Weekend Reading

12 January 2019 | by Mike Navone

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

China’s Car Sales Just Fell For The First Time In 20 Years (Charlie Zhu, @CharlieZhu, Bloomberg)

As China has continued on the path to urbanization and industrialization, we’ve seen significant increases in new infrastructure spending leading to more highways throughout the country which means additional auto manufacturing.  So much so that they have been the world’s leader in auto sales, until recently where sales fell 6%.  A slowing China economy and concerns fueled by a potential trade war has the Chinese auto buyers looking at caution ahead.  The contraction in sales is one of the clearest signs that the Chinese economy is struggling. However per capita car ownership in China is still less than half the level in developed economies so it is very likely that growth in car sales will return to solid levels over time.

You Know Your Diamond’s Cut and Carat.  But Does It Have Ethical Origins? (Tiffany Hsu, @tiffkhsu, The New York Times)

We often know the origin of the items we buy such as the farm where our cheese came from or the appellation of the wine but what about the origin of diamonds?  With the introduction of synthetic diamonds and millennials waiting longer to tie the knot, the jewelry industry is having to adapt to stay competitive.  Tiffany & Co. is looking to gain interest by offering piece of mind that their consumers aren’t buying a “blood diamond” and they will begin telling their customers the diamond’s country or origin and eventually the specific mine that it came from.  Ensemble’s President and CIO, Sean Stannard-Stockton wrote about the millennial generation in this article: Talking About The Millennial Generation

iPhone XR Revisited: The Best iPhone Apple Can’t Sell (Joanna Stern, @joannastern, The Wall Street Journal)

Does the old adage of what comes up must come down hold true for Apple?  After their historic $1Tn valuation and reports of decreasing sales on their latest phones, the stock has been trending lower in recent months.  One theory for the pullback in the stock is that their phones have gotten so reliable that consumers are holding onto them longer before deciding to upgrade.  Another contributor that has been discussed is slowing growth out of the China market.  The Wall Street Journal quoted Arif Karim, senior analyst at Ensemble Capital for his thoughts in this article: Apple Shares Sink After iPhone Suppliers Lower Outlooks

SoftBank Scraps $16 Billion Plan to Buy Most of WeWork (Eliot Brown, @eliotwb, The Wall Street Journal)

Rents for office space have been on the rise for several years and WeWork has been offering shared office spaces for either short or long-term periods at attractive pricing.  The Japanese company SoftBank was so confident in WeWork that they were planning on a $16Bn investment in the company.  Following the recent market turbulence and opposition from some investment partners, this planned investment has gone down to $2Bn.  Eliot Brown discusses the hurdles seen here throughout this article.

Starbucks CEO Kevin Johnson Reigns In Predecessor’s Ambitions: I’m Not Howard (Julie Jargon, @juliejargon, The Wall Street Journal)

In an increasingly crowed coffee marketplace, Starbucks CEO Kevin Johnson has a different vision for growth than his predecessor Howard Schultz.  Schultz had plans to open 1,000+ of the high end Starbucks Reserve cafes which offer more expensive coffees and a full bar but Johnson is scaling that number back and is focusing on developing more innovative beverages while increasing their market share in China.

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.

Source: Ferrari

We were fortunate to be invited to an important customer event Ferrari held last September at its headquarters in Maranello, Italy, at which the company premiered the first in its new line of limited edition “Icona” cars, the Monza SP1 and SP2. As one would have expected, not only were Ferrari’s marketing chops on full display at the spectacle but the customer enthusiasm was very palpable.

Apple’s customers used to generate headlines for the enthusiasm they showed for new product launches worldwide, regularly camping outside of their stores in order to get the privilege of being the first to hand over their thousand dollars to be the first to get their hands on the new products. Here, some of the world’s wealthiest and most passionate Ferrari aficionados took their very valuable time to fly halfway around the world to participate in one of the most exclusive events anywhere. Ferrari’s best customers were invited to preview the new Monza… presumably to have the early opportunity to sign on the dotted line so they may be among the privileged to hand over $1MM to own one.

 

 

While most special series limited production models that Ferrari makes have been performance-led, the limited run “Icona” line of cars will be design-led cars, incorporating and pushing forward the styling cues from some of Ferrari’s most iconic cars of the past coupled with latest technology performance developed for Ferrari’s higher end sports cars (in the Monza’s case thought to be borrowing the 812 Superfast’s powertrain). As the first in the line, the Monza SP1 and SP2 take their design cues from the classic Monza race cars of the 1950s.

