Below is the Q1 2018 quarterly letter for the Ensemble Fund (ENSBX). This quarter’s Company Focus is on Netflix (NFLX) and NOW, Inc (DNOW). You can find historical Investor Communications here and information on how to invest here. Enjoy!

The performance of the Ensemble Fund (“the fund”) this quarter was modest on an absolute basis, while being relatively strong when compared to the broader market. The Fund was up 1.93% vs the S&P 500 which was down -0.76%.

As of March 31, 2018

1Q18 1 Year Since Inception*
Ensemble Fund 1.93% 19.13% 13.11%
S&P 500 -0.76% 13.99% 12.23%

*Inception Date: November 2, 2015

Performance data represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance data quoted. Performance data current to the most recent month end are available on our website at www.EnsembleFund.com.

Last quarter, in reviewing our performance for 2017, when we slightly trailed a very strong level of market performance, we discussed that we expect our strategy to deliver a better downside capture ratio than upside capture ratio, meaning that we expect to perform better on a relative basis during down markets than during up markets.

After a strong first few weeks of the quarter when the S&P 500 rallied 7.6% and the fund continued to trail slightly, the market experienced its first real bout of selling pressure since early 2016. From the market high on January 26th, the S&P 500 declined by 7.72% through quarter end while the fund declined by 4.87% for a downside capture ratio of 63%.

While we seek to produce strong, long-term absolute returns, we know that losing less during market declines is an important element of reaching our long-term goal. Since it takes a 100% gain to reverse a 50% loss, a solid defense leaves us in a better position to play offense when the tide turns.

The most notable driver of the fund’s performance in the quarter was the over 50% rally in Netflix, which we’ll discuss later in this letter. We also saw positive performance in 14 of our 24 holdings, with double digit positive performance from Broadridge Financial, Mastercard, Ferrari, Transdigm and our new position in Booking Holdings (previously named Priceline), which we initiated during the last week of December.

On the negative side, we saw continued negative performance from Prestige Brands (which we added to in February after the stock declined sharply on a weak quarterly earnings report), as well as L Brands, which unfortunately reversed much of the very strong gains it posted in the second half of last year, and in DistributionNOW, which we exited after their disappointing earnings report which we will discuss in more depth…

Click here to read the full letter

DISCLOSURES

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Netflix (NFLX), Broadridge Financial (BR), Mastercard (MA), Ferrari (RACE), Transdigm (TDG), Booking Holdings (BKNG), L Brands (LB), Prestige Brands (PBH). These companies represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein.  Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances. 

Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Please refer to our current 13F filing or contact us for a current or past copy of such filing.

Investors should consider the investment objectives, risks, and charges and expenses of the Fund carefully before investing. The prospectus contains this and other information about the Fund. You may obtain a prospectus at www.EnsembleFund.com or by calling the transfer agent at 1-800-785-8165. The prospectus should be read carefully before investing.

An investment in the Fund is subject to investment risks, including the possible loss of the principal amount invested. There can be no assurance that the Fund will be successful in meeting its objectives. The Fund invests in common stocks which subjects investors to market risk. The Fund invests in small and mid-cap companies, which involve additional risks such as limited liquidity and greater volatility. The Fund invests in undervalued securities. Undervalued securities are, by definition, out of favor with investors, and there is no way to predict when, if ever, the securities may return to favor. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. More information about these risks and other risks can be found in the Fund’s prospectus. The Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment.

Fund Fees: No loads; 1% gross expense ratio.

Distributed by Rafferty Capital Markets, LLC Garden City, NY 11530.

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 clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. 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. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

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In his memoir, Shoe Dog, Nike founder Phil Knight described how difficult it was to raise capital in the 1960s.

There was no such thing as venture capital. An aspiring young entrepreneur had very few places to turn, and those places were all guarded by risk-averse gatekeepers with zero imagination. In other words, bankers.

Around the same time, Sam Walton (as described in Made in America) struggled to get funding to build Wal-Mart.

Nobody wanted to gamble on that first Wal-Mart…I had to put up 95 percent of the dollars…We pledged houses and property, everything we had.

In other words, in the 1960s, access to capital was a massive barrier to entry for potential disrupters. Incumbents with established banking relationships and access to credit markets had a clear advantage.

Over the coming decades, however, venture capital and private equity sprouted up, and banking deregulation commenced, making it easier for promising start-ups to acquire funding. Today, access to capital does not impede a motivated entrepreneur with a quality product or service.

Entry vs. scaling barriers

Economic moat sources – low-cost production, network effects, switching costs, and intangible assets – may remain constant, but ultimately what determines a moat is how those sources build entry or scaling barriers for competitors.

