We recently hosted our quarterly client conference call. You can read a full transcript HERE.

Below is an excerpt from the call discussing our investment in Alphabet, Inc (GOOGL)

Excerpt (Sean Stannard-Stockton speaking):

For the balance of this call I’m going to talk about our investment in Alphabet, the holding company that controls Google. While the company has moved into a lot of areas outside of just search advertisements, 20 years after its founding the core of the Google profit machine is still its ad business. As Larry Ellison first put it all the way back in 2006, Google is “a one-trick pony, but it’s a hell of a trick.”. What’s amazing is how steady the growth of Google’s ad business has been even in the face of massive changes to the internet, most importantly the shift to mobile computing. We believe the key metric for investors to track Google’s ad business is to look at the rate of growth of currency neutral ad revenue net of traffic acquisition costs. This is basically the amount of money Google collects from all of their ad products after subtracting the amount they pay to acquire traffic on their sites. For instance, when you search for something on your iPhone the results you get are Google results. This is because Google pays Apple to make them the default search engine on Apple’s iPhones. Amazingly, since 2016, the company has reported average growth in this key metric of 20% with every quarterly report showing growth of between 17% and 23%. In fact, over half of all quarterly reports have seen this metric increase by within 1% above or below the 20% average.

High growth companies aren’t supposed to exhibit this sort of stability. But think about what drives growth for Google. The most important demand driver is the time people spend online. While many tech companies offer discretionary products that see variable demand and can see abrupt declines when the economy weakens, we would posit that time spent online is more of a consumer staple type behavior. In good times and bad, people around the world are turning to Google products to answer their questions. The persistent nature of this high level of growth is remarkable and has been instrumental in driving up the intrinsic value of Alphabet.

That growth is partly being driven by YouTube. With over 5 billion YouTube videos viewed every day and growing, the ad opportunity is huge. Depending on your own use of YouTube, you may not fully appreciate the power of this platform. While famous for viral cat videos and the like, YouTube is effectively the default global video platform for non-TV type content. With more and more time spent online consuming video, YouTube is in the pole position to benefit. While paid subscription products like Netflix may be a better business model for curated quality content such as TV and movies, the ad-supported YouTube format is far superior for short form, non-narrative content.

Interestingly Google does not break out the standalone financials of YouTube, leaving the investment community to guess at how profitable it currently is. Many investors believe that YouTube is currently less profitable than Google overall and yet as they grow, they will become more profitable, leading to longer, faster profit growth than might be apparent at first glance. While we are somewhat ambivalent about the validity of this thesis, primarily because we think YouTube fueled profit growth is needed to offset other parts of Google’s business slowing and so is not strictly additive to corporate growth, we do think that the breaking out of YouTube’s financials is going to occur before too long and it may have a dramatic positive impact to investors understanding of Google’s long-term prospects.

YouTube isn’t the only part of Alphabet that may have more value than generally appreciated. When they formed Alphabet, they created two subsegments, Google and what they refer to as Other Bets. The Other Bets group contains what Google historically called Moonshots, such as Waymo, their self-driving car business, Fiber and Loon, their internet access businesses and Verily, their health sciences business. Today, the Other Bets segment is losing approximately $4 billion a year. But when I say “losing” I mean they are burning this amount of cash as they seek to build profitable businesses. Today, the existence of Other Bets inside of Alphabet reduces the company’s reported earnings by about 10%.

So, Alphabet could boost current earnings by 10% by simply shutting down Other Bets. Of course, that would be a mistake. Any reasonable investor knows that Waymo in particular, but the other parts of Other Bets as well, have significant value. So, in thinking about the value of Alphabet, you need to remove the currently money losing Other Bets segment, value Google as a standalone business without the Other Bets losses and then add to that whatever you think the value of Other Bets is.

Of course, the value of Other Bets is highly uncertain. We’ve seen some investors talk about the value of Alphabet in relation to a PE multiple it should trade at. But given the negative earnings of Other Bets, this methodology implicitly values Other Bets as a liability. Believe me, there is a wide range of venture capitalists who would happily take ownership of Other Bets and so it is clearly not a liability. We’re also seen some analysts attribute as much as a $100 billion of value to Waymo alone. While Waymo is very valuable, in our view, on a probabilistic basis, $100 billion is way too high of an estimate. It could be worth that much, but it could be worth much less. In fact, Waymo could even end up failing without ever earning a dollar of profit.

