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.


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.

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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[…]

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 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.

In recent years, the field of what was once called socially responsible investing has evolved into ESG analysis, or the incorporation of environmental, social and governance analysis into the process of stock selection. While Ensemble Capital does not market our investment approach as an ESG strategy nor seek to conform to 3rd party ESG rating systems, we believe that evaluating the value a company generates (or extracts) from all of its stakeholders is a central part of profit seeking, long term investment strategies.

Ensemble isn’t the only equity investor focused on high quality companies that has long incorporated analysis of a company’s impact on stakeholders other than shareholders into their analysis. As Lawrence Cunningham, a professor, director of the Quality Shareholder Initiative, and an expert on Warren Buffett, recently put it, “Quality investors were ESG-friendly long before it was fashionable.” But today, many investors still cling to the misguided concept that caring about the value created for stakeholders other than shareholders is a distraction from maximizing long term shareholder interests.

Today, we’re pleased to publish an illustrated white paper that reviews why shareholder interests are best served by companies who are able to manage the challenging task of creating value for all of their stakeholders. Rather than a distraction from generating value for shareholders, the value created for all stakeholders is the source of the value that accrues to shareholders.

You can download the report by clicking here.

During our second quarter 2021 portfolio update, 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, and two of our holdings, Illumina (ILMN) and Nintendo (NTDOY).

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.