My wife is an avid seashell hunter. Her family tells me this has been a lifelong obsession. She’s intent on only keeping the good ones.

Within five minutes of setting up our umbrella, I’ll look up and she’ll be halfway down the beach looking through the sand, increasingly with our kids in tow, unknowingly learning from a master.

Oil on canvas by Anna Bryant

She’ll go hunting no matter how busy the beach may be, but in the peak summer months on popular beaches, the good shells don’t last long. Either tourists grab them up or they get stepped on during an errant frisbee toss.

Instead, the best searches take place in two settings, and ideally together – on secluded beaches and after storms. Our best haul came years ago when we ventured out on kayaks to a remote part of a remote island in North Carolina where we found an elusive intact Scotch bonnet.

Author’s photo

To increase your odds of finding the highest quality shells, you need to do the work others don’t want to do and be willing to see storms as opportunities.

There’s no question that the last six months have been rough for quality-focused investors and particularly so for our strategy. With the benefit of hindsight, the beaches (if you will) for quality stocks became overrun with tourists and the storm of stagflation rolled in, sending them running for shelter and aloe vera for their burns.

While it seems many beachgoers have called it a day, intending to return next summer only when the sun is bright and the sky is clear, we’re back on the beach looking for what treasures the storm has left behind.

We consider some of our housing stocks, such as homebuilder NVR and retailer Home Depot, trading with price/earnings ratios unseen since the depths of COVID lockdowns in 2020 and see opportunity. We don’t believe either company’s recent earnings will be their peak over the next three to five years.

The velocity with which mortgage rates have risen in 2022 is indeed concerning, but it doesn’t have anything to do with the fact that the most populated age cohorts in the US are 29 and 30. As those peak millennials enter prime earnings and household formation years, the odds are good that they will look toward single-family homes to set down roots in the coming decade.

Work-from-home flexibility has increased in the “post-COVID” era, with McKinsey reporting that 58% of Americans surveyed saying that they can work from home at least once a week. This massively opens up housing options for families that can now live further away from city centers since their commuting time has been reduced. NVR specializes in building communities in the exurban areas around second- and third-tier cities, so we believe they are well positioned for this trend.

As many of us experienced during 2020, the longer you’re in your home during the day, the more you start noticing things that need repair or improvement. That leaky faucet, once tolerated when you were away 10 hours each day, is now unbearable. Working from the kitchen table with kids running around doesn’t lend itself well to productivity, so it’s time to convert a room to an office space. And so on.

We think Home Depot will continue to benefit from home renovation and repairs, both with do-it-yourself customers and their important pro contractor customers that use Home Depot as a materials supplier.

Despite the rise in mortgage rates and the doom-and-gloom headlines about the housing market right now, this does not appear to be anything like the 2008-2009 housing crisis. For one, the bulk of US homeowners currently have fixed rate mortgages, rather than adjustable-rate mortgages, and used the opportunity in recent years to refinance at low rates. The risk of mortgages “resetting” higher due to rising rates and impacting affordability is far lower than it was in 2008-2009.

Second, the amount of home equity in the US has surged well beyond levels seen before the housing crisis. As such, homeowners have considerable project financing options for remodels and renovations.

Finally, if a homeowner needs to sell their home due to job loss or some other unforeseen event, it is unlikely that they will need to offer deep discounts to entice buyers, especially with limited existing home inventory and strong demographic tailwinds.

NVR and Home Depot are just two examples of high-quality businesses that have been tossed about in this stagflation storm. We see many more opportunities across sectors left behind by fleeing quality tourists. It may not seem like it right now, but it’s a fine time to be on the beach looking for treasures.

Below is the Q2 2022 quarterly letter sent to separately managed account clients. You can find historical Investor Communications HERE and information on how to invest HEREEnjoy!

The performance of securities mentioned within this letter refers to how the security performed in the market and does not reflect the performance attributed to the core equity portfolio. Please see the chart at the end of letter, which reflects the full list of contributors and detractors based on each security’s weighting within the core equity portfolio.

You can request a copy of Ensemble Capital’s equity strategy performance presentation here. The presentation is updated by the end of the month after each quarter end.

The first half of 2022 has been particularly challenging for Ensemble’s investment strategy. On a year-to-date basis, the Ensemble Equity Composite is down an estimated 32.7% vs the S&P 500 down 20.0%. Due to our very strong returns in 2019, 2020 and 2021, even after this year’s decline, our strategy has returned an estimated 7% annually over the last three years, and 10% annually over the last five years. However, these results are less than the S&P 500’s return and are not an outcome we are satisfied with (final composite calculations will be available at the end of this month. You can download a copy of our composite performance track record here).

We recognize that our investors are not used to this degree of underperformance from us, particularly during a market decline. Over our 18-year history leading up to this year, our equity composite only underperformed by a similar amount from mid-2012 to early 2013. Because that period of underperformance occurred during a rising market, we recognize that the current underperformance occurring during a declining market is more difficult for our clients.

Relative to the S&P 500, our strategy’s performance bottomed in early May and outperformed from then until the end of this quarter. While we expect our relative performance compared to the S&P 500 to fluctuate in the months and quarters ahead, the persistent headwinds we were experiencing did begin to dissipate almost two months ago and we are hopeful that our nascent recovery will continue in the medium term.

In this letter, we will discuss the current economic and market environment and then lay out the drivers of our underperformance as well as the reasons why we believe our strategy will return to its more familiar level of performance going forward.