Source: Ensemble Capital Management

The Icona line of limited cars is Ferrari’s new “pillar” that joins its existing product families which also include sports cars, GT cars, special series cars, and its flagship hypercars.

Source: Ferrari

While the exclusive special series cars have traditionally been included among the intermittently released hypercars and special series cars, the Icona models will be released more regularly but each in limited quantities. With the debut of the Monza, Ferrari chose to limit total volume to “less than 500” units, which we found out only a few days later had all been spoken for by clients who had been given the opportunity to attend the premier, probably before having learned of the final pricing on the car a few weeks later. This is very typical of Ferrari’s exclusive model launches, they are typically sold out before the rest of the world learns of their existence. Though we were fortunate to be among those who attended, we did not have the fortune to get our hands on one… (couldn’t resist!).

Despite not coming home with one, I was fortunate enough to get my first Ferrari experience in one of my favorite models, the 458 Italia Spider, for a spin around the hills of Maranello (I had to get suited up first, of course!).

Source: Ensemble Capital Management

While driving a Ferrari is a fantastic visceral experience, talking with customers is even more powerful in understanding the power of the brand and experience in being part of the Ferrari “club”.

I had a chance to speak with some of Ferrari’s customers in attendance. An illustrative conversation with one customer makes clear the value proposition and customer enthusiasm that we believe is typical for Ferrari. He was a gentleman who had flown in that day for the evening event and was likely an executive at a company (didn’t pry too much into his background). I’ve met hundreds if not thousands of executives in the course of my career and they typically are very serious, grounded, busy people who make decisions on a regular basis that impact many, many people whose jobs depend on them with lots of customer, vendor, and investor relationships to manage. That’s a typical high tier Ferrari customer.

Now picture that same guy literally giddy with excitement, waiting in line for a chance to awkwardly contort himself into a Monza SP1 like a kid at Disneyland.

Our passions drive us, and when it comes to Ferrari’s customers, no matter their wealth, status, or age, that passion was on full display and being shared and enjoyed. When I asked him if he was thinking of getting one, he enthusiastically responded, “I’ve already signed up for one!” My guess is that he didn’t even know at that point whether the car was going to cost him $850K or $1.5MM… and it didn’t matter because he’s wealthy enough that the difference didn’t matter too much for the exclusive privilege of owning one but also knowing it will be worth more than whatever he pays the minute he gets delivery of the car because it’s a limited edition Ferrari. A Ferrari is a blend of conspicuous consumption and prudent investment and personal passion.

For many of these customers attending the event, Ferrari had arranged for them an exclusive track event the next day in Barcelona, where they would get to race around the track in their own Ferraris stored in or shipped to Europe and socialize with peers in their echelon of the Ferrari family.

And this is what it really means to be part of the Ferrari club. The customers invited to this Ferrari premier are among the global elite. Not only do they get a chance to buy exclusive Ferraris that appreciate in value over time (i.e. an investment as any coveted work of art would be, only this one is also mechanical and can be enjoyed through a physical experience), but they get the opportunity to attend several events every year with others in their peer group that share their passion in Ferrari and auto racing. It’s a sort of global level country club or aristocratic club that only Ferrari can cultivate with its rich history, its culture, and exclusive clientele. And this social networking function is just as important a benefit as the exclusivity and value of the cars Ferrari sells to its customers.

Source: CSFB 2018 Global Wealth Report

Based on its production of 9,000 cars in 2018 and statistics from CSFB’s Global Wealth indicating that there are 5MM individuals with net worth of $5MM or more, Ferrari’s current annual production penetration is only 0.2% and only 0.5% among those worth $10MM or more. It’s very likely that the collectors at its highest customer tier are worth $100MM or more, with annual exclusive vehicle sales of 500-1000 units representing 1-2% penetration among them. Which is probably why whether a Monza was priced at $1MM or $2MM was not of great concern when the offer to sign a purchase order was presented to them. On the other hand, not being invited to the next exclusive event or opportunity to purchase the next rare model from Ferrari could be a more costly missed opportunity, both socially and financially. Because of its exclusivity and limited run model selling strategy, having the means to own a Ferrari is not a sufficient condition for owning one. Ferrari has the luxury of picking customers for its exclusive models and “rewarding” them for their loyalty.

Source: Greenwood Investors

Considering that Ferrari maintains a 12-18 month wait list for production and delivery for most of its cars, combined with the social characteristics of the access it provides to its curated events, it’s not surprising that most customers would be loath to cancel their orders unless they were forced to… with others nipping at their heels waiting to take their place. As result, Ferrari sales tend to be fairly well insulated against recessionary impacts and its profit margins highly predictable.

