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, the team will discuss Blackline and Costco in more depth.

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 10 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!

“Could a greater miracle take place than for us to look through each other’s eyes for an instant?” -Henry David Thoreau

The design firm IDEO is one of the most influential companies that most people have never heard of. The mouse that you may be using to control your computer as you read this article? Invented by IDEO. But their influence goes far beyond the physical items they have designed. Instead, the company pioneered the idea of design thinking, or the practice of using concepts drawn from the field of design during the earliest stages of idea generation.

Here’s how IDEO CEO Tim Brown explained this concept in his seminal 2008 Harvard Business Review article titled Design Thinking:

“Historically, design has been treated as a downstream step in the development process—the point where designers, who have played no earlier role in the substantive work of innovation, come along and put a beautiful wrapper around the idea… Now, however, companies are asking them to create ideas that better meet consumers’ needs and desires. The former role is tactical, and results in limited value creation; the latter is strategic and leads to dramatic new forms of value.”

One simple example of the application of design thinking is found in the Keep the Change program that IDEO designed for Bank of America. The program automatically rounds-up purchases made on debit cards to the nearest dollar and transfers the extra cents to the customer’s savings account. In the first decade after launch, 12 million customers signed up for the program and set aside $2 billion in extra savings, with 99% of people who signed up for the program remaining enrolled. IDEO didn’t just design a physical debit card inspired by Bank of America, rather they designed the program concept from inception using the principals of design thinking.

In his HBR article introducing design thinking, Brown argued that design thinkers exhibit five core attributes:

  • Empathy: They imagine the world from multiple perspectives – those of colleagues, clients, end users, and both current and prospective customers.
  • Integrative Thinking: They do not rely solely on analytical processes, but seek out all salient, and sometimes contradictory, aspects of a problem.
  • Optimism: They assume that no matter how intractable a given problem is, there is at least one potential solution that is better than the existing alternative.
  • Experimentalism: They recognize that innovation doesn’t come from small tweaks, so they pose questions and explore constraints in ways that proceed in entirely new directions.
  • Collaboration: The idea of the lone genius is mostly a myth. In reality, it is enthusiastic interdisciplinary collaboration that drives the creative process. IDEO believes in this so deeply, that they actively seek to hire what they call T-Shaped People, who exhibit the ability to combine deep domain expertise, with passionate interest in learnings from a wide range of other disciplines.

At Ensemble Capital, we believe that these design thinker attributes are also often exhibited by outstanding long-term investors and business operators. The stereotypical hedge fund manager imagined by the general public might be a ruthless barbarian seeking to squeeze money out of other investors. But in reality, successful, long-term investors like Warren Buffett are often characterized by their flexible and integrative thinking, willingness to experiment and adapt, and openness to collaboration. And while maintaining a degree of healthy skepticism is important, in the final analysis great long-term investors are almost always optimists.

But what about empathy? Empathy isn’t a concept discussed much in investment management. But we believe that empathy is one of the most important traits for generalist investors like ourselves to cultivate. The fact is, when you manage a portfolio of companies across a range of industries, there is no way that you can rely on your own firsthand experiences to make judgements. Instead, you must cultivate the ability to seek to truly understand each of the stakeholders connected to a company and see the world through their eyes, not just your own.

Peter Lynch famously advised an investor to “buy what you know.” His point was that investors have an advantage when they invest in companies of which they themselves are customers. When you are a customer of a company yourself, you have a natural ability to understand the company from the customer’s perspective. Yet while this is helpful, the best investors need to cultivate an empathetic understanding of a company’s core target customers, not just the investor’s own personal feelings as a customer.

One example of a time I mistakenly substituted my personal feelings as a customer for an empathetic understanding of a company’s core target customers, was when I decided to sell most of Ensemble’s holdings in Costco in 2012. It wasn’t until 2020 that I came to fully understand why my decision had been so wrongheaded and we bought the stock back.

In 2012, I myself was a Costco member. I was married with two kids and lived in a suburban house with ample storage space to hold large size products purchased at Costco. But I had also been an Amazon Prime member since the inception of the program. Instacart launched in 2012 with Google Express (an early delivery service similar to Instacart) launching in 2013. I lived in the heart of the San Francisco Bay Area, and I was watching all of my retail shopping rapidly shift online. None of this was particularly new for me. I had started shopping on Amazon in 1999 during the Dot Com boom and used Peapod for online grocery delivery, and Kosmo.com for same-day delivery of small, local items.

