customers as the idea comes closer to fruition, but for now we can take a shot at the overall sketches of what the FUV could look like…

Lamborghini (VOW GR) made an attempt at a fast high end utility vehicle a couple of decades ago… and this is what they came up with, the “Rambo Lambo” LM002!

Source: Autoweek.com

More modern versions of the performance SUV offer incredible performance if not outstanding handling like the BMW X5M and Bentley Bentayga (Marchionne vehemently denied the FUV would look like any existing SUV!):

Source: Edmunds.com

Source: Autoweek

The Porsche Cayenne is another one that also has amazing handling capabilities and the look of a sporty but elegant SUV (to our eye at least):

 

Source: Edmunds.com

Marchionne’s other company, Fiat Chrysler (FCA IM), which spun out Ferrari last year, recently introduced a high performance SUV with an Italian flair, the Maserati Levante:

Source: Maserati.com

Lamborghini has also taken another stab in this space with the Urus concept SUV, of course with its own slightly flamboyant design philosophy that it is known for:

Source: Car and Driver

When we think about Ferraris, we think of their design sense, their elegance (at least in decades excluding the 1980’s!), and their performance embodied in cars such as the 488GTB…

Source: NYTimes.com

Or the more family friendly (2+2) California…

Source: Ferrari.com

And the most practical of all in the Ferrari line-up, the GTC4Lusso with 4 real seats and a hatchback trunk!

Source: Ferrari.com

 

Source: Ferrari.com

However, the size of the GTC4Lusso certainly starts to push the boundaries of a 2 door sports car as it pushes towards a more utilitarian segment of the market.

Source: Topgear.com “Chris Harris Drives:Ferrari GTC4Lusso

This is one long car! It is about the length of the luxury 4-door hatchback Porsche Panamera and Cayenne.

Source: MotorTrend.com

Its chassis could accommodate a 4 door, more practical shape potentially, yet still offers an incredible driving experience of the sort that Ferrari is known for. Philosophically, the company does not build cars that don’t deliver on the experience that its brand stands for and certainly it wants to remain true to this with the new model.

And yet, in order to grow its market without diluting the exclusivity behind its model line-up it needs to expand into adjacent categories and a more practical, utilitarian vehicle makes a lot of sense, especially in light of the ~40% capacity Ferrari’s factory still has available (in spite of the excess capacity, we estimate Ferrari’s return on capital to be ~100%!). In addition, traditional SUV profiles have been big sellers and profit centers for most higher end carmakers. In fact, while the 911 sports car is the iconic headline model for the Porsche brand, 2/3 of its unit sales are derived from the Cayenne and Macan SUVs. While we wouldn’t expect that high an ultimate ratio for Ferrari, a 4-d00r layout could certainly add 30-40% as it gets past its 9000 vehicle goal for 2019. With very high incremental margins on a plant that already exists today, expanding its units sales feeds its operating margins, EBITDA, and ROIC.

We believe the recent strong performance of the stock has been driven by this expectation of an expansion to Ferrari’s model line up and addressable market. While its core set of enthusiasts appreciate its 2-door sports car profile with accompanying handling, we believe that there are many (Ferrari thinks even larger contingent of potential customers) who would prefer a more practical weekend Ferrari they could drive in with their families around town, coast or the mountains in. We had observed in a previous post about Ferrari that as production figures stand today, only 2 our every 1000 people who could buy a Ferrari actually had a Ferrari available to buy and to be able to buy most new Ferrari’s you have to already own one (about 2/3 of Ferrari buyers are repeat customers)! Certainly many of these would-be buyers are not be interested in a 2 door sports car, but how many more would be in a 4-door sports car or “utility” car? The evidence suggests quite a few.

Clients of Ensemble Capital own shares of Ferrari (RACE).