We estimate that after removing Other Bets’ losses and removing the excess cash that Google has on its balance sheet (not all of its cash, just that amount we believe is not required to run the company), Alphabet is trading at around 20x what we expect them to earn in 2019. Given the company’s growth rate and its strong returns on invested capital, we think the stock will perform well from these levels.

That being said, we do have two concerns about the company’s management. In general, we evaluate corporate management primarily on their ability to create value and their abilities in allocating excess cash flow. On the first question, Google excels. It is amazing that they have become one of the most valuable companies the world has ever seen just 20 years after they were founded. As I mentioned earlier, their services have become a required part of modern life, almost a form of oxygen for internet connected populations.

But in allocating their excess capital we have been less enthusiastic. While Google has been criticized in the past for the M&A they engage in, YouTube and DoubleClick are two hugely successful acquisitions with YouTube ranking as one of the smartest acquisitions in the internet age. But Google has now built such a war chest of cash that they clearly have more than they will ever need, and we think shareholders would be better served if the company began to pay a dividend, bought back stock and used more debt in their capital structure to finance more return of capital. We had hoped that Ruth Porat, the CFO they brought in from Morgan Stanley, would be instrumental in improving capital allocation. But after some initial positive signs, it seems that for whatever reason, Porat is no longer focused on making this happen.

The other management issue we’re tracking is the company’s relations with their employee base. For pretty much all of their history Google has been considered one of the very best places to work. They have pioneered much of what we think of as modern Silicon Valley corporate culture with an employee base that has been raving fans of the company. But last year, employee concerns around the company’s work with the military and issues of gender equality and sexual harassment became flashpoints between management and employees. Of particular note to us was the various reports on the company paying large severance packages to key senior employees who were forced out after accusations of sexual harassment.

In our view, Google management’s handling of these cases has not been good. We believe for the short-term health of their corporate culture and their long-term ability to attract the best and brightest employees, they must do better. By “do better” we mean behave in a way that satisfies their employee base and preserves the belief that Google is one of the best places to work for the smartest, most technically savvy people in the world. To the extent that the company is not able to manage employee relations constructively, our confidence in the long term success of the business would deteriorate and should we decide to exit our position, something we are not currently contemplating, it would be due to our assessment of the long-term health of the business, which is very much a function of the company maintaining a positive corporate culture.

You can read the full transcript HERE.

Clients, employees, and/or principals of Ensemble Capital own shares of Alphabet, Inc (GOOGL).

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 an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. 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.

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.

We recently hosted our quarterly client conference call. You can read a full transcript HERE.

Below is an excerpt from the call discussing our investment in Landstar Systems, Inc (LSTR)

Excerpt (Todd Wenning speaking):

A lot has happened at Landstar System since we last discussed it on our Summer 2016 conference call, so we thought an update was in order.

To review, Landstar System provides a marketplace of sorts that connects shippers, agents, and carriers to ensure that freight is moved across the country as efficiently as possible.

About 90 percent of the big rigs you see on the road are driven by independent owner-operators who treat their rigs like small businesses. Some of these truckers opt to join Landstar’s Business Capacity Owner, or BCO, network because it provides them with steady business to keep their trailers full. This reduces the inherent volatility and uncertainty associated with trucking. BCO truckers are contracted with Landstar and provide exclusive service to their network. About 43 percent of Landstar’s revenue and an even higher percentage of its gross profit comes from the BCO network.

In 2018, about half of Landstar’s revenue came from its traditional brokerage business in which its agents match shippers with non-exclusive carriers. While brokerage is a lower margin business than BCO, it still leverages Landstar’s network of agents and shippers and exposes more truckers to Landstar, who may eventually join the BCO network.

Now, Landstar’s business model hasn’t changed much in the past three years, but the North American trucking environment certainly has.

When we last spoke about Landstar three years ago, the company was facing a revenue decline, as plunging energy prices led to energy-related job cuts in North America. Some of the unemployed oil and gas workers jumped to the trucking industry to move freight. As a result, truck labor supply jumped at a time with the North American industrial economy rolled into recession. This was not a good mix for Landstar. Full-year 2016 revenue fell 4.6 percent compared to 2015.

