We recently repaired my grandmother’s mantle clock. It’s a nice piece and looks good in our living room, but it only has sentimental value. The repair cost outweighs its market value.

When we brought it to the repair shop, we learned that almost all the internal mechanisms were rusted and had to be replaced. Fortunately, the external features were in great shape. It still looks like the clock I walked past in her foyer as a child.

At some point in the repair process, especially if we’d needed external replacements, it would no longer have been my grandmother’s clock. It would instead be a whole new clock that happened to resemble my grandmother’s clock.

Over a long enough timeline, the same thing happens to companies. Everything internal – from the copiers to the offices to the management teams – gets replaced. This point often gets overlooked because, like my grandmother’s clock, the exterior looks the same.

As companies get larger, the decisions made by present-day management have an outsized impact on the company’s subsequent fundamentals. What came before matters less with each passing year. As Warren Buffett quipped, “After ten years in a job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”

To illustrate, Wal-Mart today is not the same Wal-Mart led by founder Sam Walton. When Walton stepped down from the CEO role in 1988, Wal-Mart’s shareholder equity amounted to $2.26 billion; in fiscal 2021, it was $87.5 billion. In other words, 97% of Wal-Mart’s current shareholder equity was generated after Walton stepped down.

Business strategies also get replaced. Starbucks founder Howard Schultz’s early vision for the coffee house was rooted in its “third place” allure – a place other than work and home where customers could sit on comfy couches and enjoy a book or have a conversation with a friend. That strategy, by any account, was a massive success.

Just before the pandemic struck, however, over 80% of Starbucks’ U.S. orders were “to go,” and in the most recent quarter, nearly half of U.S. orders were made through drive-throughs. Starbucks is currently restructuring its U.S. store footprint and focusing on rapid fulfillment. Though the “third place” is still a key strategy in China, the U.S. strategy has been dramatically reimagined.

Starbucks 2003 Annual Report (left), New Starbucks Pickup store format (right)

If you happened to own Wal-Mart or Starbucks for the last 20-plus years, you implicitly approved of all the major changes at the company along the way. But if you didn’t give those changes any thought, your outcome was mostly luck. It wasn’t predestined that either company would have a positive outcome.

So how might we as investors, with some level of confidence and reason, explicitly approve of such changes with a forward-looking approach?

We suggest focusing on culture. Founders like Walton and Schultz set the algorithms for how their companies proactively and reactively respond to change. As investing legend Philip Fisher put it: “More successful firms usually have some unique personality traits – some special ways of doing things that are particularly effective for their management team. This is a positive not a negative sign.”

While subsequent leadership teams might tweak the founders’ mission statements, the core cultural algorithm is hard to break. So much so that when an outsider CEO goes against the grain and redefines an algorithm that works, trouble emerges.

This was the case at Home Depot in 2000 after co-founder Bernie Marcus stepped down and handed the reins to former General Electric executive, Bob Nardelli. Nardelli had no retail experience and pushed the centralized Six Sigma lean management style he learned at GE onto the Home Depot system, which had previously been decentralized and entrepreneurial in nature. Momentum at Home Depot stalled. It took nearly seven years for Nardelli and Home Depot to part ways, but once Home Depot was put back on track, it emerged stronger than ever.

Being outside shareholders, we’re not privy to the daily decisions companies make that over time determine their success or failure. But we aim to learn and understand the cultures – the algorithms – behind the businesses we own so we can better filter through daily and quarterly news flows.

A recent example is Netflix. Netflix announced it was moving into the video game space to provide subscribers with additional ways to engage with Netflix content. At first glance, you would be wise to be skeptical, as the video game industry is quite different from the TV series and movie business that’s been Netflix’s core focus for over 20 years. You might conclude that Netflix’s management is taking its eye off the ball.

Having studied Netflix for years, however, we’ve come to understand that the culture founder Reed Hastings set in motion is one that emphasizes experimentation and fast learning to create consumer surplus. Games will be available to Netflix subscribers at no additional cost. The point is to make your Netflix subscription even more of a no-brainer expense than it already is.

Without this understanding of Netflix’s culture, we may have reached a different conclusion.

A company that you’ve owned for a decade or longer is, in many ways, a different company from the one you originally bought. There’s no such thing as buy and hold with equities because corporations are organisms operating in ecosystems and, as such, are changing internally and responding to external stimuli. You can buy and hold something static like a painting or gold, but not equities.

[…]

During our second quarter portfolio update, we profiled portfolio holding Nintendo (NTDOY). Below is a replay of our live commentary on the company from our quarterly portfolio update webinar and an excerpt from our QUARTERLY LETTER.