Costco’s online offering was (and is) notably inferior to the new online shopping options that were springing up all around me. Why would I want to go spend a Saturday afternoon in a huge Costco warehouse hunting for bargains when I could spend a fraction of the time sitting at home on my laptop ordering from a range of stores, and having it all delivered to my home?

The situation seemed obvious to me. Costco was failing to make the transition to online shopping and customers were going to start canceling their memberships (as I did) at an accelerating rate. Who would want to go to Costco to shop in a world of ubiquitous, cheap delivery services?

A whole lot of people it turns out! Here’s a chart of Costco’s membership levels over time.

Not only did Costco’s membership growth not slow down as I expected, but notice how in 2020 and 2021, the period of fastest ever eCommerce growth, Costco’s membership growth accelerated!

While I recognized I had made a mistake as I watched membership continue to grow, I didn’t understand why my analysis had been wrong. The shift to online shopping did play out as I expected, but somehow the shift did not seem to impact Costco’s customer behavior despite the company refusing to build a high-quality eCommerce offering.

[…]

Emerging Manager Monthly covers asset management industry trends and profiles so called “emerging managers” or boutique investment firms. In this month’s issue, the publication profiles Ensemble Capital and discusses such topics as:

  • Ensemble’s contention that the concept of a “technology stock” no longer makes sense in a world where almost all well run companies are aggressively leveraging technology.
  • Their long-term track record of investing in competitively advantaged businesses.
  • The way in which Ensemble embraced remote work three years prior to COVID, and why they think investment firms that insist on their entire team returning to fulltime in-office work are going to find themselves at a deep competitive disadvantage when trying to attract top talent.

From the article:

“I think there are CIOs out there who have been doing this for a long time that are going to say, we want everyone back in the office. What they’re really saying is they themselves are not prepared to operate in a digital world – which is understandable, it’s hard – but this is a challenge that’s going to have to be surmounted because I don’t think you’re going to be able to hire equity analysts and say “I need you to commute for an hour and sit in this desk next to me be­cause I don’t know how to instant message.”

You can read the full article here.

Lawrence Cunningham is a professor and director of the Quality Shareholders Initiative at George Washington University, a long time collaborator of Warren Buffett in publishing The Essays of Warren Buffett for the last 27 years, and a director of Constellation Software. His most recent research looks at the behaviors of a group of investors he calls “quality shareholders” and he includes Ensemble Capital in this group.

Professor Cunningham’s concept of “quality shareholders” is well described in his book of the same name:

“Anyone can buy stock in a public company, but not all shareholders are equally committed to a company’s long-term success. In an increasingly fragmented financial world, shareholders’ attitudes toward the companies in which they invest vary widely, from time horizon to conviction. Faced with indexers, short-term traders, and activists, it is more important than ever for businesses to ensure that their shareholders are dedicated to their missions. Today’s companies need “quality shareholders,” as Warren Buffett called those who “load up and stick around,” or buy large stakes and hold for long periods.

Lawrence A. Cunningham offers an expert guide to the benefits of attracting and keeping quality shareholders. He demonstrates that a high density of dedicated long-term shareholders results in numerous comparative and competitive advantages for companies and their managers, including a longer runway to execute business strategy and a loyal cohort against adversity. Cunningham explores dozens of corporate practices and policies―such as rational capital allocation, long-term performance metrics, and a shareholder orientation―that can help shape the shareholder base and bring in committed owners. Focusing on the benefits for corporations and their investors, he reveals what draws quality shareholders to certain companies and what it means to have them in an investor base. This book is vital reading for investors, executives, and directors seeking to understand and attract the kind of shareholders that their companies need.”

Ensemble Capital was pleased to have been included in the group of investors that professor Cunningham listed as “quality shareholders” in his most recent research on this topic.

You can download a copy of the paper here.

“When you come to a fork in the road, take it.” – Yogi Berra

Despite the joy Nintendo the company generated for its customers over the last four decades, Nintendo the stock has historically been treacherous for patient investors and a boon for tactical traders.

As this long-term price chart shows, the ideal strategy with Nintendo’s stock has been to buy when Nintendo’s consoles are out of favor and sell at the peak of a hit console cycle, which is typically in the console’s fourth or fifth year.

Bloomberg, as of December 7, 2021

With Nintendo’s latest hit console, the Nintendo Switch, into its sixth year, the question is, “Will history repeat itself?”

We believe that things really are different this time around. As Nintendo of America CEO Doug Bowser put it during a recent podcast, Nintendo is aiming with the Switch to redefine “the lifecycle and vitality of video game consoles.” Further, in November, Nintendo management said that with help from the upgraded Switch OLED model, “we aim for a sixth year of growth, something never before experienced with our dedicated video game platform business.”