Source: Morningstar

Source: Morningstar

Source: Morningstar

And as would be expected given the characteristics of the brand, its undersupply relative to demand, and the emotional content of luxury goods, Ferrari has historically displayed good pricing power dynamics.

Source: Morningstar

In fact, one could posit that Ferrari has been conservative in exercising its pricing power since the wealth of its targeted base of customer has grown 50% faster than the 4% price increases it has enjoyed. Having said that, the recently appointed CEO Louis Camilleri was very upfront about Ferrari’s 5 year plan at its Capital Markets Day to maintain its exclusivity by exercising its pricing power as Ferrari migrates its future models towards hybrid powertrains, which are targeted to drive EBITDA margins higher over time as outlined in Ferrari’s plan. And as a Veblen good, this is value enhancing for customers and the company.

Source: Ferrari

In tying all of this together — our visit to Ferrari’s Icona/Monza premier event, speaking with its elite tier of customers, understanding at a deeper level the power of the brand both as a purveyor of racing, technological, and artistic passion as well as a curator of a global aristocratic club, and the financial metrics that attracted us to the company in first place, we find the mosaic of a winning formula culled from the entirety of our experience that can be represented by what we learned from attending the Monza premier event.

Everybody wins with Ferrari — the customers wins because they get to be part of a curated club of their global peers and get access to exclusive cars that they get to enjoy and that generally appreciate from the moment they take delivery; Ferrari wins because it benefits from a stable foundation of client demand for its products who highly value being part of the exclusive club and pay for the privilege through their patronage of its products (~2/3 of cars are sold to repeat buyers); and shareholders win because the brand and exclusivity Ferrari has built over its history allows it to command admirable profit margins (we estimate 60%+ incremental gross margins) that generate enviable returns on tangible invested capital (nearly 100% long term by our estimate). The combination of  the strong moat built around its globally recognized brand, the product experience and value created for the customers, and a management team focused on protecting and enhancing its value, we think it makes for an incredible business.

 

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.

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

Netflix releases interactive episode of TV show ‘Black Mirror’ (David Reid, @cnbcdavy, CNBC)
Netflix released a new interactive TV series that allows viewers to choose their own story line.  “The latest “choose your own adventure” episode is called “Bandersnatch” and follows the tale of a young coder who helps create a computer game inspired by an adventure novel.”  Ensemble Capital’s Arif Karim also recently wrote about the streaming media giant and Netflix’s Pricing Power on the Ensemble Capital Intrinsic Investing Blog.

Letter from Tim Cook to Apple investors (Tim Cook, @tim_cook)
Apple pre-announced a significantly weaker than expected December 2018 quarter and guided revenue forecasts lower for coming quarters.  The weakness has been concentrated in the iPhone business and predominantly in China.

The Vintage Ferraris That Run in the Family (A.J. Baime, @ajbaime, The Wall Street Journal)
David Donner talks about his family’s beloved collection of vintage Ferraris and what they mean for his own DNA.  Ensemble Capital’s Arif Karim wrote about Ferrari’s unique luxury brand and position in the auto marketplace in the article Ferrari Sells Veblen Goods, Not Cars in 2017.

The US government is warning Americans that if they visit China they may not be able to return home (Benjamin Zhang, @BenjaminPZhang, Business Insider)
The US State Department recently issued a warning for US travelers headed to China encouraging them to exercise caution.  “Chinese authorities have asserted broad authority to prohibit US citizens from leaving China by using ‘exit bans,’ sometimes keeping US citizens in China for years,” the State Department said in its advisory.  Ensemble Capital’s Chief Investment Officer Sean Stannard-Stockton recently wrote about tension with China has meant for the markets in The Market Decline of 2018 & What Comes Next.

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.

On December 27, Ensemble Capital’s CIO Sean Stannard-Stockton was interviewed on CNBC to discuss the market sell-off and why some high-quality, economically-sensitive stocks are trading at attractive valuations, supported by stronger fundamentals and U.S. lower-tax rates.

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.

After reading psychologist Robert Cialdini’s book Influence, Warren Buffett’s investing partner, Charlie Munger said that it, “filled in a lot of holes in my crude system.”

In other words, Munger may have intuitively understood the principles of influence, but Cialdini’s book provided the blueprints. Munger and Buffett apparently made so much money from Cialdini’s book that they sent Cialdini one Berkshire Hathaway Class A share, currently valued over $300,000.

