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

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

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

 

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

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

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Weekend Reading

20 January 2017 | by Paul Perrino, CFA

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

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

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

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

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

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

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

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

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

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

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

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

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

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

life-expectancy-potential-1

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

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

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

quality-of-care

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

hc-spending-as-of-gdp

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

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

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

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

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

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

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

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

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

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

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

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

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

Some excerpts:

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

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

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

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

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Weekend Reading

23 December 2016 | by Paul Perrino, CFA

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

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

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

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

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

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

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

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

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

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

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

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

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Weekend Reading

2 December 2016 | by Paul Perrino, CFA

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

benefits-of-diversification

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

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

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

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

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

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

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

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

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

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

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

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, 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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Despite the fact that individual companies, industries, and sectors have different fundamentals and outlooks, most of the time stocks trade as a group. How much the market is moving is usually the major driver of sector and even individual stock moves.

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

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

sector-performance

Source: @mulletHF

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

dispersion

Source: Wall Street Journal

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

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

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

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

18 November 2016 | by Paul Perrino, CFA

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

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

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

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

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

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

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

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

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

Ensemble Capital’s clients own shares of Netflix (NFLX).

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

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

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

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

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

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Source: A Wealth of Common Sense

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

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

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

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

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

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

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