During our fourth quarter 2020 portfolio update, 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, and two of our holdings, Ferrari (RACE) and homebuilder NVR (NVR).

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


While our quarterly webinar is an unscripted, more casual discussion, we also produce a quarterly letter that covers the same topics but in written form and with somewhat more detail. You can find a copy of our fourth quarter letter here.

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.

We recently came across this fascinating chart by Nick Sleep and Qais Zakaria, who formerly ran the Nomad Investment Partnership. The chart shows how an investor – for decades! – could have paid much more than market price for Wal-Mart and still achieved 10% annualized returns through June 2009 when the Nomad post was published.

We’ve done a similar analysis on Costco and found that an investor could have paid 40 times trailing earnings for Costco at any point since 2002 and earned at least a 10% compound return through year-end 2020.

In the chart below, the blue line represents what your subsequent compound return would have been had you bought Costco at the market price between 2002 and 2015. The orange line shows what your return would have been had you paid 40 times earnings for Costco during that period.

Source: Costco, Bloomberg, Ensemble Capital

Both are illustrations of how the market can consistently underprice wonderful companies, a topic which we’ve discussed here and here.

One lesson investors should not take from these examples is that you can pay up for any company. The further you get from investing in an exceptional business, the more valuation should matter to your thesis.

While many investors look at historical valuation ranges as a cross check against their bottom up valuations, when you’re looking back at the performance of long-term outperformers, the historical ranges are, by definition, too low. You should have been willing to pay much more than the contemporary multiples suggested.

As the charts above show, a better method for analyzing long-term outperformers is to consider what you “could have” paid and still realized average market returns.

At Ensemble, we estimate a fair value for every company that we own. The distance between the market price and our fair value estimate is included in our formula for determining position size. Valuation matters a great deal to our process.

Value investing is built around the “margin of safety” concept – even if things don’t go as planned, you can still have a good outcome if you bought cheaply enough.

Similarly, if you have correctly assessed a business’s underlying quality – things like its moat, relevance, management team, culture, etc. – then you also have a “margin of safety,” even if it’s harder to quantify than it is with a valuation model. We might visualize the quality margin of safety as the spread between the two lines in the above charts.

Unlike the value definition of “margin of safety” where your biggest risk is not buying cheap enough, with quality “margin of safety” your biggest risk is not buying enough or selling too soon.

With hindsight, we can look at Wal-Mart and Costco in the above periods and say that valuation work wasn’t necessary. We should have gladly paid the market price and done nothing. But investing is a forward-looking exercise.

It should never be assumed that today’s great companies will be tomorrow’s great companies. In fact, we used to own Costco and sold in 2012. (We’ve since added back a small position in Costco.) At the time, we had concerns about Amazon Prime becoming the default “membership-based retailer” and diminishing the value of the Costco membership.

In 2012, we had legitimate concerns about Costco’s moat and relevance. Any valuation work we had done on Costco took a backseat to our worries about quality. In other words, our estimation of Costco’s quality margin of safety diminished.

With hindsight, we were right about Amazon’s Prime memberships, but wrong about its impact on Costco. In a different set of circumstances, it may have played out differently. We should always be prepared to change our minds about any business we own, especially when its quality is in question.

Our biggest mistake in selling Costco in 2012 was not fully appreciating its culture and the reasons why its customers are so passionate about their memberships (i.e. Costco gives frugal people permission to splurge). We didn’t set the bar high enough. Not only did Costco survive the Amazon challenge, but it’s thriving. Membership renewal rates are at record highs.

Source: Reuters/Duane Tanouye

If we’re going to be wrong about a company, we’d rather it be due to a misunderstanding of its underlying quality than a valuation issue. Valuation being quantifiable is much easier to rationalize and come to terms with than a qualitative mistake, but we can learn more from qualitative mistakes and become better investors.

By insisting on owning only what we consider to be exceptional businesses, we believe our investment outcomes will depend more on whether we were right about the business’s quality rather than if we were right about its valuation.

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.

One of the amazing things about the rise of podcasts is that interviews of investors and business leaders are no longer constrained by the short time slots of the mainstream media. One of the best new investment related, long form interviewers is Bill Brewster of The Business Brew. Bill does an excellent job of engaging with his guests in a way that makes the audience feel like they are listening in on two friends having a deep dive conversation about a subject they are deeply passionate about.

So we were thrilled when Bill reached out to ask our CIO, Sean Stannard-Stockton, to come on his show. In the interview, Sean and Bill discuss:

  • Running an investment firm during COVID-19
  • The need for companies to lead by example
  • The necessity for investors to remain open minded
  • How to think about serial acquirers
  • The potential perils of low/slow growth investing
  • Position sizing; or figuring out how much to buy of each stock rather than just which stocks to buy
  • How an error of omission caused Sean to change how he reacts to seemingly irrational market behavior

We hope you enjoy the interview!

At Ensemble Capital, we believe that company analysis is a qualitative activity. The identification of competitively advantaged businesses, with excellent management teams, and long term growth paths is fundamentally a qualitative process. But we also believe that humans are generally terrible at deciding exactly when to buy or sell a stock and specifically how much to own.

To counter act the cognitive biases that lead human traders astray, we developed a quantitative position sizing framework that transforms our qualitative assessments into specific quantitatively derived position sizes. We believe that this approach, assigning humans the qualitative analysis at which they thrive, while assigning quantitative trading decisions to an algorithm, is a direction that many equity managers will pursue in the years ahead.

In 2019, we published a series of blog posts on our position sizing philosophy. Today we’re publishing an illustrated report focused on the details of our process.

You can download the report by clicking here.

Each quarter, Ensemble Capital hosts a conference call with investors to discuss the current market, economic conditions, and a few of our portfolio holdings.

The event will use a webinar format. Participants will have a chance to ask live questions of the research team during the Q&A portion of the event.

This quarter’s webinar will be held on Monday, January 11 at 1:30 pm (PST)

We’d love for you to join us, which you can do by REGISTERING HERE.

If you’d like to listen to our previously-held quarterly updates, an archive can be FOUND HERE.

We hope to see you there!