During our fourth quarter portfolio update, we profiled portfolio holding, Paychex (PAYX). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.


We’ve been long time shareholders of Paychex, a company that serves small and midsize businesses (SMB) with payroll, HR, and PEO services and technology. These are the types of services that are critical to the functioning of all businesses but not necessarily the core focus of their mission or value creation. And to do them properly in house with the right level of staff, without errors and in compliance with regulations, requires a level of scale we believe is in the hundreds to thousands of employees. It’s this market comprised of businesses with a handful to a couple of hundred employees where Paychex focuses its efforts to serve businesses with these mission critical needs.

Paychex was founded in 1971, went public in 1983 and has generated a 20% compounded annual total return since. It started with a payroll service offering and over time has expanded to HR services, employee benefits administration, employee management software, and then fully outsourced employee management services that now includes the 2nd largest Professional Employer Organization (PEO).

In its last fiscal year, it reported more than 730,000 clients and paid 1 in 12 private sector employees in the US generating over $4 billion in revenue, 40% operating margins, an adjusted return on invested capital of over 100%, and threw off nearly $1.4 billion in cash. This is a very lucrative business; one that is supported by a ton of value it creates for its clients doing the meticulous and important behind the scenes work that allows businesses to function every day. It’s the kind of business we’ve previously termed a “cash machine”.


Given how mission critical it is to pay employees consistently and correctly, withhold and submit taxes, gather, maintain, and update employee records, stay in compliance with regulations and provide great service to employees, it’s not hard to understand why clients would be very sticky after selecting a service provider – there are huge switching costs involved in the form of time and information burdens and the possibility of mistakes that impact employee paychecks and benefits in switching providers. Collectively the time across an entire employee pool spent to set these systems up and the risk of errors make it they type of service that you’d rather “set it and forget it” for generally risk adverse managers who are more keen to be working on delivering value for their own clients and generating revenue.

Switching from Paychex to another vendor only happens if there is a significant reason to do so – such as poor service quality, unacceptable numbers of errors, or much better capabilities. These are all factors that are within the company’s control with the exception of being able to “be all things to all people”, ie at some point some clients will grow large enough that their needs will get complex enough to move on to a more customizable platform or take the HR/Payroll services inhouse.

Paychex’ client retention looks optically low at 84%, but this has its underlying roots in a significant number of clients who go out of business in the small business market – about 20% of small businesses shut their doors in their first year, while only half remain in business after 5 years. We all know being a small entrepreneur is a risky venture, yet enough start new businesses to keep feeding the Paychex funnel of new clients to replace those lost. On the other hand, those businesses that continue to thrive fuel growth for Paychex’s business which prices many of its services on a per employee per month basis. So as retained customers grow the number of their employees and benefits, Paychex’ revenue also grows.

Paychex has seen revenue grow in the range of 5-7% in the decade prior to the COVID era. Results during the “COVID” period were surprisingly resilient aided by US stimulus packages for businesses, and then accelerated with the pent-up demand in the reopening afterwards. During this period, just like many other businesses who adapted to remote or hybrid work and offered new products as customers’ needs quickly changed, Paychex also managed to both accelerate changes within its sales and service organizations that made it more efficient and quickly brought to market new services to help customers efficiently utilize government stimulus programs such as the Paycheck Protection Plan (PPP), Loan Forgiveness, and Employee Retention Tax Credit (ERTC) programs.

Paychex’ ability to quickly build and deploy critical services that leveraged the customer employee data it already had during a tumultuous time helped a significant number of its clients survive thru the period and increase their loyalty, raising its retention rate from 82% in its May-ending Fiscal Year 2019 to 85% in FY21. In total, Paychex helped over 500,000 businesses apply for and receive $65 billion in PPP loans (9% of the total program payouts and an even larger proportion of loans disbursed to small and medium sized businesses), apply for loan forgiveness afterwards, and helped more than 40,000 clients qualify for and obtain $8 billion in employee retention credits.

In addition, the labor challenges of the past year or so have driven greater adoption of its HR services and software technologies in order to improve employee services in the form of mobile self-service options and employee benefits management for its clients. When it comes to benefits, small and medium businesses are structurally disadvantaged when competing in the marketplace to offer the best compensation packages vs large businesses. For example, many insurance offerings get cheaper per employee with scale and Paychex’s PEO service allows it to bring down the collective cost by pooling all its participating small businesses into one huge employee pool. Bringing automation technologies to its small business clients has also enabled them to work more efficiently during an inflationary period where productivity gains have been the key to preserving and growing their revenue and margins under tight labor constraints. The self-service capabilities and automation has helped also Paychex increase the productivity of its own customer service reps and salesforce, resulting in record core service margins.