Once a barrier to entry is lowered, what matters is how quickly the entrants can scale. Dollar Shave Club wasn’t remarkable only because it sold a quality blade at a lower price point, but because of how rapidly it scaled and challenged Gillette’s dominance in the space.

On the other hand, the barriers to entry in the North American containerboard industry aren’t insurmountable, but it is much harder for an entrant to scale. The major incumbents – International Paper, Georgia-Pacific, WestRock, and Packaging Corporation of America – account for about 75% of domestic production and own the majority of the corrugated box plants.

Even if you produced containerboard, you’d still likely need to sell through one of the incumbents’ box plants. Regional efficient scale advantages limit new box plant construction and enable the integrated players to act rationally.

Tangible vs. intangible

One of the biggest differences between traditional and “future” moat analysis is that the former is primarily rooted in tangible assets (plants, brick-and-mortar stores, etc.), while the latter is based increasingly on intangible assets (relationships, customer captivity, etc.).

With traditional tangible asset-based moats, barriers to entry are typically high (need for capital, expensive factories, etc.), but economies of scale are more achievable as expansion allows the spread of high fixed costs over a broader base.

The opposite is true with intangible asset-based moats. It’s easier to enter a market but much harder to scale in capital-light businesses. You could start a new social media company in your garage on a shoestring budget, but you’re up against significant network effects and switching cost advantages held by the incumbents. Further, it’s not always apparent which capital-light company is prudently scaling because they are expensing reinvestment, often resulting in near term, low reported profit margins.

You may find the following framework useful in navigating tangible versus intangible asset-based moat analysis.

Barriers to entry scale

 

Bottom line

The nature of moat analysis is shifting from a tangible-asset based evaluation to one that’s increasingly driven by intangible assets. Adapting to the change is not always easy for those brought up in the traditional value school, but we think it’s essential for investors to do so if they hope to succeed in the coming decades.

 

Clients, employees, and/or principals of Ensemble Capital own shares of Nike (NKE).

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 clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. 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. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

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

This quarter’s call will be held on Friday, April 6 at 1:00 pm (PST)

We’d love for you to join us on the call, which you can do by registering here or following the dial-in information below:

  • Dial: 1-800-895-1549
  • Conference ID: Ensemble

If you’d like to listen to our previously-held quarterly calls, an archive can be found 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 clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. 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. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

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Imagine you went back to 2007 and told investors that within the next ten years, General Electric would cut its dividend twice. You’d have been mocked and ridiculed.

At the time, GE was one of five U.S. industrial companies with AAA-rated credit, had just increased its dividend by 11% (its 32nd consecutive annual increase), and was one of the largest companies in the world by market capitalization. Such an outcome would have seemed implausible.

Yet here we are. The GE story is complex (which in itself is a problem), but one of the causes of its recent decline was consistently poor capital allocation decisions.

Here’s Morningstar’s take: “(GE’s) ambitious overhaul came with an overly aggressive midterm financial target of $2 in earnings per share by 2018, which probably colored management’s capital allocation decisions in a manner that ultimately exposed GE’s investors to unnecessary risk.”

As the GE story illustrates, the way management allocates capital can have a massive impact on long-term shareholder returns.

Simple doesn’t mean easy

At Ensemble, the two things we look for in a management team are their intent to optimize return on invested capital (ROIC) and their skill at allocating capital to maximize shareholder returns.

You’d think that these two things would be common, but they are more the exception than the rule. Indeed, our eyes light up when we see multiple mentions of ROIC (or return on equity) along with a discussion on capital allocation in annual reports, management meetings, or quarterly earnings calls. It’s that rare.

Why might this be the case? One reason is poor incentives. You never hear of a stock jumping 10% because ROIC beat expectations. No, it’s usually because the company reported better-than-expected revenue or earnings per share. Perhaps not surprisingly, two of the most common financial metrics used in management bonuses are – you guessed it – revenue and EPS. Unfortunately, neither of those metrics alone tell you if the company is creating shareholder value.

Revenue and EPS growth are essential, of course, but we believe that if the company aims to widen its moat (that is, optimize long-term ROIC) and thoughtfully allocate capital, revenue and EPS will take care of themselves.

Decisions, decisions

There are three ways a company can return cash to claimholders: pay a dividend, buyback shares, or reduce debt. There are smart and dumb uses of each. What we want to see is that management has thoughtfully weighed their options based on return opportunities.

To illustrate, at its 2017 investor day, Verisk Analytics showed how the firm allocated capital between buybacks and M&A over the previous 15 years.

