“I do believe in simplicity. It is astonishing as well as sad, how many trivial affairs even the wisest thinks he must attend to in a day… So simplify the problem of life, distinguish the necessary and the real. Probe the earth to see where your main roots run.”

– Henry David Thoreau

According to a quick Bloomberg screen, there are about 2,000 companies in our investible universe. At any given time, we’ll own between 15 and 30 of them.

To narrow down the list of potential portfolio holdings, we employ a framework borne out of both our personal and team experiences.

Over the past four years, we’ve written dozens of blog posts that have elaborated on this framework. We wanted to boil all of that down into a one-page diagram that shows, as Thoreau put it above, where our “main roots run.”

Before we invest in any company, we must believe that three key factors – management, moat, and forecastability (which informs our valuation) – are present These factors are of equal importance.

Indeed, if even one of the factors is missing, we consider the idea a trap. We haven’t written specifically about traps yet, so here’s a summary.

  • Commoditization Trap: If we have concerns about a company’s moat durability or its relevance over the next decade, we pass on it. This is true even if we like the management team and can understand the business model. Sure, great management teams can turn around struggling operations, but these examples are often best discovered with hindsight. An eroding moat or a low-growth business both hint at the company losing relevance, which we believe are underappreciated risks.
  • Stewardship Trap: An award-winning garden left in the hands of an absentee caretaker will eventually grow weeds. To remain in top condition, the garden needs constant attention from a caring steward. We don’t want to invest in businesses that, as others have put it, “any idiot” or “a ham sandwich” could run. In an age of rapid innovation, global competition, and cheap and abundant capital, every company needs competent leadership to remain relevant.
  • Complexity Trap: At times, we’ll identify companies with Visionary or Optimizer leadership and a wonderful track record of high returns on invested capital (suggesting the presence of a moat), but we don’t find the business intrinsically understandable. Sometimes key information is inaccessible or technically challenging to understand, making it difficult to fully appreciate downside risks. Other times, the business model operates in many competitive arenas and we can’t get a firm grasp of unit economics to make confident forecasts.

The majority of companies do not satisfy all three of these criteria, and are thus un-investable for us. This does not mean these are bad companies. On the contrary, most of the companies we look at fall in the top quartile of public businesses.

Indeed, it’s rare when moat, management, and forecastability are all present. But those are exactly the types of companies we want to own in our concentrated portfolio. We won’t always get it right, of course, but by setting a high standard for our portfolio, we believe we increase our odds of achieving better outcomes.

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.

Ensemble Capital’s chief investment officer, Sean Stannard-Stockton recently appeared on the Investing City podcast. The interview is a deep dive into Ensemble’s investment strategy, the history of our company, how we analyze investment opportunities, mistakes we’ve made in the past, and even an explanation of what led teenage Sean to give up on his dream of becoming a major league baseball player to go all in on investing.

Click here to listen to the podcast.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Alphabet (GOOGL), TransDigm (TDG), Mastercard (MA), Sensata Technologies (ST), and Paychex (PAYX). These companies 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.

“The son of [Reed Hastings] must not become a Jedi.”

Much to the chagrin of the traditional media Empire industry, Netflix has become the leader of the global direct to consumer (DTC) streaming media (OTT) business it founded with a staggering 150MM subscribers globally. We believe the global scale it’s built up in the business makes it too big for all but a handful of traditional media and global tech companies to compete with. For a more in depth look at its business and strategy, please refer to our deep dive Netflix report.

The market will become much more exciting with the launch of new competitors over the next year, especially offerings from the largest traditional media companies. The new Disney Plus service will launch in November 2019 in the US, Canada, Australia, New Zealand and the Netherlands, with plans to expand globally over the next couple of years. Disney’s DTC service will be followed by Apple’s TV+ and Time Warner’s HBO Max (reboot of HBO NOW plus more TW content) services in soon thereafter.

In our view, the global market is large enough to accommodate 3-5 global media players and many consumers will subscribe to 2 or 3 services offering their favorite content. We believe direct streaming services are redirecting the Pay TV industry’s traditional value chains around the world while expanding the market by leveraging global scale economics and modern low cost distribution via “smart” devices and 4G/5G connectivity.

Having said that, it is important to separate Netflix’s US (maturing) and international (nascent) markets.

“Do. Or do not. There is no try.”

In the US, as the pioneer in streaming video whose odds looked very long only 7 years ago, Netflix has already won. More than half of all Americans subscribe to Netflix, which is more than all the Cable TV subscribers combined (which are in slow steady secular decline). We don’t think there is a ton of growth left in the number of subscribers in the US, especially since a significant fraction share passwords, but we do think Netflix can continue to raise the price they can charge (we also believe password sharing is intentionally leveraged as a viral customer acquisition strategy and, in fact, paid for by its service pricing strategy).

Netflix is already quite profitable in the US, with an estimated operating margin of 25%*. Last quarter they raised the price in the US by 13% and still kept 99.5% of their subscribers, resulting in an 11% q/q increase in net US revenue. You can imagine what that does to enhance profitability given that a substantial portion of the increase falls to the bottom line (profits grew 20% q/q). Compare that with the narrative that “Netflix lost 200K US customers in the quarter, they’re losing their pricing power!”

