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.

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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.

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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.

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“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.

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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.

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Weekend Reading

31 March 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 High-Speed Trading Behind Your Amazon Purchase (Christopher Mims, @mims, WSJ)

There is a surprising world behind the price listed on Amazon’s website. “It’s like a stock market, complete with day traders, code-slinging quants, artificial-intelligence algorithms and, yes, flash crashes.” Some of Amazon’s products are supplied by multiple vendors. These vendors are updating the prices for some of their products thousands of times a day. This can lead to vendors competing for business and driving the price down, which is great for Amazon and it’s customers.

Sluggish Housing Recovery Took $300 Billion Toll on U.S. Economy, Data Show (Laura Kusisto, @LauraKusisto, WSJ)

Over the past 60 years, the average percentage of GDP related to housing is 19%; in 2016 it represented 15.6%. This gap represents ~$300 Billion. Some of this decrease is attributable to the tighter lending standards caused by the financial crisis in 2008. “I’m not suggesting that we go back to the maverick days, but I do think that there are a lot of people that could afford to repay their loans but are not buying because they’re afraid to go in for the inquisition of trying to get a loan,” Ed Brady said.

The Active Equity Renaissance: Rejecting a Broken 1970s Model (C. Thomas Howard, CFA Institute)

Passive investment vehicles have received massive inflows over the past decade. Looking at the performance of many so-called active managers, it’s no wonder. When you look under the hood, many of these funds hold hundreds of companies – essentially, they’re closet indexers. When you hold that many companies, your performance starts to mirror the benchmark. Once you subtract their fees, they’re going to constantly underperform. In a true active strategy, there is no point to hold that many companies. The author’s study finds that “The top 20 relative-weight holdings generate fund alpha, while the low-ranked holdings destroy it.”

Those Indecipherable Medical Bills? They’re One Reason Health Care Costs So Much. (Elisabeth Rosenthal, @RosenthalHealth, NYT)

For some, the part after the medical procedure can be almost as traumatic as before the procedure. It’s the daunting influx of cryptic medical bills in the mail. Part of this is caused by the medical billing process in the US and their use of codes and different coding systems. There can also be disagreement between coders at the hospital and the coders at the insurance company. This difference of opinion can result in thousands of dollars. Based on the documentation and interpretation, one coder may bill for a slightly different disease “If after reviewing a hospital chart of, say, a patient who has just had a problem with his heart, a hospital coder indicates the diagnosis code for “heart failure” (ICD-9-CM Code 428) instead of the one for “acute systolic heart failure” (Code 428.21), the difference could mean thousands of dollars.” This can cause a lot of back-and-forth between hospitals, insurance companies, and patients; all which drive up the cost of health care.

Whatever happened to free trade? (Bob Davis and Jon Hilsenrath, @bobdavis187, WSJ)

Globalization was the driving force of prosperity across the world for over half a century. This period “also expanded the labor pool globally, pitting workers in wealthy nations against poorly paid ones in developing nations. That greatly boosted the fortunes of the world’s poor, but also created a backlash in the U.S. and Europe.” But, this isn’t new. As humans tend to do, we’re repeating history. Prior to World War 1, the world experienced another period of globalization (from 1870 to 1913). After World War 1 (1918), the world saw a rise in trade barriers, which “played a role in the Great Depression of the 1930s.”

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

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

time-cover

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Crestmont Research

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

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

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

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

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Weekend Reading

24 February 2017 | by Paul Perrino, CFA

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Google Finance

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

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

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

Wanna change your initial rankings?

Here is the actual return data and ranking of performance:

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

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

 Source: Google Finance

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

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

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

Source: Google Finance

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

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

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

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

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

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