Nintendo

Nintendo’s corporate mission is to “Put smiles on faces of everyone Nintendo touches.” Given the historical cyclicality of Nintendo’s earnings, investors often criticize Nintendo for putting this mission ahead of maximizing shareholder profits. Put differently, they think Nintendo has not pressed its advantage enough when it had the opportunity. There is some element of truth to that, but we consider it a wise strategy. Indeed, delighting its customers is one of the major reasons why Nintendo has remained relevant to video game enthusiasts for nearly four decades while so many of its competitors have since faded into obscurity. It’s thinking in generations while other gaming companies think in quarters.

(For a full list of holdings and additional disclosure information related to these videos, please click HERE.)

Nintendo’s corporate mission is to “Put smiles on faces of everyone Nintendo touches.” Given the historical cyclicality of Nintendo’s earnings, investors often criticize Nintendo for putting this mission ahead of maximizing shareholder profits. Put differently, they think Nintendo has not pressed its advantage enough when it had the opportunity. There is some element of truth to that, but we consider it a wise strategy. Indeed, delighting its customers is one of the major reasons why Nintendo has remained relevant to video game enthusiasts for nearly four decades while so many of its competitors have since faded into obscurity. It’s thinking in generations while other gaming companies think in quarters.

And by staying relevant, Nintendo won over a generation of 1980s and 1990s children with iterations of hardware and games including Mario, Zelda, and Donkey Kong. Many in this original cohort of Nintendo fans now have their own children, nieces, and nephews with whom they want to share their love for Nintendo’s games. Research from the Entertainment Software Association (ESA) shows that the average age range of a video game player today is 35-44. The previous generation of parents who did not grow up with video games weren’t able to pass down their nostalgia for Nintendo to their children, but this generation is doing just that.

To borrow a line from the TV series, Mad Men, nostalgia is delicate but potent. Nostalgia binds generations. Passion for a particular sports team, for example, is passed from one generation to the next and those happy memories of quality family time carry into subsequent generations. Increasingly, families are turning to video games to create happy memories together. Another ESA survey found that the percentage of U.S.

parents who play at least one video game with their children each week increased from 35% in 2013 to 67% in 2017. While we don’t have updated survey results, we believe those figures increased during COVID-related quarantines in 2020.

Nintendo is positioned to capitalize on these trends. Unlike games on more powerful consoles like Xbox or PlayStation, which may have a steep learning curve or unfamiliar characters, both parents and kids recognize Nintendo characters and the learning curves for Nintendo games are low enough where people of any age can start playing and having fun together.

Nintendo’s IP today is in a similar place to where Disney’s was in the 1970s after the Baby Boomer generation started passing down their love for Mickey Mouse, Donald Duck, and other Disney characters to their Generation X children. In 1991, Warren Buffett remarked that Disney’s IP was “like having an oil well where all the oil seeps back in…essentially, you get a new crop every seven years, and you get to charge more each time.” Neither Mario nor Mickey Mouse negotiate for higher contracts and each new twist on the IP is gobbled up by passionate fans.

Not surprisingly, Nintendo wants to provide its fans with a more immersive experience with its characters and worlds. The first Nintendo amusement park, Super Nintendo World at Universal Studios Japan, launched this year and more are planned around the world. Nintendo fans can use their personal Nintendo accounts to connect with the parks’ features for a personalized experience. A Super Mario movie, created in partnership with Illumination Entertainment (known for Minions, Despicable Me, etc.) is slated for a 2022 release. The founder and CEO of Illumination recently joined Nintendo’s board, suggesting that more Nintendo-themed movies are in the works. Other physical world projects include Nintendo flagship stores in major cities and Mario-themed LEGO sets.

None of these projects have a direct impact on Nintendo’s bottom line, but they encourage more engagement with Nintendo’s gaming IP. A key advantage for Nintendo is that it has four decades of game content with which its fans can engage after watching a Nintendo movie or going to a Nintendo amusement park. To illustrate how this can work, after the Netflix series Witcher, which is based on a game developed by CD Projekt Red, became a hit show, demand skyrocketed for legacy Witcher games.

Skeptics argue that Nintendo’s latest hardware iteration, the Nintendo Switch, will follow the course of previous console cycles and start gathering dust in drawers until the next hardware generation is created. We disagree. For the first time in over 30 years, Nintendo is only producing one piece of hardware. Previously, it manufactured two pieces of hardware at the same time – one that’s handheld and another that hooks up to your television. Switch is the best of both worlds and allows Nintendo to focus all its resources – manufacturing, marketing, development, etc. – into one platform. Importantly, Switch has an operating system that can migrate to future hardware iterations, much like the Apple iOS stays with iPhone users as they upgrade every few years.

Another argument in favor of Switch’s durability is that Nintendo is embracing third-party game development, which is a[…]

During our second quarter portfolio update, we profiled portfolio holding Illumina (ILMN). Below is a replay of our live commentary on the company from our quarterly portfolio update webinar and an excerpt from our QUARTERLY LETTER.