Since then, it’s been almost a 180-degree turn for the North American trucking environment. The U.S. industrial economy, as measured by US Manufacturing PMI, rebounded after early 2016 lows, as did energy prices. Demand for domestic freight carriers jumped while carrier supply was constrained in a tight labor market.

After falling 7.2 percent in 2016, Landstar’s revenue per load grew almost 6 percent in 2017 followed by an astounding 16.7 percent in 2018. When you add in load growth, total revenue grew 15.1 percent and 26.6 percent in 2017 and 2018, respectively.

While freight prices seem to have peaked in 2018, we believe prices have reverted to trend after a few years of weak pricing in the middle of the decade. We’ve long believed, and continue to believe, that U.S. truck driver supply is structurally constrained. According to the Bureau of Labor Statistics, the average age of a U.S. truck driver is 55 years old. The core “trucking generation” aged 45 to 54 accounts for 29.3 percent of the labor force, while 25 to 34-year-olds are just 15.6 percent of truck drivers. We’ve seen trucking companies offering huge cash signing bonuses to licensed commercial drivers, without a noticeable jump in the driver pool. In short, there aren’t enough young drivers coming up to replace the older ones.

Here’s an incredible statistic from Landstar’s 2018 results: the average Landstar BCO driver earned a record $197,000 in gross revenue. Now, that’s before expenses like gas, maintenance, and tires, but still a great income. In fact, it was so good last year that some BCOs decided to take the last few weeks of December off – they’d already made more money than they needed for the year.

The agent node of the Landstar network also had a record-setting 2018, with 608 agents generating more than $1 million of revenue – up from 542 in 2017.

Given this success, we think Landstar’s network is strengthening. It’s attracting more truckers and agents – indeed, Landstar recently said both the BCO and agent pipelines are full, despite a tight labor market. This creates a virtuous cycle. When Landstar adds truckers and agents, more shippers make Landstar their first and only call to move their freight. In turn, more shippers attract more truckers and agents to Landstar. And so on.

An important point to make about Landstar is that it generates 70% incremental operating profit margins on net revenue and their market share is under 10%. We think they have plenty of room to drive profit growth in the decade to come.

Now, the two biggest questions we get about Landstar are recession risk and technology risk.

As for recession risk, Landstar is a capital-light business with a mostly variable cost structure. Remember, BCO-derived gross margins remain steady throughout the cycle. Landstar’s gross margins fall in periods of strong demand, as lower-margin brokerage operations account for a greater percentage of revenue. Without the BCO structure, Landstar would be far more sensitive to the ebb and flow of the industrial economy. So, while far from recession proof, Landstar is recession resistant.

Importantly, Landstar remained free cash flow positive during the financial crisis and subsequent soft patches in the U.S. industrial economy. Because it doesn’t own any trucks and operates as a marketplace, or platform, capital expenditure requirements are low – between 1 and 2 percent per year. This reliable cash flow has allowed Landstar management to make countercyclical investments and opportunistic buybacks, along with a growing dividend, across the business cycle.

One technological threat to Landstar’s business is Uber-like apps that directly link shippers and carriers, bypassing the brokerage agent. But one of the reasons that Uber and Airbnb have been so disruptive is that they unlocked previously dormant supplies of cars and properties, respectively. This is not the case for trucking. Additionally, Landstar isn’t sitting on its hands. They’re also developing better software to save carriers load processing time that could further reduce system costs.

The second technological threat is autonomous-driving trucks. While the technology is perhaps already there, we think regulations will require a human driver or engineer to be in the truck cab for some time to come. Airplanes, trains, and other heavy transportation vehicles, for example, use various amounts of “autopilot” but still have captains, conductors, and engineers at the ready. As we’ve seen with autonomous driving automobiles, there’s massive headline risk for any accident related to driverless vehicles, even if, on the whole they are safer than human-driven vehicles. Also, we expect that any initial shipments by autonomous trucks will carry commodity, low-cost items like boxes of diapers and food. Landstar carries a lot of special loads like automotive, machinery, and hazmat, where we think human drivers will remain the standard due to the costly freight and related liabilities.

So in all, we remain enthusiastic about Landstar’s business model and have high confidence in its management team’s ability to widen the moat and increase shareholder value.

You can read the full transcript HERE.