The pandemic period has brought to light the importance of adaptability and resilience in business’ ability to thrive over time. The common adage, “the only constant is change”, was very much emphasized during that period. However, more broadly we’ve seen technology really start to penetrate all types of businesses especially over the past decade with the proliferation of the internet everywhere and smartphones in everyone’s pockets. Prior to the pandemic there was some worry that Paychex was too slow to adapt to the consumerization of business services and the self-service buying and control that an increasing proportion of a “digital native” business owners and employees have come to expect. However, despite the company’s origins in the 1970s mainframe era and its coming of age in the 1980s and 1990s PC period, Paychex has shown an ability to adapt at a[…]

During our fourth quarter portfolio update, we profiled portfolio holding, Masimo (MASI). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.


2022 was a wild year for Masimo – and that’s saying something given the concurrent volatility in the market at large. In February, Masimo announced it was acquiring a consumer audio holding company called Sound United, which owns higher-end audio brands like Polk, Denon, and Bowers & Wilkins. The deal price was for $1.025 billion, but the stock dropped 37%, representing nearly $5 billion in market value, on the day after the announcement. The amplitude of the drop relative to the deal value suggested investor revulsion that went far beyond the acquisition itself.

At first glance, we were also puzzled by the company’s decision to acquire Sound United. In particular, we were disappointed by the way the deal – by far the largest in Masimo history and a departure from its stated M&A strategy – was communicated to shareholders. For example, Masimo did not hold a separate conference call with investors to specifically discuss the deal and instead combined it with its routine fourth quarter earnings conference call, which greatly limited the time that analysts had to ask questions and diminished what was otherwise a strong quarter for the core healthcare business. Compounding the problem, Masimo’s founder/CEO Joe Kiani told investors he was an “audiophile,” which raised concerns about this being a pet project, and management declined to answer certain questions due to stated worries about potentially tipping off competitors.

We spoke directly with management after the conference call, where we communicated our concerns and shared our feedback about poor investor communications.


Having owned Masimo for three years prior to the deal being announced, we had conviction in our fair value estimate for the legacy healthcare business and thought the post-acquisition share price significantly discounted that valuable franchise. While the plunging stock price was hard to take and it would have been emotionally easier for us to exit the stock, the discounted price was already the new reality, and it was our job to freshly evaluate the opportunity as it was now presented. The discounted share price provided us time to learn more about Masimo’s strategy and give them time to develop products with Sound United, some of which we were able to see at Masimo’s much-awaited investor day in December at company headquarters.

In August, an activist investor, Politan Capital, acquired a nearly 9% stake in Masimo, and though we have no comment on the merits of Politan’s strategy, we do believe their interest in Masimo aligns with our own take that the current market price dramatically undervalues Masimo’s core health franchise.

Looking back at a blog post we wrote in November 2019, we wrote that “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 continue to believe this is the correct way to view Masimo rather than as a “healthcare” company. It’s an engineering-first culture that happened to solve difficult problems in the healthcare industry and developed expertise in the field, including regulatory and R&D know-how.

Masimo’s motivation for the Sound United deal is clearer when viewed through this lens, as there are a number of markets where highly accurate non-invasive sensors can be used to improve lives. One of the ways in which Masimo might achieve this is through remote patient monitoring using its W1 Watch. In March 2020, when hospitals were overrun and struggling to triage COVID patients, Masimo came up with a solution to remotely monitor patients with medical-grade sensors that within weeks received emergency FDA approval. By February 2021, Masimo SafetyNet technology was deployed to 200 hospitals to keep track of patients at home who were not critical enough to be admitted, while keeping hospital beds reserved for the most ill patients. In October 2020, Masimo shared that an additional 2,000 hospitals were evaluating the product. The stressful rush on hospitals was relatively short-lived, thankfully, but provided a high profile use-case for monitoring patients outside of the hospital setting.