Illumina

We all know that DNA is the code of life, found within the nucleus of every cell of our bodies and all life forms on Earth. Complementing DNA is a sister molecule called RNA, which is used by cells to transmit the instructions of the DNA from the security of the nucleus outside to the rest of the cell, where ribosomes read the triplets of base pairs called condons to assemble the appropriate amino acids into proteins. Proteins are the building blocks of cells and the action and signaling mechanisms of life, from components of individual cells all the way up to coordinating the functioning of entire complex organisms such as animals and plants comprised of billions or trillions of cooperating cells. In addition, as we’ve become all too familiar over the past year, DNA and RNA are also key encoding mechanisms for pathogens such as bacteria and viruses.

(For a full list of holdings and additional disclosure information related to these videos, please click HERE.)

The key to understanding life is to understand the entire chain of mechanisms that comprise it, from the basic code in its DNA and RNA through the proteins they lead to building, to the coordinating systemic actions that they enable to create actions in the organisms they govern (commonly referred to as “omics”, i.e., genomics, transcriptomics, proteomics, etc.). This understanding also helps us to understand diseases that occur when those essential mechanisms fail or change and eventually how they might be fixed.

Furthermore, by understanding biological methods of action, we can do what humans always do with increasing scientific knowledge — use it to engineer new solutions to improve our personal and societal lives, a form of engineering commonly referred to as synthetic biology, in which we co-opt biological mechanisms at the cellular level to create these solutions.

Underpinning the majority of this crucial science and medicine is one company – Illumina.

Illumina’s gene sequencing instruments and associated consumable reagents and specialized flow cells are used in 80-90% of all sequencing applications (according to a study by the UK’s competition regulator, the Competition and Markets Authority). Its platform is at the heart of the trillions in value that companies across research, diagnostics, DNA/RNA based treatments, and the revolution across multiple industries that synthetic biology will be shaping over the next few decades.

The combination of Illumina’s “Next Generation Sequencing” or NGS platform, big data analytics/machine learning in computing, and crucial advancements in biology are driving a revolution in both the understanding of the code of life and in the creation of new techniques to manipulate that code in the diagnosis and treatment of disease. Just as important, is the creation of new manufacturing techniques leveraging Nature’s billion-years of design refinements embodied in the innumerable biological factories that exist everywhere on earth – the plethora of living cells.

What this will enable over the next few decades will look like science fiction and it will be widespread in its impact. The most familiar example of this innovation, unfortunately, are the RNA vaccines manufactured by Moderna and the BioNTech-Pfizer, but even more spectacular bioengineering to come will border on the miraculous – like cures for inherited diseases such as sickle cell anemia, hemophilia, and thalassemia, muscular dystrophy, certain forms of progressive blindness, screening for and curing many forms of cancer, saving babies from developmental issues, replacing old organs with new ones grown in a lab from your own cells, and maybe even slowing or reversing aging. All of these are mechanisms whose root causes lie in our DNA. Being able to read (sequence) DNA accurately, quickly, and cheaply, understand what it means (what proteins they encode), and how expression of the DNA is regulated will meaningfully impact all our lives over the next few decades.

Take for example the RNA vaccines developed by the NIH in conjunction with Moderna and BioNTech/Pfizer: the original SARS2 Coronavirus at the start of the pandemic in Wuhan had its RNA (some viruses use RNA as their (in)secure code, not DNA) sequenced using by Illumina instruments. That RNA sequence was then shared electronically with scientists around the world including the National Institutes of Health (NIH) in the US, where scientists deciphered the viral RNA sequence to identify the pieces that coded for the spike protein used by coronaviruses to enter their victim’s cells. Then Moderna and BioNTech went to work on manufacturing a stabilized mRNA vaccine at scale and getting it into the clinical trial process.

Though this is the most relatable example of a gene therapy application and an important life changing one for most people, it is only the beginning. And it is a crucial demonstration of the power that genomic sequencing has unlocked in the quest to improve our health and lifespans as well as its similarity to the computing world where code run on hardware drives so much of our daily lives. In this case, the code is the DNA/RNA sequence while the hardware is living cells executing that code, just as all of our cells do every second of our lives.

Illumina’s role in innovating, putting the pieces together across biology, chemistry, physics, and computation, and successfully commercializing sequencing instruments has been crucial in bringing down cost of DNA sequencing in the context of “Next Generation Sequencing” (NGS), which have reduced the price of sequencing a whole human genome by 99.99% from $10MM in 2005 to less than $1000 today and time to less than a day. For an even more dramatic perspective of just how far and how fast we’ve come, the first human genome was completed in 2003 at a cost of $3B and over a decade of work.

The[…]

Over a long enough timeline, every quality company faces a reckoning.