Never underestimate the potential return on investment from reading books. Or from writing them, apparently.

Instant gratification

In a similar vein, I’ve learned through experience and study that investors often overreact to negative news. They sell first, ask questions later. I learned from Michael Mauboussin, for example, that stress from volatility shrinks investors’ time horizons. And because we feel losses more than we feel equivalent gains, there’s pain relief in selling.

You don’t need to be an investing genius to conclude these moments tend to be good long-term buying opportunities. If you can hold your own nerve, that is.

My crude but important understanding of the subject was enhanced when I recently came across the concept of “hyperbolic discounting.”

That’s a $5 word

Hyperbolic discounting is a fancy way of saying that people discount the near future more than the distant future. In Willpower: Rediscovering the Greatest Human Strength, Roy Baumeister writes, “as we approach a short-term temptation, our tendency to discount the future follows the steep curve of a hyperbola…As you devalue the future, you lose your concern about a hangover tomorrow, and you’re not focused on your vow to go through the rest of your life sober.”

A rational actor will discount future rewards at an exponential rate, as illustrated by the present value formula most investors will recognize:

PV = Cash Flow / (1 + r)t

Here, the “reward” is the cash flow, “r” is the discount rate, and “t” is time. For example, the present value of $100 received in three years’ time with an 8% discount rate is $79.

This rational formula becomes irrational under hyperbolic discounting. Here’s an illustration of how it might look, with “t” now magnifying the denominator.

PV = Cash Flow / [(1 + r )* t]

Using the previous example, rather than present value being $79, it’s now $23. Note: nothing about the cash flow or the discount rate has changed – only the impact from time.

Putting it into practice

Now, let’s assume we’re determining the present value of an asset with cash flows of $100 per year for 10 years. We’ll stick with an 8% discount rate.

The rational actor using exponential discounting would assume a fair value for the asset at $671. On the other hand, the irrational actor using hyperbolic discounting would assume the fair value is less than half that amount at $271.

Exponential Hyperbolic
1  $          93  $          93
2  $          86  $          46
3  $          79  $          31
4  $          74  $          23
5  $          68  $          19
6  $          63  $          15
7  $          58  $          13
8  $          54  $          12
9  $          50  $          10
10  $          46  $            9
SUM  $        671  $        271

Here’s how the cash flows look graphically.

The above table illustrates how the market can dramatically undervalue strong businesses when it goes into panic mode.

Assuming no change to the long-term cash flow outlook or riskiness of the business, hyperbolic discounting by market participants will alone drive its share price lower.

This is the mercurial Mr. Market that Benjamin Graham famously described in The Intelligent Investor: “Often…Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.” Herein lies the opportunity for long-term investors.

To be fair, it’s hard to know before the fact if the market is panicking or if it’s making rational adjustments. Maybe your own cash flow projections are wildly off, or maybe you’ve underestimated the business risk.

We believe that the better you understand the business, the drivers of its fundamental performance, and its moat sources, the more likely you’ll be prepared to take advantage of the market’s emotional swings.

Capitalizing

During the fourth quarter, for example, we added to our position in Broadridge Financial Solutions, a provider of investor communications, trade processing, and wealth management technology, as the stock fell nearly 30% from its September highs. From our perspective, there was little news that directly impacted the underlying business. Even if we are about to enter a recession, most of Broadridge’s revenue is recurring and their services are mission-critical to its customers. Further, the board recently boosted the dividend by 33%, suggesting long-term confidence in cash flow growth.

Though we acknowledge that our cash flow projections will be wrong to some degree, we think Broadridge is one of the more intrinsically-forecastable businesses we own. Despite the stock’s decline, we made no changes to our cash flow outlook and affirmed our discount rates.

It could very well be that hyperbolic discounting took over with Broadridge. Amid rising concerns about the financial markets, Broadridge may have become a “sell first, ask questions later” target by association.

Or at least we think so. Time will tell if our assessment was correct.

Bottom line

Right after he introduces Mr. Market in The Intelligent Investor, Graham added: “Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.”

Ultimately, this is what we’re after at Ensemble. We aim to pay good prices for great companies and then be patient with them. That said, we want to be ready to both buy and sell when market participants underprice and overprice stocks for emotional reasons.

We don’t always get it right, but by remaining fundamentally-focused on the businesses we own and not getting caught up in the madness ourselves, we believe we have a good shot of taking advantage of price fluctuations driven by hyperbolic discounting as well as euphoria.

As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Broadridge Financial Solutions (BR). 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.