Clients, employees, and/or principals of Ensemble Capital own shares of Landstar Systems, Inc (LSTR).

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 an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. 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.

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.

Below is the Q1 2019 quarterly letter for the ENSEMBLE FUND (ENSBX)This quarter’s Company Focus is on Landstar Systems, Inc. (LSTR) and Alphabet, Inc (GOOGL). You can find historical Investor Communications HERE and information on how to invest HEREEnjoy!

The performance of the Ensemble Fund (“the Fund”) this quarter was strong, showing a sharp reversal in both absolute and relative performance compared to last quarter. The fund was up 17.39% vs the S&P 500 up 13.65%.

As of March 31, 2019

1Q19 1 Year 3 Year Since Inception*
Ensemble Fund 17.39% 10.07% 15.95% 12.21%
S&P 500 13.65% 9.50% 13.51% 11.43%

*Inception Date: November 2, 2015

Performance data represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance data quoted. Performance data current to the most recent month end are available on our website at WWW.ENSEMBLEFUND.COM.

Fund Fees: No loads; 1% gross expense ratio.

The strength in our equity strategy during the quarter was supported by positive returns from every stock in our portfolio with notable 30%+ moves from Netflix (6.4% weight in portfolio), Ferrari (8.4% weight in portfolio), TransDigm (4.9% weight in portfolio), and Tiffany (4.0% weight in portfolio) and 20%+ rallies in Mastercard (7.3% weight in portfolio), Paychex (5.0% weight in portfolio), Trupanion (2.3% weight in portfolio), Fastenal (2.8% weight in portfolio), and Verisk (3.2% weight in portfolio). On the weaker side we saw low single digit gains in Sensata Technologies (5.4% weight in portfolio), Charles Schwab (4.6% weight in portfolio), and Booking Holdings (7.3% weight in portfolio).

While over the medium to long term our investment returns are primarily driven by security selection and the individual corporate performance of the companies in our portfolio, the dominant driver of our strategy’s performance over the last two quarters has been shifts in market expectations around economic growth. We have been relatively overweight to more economically sensitive names for much of the past few years due to these types of stocks generally being relatively inexpensive in our view, while more economically defensive companies have seen their stocks trading at historically rich valuation. This led to our portfolio exhibiting more downside than the market as recession fears became pervasive in the fourth quarter and to strong outperformance this past quarter as market action was driven by the idea that recession fears had become overblown and decent economic data was reported.

The rally in Netflix was primarily driven by a general reversal of the downside that many higher volatility stocks saw during the fourth quarter. However, Netflix also reported another strong quarter of new subscriber additions and, very importantly, they announced a large price increase. Netflix strikes some people as an atypical investment for Ensemble. With its very high PE ratio on current earnings there is a general perception that it is more of a momentum play than a long-term cash generation machine of the type we seek. But we believe that Netflix is building a dominant global media company and, importantly, they are currently intentionally underpricing their service as part of a strategic plan to build a subscriber base well in excess of any competitor. While we have yet to see how it impacted first quarter subscriber growth, the almost 20% price increase on the heels of high single digit price increases in recent years demonstrates the strong pricing power both we and the company believes they have.

The rally in Ferrari was supported by the company’s earnings report in which management said that they had not seen any unexpected impacts to their order books as a result of the recent global market volatility. While it seems obvious that an entirely discretionary product like a Ferrari would see significant weakness in demand during recessions, historically Ferrari has been the most recession resistant automaker. Due to the long wait list to buy a Ferrari and the fact that the vast majority of Ferrari buyers can still afford a Ferrari even in the midst of a recession, the company does not see the sort of drop off in sales that most automakers experience during periods of economic weakness.

TransDigm’s rally was particularly satisfying for us. Back in early 2017, a well-known short seller accused the company of a wide range of bad behavior that focused on defrauding the Department of Defense via overcharging them for the company’s spare airplane parts. After extensive diligence on our part, we concluded that these accusations were wrong. After a near 25% decline in the wake of the short report, the stock has more than doubled in the past two years. During the last quarter, the Office of the Inspector General, that had begun auditing the company’s sales at the request of two politicians who were sent the short report, concluded their work. While the audit found that TransDigm earns very high profit margins on their sale of aftermarket parts to the Department of Defense, it did not find any wrongdoing and it supported our view that sales to the Department of Defense were done at similar pricing to what commercial airlines pay. As the sole source provider of low-cost parts that are required to be replaced on set schedules by the FAA, TransDigm earns very strong profit margins and returns on capital. But that does not mean they are overcharging their customers. While the Office of the Inspector General recommended that the military begin requesting much more stringent cost information even for low priced products, the Department of Defense has been moving in the opposite direction in recent years as they attempt to streamline purchasing of low-priced products so that they can efficiently ensure a fully operational air force.