According to Bloomberg data, only two of our current holdings – Costco and Fastenal – have not suffered a 30% or more sell-off (or “drawdown” in industry parlance) at some point in the previous decade. And even those two fell by more than 20% at some point. Netflix fell an astounding 80% in 2011 during its bumpy transition from DVD to streaming video.

While we didn’t own all these companies during their drawdowns, it’s a good reminder that the market can offer wonderful buying opportunities on high quality businesses. The catch is that sometimes a sell-off is justified and it’s not obvious in the moment what the right move should be.

Here’s how we think through the issue.

Quality companies tend to carry premium valuation multiples. The market is right to have lofty expectations for companies with attractive growth prospects and high returns on invested capital.

The moment those expectations are challenged, however, investors typically sell first and ask questions later. This action is not always irrational.

Research done by Credit Suisse HOLT looked at the performance of different investment styles across the largest 1,800 global companies between 1990 and 2014. The “best in class” group – those companies scoring in the top 40% of the sample in HOLT’s quality, momentum, and valuation metrics – was the best performing cohort.

Sounds good for quality, right? However, the second-worst performing group of the nine studied were “quality traps” – companies scoring in the top 40% in quality, but in the bottom 40% in the momentum and valuation metrics. Quality traps stay expensive as their fundamentals deteriorate. This cohort’s performance only just eclipsed the “worst in class” group, which ranked in the bottom 40% in all categories.

Put another way, the quality factor has a wide dispersions of outcomes. If you pay for a ruby but get a rhinestone, you’re not going to have a good outcome. And in the market, you don’t know for years if the ruby you paid for is actually a ruby or a rhinestone. Therefore, at the faintest hint of rhinestone, the market reacts sharply against ruby-priced businesses.

No one wants to own a quality trap, but these drawdowns in quality companies also present opportunities for investors who have conviction in the strength of the underlying business.

How might we do that? Let’s start with what the market is telling us when a company’s stock has a big drawdown. It’s saying the company’s future cash flows will be lower than what the market price suggests or the risks associated with those cash flows are underappreciated.

Here’s how our investment philosophy – anchored in moat, management, and forecastability – is designed to respond to such challenges.

First, a moat allows a company to sustainably generate ROIC above its cost of capital and produce more distributable cash flow for a given level of growth. Having a deep understanding of the company’s moat sources helps us evaluate the impact of the event on the underlying business. If we conclude the moat is intact despite new information dragging the stock lower, we’ll be more likely to hold – or even buy more.

Moats also give management teams time to respond to new challenges. But what management does with that time is critical, and especially so in a pinch. If they are poor capital allocators, have too much debt, or oversee a bland or even destructive corporate culture, a crisis will only exacerbate those issues and the moat will erode. As such, we aim to avoid low-caliber management teams.

Finally, the better we understand the company’s unit economics – how the company turns revenue to profit for each unit sold – and its key metrics for success, the more likely we are to recognize material versus transitory impacts.

To illustrate, shares of Masimo declined almost 30% from January to early June this year. Having built conviction in Masimo’s moat and management and understanding its business strategy, we confidently increased our position during that time. It’s still too early, of course, to determine if that was a wise move or not, but the drawdown never caused panic on the team.

On the other hand, we exited our position in Prestige Brands (now Prestige Consumer Healthcare) in May 2018 after a protracted sell-off in the stock, which we’d used to slowly build a position in Prestige. Even though the stock appeared “cheap” on a price/earnings basis when we sold, our conviction in the company’s moat withered as it became clear that bargaining power lay with the products’ distributors rather than at Prestige. Since we exited, Prestige shares have underperformed the S&P 500 on a total return basis (as of July 19, 2021).

Once we lose conviction in a company’s moat, management, or forecastability, we exit the position. Others might successfully invest in “turnaround” businesses, but it’s not the game we play.

All quality companies have large drawdowns at some point, so we as long-term investors should be ready for such occurrences. The less we allow price swings to determine the narrative and instead focus on core business performance, the better our long-term investment performance should be.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

For the second time in recent years, Ensemble Capital has been named to Financial Advisor Magazine’s list of Top 50 Fastest Growing Registered Investment Advisors. Our 38% growth in assets under management in 2020 placed us at 45th on the list.

Click here to read the article and find the associated ranking lists.

Financial Advisor Magazine
To be eligible for the Financial Advisor Magazine RIA rankings, firms must be independent registered investment advisors and file their own ADV statement with the SEC. They need to provide financial planning and related services to individual clients and complete a survey. In 2021 Ensemble Capital was ranked by AUM at #264 and was ranked by AUM growth at #45. Ensemble Capital did not pay a fee for inclusion in these listings. These listings do not evaluate client experience and are not indicative of the firm’s future performance.