In January 2017, we wrote a post on the opportunities and threats of investing in healthcare stocks over the next decade.

To recap, over the prior 20-year period, the U.S. healthcare sector outperformed the S&P 500 by nearly two percentage points per year, on average. Many companies reaped the benefits of a highly inefficient U.S. healthcare system, where prices surged without delivering proportionate value to patients.

We continue to believe this is unsustainable. Whether it’s through government action or market forces, changes are on the horizon for the U.S. healthcare industry to better align costs with outcomes.

As such, we demand two things when looking at new healthcare companies:

  • Do these products and services improve patient outcomes?
  • Do this company’s products and services help reduce system-wide costs?

Frankly, we have not found many companies that fit both criteria. Yes, there are many technological advances occurring in healthcare. In fact, PwC expects healthcare to have the most R&D spending in absolute dollar terms of any industry by 2020.

Unfortunately, innovation in healthcare doesn’t always translate into improved outcomes and lower system costs.

To illustrate, here’s what the Congressional Budget Office wrote in a 2008 study:

The added clinical benefits of new medical services are not always weighed against the added costs before those services enter common clinical practice. Newer, more expensive diagnostic or therapeutic services are sometimes used in cases in which older, cheaper alternatives could offer comparable outcomes for patients.

We think one of the intrinsic problems is that, because it’s the incumbents – i.e. the primary beneficiaries of an inefficient system – doing the bulk of the innovation spending, there’s little incentive for them to change the status quo.

California-based Masimo piqued our interest because it takes an outsider’s approach to finding healthcare solutions. Indeed, the company’s mission statement is “Improving patient outcomes and reducing the cost of care.” A natural fit.

But this isn’t just marketing spin. The company’s founders, Joe Kiani (current Chairman & CEO) and Mohamed Diab were electrical engineers by trade and started Masimo in 1989 after working with early versions of pulse oximeters that used sensors to measure oxygen levels in the blood.

Those early pulse oximeters were particularly unreliable when the patient was in motion – think premature babies, emergency situations, etc. Medical professionals would either use invasive procedures (via syringe) to get a more accurate reading or assume the reading from the sensor was correct and risk misdiagnosis.

We’ll get into more details in a moment, but fast-forward to today and Masimo’s pulse oximetry sensors are the standard of care in most of the country’s operating rooms, NICUs, and ICUs.

From our recent trip to Masimo’s headquarters for an investor day, we confirmed that the company’s engineering-first spirit remains a key differentiator in Masimo’s corporate culture. Each solution starts with first principles and a blank sheet of paper rather than starting with the status quo.

Put another way, Masimo is a technology company pursuing better solutions in the healthcare industry, rather than a healthcare company using technology as an avenue for higher-priced solutions. We consider Joe Kiani to be a Visionary-Outsider leader of a company that’s running circles around incumbents with eroding moats.

Okay, let’s take a step back. How does Masimo fulfill our first criteria to improve patient outcomes?

Starting with Masimo’s core business – Signal Extraction Technology (SET).  With FDA approval in 1998, Masimo’s proprietary SET was the first platform to accurately measure pulse ox when the patient is in motion (common in emergency situations) and low perfusion (low levels of oxygen).

With the use of LED sensors and encrypted algorithms, Masimo sensors obtain vital information in a non-invasive manner. In non-medical terms, it shoots a known quantity of light from one sensor and gets a reading based on the amount of light it receives on the other end. These are similar principles to how your Apple Watch or FitBit operate.

Impressively, SET’s alarm reliability during motion and low perfusion settings remains generations ahead of the other major player in pulse oximetry, Nellcor (now owned by Medtronic). One study showed that while Masimo SET had 3% missed true alarms and 5% false alarms, Nellcor’s N-600 sensors had 43% and 28%, respectively.

Despite such a wide lead in performance, Masimo announced at their investor day that they had made their SET even more accurate.

We think this speaks volumes of the company’s culture. With that type of lead, most medical device companies would declare victory, drop R&D spending, and harvest higher cash flows. Instead, Masimo pushes further. One false alarm is too many.