The weak rebounds in Sensata, Schwab and Booking each had company specific drivers. With Sensata, the ongoing threat of tariffs on autos has been a persistent concern. These potential tariffs are not just related to the US-China trade war, but also to efforts by the Trump administration to deem imported autos as a national security concern and thus allow for tariffs to be imposed on foreign automakers, including those of key allies of the United States, in ways that would otherwise violate trade rules. But we would note that Sensata sells sensors to every global automaker of note meaning that so long as cars are being bought, it doesn’t really matter to Sensata which country they are being made in.

Schwab continues to gather client assets at an astounding rate. However, as we detailed on last quarter’s call, Schwab’s profit model has shifted towards their interest rate sensitive bank, so the recent declines in interest rates and flattening of the yield curve will limit the company’s near-term earnings power.

While investors have been negative on Booking for much of the past year, we would note that far from seeing their growth rate crumble, 2018 saw high teens revenue growth and EBITDA growth. Their guidance for Q1 was somewhat disappointing. However, when viewed on a currency neutral basis and accounting for Easter travel bookings falling into Q2 rather than Q1 this year, given the holiday falling in late April rather than late March, we think the company is continuing to see solid core demand trends. Although they are seeing some weakness in Europe, their largest market, it appears that much of that weakness is due to uncertainty related to Brexit, potential auto tariffs hurting the German economy, and protests in Paris. As those issues come to a resolution, we would expect demand in the EU to continue to be fine and would point out that Booking’s strong growth over the last decade has occurred within the context of a weak Europe economic environment.

Last quarter we wrote about the rising risk of a recession; where we discussed our outlook for equity markets and framed it by listing three primary outcomes:

  1. If no recession occurs: The stock market will likely generate very strong returns over the course of the next couple of years.
  2. If a mild recession occurs: With the stock market already selling off by the magnitude that would typically be associated with this outcome, there may be limited downside even if things play out this way. (To reiterate, this is what we said last quarter, prior to the recent large rally)
  3. If a severe recession occurs: In this event, there may be considerably more downside for US equity investors.

CLICK HERE TO READ THE FULL LETTER

 

DISCLOSURES

Investors should consider the investment objectives, risks, and charges and expenses of the Fund carefully before investing. The prospectus contains this and other information about the Fund. You may obtain a prospectus at www.EnsembleFund.com or by calling the transfer agent at 1-800-785-8165. The prospectus should be read carefully before investing.

An investment in the Fund is subject to investment risks, including the possible loss of the principal amount invested. There can be no assurance that the Fund will be successful in meeting its objectives. The Fund invests in common stocks which subjects investors to market risk. The Fund invests in small and mid-cap companies, which involve additional risks such as limited liquidity and greater volatility. The Fund invests in undervalued securities. Undervalued securities are, by definition, out of favor with investors, and there is no way to predict when, if ever, the securities may return to favor. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. More information about these risks and other risks can be found in the Fund’s prospectus. The Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment.

Distributed by Rafferty Capital Markets, LLC Garden City, NY 11530.

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 4 of a four part series. Part 1, Part 2, and Part 3)

In the previous parts to this series we looked at the risks associated with low growth businesses, provided a case study of this risk manifesting itself in our portfolio, and showed that this risk is more urgent for the universe of companies that generate high returns on invested capital (the very types of businesses we focus on). In this final post in the series, we are going to explore what a New Normal (lower growth) economic environment means for valuation.

In our previous posts in this series, we assumed 5% as the baseline rate of growth that the average company will produce. This is in fact the historical average level of growth for both corporate revenue and GDP. When we looked at the impact of a slowing growth rate for a particular company, we were assuming that the slower growth rate applied only to the company in question and market/economic growth rates remained similar to the historical average.