Masimo’s W1 Watch is focused on medical-grade health monitoring and there are no apps or frills as found in competing “wellness” focused smartwatches. During the investor day, Masimo shared data showing its W1 Watch caught every adverse medical event tested during a patient’s sleep cycle while the Apple Watch only caught between 6% and 7%. If you wear a watch designed to alert you and your medical team to life-threatening episodes, your watch cannot miss true alarms, nor can it produce many false alarms. The former could be catastrophic, and the latter would make the device unusable as false alarms would cause undue stress and greatly reduce doctor-patient confidence in the product.

The opportunity for continuous and remote patient monitoring is massive. From the hospital point of view, many hospitals are losing money with each Medicare/Medicaid patient and need to find ways to reduce per patient costs. Being able to confidently send patients home and monitor their progress in that setting could help hospital systems save money and help patients recover more quickly. Additionally, hospitals are penalized by Medicare/Medicaid when patients are readmitted within 30 days of discharge with the same ailment. There’s clear monetary motivation for hospitals, in appropriate circumstances, to monitor patients at home rather than in the hospital setting.

From the patient point of view, recovering at home is generally preferable to recovering in the hospital and also reduces the risk of catching viruses and infections. Patients are also often nervous about being sent home, worried about adverse scenarios occurring away from medical care. Medical-grade monitoring can help reassure recently discharged patients and those with chronic conditions like COPD and congestive heart failure and reduce the impulse to rush to the emergency room.

Masimo has submitted 510k approval for the W1 Watch with the FDA. The W1 is available today and can currently be used to share live medical data with your doctor through printed reports or with loved ones concerned about your health.

We were pleased to see that Masimo is further leveraging its Sound United acquisition by enabling W1 Watch users to plug into Denon’s HEOS connectivity technology, which connects user data to Masimo’s HIPPA-compliant cloud. In other words, if you have a Denon speaker with HEOS in your home, it’s another way beyond your smartphone to get your health data to the cloud. Like a “Trojan horse” of sorts, Masimo announced at the investor day that they are turning on this functionality to 4 million households with Denon speakers in 2023 with more to come in 2024.

As more people “age in place” or spend their retirement years at home, the more they will rely on at-home health services. A benefit of the Sound United deal is that there’s a network of professional independent contractors who install home audio equipment made by Sound United’s brands. It does not seem a stretch to imagine that these contractors can also install remote[…]

“You’ll hear a lot of managers say, “Hey, I bought the market in the financial crisis,” but they’re probably not going to get on TV and say, “and I threw up in the trashcan for it.” – Dan McMurtrie

If you’ve been an equity investor over the last year, you have been experiencing stress. If you haven’t, then you simply aren’t paying attention. But it is important for equity investor to appreciate what exactly it is that they get paid premium returns for in the first place. In our view, those premium returns come from the successful management of anxiety.

While academic research suggests that the source of equities’ long term return premium is a function of equity market volatility, in this post we will argue that this is wrong. The premium rate of returns generated by equities over the long term is a function of the elevated level of anxiety that equity owners must manage relative to bond investors.

First, we want to make clear the difference between anxiety and stress. Stress is a function of external issues. Stress can be relieved by resolving those external issues. But anxiety is a particular reaction to stress that is related to internal issues or how a person reacts to stress.

According to the Mind Mental Health institute, “anxiety is what we feel when we are worried, tense, or afraid – particularly about things that are about to happen, or which we think could happen in the future. Anxiety is a natural human response when we feel that we are under threat.”

In the book The Upside of Stress: Why Stress is Good for You and How to Get Good at It, author Kelly McGonigal argues that stress itself is not bad. Rather it is how people react to stress that determines whether they take a path towards a good or bad resolution of the external stressor. McGonigal makes the case that stressors are a natural part of life. Stress is simply a catalyst that triggers people to react to external events that threaten them in some way. And reacting to threats helps people lead happy, productive lives.

But because stress is uncomfortable, and persistent stress can lead to anxiety, humans often react to threats in ways that are unhelpful. This unhelpful behavior is a function of people seeking to end the stress and anxiety as quickly as possible no matter the cost, rather than managing their stress and anxiety as they seek to take steps to appropriately react to the external stressors.

Investing is an activity that triggers stress. Money in general is an area of high stress for most people. Investing is the act of taking money you’ve earned and exposing it to potential loss in exchange for a potential gain. Even though stocks generate higher rates of return over the long term, they also run the risk of generating significant losses over the short term.