As the slide mentions, Verisk decides on buybacks or M&A depending on the available opportunities. Even if they don’t always make the correct assessment in hindsight, we like that there’s a process in place.

We were further impressed that Verisk followed the above slide with IRR results from their capital allocation decisions.

Again, this level of transparency is rare, but we welcome it and would like more companies to follow suit.

Bottom line

Companies with moats are rare, as are companies led by thoughtful capital allocators. Companies that have both are exceptional and are precisely the kind of firms we want to own in our portfolio.

 

Clients, employees, and/or principals of Ensemble Capital own shares of Verisk Analytics (VRSK).

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 clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. 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. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

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From the Planet Money Podcast:

“When elevators were first invented, they were like cars – big things that could kill you. And so like cars, they needed a driver… There are accounts in the 19th century of very bad things happening. So they tried to make it safer – they automated it. They created automatic doors with safety bumpers, automatic stopping and then a driverless elevator. It was like the Google car of its time. And people hated it. The elevator industry decided they had to convince people to rethink what an elevator was. It wasn’t a gritty, dangerous transportation device. It was an elegant room that magically did your bidding.”

You should go listen to the whole podcast. It is one of the most important pieces of journalism that relates to self driving cars.

I bring it up today because tragically someone was killed by a self driving car in Phoenix. It was the first known pedestrian death involving a self-driving vehicle. At the same time, 15 pedestrians were killed today by a human driven car. My heart goes out to the family who lost a loved on in Phoenix as well as to the other families who lost a loved one in an accident that won’t receive national news coverage. For those families, speculation about the evolution of self driving cars is academic. But these topics are important to address because over the next year another 5,500 families are going to lose a loved one who was a pedestrian hit and killed by a human driven car. Horrifyingly, another 35,000 vehicle occupants will die in a crash over the next year, and a stunning 4.6 million people will be seriously injured.

So what we know about driving is that it is an extremely dangerous activity that has a lot of room to be made safer. Self driving cars may not be safer than human drivers today. But whether it takes five years or 50, it seems implausible to think that human drivers will remain the safest way around which we can organize our transportation system.

But when self driving cars are discussed, especially the question of when they will become ubiquitous, the focus is usually placed on the technological hurdles that need to be overcome. What the Planet Money Podcast makes clear is that the path to success almost certainly will need to climb steep psychological and sociological barriers as well.

At Ensemble, we believe that wide spread usage of self driving cars are a question of when not if. This is important for investors in almost all types of businesses because the US economy is organized around the passenger vehicle and cargo truck-based transportation system. The rise of a self driving vehicle based transportation system will have widespread ramifications that are difficult to predict and stretch far beyond the auto sector.

  • How will parenting and norms around working outside the house change if children do not need a parent to drive them to school?
  • How will metro areas reorganize themselves and what will happen to property values if previously prohibitive commuting distances become highly productive focused work periods?
  • How will airport infrastructure evolve if someone in Seattle can get into their car at 9pm, doze off to sleep and wake up for a morning meeting in San Francisco?
  • What will happen to the 4 million people (2.7% of the total working population!) who drive for a living or whose jobs directly relate to human driven cars?

Humans as drivers is so deeply embedded into our society that a driver’s license is our primary form of national ID.

We can see today how the internet reorganized our society in ways that was unthinkable early in its development. We think something similar will play out around self driving cars. But the systems in play are so complex and interconnected that it is impossible today to forecast what those changes will look like and how long they will take to come to fruition.

But what we do know is that the primary limiting factor to self driving cars is not technology. Given the state of self driving cars today, it is easy to see that from a technological standpoint at some point we’ll look back on human driven cars as anachronistically as we might today think of human operated elevators. Instead, the big challenges to overcome are the very real psychologically and sociologically complex problems that will need to be addressed.

As this paradigm shift unfolds, investors in public companies across a range of sectors will need to track these technological, sociological and psychological developments. There will be big advancements and big setbacks. There will be unexpected ramifications and unrealized dreams. But what investors won’t be able to do is dismiss the changes as something only relevant to venture capitalists or tech investors. Just as the internet has laid waste to seemingly unrelated industries because of the way it empowered entirely new paradigms, self driving cars will have similar impacts across just about every commercial sector.

Our hearts go out to the family of the woman who died in Phoenix and the families of the 100+ people who died in human driven car accidents on the same day. While we don’t know how all these changes will play out, we do think that our children, and certainly their children, will navigate a much safer transportation system and likely be as horrified to think of climbing into a human controlled car as we would be to find out that a man with his hands on a pulley was responsible for making sure our elevator made it safely to the right floor.

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 clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. 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. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

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