Weekend Reading

16 February 2019 | by Katherine Fischer, CFA

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

Amazon Slashed Prices at Whole Foods.  Now They’re Climbing Back Up.  (Heather Haddon, @heatherhaddon, Wall Street Journal)

When Amazon acquired Whole Foods in 2017, the online marketplace attempted to change Whole Foods’ reputation of being too pricey by cutting prices across the board.  With rising costs of grocery items and pressure from many consumer-product makers, however, Amazon has chosen to raise some of their prices back up again.  “At Whole Foods, a basket of 40 select items purchased from their stores cost $191 last month, according to the Telsey Advisory Group, up more than 3% from what the same basket of goods cost last fall.”  Todd Wenning touched on the recent trend of consumer brands raising prices in his blog post The Many Ways to Mortgage a Moat.

Why People Still Don’t Buy Groceries Online (Alana Semuels, @AlanaSemuels, The Atlantic)

“Twenty-two percent of apparel sales and 30 percent of computer and electronics sales happen online today, but the same can be said for only 3 percent of grocery sales, according to a report from Deutsche Bank Securities.”  Due to the complexities and cost of delivering groceries (i.e., keeping frozen items cold, keeping chips from being crushed, keeping produce fresh), delivering groceries is a challenging proposition and one that might not make sense for many consumers.

Apple Lose Ground to Huawei as China Shipments Slump 20% (Dan Strumpf, @DanStrumpf, Wall Street Journal)

Apple continues to lose traction in China as more Chinese consumers choose Huawei over iPhones.  Huawei has continued to release high-end phones that have contributed to its increasing market share gain over Apple.  They expect to unveil a foldable 5G-ready phone in Barcelona later this month.  “Apple, now the fourth-biggest vendor in China, was the country’s top smartphone seller as recently as early 2015.”

Trump Flexible on China Tariff Deadline as He Seeks ‘Real Deal’ (Saleha Mohsin, @SalehaMohsin, Andrew Mayeda, @amayeda, Margaret Talev, @margarettalev, Bloomberg)

Negotiators from the US and China continued talks this week to come up with a plan to resolve the trade war between the two countries.  President Trump indicated that he would be willing to extend the March 1st deadline to come to an agreement if both parties were close to reaching a real deal.  ‘“If we’re close to a deal where we think we can make a real deal and it’s going to get done, I could see myself letting that slide for a little while,” Trump told reporters during a cabinet meeting Tuesday. “But generally speaking I’m not inclined” to delay raising tariffs, he added.’

Tech is Splitting the US Workforce in Two (Eduardo Porter, @portereduardo, New York Times)

Automation is splitting the world into two very distinct worlds: highly educated professionals at good companies earning a substantial income, and then less educated workers who are stuck at businesses like hotels, restaurants and nursing homes and who generate much less income.  Economists are beginning to rethink the assumption that technological progress helps raise everyone up financially.

Supercars That Will Put a Big Dent in Your Wallet but Not Drain It (Tom Voelk, @TomVoelk, New York Times)

“Modern engineering and materials have given automakers the ability to create performance vehicles with capabilities unheard-of 20 years ago. In today’s dollars, that circa-1985 Countach would start at $325,000. A car that’s infinitely more capable and better engineered can be had for half of that — obviously not inexpensive, but down from the stratosphere.”  Arif Karim recently wrote about one famous supercar manufacturer in his recent blog post Joining the Winner’s Club with Ferrari.

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.

When investors worry about a company’s eroding moat, they’re usually focused on external threats. A new competitor with a revolutionary technology or offering.

But the external threats often come after a company has mortgaged its moat.

Over the edge

Companies mortgage their moat when they press their advantage too hard and alienate stakeholders in the process. This practice can be particularly tempting for executives aiming to maximize short-term performance at the expense of long-term durability.

To illustrate, a recent Wall Street Journal article talked about how many of the big consumer packaged good brands are aggressively raising prices despite falling volumes. We think this is a dangerous strategy in product categories where there are reasonable substitutes, as it could make loyal customers shop around and try other branded and private-label offerings.

Companies with strong family ownership often take a different approach. According to Credit Suisse, public companies with meaningful family ownership, as a group, tend to outperform the market. They also tend to have more conservative balance sheets and post better fundamentals than their peers. One reason for this could be that family-owned companies care more about the firm’s legacy over generations than meeting quarterly targets.