Despite these comments from management emphasizing that this Switch cycle is different, we think the current market price and consensus estimates incorrectly reflect a return to past console cycle patterns.

Here are four reasons why, beyond management commentary, we disagree with the consensus outlook.

  1. COVID noise. Nintendo Switch was gaining momentum going into the pandemic, and global stay-at-home advisories pulled demand forward in 2020. While this was a net positive for Nintendo as it brought more people onto the Switch platform and encouraged more third-party developers to create or port games for Switch, it also meant that Switch hardware sales this year would have a difficult comparison period.

 

In fact, Nintendo’s stock price decline began in early July 2021 after it announced the new Switch hardware would be an “upgrade” (Switch OLED) rather than a next-generation console, dubbed Switch “Pro” by Nintendo watchers. The implication, skeptics argue, is that potential Switch buyers will just wait for the next console generation and current users would continue to play their existing hardware.

Nintendo’s share price has languished in recent months on these concerns, particularly since management reduced its full-year hardware sales guidance due to chip shortages and broader supply chain issues.

Historically, all these factors would be good signs that it’s time to bail on Nintendo’s stock. The year-over-year growth in hardware sales will be lower and the “peak” has been eclipsed, the logic would say. Consensus estimates, as shown in the red bars below, suggest that sell-side analysts think there’s further Switch erosion from this point forward. These estimates reflect a continuation of standard console cycle dynamics, which we disagree with.

Source: Canalyst, Visible Alpha, and Ensemble Capital. Red bars = consensus forecast.

It’s worth noting, however, that despite the projected year-over-year decline against a difficult 2020 comparison, Switch momentum is still positive relative to pre-COVID demand. As the above chart shows, Switch hardware sales in the current fiscal year – based on management guidance, consensus, and our own estimates – will likely be higher compared to fiscal year ended March 2020.

If Switch were indeed losing steam, we wouldn’t likely see Switch OLED units continually sold-out and gobbled up as soon as some inventory hits the market. As of this writing on November 23, the lowest secondary market price for OLED on Walmart’s website is $481.99 – a nearly 40% premium to the retail price. On GameStop’s website, the original Switch is still retailing for $299.99 with pre-owned and refurbished versions selling with only a $20 discount to the new price. In fact, the new and refurbished versions are currently sold out completely at GameStop.

In short, if Nintendo had adequate supply, it could sell a lot more consoles this year.

This generation of Switch will eventually phase out, but we think new Switch generations will layer on top and eventually replace demand for the current generation.

  1. Connection to fans. As of September, Nintendo gathered over 250 million Nintendo Accounts across 164 countries. At minimum, this means Nintendo now has over 250 million emails from which it can directly communicate with its fans and keep track of how they engage with the Nintendo IP. As Nintendo unveils theme parks, flagship stores, and other events, these direct relationships will better personalize the experience for the Nintendo fan. This invaluable source of connection, data, and analytics was not available prior to 2015.

Source: Nintendo

On top of the Nintendo Accounts, which includes mobile-only users, those with Switch consoles can also pay for a Nintendo Switch Online (NSO) account. As of September 2021, there were over 32 million Switch Online members against over 90 million Switch hardware units sold to date. We think penetration could increase even further as Nintendo adds more value to the membership over time.

Source: Nintendo

Plans for NSO start at $19.99 per year and the basic plans include save cloud data, access to legacy NES and SNES games, and online play. In October, Nintendo released the NSO Expansion Pack which adds access to legacy Nintendo 64 and Sega Genesis games and Animal Crossing content.

In previous console generations, Nintendo would have to win back its customers whenever it launched a new platform, as would every other console maker. There was no carry-over of player data from one generation to the next. There was some backward integration in more recent Nintendo consoles, where players could play games from previous consoles on the current console, but it was limited. Switch Online changes that dynamic.

Not only can Switch owners play legacy Nintendo system games through NSO, but NSO’s cloud save data will allow you to maintain your game progress in future console generations. Put differently, your playing data will stay with you wherever you go in the Nintendo ecosystem. It’s already being implemented. If, for example, you stop playing Animal Crossing: New Horizons for four months, when you come back to play, the characters on your island will say they haven’t seen you in four months.

While it’s debatable what form the next Switch console generation will take, Nintendo has signaled through direct-to-customer relationships, opening the legacy game library, and cloud storage that there’s an intention to provide a more continuous and immersive Nintendo experience.

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