Now, even though Masimo’s technology has long been superior, it’s taken more than a decade to win half the pulse oximetry market share. This speaks to the switching costs involved in pulse oximetry.

It’s a classic razor-and-blade business model. The company sells technology boards that go into both Masimo-branded monitors and OEM-branded monitors. This equipment typically gets replaced every 10-12 years, so it’s a slow product cycle. Masimo then sells disposable sensors with a 5-7 year contract. About 80% of its sensors are single-patient use (one-week life), with the rest being reusable silicon sensors (six-month life).

Even after the hospital decides to make a change, new monitor integration takes another 1-2 years start to finish, which further adds to switching costs. On this point, Masimo boards already have all the various readings (SET and rainbow) installed and it’s up to the hospital to “turn on” various components.

Even though winning share is a slow process, once Masimo wins the business, it’s typically locked in. The company boasts a 98% customer renewal rate.

Though the SET patents have expired, Masimo successfully defended them over the past decade, winning a $265 million settlement plus royalties from Nellcor in 2006, followed by a 2016 settlement with Philips that resulted in a $300 million cash payment plus a multi-year business partnership to sell Masimo boards in Philips monitors. Philips has a 50-60% market share in the U.S. high acuity monitoring market, so this is a massive opportunity for Masimo to extend its installed base and establish more presence on the general floor of hospitals. (More on that in a moment.)

Masimo’s SET algorithms are also proprietary and encrypted, which will make it challenging for upstarts to match its current performance.

Finally, Masimo has smartly reinvested its SET cash flows in new products that leverage its expertise in sensors and monitors.

Masimo’s rainbow technology, for example, uses an upgraded sensor to provide medical professionals with a portfolio of critical health metrics. Among these additional readings are hemoglobin, carbon monoxide, and acoustic respiration rate.

Rainbow patents have 10-15 years remaining, which will help Masimo defend its lead over competitors in monitoring sensors.

Put simply, we think Masimo is generations ahead of its competition in non-invasive sensors. The other major players have shown more interest in milking their sensor business for cash flow rather than reinvesting in innovation. Upstart competitors will need to run the gauntlet of regulatory approvals and slow product cycles before they can go head-to-head with Masimo’s current offerings. So by the time they get into the arena, we think Masimo will have further extended its technology lead.

Masimo has already fully penetrated the critical care beds in U.S. hospitals, where patients’ vital signs are continuously monitored.  But this is not the case on the general floor – yet. Only 10% of general floor beds in the U.S. use continuous monitoring.

If you’ve ever been in a general floor bed yourself or assisted a loved one, you know the routine. The nurse comes in every few hours to check your vitals. He or she might jot them down on a tablet or laptop – but often it’s pen and paper.

This can result in transcription errors and may miss sharp, unexpected changes in a patient’s health, such as an opiate addict’s breathing capacity crashing in between nurse visits. Through Masimo’s Patient SafetyNet platform and sensors, the hospital gets real-time, non-invasive, and continuous patient monitoring solutions on the general care floors. This is a win-win-win for patients, nurses, and hospitals.

Rather than doing spot checks, nurses can monitor patient vitals 24/7 from a screen at the nurses’ station. If a patient’s reading turns from green to yellow or red, it’s time to check in on the patient. This saves the nurses time and allows them to spend more time with the patients who need the care.

For hospitals, continuous monitoring reduces liability risk. Why would you want to risk a patient crashing in between spot checks and deal the subsequent lawsuits that would surely follow? When you start from first principles, there’s no reason why hospital patients shouldn’t be monitored from the time they’re admitted until the time they go home.

Change at hospitals can be frustratingly slow, but we consider many of Masimo’s solutions to be inevitable.

I could write thousands of more words on Masimo’s innovative products – brain function monitoring, automating operating rooms, etc. – but I’ll discuss one more innovation.

Last year, Masimo announced it was one of eight companies (out of more than 250) selected by the FDA for expedited approval of a system designed to detect respiratory problems related to opioid overdose.