While academics cite this volatility as the reason why stocks earn high rates of returns, it is important to recognize that the volatility is just an external issue which is likely to trigger stress, and may trigger anxiety, but it is the successful management of anxiety, not the volatility itself, for which equity investors are paid premium returns over time.

The chart below shows the high, low, and average annualized rate of returns of stocks and bonds over 1, 5, 10 and 20 year rolling periods since 1950.

Over short term time periods of one year, the returns to equities can be decidedly negative and much worse than bonds. But over 10 year periods, equity investors rarely earn lower returns in stocks than in bonds, and when they do, the underperformance is relatively minor. Over 20 year periods, stocks are less risky than bonds in that their worst returns have been significantly superior to the worst returns earned by bonds. In fact, over this longer time horizon, the worst return for stocks has been better than the average return for bonds.

Most equity investors say that they are long term investors. If you are investing in stocks, you should have an investment time horizon of at least 10 years before you need the money back to spend. For time periods shorter than 10 years, while stocks are likely to do better than bonds, there is a significant potential that stocks will do worse. Due to this, we would argue that investing in stocks for periods of less than 10 years is a form of speculation and your returns will be dependent at least in part by how lucky you are. So, to be clear, our argument in this post relates to long term investing.

Let’s use a quick example to illustrate the degree of risk in stocks vs bonds over a 20 year time horizon. Using the 20 year rolling returns from the chart above, a $100,000 investment made at the beginning of each of those 20 year periods in either stocks or bonds would have grown to the level displayed in the grid below.

Best Worst Average
Stocks $2,310,000 $321,000 $882,000
Bonds $965,000 $122,000 $309,000


As you can see, while conventional wisdom holds that stocks are riskier than bonds, in fact, over 20 year periods stocks deliver better average returns, dramatically better returns during great periods, and yet still deliver better returns under the worst outcomes.

But along the way, equity investors are faced with a multitude of external stressors. In this next chart, Michael Batnick of Ritholtz Wealth Management illustrates the many stressors that investors faced over the 10 year period from 2009 to 2019, during which time the stock market delivered an average rate of return of 19.5% a year.

Source: The Irrelevant Investor

Each of these external events was a stressor. These stressors demanded that an investor process the new information and try to determine what it meant and how they should react. But anyone who has invested for long knows that there will be periods, much like the period we are in today, when these external stressors begin to accumulate and our ability to process them degrades.

If investors do not proactively seek to effectively manage their reactions to these stressors, they tip into a stake of anxiety. If this anxiety goes on long enough, it can lead to investors feeling “worried, tense or afraid – particularly about things that are about to happen, or which we think could happen in the future.”

The fact is every investor who has been at this work long enough has[…]

Below is the Q4 2022 quarterly letter sent to separately managed account clientsYou can find historical Investor Communications HERE and information on how to invest HEREEnjoy!

The performance of securities mentioned within this letter refers to how the security performed in the market and does not reflect the performance attributed to the core equity portfolio. Please see the chart at the end of letter, which reflects the full list of contributors and detractors based on each security’s weighting within the core equity portfolio.

You can request a copy of Ensemble Capital’s equity strategy performance presentation HERE. The presentation is updated by the end of the month after each quarter end.

2022 was not a good year for the Ensemble equity investment strategy. Not only was our strategy down 28.60% for the year, but we underperformed the S&P 500 by 10.47%. However, most of the damage was experienced during the first few months of the year, with our strategy returning to outperformance in mid-May, generating a 4% gain while the S&P 500 has declined by 1% since then. After our strategy outperformed by 2.25% while the market fell 4.88% in the third quarter, our strategy finished the fourth quarter up 9.12% while the S&P 500 rallied 7.55%. This means that in the second half of 2022, our strategy was up 6.3% while the S&P 500 was up 2.3%.

The three quarter period from the fourth quarter of 2021 to the second quarter of 2022 represents the fifth time since our strategy’s inception in 2004 that we have underperformed the market by a cumulative 5% or more. Over the subsequent year following the first four instances, our strategy outperformed our benchmark by an average of 5.88%. Over the first six months following our most recent period of sharp underperformance, we have outperformed the S&P 500 by 3.95%, which annualizes to nearly 8%, putting us well ahead of the sort of relative performance recovery that we have seen after past periods of underperformance.