To illustrate, we heard notes of this in Ferrari’s capital markets day in September, which we attended in person. Here’s CEO Louis Camilleri:

“Beyond the numbers, you can rest assure that the entire management team and all the men and women of the Ferrari family will work continually and incessantly with the relentless dedication and, yes, with passion to excel and delight our customers, shareholders, and racing fans.”

Cutting into muscle

Well-meaning executives can also mortgage their moat by “over-optimizing” their operations, depriving the company of oxygen needed to deliver on its long-term strategy.

Analysts herald companies that announce cost-cutting initiatives, yet we see little discussion of the non-obvious yet important impacts of those costs. A company slashing SG&A costs, for example, may be harming employee morale by reducing benefits. A company cutting back on R&D may impair its ability to compete during the next product cycle.

Conversely, companies that ramp investments and expenses to the detriment on quarterly margins often get criticized by investors. (And to be fair, sometimes for good reason.) When we believe a company has high returns on incremental invested capital, however, we want them to invest more and widen the moat.

Bottom line

Here are some ways that companies can mortgage their moat in relation to basic moat categories.

If the moat source is… …beware of
Network effect Poor user curation, alienating one side of the network
Switching costs Taking customers for granted with a lack of innovation and service, Raising prices too aggressively
Intangible assets Cutting back on investments to support brands (marketing) and new products (R&D), Raising prices too aggressively on search-cost brands.
Cost advantages Dismissive of new methods and technology, Sticking with what always worked so as to not frustrate legacy employees and systems
Efficient scale Pursuing a volume-over-price strategy

By focusing on the sources of the company’s economic moat, we hope to more quickly recognize situations in which management may be mortgaging their moat. If we do this correctly, we stand a better chance of getting out of the castle before the siege.

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Ferrari (RACE). This company 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.

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.

Weekend Reading

9 February 2019 | by Mike Navone

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

Fox executive calls rival netflix’s viewership figures misleading (Joe Flint, @JBFlint, The Wall Street Journal)

Netflix has experienced explosive growth over the past decade and there are now more Netflix subscribers in the US than traditional cable subscribers.  With that kind of growth, there’s bound to be some skeptics and 20th Century Fox executive John Landgraf is one of them.  Landgraf purports that Netflix has been releasing misleading viewership numbers to inflate the popularity of their programming.  Netflix has proven to be able to sustain growth with consistent 20%+ price increases in their monthly plans without significantly impacting their subscriber numbers.

Showcasing the power of startup women’s health brands, P&G buys Thhis is L (Jonathan Shieber, @jshieber, TechCrunch)

Few legacy consumer brands can have dominant share in their marketplace, especially for things like retail products for women’s healthcare.  As competition increases, legacy brands are deciding the solution is to acquire younger, smaller and more innovative companies.  That’s what happened with P&G and their $100M acquisition of This is L, a startup retailer of period products and prophylactics.  Jonathan Shieber talks about the financial outcome and the deal’s implications for mission-driven companies.

UK new car sales fall as electric and hybrid cars surge in popularity (Alyana Vera, City A.M.)

Sales for diesel engine cars dropped in the UK last year while the demand for electric and hybrid plug in cars surged.  Electric cars continue to gain popularity despite the UK government slashing subsidies for the electric cars.  The outcome of this increased demand could be a win for both the environment as well as the manufacturers.  Ensemble President and Chief Investment Officer, Sean Stannard-Stockton gave a presentation about auto sensor producing giant Sensata in his Sensata Technologies Presentation which includes a discussion of the company’s sensors for electric vehicles.

JPMorgan says 2020 ‘might not be year to think about recession’ (Joanna Ossinger, @ossingerj, Bloomberg News)

The fourth quarter of 2018 had many investors worried that the US economy was on the brink of a recession but following the recovery in the market so far this year, some might say those thoughts are long gone.  JP Morgan analysts noted the recent change in tone from the Federal Reserve and stated “That means investors shouldn’t be driven by fears of recession now.”  In this article, Ossiger discusses cyclical indicators and global economic growth and how these are related to recession risk.  Ensemble President and Chief Investment Officer, Sean Stannard-Stockton wrote about his thoughts on a recession in a recent article We Might Not Have A Recession…For A Long Time

 

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.