As I began to run some numbers on the market opportunity, I couldn’t believe the data I was seeing. Among them:

  • In 2017,  there were 191 million opioids prescriptions written in the U.S.
  • 92 million U.S. adults used a prescription opioid in 2015.
  • In 2017, there were 47,600 opioid overdose deaths in the U.S.; 17,029 deaths related to prescription opioids.

Those numbers are staggering.

One of the key risks of opioid use is respiratory depression where your brain is deprived of oxygen and you run the risk of cardiac or respiratory arrest. The scary thing is that people typically do not know beforehand how they will react to opioids.

Masimo knew from its hospital-based patient monitoring systems that its sensors could greatly reduce the risk of respiratory depression in patients prescribed opioids. So, it created Opioid SafetyNet: a take-home, direct-to-consumer monitoring system that connects to a smartphone and alarm to alert the patient, caregiver, and emergency services when respiratory depression is occurring.

Masimo believes it has a market opportunity of over $4 billion with Opioid SafetyNet, even under the assumption that opioid prescriptions are reduced by 30% as a preventative measure.

Beyond the market opportunity, the system has the potential to save thousands of lives – the benefits from which cannot be fathomed from a personal, familial, and societal standpoint. The Opioid SafetyNet product is currently pending FDA approval.

Okay, so we’ve seen how Masimo’s products are dramatically improving patient outcomes. How are they reducing systemwide costs?

First and foremost, the high accuracy of Masimo’s non-invasive sensors relieve doctors and nurses from having to extract blood via syringe, often while the patient is in motion, to get patient data. These invasive procedures raise the risk of infection and potential liability to the doctors, nurses, and the hospital. It’s also a win for the patient, of course, who doesn’t get stuck with more needles than necessary.

Second, Masimo’s sensors and monitors greatly reduce the number of false alarms and are more accurate with true alarms. False alarms are a waste of time for the medical professionals who rush into the room (at the expense of other patients) and do unnecessary procedures, which increase the cost of care.

Finally, by streamlining patient monitoring in all hospital settings, Masimo’s products help hospitals run more efficiently. Decluttering operating rooms, shortening patient time in ICU beds, and accelerating surgery times benefits everyone involved. Again, a win-win-win for medical professionals, the hospital, and the patient.

Medical devices have long been an attractive segment of the market – steady demand, long product cycles, high returns on invested capital, and so on. Indeed, since 2009, the iShares U.S. Medical Device ETF (IHI) has significantly outperformed the S&P 500 ETF (SPY).

Bloomberg, as of 11/3/2019

Despite medical equipment being an attractive industry as a whole, we think most of the industry fails to achieve both of our investment criteria – improve patient outcomes and reduce system costs. Masimo does both and does it in a unique way – by starting with first principles when developing a product and relentlessly innovating in pursuit of a higher standard. We think the innovative culture at Masimo will lead to unpredictable value creation – new products and services we can’t currently measure.

In short, we believe Masimo is doing well by doing good. Naturally, they’re profit-motivated like any business, but we also think the company has a rare intrinsic motivation to save lives and solve big problems. Kiani sets the tone for Masimo’s culture. During our visit to headquarters, we noted that there was a “founder’s pedigree” among the employees we met – someone who, like Kiani, is dedicated to saving lives, creating step-change products, and out-innovating stodgy competition.

And that, in itself – beyond the switching cost and intangible asset-based moat sources – could be Masimo’s most important moat source.

All images come from Masimo’s website and investor presentations, unless otherwise noted.

For more information about the positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

 

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

Google (officially known as Alphabet) is a long time holding of Ensemble Capital. On Monday, our chief investment officer Sean Stannard-Stockton was interviewed on CNBC’s Squawk Box Asia about Google’s earnings report released that day.

In the clip below, Sean discusses why initial market disappointment in the results is misplaced, the fact that the core advertising business showed another quarter of accelerating growth, and why the apparent missed expectations for earnings per share were clouded by non-operating expenses and in fact came in just fine.


Click here to watch the video if you are viewing this in your email.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

On September 26, Interactive Brokers announced its Interactive Brokers Lite service, offering commission-free trading on all US listed stocks and ETFs. Interactive Brokers (aka IB) is a relatively small online broker with AUM of about $160B vs Schwab’s $3.7T. In the last year alone, Schwab added $200B in net new AUM from customers.