But the New Normal thesis posits that economy wide growth has permanently slowed to a 4% average rate vs the 5% historical rate. We believe that the slower growth rate since the financial crisis may be a cyclical reaction to the debt crisis and the drags to growth may be fading with the return to Old Normal 5% growth that was seen in 2018 for the first time in a decade being a trend that will persist. But we fully recognize that in fact the New Normal thesis might be right, we might be at the tail end of economic growth and last year was more of a cyclical overshoot of the New Normal 4% average.

So given the risk of low growth that we’ve illustrated in this series, what is the risk of the whole economy slowing to 4%? Interestingly, it is less of a risk than you might think and in theory may lead to the market trading at higher valuations than it has historically.

Here’s the chart we showed earlier showing the impact to valuation of slower growth. A decline in the long term growth of a company from 5% to 4% results in a 20% decline in the free cash flow multiple the company’s stock should trade at.

But this chart assumes “all else equal”. What happens if the whole economy and corporate revenue growth slows from 5% to 4%? One thing that likely happens is interest rates decline. In general, the 10-year treasury yield has been about equal to nominal GDP growth rates. While this relationship is far from perfect, academic theory suggests that risk free interest rates should decline if growth is slower and in practice we see low interest rates around the world in low growth countries.

So in a world where economy wide growth declines, you get a negative impact to valuation as shown in the chart, but you also get a positive offset from lower interest rates which boosts the value of any business that can use debt financing.

Our math suggests that the forward 15.5x average PE ratio the US stock market has traded at is exactly what valuation math suggests it should trade at if you assume the following:

  • 9% equity cost of capital (ie. the rate of return equity investors demand and the rate the market has actually returned).
  • 7% debt cost of capital, which is what you would expect over the long term if you assume 5% risk free rates and a 2% credit spread (the historical spread) based on the BBB+/A- average credit rating of the S&P 500.
  • 10% ROIC (the average historical rate)
  • 30% effective taxes (the average historical rate)
  • 5% growth

If you lower growth to 4%, the fair value PE for the market falls to 13.2. This 15% decline is less than the 20% decline in the chart above because in this instance we are talking about PE ratios rather than free cash flow yield. But the math is the same.

But if we assume this slow down is economy wide and so interest rates decline by 1% as well, then the fair value PE moves back up to 15.4. This looks like such a small change from the Old Normal PE level, it might be tempting to say slower growth doesn’t matter. But keep in mind that the benefits of debt financing vary between industries and companies. So a New Normal world would be one in which companies with high sustainable debt capacity would trade at higher than average multiples while debt free companies would trade at lower multiples. But the net effect on the market over all would be minimal.

But what about the equity cost of capital? Historically equity investors have demanded about 4% higher annual returns than debt investors in the same companies. In a low growth, low interest rate world, would equity investors still demand 9% annual returns or would be be OK with the same 4% “equity risk premium” over now lower bond yields and thus price stocks to generate 8% returns? If after lowering growth and interest costs, we also lower the equity cost of capital to 8%, the fair value PE shoots up to 19x.

Wait, how could low growth result in higher valuations? Most people are used to seeing high earnings multiples in the context of high growth companies. But a high multiple just means equity investment returns are going to be lower going forward than they would be under a lower multiple. And so to generate a lower rate of return on stocks (8% instead of 9%) you need a higher PE multiple.

In this chart, we summarize how changes to future growth and the cost of capital would impact the fair value of the market.

This isn’t just academic theory. Look at how Japan’s stock market over the last 20 years has seen 2% average growth in corporate revenue, low equity returns and low interest rates and traded at an average PE of 22x. So high earning multiples can be a result of high growth or high returns on invested capital, but it can also be a result of low cost of capital. The lower the return that debt and equity investors find acceptable, the more they will pay for a stock or bond.

 

Remember all the times you’ve heard people say that we live in a “low return world”? Well low returns come from high PE ratios, not low PE ratios (all else equal). So if you believe in a low growth, low return, New Normal world, than you should expect to see the stock market trade at higher than average PE ratios, not lower. This is true based on theory and it is what we see in practice.

So a low growth stock in an Old Normal growth world has material downside risk to valuation. But a low growth world, if that is indeed what the future will bring, is likely to result in similar or even higher than average valuation for the market overall.