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

5 August 2017 | by Paul Perrino, CFA

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

iPhone’s Toughest Rival in China Is WeChat, a Messaging App (Tripp Mickle and Alyssa Abkowitz, @trippmickle and @AlyssaAbkowitz, WSJ)

Creating a user’s ecosystem is powerful. WeChat was able to shift a user’s ecosystem from the mobile phone’s operating system to a single application. With WeChat, you can “message friends, pay restaurant bills, hail cabs, play games and stream videos […] [, and run] ‘mini programs.'” This shift moves the importance from the device to the app.

Gambling on the Dark Side of Nudges (Philip Newall, @pnewall, Behavioral Scientist)

When complexity is introduced, the seller is able to improve their margins because of the buyers behavioral and cognitive biases. This can be seen in gambling. Bookmakers use peoples inability to accurately calculate the probability of events to charge a higher premium and earn a greater return. But, this isn’t limited to gambling, it’s also present in the financial world (through subprime mortgage and structured finance products).

The Cult of the Line: It’s Not About the Merch (Ruth La Ferla, NYT)

Apple popularized the trend of long lines for product releases. After almost a decade of this behavior and other retailers following suit, its created a generation that is used to waiting in line. It’s even created a “new community.” “When 200 to 300 kids are lining up outside of a store, it’s because they want to be part of something.”

The Great Escape: How Credit Raters Ducked Reform (Sid Verma, @_SidVerma, Bloomberg)

Credit Rating Agencies (CRA) played a role in the financial crises. “‘This crisis could not have happened without the rating agencies,’ the Financial Crisis Inquiry Commission concluded in 2011.” Since the 1970’s CRA’s have received payment from the bond issuers. This large potential conflict of interest, which may have contributed to the lofty ratings of some banks before the financial crises, is still in place today.

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

In Urban China, Cash Is Rapidly Becoming Obsolete (Paul Mozur, @paulmozur, NYT)

China is stepping up and leading the world in mobile payments. Adoption has been staggering. $5.5 trillion payments were made via mobile devices in 2016, compared to $112 billion in the US.”Enterprising musicians playing on the streets of a number of Chinese cities have put up boards with QR codes so that passers-by can simply transfer them tips directly.” This shift doesn’t come without problems. Foreigners (tourists and businesses) may find it more difficult to transact.

Visa Takes War on Cash to Restaurants (AnnaMaria Andriotis, @AAndriotis, WSJ)

The US isn’t stagnant in the cashless endeavor. Visa is helping small businesses purchase the technology to process payments of debit cards, credit cards, and mobile phones. “Visa has long considered cash one of its biggest competitors and has been taking steps to chip away at it. Getting rid of cash is a priority for Visa.” One benefit in the favor is millennials, who often prefer cashless payments.

Why the Post Office Gives Amazon Special Delivery (Josh Sandbulte, WSJ)

“In 2007 the Postal Service and its regulator determined that, at a minimum, 5.5% of the agency’s fixed costs must be allocated to packages and similar products. A decade later, around 25% of its revenue comes from packages, but their share of fixed costs has not kept pace. First-class mail effectively subsidizes the national network, and the packages get a free ride”

Buffett’s Bet on Store Capital Shows Not All Retail Real Estate Is Equal (Sarah Mulholland and Noah Buhayar, @SMulholland_ and @NBuhayar, Bloomberg News)

The rise in Amazon (AMZN) has lead to the downfall of many retail companies and their landlords. During these broad sell-offs good business become attractive for investment. For Buffett, it was Store Capital. Their properties focus on “internet resistant” businesses, such as “preschool facilities, health clubs, dine-in movie theaters and pet-care sites.”

Sign of the Bottom? New ETFs Will Bet Against Beaten-Down Retail Stocks (Chris Dieterich, @chrisdieterich, WSJ)

New ETFs can be the signs of a market top. By the time a fund company takes notice of a trend (or hot trade) and builds an ETF product to participate in that trade, it’s usually too late.  REMX and YLCO are both examples of the launch of the ETF is followed by the peak in their respective market. ProShares has ” filed plans with securities regulators last week for new double- and triple-levered ETFs designed to rise on days that retail stocks fall. Also coming is an ETF that goes “long” online retailers while “shorting” traditional ones.”

