Michael Lewis’s classic book, Moneyball, describes how the Oakland Athletics baseball team used quantitative analysis in the early 2000s to scout promising talent.
In one example, A’s researchers found that on-base percentage was a stronger indicator of success than batting average, yet the latter was the preferred metric used by scouts. Identifying useful factors like on-base percentage helped the A’s win more games on a smaller budget.
Using backtests of historical data, the investing world has similarly sought out and identified promising factors of outperformance. Included in this group are:
- Size – small beats large
- Value – cheap beats expensive
- Momentum – winners tend to keep winning
- Quality – well-run companies outperform poorly-run companies
To illustrate, a 2016 study by Fidelity found that, from 1985 to 2015, the Quality factor posted 1.59% annual excess return relative to the Russell 1000 Index.
Since we at Ensemble focus our research on firms we consider to be high quality, I wanted to take this post to explain how our approach differs from a traditional Quality factor portfolio.
Depending on the study, the definition of Quality will vary at the margins, but generally tries to capture the following traits:
- High returns on investment (ROE, ROA, ROIC, etc.)
- Low amounts of leverage (debt/equity, interest coverage, etc.)
- Reliable growth (cash flows, low accruals, earnings stability, etc.)
We have no problem with these metrics and agree they can be strong indicators of quality. However, simply screening for companies with these attributes has two shortcomings.
First, because the screens are backward-looking, they tend to show a lot of “legacy moats.”
Companies with legacy moats rely on advantaged existing assets and have impressive historical profitability and growth. As such, they’re natural fits for quality screens. This may have been a positive signal in previous eras, when return on invested capital (ROIC) persistence was much stronger (i.e. winners were more likely to keep winning), but that dynamic is changing.
Due to rapid technological innovation, capital availability, and globalization, barriers to entry in many industries have fallen. Whether it’s through a platform-based business model (e.g. Uber, Airbnb), software-as-a-service (Slack, Salesforce), viral marketing (Dollar Shave Club), or influencer marketing (Spanx), there are myriad ways to challenge today’s blue chips. Jeff Bezos’ statement that “Your margin is my opportunity,” nicely summarizes the threat upstart competitors pose to incumbents now.
And as Michael Mauboussin’s research has shown, “The market rewards improvement and punishes decline in economic returns.” In other words, it’s very hard to outperform the market by owning firms with declining ROICs, and legacy moats are particularly susceptible to ROIC erosion.
Second, traditional quality screens can overlook what we call “emerging moats.”
Emerging moat companies have a huge market opportunity and have plenty of high-return projects in which to invest. Because of the high returns on incremental invested capital, they’ll have bigger capital expenditures (leading to lower near-term free cash flow) or increased expenses (leading to lower near-term profitability) as they establish their competitive advantages.
This is particularly true with platform-based businesses, such as Alibaba, Facebook, and Booking Holdings. Because platform moats are driven by network effects, these companies are rightly motivated to scale quickly and prudently. As a result, their financial profiles during the ramp phase typically don’t fit quality screens. Looking under the hood, however, can reveal early stage moat development.
Correctly identifying emerging moats is admittedly difficult, but can be a lucrative endeavor. As a successful emerging moat scales, it should produce stronger ROIC and more profitable growth. In turn, other investors should re-rate the company’s prospects and drive the stock price higher.
How we address it
While the Quality factor screens can be informative in identifying strong past performers, we find more value in doing qualitative research centered on moat analysis. Rather than depend on historical data, we examine each company’s moat durability over the next decade. Our moat analysis will turn out to be wrong now and then, but we believe we’ll do better looking ahead than relying solely on quality screens.
As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Booking Holdings (BKNG). 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.
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