Do not go gentle into that good night. Rage, rage against the dying of the light. – Dylan Thomas

What do we say to the god of death? Not today. – Game of Thrones

Financial theory tells us that eventually a company’s returns on invested capital (ROIC) will decay toward its weighted average cost of capital (WACC), or discount rate:

Of course, “eventually” can be tomorrow or in 30-plus years.

The difference between days and decades in a company’s competitive advantage period is massive, yet is often overlooked, as Michael Mauboussin and Dan Callahan note:

Despite the unquestionable significance of the longevity dimension (of sustainable value creation), researchers and investors give it insufficient attention.

Why does longevity get ignored? According to New York University Professor Aswath Damodaran, almost 85% of equity research reports are based on some relative valuation metric. In other words, most investors are laser-focused on what might happen over the next few quarters or years. What happens to a company in year five and beyond is of little concern to renters of stocks.

But even if you take a long-term ownership perspective like we do, it’s easy to be dismissive of competitive advantage longevity.

Let’s say you’re building a five-year discounted cash flow model to estimate a company’s fair value, your terminal value (i.e. which assumes the company operates in a defined state in perpetuity) accounts for between 70-75% of your fair value estimate. A huge swing factor.

It’s rational to assume that the good times won’t last forever. As such, prudent analysts will assume some amount of ROIC decay in their terminal assumptions. But, again, the billion-dollar question is, “How long will it take for ROIC to decay to WACC?”

Assume the decay is too rapid and you’re undervaluing the business; assume it’s too slow and you’re overvaluing the business.

One thing we’ve noticed is that, while companies with top-quintile ROICs tend to fade toward WACC like any other cohort, they often stabilize at a rate still above WACC. Put another way, while it’s unlikely for a 50% ROIC company to sustain that level for decades, there’s a good chance it will still produce ROICs above WACC (say, in the 20% range) for an extended period. Assuming, of course, the company’s moat remains intact.

Source: McKinsey

As investors, our job is to compare our outlook with what is already baked into the market price. For example, if you think a company can generate 20% ROICs for two decades, but we conclude the market price already assumes these results, there’s no opportunity for alpha.

But because so many investors are ignoring ROIC longevity, we believe that, on average, market prices expect fade to happen relatively abruptly. To be fair, the market is right to be skeptical of extended competitive advantage periods. It’s the exception rather than the rule for companies to build moats in the first place, let alone successfully defend them for decades.

Those companies that can defend their moats, however, extend their competitive advantage period and require the market to continuously revise estimates higher. Somehow, these ROIC machines cheat natural decay and increase the company’s intrinsic value year after year.

Consider this chart for Fastenal, which stretches back to 1991 and compares its ROIC (shaded) with its stock price (white line). I’ve inserted a red line at 10% to approximate WACC over this period.

Source: Bloomberg as of May 5, 2019

An investor in 1991 might have prudently forecasted 10 years of cash flows and ROICs, with a terminal ROIC approximating WACC. Eventually, someone will compete away Fastenal’s advantages. Right?

Yet, as we see in the above chart, Fastenal’s ROIC held above 15% since 2001. In fact, it’s approaching all-time records set in the mid-1990s.

So, while the market kept expecting Fastenal’s ROIC to fade toward WACC, it never happened. Consequently, the market had to frequently revise expectations higher, which is reflected in the steadily rising share price (white line).

For some additional examples, here’s 3M:

Source: Bloomberg as of May 5, 2019

Paychex:

Source: Bloomberg as of May 5, 2019

And here’s Home Depot, which despite sharp ROIC decay during the housing crisis, is now producing ROICs well in excess of pre-crisis highs. About as many people expected that outcome as expected Lazarus to rise from the dead. Consequently, the stock price has concurrently and justifiably soared.

Source: Bloomberg as of May 5, 2019

Of course, it’s easy to identify ROIC machines with hindsight. Over the past 30 years, each of these companies has faced controversy, fierce competition, and macroeconomic headwinds. At many points along the way, investors could have talked themselves out of their position – and perhaps quite reasonably.

So, how might we identify a future ROIC machine and have the confidence to hold tight in periods of uncertainty?

First and foremost, we need to find companies with economic moats that can be defended and ideally widened over the next decade. This is no small task, of course. Once we’ve invested, we regularly evaluate the moat to see if it’s widening or narrowing.

Second, we want companies run by engaged management who understand the firm’s advantages and reinvest to strengthen those advantages. Incentives matter, for sure. But beyond that, we want to see thoughtful capital allocation and an intelligent use of debt. Owner-operators are particularly appealing.

Third, we seek companies we consider intrinsically understandable and forecastable. If we can’t fully appreciate the company’s opportunities and risks or we aren’t comfortable forecasting its financials, there’s no way we’ll hold on when times get tough.

Fourth, we seek companies with vibrant corporate cultures that are flexible and like a good challenge, for they will certainly come if the company’s successful. Costco’s ability to survive and thrive in a changing retail landscape is testament to its corporate culture.