 

 

 

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 post below is an excerpt from the recent ENSEMBLE CAPITAL QUARTERLY CONFERENCE CALL. You can read the full transcript HERE.

Ferrari (RACE), manufactures super cars that are specifically made to cater for the pleasure of drivers and collectors at the top end of the automotive food chain, those in the top 0.1%.  Its cars are luxury goods that are inspired and derived directly from the Formula 1 racecars the company designs, builds and races through its Scuderia Ferrari racing team.

Ferrari’s cars are anything but practical cars – they are race-inspired expressions of something about their owners, who are among the elite few that are able to possess and experience one of their machines.  It is a purely luxury item that is either the fulfillment of a dream, a statement that you have arrived, are a passionate auto aficionado, or that you are free.

Ferraris are more about the emotion, the passion, and the experience than they are about transportation. The sound, the speed, the F1 racing legacy, and the conspicuous shapes are all part of the experience that come with owning and driving a Ferrari.

Ferraris are an entirely discretionary purchase, akin to other luxury good items like high-end handbags, watches, jewelry or art.  All of these serve a more abstract purpose outside of the semblance of utility their exact form may indicate.

Its brand and reputation was born of F1 car racing when its founder and race car driver turned businessman Enzo Ferrari founded his own racing team and race cars in 1945 then later decided to sell a few of his race inspired cars to help fund his racing ambitions.  That DNA and reputation has helped carry the brand to its place today, as an expression of the limits of what a car can achieve with a distinctively Italian design flair.  From the core of its performance capabilities, to the way it looks, and sounds, and ultimately how it makes its driver feel about himself or herself, the cars that Ferrari builds are an experience built on a long legacy and culture of racing, passion, and winning.

Of course, we haven’t mentioned a very important aspect of owning a Ferrari — that is being part of an exclusive club. There have only been 7-8K Ferraris sold globally in each of the last 5 years. In order to buy the latest high-demand Ferrari or a limited edition supercar, you have to own one or more Ferraris first.  In other worse, being able to afford one does not entitle one to actually buy one. 2/3 of new Ferrari buyers are repeat buyers, at an average price of $250K-$1MM+. These are incredible statistics that bode well for the makings of a highly profitable and defensible business.

To get a sense of how limited Ferrari’s cars are, in 2016, there were 1.3 million individuals in the US with a net worth over $5 million and only 2700 Ferraris allocated to the US. So only 2 out of every 1000 of these individuals could actually buy a new Ferrari. Of course, many of these folks couldn’t care less about a Ferrari, but it goes to show the relative scale of potential buyers to available cars. The company actively cultivates a supply-demand imbalance in order to preserve the value of both new and used Ferraris thereby creating scarcity value.  This is a tactic that many other luxury brands employ as well, including luxury hand bag brands like Hermes (RMS FP) and swiss watch makers to create both an aura of exclusivity among their customers and preserve the value of their products.

All of these examples comprise a category of goods referred to as Veblen Goods. These are products whose attractiveness to their consumers actually increases as their price premiums increase, in contrast with the economic principle that applies to most goods that demand increases as price decreases.  This increasing price tactic is offset by the ability of numbers of consumers who can actually afford to buy their goods despite their increasing desire to buy them. And that is where the supply/demand and pricing balancing act comes in.

In fact, when it comes to its very limited edition supercars like the LaFerrari, Ferrari’s million dollar plus 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 to multiples of their purchase price.  The LaFerrari went into production in 2013 with the limited run 499 vehicles that sold for over a million dollars each.  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 after production ended.  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! This phenomenon is a huge contrast to the price of 99% of cars, whose value declines the minute you drive it off the lot and continues to do so every year thereafter.

The strong brand and experience is at the heart of Ferrari’s moat and drives the underlying economics of its very profitable business.  It is also what points to our analogy of comparing Ferrari collectors to art collectors with price appreciation dynamics that accompany the limited run pieces.