So it surprised the market when, on October 1, the behemoth Schwab (SCHW) announced that it too would eliminate trading commissions for US and Canadian Stocks, ETFs, and Options commissions.

Source: Bloomberg:Online Brokers performance 9/23/19-10/24/19

With that move, Schwab effectively killed the business that birthed it 44 years ago.

IB’s management was taken aback by its impact on the industry a few weeks later during its earnings conference call:

“ we did not expect such a swift reaction in the sense that we thought that we come out with IBKR Lite as an additional offering and that we go on for a while, and will attract some customers and then eventually, other people will start reducing and maybe all go to zero. So this — this very swift reaction was a surprise to us.” – Thomas Peterffy, Founder and Chairman, Interactive Brokers Group (IBKR), 3Q 2019 Earnings Call

Schwab’s price cut was put into effect a week later on October 7, coinciding with the release of its founder and Chairman, Mr. Charles Schwab’s new book Invested. Charles Schwab was one of the key figures fathering and successfully growing the discount brokerage industry after the SEC deregulated trading commissions on May 1, 1975 (aka May Day). He adopted the use of computing technology and operational efficiency to continually drive down the cost, and with it the price, of trading shares.

By offering better value to customers, Schwab (the eponymous company) was able to grow its scale and with scale it improved its efficiency, which allowed it to further invest in technology, service capabilities, and lower prices resulting in further improving value and winning over more customers.

In examining its history, it’s clear that Schwab’s culture has played an important part in the use of technology and efficiency as a force for disruption and commoditization, either as a leader or fast follower (as in the latest incident swiftly following on the heels of IB).

As a result of this, Schwab has earned its customers trust and business, which has enabled it to leverage growing scale to disrupt lower value services (commissions, index funds, vanilla mass financial advisory) while climbing up the value chain of higher value services, thereby broadening its platform and scale. Most recently, that strategy has been embodied in Schwab’s dual mantras of viewing its service delivery “Through Clients’ Eyes” and with “No Trade-offs”, delivering everything the client wants at the lowest effective price in its market.

On the surface this looks like bad business, but delve a little more deeply and it becomes clear that it’s all in the service of scale and efficiency which trumps “price” as a driver for long term competitive advantage in this business.

Source: Charles Schwab, Fall 2019 Business Update

As the most scaled and efficient player in its industry, Schwab has the best expense efficiency on AUM (referred to by Schwab as EOCA = Expenses on Client Assets).

Source: Charles Schwab, Winter 2019 Business Update

The scale and efficiency have allowed Schwab to deliver lower prices to customer over time while increasing profits for shareholders – a win-win scenario we love to see in companies because it represents a non-zero sum relationship between a company and its customers.

Source: Charles Schwab, Fall 2019 Business Update

Despite its relatively small size, IB is a credible player, especially among active traders, to have elicited a response from Schwab (we were not surprised) — the type of aggressive response that had been brewing as the new style of “fintech” players like Robinhood have arisen, leading their value proposition with commission free trading while monetizing client trades via order flow.

IB’s move essentially brought that commission-free/order-flow monetization model into the boundaries of the mainstream discount brokerage business, and Schwab’s aggressive move brought the model from the boundaries into the center, and forced the rest of the industry to follow suit  and leaving them to nurse their now wounded financial models.

The timing may have been surprising, but the end state of commissions was not to anyone who has been paying attention. When computers do all the trading, the marginal cost (and revenue) trend to zero. The trading infrastructure has transformed from expensive people to predominantly cheap computers, and so did the business model.

Source: Vice.com, Ensemble Capital Management

Luckily for Schwab’s investors, its strategy of moving up the value chain (vertical expansion) and creating increasing platform leverage across market participants (horizontal expansion) have rendered its original trading commissions business, the most commoditized segment, of low importance to the whole at just 3.5% of revenue and ~8% of profits. Some modest expense control is all it would take to offset most of loss or ~6% incremental growth in AUM (all other factors being equal).