As we’ve discussed in our post on Netflix’s pricing power, immediately after past price hikes, there have been one or two quarters of increased subscriber churn followed by a bounce back in subscriber growth. The June 2019 quarter was just the latest quarter to see a similar, expected phenomenon though the exact magnitude of the impact is always hard to forecast. We believe the churn is due to initial “sticker shock” and Netflix’s customer friendly policy of clearly alerting people to price increases with a simple button to cancel. But about a quarter or two later, most of these churned-off subscribers hear about a show that all their friends are talking about or realize how wonderful the convenient advertising-free service had been and sign back up, realizing that it is still an amazing bargain at $13/month for essentially a mini-cable bundle offering thousands of hours of instantly on-demand shows and movies.

“I’ve got a bad feeling about this.” 

Investors are quite worried about Disney’s new steaming services, and for good reason, given its well-regarded global brand with strong marketing capabilities, popular IP based video franchises (Disney characters, Star Wars, Marvel, Pixar, etc.), and its multi-year commitment towards global expansion of its streaming services. But Disney is very late to the game and has a lot to learn about going direct to consumer with a subscription business, the execution of which is tougher than most realize. No doubt, Disney will figure this out through years of dedicated experience as Netflix has over the past 2 decades.

“Be careful not to choke on your aspirations, Director.”

After everyone thinking Netflix was bound to fail, the iconic Disney has smartly and humbly realized that their only choice is to try to copy Netflix’s strategic playbook (literally!) to scale quickly and stay relevant in the long run. We believe Disney’s new service is likely to be a big success. But the “product” it is delivering to its subscribers is primarily going to be Disney’s brand of movies and shows. So, it will be more like HBO (a great niche premium channel) while Netflix has a broader set of content akin to an entire cable bundle (a broad selection, cable TV replacement). Disney is hoping that by bundling Hulu with Disney Plus for the same price as Netflix that they can compete directly, but Hulu is not new and has attracted about 30 million compared to Netflix’s 150 million.

That said, it would not be unexpected to see a quarter or two of impact to Netflix’s gross subscriber additions in the US, as a certain proportion of new to streaming video customers give Disney Plus a try, and churn rates to increase, as those Netflix subscribers who value it the least get over their inertia (inertia is a beautiful thing in subscription businesses!) and try a big new competitively priced service instead. A couple of quarters later, we believe we’ll see the playing field become more balanced, with the vast majority of Netflix’s subscribers keeping their service while many of Disney Plus’ new subscribers will be adding it as their second streaming service.

The bigger impact to the entire market will be that the surge of streaming service options, each with its own package of unique content, will finally kill cable television service model. If for $25-40/month you can get Netflix, Hulu, Disney Plus, ESPN Plus and Amazon Prime video, who will keep cable TV? This will free up $100/month of video spending for most households and, while Disney and others will certainly win some of that, we believe Netflix will remain the default service and the de facto leader while the traditional cable companies’ ongoing businesses will be to supply the broadband pipes connecting them.

“The Force is strong with this one.”

Despite its scale and leadership advantages in streaming video, Netflix isn’t sitting still. They are taking their large US profits and reinvesting in dominating international markets where they are far ahead of everyone else. This makes the company look less profitable overall since they grow via income statement spending (outsized content and marketing budgets), not capex as a physical assets company traditionally would have. And though its international business just turned the corner on profitability, we believe it has a long way to grow as the US market has done. Longer term we expect they will raise prices in their international business just as they have successfully done in the US .

At today’s $16/month for their top tier service with four 4K simultaneous streams, people can share the service and pay as little as $4/month each (or subscribe separately to a single mobile stream in some emerging markets like India), which is a bargain for all the billions of dollars of great content they get access to so affordably and conveniently. However, the fixed cost nature of content makes each of even the lowest priced marginal subscribers very profitable and their aggregated spending continues to feed the Netflix content engine that benefits all existing subscribers, even as they scale the add grows the Netflix’s overall margins.

“You can’t stop the change, any more than you can stop the suns from setting.”

So bottom line: we do think competition is ramping up and Disney will be successful, but we never expected that the other media players would fail to compete forever. The fact that they are now recognizing that Netflix has successfully pulled the rug from under their businesses and must be copied doesn’t change our positive view on the company, especially since we believe it is far ahead of the competition on its ability to recruit and retain subscribers, source a variety of locally and globally relevant content, and access deeper into the global market with local partnerships, and most importantly, its culture of customer focus and innovation.

Netflix has already grown to become a global scale media company, so the onus is on the competition to execute and invest billions (in the form of losses for years) in order to do the same to be viable long term competitors.

*Pro forma ECM estimate based on reported US contribution margin and geographically proportionate operating expenses.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of 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.

Ensemble senior analyst Todd Wenning was featured in two recent podcasts.

On the Planet Microcap podcast, Todd talked about his professional background, the Venn diagram of his investment philosophy, Ensemble’s framework for evaluating Visionary and Optimizer management teams, and why Ensemble focuses on companies with high returns on invested capital and economic moats.