Finally, we prefer companies who are value accretive to all stakeholders – not just shareholders. By this, we mean they also positively impact suppliers, customers, employees, and the communities in which they reside. As Professor Vicki TenHaken writes in her book Lessons From Century Club Companies: Managing for Long-Term Success: “Close-knit, mutually-supportive relationships heighten the company’s ability to weather challenges as well as to learn and adapt over time.” In other words, improve longevity.

Here’s Fastenal CEO Dan Florness on this topic: “There’s customers, there’s employees, there’s suppliers, and there’s shareholders. It has to work for all four for our business to be successful short-term and long-term.”

It’s a tall order, but if we can accurately check off these five criteria and pay a good price, we think we stand a good chance at finding and benefiting from the next ROIC machine.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Fastenal (FAST) and Paychex (PAYX). 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

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.

In late April, I wrote another article for British investing publication, Investors Chronicle. This time around, I focused on what we call idiosyncratic companies – businesses that don’t compare well to others and are hard to categorize.

We love these sort of companies because they are often misunderstood and/or misvalued by the market. While we at Ensemble value companies based on expected cash flows, growth, and returns on invested capital, many other market participants rely on rules of thumb or relative valuation to “price” companies. These shorthand approaches have their place, but are less useful when a company has a differentiated business model.

In the article, I highlight two of our current holdings that we consider to be idiosyncratic: Ferrari and First Republic. We believe both of these companies are sector hybrids of sorts – Ferrari is part consumer luxury and part automotive company; First Republic is part high-end consumer services and part bank.

Please enjoy the article and, as always, feel free to CONTACT US with questions and comments.

CLICK HERE FOR THE ARTICLE, “BREAKING THE MOULD”

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

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

4 May 2019 | by Mike Navone

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

How Schwab Ate Wall Street (Lisa Beilfuss, @LisaBeilfull, The Wall Street Journal)

As the finance industry continues to evolve, keeping a competitive edge with your business can prove to be quite a challenge. The phrase “Talk to Chuck” might come to mind when thinking about a finance company that has experienced considerable growth since it went public in 1987.  Charles Schwab has increased their suite of services available for consumers and has followed a formula of keeping prices low which has led them to become a globally recognized financial institution.  This article looks into the history of the company and the practices Charles Schwab has used to keep their competitive advantage in an increasingly challenging space.

Changing San Francisco is Foreseen as a Wealthy Haven for Wealthy and Childless (Wayne King, The New York Times)

It’s no secret that for the last decade the San Francisco real estate market has been booming and as wage growth struggles to keep up with the cost of housing, many SF residents can be left feeling squeezed out.  History seems to be repeating itself, so much so that The New York Times republished an article on this very topic from 1981.  The article goes on to discuss the demographics and how many of the residents live “nontraditional” lifestyles.  The various contributors to the increases in the cost of housing in San Francisco in the early 1980’s strike strong similarities to those forces that are driving up prices today.

Recessions vs. Bear Markets (Ben Carlson, @awealthofcs, A Wealth of Common Sense)

The stock market continues its upward trajectory for 2019 and for many investors, a strong market can give pause or concern about an upcoming pullback or even a recession.  Ben Carlson explores his thought process on this and how the overall stock market and the economy shouldn’t be thought of as one, but rather two separate entities.  “…frankly, the economy is not a market. It’s a collection of goods and services produced within a specific period of time and it’s much harder to measure than the stock market.”

Netflix Isn’t Being Reckless, It’s Just Playing a Game No One Else Dares (Netflix Misunderstandings, Pt. 3) (Matthew Ball, @MediaREDEF, Redef)

An “On-demand” mentality is something that has been becoming more normal in everyday life from ordering your laundry pickup from your smartphone to having your groceries delivered. Watching TV is no exception to this and Netflix has shown dominance in the space.  Netflix has been able to repeatedly increase pricing without losing a material amount of subscribers as they continue to invest billions in producing new content around the globe. Ensemble Capital’s President and Chief Investment Officer, Sean Stannard-Stockton was featured on CNBC discussing his thoughts on Netflix 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.

Following up on a 2017 interview with Sean, The Motley Fool sat down for a second interview to get into more detail about his investing philosophy and how Ensemble approaches the market.

Included in this conversation are Ensemble’s thoughts on a number of holdings, including Ferrari, MasterCard, and Broadridge, and why we avoid owning “low growth” companies.

You can read the full interview transcript here.

 

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares Ferrari (RACE), MasterCard (MA), and Broadridge (BR). 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.

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.

Last week, Ensemble Capital’s CIO Sean Stannard-Stockton appeared on CNBC with his take on Netflix’s latest earnings report. During the interview, Sean also explained why we think Disney’s upcoming streaming service won’t be a significant competitor to Netflix despite likely being a big success for Disney.

 

Netflix had a ‘perfectly good’ quarter, investor says from CNBC.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares Netflix (NFLX). This company represents 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.