Source: Ensemble Capital Management

Building the business this way needed healthy doses of both long-term foresight (where does competitive advantage come from today and in the future – i.e. customer value and scale) and near-term opportunism (what should be within the business’ focus area to invest in and what’s not).

TD Ameritrade’s (AMTD) CEO Tim Hockey candidly admitted during its 4Q2019 Earnings Call:  “The best time to have, I think, build out a proprietary product offering was probably 25 years ago. There is a significant price point pressure obviously on active and passive… But as we know, you need absolutely massive scale for an offering and asset management fees base and so we don’t think that makes sense for us.”

In fact, as we’ve discussed in our previous post here, Schwab has increasingly shifted its customer monetization strategy from explicit fees via commissions and AUM based investment fees towards implicit fees based on opportunity cost of cash balances via net interest margins (NIM) at its Bank.

Therefore, Schwab wins over and retains customers with the lowest fees on the ~90% of their investment portfolio, thus accelerating market trends of declining AUM fees which is good for clients and a key decision point for them, while making money on the residual ~10% of their portfolio cash balance that is automatically swept into its Bank.

In its most recent 3Q 2019, proforma operating margins hit nearly 48% and 21% ROE (45.6% and 20% including a $62MM charge in 3Q19). For all of 2019 we expect a nearly 47% proforma operating margin and 20% ROE, while we expect to see only a modest impact to 2020 profitability of less than 5% from the commissions cut due to offsetting expense controls and some incremental AUM growth.

The impact of eliminating trading commissions is asymmetric across the major online brokers, with Schwab most insulated with only about a 3-4% net revenue impact and 8% hit to earnings (before expense adjustments), while TD Ameritrade (AMTD) noted a 15%-16% impact to revenue and E-Trade (ETFC) could see about a 10% impact. Goldman Sachs estimated a much deeper initial impact to earnings for AMTD and ETFC at -32% and -24%, with expense controls likely to mitigate some of the impact.

But there is no doubt the impact of the commission cuts has significantly weakened competitors AMTD and ETFC ability to invest in client service and technology investment going for several quarters to come.

On that note, TD Ameritrade’s management commentary is an interesting contrast to Schwab’s CFO commentary:

“we know that this boost to business alone will not replace all of the lost revenue. Accelerating and diversifying revenue remains a strategic priority – one that will guide continued exploration and efforts to recoup the lost economics over time. Over a year ago, we also started a formal strategic resiliency program to inject more discipline into how we allocate resources. Our work involved identifying our strategic differentiators – the things we can be really good at and win (things we could potentially accelerate) – as well as what we need to do to keep the lights on… Now, we’re tackling what’s left – the non-differentiators and things that don’t drive growth – to slow or stop investments and redeploy them to the things that matter.”

“Charging for help/advice. With the commission reset, we have shifted from the premium price in the market, ensuring that our value to customers justified that price, to an environment where we are providing extraordinary value to our customers. We have received numerous phone calls concerned that zero commissions could result in less insight to customers, fewer interactions with our highly qualified people, etc. We have been exploring a number of potential ways to monetize this value, but fear of cannibalization or being perceived as charging beyond a premium price had held us back. Now, armed with segmented customer data, both on profitability and usage of services and information, we are well positioned to begin to monetize this value. This could take the form of recurring fees for premium services or charging for episodic advice. Where the customer does not attribute value to these services, we can adjust our costs accordingly.”Management Commentary, 3Q 2019 TD Ameritrade

In contrast, Schwab’s commentary took on a different tone that is reflective of its business’ strategic and financial positioning going into the price cuts:

Why did we take this step, and why now? [We are] continuing our tradition of challenging the status quo on behalf of individual investors… it’s the right move from a competitive standpoint. There has been a clear pause in the so-called commission wars among the “traditional” e-brokers since the price reductions we made [offensively] in 2017. At the same time, we are seeing new firms trying to enter our market – using zero or low equity commissions as a lever. We’re not feeling competitive pressure from these firms…yet. But we don’t want to fall into the trap that a myriad of other firms in a variety of industries have fallen into and wait too long to respond to new entrants. It has seemed inevitable that commissions would head towards zero, so why wait? We have a business model that doesn’t depend on commission revenue, a long-term orientation and a history of being willing to disrupt ourselves based on client needs and competitive dynamics. That’s exactly what we are doing here – we’re making these pricing changes because we believe they enhance both our value proposition and our competitive positioning, encouraging the consolidation of client assets and trades at Schwab.”CFO Commentary, Charles Schwab 