Click here for the Planet Microcap podcast.

On the Chit Chat Money podcast, Todd discussed his articles on the innovation hype cycle and hyperbolic discounting, as well as why he is a believer in the liberal arts as a good training ground for investors.

Click here for the Chit Chat Money podcast.

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.

This is Part 3 in our series about position sizing. Click on the links to read Part 1 and Part 2.

Investors talk incessantly about what investment they think is a good buy. But rarely do investors discuss how much of any given investment to buy. But this second question is vitally important. While much of Wall Street does not think robustly about this question, gamblers certainly have and we can learn something important from their insights.

If you are presented with a bet, you can calculate your expected winnings (the amount you’ll earn on average each time you bet) by multiplying the probability of winning times the amount won per bet and then subtracting the probability of losing times the amount lost per bet.

Let’s say I offer you two different bets:

  1. There is a bag of 100 marbles. One is red and 99 are green. For every dollar you bet, if you pick a green marble I’ll pay you $1.02. If you pick red you lose your dollar. The expected return works out to you earning on average $1 every time you bet. Basically 99 times you’ll earn 102% and once you’ll lose 100%. So for every bet you make you will earn a 100% return on average.
  2. There is a bag of 100 marbles. 99 are red and one is green. For every dollar you bet, if you pick a green marble I’ll pay you $199. If you pick red you lose your dollar. The expected return works out to you earning on average $1 every time you bet. Basically 99 times you’ll lose 100% and once you’ll earn 19,900%. So for every bet you make you will earn a 100% return on average.

The expected return of the two bets is the same. Therefore, in theory, you should be indifferent between the two bets, especially if you’re allowed to make the bet over and over again so that the long term probabilities play out.

But what if instead you had to bet your life savings on one of these two options? Most everyone would pick bet #1. This is because if you bet everything and lose, you won’t get a chance to bet again (because you’ll be broke). You’ll never get to the long term. In other words, when deciding which bet to make, you only really care about the expected return. But if you are trying to decide how much to bet, you also need to take into account the likelihood of winning.

Now anyone using common sense can understand that you should bet more on option #1 than on option #2. But exactly how much should you bet on each? Or if you are managing a portfolio of stocks and you find two stocks that each have 100% expected return in your opinion, but different likelihoods of working out successfully, how much of your portfolio should you invest in each situation?

Fascinatingly, in situations such as the bag of marbles example where both the exact odds of winning and the exact payoff is known in advance, there is an exact answer. Known as the Kelly Criterion, the formula was discovered by a Bell Labs researcher in 1956 and used by his friend Ed Thorp as part of blackjack gambling system that was so successful the Las Vegas casinos banned Thorp and were forced to change the rules of blackjack. Thorp then went on to become an extremely successful investor deploying many of the same concepts. You can read this amazing story in the book Fortune’s Formula.

But to deploy the Kelly Criterion to calculate the exact amount of your portfolio you should invest in a given stock, you must know the exact amount you will earn if you are “right”, the amount you will lose if you are “wrong” and the probability of each happening. Unfortunately, this information in unknowable when it comes to investing in stocks. But that doesn’t mean the Kelly Criterion is worthless to investors. It simply means that the formula itself (described here) is not applicable, but the concept that the key drivers of position size should be expected return and probability of success is still valid.

Interestingly, almost every Wall Street research report will address the expected return portion of the equation. “We think this stock can get to $100 over the next 12-months,” “our price target for the stock is $75,”we think the stock can double over the next three years.” But while these types of forecasts are part of every discussion of every investment opportunity, the standard stock research report makes no mention of the probability of success. For that matter, despite the industry generating an extraordinary volume of research on which stocks to buy, the literature on how much of each stock to buy is unbelievable thin. Yet how much of a stock to buy is a decision that needs to be made every single time any investor makes an investment.

How likely an investment is to pay off at or better than your estimate of its expected return must be a key input to position sizing. But estimating this probability is difficult and the best process varies depending on your investment strategy and in particular your time horizon.

For a short term oriented investment strategy in which an investor makes investments based on known catalysts such as the probability that a biotech company will have a new drug approved, most of the attributes of the company can be ignored and the investor can focus on the specifics of the catalyst in question. But for a long term oriented strategy in which an investor makes investments based on their assessment that a particular company is superior to competitors in its ability to generate cash flow, the catalysts are mostly unknown and so the probability of success must be estimated based on an assessment of the company itself.

The Kelly Criterion fails as a useful formula to calculate portfolio position size in long term investment strategies because half the equation (expected return) can only be estimated and the other half (probability of success) cannot even be estimated with any precision. But as long as we can simply rank investment opportunities and differentiate between those that are more likely to succeed vs those that are less likely to succeed, we can use the key insight of the Kelly Criterion to decide which investment opportunities deserve more of our capital and which deserve less.

In the next post in this series, we’ll explain how we go about ranking the probability of success for companies in our long term oriented investment strategy and how this process drives our position sizing process.

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.