So what went wrong and what do we expect in 2023 and beyond? Diagnosing the drivers of our underperformance this year is critical to informing whether our strategy needs to change or, as during past periods of underperformance, the types of companies we invest in have temporarily fallen out of favor and we should stay the course.

Importantly, the large majority of our portfolio companies grew revenue and earnings in 2022. Many of them substantially. With our portfolio growing revenue, earnings, and cash flow in the aggregate during the year, more than 100% of the decline in the market value of our portfolio is explained by lower valuations placed on our holdings by other investors. The question is whether this decline is a reflection of our portfolio having been previously overvalued, or whether some catalyst has triggered a compression in valuations that have brought them down to unsustainably cheap levels.

We have discussed our take on this issue repeatedly this year, starting in early March when we wrote about the “stagflation panic” gripping the market. In May, one day before our relative performance bottomed, we wrote about the “disconnect between corporate fundamentals and stock prices,” which we believed was being driven by the stagflation panic. In September, we released an analysis of equity market performance during the stagflationary 1970s and demonstrated that the acute underperformance experienced by the types of growth stocks that have hurt our performance this year was fully reversed after the 1970s stagflationary concerns came to an end.

Stagflation is the name for economic conditions that combine high inflation and weak real growth at the same time. If stagflationary concerns were the major driver of our underperformance, then we should be able to observe a correlation between our underperformance and stagflationary indicators, and in fact this is exactly what we see. Market based expectations of future inflation peaked this past spring, less than a month before our strategy flipped back to outperformance. Actual observed inflation peaked in June, just a month after our underperformance came to an end. Real GDP growth was strong in 2021, but reported as being in contraction in the first half of 2022, during our period of steep underperformance, before flipping to nicely positive real GDP growth in the 3rd quarter with most indicators pointing to another quarter of strong real GDP growth in the just finished 4th quarter.

We can also see clearly that as of today, many of the stocks that have most hurt our performance this year now trade at valuations well below their long term average. For instance:

  • Netflix trades at price to earnings and price to sales ratios that are about half or less than its 10 year average. The stock now trades at valuation levels last seen in 2014, prior to the company emerging as a credible threat to legacy media.
  • Illumina, a highly profitable business whose earnings and cash flow are currently being negatively impacted by their early stage GRAIL cancer detection business, which they will likely be spinning off in 2023, now trades at a price to sales ratio of about half its 10 year average. The last time the stock traded at this low of a multiple of revenue was in 2013, prior to the company coming to dominant the genetic sequencing industry.
  • First Republic trades at a PE ratio of under 15x, 25% below its 10 year average at levels seen only at the bottom of the initial COVID selloff in March of 2020 and a decade ago back in 2013.
  • Google, even including the money they are spending on pre-revenue activities such as their self-driving car unit Waymo, sells at price to sales, price to earnings and price to cash flow multiples that are a third less than their 10-year average. Today, the stock trades at or below valuation multiples seen in 2009 at the bottom of the Financial Crisis stock market crash.

But while we believe that our portfolio holdings were not overvalued at the end of 2021, this is not to say that we don’t think there was any excessive speculation in financial markets. In this letter two years ago, in early 2021, we called out what we argued were obviously bubble-like valuations in some corners of the stock market.

We wrote, “there appears to be clear signs of speculative activity in some parts of the market. Stories of new investors gambling their stimulus checks on cryptocurrency, electric vehicle SPACs and Software as a Service stocks are everywhere…” And we pointed to the Goldman Sachs Unprofitable Tech Company Index as one measure of the speculation.

In the chart below, we show the five year track record of the Unprofitable Tech Company Index, the S&P 500, and a representative account from within our equity composite. After rallying an absurd 420% from the COVID bottom in March 2020 to its high in February 2021, the Unprofitable Tech Company Index has lost nearly all of its gains and has now lost money over the past five years. On the other hand, while the Ensemble strategy has given up the outperformance we achieved earlier, the five year returns to our strategy have been approximately the same as the S&P 500[…]

During our fourth quarter portfolio update webinar, Ensemble Capital’s Chief Investment Officer Sean Stannard-Stockton and senior investment analysts Arif Karim and Todd Wenning discussed the current market and economic situation. They also commented on fourth quarter performance and discussed two of our holdings, Masimo (MASI) and Paychex (PAYX) at length. The webinar concluded with a live Q&A session with the team.

Below is a replay of the full webinar as well as a link to Ensemble Capital’s QUARTERLY LETTER.