“This elimination of commissions is something that we have been anticipating, was inevitable for over a decade. And we’ve been aggressively at work over the last couple of decades executing on strategies that reduced our reliance on commissions from a level of almost half of our revenue down mid-single digits. And while some might have been surprised by the timing of our move, our view is that anyone carefully following our commitment to the virtuous cycle would likely have anticipated it…

Now importantly, price is only one aspect of our commitment to delivering the best combination of value service and capabilities to all investors. Whether it’s our industry-leading client service, our broad range of solutions, our robust research tools and our industry first and still only satisfaction guarantee. We’re committed to serving investors in a manner unmatched by any competitor… in reality the virtuous cycle is not intended for short-term timeframes. It’s designed to be effective over the years, many years, and even over decades…

It begins at 12 o’clock by challenging the status quo on behalf of investors… how that has benefited our clients. Pretty remarkably what clients pay us in total for our services has declined by about 80% over the last 30 years. And as we share the benefits of our scale and efficiency with our clients, they bring us more assets. With assets growing exponentially over the same 30-year time horizon. Our commitment to operating efficiency and technology investments has enabled us to consistently grow our pre-tax margin over the last 30 years, even as our revenue per dollar client assets again has declined by about 80%. And our stockholders have benefited, as our net income and earnings per share have grown dramatically… of course, the virtuous cycle works, because we continue to make a variety of investments that benefit our clients. Sometimes we do so in services, products, capabilities, sometimes in price, as we did a couple of weeks ago.”Walt Bettinger, President and CEO, Charles Schwab during 3Q19 Business Update Call

We believe Schwab’s business stands to benefit the most because of the relatively small impact to its revenue and income and the broad, efficient set of high quality service it offers to clients. While the commission cuts mean Schwab offers an even more compelling value to its customers for its existing suite of high quality services, a disadvantaged competitor like TD Ameritrade is trying to figure out how to charge for its “premium” services for customers, effectively raising prices for service in other ways and depressing its value proposition.

Decades of experience  indicates the companies offering higher value propositions win more customers. By  continuing to pursue aggressive reinvestment in both client service and technological efficiency, Schwab can continue to leverage its growing scale to further improve upon the value proposition it provides clients while continuing to drive down its expense (efficiency) ratio. We believe the gap in differentiation will only get wider now that the smaller competitors are much weakened financially, which is why it made sense for Schwab to be so aggressive in cutting commissions both in 2017 and again October 2019.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

“A little learning is a dangerous thing. Drink deep or taste not the Pierian spring; There shallow draughts intoxicate the brain and drinking largely sobers us again.” Alexander Pope, 1709

Arif and I have just returned from a week long research trip to China with Rui Ma and Ying-Ying Lu, the hosts of the excellent TechBuzz China podcast, who gave us an immersive, deep dive into the Chinese business ecosystem.

We were fortunate to have a dozen of our investor friends join us from the US, Canada, Dubai, London, Singapore, Spain and Mumbai. We visited with 28 company representatives, industry experts, and government representatives in Beijing, Shanghai and Hangzhou. From executives at well-known global companies such as Didi, Xiaomi, and Ctrip, to companies less known to western investors such as Qutoutiao, Nio, Bilibili, LexinFintech, MOGU Inc, Club Factory, and Ruhnn.

While we do not currently have any direct investments in Chinese companies, nor do we plan to make any in the foreseeable future, we believe that US and global investors can no longer simply say that China is outside their circle of competence. As investors in global businesses, we know that China’s economy and their thriving corporate sector will play an ever-increasing role in global business. So, we decided we needed to spend some time there ourselves. In this series of posts, we’ll share some of our takeaways from the trip.