As a result, Ferrari shows an exceptional return on invested capital of ~100% with very little incremental capital required for it to grow its business at the rates it targets, in the 5-10% range. The low capital intensity results in strong free cash flow generation, which is at the heart of any company’s long term value. Finally, its 12-18 month waiting list and its deliberate strategy of undersupplying its market demand makes it highly resistant to declines during recessions, adding predictability and resiliency to its business model.

By comparison, the average S&P 500 company has about a 10% return on invested capital. Incredibly, Ferrari’s return on invested capital is in the same league as high IP content, asset light companies such an Apple (AAPL), Alphabet (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, cyclical, low P/E automakers for the same reason.

Just like Paychex (PAYX), a company we’ve discussed in a past conference call, we believe the high sustainable return on invested capital coupled with strong free cash flow generation entitles Ferrari to a much higher than average P/E multiple in the high 20’s, despite the fact that it is not a super-fast growing company.   If you are interested to learn more about Ferrari and how we view its valuation, we invite you to read our blog post published in May on the Intrinsic Investing website titled “Tesla vs. Ferrari – What RACE and TSLA Tell Us About The Winning Formula For Stocks”.

Ensemble Capital’s clients own shares of Alphabet (GOOGL), Apple (AAPLE), Ferrari (RACE), Mastercard (MA) and Paychex (PAYX).

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 post below is an excerpt from the recent ENSEMBLE CAPITAL QUARTERLY CONFERENCE CALL. You can read the full transcript HERE.

I’d like to provide a brief update on Advisory Board Company, whose stock has doubled since March of this year. As we described in our blog post about the company written at that time, Advisory Board provides software and consulting services to help hospitals reduce the cost of health care while improving patient outcomes.

The US health care system is fundamentally inefficient to a degree far out of step with the rest of the world. While Americans pay 50% more per capita for health care than the best in class health care system provided in Switzerland, the life expectancy here is as low as that seen in Chile and the Czech Republic, who spend 75% less per capita than we do. As you can see in the chart we published in our post on the company, health care systems around the world fall on a curve that neatly describes the relationship between per capita spending and life expectancy. The US is the only country where this relationship between spending and outcomes is fundamentally broken.

Earlier this year, market participants sold Advisory Board stock down to its cheapest valuation in history outside of the 2008-2009 financial crisis. Investors were concerned by the slowdown in Advisory Board’s revenue growth and worried that the company’s significant push into providing services to higher education institutions was a mistake, despite education suffering from similar issues around weak student outcomes in relation to runaway costs.

As with all of our assessments of a company’s fair value, we focus on cash generation. Both of Advisory Board’s businesses generate outstanding levels of distributable cash flow even while offering long-term growth potential.

Earlier this year, the activist investment firm Elliot Associates, run by famed hedge fund manager Paul Singer, recognized the disconnect between Advisory Board’s public market price and the actual intrinsic value of the business. After taking an 8% position in the company, Elliot Associates pushed the company to sell themselves, likely splitting up the education and health care business to two separate buyers. The stock has been rapidly appreciating ever since, rallying over 10% in early July as Bloomberg reported that United Health was emerging as the leading bidder for health care while private equity firm Vista was the mostly likely bidder for the education business. With earlier reports suggesting over 20 bids had been submitted for the company, it seems clear that no matter what price the company ends up selling for, or even if a deal falls through, Advisory Board is a company with significant intrinsic value that the market has underappreciated.

We sometimes use the phrase that we bring a “private equity approach to public market investing.” This simply means that we make investment decisions not as stock analysts seeking to guess which way the stock will move, but as business analysts seeking to understand the economic value of the companies we analyze. We believe that over time, public markets value stocks on the same basis as private markets do. In this way, markets are efficient over the longer term.

But in the short term, public markets often misprice stocks relative to pro rata ownership in the company they represent. This is what Benjamin Graham meant when he said that “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

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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