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

The Futility of Market Timing (Albert Bridge Capital)

Albert Bridge Capital walks through the math of market timing to show that even if you are a genius at it, the pay-off is not that great over the long-term.  But the consequences of getting it wrong can be big.  Buying at the low of the market or the high of the market in a given year has very little impact on your rate of return over the following 30 years.  While Ensemble doesn’t try to time the market, we do try to be thoughtful about the economy and what that means for the companies we own in client portfolios.  Sean Stannard-Stockton recently wrote about why we might not have a recession for a long time.

American Railways Chug Towards Automation (Rhiannon Hoyle, @RhiannonHoyle, The Wall Street Journal)

Mining giant Rio Tinto has been working for the last ten years on a driverless train system called AutoHaul.  Rio Tinto is hoping to increase both efficiency and safety in the 200 locomotives they currently manage.  Rail-freight companies are known for providing high paying jobs with an average annual salary of $125,000 and around 5 million tons of goods are moved each day on the US network, generating over $70Bn in revenue annually.  This article explores some advantages of autonomous trains like eliminating inconsistent wear and tear by human operators as well as optimizing fuel consumption.

What Made the TV Show ‘You’ a Hit? Netflix (John Koblin, @koblin, The New York Times)

A television series by the name of ‘You’ began airing on Lifetime in September of 2018 with little success followed by a no-go for a season 2.  It wasn’t until the show debuted on video streaming service Netflix that it started really gaining traction.  ‘You’ is now on track to be watched by 40 million households within its first 4 weeks of streaming on Netflix and the show will begin filming their second season this February.  Ensemble Analyst Arif Karim, CFA wrote about Netflix and their pricing power here.

Silicon Valley’s Unbridled Optimism Gets Fresh Reality Check (Rob Copeland, @realrobcopeland, The Wall Street Journal)

Silicon Valley and environments at start-up companies are often glamorized with ideas of lavish offices and healthy salaries once a venture capital firm comes in but what if the days of optimism are coming to an end?  US Venture capital deals dropped to 882 in the fourth quarter of 2018, down from more than 1,500 three years earlier.  The attitude among technology investors is shifting, said venture capitalist Josh Wolfe of Lux Capital, “swapping ’fear of missing out’ for ’shame of being suckered.’ ”  It can be extremely challenging to identify a company to invest in sometimes within, but especially out of your core competence.  Ensemble analyst Todd Wenning, CFA wrote about core competence in his article Making Sense of Understanding.

Sneakers? Check. Mascara? Check. Makeup is the New Workout Gear (Anne Marie Chaker, @annemariechalker, The Wall Street Journal)

Makeup and a strenuous gym workout don’t sound complimentary at first blush, but that’s not what CoverGirl and other cosmetic giants are saying.  As apparel companies have successfully demonstrated that workout clothing can be worn both at the gym as well as fashion wear, makeup companies are taking cues for their next move.  Beauty brands like CoverGirl, Estee Lauder and popular drugstore brand Wet n Wild have all debuted makeup lines designed to be sweat proof, humidity proof, and wearable for 24 hours and they try to go after this untapped segment of the market.

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.

Back in August, we wrote about how the New Normal economy, featuring low growth, that had persisted for a decade might be coming to an end. We featured a chart in that post highlighting how US economic growth during the first half of 2018 had accelerated to the highest rate since prior to the financial crisis. The chart below is a long term version of that data, which shows year over year nominal GDP growth over the past 30 years.

The green zone shows the 4%-6% average economic growth that existed prior to the financial crisis. The red box shows the 3%-5% average economic growth that has occurred since the financial crisis. The red zone captures the period of time that is characterized as the New Normal (the background on this concept is captured in our prior post on this subject).

Economic expansions don’t die of old age. They die because growth reaches unsustainably strong levels, businesses and consumers over spend and over invest thinking the high growth rate will last forever, and when growth invariably slows, over spent, over invested, over indebted businesses and consumers cut back sharply causing a recession.

If the New Normal is the new sustainable economic growth range, then the strong recent growth may be unsustainable and thus a recession may occur soon. This is why recent recession fears, despite not yet being supported by much in the way of data, are valid.