From 2009 to 2018, Ensemble Capital held a large investment in Apple in our equity strategy. As the company became big in China, we came to understand that Chinese users spent so much of their online life in WeChat, an app made by Chinese tech giant Tencent, and that they were not nearly as loyal to the iPhone as users in the rest of the world. This was because a Chinese iPhone user could buy the new, cool Android based phone, download WeChat and have all of their content ready to go. While in the past, the iPhone was far ahead of other phone makers, today there is a proliferation of other high-end phones, such as this $3,000 phone that is wrapped entirely in screen that was on display at Xiaomi during our visit.

Given that WeChat is barely used in the US, it can be hard for US based investors to appreciate the importance of WeChat to the Chinese online experience. Let’s just say that in many ways, WeChat *is* the internet in China. With Google not available, Baidu’s search results reveal a spammy mix of irrelevant ads, and with much of the internet outside of China blocked, the “world wide web” just isn’t a terribly important part of the Chinese internet experience.

Looking at our portfolio, about half of our holdings have some sort of intersection with China. In some cases, it is companies like Tiffany or Starbucks who have material sales into China. Other times it is businesses like Netflix or Google, who do not do business in China, but which possibly could over the long term. And then there are businesses like Mastercard, which after being blocked out of China and watching it become the only country with a non-Mastercard/Visa-based, robust payment infrastructure, now finds itself facing possible competition with these Chinese tech/payment giants in emerging markets or even in the US where “we accept Alipay” stickers have started to pop up in some locations.

Many investors don’t appreciate the level of latent knowledge they already have about a company or industry before they start researching a company. For instance, most American investors would know before they even started researching a company like Starbucks that coffee can be bought at lots of different retailers, but the nuanced difference between buying coffee at Starbucks, McDonald’s, Dunkin Donuts, Peets or a Third Wave coffee shop is something American investors already understand intuitively.

There is even knowledge you don’t know that you know. For instance, American office workers don’t order coffee for delivery all that often. Why is that? Many American investor may not even be conscious of the fact that this is true in large part because the vast majority of American companies offer free coffee on site to their employees. But this is not true in China.  And, so while it might seem strange to Americans that ordering coffee for delivery is big business in China, the reason has to do with subtle but important cultural differences that are entirely understandable if you take the time to learn about them.

Over the coming week or two, we’ll be publishing a series of posts on our key takeaways:

  • The rise of local Chinese brands
  • New Commerce
  • Two Chinas
  • The context that allowed for China’s rapid growth

As you read these posts, don’t get the impression that we’re experts on China. Our hosts for the trip are very much experts on China and if you’re an English-speaking investor who wants to expand your circle of competence related to China, we strongly recommend you listen to their excellent TechBuzz China podcast.

If you look back to the quote opening this post, you’ll note that we are acutely aware that a little knowledge can be a dangerous thing if you believe that knowledge makes you an expert. But the only way to become an expert is to wade through the early phase of having a little knowledge, recognize that you may have a tendency to get “drunk” on this knowledge and then keep learning more until you come out the other side and are “sober” again.

44% of the revenue of the S&P 500 comes from outside the US. Global markets have become far more correlated to each other as the world has globalized. The major global economic engines are now China, the US and the EU. But the thing about China is that it is changing so quickly. So knowledge that you have about China can get out of date quickly.

For instance, here is a photo we took of the Shanghai financial district. It simply dwarfs Manhattan and looks and feels far more developed than any of the mega cities in the US or EU.

And here is a photo of the exact same location in 1991.

We believe it is critically important for all active equity investors to decide that if China is not currently in their circle of competence, it is time to start building that competency now. And while a week long trip won’t do the trick, nor will sitting at your desk reading research reports.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.

Ensemble Capital’s Senior Investment Analyst, Arif Karim, was recently interview by Bo Börtemark of the Investing By The Books investment blog whose insightful questions guided an in depth look at Ensemble Capital Management’s investment strategy, our research process, and Arif’s journey as an investor beginning with a serendipitous request by a desperate high school math teacher eager to fill spots in a local stock market competition to a career epiphany precipitated by legendary fund manager Peter Lynch!

CLICK HERE to read more in Arif’s inaugural interview.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE

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

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.