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 of a four part series. Part 1, Part 2, Part 4.)

In Part 1 and Part 2 of this series, we explained how low growth stocks exhibit what we believe is an underappreciated risk profile and we provided a case study of an investment we made that worked out poorly due to this risk manifesting itself. In Part 3, we’re going to examine why low growth risk is a bigger risk to the highest quality companies which generate high returns on invested capital (the very companies we focus on owning at Ensemble Capital) while low growth risk is less pronounced for weak companies that don’t generate above average returns on capital.

As much as we talk about return on invested capital (ROIC), what also matters is the amount of capital a company can put to work at these high returns. Most simply, ROIC measures how many incremental dollars of earnings a company earns by reinvesting their earnings.

As a simple illustration, a company with an average 10% ROIC needs to invest 50% of their earnings to grow 5% (10%*50%=5%). A company with a 50% ROIC only needs to reinvest 10% of earnings to grow 5% (50%*10%=5%). In the former case, $0.50 of every dollar of earnings is not needed to fund growth, while in the latter case $0.90 is not needed to fund growth. This means that the higher ROIC company will generate 80% more free cash flow than the average ROIC company making the company 80% more valuable. This is why we focus on ROIC in our analysis. High ROIC businesses are significantly more valuable than average ROIC companies even when they produce the same level of growth.

This isn’t just an academic exercise. The higher ROIC=higher value theory is apparent in market prices. For instance, the payroll processing company Paychex has been awarded a high valuation by the market over time even while generating modest growth. But Paychex generates near 100% returns on invested capital. Using the math in the example above, we can see that the stock should trade at a PE multiple of about 90% above the average stock. 100%*5%=5%, so 95% of earnings are available to distribute to shareholders. 95%/50%=90% premium.

And guess what, over its long history, Paychex has traded at an average PE of 30.5x vs the S&P 500 of 16.2 or an 88% premium.

ROIC isn’t a secret formula. But its value is deeply under appreciated by most investors. That’s why so many Wall Street analysts have regularly under estimated the value of the business. In many Street reports on Paychex, the analyst acknowledges the quality of the business, but points to the modest growth rate to argue that since it is pretty similar to the growth rate of the overall market, Paychex should also have a market like PE ratio. But as we just showed, a company with the ROIC profile of Paychex should trade at a much higher PE ratio than the average company even if their growth rate is similar to the average company. And we’ve shown this is actually how the market prices stocks even if many investors underappreciated the value of ROIC.

However, ROIC is only valuable if there is growth available and so it is productive to reinvest your earnings. If we use the exact same example as above, but you assume 1% growth you get a company with an average 10% ROIC needs to invest 10% of their earnings to grow 1% (10%*10%=1%). A company with a 50% ROIC only needs to reinvest 2% of earnings to growth 1% (50%*2%=1%). In the former case, $0.90 of every dollar is not needed to fund growth, while in the latter case $0.98 is not needed to fund growth. This means that the higher ROIC company will generate 9% more free cash flow than the average ROIC company making the company 9% more valuable.

So even under conditions of low growth, high ROIC businesses are worth more than average ROIC businesses. But the premium value of high ROIC is related to the amount of growth that high ROIC can be applied against. You can do the same exercise using high growth rates and you’ll find that the premium for the high ROIC business increases. So long term sustainable growth rates have an outsized impact on high ROIC business. For better or for worse.

High ROIC businesses are very efficient deployers of capital in terms of the bang for the buck they get on new dollars they invest into their business. But being so efficient means that when their growth opportunity declines, they don’t get that much benefit to their free cash flow. Average ROIC businesses on the other hand are so capital inefficient that while lower growth is bad, it frees up a lot of additional cash flow when growth slows.

Most investors focus on the relatively near term financial results of a company. But most of the value of a company is based on its long term cash flows. This is why the long term sustainable growth rate has such a large influence on valuation. No business can grow faster than the economy over the long term because the math of compounding growth rates would lead to the company becoming bigger than the whole economy before too long. But businesses certainly can grow slower than the economy. So while fast growth firms have more risk if you’re focused on near term results, low growth companies exhibit more risk if you care about long term results and this risk is compounded if, like Ensemble, you intentionally target high return on capital companies that generate a lot of additional value from each incremental unit of potential growth.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Paychex (PAYX). These companies 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.