But if the Old Normal is returning, then the current rate of growth is still within the sustainable range and we’re likely some time off from a recession. In fact, we may even need to grow above the top of the Old Normal range for a number of years in order to back fill the years of sub-normal growth we experienced during the New Normal period. That output gap is substantial and can be seen in this chart.

If this optimistic outlook is correct, the next recession may be many years away. But investors need to always ask “why” a trend is behaving the way it is. If the New Normal represented a temporary trend, why did it happen and why would it be fading?

As we discussed in our first post on this subject, research shows that almost all financial crises in history have been followed by sustained periods of sub-normal growth. This is mainly because there is so much debt to work off that rather than paying down debt during the recession and being able to lever back up during the recovery, after financial crises, consumers and businesses are stuck paying down debt loads for a long time. Research shows that on average, about 10 years after a financial crisis, the old growth trends reemerge and in fact it has now been 10 years since the US and Global financial crisis.

One way we can see the repairs made to the US economic engine is by observing employment trends. The jobs report released this morning was very strong and represented the 100th month of consecutive jobs gains. But under the surface, something even more interesting is happening. People who have been out of the workforce entirely for the last decade are returning. Known as the “participation rate”, in recent years the percentage of people who wanted to work has been abnormally low. Some of that is due to aging demographics, some of it has to do with cultural changes, some of it might even have to do with the methamphetamine epidemic or the popularity of immersive video games. But part of it might be that the economy was so weak that some people decided it wasn’t even worth looking for a job.

Over the last couple of months the unemployment rate has been going up, even as the economy added more jobs. This is because the participation rate has been moving higher at a faster rate than jobs gains. More people are entering the workforce which increases the denominator in the unemployment rate calculation (the unemployment rate is the percentage of people who don’t have a job who want a job and are actively looking).

The chart below shows the participation rate for “prime age” Americans. What we see is that during the Old Normal period, the participation rate ran at a structurally higher level but declined and stayed low during the New Normal recovery.

Similar to the GDP growth chart above, we’ve put a green box around the Old Normal range and a red box about the New Normal range. As of today, the participation rate for women has shot back up into the Old Normal range and the participation rate for men is making a significant recovery. For economic growth to continue at the current 5% or so rate without causing inflation or triggering a recession, we need to see more people participating in the labor force.

As you can see, female participation has only just recovered to average Old Normal levels while male participation rate would have significant improvement still to come if indeed we’re headed back to the Old Normal. In thinking about “why” the New Normal may not be “normal” at all and instead have been a temporary (although painful persistent) result of the financial crisis, the behavior of the participation rate may be one of the best explanations. If that’s correct, then in the years ahead tracking this metric will be just as important as tracking the number of new jobs added each month. New jobs represent more people adding to economic growth, while the participation rate helps measure the amount of “gas” is being added to the economic “tank”.

At Ensemble Capital, we don’t spend much time trying to predict short term economic activity. We think there is little evidence that anyone can do this well, so we spend our time on more productive activity. But we do spend a lot of time thinking about what are the right long term economic trends that we should expect our portfolio holdings to be operating within. It isn’t so important to try to guess what rate the economy will be growing at next quarter, but it matters a lot if GDP growth averages 4% or 5% over the next couple of decades. Just check out the size of the output gap in the chart above from just 10 years of lower growth.

The fact is no one knows if the future will be more like the Old Normal or more like the New Normal. Mohamed El-Erian, the economist who coined the phrase New Normal, said back in August that he believes the US economy has exited the New Normal and is reentering the Old Normal paradigm of higher growth. But just like us, El-Erian doesn’t know for sure.

But while the future is difficult to predict, the behavior of the economy over the next year or two is going to likely “settle” the Old Normal vs New Normal debate, at least temporarily. If a recession occurs, it will be difficult to argue that for some reason the Old Normal is going to return over the long term. But if a recession does not occur, economic growth persists in the Old Normal 4%-6% range where it is currently running, and the participation rate keeps increasing, it will become increasingly difficult to argue that for some reason the economy has to slow back down because it will become apparent that this 4%-6% growth rate is not an “overheating” economy at all but instead is just normal.

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.