Coming into 2022, the US economy was robust. Real GDP in the fourth quarter of 2021 grew 5.5% vs the year ago period. Inflation was running at between 4% and 7% depending on the measure of inflation used, but most economists and investors believed this inflation was primarily being driven by a shortage of workers, supply chain issues, and the relatively slow restarting of production that was shut down during the pandemic. Because capitalism is extremely good at producing whatever level of goods and services that customers demand, it was assumed that once the pandemic related constraints on economic production faded that supply would catch up with demand and inflation would decline.

In addition, because employment was still below pre COVID levels but growing quickly, wage growth was strong, and American households had low levels of debt and high levels of cash on their balance sheets, it appeared very likely that strong demand growth would continue.

But over the first half of 2022, a number of developments shattered confidence in this positive outlook so dramatically that today most people assume that a recession is inevitable and that even a contraction in demand may not bring inflation down to reasonable levels. With the growth outlook greatly diminished and inflation worries still raging, investors have greatly downgraded the valuation multiples they assign to most stocks, with a particularly dramatic reduction in valuations for high growth businesses or those whose fundamental results are economically sensitive.

Despite the market being down 20% so far this year, revenue and earnings for the S&P 500 increased by over 10% in the first quarter with continued growth expected in the second quarter. This has led to the PE ratio on the S&P 500 to contract by nearly 30% in the last six months with much larger contractions in higher growth or economically sensitive stocks.

Back in early March, two weeks after the Russian invasion of Ukraine, we authored a piece about the stagflation panic sweeping the stock market. The inflation prior to the invasion was a function of pandemic related supply and demand imbalances which meant that the inflation would be mitigated either through supply recovering or a contraction in demand. But the inflation related to the war in Ukraine is being driven by supply constraints that may not be resolved in the near term and these constraints are primarily on necessary products, such as food and energy, for which demand rarely declines even in the face of high prices. Thus, unlike typical inflation issues which can be cured via slower growth or a recession, the risk of stagflation, or periods when inflation remains high even in the face of slow or contracting growth, increased significantly.

In addition, after successfully preventing mass spreading of COVID over the past two years, China experienced new outbreaks in some of their major cities. With a population that is far more at risk to contracting COVID due to the relatively ineffective Chinese vaccine, low levels of vaccination among older people, and a population that has mostly not contracted COVID to date, the risk of a major, deadly wave in China is very real. This risk caused China to put some of their major cities into lockdown, limiting production of goods that the rest of the world would like to buy and putting further pressure on inflation. That being said, a slowdown or recession in China also reduces demand for oil and global transportation of goods, so there are also ways in which China’s COVID issue causes some parts of the inflation issue to dissipate.

But despite these major developments, the outlook for real economic growth and inflation are still uncertain. Recessions, inflation and the economy more generally are hard to forecast, as evidenced by how dramatically the economic outlook has changed over just the past six months. Just as the economic recovery of the past two years has been highly unusually, so too is the current slowdown and possible recession likely to look very different from historical patterns.

On the positive side, companies continue to report that supply chains are healing. The cost of moving goods around the world by ocean, air or truck have declined materially this year as supply and demand have become more balanced. The price of lumber, which soared as much as 400% in 2021 as home building activity increased sharply while lumber suppliers raced to restart production, has now declined by nearly 60% since early March of this year. Even the price of oil and wheat, two products facing significant supply constraints due to the war in Ukraine, have seen their prices decline significantly from post invasion highs.

Importantly, American households, whose spending makes up 70% of the US economy, have been resilient. With approximately 2.7 mil new jobs added[…]

During our second quarter portfolio update webinar, Ensemble Capital’s Chief Investment Officer Sean Stannard-Stockton and senior investment analysts Arif Karim and Todd Wenning discussed the current market and economic situation, as well as recent portfolio performance. There was also an extended Q&A session with the team where various topics were addressed, including interest rates, inflation, and individual holding commentary.

Below is a replay of the full webinar as well as a link to Ensemble Capital’s QUARTERLY LETTER.

(If you’re viewing this by email, CLICK HERE to watch the video.)

While our quarterly webinar is an unscripted, more casual discussion, we also produce a quarterly letter that covers the same topics but in written form and with more detail. You can find a copy of our second quarter letter HERE.

Each quarter, Ensemble Capital hosts a webinar to discuss the current market, economic conditions, and a few of our portfolio holdings.

Given the myriad topics on investors’ minds in the current market, the webinar will have a different format this quarter. Rather than have prepared remarks on two of our portfolio holdings, the team will open the floor to live Q&A earlier in the webinar to answer your questions.

This quarter’s webinar will be held on Monday, July 11 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!

At the recent 2022 Berkshire Hathaway annual meeting weekend in Omaha, senior analyst Todd Wenning presented our current thesis on Masimo at the MOI Best Ideas conference.

Among other topics, Todd discussed our thoughts on the controversial acquisition of Sound United, a consumer audio business. The $1.025 billion deal raised questions about Masimo’s future business model, which had previously been concentrated on its in-hospital operations.

You can listen to the 13-minute audio recording and view the slideshow presentation by clicking here.

For additional thoughts on Masimo, please see the following blog posts: MASIMO: DOING WELL BY DOING GOOD and WEBINAR TRANSCRIPT: MASIMO UPDATE.